My Wife’s Cosmetics and Skateboarding

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My wife uses Bobbi Brown cosmetics and I doubt most of you really care. Like me (and I’m guessing all the guys who read this), until right now, you’ve probably never heard of Bobbi Brown. Maybe some of my women readers know it. 

I care that my wife looks great but not what brand she chooses.
 
Hmmm. That sentence is probably worth some discussion, but first I’d like you to check out Bobbi Brown’s foray into skate. It’s seems they made some pink skateboards “…to empower women to try something that isn’t typically thought of as a woman’s sport.” They got pro skater Eli Reed “To teach a bunch of fashionable newbies how to skate in two hours’ time.” It doesn’t look like too bad a job.
 
Anyway, go take a look at the brand’s blog post on the subject. If you don’t hit your mute button, you’ll have to listen to “I Feel Pretty” from West Side Story as the background music. Oh what the hell- don’t mute it. You ought to get the whole effect (The music on the actual video of the session is better).
 
First I laughed. I mean, it’s not like this is the first time any of us have seen skateboarding used in a way that’s not precisely consistent with its roots as most of us think about it. Then I got a little morose and thought about how much I missed skateboarding being kind of dark, underground, urban, mysterious, exclusive. Maybe that’s a long way to say core.
 
Finally, I got around to thoughtful and thought, “Hell, if something is getting new people to skate, do I really care what it is?”
 
Now it gets complicated. I guess if I’m a core skate brand, I do care. Because “getting people to skate” doesn’t mean they are going to go out and buy a branded deck. A skateboard won’t be a statement to most of these people. It will be a tool they use to do something they enjoy. Like, I suppose, a snowboard has become. Or a basketball? Or golf clubs? Pick an activity.
 
It is the duty of every brand manager to convince her customers and potential customers that her brand is “better” than the competitors’ brand even, or maybe especially, when meaningful differences are hard to discern. But as quality improves (plateaus?) and distribution broadens it gets harder and harder to convince people that product differences, even if real, matter.
 
The skate industry spent many years and a whole lot of money explaining to people that a “real” skateboard was made of seven plies of laminated Canadian maple and nothing else. They succeeded. Then two things happened.
 
A lot of people said, “Well, we can laminate those seven plies of Canadian maple too, and we’re willing and able to sell it for less.” And they did.
 
And some skaters, especially those just discovering the sport (and they did think of it as a sport- not a lifestyle) said to the industry, “You’re right- a skateboard is made of seven plies of laminated Canadian maple just like you said and just like these cheaper decks.” Excuse me if I don’t go through the entire industry lifestyle cycle, product becoming a commodity argument again here.
 
That brings me back to my earlier comment about caring how my wife looks, but not what brand of cosmetics she uses. The only thing I experience with cosmetics is the result. I don’t care about Bobbi Brown, its secret sauce, or the fraternity of users. My wife, on the other hand, could tell me in so much detail that I’ll never ask (though maybe I will now just to see what answer I get) why she uses the product. Part of the answer may be that she got a good price on it, but that won’t be the whole answer.
 
There is, of course, and will always be, a “core” skate market. That market, I expect, will come and go with demographics, because it usually has. And it won’t include just people who buy branded decks.
 
But now that product quality is high and distribution broad, a lot of, new skaters will experience skating like I experience cosmetics. As long as it works, I just don’t care about the details.
 
Bobbi Brown, I assume, is interested in selling cosmetics- not skateboards. They just decided, “Oh this might be fun. Look what we’re doing.” It could have been something besides skateboarding. I’m sure it will be in future blog postings. Was there a business calculation there? Of course.
 
Bobbi Brown’s skateboarding experiment felt inclusive and nonjudgmental. They were just having fun which I think is what you’re supposed to do when you skate.
 
Remember when we all (including me) mocked scooters when they came out? I thought they’d be a flash in the pan. They went through an amazingly accelerated business cycle and became a commodity. But it seems that some kids don’t care about that and just think scooters are fun. Somebody is making those things and selling them for, I’m guessing, a profit.
 
What if some core action sports company, skate or otherwise, had branded those things and started to sell them with a longer term perspective? Big risk? For sure. Leads to being mocked by your peers? Probably. Alienates some of your existing customers? Almost certainly. But who knows what might have happened. Business is a risk.
 
The core skate market has always had a sort of insular arrogance to it that was part of its marketing positioning and, for a long while, served it well. But the whole action sports industry, if that’s what we still are, has evolved to a point where being inclusive and nonjudgmental makes a whole lot more sense.
 
Longboards come to mind. They came out of nowhere, were kind of ignored in a “You’re not cool wish you’d disappear” sort of way by the core skate market and are now a big, big chunk of the skateboard market. Half? Part of that is because of demographics. But part is because they are inclusive and nonjudgmental. However you want to ride down a hill and whatever strange looking contraption you can design is fine with them. In fact, they will probably want to know more about why, exactly, your  contraption is strange looking. This does something to advance the technology and keep the product fresh. As I’ve written before, it feels a bit like the bike market.
 
Cosmetics is a cut throat industry with, as far as I know- and that’s not very far, most product differentiation created by marketing. And they have the advantage of every woman in the world wanting makeup. I gained great insight into this when my mother, fresh out of hip surgery and still groggy from anesthetic, asked for her makeup kit. I don’t understand it, but I acknowledge it.
 
Maybe inclusive and nonjudgmental has become more important than “cool.”

 

 

Tilly’s Quarter and Their Business Approach

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Just for fun, let’s jump right to some comments in the conference call for Tilly’s quarter ended October 27, 2012. In discussing the quarter’s results, CEO Daniel Griesemer notes that, “While our third quarter comparable store sales growth of 1.9% [They were 8.5% in the same quarter last year] was below our expectations, this represents high quality growth at healthy margins.” 

Like other retailers I’ve reported on, he noted that back to school was strong, but then the market softened nationally. This seems to have carried into November for at least some companies.
 
He goes on to note that “…we chose not to pursue a course that would deliver a higher comp at the expense of earnings.”
 
I kind of like that approach. If you’ve followed me for more than a little while, you know that in the current and projected economic environment I’ve been a proponent of improving earnings through higher margins, better operations, and controlled distribution rather than big sales increases. My thinking is pretty simple; big sales increases are hard to come by right now. Focusing on operating income rather than sales makes some opportunities that exist among the interplay of production, distribution, marketing and operations in general clearer than they have been in a sales growth focused organization.
 
Just to give one example I’ve used before, the best marketing a brand can probably do is have a retailer sell through at full margin and then have to tell customers, “Sorry, sold out!”
 
This isn’t a panacea. Remember Billabong announced when the recession started that they were going to control promotions to support the brand and its image even at the expense of sales. We found out when they released their new strategic plan that they thought they had some operating issues to deal with. I agreed with Billabong’s decision. But what we now all know, and what I think Tilly’s CEO would agree with, is that the decision not to focus quite so much on sales growth requires that you look for the connections among the other parts of your business that not only reduce expenses, but improve the brand’s positioning.
 
In the case of a retailer, that has the potential to change the way they evaluate and decide to carry brands. Hey brands, that should resonate with you and lead you to evaluate your marketing and distribution differently.
 
Two other points from the conference call. First, like pretty much everybody else, Tilly’s is trying to give its customers an integrated experience across every touch point they have with the customers. CEO Griesemer says, “…we want our customer to get the same great Tilly’s brand experience across every channel, every access point; be it social media, or mobile, or in-store, or online, or through our catalog or e-mails, or whatever else – events, or all kinds of things.”
 
Working towards this consistency is no longer a choice.
 
And second, in my last two posts I’ve talked about Zumiez’s and PacSun’s quarters. I’ve compared them, saying Zumiez has a niche it owns but has to find a way to grow out of it without damaging that niche. PacSun, on the other hand, lost its niche and is trying to get a niche back to attract its customers.
 
Tilly’s CEO, talking about the action sports space in response to an analyst question, says, “Yes, we share an action sports-inspired lifestyle kind of platform with a whole lot of people. But as you well know, that has migrated significantly.” Later, still responding to that question, he says, “…this is a unique business with a unique customer. I think we’re going to continue to make sure we communicate that, so people resist the temptation to pigeonhole us into one particular category.
 
As action sports becomes comingled with fashion, youth culture or whatever you want to call it, figuring out where along the spectrum they belong is an issue Tilly’s is sharing with all brands and retailers in this space.     
 
Well, that was a little more fun than just starting with a bunch of numbers, but I suppose there’s no way to avoid that. If you’re so inclined, you can read the 10Q yourself here.
 
Sales for the quarter were up 16.4% from $107.3 million in last year’s quarter to $125 million this year. Ecommerce sales rose from $11.1 million to $12.7 million. They ended the quarter with 161 stores in 27 states. Average net sales per store declined from $730,000 to $705,000 and average sales per square foot were down from $94 to $90.
 
I would love to have some detailed information on how retailers thought ecommerce sales were impacting brick and mortar sales. Tilly’s does note that the 1.9% comparable store sales increase was “…due to higher net sales through our e-commerce store.” That’s not a surprise given the numbers on sales per store and square foot quoted above. 
 
The gross profit margin rose pretty much not at all from 33.4% to 33.5%. Selling, general and administrative expenses rose from $23.5 million to $27.9 million or from 21.9% of sales to 22.4%. Store selling expenses were up 17% to $18.8 million but as a percentage of sales rose 15.0% to 15.1%. 
 
Operating income rose from $12.3 million to $13.9 million, but net income was down 23.5% from $12.2 million to $9.3 million. The decline in net income was completely due to an income tax provision that rose from $140,000 to $4.53 million. That was the result of changing from a subchapter S to a C corporation as part of going public. You should look at this quarter’s tax provision as a percentage as more typical of what Tilly’s will experience going forward.
 
Okay that’s it. No big financial issues, and anyway I thought the first part of the discussion was way more interesting than this part.

 

 

Pacific Sunwear’s Quarter; Look! It’s a Profit!

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PacSun earned $948,000 in the quarter ended October 27 compared to a loss of $17.6 million in the same quarter last year. Their comparable store sales rose 1%. It’s the first time that’s happened since the third quarter of 2007. Their loss for nine months is $32.2 million compared to a loss of $68.3 million in nine months in the previous year. 

Okay, progress though not the end of the turnaround road. They did it by increasing their gross margin from 24.4% in last year’s quarter to 26.6% this year and by cutting selling, general and administrative expenses (SG& A) from 30.2% of sales to 27.2% of sales. Sales increased only slightly from $226.8 million to $228.4 million.
 
Remember, this is a company that’s still closing stores. They closed a net of five during the quarter and ended it with 722 stores compared to 820 a year ago. They expect to have closed an additional 75 stores by the end of the fourth quarter in January. I would guess that those closings will largely happen after the holiday shopping season.
 
Most of the gross margin increase came from the improvement in the merchandise margin from 47.2% to 49%. Of the 3% decline in SG& A, 1.80% came from a decline in non-cash impairment charges for long lived assets. These assets are mostly furniture, fixtures, equipment and leasehold improvements for stores being closed. In last year’s quarter, the charge was a bit over $7 million. This year, it was only $533,000.
 
They’ve now written those assets down to $6 million and, as of the end of the quarter, think they can recover it all. Is so, we shouldn’t see any future write downs for store closings.
 
There was also a 0.8% decrease in depreciation (which you’d expect as stores get closed and there are fewer assets to depreciate). There was also a 1.1% decrease in other SG& A expenses “…primarily due to the timing of advertising expenses and a decrease in consulting fees.” To the extent the decline was due to timing, I assume it just moved to the next quarter. Finally, there was an offsetting 0.7% increase in compensation due to an increase in employee benefits.
 
I also want to point out that net income includes a $5.6 million “Gain on derivative liability.” This has to do with their estimate of the fair value of the Series B Preferred shares using “highly subjective” inputs. Now I’m guessing that nobody really wants to get into those details, but should I be wrong, you can check out footnote nine in their 10Q. My holiday gift to you.
 
Over on the balance sheet, we see that cash has risen from $8.3 million a year ago to $23.9 million. Cash is good. Inventories are down from $152 million to $137 million as you’d expect with stores being closed. The inventory decline on a comparable store basis was about 4%. Current assets at $182 million are down just $3 million with cash basically replacing inventory on the balance sheet.
 
Net property and equipment has declined from $158 million to $131 million with the store closures and asset write offs we’ve discussed. Total assets are down $28 million to $348 million.
 
Current liabilities are up slightly from $129 million to $132 million, which is a bit of a surprise. Accounts payable are down $22 million which again makes sense with stores closing, but other current liabilities have jumped from $39 million to $65 million over a year. Oh- that’s mostly the derivative liability thing and a $6 million increase in accrued compensation and benefits.
 
Long term liabilities have risen 37% from $96.4 million to $132.2 million. Deferred lease incentives and rent are down (again, it’s the store closings). But other long term debt and liabilities have risen in a year from $55.2 million to $100.5 million. Shareholder equity is down 45% from $150.4 million to $83.3 million.
 
Okay, well those balance sheet numbers make me scurry to the cash flow for nine months. I see that net cash used in operating activities has fallen from $45 million to $22 million. And cash used in investing activities has fallen from $9.8 million to $3.1 million. That’s an improvement, but we’re still a long way from a positive operating cash flow.
 
CEO Gary Schoenfeld told the analysts that PacSun continues to be “…focused on 3 main tenets of our strategy: authentic brands, trend-right merchandising and reestablishing a distinctive customer connection that once again makes PacSun synonymous with the creativity, optimism and diversity that is uniquely California.”
 
He left it to poor Mike Kaplan, the CFO, to provide the guidance for the fourth quarter. Excluding the stores to be close by the end of the quarter, they expect comparable store sales to be down 1% to 3%. They project a “…non-GAAP net loss per share from continuing operations of $0.09 to $0.17 for the quarter…” I imagine that will translate into a loss at the net income line.
 
They reasonably pointed out that this year’s fourth quarter includes an extra week, which incurs expenses at the usual rate, but has weak revenue because of the time of the year.
 
I was all excited when I saw the profit and positive comp for the quarter, but less excited after I’d been through the numbers. There’s no doubt there’s been a tremendous amount of progress. Lots of battles won, but the war goes on. The company is still cash negative, and to some extent the positive comp (and it was only 1%) is the inevitable result of closing enough stores that aren’t performing. But when you get down to your good stores, you need to be doing better than 1%.
 
It’s not easy for me to evaluate PacSun while they are still closing bunches of stores. Apparently, that will mostly be over at the end of January. It’s interesting that yesterday I was reading and writing about Zumiez, and wrote that they had a solid market niche that they had to continually validate but also break out of as the action sports lifestyle market changed. That’s both their challenge and their opportunity.
 
PacSun’s challenge, on the other hand, is to figure out and establish to the satisfaction of their customers what their market niche is. They lost their “distinctive customer connection” and are working to get it back. But that means they aren’t gated, at least compared to Zumiez, by their historical market positioning. And that might be a good situation to be in right now.

 

 

Zumiez’s October 29 Quarter and a Strategic Observation

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Zumiez reported sales growth during the quarter of 16.9% from $154 million to $180 million. Without the Blue Tomato acquisition, sales would have risen 11.7%. The gross profit margin fell from 38.9% to 37.3%. Selling, general and administrative expenses rose from $37.1 million to $45.7 million, or by 23.2%. As a percentage of sales, they rose from 24.1% to 25.4%. 

Net income fell 10.4% from $14.1 million to $12.7 million.
 
Comparative store sales were up by 3.7% and ecommerce sale were 10.7% of the total, up from 6.4% in the same quarter last year (Remember that now includes Blue Tomato, which does quite a bit of online business). Zumiez ended the quarter with 495 stores; 471 in the U.S., 19 in Canada and 5 in Europe. They’ve added a net of 48 stores since October 29, 2011.
 
Let’s remember that the July 4 acquisition of Blue Tomato in Europe for $74.8 million plus contingency payments of up to $28.6 million had an impact on their results, as has the new ecommerce fulfillment center in Edwardsville, Kansas and moving their home office from Everett to Lynnwood, Washington. Without the costs associated with the corporate relocation and Blue Tomato acquisition, SG&A would have been 23.7% of sales; lower than the same quarter last year.
 
The 1.6% decline in gross margin “…was primarily due to a 90 basis points increase in ecommerce fulfillment and ecommerce shipping expenses and an 80 basis points impact of a $1.4 million charge recorded during the three months ended October 27, 2012 related to a step-up in inventory to estimated fair value in conjunction with our acquisition of Blue Tomato.” They gained 40 basis points by leveraging store occupancy costs over higher comparable store sales. It’s noted in the conference call that product margins would have improved slightly without Blue Tomato.
 
During the quarter, Zumiez booked $2 million in expense as part of the expected contingency payment for Blue Tomato. This explains part of the increase in the SG&A expense line. There was also a 1% increase in corporate costs and a 0.3% increase in amortization of intangibles as a result of the Blue Tomato deal. These increases were offset to some extent by a 0.4% decline in incentive compensation and a 0.9% improvement in store operating efficiencies.
 
Zumiez’s lease on its former corporate headquarters doesn’t expire until 2017, and they’ve got some ongoing costs for it. During the quarter, they booked $200,000 in cost of goods sold and $300,000 in SG&A. 
 
The balance sheet shows the impact of the Blue Tomato acquisition. If it’s slightly weaker than it was a year ago I guess, it’s still very solid, so no discussion is required.
 
Zumiez’s 10Q (see it here) tells us that, “The activity of Blue Tomato that was included in our condensed consolidated statements of income from the acquisition date to October 27, 2012 was net sales of $9.6 million and a net loss of $1.8 million.”  Of those Blue Tomato sales, $8.1 million were during the quarter. It doesn’t tell how much of the loss was during the quarter, but it obviously had a negative impact.
 
In theirs earnings release and conference call, Zumiez acknowledged that their sales and earnings during the quarter were below what they expected. “The shortfall in sales came primarily from softness in Europe, which we attribute to unfavorable weather and pressure on consumer spending as a result of difficult macroeconomic conditions,” said CEO Rick Brooks.
 
As an aside, I’d encourage all of you not to think the crisis in Europe is over. I didn’t quite know whether to laugh or cry when I heard that some of Greek’s debt had been effectively converted into zero coupon, perpetual bonds. Financial alchemy is so much fun!
 
For the fourth quarter, Zumiez expects same store sales to decline by 3% to 4%. 
 
“The fourth quarter guidance assumes a decline in product margin compared to last year, primarily related to a modest decline in our domestic margins as a result of our current sales projections and lower margin experienced for our Blue Tomato business due to their product mix and effects of the inventory step-up.”
 
They expect that acquisition related charges during the quarter will be $3 million.
 
To sum it up, Europe and Blue Tomato aren’t performing to expectations, there have been some substantial, though expected, costs for the acquisition and changes in location, winter business is weak, and the economy’s none too great in North America either.
 
With that as background, let’s move on to the strategic question I alluded to in the title.
 
Zumiez has positioned itself as an action sports lifestyle brand. CEO Brooks noted in the conference call that he believed in that lifestyle. “The lifestyle has real resonance,” he says.
 
I read public information not just to tell you how an individual company is doing, but to look for issues that everybody in this space probably needs to think about. The one I find myself thinking about right now is just what is the action sports lifestyle market and how big is it?
 
It’s hardly the first time this issue has been raised, and not just by me. The action sports industry is really pretty small, or at least that’s what I believe. And it’s been compromised by big players in youth culture, fashion, urban street wear; pick your term. The borders are no longer as clear as they once were.
 
When Volcom was sold to PPR, I complimented them on selling at the right time before they needed a deal. Volcom owned their market niche, but where did they go from there? They needed expertise they didn’t have to branch into the larger market. How successful they will be is still an open issue.
 
Zumiez is the core action sports shop in the mall. They own that niche. It’s been validated by other brands opening their own mall retail stores. But when you’re so successful, and so closely identified with a niche, how do you grow and how to you respond as the market evolves away from core action sports while still keeping your credibility in the market you’re successful in? 
 
Zumiez can and will open more stores (their target is 600 to 700). But as an example of what I mean, I want to focus on Zumiez’s discussion of its men’s footwear business in the conference call.
 
Here are CEO Rick Brooks’ comments on that business:
 
“I read it in many of your notes that we’ve seen athletic footwear really start to take off both in the sense of athletic shoes, but we’re seeing that really calling out basketball and running as categories. Obviously those are areas that we play.”
 
“If you don’t come to us for basketball shoes or for running shoes, they come to us for a skate shoe. So I think that we have some challenges there relative to just a cyclical cycle in footwear.”
 
“I would anticipate that we’re probably more likely in the early phases of an athletic footwear trend, than the later phase at this point based upon our experience what we see in the marketplace.”
 
“So as we think about what we’re going to do with footwear going forward, we definitely think we have some opportunities where we know we’re missing a few things with some key brands in our current business.”
 
I’d love to dig in more deeply on this subject with Rick. But what I’m hearing him say is that there’s some men’s footwear product Zumiez could be carrying they don’t carry now that would be responsive to market trends.
 
But it seems to me that product isn’t necessarily representative of the action sports lifestyle. The question for Zumiez (and other companies as well) is the extent to which they respond to these trends.
 
Do they carry it and compete for the customer who wants that product? Or do they decide that it’s not representative of the action sports lifestyle? If they carry it, they may hold onto a customer they would otherwise lose. But they may also find themselves in a market where their advantage is less (because it’s not all about the action sports lifestyle) and could even confuse their core customers. If they don’t carry it, they may lose a customer they had before and find themselves isolated as the market changes.
 
Well, this is why companies have managers, and I imagine Zumiez managers asks themselves this question every day about every product and every brand they carry or consider carrying. They’ve responded at least partly with an emphasis on systems that get the right product to the right stores (micro sorting they call it) and by giving store managers quite a bit of discretion, as they describe it, in selecting inventory.
 
But more globally, the issue is just what is the action sports lifestyle market? It’s not what is used to be.

 

 

Paul Naude Offers AUD 1.10, Billabong Reduces Full Year Forecast

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This is just intriguing. There is so much happening and it’s going on so fast (at least in corporate terms). It’s like a novel you can’t put down or a soap opera where waiting for the next episode to find out who does what to whom is excruciating. 

Like you, I’m working from the Billabong announcement and a couple of press reports so I have no solid information you don’t have. But I’ve always been a student (and sometimes a practitioner) of turnaround management and organizational evolution and this is fascinating. Dare I say fun (for me at least)?
 
All the numbers are in Australian Dollars.
 
Let’s start with a review. In February, Billabong turned down a $3.30 bid from TPG Capital (subject to due diligence) as too low. Subsequently, Bain and TPG withdraw offers of $1.45 after some due diligence (The TPG offer was made on July 24 and withdrawn on October 12.). Meanwhile, on April 12th, Billabong closed a deal to sell half of Nixon to TCP for proceeds of $285 million to be used to pay down debt. Former CEO Derek O’Neill departed the company on May 9 and Launa Inman was appointed Managing Director May 12. On June 21st, Billabong announced that it would sell shares at $1.02 (44% below the previous closing price) to raise an additional $225 million to pay down debt.
 
On August 12th, the company released and Ms. Inman presented Billabong’s half yearly results and plans for going forward. I wrote rather extensively about that.
 
Now Paul Naude, who took a leave of absence as a Director and President of the Americas on November 19, has made a contingent offer of $1.10 per share. When he did this last Friday, Billabong’s shares were trading at $0.73 each.
 
Just to increase the intriguing factor even more Billabong, at the same time they announced Paul Naude’s offer, released a trading update where they reduced their expected EBITDA from $100-110 million in constant currency to $85-92 million in constant currency. But that eighty-five to ninety-two million number is before $29 million of “significant items.” If you include those, the year-end constant currency range is from $56 to $63 million. The release does not describe the previous EBITDA estimate as excluding any “significant items.” As a result, I’d tend to compare that prior estimate to the $56-$63 million estimate. Using the midpoint of both estimates, that’s a decline of 43%.
 
The press release, should you want to read it yourself is on this page at the Billabong site. Right now, it’s the second on the list and is called “Bid Proposal and Trading Update.” This is the third time this year that Billabong has reduced its expected results. You can read for yourself the details of the causes in the release. We can sort of sum it up by saying soft sales and a lousy economy.
 
When I discussed Paul Naude’s decision to put together an offer back in November, I speculated that the offer price might be lower than what we’d seen before. Now I have to wonder, with the price of the stock having fallen since the downward revision of the year end results, if it might be reduced further. I also discussed briefly in that article just how a leveraged buyout, which this deal would be, works.
 
If I could ask Paul one question, it would be, “What did you know, and when did you know it?” It seems likely to me that when he took his leave of absence a month ago, he must have had some sense of the continued deterioration of business conditions. Yet the conditions under which he was allowed to pursue the deal required that he use no confidential information. Regardless of what he knew or was concerned about then, he had to put together his offer, and represent it to his potential partners, using only public information. That would have been the EBITDA estimate of $100 to $110 million.
 
Were I Paul’s partners (Sycamore Partners Management and Bank of America Merrill Lynch) the first question I would have asked in the first meeting was, “You were a director and the President of the Americas as Billabong’s performance went south. Now you’re coming to us and explaining how under your leadership this can turn into a really good investment. Explain to us why your really good ideas couldn’t be implemented.” 
 
I gather he had a really good answer. 
 
We’re a long way from a deal (Remember, I thought there would be a deal with TPG). Whether or not Billabong has to make a deal at some price depends on their balance sheet. If there should be a deal I’d expect the price to decline further as a result of the reduction in projected year end results. And I’m guessing you’d see some brands sold following the deal to pay down debt. The thing I’d be most interested to watch is how they’d propose to manage their brick and mortar retail.
 
I’ll keep watching and speculating right along with you. 

Winter Resorts Targeting Baby Boomers: I’m a Little Worried.

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Well, you know me. I’m always a little worried about something. But hopefully, the fact that I have a tendency to bring up issues people wish would just go away is part of the reason you read me. 

We’ve all known that winter resorts tend to be dependent on the baby boomers for a big chunk of their business. You need a lot of disposable income and free time if you’re going to visit them regularly. I just took that as a fact and didn’t think much about it until I saw this article called “Best Ski Resorts for Senior Skiers.” It talks about programs that resorts have in place for senior skiers/boarders.
 
“Well, that sounds great,” I thought. But then I read, “All the marketing to boomers seems to be paying off as the National Ski Areas Association reports an 11 percent increase in skiing and snowboarding for people 45 and older. Strangely, on the flip side, there’s been a decrease in skiers 35 and younger.”
 
I kind of new that too. But seeing the two statistics in juxtaposition made my alarm bell go off. I wondered if by doing marketing, building facilities, and holding events that targeted the baby boomers, you weren’t guaranteed to be turning off younger (and more importantly potential) boarders/skiers. I wonder what the decrease in skiers 35 and younger is, what the size of that group is, and how it compares to the 11 percent increase in the over 45 crowd.
 
I’m sure you can see where I’m going with this. The over 45s are going to stop visiting winter resorts a lot sooner than the under 35s and I don’t think there’s any amount of marketing or new programs that can change that. Every resort is different, and it may be a great tactic to attract older people with lots of money. But strategically, if you look beyond some limited number of years, it’s kind of a recipe for self-destruction. I mean, I don’t ever want to get the point where there are emergency medical care facilities on the mountain instead of bars, most skis are sit down, and some visitors need minders on the mountain so they don’t get lost (Oh-shit-I’ve gotten lost a time or two).
 
Haven’t we been spending, as an industry, a whole bunch of money and effort to attract new participants? If we’ve had so little success, why is that? Or maybe we’ve been successful, and the decrease in the under 35 crowd would have been a whole lot worse without it. But even if that’s success, it’s not enough success.
 
The devil is in the details, and it’s certainly possible for a given resort to balance its programs and facilities to appeal to a wider demographic spread. And yet, I would not be the only person who believes that if you think everybody is your customer, then nobody is your customer.
 
Maybe the Mountain Rider Alliance has some good ideas about how to manage this. Look at the way they are defining their potential customers. Full disclosure; I’m on the Mountain Rider Alliance (unfortunately unpaid) Advisory Board.
 
Hell, maybe resort managers have decided they can milk the boomers until global warming turns some of them into summer resorts. I don’t really think that’s true, but some years ago I had occasion to attend and make a presentation to the scuba diving association. They had some issues remarkably similar to the winter sports business. I learned a lot, and got quite a good perspective. You know, it wouldn’t hurt for NSAA to start a conversation with the golf trade association if they haven’t already. Golf is another sport that takes a lot of time and money to participate in (In my case, without much in the way of results). I’m not suggesting this because I believe all winter resorts can or should build golf courses (though of course some have) but because I think the cross fertilization of ideas concerning attracting participants might be valuable.
 
What I guess I’m reminding you of is that dependence on baby boomers cannot be a long term strategy. And dependence may reduce your ability to transition away from them as demographics will eventually require (is requiring?). It is also possible (I think likely) that this country’s economic profile over the next couple of decades may require winter resorts to rethink their offerings and financial model.

 

 

Decker’s Quarter: The Issue is Not with Sanuk

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The September 30 quarter (here’s the link to the 10Q) was not one of great happiness for Decker, the owner of UGG, Teva and, of special interest to us, Sanuk. But perhaps we should be interested in their other brands as well. Most of you who sell shoes and sandals are competing directly in the broader casual footwear market after all. 

Anyway, Decker’s sales fell 9.2% from $414 million to $376 million. In last year’s quarter, the gross profit margin was 49%. This year, it came in at 42.3%. Net income was down from $62.3 million to $43.1 million. What happened?
 
Well, it’s not Sanuk’s fault. Its sales for the quarter grew $15.6 million to $18.3 million, or by 17.3%. $1.3 million of these sales were on line. Sanuk is not sold in Decker’s retail stores. The brand’s sales for the whole year are projected to be $95 million. 
 
Sanuk’s operating income was up nicely from $1.5 million to $3.2 million. However, that increase “was primarily the result of a $1,400 reduction in accretion expense related to the contingent consideration liability from the Company’s purchase of the brand, a $900 reduction in amortization expense largely related to an order book that was fully amortized in 2011, and $500 of increased gross profit, partially offset by approximately $600 of increased marketing and promotional expenses.” After reading that closely, it’s hard to conclude that the operating income increase was primarily the result of selling more product.
 
Sanuk’s wholesale sales growth was the result of an increased selling price “…partially offset by a decrease in the volume of pairs sold.” Apparently they didn’t just increase prices for Sank. There was a shift in the product mix (sorry, no details given) and the introduction of a new shoe and boot line with higher prices.   
 
Unhappily for Deckers, Sanuk’s wholesale business represented only 4.9% of total revenue during the quarter. UGG, with revenues in the quarter of $284 million (down from $334 million), represented 76% of quarterly revenues.
 
Sheepskin is a primary material in UGG products. The cost of said sheepskin was up 30% in 2011 and another 40% in 2012. Obviously this sent the costs of UGG products through the roof. Deckers responded by raising prices and found that, as Chairman, CEO and President Angel R. Martinez put it“…our price increases over the past 2 years had pushed us above the consumer’s price value expectations for the UGG brand.” The warmest winter in the U.S. since they started keeping records didn’t help either.
 
There was probably no good answer for Deckers in the short term. Either they could hold their prices and see their gross profit go to hell, or they could raise prices to hold margins and see their sales drop. Not a happy place to be. The lesson for all of us, and I think it’s especially important these days, is that no matter how sophisticated your strategy, how well thought out your competitive positioning, how differentiated by marketing and features your product, and how many people “like” you on Facebook, every product can be substituted for and sometimes the stuff just costs too much.
 
Deckers sees sheepskin prices coming down some, and they “…made the decision to adjust our domestic pricing in mid-September on select classic styles, retroactive to all orders shipped since July 1.” They reversed some, but not all of their price increases. The issue is whether they can make enough of the price increases stick so that, given a decline in raw material costs that it sounds like will be less than the initial increase, they can recover their gross margins. Price increases, even when justified, have to be gradual I think.
 
Mr. Martinez goes on to say, “The price adjustment has been mischaracterized in recent industry coverage as “discounting.” But in fact, it’s an important strategic decision that we believe is in the best interest of the brand for the long term.” The good thing is that it sounds like they didn’t close this product out or take it to other channels. They worked with their existing retailers for everybody’s benefit, which is something we in the action sports world perhaps haven’t always done as well as we could. But I wonder where that high quality strategic analysis was when they raised their prices so much in the first place. Maybe subsumed by some pressure to make the quarter?
 
Deckers has hit what we hope is a one time bump in the road due to the large and rapid increase in the price of sheepskin. Sanuk seems to be doing fine. Given the price Deckers paid for it, I imagine they will push the brand for even better results. Please don’t push too hard.

 

 

Another Possible Retail Future

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We’ve all been watching for a while now as online and brick and mortar retail have collided and converged. We know it’s here to stay and that there’s a lot of evolving left to do. None of us know what the end product will look like (though maybe it’s better to acknowledge that there is no end product- just way points along the path). 

I think I might have stumbled on one of those way points. There’s a new concept store in the Seattle area called Hointer. No idea where the name came from or what it means, but it’s a fascinating combination of internet and brick and mortar.
 
 When you walk in the store (which at this point is men’s pants only), you download an app on your smart phone. There’s one pair of each style of pant hanging in the store. You scan the tag on that pair, put in your size in the app, and the pants shows up in the changing room for you to try on in what they say is 30 seconds. If you want to purchase after trying it on, you swipe your credit card in the scanner in the fitting room. Your receipt will be emailed to you. If not, you just put the pants in a chute in the changing room and as it falls to wherever it goes and is automatically removed from the pants you’ve selected and returned to inventory.
 
Unless you want to, you never need to interact with a sales person. I’m not quite sure if that’s good or bad. Depends on the shopper I suppose. And of course, the store keeps up to date track of its inventory and that inventory is shared with its suppliers.
 
I’ve had a tendency in recent years to harp on the importance of inventory management and operational efficiency. This store seems to make that a virtuous part of the selling process which I really love.
 
I haven’t been in the store yet. I’d want to know a lot more about the cost of the required technology, the impact on operating expense, and the comparative price points of the product. I’m also curious about the complexity that will occur as the product line is expanded.
 
Here’s a link to a news story where the reporter goes through the purchase process. I hope you’ll watch it.   Sorry about the short commercial at the start of the video.

 

 

SPY’s Quarter; Strategy and the View from the Balance Sheet.

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About a hundred years ago, around 1998, I spent a year as one in a long line of people who believed in the Sims brand enough to try and get it some traction (Some of you who are reading this are smiling; some are laughing. At me or with me- who knows). 

Sims benefitted from having a group of really competent people who had been with the company for a long time and were totally loyal to the brand. In difficult circumstances, while I was there and after, they cleaned up the brand and created a company that was doing $20 plus million a year, earning an operating profit, and had the potential to grow some.
 
But no matter how well they operated, they couldn’t overcome the high level of debt on the balance sheet and the discontinuities this created between what was good for the brand and what was good for the shareholders/debt holders.
 
Which, as you were probably expecting, gets me around to SPY.
 
Strategy and Balance Sheet
 
SPY’s sales grew 7.6% in during the quarter ended September 30, rising from $9.2 million to $9.9 million. They cut their operating loss from $2.4 million to $1.2 million and their net loss from $2.98 million to $1.78 million compared to the same quarter last year. As usual, there are some details to be discussed, and we’ll get to that. But first, let’s talk about the strategy and the balance sheet.
 
If you’ve followed SPY over the last few years through what I’ve written or other sources, you know that they’ve experienced a lot of challenges; some self-inflicted, some not. There’s been the Italian factory they bought then sold, a lawsuit with a former CEO, the detour into, and then out of, licensed brands, some inventory problems, management issues and turnover (now apparently ended), a lousy economy, and the August 2012 announcement that the company was reducing “…the level of its expenses to lower its breakeven point on an operating basis.”   Through all of the tumult, the SPY brand has somehow maintained credibility in the market.
 
Now, the company is refocused exclusively on that brand and it feels like the company is making progress. But sunglasses are a very competitive category produced by an awful lot of companies. It’s a high margin product so naturally everybody wanted a piece of that. Inevitably, that margin will come down (is already coming down?) because that’s what happens.
 
SPY needs to grow its revenues so that it can afford the cost structure it has to have to compete against much larger and better capitalized companies. To accomplish that, and to clean up all the problems mentioned above, they’ve had to invest and invest and invest. That gets us over to the balance sheet.
 
In the year since September 30, 2011 notes payable to stockholder have risen from $10.5 million to $17.5 million. The majority shareholder has lent the company another $7 million over the year. Interest on the debt is not being paid in cash, but is accrued as additional debt. Under current liabilities, the line of credit outstanding has risen by $2.1 million from $2.5 million to $4.6 million. Stockholders’ equity has dropped from an already negative $4.3 million to a deficit of $12.8 million. The only thing keeping SPY afloat is the willingness of the majority shareholder to lend the company money, and the 10Q tells us they are going to need more; “The Company anticipates that it will continue to have requirements for significant additional cash to finance its ongoing working capital requirements and net losses.”
 
Well, it’s hardly unusual for a company in this industry to find itself at the point where it needs the financial, back office and/or design/manufacturing strength of a larger company so they can “Take it to the next level” whatever the hell that means.
 
If it’s a company like Sanuk, who was more or less the same size as SPY when it was acquired by Decker and was growing, profitable and no doubt had a solid balance sheet, you can get paid a lot of money. But if you’re losing money, require more investment, and your balance sheet is upside down you don’t quite get such a good deal. In those circumstances, in our industry, “Taking it to the next level” has meant some of your debt gets assumed, you get an earn out if the company performs, and people get to keep their jobs.
 
My guess is it would make sense for SPY to be bought by a larger corporation. But whatever we might conclude the brand is worth, nobody is going to come anywhere close to paying the majority shareholder the $17.5 million he’s owed for a company that’s losing money and needs further investment.
 
There are also, of course, other shareholders who’d probably rather not lose their money. I don’t know exactly why or how SPY came to be a public company in the first place, but this would probably be more easily managed if it wasn’t a public company, though way less fun for me.
 
Nuts and Bolts
 
In the August restructuring, they took a $700,000 charge for the reduction in expenses I mentioned above. This one-time cost was for changing the direct part of its European business to a distribution model and for reducing its marketing spend. The result was a staff reduction of 20 positions.
 
For the quarter, 16.4% of its revenue, or $1.63 million, was international. I would expect that going from a direct to a distribution in Europe, while reducing some costs, will also lower their gross margin on the product being sold there. The reduction in their marketing spend, while understandable given their financial condition, is the opposite of what they’d indicated they were going to do in the past. See the conflict between what the brand and the balance sheet requires?
 
While overall sales grew by 7.6% in the quarter, the sale of the SPY brand during the quarter rose $1.4 million or 17% to $9.8 million. That included $800,000 of SPY closeouts. In the same quarter last year, the closeout number was $300,000. As we’ve noted, total sales were $9.9 million. Only $100,000 of revenue came from the left over inventory of licensed brands they’ve been getting out of. They don’t expect any significant future sales from those brands. It’s great to see that done.
 
The gross profit margin was 44% compared to 35% in last year’s quarter. The increase was the result of a number of factors, including the negative impact of the write down of the licensed brand inventory last year, purchasing more lower cost product from China, and decreased freight cost (they avoided some air freight). These positive factors were somewhat offset by lower international margins, increased closeouts, inventory reserves, and discounting, and some changes in accounting for product from the Italian factory.
 
Increased inventory reserves, discounting, and closeouts don’t sound all that positive. What would be really nice is if they would tell us the gross margins on just the SPY branded product since that’s where the company’s focus is.
 
Selling and marketing expense increased by $0.4 million, or 12%, to $3.8 million. They say this was “…driven primarily by increased marketing efforts to promote our SPY brand and our new SPY products and a portion of restructure expense included in 2012.” Yet if we breakdown the increase, there was a $500,000 charge as part of the restructuring which was meant to reduce exactly those costs. They spend an extra $100,000 in marketing costs and had a $200,000 decline in consulting and other marketing expenses.
 
So the increase was to promote the brand, but some part of the increase was a charge to cut those costs. Once again, I can only point to the conflict between the interests of the brand and the reality of the balance sheet.
 
I would expect there will come a point when the major shareholder who’s been financing SPY will be tired of putting in more money and it will be interesting to see what happens then. In the meantime, SPY has whittled its non-operating issues down to not much, and perhaps a good holiday season will result in a strong December quarter. 

 

 

Paul Naude Explores Billabong Leveraged Buyout

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I suppose you have all heard that Billabong Director and President of the Americas Paul Naude has stepped aside from his duties for six weeks to try and pull together a leveraged buyout of Billabong. You can see the Billabong announcement and the conditions under which he is working here at Billabong’s investor web site. It’s the first link under Recent News called Company Update. 

To be clear, I have no information that’s not public. However, I thought it might be useful to review just what a leveraged buyout is and how it works. And, I’ve got a couple of questions.
 
In a leveraged buyout, the buyer (or buyers) purchases the target company by using some of their own money (the equity portion) and borrowing the rest. The loan amount is secured by the assets of the target company.
 
You might reasonably ask, “How much of the purchase price is equity and how much is debt?” It used to be that you could borrow most of the purchase price, but that was back in the good old days. I’m not close to the leveraged buyout market, but I’m guessing you have to put up more equity now. That’s both because lenders are a bit more cautious then they use to be and because it’s harder in this economy (in general- I can’t speak to the specifics of Billabong) to put together a plausible business model that shows fast revenue growth to be used in paying off the debt.
 
On the other hand, interest rates have come down to historically low levels even, or maybe I should say especially, for lower rated debt. People seem to be forgetting again that there is an inevitable relationship between risk and return. You may recall that’s what got us into our current economic/financial mess in the first place.
 
Anyway, the point is that lower interest rates make it easier to make a deal pencil out. Once a leveraged buyout is complete, the new owners have to pay down the debt. They typically try to do that by some combination of asset sales, expense reductions, improved efficiencies and revenue growth.
 
You remember that Billabong had to sell half of Nixon and then a few months later raise additional equity to address concerns about their balance sheet. By definition, in a leveraged buyout, their balance sheet would deteriorate again as they added the debt used to purchase the company to it. The former owners and banks won’t care, because they will get their cash and be gone. The new owners will understand that they are taking higher risk but hey, that’s the business they are in and their plan will have convinced them that the risk is justified by the potential return.
 
We also remember, of course, that a couple of potential buyers evaluated Billabong to see if they might be interested in buying it and choose not to. Why? Well, we don’t know specifically but I think it’s fair to say that they didn’t see the risk as justifying the potential return.
 
Below is a chart of Billabong’s stock price from an article in The Australian that will remind you of the series of events.
 

       
 
One would assume that Paul Naude knows why Bain and TPG pulled out, but on the other hand maybe they had no obligation to explain it to the Billabong Board of Directors.
 
That doesn’t really matter anyway. When I evaluate a company, as you know, I do my own analysis and don’t pay attention to anybody else’s conclusions. Perhaps after I did that with Billabong I’d:
 
–          See the risks and returns a bit differently than Bain and TPG.
–          Think I could get it for a lower price because of the performance of the stock since the October 12th withdrawal of TPG.
–          Believe that the transformational strategy had the potential to drop a lot of Australian dollars to the bottom line pretty quickly.
–          Be prepared to be more aggressive in selling assets to pay down debt.
–          Think that the Australian dollar was going to depreciate a bunch over the next year.
 
Paul didn’t take this step without thinking it through. His experience with the company, reputation in the industry and, I assume, willingness to be CEO and put up some of his own money, is at least going to get him listened to. His agreement with Billabong keeps him from disclosing any confidential information, so I wonder if he won’t go back to TPG and/or Bain and show them a different vision of reality. They’ve already got the confidential information.