A Little More Information on Volcom’s Sale to PPR

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Often when a deal happens, all you know for sure is what’s in the press release. Typically that press release doesn’t offer a completely objective perspective about the process and motivations that lead to a deal. But if it’s a public company, and you’re willing to dig into mounds of fine print, sometimes you can find out a bit more.

That would be true with PPR’s acquisition of Volcom. Don’t get all excited. I don’t have any deep dark secrets to tell you. There’s nothing that would change my opinion that Volcom made themselves a good deal at the right time for the right reasons (in fact, this reinforces my opinion). But we’ll know a bit more about how and why the deal happened.

When I reviewed Volcom’s last quarterly report, I noted that a law suit had been filed as a result of the deal alleging that Volcom and PPR had done various bad things not in the shareholders’ interest. A second one was also filed but both are now being settled. We don’t know the terms, but one of the conditions was that Volcom amend its Schedule 14D-9 to include some more information on the deal. So we have the plaintiffs in those two lawsuits to thank for some of the additional insight.
 
From various documents filed as part of the deal, we know that the first contacts between PPR and Volcom management was on February 8th and 9th, 2010 where “…there were initial discussions about the businesses and histories of Volcom and PPR, as well as ways the companies might work together.” On March 11, PPR told Volcom they were interested in a potential strategic transaction. No purchase price was mentioned. There were ongoing meetings and conversations through April, but around April 28, Volcom told PPR that it intended to pursue its strategic plan “…rather than continue talks with regard to any potential strategic transaction…”
 
There was further contact on July 15 that lead to an informal meeting in Newport Beach, California between PPR CEO Pinault and Volcom CEO Richard Woolcott and President Jason Steris. Nothing happened and there were no further discussions for several months.
 
Meanwhile, on October 22 another company contacted Volcom and said they were interested in acquiring Volcom. Volcom had conversations with that company between October 25 and the end of December, 2010. Bidder A (as this company is called) signed a confidentiality agreement and proceeded with its evaluation of Volcom. On February 1, Bidder A informed Volcom that its review supported a price from the low $20s up to $25.00 a share.
    
It was December 16, 2010 when PPR contacted Volcom again about a potential strategic transaction. A confidentiality agreement was signed on February 1, 2011. Due diligence was undertaken for about two months and on March 4, PPR told Wells Fargo Securities (representing Volcom) that their analysis supported a price of $23.00. On March 17, Wells told PPR that Volcom was talking to other potential buyers as well.
 
PPR formally bid $23.00 a share on April 21. There were some additional meetings. PPR increased its offer to $23.50 on April 29.  The first offer was contingent, among other things, on CEO Wolcott’s “…entry into a new employment arrangement with PPR.” The second offer “…was not conditioned upon Mr. Richard Woolcott’s entry into a new employment agreement.”
 
I have no idea if that change has any significance at all. But the lawyers thought it was important enough to be included in the narrative so I’m just curious.
 
Now it gets interesting. On May 1, Wells contacted PPR’s representatives and told them their bid of $23.50 per share was not the highest. Bidder A had bid $24.00 earlier in the day. They recommended that PPR increase its offer before the Volcom Board of Directors started discussing the offer later that day.
 
Damn! This even gets exciting when you read about it in lawyer speak. It’s what makes doing deals “fun.” Think of the sense of urgency, the impact of different time zones and the fact that there were three companies involved. And three sets of lawyers. And, I assume, three sets of financial advisors. PPR increased its offer to $24.50.
 
In what I’ll call “dialing for dollars” Volcom’s representatives went back to both PPR and Bidder A and asked them to increase their bids. Both declined.
 
“Later in the night (Central European Time) of May 1, 2011…” Volcom’s lawyers told PPR’s lawyers “…that if PPR were willing to modify certain terms of the proposed merger agreement, the Volcom Board of Directors was prepared to approve the merger agreement and sign it immediately.” Those modifications obviously happened and “The Merger Agreement and Share and Voting Agreement were executed by the parties in the morning (Central European Time) of May 2, 2011.”
 
The Schedule 14D-9 lays out this whole process in much more detail on pages 10-22. You might want to take a look at it.
 
In those pages, we also learn something about the motivation for the deal. In the normal course of business successful companies will be approached by various entities about possible strategic transactions. This was true for Volcom from 2007 through 2009. As a public company, they have a fiduciary responsibility to consider if any of these transactions might be in the best interest of their shareholders. It feels from reading the pages above that it was somewhere around the end of 2009 when Volcom decided to look at the possibility of a transaction more seriously.
 
Not that they had to do one- but the world had changed enough (financial crisis, great recession, difficulty in growing) that taking a more serious look made sense. Still, in August 2010, Volcom released some financial projections as part of their five year plan that showed the company growing its earnings per share from $0.91 in 2010 to $3.37 in 2015. If they thought they could accomplish that, why sell at $24.50 a share?
 
I don’t know the answer to that, but I do know that in August of 2010, and prior to that when the projection was being prepared, we were all hoping for an economic recovery that has turned out to be more anemic than expected. People who don’t change their opinions when the facts change probably shouldn’t be running companies. Maybe those projections were part of the negotiations. The documents indicate they were provided to the potential acquirers.
 
As noted in the Schedule 14D-9, Volcom considered the risks of being independent when evaluating the offers to buy the company. “The Board of Directors considered in its assessment, after discussions with the Company’s management and advisors, the risks of remaining an independent company and pursuing the Company’s strategic plan, including the risks relating to:
               • increasing competition in the branded apparel and eyewear industries; and
               •trends in the branded apparel and eyewear industries, including industry consolidation, input costs and pricing trends.”
 
They put it a little more strongly in the revised Schedule 14D-9 where they replaced an existing paragraph with the following as they explained the background and justification for exploring a transaction (emphasis added by me):
 
“…in light of the Company Board’s further review of the recent state of the sports apparel and eyewear industries and the increased competitive challenges for the Company, the Company Board authorized members of Volcom’s executive management team to formally engage Wells Fargo Securities to act as financial advisor to Volcom to explore a potential sale of Volcom and authorized Wells Fargo Securities and members of the Company’s executive management team to continue discussions with Bidder A.”
 
In a fairly short time, then, Volcom management had gone from a very positive August 2010 projection to thinking they should sell the company for a price that would be way too low if they still thought they could make those projections while staying independent. Good for them. I can’t resist pointing out that I’ve highlighted the same issues Volcom identified in my analysis of their public filings, so I can’t really do anything but congratulate them on their insightfulness.
 
For those of you who might want to sell a company someday, I’d note again that Volcom negotiated from a position of strength when they did not have to do a deal. Look how long it took, and of course it’s not closed yet. Even when you’re not a public company, doing it well takes a long time and is a lot of work.    

 

 

Orange 21’s (Spy Optic) March 31 Quarterly Results; Additional Financing Required.

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Really, not that much has changed at Orange 21 since I wrote about their annual report and management restructuring back in April. But its quarterly 10Q “…anticipates that it will need additional capital during the second quarter of 2011 and in subsequent periods to support its planned operations in 2011, and intends to raise cash through a combination of debt and/or equity financing from existing investors.” The discussions with the shareholders had already started at the date of the filing.

With revenues for the quarter of $6.7 million (down from $8.3 million in the same quarter last year) Orange is pretty small for a public company. Frankly, I have no idea why it went public. Probably, when times were better, there was a plan to use it as a base to build a larger company through acquisitions. But it’s to our benefit that it went public because they are required to tell us what’s going on.

Sales for the quarter were below expectations, falling 9% even ignoring the $900,000 decline that resulted from the sale of its factory in Italy (LEM). Gross profit fell, but gross margin rose from 45% to 51%. However, most of that increase resulted from the sale of LEM and the elimination of the lower margin product it produced for third parties.
 
Sales and marketing expenses were up 40% to $2.8million. Around half of the increase was due to the new licensed brands. General and administrative expenses, in contrast, fell by 15% due mostly to the elimination of costs associated with LEM.  There was a net loss of $1.57 million compared with a loss of $937,000 in the same quarter last year.    
 
As you may recall, Orange was a smaller, solid brand that got into some trouble due to a bit of management chaos, and the general economic and competitive environment. I’ve told the complete saga on my web site in various articles as well as the public filings allow me to. More recently, to make a long story short, they decided (correctly I think) that the Spy brand by itself didn’t have enough critical mass to support the expense structure it needed and they didn’t see it getting that mass quickly enough. So they diversified  by making deals to make and market sunglasses for O’Neil, Jimmy Buffet’s Margaritaville brand, and Mary J. Blige.
 
Those deals came with various financial requirements, including minimum royalty payments, research and development expense, marketing costs, and the need to build inventory prior to the launch. As enumerated in other articles, it was a bunch of money. The major shareholder, whose company owns nearly 50% of the stock, has already contributed $7 million to Orange and apparently, along with other shareholders, he’s being asked to put in more.
 
Three things have happened that explain the need for more capital. The first one I’m certain of; the economic recovery just hasn’t gotten the traction we all hoped it would.   The second I don’t know for certain but strongly suspect; sales of the licensed brands haven’t been as strong as was hoped. Finally, the deal to sell LEM included certain minimum purchases from LEM for 2011 and 2012. As of March 31st, the minimum purchase amount for 2011 was almost $5 million at the current exchange rate. For 2012, it’s about $2.5 million. It would be interesting to know what kinds of gross margins those purchases will generate. Certainly part of the reason you get rid of an Italian factory is that the product is expensive- especially when the Euro is fairly strong. We’ll see how long that lasts.
 
The really interesting thing to focus on in the story of Orange 21 is the dynamics of entrepreneurial companies that get into some trouble. That where the learning is for us and it seems to be more or less the same in every turnaround I’ve ever worked with or heard about.
 
It all begins, as I’ve said before, with denial and perseverance in a period of change. It starts with some unrealistic expectations (entrepreneurs are, by definition, optimists). There are frequently some clashes of egos and often an entrepreneur can’t get out of their own way as the business grows and changes. The environment that’s created can be highly charged. Employees can be intimidated and pointing out issues or suggesting that some plans are too aggressive can be viewed as negative.
 
With a bias towards believing that the sky’s the limit and a conviction they can solve any problem, it’s hard to ever get to the point where you don’t see it working out and consider cutting your loses. Suddenly, you find yourself “all in” with no obvious options but to march forward.
 
I don’t know that this describes the evolution at Orange 21. Certain events, such as the purchase of the factory, and the dispute with former CEO Mark Simo might fit the pattern but it’s hard to know. Whatever the internal dynamics, the company finds itself with a weak balance sheet supported by their major shareholder and with additional cash requirements. There’s now a new management team and we’ll have to give them some time to work. But lacking a stronger economic recovery or a takeoff in sales of the licensed brands, one wonders what the next step is.

 

 

Skullcandy’s Latest Filing for its IPO

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On June 1st, Skullcandy filed a third amendment to the registration statement for its initial public offering. Once again, I haven’t compared the documents word for word to spot every change. The addition I want to bring to your attention is the inclusion of financial statements for the quarter ended March 31, 2011. Here are the summary financial statements for the quarter directly from the filing.

 

       

Three Months Ended March 31
         ( in millions of dollars)
         

2010

2011

Net Sales
        

$21,658

$36,018

Cost of Goods Sold
      

$10,660

$17,703

Gross Profit
      

$10,998

$18,315

Selling, General and Admin. Expense
  

$7,572

$14,399

Income from Operations
    

$3,426

$3,916

Other (Income) Expense
    

$1,526

($13)

Interest Expense
      

$2,189

$1,998

Pretax Income
      

($289)

$1,913

Income Taxes
      

$512

$852

Net Income
      

($801)

$1,079

 
 

 

 

 

 

 
 
You can see the improvement from last year’s first quarter to this year’s yourself. Sales were up 66 percent. The gross profit margin stayed constant at 50.8% and instead of a loss of eight hundred thousand dollars they made a bit over a million bucks. Domestic sales rose $9.5 million, or 50.3%. They represented 78.9% of first quarter sales. $4 million of the increase was due to “…net sales to large national retailers, including Best Buy and Target…”  It’s worth noting that during the quarter, three customers accounted for 37% of sales (two were 14% each and one was 9%) and 51% of receivables. I assume Target and Best Buy are two of them.
 
They provide two March 31 balance sheets. The first is the actual one and the second a proforma balance sheet that assumes that certain convertible debt and preferred stock is converted into common stock as if the public offering had occurred on March 31st.
 
The actual balance sheet shows negative stockholders’ equity of $20.2 million. The pro forma balance sheet has a positive equity of $8.9 million due to those conversions. But this pro forma balance sheet does not include the capital that would be raised by the offering. Skullcandy really needs that capital to solidify its balance sheet and pursue its growth strategy.
 
I wrote about Skullcandy when they first filed for their IPO, which they filed the first amendment, and the second. My thoughts really haven’t changed. Let’s hope that in a couple of more weeks, we see their team on CNBC ringing the opening bell on their first day of trading.    
 

 

 

Sanuk Gets Bought, Who’s Deckers Anyway, Analysis of the Deal, Broader Industry Implications, and Related Ramblings

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Three times sales?!?! They sold a $43 million company for $120 million cash plus an earn out?!?! Not in the middle of snowboard industry lunacy in the mid 90s did a company go for three times sales. Okay, there are three possibilities. First, the team at Sanuk (here’s the website link) is a bunch of silver tongued negotiating devils. Second, the management team at Deckers went drinking with the management team at Sanuk and the Sanuk team won. I suppose that’s just a variation of the first one.

The real second possibility, then, is that the guys at Deckers are desperate to be cool and didn’t know what they are doing. As you’ll see below where I describe Deckers, that’s unlikely. Decker’s history makes that clear.

The third possibility is that Sanuk’s margins justify this kind of purchase price. As much as I would like it to be one of the other two (because that would make a much better story) I’m think that’s probably it; Sanuk’s margins are through the roof.
 
Let’s look at the buyer, the seller, and the deal in a little more detail and see why I think that and what we can learn.
 
Deckers is a billion dollars company (2010 revenues) founded in 1975. In 2010 it earned $160 million. In 2006, revenues were $304 million and net income $30 million and yes, I wish I’d bought the stock back then. It owns the Ugg, Teva, Simple, TSUBO, Ahnu and Mozo brands. In 2010, Ugg was $875 million of its revenue and Teva $100 million. Obviously, the other brands are pretty small. Probably smaller than Sanuk.
 
25% of their business is international, and that’s where they see the most growth potential. They have 27 stores worldwide, and can see that growing to 150 in five years.   Here’s how they describe their business:
 
“We strive to be a premier lifestyle marketer that builds niche brands into global market leaders by designing and marketing innovative, functional and fashion-oriented footwear developed for both high performance outdoor activities and everyday casual lifestyle use. We believe that our footwear is distinctive and appeals broadly to men, women and children. We sell our products, including accessories such as handbags and outerwear, through quality domestic and international retailers, international distributors, and directly to end-user consumers, both domestically and internationally, through our websites, call centers, retail concept stores and retail outlet stores. Our primary objective is to build our footwear lines into global lifestyle brands with market leadership positions. We seek to differentiate our brands and products by offering diverse lines that emphasize authenticity, functionality, quality and comfort and products tailored to a variety of activities, seasons and demographic groups.”
 
You can see why Deckers would be interested in Sanuk and why Sanuk might feel it was a good match.
 
Deckers is another billion dollar company with solid brands that plans to expand internationally and into retail and wants a solid entrée into the action sports/youth culture market. Well, there’s a new strategy none of us have ever heard of.
 
Sanuk is a strong, some would say unique, brand that, to use the old cliché, got a deal they couldn’t refuse. Let’s look at that deal as best we can and see why they got it.
 
What do we know?  Not much, but why let that stop me from a little financial fantasizing.  Purchase price of $120 million cash plus a five year earn out. 2010 Sanuk sales of $43 million. Deckers says the deal will add to their earnings this year. Even at that price.
 
I picked myself up off the floor after I initially saw the price and called somebody who’s familiar with our industry and has been both a strategic and a financial buyer of companies like Sanuk. Strategic buyers pay more and Deckers is definitely a strategic buyer in the case of Sanuk. What she told me is that the price discussion might start somewhere around eight to ten times EBITDA (earnings before interest, taxes, depreciation, and amortization) for this kind of deal.
 
I don’t know how to value the earn out, so let’s just work with the $120 million purchase price and assume they paid nine times EBITDA. That means that Sanuk’s EBITDA was $13.3 million.
 
I’m not going to try and get specific because, let’s face it, I’m creating this analysis with very limited information. But I’m guessing Sanuk’s depreciation and amortization is pretty low because they haven’t bought any companies and I don’t think they own a factory. With the margins Decker’s purchase price implies, they may not have had to pay much interest expense either. The biggest number below EBITDA, then, would be taxes. Pick a tax rate and remember this is California. Whatever reasonable rate you pick, you’ll see there’s a bunch of money going to the bottom line.
 
Let’s wander back to the upper part of their income statement. What do you think Sanuk spends for selling, general, and administrative expenses? I have no idea. What if we assume $10 million? That would be 23% of 2010 sales. Amortization and depreciation would be included in that. That would suggest that Sanuk’s gross margin is north of 60%. How much? You decide.
 
While we’ve been talking about 2010 numbers, it’s almost June of 2011. I’m guessing sales might be up for Sanuk this year, and that was certainly part of the discussion. Buyers don’t like to pay sellers for what might happen in the future. Hence the earn out. But significant growth in 2011 would help explain why the deal would add to Decker’s earnings this year.
 
Let’s talk strategically about some of the deals we’re seeing. The Wall Street Journal’s online Market Watch (catchy name) reported PPR CEO Pinault as saying, during his discussion of the Volcom acquisition, that “PPR didn’t make an offer for Volcom’s larger rival Quiksilver Inc. because Quiksilver has ‘reached a level of maturity.’” I agree with him and have raised the issue myself of where Quik’s growth could come from.
 
There’s kind of a perfect storm forming. Sellers remember that during the financial crisis and associated recession there were just no buyers out there unless you wanted to give your company away. They are also sitting there and wondering just how strong the economic recovery is and will be in the future. And they recognize that as the action sports business evolves into the youth culture business or maybe just the fashion business that they need some help breaking through in a number of areas that a large parent can provide.
 
Buyers need to reach the demographic our industry represents. Not just by age, but by culture and attitude. There’s some evidence that growing that kind of business internally is hard. Nike finally got it right, but it took them a lot of tries and a long time.
 
If you need to be in this market, and you can’t build it internally, it looks like you have to buy somebody. Should you buy somebody big? Well, there aren’t very many big ones and those that are big may have reached “a level of maturity” that makes them less attractive. Besides the intangibles you want to acquire aren’t necessarily related to the size of the acquired company. Is Volcom seven and a half times cooler than Sanuk just because it’s that many times bigger by revenue? Nah.
 
You are also making this acquisition because, as a strategic buyer, you believe that through your sourcing, back office, financing and existing distribution you can help the acquired company grow and be more efficient. A larger acquisition may not need that kind of help and the synergies you’re expecting may not exist. If there are no synergies, you probably can’t afford to be a strategic buyer and the price you’re willing to pay has to go way down.
 
You can see why more deals like this are happening in our industry. The economy is at kind of an inflection point where they make sense and market dynamics make them attractive to buyers and sellers.

 

 

Zumiez’s Quarter: Good Result, Same Concerns Everybody Else Has

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Zumiez filed its 10Q yesterday for the quarter ended April 30. It was a pretty good quarter compared to the same quarter the previous year. Sales were up almost 19% to $106 million on a comparable store sales increase of 12.6%. The number of comparable store transactions increased but dollars per transaction fell. They also opened a net of nine new stores during the quarter, including their first two in Canada. They have opened a total of 30 since the first quarter of 2010.

Private label represented 18% of revenues for fiscal 2010. They don’t provide that information by quarter. Shoes are 23% of sales. They indicated that they carry around 400 brands in total at some time during the year, and that 200 of those are “brands of size.” Don’t know how big you have to be to be one of the 200.

 Ecommerce sales represented 6.2% of those sales, or $6.56 million. For the same quarter last year, they were 3.1% of sales or $2.76 million. That’s an increase of about 151%.
 
The gross profit margin increased from 28.6% to 31.6%. About half that increase is the result of not having the costs of relocating their distribution center that they had last year. Most of the rest is from spreading their costs over that 12.6% comparable store sales increase.
 
Selling, general and administrative expenses rose from $28.8 million to $30.9 million, but fell as a percentage of sales from 32.3% to 29.2%. The decline was due to sales growing faster than those expenses, which they should. Net income went from a loss of $1.9 million in last year’s quarter to a profit of $1.88 million.
 
The balance is strong, with cash up, equity increased, and no long term debt. Inventory was more or less flat compared to a year ago. Nice to see that on rising sales. They expect to grow their inventory more slowly than sales for the rest of the year.
 
Zumiez’s biggest concerns are the two that all companies in our industry have. Those would be, first, “…fluctuations and volatility in the price of cotton, foreign labor costs and other raw materials used in the production of our merchandise.” They see a 10% to 15% increase in the price of the cotton based products in their business in the second half of this year. They point out that about half their products are not heavily cotton based.
 
The second are general economic conditions and consumer receptiveness to higher prices that may result as they selectively pass through higher costs. “Yes we have some confidence but how our competitors react and how the consumer is feeling will ultimately dictate on whether our price increases will be received at the consumer level.”
 
Some of those price increases have already started. “We’ve taken areas that we felt like we had high confidence that we could raise prices and we did raise prices and we’ve really not seen any velocity slowdown. I will say it’s not broad-based price increases and they’re strategic and they’re areas that, again, we felt had a higher level of confidence we would have success and we did have success.”
 
They highlighted in the conference call that their inventories were “…some of the cleanest we’ve had in a long time…” and note that they had “…more full priced selling this year versus last year.”
 
They also credit fresh product and unique brands for their success, but I kind of want to highlight the inventory thing. I think clean inventories are a way to sell at a better margin with lower investment and expense. Even if you give up a few sales, you end up better off at the bottom line. So thanks, Zumiez, for making my speech for me.
 
There’s enough market volatility and uncertainty looking forward that Zumiez isn’t offering any sales or earnings guidance beyond the current quarter. That says a lot about what things are like out there.
 
Well, we’re all going to wait and see what the world economy brings us. Zumiez, while it waits with the rest of us, will just continue to apply the business model they’ve developed over many years. It’s not just that they evolved a model which has been validated by events, but that they’ve been consistent in applying it that has them so well positioned.

 

 

Skullcandy Files Another Amendment to Its S1

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Skull filed another amendment to its S1 on May 11. You can see it here.  I confess that I have not compared both documents side by side and word for word to discover differences. I can tell you that the newly amended S1 has pretty pictures in it at both the beginning and the end which will be part of the prospectus.

I spot checked the numbers and did not notice any changes. That doesn’t mean there aren’t any. A smart guy named Fred made some interesting comments when I posted my article on the first amendment. You can see those comments below the article. He suggested we’d probably see another amendment showing strong first quarter numbers, but those numbers are not included in this filing.  I imagine we will see them before this deal is done.

Here are Skull’s net sales and net income numbers for the last five years ended December 31 of each year (in thousands of dollars).
 
 

2006

2007

2008

2009

2010

Net Sales

9,105

35,346

80,380

118,312

160,583

Net Income (Loss)

632

6,258

13,019

3,547

(9,723)
 
Next, here are the “adjusted EBITDA” for the same five years. EBITDA is earnings before interest, taxes, depreciation and amortization but in this case it’s not that because it’s “adjusted” as described below.
 
 

2006

2007

2008

2009

2010

Adjusted EBITDA

966

9,864

21,359

30,838

38,964
 
Obviously, the adjusted EBITDA trend looks better than the net income trend. Here’s what management says about the adjusted EBITDA numbers. Sorry for the long quote, but I’d prefer you hear it directly from them rather than get my interpretation. Please do take the time to read it. I recommend slowly.
 
"EBITDA, for the periods presented, represents net income (loss) before interest expense, income taxes and depreciation and amortization. Adjusted EBITDA gives further effect to the recording of compensation expense associated with one-time charges of $17.5 million in management incentive bonuses and $2.9 million payable as additional consideration to certain employee stockholders pursuant to the securities purchase and redemption agreement, and to the recording of additional other expense of $14.6 million, which represents the fair value of amounts payable as additional consideration to non-employee stockholders pursuant to the securities purchase and redemption agreement. For a more detailed description of this transaction, see “Certain Relationships and Related Party Transactions—Series C Convertible Preferred Stock Financing and Stock Redemption—Securities Purchase and Redemption Agreement.” These expenses were one-time charges associated with a historical capital transaction and management believes they do not correlate to the underlying performance of our business. As a result, we believe that adjusted EBITDA provides important additional information for measuring our performance, provides consistency and comparability with our past financial performance, facilitates period to period comparisons of our operations, and facilitates comparisons with other peer companies, many of which use similar non-GAAP financial measures to supplement their GAAP results. Our management team uses this metric to evaluate our business and we believe it is a measure used frequently by securities analysts and investors. Adjusted EBITDA does not represent, and should not be used as a substitute for income from operations or net income (loss) as determined in accordance with GAAP. Our definitions of EBITDA and adjusted EBITDA may differ from that of other companies."
 
There- that’s clear enough, right? And if you understand it, but note and agree with their admonition that adjusted EBITDA “…should not be used as a substitute for income from operations or net income (loss) as determined in accordance with GAAP,” what do you decide as a potential buyer of the stock?
 
That’s the tactical issue for the people trying to sell this stock. They have to explain. Regardless of the quality of the business model, GAAP accounting shows declining profit leading to a loss on higher sales over three years.
 
Tell the truth- some of your eyes glazed over when I asked you to read the explanation above. Hell, my eyes glaze over sometimes when I have to read this stuff. If you were selling this stock, which would you rather say? “Here’s a fast growing company with a great business model that’s increasing its profitability with its sales,” or “Here’s a fast growing company with a great business model that lost $10 million last year but don’t worry, I’ve got an explanation you might understand if your eyes don’t glaze over.”
 
You’d like to have investors focusing on the viability of the business strategy and the company’s financial position after the offering. When I first wrote about Skull’s public offering on February 4th, I summarized their strategy this way. “I think the key to being able to continue their growth while keeping their profitability up is as simple, and as difficult, as keeping SC cool in Best Buy and other places as their distribution grows.”
 
I still think that puts it pretty well.

 

 

Volcom’s March 31 Quarter and Some Related Thoughts on the PPR Deal

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We’re probably down to the last one or two quarterly filings we’re going to see from Volcom as all filings will cease when the PPR acquisition of Volcom closes. There was no conference call this quarter because of the impending deal, so all I’ve got to work with is the 10Q.

Total revenue was up 12.6% compared to the same quarter last year from $77.4 million to $87.1 million. Keep in mind that they completed the acquisition of their Australian licensee last August. This is responsible for $5.16 million of the total product revenue increase of $10 million for the quarter. Gross margin on product fell from 4.1% from 53.9% to 49.8%. “This decrease,” they say, “is primarily due to more in season discounted product sales and lower margins achieved on off-price sales during the three months ended March 31, 2011 compared to the three months ended March 31, 2010.”

Revenue for the quarter rose in each of Volcom’s four segments; United State, Europe, Electric and Australia. Operating income, however, fell in all four. In the U.S., it was down from $2.74 million to $897,000. In Europe the decline was from $8 million to $6 million. Electric’s operating income fell from $266,000 to0 $119,000. Australia showed an operating loss of $26,000.
 
Selling, general and administrative expenses rose from $31 million to $36.6 million. $2.2 million of the dollar increase was the result of the acquisition of the Australian licensee. Payroll accounted for another $900,000, advertising and marketing for $800,000 and increased bad debt expense $700,000. As a percentage of revenues, it rose from 40% to 42%.
 
The result of the lower gross margin and higher operating expenses is a net income that fell from $7.5 million to $4.6 million.
The balance sheet is still strong. It will shortly become irrelevant with the closing of the acquisition, but I would note that accounts receivable rose 22.6% to $73.2 million. I assume that part of that is due to receivables acquired when they bought their Australian licensee, but I don’t know how much.
 
In an interesting but probably ultimately unimportant development, a class action lawsuit was filed on May 4 (two days after the PPR deal was announced) claiming Volcom’s directors breached their fiduciary responsibility.  “The complaint alleges that the Offer and Merger involves an unfair price, an inadequate sales process, and that defendants agreed to the transactions to benefit themselves personally.”
 
Volcom says the case lacks merit, and I imagine they are right. The lawsuit’s contention, or at least one of them, is that Volcom only talked to PPR and if they had shopped the company more widely, they should have gotten more money. Maybe, but I still think the deal
was fully priced.
 
Over the last year, and maybe more, we’ve noticed that Volcom has had some issues with too much inventory and has had to discount to move it. We see the receivables increase and the allowance for bad debt that’s more than 10% of receivables. We note their comments (like other companies) about issues with rising costs and deliveries.
 
I’ve written about what a great job Volcom has done in defining and owning their market space, but how it can be hard for a company to grow out of a market position it is so closely identified with. Related to that I’ve noted some of the apparent challenges the brand has had in the department stores.
 
Volcom’s management didn’t need to sell the company. But if I and others have noticed some of these issues, you know Volcom’s spent a whole lot of time figuring out how to manage them. Apparently, the conversation with PPR took place over a year. With its balance sheet strong, and the brand’s integrity intact, I suspect Volcom looked at the strategic issues I’ve highlighted above and decided it was a good time to negotiate from a position of strength. That’s how you’re supposed to handle the market issues that lead to consolidation.
 
Obviously, PPR will help Volcom manage any cost, manufacturing and delivery issues it has. More importantly to Volcom’s shareholders, though, is that the company found a strategic buyer willing to pay a premium over what a strict financial analysis might suggest the company is worth.
 
PPR’s brands may be sophisticated, but they aren’t cool. Volcom is cool and, PPR is assuming, will help them break into a customer group they don’t really understand and haven’t been able to crack. I think they’re right, as long as they don’t “help” Volcom so much that they try to make it into something it ain’t.

 

 

Skullcandy’s IPO; What’s New?

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I guess it was around the time of the SIA show in Denver that Skullcandy announced they were going to do an initial public offering. They came out with the draft of the prospectus, and I took a pretty detailed look at it.

Typically, the “quiet period” after you file with the SEC lasts 40 to 90 days while they review your prospectus (known as a form S-1). When 90 days passed and I hadn’t heard anything, I got a bit curious. The company isn’t allowed to tell me anything so I went to the Security and Exchange Commission web site and searched for Skullcandy documents. Guess what? I found a revised S-1 dated April 28th.

The original S-1 had an income statement for the nine months ended September 30, 2010 that showed (in millions of dollars):
 
Net Sales                                           $95,940
Cost of Goods Sold                          $46,629
Gross Profit                                        $49,311
Selling, General and
 Admin. Expenses                            $30,206
Operating Income                            $19,105
Other (Income) Expense                $14
Interest Expense                             $6,559
Net Income                                       $7,645
 
The amended S-1 shows the income statement for the whole year ended December 31, 2010 and the picture is a bit different.
 
Net Sales                                            $160,583
Cost of Goods Sold                          $75,078
Gross Profit                                        $85,505
Selling, General and
 Admin. Expenses                             $67,602
Operating Income                             $17,903
Other (Income) Expense                 $14,556
Interest Expense                               $8,387
Net Income (Loss)                           $(9,723)
 
If you look back at the sales numbers for the 2009 complete year, you see that sales in 2010 grew nearly 36%. The gross profit margin was 48.6% in 2009. It was 53.2% in 2010. That’s a good improvement. So how did they turn a nine month profit of $7.6 million into a loss of $9.7 million for the year and $17.3 million for the final quarter of 2010?
 
For the whole 2010 year, compared to 2009, Selling, General and Administrative Expenses rose from $27 million to $67 million. This included, in the fourth quarter, “…one-time charges of $17.5 million in management incentive bonuses and $2.9 million payable as additional consideration to certain employee stockholders pursuant to the securities purchase and redemption agreement.”
The “Other” expense of $14.6 million in the fourth quarter “…consisted primarily of $14.6 million resulting from recording the fair value of amounts payable to non-employee stockholders as additional consideration pursuant to the securities purchase and redemption agreement.”
 
They also disclosed that “Additionally during the quarters ended March 31, June 30, September 30 and December 31, 2010, we recognized other expense of $1.5 million, $2.2 million, $3.7 million and $7.2 million, respectively, which represents the changes in the fair value of amounts payable as additional consideration to non-employee stockholders pursuant to the securities purchase and redemption agreement.”
 
Meanwhile, over on the year-end balance sheet, there’s a stockholders’ equity deficit of $22.7 million, up from $18.8 million a year ago. Next to that is an unaudited pro-forma balance sheet for the same date that “… gives effect to the conversion of all outstanding shares of preferred stock into 321,980 shares of common stock, the conversion of the convertible note into 275,866 shares of common stock, the payment of accrued interest on the convertible note and the reduction of deferred debt issuance and debt discounts related to the convertible note, as if an initial public offering occurred on December 31, 2010.”
 
Doing all this gets their stockholders’ equity up to $6.4 million. Against that, the pro forma balance sheet shows total liabilities of $77 million. That’s a debt to equity ratio of 12 times and that’s high. The current ratio, at 2 to 1 is fine.
 
Here’s how I read this. Skullcandy is counting on the success of its IPO to reduce its leverage and give it the working capital it needs to execute on its plan. Shareholders and executives have taken a bunch of cash out of the company in the fourth quarter, resulting in a big loss. They were entitled to do that under existing agreements, but how does it look to a potential stock purchaser? Those potential investors also see a company whose 2008 net income of $13 million fell to $3.5 million in 2009 even as sales grew 47% to $118 million. Now, on sales of $160 million, there’s a loss of almost $10 million.
 
It can be explained as I did above. But if you have to explain, you have a problem. I’m not quite sure people are in a hurry to invest in companies that lose money, even with a valid explanation. It will be interesting to see if this deal happens and what the pricing is. It may be even more interesting to see what Skullcandy does if it doesn’t happen. 

 

 

PPR Buys Volcom, Probably

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You know, I should have seen this coming and been sitting on 10,000 shares. But no such luck and anyway, I don’t own shares in companies I write about. Still, the deal’s not a complete surprise. Vans, DC, Reef, Sector 9 and Hurley are a partial list of industry companies that have been acquired by larger companies that wanted to get into or expand their action sports offering and grow their credibility with that customer group. Consolidation is not new, and most successful companies in our industry seem to reach a point (usually as they start to grow into the larger fashion market) where they perceive they need some help to continue growing and succeed in that broader market.

Volcom has been showing some symptoms of needing that help. Last time I wrote about them, in March, I said,

“But there comes a time, especially as a public company, when that strong brand positioning with a targeted consumer can make growing more of a challenge as the new customers you need don’t feel a strong connection with the brand and the customer you have may feel alienated if and as you do what you have to do to build a connection with the new one.”
 
“It’s not like this is a surprise to anybody who’s been around our industry for a while. Large or small, public or not, every company deals with this when they grow. I wrote last week about how Quiksilver is pushing its DC brand and my concern that they might push it too hard. Burton, when it changed its name from Burton Snowboards to just Burton, was dealing with this issue.”
 
I noted in the article that Volcom was counting on some broader distribution including the department store channel for growth, but that I wasn’t quite sure a company with the motto “Youth Against Establishment” fit in the department stores.
 
I went on to say, “Volcom says they make premium product that typically sells at premium prices and they’ve got a very distinctive image they’ve worked hard and successfully to build over 20 years. That sounds boutique like to me- not department store. Just saying.”
 
They’ve also had some issues with dependence on PacSun and too much inventory. In 2010 revenues were up 15.2% over the prior year, but net income increased hardly at all, from $21.7 million to $22.3 million. A decline in gross margin from 50.2% to 49.2% explains most of that.
 
During PPR’s conference call announcing the acquisition, one analyst ask why, if Volcom actually believes it can earn $2.20 to $2.40 a share in 2014 it was selling now for this price. The PPR CEO answer was something along the lines of “Uh, oh, well, I guess they think it’s a fair price.” Great question I thought and maybe Volcom’s answer has something to do with the issues I raised.
 
By the way, the reason I put “probably” in the article title is because no deal is done until it’s closed. Also, from time to time an offer from one company will result in a higher offer from another company. The board of directors of a public company has a fiduciary responsibility to do what’s in the best interest of their shareholders. They couldn’t just ignore a better offer they think has an equal chance of closing. Of course, what’s “better” can be open to interpretation. I don’t actually expect there to be another offer. PPR, as we’ll get to next, is an 800 pound gorilla and I consider the deal fully priced.
 
PPR had 2010 revenues of 14.6 billion Euros (2.3 billion of which was sold online). That’s north of $21 billion at the current exchange rate. Western Europe is about 59% of their revenues.  North America is 16%. They have 60,000 employees and their products are distributed in 120 countries. Volcom, at $321 million in revenues in 2010 is a tad smaller, but much, much cooler. It’s around 1.5% of PPR’s revenues. I’d like to tell you all about them, but their web site is in French. I guess I can at least say they are a French company.
 
 Oh- wait- here’s the English version. Their luxury group of brands includes Gucci, Bottega Veneta, Yves Saint Laurent, Balenciaga, Alexander McQueen, Boucheron, Sergio Rossi, and Stella McCartney. I’m pretty sure none of these brands are hanging in my closet even though I’m such a fashion forward guy. The Stella McCartney stuff just doesn’t accentuate my bust.
 
They also own PUMA, FNAC and Redcats. Okay, I know what PUMA does. FNAC is apparently in the process of being sold. In 2010, the luxury group was 27% of sales and PUMA was 18%. PPR has over 800 stores globally. Here’s a link to the English version of their 356 page reference document which I am not reading. It has some easy to absorb graphics you might be interested in. It’s a big file and a bit slow to download.
 
This is PPR’s first adventure into the action sports market. It should be interesting to watch. On an operational level it seems obvious that Volcom should benefit from PPR’s size in terms of systems, manufacturing, access to capital and operations. Those synergies are usually real, but also usually harder to achieve than people expect. I guess Volcom will report through PUMA. It was interesting to hear PPR management say that Volcom was complimentary to PUMA and then note that PUMA was not involved in action sports. Maybe they just meant complimentary in terms of getting Volcom into shoes in a much bigger way, which apparently we can expect.
 
PPR, of course, is particularly well situated to increase Volcom’s presence in Europe, where both Volcom and PPR think they have a lot of room to grow. It sounds like we can expect to see quite a few more Volcom stores worldwide (no numbers given). I wonder if Volcom product would fit into any existing PPR owned stores. Many PPR brands can reasonably be characterized as boutique brands and, as I suggested before, if Volcom’s description of their brand and its positioning is accurate, maybe that’s where they belong. But I have a hard time seeing Volcom in a Gucci store at the moment. Maybe Europe is different.
 
Volcom may be strategically important to PPR, but it’s an awfully small piece of the whole. As I listened to the PPR executives describe Volcom, it felt like they were reading Volcom’s description of itself and its market position right out of Volcom’s 10K. Even though they’ve been talking for a year, I was left unsure if PPR “got it” or not. Over the years, I’ve watched European companies try to break into the U.S. action sports market and just do it wrong. I’ve watched U.S. companies have the same problem going to Europe, if only because we start out thinking of Europe as one market.
 
One European analyst called Volcom a “sports” company and inquired of management if they were thinking of launching a PUMA action sports brand. Happily, PPR made it clear that was a bad idea. There was also a question about whether Volcom and PUMA could be distributed together.
 
PPR talked about “…building the Volcom business globally while maintaining its authenticity” and keeping it positioned as it is today without changing the target customer. Of course that’s what they want to do, or they wouldn’t be buying Volcom. But as I’ve written, it’s also the challenge. Every action sports brand comes up against this. At some level growing and maintaining authenticity becomes as challenge. PPR has, of course, dealt with all forms of distribution and growth issues, but I am not aware that PPR management has experience with this in the youth culture market. Growth, after some point, requires changing, or at least expanding, the target customer.
 
They will be relying on the Volcom team to continue managing the brand. The deal, however, is an all cash one at $24.50 per share (22.6 P/E ratio according to one investment banker) with no earn out component we learned in the conference call. I sure hope Richard Woolcott and his team are happy working with PPR.
 
Given the challenges Volcom faces, they’ve made themselves a good deal at the right time. PPR can certainly make them more efficient operationally, in manufacturing, and financially. They will help Volcom grow especially in Europe, and there will be an expanded retail presence. In the longer term, if PPR and Volcom managements have some patience with each other, we might see Volcom make a transition into the fashion market in a way no other action sports brand has done.
 
Youth Against Establishment indeed.

 

 

Notes from the Skateboard Industry Conference and Hotel Lobby Bowling Event

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IASC and BRA did a great job putting on the annual skateboard industry conference this week at the Doubletree in Orange, CA. The attendance was good, the subjects all worthy of attention, and the beer sponsor much better than last year. Credit also has to go to Steve Van Doren and Vans for providing some food, some goodies, and use of their skate park which, happily, was within walking distance of the hotel.

There was also a floor show Tuesday night at the hotel (technically, it was Wednesday morning).   I’m told it involved some conference participants, four cop cars, and a red bowling ball that was prominently displayed the next day in the conference room. My only real complaint about the conference is that if there’s going to be entertainment, could you try and schedule it before I go to sleep?

Oh- and it would have been nice to have more than five or six retailers at the conference.
 
I wrote last week about distribution in anticipation of running the distribution panel at the show. But we spend north of an hour on distribution in the round tables and the conference was running an hour late, so the actual panel was cancelled by acclimation. As that panel was all that was standing between the participants and food, drink, and skating and it was the last panel of the last day, I won’t be surprised if it was the favorite panel of the whole conference. Thanks to Frank Messman from Blackbox, Timothy Nickloff from Sole Technology and Darin O’Brien from Nike Skate for being ready to participate. Maybe next year.
 
Now, I want to get the slightest bit serious. And probably way, way too direct for some of you. Please don’t shoot the messenger. Or shoot him- but do it in a cogent and thoughtful way from which we all learn something.
 
These are the assumptions on which my argument is based:
 
1.       There is way too much skate hard goods product out there and with the availability of blank skateboards and deck printing machinery, there are essentially no barriers to entry.
 
2.       The “core’ brands continue to pursue much the same business model they have always pursued where pro riders (of which there are also too many) form the basis for differentiating the brand.
 
3.       There’s less margin and margin dollars to go around and not enough to split between distributors and brands if the brands are going to continue to follow the same team based business model. The brands can’t afford to carry out their traditional marketing models at the level they used to.
 
4.       Long boards are taking a certain percentage of the traditional skate market to the extent that skaters who just want to cruise are choosing longs over short. They may be less influenced by the pros.
 
5.       Distributors allow some brands that would otherwise not be in business survive- at least for a while. This creates a cash flow dependence on the distributor.
 
6.       Companies who had confidence that their brand was competitively distinctive in the market and who had the balance sheet to survive the transition might tend not to sell through distributors.
 
7.       If the hard goods market isn’t healthy, the skate shoe and apparel market will suffer.
 
No brand has shared with me their financial statements, and no doubt there are exceptions to what I’ve described above. Each brand is different. But in general this model of doing essentially what’s been done before and hoping things get better can’t continue. How might it change in a positive way?
 
Demographics might start favoring skateboarding again. Angel Ponzi from Board-Trac told us that the drought of new kids of skating age is ending and that we’d see a surge in skate age kids. That’s good news, but it’s obviously a very gradual, multi-year process.
 
Technology may be increasingly accepted. As it was explained to me, pros who want nothing to do with new technology are finally retiring and are being replaced by riders who have grown up with it. This is also not a short term process, but I’d say we’re a couple of years anyway into it and it might start getting some traction. It’s not a panacea. It won’t work for every brand and it’s going to require some retailer rethinking and retraining by the brands. Let’s call it clinicing, like they do in the snowboard industry. That came up at one of the round tables.
 
Most sports (don’t mean to offend anybody by calling skate a sport) have something new every year that, even if it isn’t a major breakthrough, is at least a talking point that allows some differentiation and, hopefully, improves performance. In a lot of industries, it means higher prices and margins due to increased consumer interest and limited availability. It also increases barriers to entry. I heard one suggestion that skate boards were already so refined over many years that it was hard to improve on them. I hope that proves to be wrong.
 
There could also, theoretically, be some mergers among brands. That’s financially efficient because it allows you to spread your overhead, but it doesn’t solve the problems of no barriers to entry and lack of product differentiation. Along those lines, there was awareness at the conference of what Mike West, owner of the 686 brand of snow outerwear was doing. He’s recently announced that he’s going in to the fulfillment business in partnership with a Canadian company he has a long term working relationship with to help small industry brands operate more efficiently. He expects to spread his overhead and make a few bucks.
 
I suspect mergers are unlikely due to the long term personal relationships among brand executives. Oh hell, let’s just say egos. I am not quite certain that the owner of one brand would step aside to let his long term competitor run it, and I suspect that there is inadequate liquidity for buy outs.
 
My personal belief, and I’ve been saying this for some years, is that product differentiation via technology is the answer. Or at least, I don’t know another viable choice.
 
I do know that a small business with no barriers to entry and limited product differentiation and a business model that needs big advertising and promotion expenditures and shares its revenue with distributors over whom it has no control is unlikely to prosper in the current and foreseeable business environment- no matter how healthy skating is as an activity.  I’ve been known to say that not taking a risk is the biggest risk of all.  I think that might be relevant here.