Monday, May 30, 2011

Overwhelmed by Scope Creep

I'm not going to impress anyone with my financial ratio analysis.  Or my valuations skills, either. I think my strong point is studying existing assumptions and exploring, through a trader's vantage point, what can be applied or exploited. So when I started to analyze the turnover ratio on SKX, I felt that I had just enough skill to verify the validity of the company's statements, but not enough to know if these factors were out of line with theoretical or practical experience. I borrowed heavily from the Nasdaq Guru site.

Things I know, Things I don't know and Things I don't know I don't know
Also, I think the next steps are:
  • would be to do the same to Reebok, a "toner shoe" competitor
  • analyze the larger customers of SKX,  such as Brown Shoe (Famous Footwear), etc.
  • get retail sales data, if possible, or extrapolate
  • analyze trends vs fads, life cycles, etc.
  • analyze customer satisfaction
  • quantitative analysis
  • study other lines of shoes in SKX, including the expanding International sector
  • find things I don't know I don't know

But then, as it is said in the computer industry, there would be "scope creep". I only need to find one trading edge to exploit a widely held misconception. So let's just start with the turnover.

The company management traditionally can only see clearly for the next 2 quarters. The high peak seasonality of Spring and early Summer is coming to an end. Let's see if the inventory improves for the next reporting period in July. After that we have the Back-To-School & Xmas season.

Management comments are from Mar 1, 2011 10K and May 9th, 2011 10Q data
First Step 
  From Management :
    Our earnings and margins in the first quarter of 2011 were negatively impacted by several factors, including the sell-through of excess toning inventory that resulted from the domestic market being saturated with competitors’ lower priced toning product. Sales of lower margin product through our domestic wholesale channel and lower retail margins due to increased promotional activity caused by excess toning inventory levels contributed to lower earnings and margins in the first quarter.
    We expect that the excess toning inventory will impact our net sales, margins, results of operations, and earnings per share during the remainder of 2011. However, we believe that new styles and lines of footwear that we will be launching later this year will have an offsetting positive impact on our results of operations in the second half of 2011.

Using danger warnings in green paragraphs below:

1. Advanced sales – An increase in sales in a given reporting period usually results in increased inventory turnover, but that increase in sales (and turnover) may be due to a temporary factor. If it were, then you would be wrong to conclude that the increase in inventory turnover means you are operating more leanly. For example, a sales jump in one period may reflect advanced purchase of items that are usually bought in the next reporting period.
Failsafe: Check several reporting periods to be sure that the increase in turnover resulting from increased sales is not due to advance sales or some other temporary factor. If the increased sales and improved turnover rate hold over several reporting periods, then it is probably not due to advance sales.

Nasdaq Guru site based on book by Motley Fool
    This methodology strongly believes that companies, especially small ones, should have tight control over inventory. It's a warning sign if a company's inventory relative to sales increases significantly when compared to the previous year. Up to a 30% increase is allowed, but no more. Inventory to Sales for SKX was 15.60% last year, while for this year it is 19.86%. Although the inventory to sales is rising, it is below the max 30% that is allowed. The investor can still consider the stock if all other criteria appear very attractive. 

2. Phantom sales – Sales made to a customer with the understanding that they will be returned for credit before payment is due.
Failsafe: To avoid this danger, you need to take two steps. First, check several reporting periods to be sure that the increase in turnover is not due to phantom sales. Also look for improvements in turnover in one period that are offset by a decrease in turnover in a subsequent reporting period as goods sold in the prior period are returned and re-entered into inventory. In addition to abnormal inventory turnover fluctuations, these phantom sales will typically result in an increase in accounts receivable as a percentage of sales. Thus, the improved inventory turnover will be offset by a decrease in accounts receivable turnover or the ratio of accounts receivable to sales.

Nasdaq Guru site based on book by Motley Fool

    This methodology wants to make sure that a company's accounts receivable do not get significantly out of line with sales. It's a warning sign if a company's accounts receivable relative to sales increases significantly when compared to the previous year. Up to a 30% increase is allowed, but no more. Accounts Receivable to Sales for SKX was 16.16% last year, while for this year it is 13.74%. Since the AR to sales is decreasing by -2.42% the stock passes this criterion. 
The management did mention that there were some customers returns that were affecting the financial statements.

3. Discount-driven sales - Offering large discounts may also generate a boost in sales. Such discounts erode the company’s profit margins, but will boost revenue and rate of inventory turnover. The company might look like it is becoming more Lean, when in fact it may simply be pushing products into the marketplace using artificially low pricing.
Failsafe: Watch the gross margins reported by the business. Gross margin is the difference between the dollar value of sales and cost of goods sold (also termed cost of sales). If inventory turnover is increasing, but gross margins as a percentage of sales are decreasing, then this may indicate a problem.

From management:
    We anticipate our domestic revenues and margins will be lower in 2011 compared to the same period in the prior year as a result of reduced demand in the toning market. We will continue to aggressively work through our older toning inventory until customers’ demand is in-line with supply, which we anticipate will be during the second half of 2011.
    Our factory outlet stores provide opportunities for us to sell discontinued and excess merchandise, thereby reducing the need to sell such merchandise to discounters at excessively low prices and potentially compromise the Skechers brand image.

One thing I did notice was that their website pricing on their women's toner shoes are not being discounted. However, other online sites channels are.

4. Supplier-financed inventory – It is possible to reduce materials and supplies inventory and show improved inventory turnover by forcing your supplier to carry the inventory for you. The supplier assumes the cost of maintaining inventory and passes that cost on. Or, you may reduce inventory by use of express shipment or other costly means of delivery to ensure the availability of materials and supplies when you need them. Improved materials and supplies inventory turnover, in these cases, would not mean that you were operating more leanly.
Failsafe: To detect this shift of cost to suppliers, monitor changes in the unit cost of products that result from the increased cost of materials and supplies. Solutions to maintaining inventory that simply shift cost to suppliers return the cost in added mark-ups to the materials and supplies you purchase. This results in a rise in your product's unit cost.

From management:
    Our cost of sales includes the cost of footwear purchased from our manufacturers, royalties, duties, quota costs, inbound freight (including ocean, air and freight from the dock to our distribution centers), broker fees and storage costs. Because we include expenses related to our distribution network in general and administrative expenses while some of our competitors may include expenses of this type in cost of sales, our gross margins may not be comparable, and we may report higher gross margins than some of our competitors in part for this reason. 
5. Customer financed inventory solutions – Depending on your marketplace, it is possible to maintain low finished product inventory at the expense of your customer. In many marketplaces, competition is still not keen. You can survive— even grow, based on not being worse than your competitors. You can, for example, maintain low finished product inventory by having your customer wait for products forcing your customer to maintain higher inventory so he or she can sustain operations while waiting for your deliveries. In essence, you produce to order, not to need. When you are done, the product ships.
Failsafe: Use information on customer satisfaction with the availability of products and timeliness of delivery to balance your judgment about whether improving inventory turnover reflect true lean operations. If it is leanness that has produced the improvement, then customer satisfaction with availability and timeliness will remain high.

From management:
    As of December 31, 2010, our backlog was $588.9 million, compared to $454.7 million as of December 31, 2009. Backlog orders are subject to cancellation by customers, as evidenced by order cancellations that we have experienced over the past few years due to the weakened U.S. economy and the toning market becoming saturated with lower priced products. 
6. Waste inflated COGS – The cost of goods sold can increase due to total sales or because of increased rework or scrap. In other words, the same number of sales occurs but the cost associated with producing the products sold increases due to waste (defects, scrap, spoilage). When finished products are discarded because defects are discovered, the cost associated with that waste is captured in COGS. Consequently, the numerator of the Inventory Turnover ratio increases. Since the defective products are not in inventory, this waste also decreases the average cost of inventory, the denominator of the Turnover ratio. As the numerator increases and the denominator decreases, the ratio goes higher. It looks like you are operating more Lean— yet, you are actually operating LESS Lean.
Failsafe: A remedy for this distortion is to extract from the COGS any expense due to manufacturing wastage. The formula would be as follow: (Cost of Goods Sold – Cost of scrapped and damaged items due to manufacturing) / average dollar value of inventory.

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