We wrote an article shortly after Birkenstock Holding plc (NYSE:BIRK) went public where we shared our skepticism about the company’s valuation. There is no doubt that they own a valuable brand for which many consumers are willing to pay a premium, but that was already reflected in the share price and then some. While shares are trading at a slightly higher price today, they have significantly underperformed the S&P 500 Index (SPY) on a total return basis. The company also just disappointed investors by missing both revenue and profit expectations in its third quarter and providing weak forward guidance.

If this were not bad enough, insiders have been aggressive sellers of the shares. Back in June, it was announced that the controlling shareholder, private equity firm L Catterton, and some employees, including members of management, were selling millions of shares. Now, we cannot fault them for selling if the market is willing to pay such a lofty valuation for the company. Still, it is clear that insiders find the current valuation elevated enough to at least reduce their stakes in the company.

Third Quarter Financial Results

While the most recent quarterly financial results were not particularly bad, they were certainly not enough given the high expectations reflected in the current valuation. Revenue increased by 19%, thanks to a higher average selling price (ASP) and volume increases. The company did not share specifics on how much each component contributed, despite analysts asking for more details during the recent earnings call. It is a shame that the company is not more open and willing to share this information, as we believe volume growth is more sustainable than price increases.

Another concern we have is that their more strategic distribution channel, direct-to-consumer, was the one that experienced the lowest growth rate at only 14%. This is despite having significant room for improvement in their website’s positioning, given that according to Similarweb they rank #70 in the U.S. in the Fashion and Apparel category, well behind competitors like Crocs, Inc. (CROX).

We are also worried that despite increasing the average selling price (ASP), gross profit margins still went down. Birkenstock lost roughly 220 basis points in gross margin compared to the previous year’s quarter, which the company attributes to under-absorption of new production capacity and an increase in the percentage of product sold through wholesale B2B channels.

Risky Strategy

Even though it has worked very well for companies like Hermès International Société en commandite par actions (OTCPK:HESAY) with their Birkin bags, we think most companies take enormous risks by engineering an artificial scarcity of their products. This paves the way for competitors to satisfy the unmet demand and then grow from there. If the competing product turns out to be of relatively good quality they might remain loyal to the competing brand, and even recommend it to other consumers.

During the earnings call, David Kahan who is President of the Americas region said that he estimates they are only meeting around 70% of the existing demand. We are skeptical that they are leaving that much unmet demand, especially when they showed relatively weak DTC growth in the quarter. If they are really turning away that many customers it could backfire, as eventually a competitor will come up with a good enough alternative to satisfy these customers that were priced out or turned away by the company.

And I’ll say demand is not a finite measure. If I say 70%, maybe it’s 70%, but there’s no way we’re coming anywhere near the demand of what people are seeking with the product.

Product Variations

Surprisingly, while they are turning customers away, they are simultaneously creating different variations or SKUs to broaden the appeal of the product.

Some customers might be willing to pay a higher price for a more tailored product to their preferences, but that comes with added risks and higher costs. We were particularly surprised by the defensive attitude management took during the most recent earnings call when asked about the complexity this increase in SKUs creates. It appears CEO Oliver Reichert even got a little offended when asked the question by an analyst.

Jim Duffy, Stifel

Thank you. I wanted to talk about product and assortment. Really encouraging to see the uptake of closed-toe styles. As you look into next year, can you talk about SKU count and color proliferation? And I’m curious how you manage that complexity in your B2B channel.

Oliver Reichert, Birkenstock CEO

Thank you for the question, Jim. The truth is, we don’t see any complexity that’s really outstripping our intelligence. It’s more like it’s a very, very good sign that we’re getting wider and deeper in the doors, in the wholesale doors. So if you go to a big wholesale door, you may find us in the sport athletic environment, you may find us in the outdoor environment, you may find us in the high-fashion areas, female or male, kids, wherever, could be in the mall, could be in the like orthopedic environment. So we fit in every single niche. And, yes, we deliver a lot of new products in these new wide category segments, as we promised, prior to the IPO. And as we said in the presentation and in the previous remarks, the growth rates, the sell-throughs are very encouraging. And we will develop this step-by-step, as always, very mindful, globally relevant. And this is what we’re doing, this is what we’re executing. We deliver best-in-class margins. We deliver best-in-class growth rates and that’s what we’re doing. So no naughty things, no crazy stuff, just step-by-step.

Jim Duffy

I wasn’t accusing you of naughty things. I’m more curious about as you grow the closed-toe.

Oliver Reichert

I feel already accused, Jim. I feel already accused, sorry.

Growth

While Birkenstock’s growth has been remarkable, the growth rate has been trending down for some quarters now. So far, the company has managed to increase volumes and price at the same time, but few companies manage to do this for long. At some point, we believe they will have to choose which growth vector to prioritize. The decelerating revenue growth rate suggests that the company is likely reaching an inflection point, at which an increasing number of customers will search for alternatives.

Balance Sheet

On the positive side, the company has generated significant cash flow since its IPO, which has allowed Birkenstock to reduce its net debt and leverage. The net debt to adjusted EBITDA ratio at the end of the quarter was 2.1x, and management shared during the earnings call that they are confident it will be at 2x or less by the end of the year, and will continue trending down.

Valuation

Even after the post-earnings decline, we believe shares remain considerably overvalued. Birkenstock currently trades with a significantly higher forward Price/Earnings ratio than NIKE, Inc. (NKE) and LVMH Moët Hennessy – Louis Vuitton, Société Européenne (OTCPK:LVMUY). Even on an absolute basis, we consider a 35x multiple excessive, especially when the company is showing signs of rapid growth deceleration.

Risks

The biggest risk we continue to see is the sky-high valuation at which shares currently trade, which is even more concerning when combined with decelerating growth. We also find the strategy of creating artificial scarcity risky, even if it pays dividends in the short term it could backfire in the longer term by giving competition an opening. Finally, we see potential governance issues with one investor essentially controlling the company.

Now, this does not mean we see shares as a particularly attractive short either, as we see no immediate catalyst for a share price decline, and even if the company underperforms the market for some time it could still eventually grow into its valuation.

Conclusion

After reviewing the most recent financial results from Birkenstock, we continue to believe shares are overvalued with an unattractive risk/reward balance. With revenue growth decelerating, gross profit margins contracting, and insiders selling, we do not find much to like at current prices. There are several important risks, in addition to the demanding valuation, including the potential backfiring of their “artificial scarcity” strategy. For these reasons, we are maintaining our ‘Sell’ rating, even though the Birkenstock brand is strong.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.