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Is China Skechers’ Achilles Heel?

Skechers’ share price could be heading south, according to a New York hedge fund.

Spruce Point Capital Management said Skechers‘ shares could plunge 30 to 50 percent as a result of the footwear firm’s China business and the threat of another “inventory episode.” Skechers did not respond to a request for comment.

Short interest in Skechers shares is roughly 3.8 percent, not yet high enough to suggest negative investor sentiment. Traders will sell a security short if they believe the share price will drop.

Spruce Point believes Skechers is maxed out in China, which is why it see the shoe company’s current share price of around $38.37 as of Wednesday afternoon potentially tumbling to $18.60 to $26 a share.

Skechers squeezed about 20 percent of last year’s revenue out of China, said Spruce Point, which believes second-quarter China revenues likely shrank 25 percent from a year ago. Covid-related restrictions and economic headwinds could drive similar revenue challenges for all of Asia-Pacific, it added.

Spruce Point cited data from Magic Mirror Market Intelligence and the China National Securities Research Institute estimating that year-over-year sales for the mid-June Chinese Dragon Boat Festival promotional period dropped 28 percent, making it the second-worst performer behind Under Armour’s 35 percent plunge. Puma was up 188 percent, with Nike rising 171 percent.

Spruce Point’s field research indicates that Skechers’ market position could be faltering because the “fast follower” and heavy discounter doesn’t invest in innovation the way Nike, Adidas and others do, which is key to courting the discerning Asian consumer.

“Longer term, we see local Chinese brands and a resurgent Nike gaining ground in China, while those familiar with Skechers that we spoke with expressed an array of frustrations about the product offering, distribution strategy, and operations,” Spruce Point said in a research note.

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The investment manager is also concerned that Skechers could find itself stuck with another “inventory aging” problem if stock piles up like it did in the third quarter of 2015 and second quarter of 2018, with the former due to slower domestic wholesale sales and the latter because of too much product in its international wholesale channel, particularly in China.

“To make matters worse, Skechers’ year end 2021 purchase commitments with foreign manufacturers rose a massive 82 percent to $2 billion, representing relative levels 40 percent to 50 percent above pre-COVID averages,” Spruce Point said.

The hedge fund also accused founder-led Skechers of nepotism, self-enrichment and related-party transactions in a corporate governance attack that suggests an activist takeover isn’t out of the realm of possibility.

Many brands have faced slowing sales in China. The country relaxed Covid restrictions in June following a two-month lockdown in certain cities including Shanghai, but a new virus surge could bring restrictions back and bring a fresh wave of sales challenges.

On Friday, China’s National Bureau of Statistics said second quarter gross domestic product (GDP) growth slowed to 0.4 percent, in part due to Covid lockdowns. On a quarter-to-quarter basis, China’s economy contracted 2.6 percent. Goldman Sachs to cut its full-year GDP forecast to 3.3 percent, well below China’s 5.5 percent GDP target.

Skechers last month refuted a report that a shipment of its products made in China was seized by U.S. Customs and Border Protection on the suspicion of forced labor under the Uyghur Forced Labor Prevention Act.

In April, the company reported first quarter net earnings of $121.2 million on net sales that rose 26.8 percent to $1.82 billion. Chief financial officer John Vandemore said during the company’s fourth-quarter earnings report that Skechers continues to be “very optimistic about the long-term prospects for the brand in China,” adding that it was looking forward to making investments in its second distribution center.

At the time, Skechers guided second quarter sales to $1.75 billion and $1.80 billion, and forecasted fiscal year 2022 sales at $7.2 billion to $7.4 billion.

Skechers plans to report second-quarter earnings on July 26.