Skechers Downgraded to Neutral

We have downgraded our long-term recommendation on California-based footwear manufacturer and retailer Skechers U.S.A., Inc. (SKX - Analyst Report) to ‘Neutral’ from ‘Outperform’, based on its continuously declining total net sales in fiscal 2012. As a result, we prefer to remain on the sidelines until we witness a top-line growth.

Skechers’ total net sales tumbled 26.2% and 11.6% in the first and second quarters of 2012, respectively, reflecting lower sales across all divisions except domestic retail in the first quarter, whereas the sales dropped in the second quarter due to lower sales across domestic and international wholesale channel.

Moreover, Skechers, which competes with Nike Inc. (NKE - Analyst Report) and Deckers Outdoor Corporation (DECK - Analyst Report), does not have a long-term contract with any independent contract manufacturers. Therefore, the fall in production, poor quality, failure to meet production deadlines or increased manufacturing costs could result in cancellation of orders or demand for reduction in prices, which in turn, could adversely affect Skechers’ revenue and earnings.

On the flip side, Skechers is now showing some signs of stability as evident from its better-than-expected second-quarter 2012 results. The company delivered a quarterly loss of 4 cents per share that fared far better than the Zacks Consensus Estimate of a loss of 12 cents, and showed a substantial improvement from a loss of 31 cents incurred in the prior-year quarter. Skechers anticipates returning to profitability in the second half of fiscal 2012, sustaining the momentum in 2013 and thereafter.

Further, management remains committed to focus on new lines of products, opening of additional stores and increasing distribution channels with the development of international distribution agreements, to improve its sales and profitability. Therefore, Skechers, through its subsidiaries and joint ventures, is poised to enhance its global reach in the footwear market.

Another major element, which could prove accretive to the company’s growth and profitability, is its intention of lowering operating expenses relative to total revenue in the rest of 2012. Further, Skechers expects to double its company-owned subsidiary business in Japan in the next 3 to 5 years.

Considering these factors, we think that the current valuation is fair and adequately reflects Skechers’ future growth prospects. Our new long-term Neutral recommendation is supported by a Zacks #3 Rank (short-term Hold rating).