DECK

Business Context and Reporting Period

Company: Deckers Outdoor Corporation
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2007
Business Overview: Deckers designs, produces, and markets footwear under three primary brands: Teva (sport sandals), UGG (luxury sheepskin boots), and Simple (sustainable footwear). The company operates through wholesale and Consumer Direct segments. The business is highly seasonal, with Teva sales peaking in Q1/Q2 and UGG sales peaking in Q3/Q4.

Key Financial Metrics

(Amounts in thousands, except per share data)

Liquidity: The company maintains a $20,000 revolving credit facility with Comerica Bank. As of June 30, 2007, there were no outstanding borrowings, and $19,948 remained available. The company holds significant liquid assets in cash and short-term investments.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 26.4% for the quarter and 28.2% for the six months compared to the prior year periods. This was driven primarily by a 59.1% increase in UGG wholesale sales and a 5.4% increase in Teva wholesale sales.
• Profitability: While net income increased 46.5% year-over-year for the six-month period, operating income for the quarter decreased 26.8% due to lower gross margins (impacted by inventory write-downs and higher international sales mix) and increased SG&A expenses.
• Cash Flow: Net cash used in operating activities was $5,788 for the six months ended June 30, 2007, a reversal from the $11,839 provided in the prior year. This was primarily due to a significant increase in inventory levels ($35.8 million outflow) to prepare for the UGG fall/winter season and a decrease in income taxes payable.
• Inventory: Inventories increased 104.7% to $66,256 from $32,375 at year-end 2006, largely due to a $38 million buildup in UGG inventory.

Guidance, Outlook, and Risks

Management Commentary and Outlook

• Full Year 2007 Sales: Management expects full-year sales to be approximately 35% higher than 2006.
• Brand Growth: Teva is expected to grow ~10%; UGG ~45%; and Simple ~20% for the full year.
• Earnings: Diluted EPS is projected to be approximately 25% higher than 2006, excluding a $15.3 million non-recurring impairment loss recorded in Q4 2006 related to the Teva trademark.
• Margins: Gross margin is expected to be approximately 44.0% for the full year. SG&A is expected to range between 20% and 25% of net sales.

Risks and Contingencies

• Restatement and Internal Controls: The company restated financial statements for 2004-2006 due to underreported payroll expenses and underpaid taxes in China. Management concluded that disclosure controls and procedures were not effective as of June 30, 2007, citing a material weakness in internal controls over financial reporting regarding the China subsidiary. A remediation plan is underway.
• Contingent Liability: Management estimates a potential loss range of $4.4 million to $7.2 million related to the China tax and payroll matters. The lower end ($4.4 million) has been accrued.
• Seasonality: Results are heavily influenced by seasonality, with UGG driving revenue in the second half of the year.
• Intellectual Property: The company faces ongoing litigation regarding trademark infringement and counterfeit products globally.

Investor Verification Checklist

• Restatement Impact: Verify the full extent of the financial restatement and the status of the remediation plan for internal controls over the China subsidiary.
• Inventory Levels: Assess the risk of inventory obsolescence given the 104.7% increase in inventory, particularly for UGG, and the associated write-downs already recorded.
• China Tax Exposure: Monitor the resolution of the China tax and payroll dispute to determine if the accrued $4.4 million liability will increase.
• UGG Sustainability: Evaluate whether the 60%+ growth in UGG sales is sustainable or if it is subject to fashion cycle volatility.
• Cash Flow Conversion: Review the ability to convert the significant inventory buildup into cash flow in the upcoming quarters.