Streetwise

Lauren Rudd

Sunday, January 29, 2012

Look for the Undervalued

Given the recent meetings in Davos, Switzerland and the frenzy over Wall Street compensation and bonuses, not to mention the Administration’s recent call for an end to securities fraud, I can count on receiving letters espousing contempt for Wall Street and its malfeasance.

While Wall Street must be held accountable for its actions, the fires of greed are often lit by a lax regulatory environment and nurtured by a flow of Street enriching compensation. And the preamble is always the same, the promotion of minimal risk and exalted returns. At the same time investor naivety often leads to an unrestrained contagion of euphoria resulting in carnage of the gullible and a decimation of investment expectations.

However, I hold to a more upbeat opinion regarding the Street with the premise that quality companies will see enhanced shareholder valuations under a codicil of rising dividends and increased retained earnings. A corollary to that unwavering belief is that there will always be undiscovered or unappreciated investment opportunities.

A good example is Deckers Outdoor Corporation, the manufacturer of Ugg boots and a company whose depressed share price is not, in my opinion, merited by the company’s underlying valuation. Nonetheless, the company has come under pressure due to the Street’s dissatisfaction with the company’s potential 2012 performance. Some on the Street are saying that retailers are seeing less demand for the "boots with the fur."

More specifically, a possible shift in consumer tastes could lead to order cancellations in the first quarter due to adequate inventory levels and a more conservative buying pattern by retailers. That pattern is projected by some to extend to orders for the all-important winter buying season.

I am not nearly as pessimistic. Currently the company’s earnings expansion has kept pace to the point where the shares trade at a reasonable 15 times its consensus 2012 earnings projection of $5.90 per share. Given the consensus 17 percent earnings growth rate, the 15 multiple is in-line with that growth expectation.

So the question comes down to the fickle nature of high-end apparel shoppers. If the UGG brand is becoming too ubiquitous, Deckers could potentially have to choose between reducing margins to move product or accept a reduction in their primary revenue stream.

This standard pricing decision is difficult enough for firms that face the traditional supply versus demand curve featured in most economic textbooks. However, in the world of high end fashion, there is an additional level of complexity.

Luxury or premium buyers actually prefer to pay a higher price for specialty retail items. Whether it is because of the perceived value associated with a higher price, or because wearing a premium brand cements their affluent image, the traditional supply versus demand curve can be inverted as higher prices drive more demand from high-end consumers.

Meanwhile, the company’s third quarter results were excellent. Net sales increased 49.1 percent to $414.4 million, while the company’s gross margin increased by 1.9 percentage points to 49.0 percent as compared to 47.1 percent a year ago. Earnings per share rose by 48.6 percent to $1.59, as compared to $1.07 for the same period last year with same store sales increasing by 15.4 percent.

As a result, the company raised its 2011 guidance with revenues now projected to increase approximately 33 percent over 2010 levels, while earnings per share will come in approximately 22 percent higher at $4.91 per share. This guidance is based on a gross profit margin of approximately 50 percent and expenses as a percentage of sales of approximately 29 percent.

The intrinsic value of the shares using a discounted earnings model is $172 per share, while the more conservative free cash flow to the firm model yields an intrinsic value of $151 per share. The shares recently closed at $81.41.