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Skecher's Shape-Ups Face a Flabby Future

Skechers USA (SKX) is looking for profits to rebound come the second half 2011, once the footwear maker clears distribution channels of lower-margin toning shoe inventories. Given new entrants are flooding the market with cheaper substitutes, that outlook could prove way too optimistic.

Skechers offers diverse lines of fashionable footwear, from sandals and dress casual to multi-purpose sneakers. Despite a plethora of image-driven advertising and marketing campaigns intended to build brand awareness, company growth remains hostage to the popularity and corresponding sales of its branded toning shoes, called "Shape-ups."

Shape-up toning shoes feature a unique "kinetic wedge and rocker bottom designed to imitate the sensation and benefits of walking on soft sand," according to the company's website, and when worn regularly for walking and exercising, the rounded-sole athletic footwear (allegedly) helps the body burn more calories, tone muscles, and improve posture -- or so say (paid) endorsements from celebrities ranging from television reality star Kim Kardashian to hockey great Wayne Gretzky.

Sales of the muscle-toning shoes in the United States were estimated at more than $1.0 billion last year, up from about $360 million in 2009, according to research firm SportsOneSource.

To management's credit, the company recognized the willingness of American consumers (mostly women) to purchase footwear products developed to (allegedly) firm-up lower body muscles -- and seized first-mover advantage in that niche. However, recent quarterly results suggest that the days of explosive sales and easy profits are over:

Although net sales for the fourth quarter of 2010 increased 17 percent year-on-year to $454.6 million, net earnings declined 89 percent to $3.2 million, or seven cents per share. Gross margin in the fourth quarter fell 820 basis points to 40.5 percent, as order cancellations and the introduction of lower-priced toning shoes from competitors forced the company to aggressively discount and increase spending on promotional activities, according to Skecher's 2010 annual regulatory filing.
The consensus share-net estimate had been 10 cents, according to FactSet.

You can see signs that toning/shaping footwear growth is decelerating in Skechers' year-ending 2010 inventories, too. Those increased year-over-year by $172.4 million, or 78 percent, mostly due to order cancellations (an estimated $110 million) from U.S. customers during the second half of last year.

There's a disconcerting dearth of transparency at Skechers when it comes to its footwear products, as management refuses to break down the actual percentage contributions of its toning shoes to aggregate sales.

Hiding behind the numbers
"Hiding behind the numbers is important to them," Marshal Cohen, chief industry analyst at market consultant The NPD Group, told me via email. "They don't want to expose their vulnerable position (dependence on toning segment) that this meteoric growth created."

Chief executive officer Robert Greenberg would rather industry watchers ignore concentrated portfolio risk and the hiccup in operating performance. Instead, the CEO bragged on his last earnings call about company milestones, such as being named "Company of the Year" for 2010 by Footwear Plus magazine.

CEO Greenberg would also have us believe longer-term financial performance of Skechers is insulated from the distinct possibility that toning/shaping shoes could be just the latest casualty in footwear fads -- think Heely's (HLYS) "wheels on heels" or the plastic-foam clogs made popular by Crocs (CROX):

"In 2010, we broadened our product range with increased kids offerings, fresh fitness styles, and a larger assortment of boots," said Greenberg.
For a company that brags about new product innovations, it's worth noting that Skechers spent just $12.6 million on product design and development in 2010, as compared to $154.6 million on "image-building" advertising and promotional campaigns, according to regulatory filings.

Millions for image-building, a pittance for development
Depending on which industry analyst you talk to, Skechers probably held a 50-60 percent share of the U.S. toning-segment market in 2010. Assuming a conservative value of $1 billion in U.S. aggregate toning-shoe sales last year, Shape-ups contributed roughly $500 million to $600 million, or 25 percent to 33 percent, of the $2.0 billion in Skechers' 2010 revenue.

Here's another sobering forecast: SportsOnesource analyst Matt Powell expects the toning shoe market growth to slow to 20 percent in 2011, according to Reuters, due to the excess supply of inventory in distribution channels from a flood of new entrants.

"Nothing endures but change," said the pre-Socratic Greek philosopher Heraclitus (circa 535 BC - 475 BC).
In my opinion, the business model that drove early retail successes for Skechers is now obsolete. As illustrated to me by NPD's Cohen:
When Skechers entered the market they only had MBT (by Swiss Masai) to compete with at much higher prices. Skechers gained the early momentum after copying the concept that MBT had in the market at $250 at a more affordable price -- $100.Then Reebok entered and since then another 11 brands and over 40 styles have come into play.
The popularity of toning shoes first showed signs of weakening last summer. Early on, Shape-ups were advertised aggressively as a "great way to exercise while you went about your busy day." However, research findings published by the American Council on Exercise (ACE) disputed company claims that wearers could get in shape by just stepping into Shape-ups or Reebok's EasyTone without setting foot in a gym.

Specifically, the independent study found no evidence that footwear with unstable, rounded sole designs could improve muscle strength and tone or aid in burning off more unwanted calories any better than conventional running sneakers.

"Toning" is fading
My own recent channel checks suggest the novelty of toning footwear is fading even faster than legendary golfer Sam Snead used to do by the 18th hole at every U.S. Open tournament. For example, retailer Olympia Sports is discounting Shape-ups more than 50 percent, with some models being offered below $50. Over at Wal-Mart (WMT) and Khols Department Stores (KSS), Avia-branded knock-off toning shoes are aggressively priced to move at $29.99 a pair (or cheaper).

"There is nothing so useless as doing efficiently that which should not be done at all," said the late great management guru Peter F. Drucker (1909 - 2005).
Chief operating officer David Weinberg indicated on the last conference call that Skechers would try to lower its inventory level over the next two quarters while "generating reasonable margins." Don't believe him: Other traditional distribution outlets, such as athletic retailers Footlocker (FL) and Finish Line (FINL), have admitted on recent conference calls that toning sales are slowing more than previously thought.

Furthermore, toning shoe sales declined 43 percent in March, after falling 23 percent and 16 percent the prior two months, according to UBS analyst Michael Binetti.

Raw material costs, from cotton to oil are soaring, as are labor costs in Skechers' Chinese manufacturing plants (where most of its footwear is made) due to the rising yuan. More expensive cost-of-goods means lower gross margin in an already weakened pricing environment for toning footwear.

Rebates are coming, profits are going
Looking ahead, Skechers will likely need to aggressively rebate lost profit to such retailers to ensure continued visible shelf space and movement of Shape-up shoe inventories -- further pressuring operating margins. I suspect, too, that much of this $399 million in bloated inventory will be written down in coming quarters, meaning another hit to earnings.

Skechers' management is looking abroad (non-U.S. markets currently account for about 22% of wholesale sales) -- specifically, Chile and Brazil in South America and China and Japan in the Far East -- to offset slowing domestic sales. However, as the Roman philosopher and statesman Seneca said almost two millennium ago: ""If one does not know to which port one is sailing, no wind is favorable."

When it comes to foreign markets, no amount of "trend influencing" creative ad campaigns will slow the flood of heightened competition coming from the big guns, like Adidas or Puma, not to mention the cheap knock-offs flooding the market. All this competition is likely to suck the wind out of any anticipated turnaround for Skecher's toning shoes, whose future looks flabby indeed.

Image via Flickr user _Fidelio_, CC 2.0
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