Tilly’s Quarter: The Connection Between Operations and Marketing

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We need to start by recalling that Tilly’s converted from an S to a C corporation on May 2nd, 2012 and went public May 3rd.  That had an impact on its comparative financial statements.  Let’s review the GAAP results than look at that impact. 

Sales grew 20.5% to $105 million from $87.3 million in the pcp (prior calendar period- same quarter last year). They ended the quarter with 155 stores, up from 131 at the end of the pcp. Comparable store sales were up 5.1% compared to 15.2% in the pcp. Ecommerce sales were $9.8 million, or 9.3% of total sales.
 
The gross profit margin was essentially the same, rising one tenth of a percent to 29.6%. However, the merchandise margin fell by 0.3% but was offset by a 0.4% improvement in leveraging their costs over more stores and sales. Selling, general and administrative expense (sg&a) rose from $22.2 million to $34.5 million. As a percentage of sales, they rose from 25.4% to 32.8%.
 
As a result, they went from pretax income of $3.5 million in the pcp to a loss of $3.3 million. Net income fell from $3.5 million to a loss of $1.2 million.
 
Okay, now the IPO impact. There was “a one-time charge of $7.6 million, or 7.3% of net sales, to recognize life-to-date compensation expense for stock options that was triggered by the consummation of our IPO during the quarter.” That was charged to sg&a and without it, those expenses as a percent of sales rose only 0.1%.
 
The income tax result included a one-time $1 million net tax benefit that resulted from converting from an S to a C corporation as part of going public.
 
Tilly’s says that if you adjust their income statement for the stuff related to going public, their proforma net income for the quarter would have been $2.6 million instead of the GAAP loss of $1.2 million. That’s still down from the $3.5 million profit they reported in the pcp. However, they also provide a proforma income statement for the pcp, and say that profit would have been $1.7 million compared to the $3.5 million they reported.
 
The balance sheet is fine. Changes reflects the IPO, the growth of sales, and the opening of new stores.
 
Okay, those are the numbers. On to the fun stuff. As you know, “Tilly’s operates a chain of specialty retail stores featuring casual clothing, footwear and accessories for teens and young adults.”
 
 According to President and CEO Daniel Griesemer, They “…plan to capitalize on the significant opportunities we see to expand the Tilly’s action sports-inspired lifestyle brand, through the following four growth drivers. By expanding our store base, by driving comparable store sales increases, by growing our e-commerce business, and by increasing our operating margins.”
 
Fair enough I guess. That’s pretty much what every retailer wants to do. Ah, here’s a little more useful information. He goes on to say, “By flowing in merchandise to our stores five days a week, we continue to offer our customers new, on-trend and relative merchandise across a broad assortment of brands and categories. This also allows us to quickly identify and satisfy emerging fashion trends. We drove traffic to our stores by staying connected to our young dynamic multitasking customer as we engaged them through our catalogs, e-mails, in-store events and contests, social media and grassroots community programs, and traditional media.”
 
Here’s another quote from him: “One of the things that we have been good at for a long time is inventory discipline, keeping our inventory current and fresh and full of the most relevant product that our customer wants. Our dynamic business model is built around flowing newness into our stores almost on a daily basis, and addressing the opportunities that we have by reordering and getting back into and expanding key trending fashion trends and categories.”
 
Here’s one more, then I’ll stop. “Constantly flowing in newness and testing new brands, and so I am pleased that you saw it and we’re continuing to go forward with it.”
 
If you’ve been reading many of my articles over the last year or so, you’ll recognize some familiar themes here. Good inventory management that permits a focus on gross margin dollars rather than sales growth. The criticality of operating well. Connecting with your customers the way they want to connect with you. The importance of new brands. Identifying and being on trend. The blurring of the lines between brands and retailers and the additional pressures retailers will put on brands.
 
I doubt doing any of this was ever a bad idea; it just wasn’t so necessary. Note the imperative of a close connection between operations and marketing. Tilly’s talked about its promotions being executed as planned. That is, they weren’t done in response to what competitors were doing or because they had to dump some inventory that hadn’t sold. You won’t be able to take that approach if you’re logistics and inventory management aren’t right.
  
As usual, good strategic and operating ideas will, eventually, be adopted by most management teams- at least at companies that expect to prosper. When that happens, they cease to be a source of advantage. That seems to be what’s going on in our industry. It’s not that Tilly’s is doing anything wrong. Their history is one of success. But, as I’ve been pointing out, many companies are doing the same things. What was innovative begins to become standard practice.
 
I think we’re early in what I’d construe as a massive change in the consumer market and the retail/brand relationship. But if everybody is catching on, it’s time to give some consideration to what will happen next.

 

 

Zumiez Releases More Information on Blue Tomato

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Life is so not fair. Here I am on vacation, vowing to just get the Zumiez analysis done. I do that, I send it out and now I can relax, right? Nah. Literally 20 minutes later, along comes an 8K/A from Zumiez filed with the SEC giving us the Blue Tomato financial statements.

Let’s try and keep this short. First, here’s the link to my article on Zumiez’s quarter. I noted in that article:

“The Blue Tomato acquisition closed on July 4th. They paid $74.8 million for it (59.5 million Euros actually). Blue Tomato has 5 retail stores in Austria and a big online business. Lord knows Zumiez didn’t pay that price for 5 stores so it’s clearly a really big online business. There are also potential additional payouts totaling $27.2 million at the current exchange rate, part of which is in Zumiez stock, through April 2015.”
 
The presentation of financial statements in Austria is different from the U.S., but my review of the notes suggests that accounting standards are similar. There’s actually a footnote describing the differences and for our purposes, they aren’t that different.
 
The April 30 balance sheet (numbers in Euros) for Blue Tomato shows current assets of 13.85 million. That includes merchandise inventory of 3.9 million and cash of 5.2 million. There are also trade receivables of almost 1 million which I wouldn’t necessary expect from a retailer, but things work differently in Europe. Maybe it’s just money due from the credit card companies.
 
Fixed assets are 2.6 million. I assume that’s the net value after depreciation. There is only 355,000 in intangible assets. Liabilities are 2.85 million, of which 1.85 million is bank loans and overdrafts. Equity is 9.26 million. The balance sheet then, is very solid.
 
The income statement is for the 2011/12 fiscal year, but it doesn’t say on the income statement what month that year ends. I’m guessing it’s April 30 since that’s the balance sheet date. Revenue from merchandise sale was 29.5 million. Expenses for materials and other purchased services were 16.78 million, giving a gross profit of 12.69 million, or 43%.
 
However, this is a retailer. Remember that in the U.S. a retailer would typically include in cost of goods sold certain salaries and occupancy costs. Blue Tomato doesn’t present its numbers that way. That’s neither right nor wrong- just different.
 
Total personnel expenses, we see next, were 3.4 million of which 20.5% was for payroll taxes and contributions. Blue Tomato had 137 employees. They report operating income of 4.7 million, but that includes “other expenses” of 4.05 million. That’s kind of a big number to not identify. I’ll check the footnotes. Nope, no note explaining that.
 
Blue Tomato’s net income for the year is 3.49 million, or 11.8% of revenue.
 
Zumiez goes on to provide us with some more information in the form of unaudited, proforma income statements for the year ended January 28, 2012 as if the Blue Tomato acquisition had occurred on January 30, 2011. As Zumiez points out, all we’re doing here is adjusting some numbers and applying U.S. generally accepted accounting principles, and there’s no reason to think this actually represents how the year would have gone. Still, it’s instructive.
 
The bottom line is that Zumiez reported a net income of $37.4 million in the year ending January 28, 2012. If you add Blue Tomato in and adjust its accounting to U.S. standards, the net income of the consolidated entity is $30.92 million, a decline of 17.3%. Since Blue Tomato made money, how come?
 
First, as I discussed in my original article, there’s a write up of inventory value of $2.2 million that increases the cost of goods sold. But the bigger number is the increase in selling, general and administrative expenses of $11.25 million. That includes $2.3 million of additional amortization expense for the acquired intangible assets, $200,000 of additional depreciation expense, and $8.7 million of future incentive payments to the owners of Blue Tomato.
 
There’s also a tax benefit of $2.3 million.
 
I guess everybody is trying to figure out if Zumiez got a good deal, or paid too much or what. It’s very much a strategic purchase which means we won’t really know for a while. Let’s put it this way; with the limited information I have, I’d say they paid a lot, but purchased a high quality business. If it continues to grow, and offers Zumiez international expansion opportunities, it will have been a good deal.

 

 

Zumiez’s July 28th Quarter; Forget the Numbers. I Might Have Had a Strategic Epiphany

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Okay, I don’t mean it. No way I can ignore the financial results. It’s just not the way my mind works. But I was so struck with something President and CEO Rich Brooks said in their conference call that I wanted to start there. He said, as a brief part of a longer answer to an analyst’s question, “…we are an action sports lifestyle retailer.”

Well big deal, right? We all knew that. But for some reason, I paused, thought, and on the margin wrote, “Yeah, but is anybody else?”

That opened a mental floodgate. Well, obviously some independent, specialty retailers still are. And I guess some smaller brands (especially in hard goods) are all about action sports. But I perceive that most of our not small brands and multi-outlet retailers are more focused on youth culture than on action sports, though action sports is certainly an important part of that focus. Many of these brands and retailers would say they have their roots in action sports, or have a focus there, or however they put it, and they do. But more and more, with growth, their customers are increasingly removed from the action sports market.
 
The conventional wisdom, which I’ve supported, is that this is inevitable with growth, and is especially inevitable with public companies that have to seek regular growth. They use their roots in action sport to make their brand or stores or both attractive to the broader youth culture or fashion customer that they have to have to get the sales growth. Their target has to be the broader market. Being only an action sports brand or retailer probably restricts growth. 
 
Zumiez, on the other hand, starts with the action sports participant or close follower as their target, focuses there, and invites the broader customer base in if they’re interested. That doesn’t change as they grow. As they describe it, everything they do in their stores from the people they hire, to the way they merchandise, to the brands they sell are action sports based.
 
I suppose I’m oversimplifying this distinction to make a point- which I will eventually get to. Certainly some brands can argue that they are just as action sports focused as Zumiez. Yet as they work to grow their customer base past action sports, that argument gets harder to make.
 
To the extent this distinction is accurate, other brands and retailers are essentially building Zumiez’s market niche and competitive advantage for them. That’s why “…we are an action sports lifestyle retailer,” struck me. Zumiez’s competitors are doing its work for it. That’s my point.
 
Maybe I’m the only one surprised here. Zumiez’s management will tell you they’ve been pursuing this same market positioning since the company’s founding in 1978. And of course my analysis only becomes valid (if you think it is- can’t wait to hear) after the action sports market got much more inclusive, more broadly distributed, and of interest to really big players in the branded consumer products market. So to that extent, I guess Zumiez got a bit lucky.
 
Zumiez stuck to its strategy even as the market changed. Other brands and retailers chose to expand their focus with that market evolution. I’m not suggesting one is right and the other wrong, but it seems to have worked for Zumiez so far.
 
And, now those boring numbers. Probably shouldn’t say that. This will be where people stop reading.
 
Sales for the quarter ended July 28th were $135 million, up 20.4% from $112 million in the pcp (prior calendar period- same quarter last year). They ended the quarter with 457 stores in the U.S., 17 in Canada and five in Europe. Ecommerce sales were 6.9% of net sales compared to 5.3% in the pcp. Comparable store sales rose 9.5%. They ended the quarter with 50 more stores than a year ago.
 
The Blue Tomato acquisition closed on July 4th. They paid $74.8 million for it (59.5 million Euros actually). Blue Tomato has 5 retail stores in Austria and a big online business. Lord knows Zumiez didn’t pay that price for 5 stores so it’s clearly a really big online business. There are also potential additional payouts totaling $27.2 million at the current exchange rate, part of which is in Zumiez stock, through April 2015.
 
Acquisitions complicate financial statements a bit. Let me walk you through the impact. First, Blue Tomato contributed $1.5 million in net sales and a net loss of $600,000 during the quarter. There were $1.5 million in transaction expenses (stuff like legal fees) they booked as part of selling, general and administrative expense (sg&a) during the quarter. They also booked there $700,000 for the first anticipated incentive payment.
 
The inventory they acquired had to be written up $2.2 million and is being expensed to cost of goods sold over 5 months. That’s the period over which they expect to sell the inventory. Half a million of that was booked in the quarter and I guess most of the rest will be in the next.
 
There was also a $500,000 net foreign currency gain in the quarter, mostly from the Blue Tomato deal, that was part of other income.
 
We’re not quite done with Blue Tomato, but let me tell you that Zumiez had net income of $2.07 million in the quarter, down 19.5% from $2.59 million in the pcp. Zumiez shows some pro forma financial information “…as though the acquisition of Blue Tomato had occurred on January 30, 2011.” You can review Zumiez’s 10Q here if you’re interested in all the adjustments they made (see page 11). I’m sure you’re all rushing to see that.
 
What they report is that, on a proforma basis with Blue Tomato included, they would have had a profit of $930,000 this quarter and a loss of $1.07 million in the pcp.
 
And while we’re on one time event kind of stuff, you will recall that Zumiez move their home office and ecommerce fulfillment center. That cost them $1.3 million in the quarter.
 
The gross profit margin grew 1.4% from 33% to 34.4% in the pcp. Most of that came from product margin improvement of 1.2%. Sg&a expenses rose from $33.5 million to $42.6 million. As a percentage of sales, it rose from 29.8% to 31.6%. Most of the increase was the result of the Blue Tomato and relocation expenses already described.
 
Earnings before income taxes rose from $4 million to $4.8 million, but an increase in the tax rate from 35% to 56.5% left them with a lower net income. They “…estimate our effective tax rate will be adversely impacted by the tax effects of the acquisition of Blue Tomato.”  That’s what we’re seeing here. I’m not clear how long that impact lasts.
 
Let me see if I can work my way around to a closing by reviewing some comments that were made by Zumiez management in the conference call. CEO Brooks starts by talking about the continuing key drivers of the business; “…higher store productivity, domestic new store growth, greater penetration in e-commerce, and international expansion.”   He talks, as he has before, about Zumiez’s “…highly differentiated product assortments and exceptional in-store experience continues to attract and engage our core consumer…” Nothing new there.
 
Then, later, in response to an analyst question, he says, “I think our buyers do great job in terms of driving our margin forward and negotiating with our partners on price. I would also add that our inventory levels are, in terms of the quality of inventories, are in very good shape.” He also talks about how their brand selection, buying and inventory management means that most of their promotions are planned tactics as opposed to responses to market competitive conditions.
 
Further discussion is about the ongoing implementation of inventory assortment planning tools. “We’re talking,” he says, “about being able to, at a SKU level, be able to assortment plan on every brand category combination by week, by location. So, very powerful tools that allow us to build up from those base-level sort of plans up to what our overall open-to-buy planning is, and of course reconciling those things together.”
 
Finally, he talks about it becoming “…an omni-channel world.” Zumiez see online and brick and mortar as increasingly integrated going forward. He expects this integration to proceed “…to the point where I’m not sure I’m going to be able to tell you in future what’s driving volume and transaction in stores and what’s driving volume and transactions online because they’re going to be that tightly integrated. The consumer gets to choose and all that’s important is that we’re in every channel they want and the way they want us, with a great brand experience and the product they want.”
 
I’ve been pointing recently to how other companies are responding, in a way similar to Zumiez, to the power of the consumer, the need to offer them experiences (due to availability and lack of differentiation in product), the need to operate well and the tie in between those quality operations and your marketing, and the breakdown between the historical brand/retailer business model. You know- retailers becoming brands and brands becoming retailers.
 
You can see in Zumiez’s discussion how they see the pieces fitting together. Other companies have essentially said the same thing. I suppose they always did fit together, but in better economic times it wasn’t quite so important.
 
There is one fly in the ointment here. When Rick Brooks talks about his buyers doing a great job, what I hear is how hard they are squeezing their suppliers. Well, that’s their job. And it’s certainly true that their strategic positioning and investment in systems, which I have highlighted, may give them the ability to do that.
 
As everybody knows, the relationships between brands and retailers are evolving fast. But both sides still need to make money.
 
Zumiez made a strategic decision in acquiring Blue Tomato that in the short term (I’m not quite sure what “short term” means) has hurt their financial results and the market didn’t like it. Oh well. I think public companies are too quarter to quarter oriented anyway. We didn’t get any information about it this time, but I’m sure that some European stores are in Zumiez’s future now that they have a management team over there to lead implementation. As management emphasized, Blue Tomato’s culture is very similar to Zumiez’s. It will be interesting to see if they can pull off the same kind of brand positioning in Europe that Zumiez has in the U.S. when they do open more stores there.   

 

 

PacSun’s Quarter: Still Losing Money, But Elements of the Strategy Becoming Clearer

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Strategies don’t bear fruit in a quarter, or even in a year. There’s still a lot of work to be done before we can say that PacSun’s strategy has been successful if only because the company is still losing money. The goal has been the same for a couple of years now; to make PacSun relevant to its target customers again. Let’s see how they’re doing.

First the bad news. As reported, PacSun had a net loss of $17.5 million in the quarter ended July 28th compared to a loss of $19.3 million in the pcp (prior calendar period- the same quarter the previous year). Here’s where you can see the 10Q yourself.

Sales, however, rose 4.7% from $200.9 million to $210.3 million. Gross margin rose from 23.6% to 27.5%. They credit 2.6% of the gross margin increase to the merchandise margin going from 48.8% to 51.4% “…due to an increase in initial markups and a decrease in promotions.” 1.1% of the gross margin was due to same store sales rising by 5% and some “…reduction in rent expense related to negotiations with our landlords.” Comparative store sales were up 7% in men’s and 2% in women’s. On line sales rose 15%. They mention in the conference call that they are seeing a higher average unit retail “…offsetting a modest decline in traffic.” They expect that to continue in their third quarter.
 
PacSun had 727 stores open at the end of the quarter compared to 821 in the pcp. They expect to end the year with 625 stores.
  
For any new readers, I’ll remind you that a brand’s gross margin is mostly its merchandise cost while a retailer’s gross margin adds other expenses to cost. In PacSun’s case this includes buying, distribution and occupancy expenses.
 
Selling, general and administrative expenses were essentially stable at $64 million. As a percentage of sales they fell from 31.8% to 30.2%. The loss from discontinued operations was zero compared to $1.8 million in the pcp.
 
That results in a loss from continuing operations after taxes of about $17.5 million for both periods. However, this year’s quarter includes an $8.2 million loss on a derivative liability that’s related to the 1,000 preferred shares of stock issued to Golden Gate Capital as part of the $60 million term loan PacSun received from it. The change in value has to be reported at fair value every quarter. If you look at their operating loss before that and taxes it fell from $16.5 million to $5.7 million.
 
The balance sheet shows a current ratio that fell slightly from 1.44 to 1.27 over the year. Total liabilities to equity improved from 1.43 times to 0.78 times. Cash on hand rose from $13 million to $34 million. Inventory declined 11.4% to $145 million, consistent with the closing of stores. More importantly, on a comparable store basis, it was down 6%. Shareholders’ equity fell by half, from $166 million to $82 million.
They reported $18 million in positive cash flow. Net cash used in operating activities declined from $43.7 million to $13.5 million.
 
I’m sure you’re all tired of boring numbers by now, so let’s get on to the fun, uplifting strategic stuff.
 
In his opening comments on the conference call, CEO Gary Schoenfeld described their strategy this way:
 
“…we continue 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.”
 
They talk about the important role of new brands. CEO Schoenfeld mentions how they are finding them at trade shows he’s just come back from.
 
It’s interesting to watch the relationship between brands and retailers evolve. Years ago, I cautioned new brands about getting too involved with big retailers too quickly. I wouldn’t give that advice anymore. There used to be a certain negative stigma to a brand jumping out of the core specialty channel too quickly. As the customer base has broadened, the number of core specialty retailers declined, and the sensitivity of large retailers to brand management improved, a strong relationship with a major retailer can jump start a small brand.
 
We all know retailers are building their own brands, and some brands have made exclusive arrangements with big retailers. I wonder if we won’t see large retailers trying to buy brands as they become important to that retailer.
 
New brands fit into PacSun’s positioning as a California lifestyle brand. Take a look at their Golden State of Mind web site. The web site “…allows the user to experience all things California in 6 key categories, including fashion, music, art, entertainment, action sports, and of course, with our brands.” For PacSun (and for most others I’d say) it’s not just about action sports anymore. Hasn’t been for a while.
 
Schoenfeld goes on to say, “Customers are experiencing our brand and our unique filter of California lifestyle through multiple touch points in our stores and online, and we believe this will continue to be a critical differentiator for PacSun as we reestablish and emotional connection with customers across the entire United States.” True, but of course they aren’t the only one trying to do it.
 
Now the next piece of the mix. Remember that before Gary Schoenfeld became CEO, PacSun was placing the same assortment in all its stores? He started the process of changing that. This involves improved or new systems with timely information about what’s selling where. But it also requires discussions with the brands you buy and the manufacturers of your owned brands and some changes in logistics and inventory management. It’s operations, but it’s also marketing. You can’t separate the two in the existing competitive environment.
 
One more quote from Gary Schoenfeld: 
 
“I think we have gotten better at how we segment between store groups. But all of that, I think we can continue to improve upon as we go forward. And then probably the fourth element that’s common to both genders has been just an overall effort towards reducing SKU count, and therefore, making the stores easier to shop and easier to showcase key brands on the Men’s side and key fashion ideas, as well as critical essentials business on the Women’s side.”
 
Regular readers will know I’ve been writing for years about how operating well is a requirement just to get the chance to compete- not a competitive advantage. And even more recently I’ve described how a number of industry companies are bringing together online and brick and mortar, controlling all their consumer touch points, and working to provide the unique experience the consumers is demanding.
As they describe it, that’s what PacSun is trying to do. I don’t have any doubt that it’s the right approach. The market is demanding it. Though there are savings from operating well, I see the strategy as costing some money to implement.
 
PacSun got the $60 million term loan from Golden Gate Capital to have the resources and buy some time to implement its strategy. Some of the quarter’s financial metrics are encouraging and, as I said, I think it’s the right strategy.  But others are taking the same approach and have more financial resources.
 
I’ll end where I started. Strategies don’t bear fruit in a quarter, or even a year. This is a work in progress.

 

 

Spy’s Expense Cuts

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Spy announced on August 27 that they were reducing their North American and European employment by 20 positions, going to a distribution model in Europe (they had been direct previously), and spending less on marketing. They think these changes will cost them  $1.2 million in the quarter ($1.0 million in cash) during their 3rd quarter, but that they “…could result in annual operating cost savings of up to $6.0 million in 2013.”
 
Back on July 2nd, Spy filed an 8K announcing, among other things that they expected to raise some form of equity capital by August 31st. There has been no announcement that any equity has been raised.
 
When I wrote about Spy’s June 30 quarter, I pointed out that their majority shareholder had increased the line of credit to the company to $10 million (and that Spy owed him $15 million). I said (and had said before) that Spy’s brand focus was correct. I also said, “As long as Costa Brava is willing to fund them, they can continue to pursue their strategy.”
 
I feel strongly both ways about what Spy is doing. On the one hand, the balance sheet and cash run rate certainly seems to require expense reduction. On the other hand, their strategy has been to invest in the brand to get revenues to a level that could support the required marketing effort. For all the progress Spy has made in increasing brand sales, it looks like somebody think it hasn’t happened fast enough to justify the continuing required cash investment.
 
They don’t give a breakdown of exactly where the personnel and expense reductions happened. I’d be very interested to know that so I could better judge if this was a tactical decision to increase the U.S. focus or a more fundamental strategic decisions by funding source Costa Brava that that they couldn’t just keep pouring cash in.
 
What we do know from their 10Q is that in the quarter ended June 30, North American sales were $8.73 million and international only $740,000. You wonder how much expense there could be in Europe given the level of revenues there.  
 
Going from a direct to a distribution model in Europe does indeed reduce expenses. But it also reduces revenues since you aren’t going to be selling direct and your distributors will want to make a few Euros too. They didn’t indicate how much that reduction might be. Depends, I suppose, on the distributors and how quickly they can be up and running. 
 
I’ll look forward to their filling us in on how that transition is going. For all I know, this is a really positive development, but they haven’t supplied us with enough details to know that.

 

 

Billabong’s Year and New Plan; I Wish They’d Done This Sooner

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Billabong’s fiscal year ended June 30. On August 27, they released their full year results and presented their promised strategic plan. The financial results were poor but not unexpected, coming in at the low end of their guidance. The good news is that it looks like they wrote off, wrote down, reserved for or expensed every item they could find that might possibly represent a problem or stand in the way of their new strategic plan. 

I refer to this as the “big bath” approach. That is, if things look bad and your audience is going to hate what you tell them anyway, might as well get all the bad news you can identify behind you. This is good because not only does it mean fewer negative influences going forward (both financially and in terms of management focus) but there’s a reasonable chance that some of these assets you’ve written down will turn out to have some value that will go right to the bottom line in future periods.
 
A really good time to do this is when you have a new Managing Director and CEO coming in and, as you’re aware, Launa Inman joined Billabong on May 9th, coming from Target Australia (no relationship t Target in the U.S. except that they license the name.
 
CEO Inman presented her strategic plan for the company, and I’ll get into the details below. Much of her approach is what I’d call blocking and tackling. That, by the way, is a very, very good thing. It’s fundamental, but it’s critical. Those of you who have followed my suggestions for how companies should be approaching a lower growth, consumer centric environment won’t be surprised that I like what she proposes for Billabong.
 
Housekeeping
 
Here are a few things to keep in mind as we go through this. First, all the numbers are in Australian Dollars unless I say otherwise. Second, “pcp” means prior calendar period.   Third, The Australian Dollar is worth US$ 1.03 today (August 31). On June 30, it was worth US$ 1.016. Fourth, if you want to review the financial report, conference call transcript, or the slides for the fiscal year review or new strategic plan, you can find them here.
 
The TPG Offer
 
I imagine most of you were hoping to find out what’s going on with the July 23rd offer from TPG International to buy Billabong for $1.45 a share. Me too. But all we found out on the conference call was that the confidentiality agreement had been signed and the due diligence commenced. However, in footnote 41 on page 123 of the financial report, I did find the following:
 
“There is no guarantee that, following the due diligence process, a transaction will be agreed or that the Board will recommend an offer at the current proposed offer price. In fact, the Board does not believe that the proposal reflects the fundamental value of the Group in the context of a change of control transaction.”
 
Billabong’s board of directors doesn’t think $1.45 is enough. As you’ve probably noticed, there’s some speculation that other buyers might be out there lurking in the lichens. This will be interesting to watch.
 
The Year’s Results
 
Here’s the broad brush. Billabong lost $276 million on revenue of $1.44 billion. Last year, they earned $119 million on revenue of $1.56 billion. Cost of goods sold rose from $728 million to $765 million. Gross margin fell from 53.3% to 47%.
 
I’m going to go ahead and present some of the other income statement numbers, but starting with sales, I’m going to go back to clarify and explain a bit.
Selling, general and administrative expenses (SG&A) rose 14.2% from $564.7 million to $645 million. Other expenses rose 275% from $144.8 million to $544 million. Last year’s pretax profit was $88.7 million. This year’s pretax loss was $522 million. There was an income tax benefit of $40 million this year and you have to then add in the $206 million gain on the sale of 48% of Nixon to get to the net income number.
 
Billabong operates in three segments. Australasia includes Australia, New Zealand, Japan, South Africa, Singapore, Malaysia, Indonesia, Thailand, South Korea and Hong Kong. The Americas is the U.S., Canada, Brazil, Peru and Chile. Europe is Austria, Belgium, the Czech Republic, England, France, Germany, Italy, Luxembourg, the Netherlands and Spain.
 
The Rest of the World “…relates to royalty receipts from third party operations.” I conclude that the countries listed in the three segments are where Billabong has its own operations. The royalties were $2.6 million during the year.
 
Here’s the revenues and EBITDAI for the three segments for the last two years. 
 
 
I know most of you know this, but EBITDAI is earnings before interest, taxes, depreciation, amortization and impairment charges. Call it the operating result. The impairment charges total $343 million. We’ll discuss them below.
 
Now, the plot thickens. Billabong adjusts the numbers above to “…exclude significant and exceptional items…” These are “…items associated with the strategic capital structure review…” 
 
“Significant income and cost items associated with the strategic capital structure review includes
but is not limited to, doubtful debts, inventory write downs and redundancies partially offset by the gain on sale of 51.5% of the Nixon business (significant items). Exceptional items include other costs and charges associated with certain initiatives outside the ordinary course of operations (exceptional items) (collectively significant and exceptional items).”
 
Here’s the numbers for the recent year with those items removed. 
 
 
It’s a miracle. Instead of an EBITDAI loss in its three main segments of $74 million, Billabong shows an EBITDAI profit of $118 million and a net income of $33.5 million instead of a loss of $275 million.
 
There is justification for making some of these adjustments, and I’m not against trying to show a true picture of operating results. But I’m not quite certain how bad debts and inventory can be removed from operating results. I mean, if some of the inventory ain’t worth much, and you can’t collect the receivables, that’s pretty much about how you operated I think. 
 
I guess the argument is that they identified and took these write downs because of their strategic review, and are starting fresh, have a new CEO, and just want to clear the decks (see “the Big Bath” discussion at the start of the article).
 
In the Australasia segment, they note that “Sales…increased over the pcp principally as a result of the inclusion of a full year of trading for the prior year acquisitions of SDS/Jetty Surf and Rush Surf in Australia.” I conclude revenues would have been at best even without that acquisition related revenue. They mention as factors reduced June shipments and a highly promotional environment. Australia represented 65% of the total segment revenues.   
 
In the Americas, they point to wholesale and retail performance in Canada as a major reason for the reduction in EBITDAI margins. They note issues with West 49 on a couple of occasions. The U. S. was 59% of this segment’s total revenue.    
 
They talk about the impact of sovereign debt issues in Europe having “… a significant adverse impact on consumer confidence and demand, especially in southern European territories…” The result was delays in shipments, weak in-season repeat business, and soft trading conditions in their owned retail. CEO Inman noted that Billabong has historically been very strong in Southern Europe. Unless you live under a rock somewhere, you know that things are pretty bad there. The comment in the conference call  that about 25% of their accounts in Europe having closed was indicative of the situation. France, interestingly, is 83% of the European segment’s total revenue for the year ended June 30, 2012 which further illustrates how bad Southern Europe must be if it can have the impact.
 
Wholesale revenues were $1.07 billion. However, that includes sales to owned retail. If you eliminate sales to owned retail, you get down to wholesale revenue for the year of $831 million. Retail revenues were $719.6 million. Billabong had 634 company owned stores at year end. Same store sales grew 1.4% in the U.S., but fell 10.4% in Canada, 1.9% in Europe, and 3.7% in Australia.  
 
Let’s move on now and look at expenses.
 
The cost of goods sold amount includes $73.5 million of the “significant” items. This includes both a loss on inventory already sold as well as an allowance for writing down inventory that is “realizable below cost.” Total June 30 inventory was $293 million, so that’s a pretty big number. It also goes a long way towards explaining the decline in the gross margin.
 
There’s a pretty long list of “significant” items included in the general and administrative expenses. I thought the best thing to do was just pull the list from the financial report.
 
 
There was another $6.5 million as well, bringing the total to $117 million.
 
As noted above, SG&A totaled $645 million for the year including this $117 million. The $33 million doubtful account expense is a result of their decision to stop working with certain wholesale accounts. That decision, Billabong believes, means the receivables are less likely to be collected and so they’ve taken a provision for them.
 
Billabong closed 58 stores during the year ended June 30, and expects to close an additional 82 during this year. That explains the early termination expense of $58 million.
 
Just to remind everybody, most of these large expenses (and the inventory charges) ultimately free up working capital and reduces annual expenses. So while it hurts in the period you take these charges, it’s a continuing benefit in future periods.
 
Down in other expenses there’s a $343 million charge mostly for impairment of goodwill, brands and intangibles. This is a noncash charge, but it is a real indication of declining expected cash flow and value of the assets.   Along these, lines we see in other income a credit of $22 million for a reduction in already booked earn outs for acquisitions.
 
Equity on the balance sheet fell as a result of the loss from $1.196 billion to $1.027 billion in spite of the gain on the sale of Nixon and the equity raised. But total liabilities fell by 47% from $834 million to $441 million. The total liabilities to equity ratio stayed constant at 1.02 times.
 
Cash rose from $145 million to $317 million but the current ratio deteriorated, going from 2.34 times to 1.47 times. However, that’s mostly because current borrowings rose from $15 million to $229 million, while longer term borrowings fell from $597 million to $249 billion.
 
Receivables fell by 34.5% reflecting in part the elimination of Nixon receivables as well the write down of $33 million for doubtful accounts. Impaired receivables rose from $21 million to $52 million over the year. Just because it is classified as impaired doesn’t mean all or part of a receivable won’t be collected. Billabong increased the provision for its impaired receivables from $20 to $40 million.
 
I guess the way to look at the financials- and especially all the write downs and impairment charges- is to say that they represent an acknowledgement of some mistakes made and opportunities to do some things better.  The question then becomes if they have identified the mistakes and what are they going to do differently. That takes us to CEO Launa Inman’s strategic presentation.
 
What’s the Plan?
 
I thought the meat of the presentation started when she looked at Billabong’s challenges. Externally, these were the “unprecedented macroeconomic environment,” the impact on the Billabong brand of the shrinking account base, and the strength of the Australian dollar.
 
Internally, the challenges she focused on included the organization’s inability to keep pace with its global expansion, the poor performance of the Billabong brand, problems in implementing the retail strategy, and issues with the supply chain costs and responsiveness. That last one includes not just where you have stuff made, but how you move it and how you manage your inventory. It has a lot to do with information systems, or the lack of them. 
 
I want to make two points here. The first is that the internal challenges would have been, and were, challenges even if the external ones hadn’t been as severe. Cash flow and fast growth, I’ve said a time or two, covers up a lot of problems. When the good times ended, the problems became harder to ignore and got meaningful quickly.
 
Second, Billabong had tended (before West 49) to acquire strong brands with solid management and, I’m told, let them run pretty independently. I liked that approach, but you can see how it could create some inefficiencies a company can’t afford when times aren’t quite so good even if the management teams at each company ran their brands well. CEO Inman noted, “One of the things we as an organization have is great entrepreneurs who really understand the customer in many ways but yet at the same time we’ve never really analyzed the data to ensure that everything we do going forward has facts and is fact based so that we can make clear and concise decisions. “      
 
They started to address their challenges by collecting some information. They spent $20 million on consultants doing it. I like the sound of that.   They measured the size of their markets. They did extensive customer research in the U.S., Australia, and France. They did it for all their brands and for snow, skate, and surf. Who are our customers, how do they perceive us, and why do they buy from us Billabong wanted to know. CEO Inman noted, “This was in fact the first time that this research has ever been actually done.”
 
Part of their work with consultants was “… to have a real deep dive into the profitability of the brands, of the actual retail outlets, the supply chain and also even look at the opportunities of e-commerce.”
 
How you can run a business without that information (as best you can get it) is beyond me, and I think it’s great they started with this research even at a time when money was tight. You can’t fix it if you don’t know what’s broken, and an objective, outside, opinion not based on anecdotal evidence is a good place to start.
 
Billabong, as part of its research, benchmarked itself against leading brands (not just in action sports) to see where it stood. Among the things they found out was that “…We had the highest awareness within the board sport market but yet for all that we weren’t really differentiated.”
 
So what are they going to do? They’ve got short, medium and long term plans and you really ought to review the presentation yourself at the Billabong web site. This damned article is already 2,500 words and I’m not done yet. I hope somebody actually reads this far.
 

 

 

Billabong is going to measure, measure, measure. Launa Inman thinks if you don’t measure stuff, it doesn’t get done and that’s certainly my experience. I’m guessing this might be a new experience for some of the brand managers at the level I expect it to happen.
 
They are going to be consumer centric in everything they do. I hope that means they are going to work very hard to control the consumers’ experience at every point where Billabong touches them.  That’s just the environment we’re in. The consumer has perfect information and endless choices. They don’t need you- you need them. Consumers take for granted the product. What you have to give them is a good experience.
 
They are going to focus particular attention on RVCA, DaKine and Element. These are the three brands identified by their research as having the greatest growth opportunities. That doesn’t mean there aren’t opportunities in other brands, but you if you focus everywhere, you focus nowhere.
 
They also talked about simplification. Billabong has 25,239 unique styles, 500 suppliers, something like 13,000 wholesale customers, and 625 stores (we know this number is going down). Those stores are under 15 names and they have 35 web sites. Aside from the customer confusion, imagine the costs savings from rationalizing this a bit. 
 
Billabong has imagined. They found, during their research, that 34% of their styles give them 1% of their sales. They must have just fallen off their chairs when they saw that. I don’t think I would have believed it the first time I heard it. They are going to cut the number of styles by 15% this year. When they see how that works out, they’re going to look to cut it another 15% next year. It cuts costs, but it also “…enables us to concentrate on delivering the correct proposition to the consumer.”
 
Years and years ago, I commented on the snowboard industry’s tendency to increase the number of styles they offered as a response to what their competitors were doing, rather than focusing on what their customers wanted. I guess Billabong is figuring that out too.
 
Moving right along on simplification, they noted that that 85% of product purchases come from 19% (that’s 95 out of 500) of suppliers. What do you think is going to happen to their number of suppliers? I’d be really curious to know how many suppliers go away just from cutting the 34% of styles that give them 1% of sales.
 
Speaking of interesting statistics, Billabong found that 80% of their sales came from 11% of their customers. You can hardly go wrong by focusing on what that 11% want from you. I’d go so far as to say that will probably solidify brand positioning and perception by focusing there. Here are a couple of quotes from Launa Inman that are related to this.
 
“This is all about the experience. It’s all about making them [the customer] feel part of the tribe, and that what we need to work on.”
 
“When we analyzed the issues that have faced the retail, there were some stand-outs, and the most important one is the ability of the organization to integrate the brands as they bought them. The second thing is we were not consumer- and customer-centric enough, but that is changing. In our quest to try and increase profitability, we’ve started to push our own family brands and without understanding whether that was right for the customer, and those are the things that we are now going to be doing.”
 
One of the things that’s going to be required to do all this is better systems. “That means that we need to have organizational design and structure. We need to relook at our IT systems. No strategy can be carried out today unless it is underpinned by good IT.”
 
As I pass 3,000 words, I find myself desiring to figure out how to end this. I haven’t covered everything I’d like to cover, but let’s try and summarize and reach some conclusions.
 
Let’s start with something CFO Craig White said during the question and answer part of the conference call.
 
“Essentially, if you look at the next four years, what you should expect to see is reasonably modest revenue growth, but real margin expansion as we get leverage through improvements in the supply chain and so on…”
 
I think he’s saying, and I agree, that revenue growth isn’t going to be easy to come by as difficult economic conditions persist, but that there are a lot of opportunities to bring more dollars to the operating profit line by running the business better. In Billabong’s case, it may represent the best way to improve profitability in the next year or two.
 
As I’ve written, operating efficiently can no longer provide a strategic advantage. It’s a minimum bar that gives you the opportunity to compete. Companies like VF and Nike, and now Billabong, have figured this out. And as I said in the title, I wish they’d figured it out sooner.
 
But it isn’t just about operating efficiently. Operating well saves you a lot of money. Just as importantly, it gets the right product in front of the right potential customers with the right presentation in a coordinated way at the right time. You have to be consumer centric, and good operations are a critical part of that.
 
When brands started becoming retailers, and retailers brands, it seemed to be focused on generating a little more gross margin (less than most people think- running retail is expensive) and responding to your competitors. What really mattered, however, was that it allowed better control of distribution, and the ability to manage the points of contact with your consumer and the quality of the experience you offered them.
 
Billabong is saying they’ve figured that out and have a strategy to achieve it based on solid data they worked hard to get. It’s kind of conceptually simple, but not quite so easy to implement. As they acknowledge, it’s a multiyear process.
 
It’s also going to require an evolution of their culture. How do you balance entrepreneurial people with the intention to “…totally integrate, in time, our single brands as well as our pure play e-commerce, and also our bricks and mortar.” That may prove to be the most challenging part of the whole plan.

  

 

 

 

Spy’s June 30 Quarter. Brand Sales Up, But Gross Margin Falls. What to do About the Balance Sheet?

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In the conference call discussion of their results Michael Marckx, Spy’s President and CEO, emphasized two things. The first was the total focus on the Spy brand. The second was that they had a solid and complete management team that was in agreement on the company’s strategy and direction.

Those are good things. In spite of the sales increase, however, the company continues to lose money, and can only pursue its strategy with the help of continuing loans from its largest shareholder. Here are the details.     
 
Sales for the quarter rose from about $9 million to $9.5 million, or by 5.3% compared to the same quarter last year. Sales of Spy products were up $1.1 million, or 13%, to $9.3 million. That number includes $300,000 of Spy brand closeouts. There was also $200,000 in closeout sales of the licensed brands (O’Neill, Melodies by MJB, and Margaritaville) that they no longer sell. I’d note that the licensed brands closeout sales were down from $800,000 in the same quarter last year, so hopefully we’re coming to the end of that. Sunglasses represented 94% of revenue during the quarter.
 
 
Total gross profit fell from $4.88 million to $4.75 million even with the sales increase. Gross profit margin was down from 54.3% to 50.3%. They give four reasons for the decline.
 
The first is reduced gross margin on international business due to poor European economic conditions (International sales in the quarter were $790,000). Second, some of the product they sold that they bought from LEM (the Italian factory they used to own) has gotten more expensive, but they’ve got a deal that requires them to continue to buy some product there. Third, there was an increased level of discounting which they say is “…primarily due to increased levels of sales to major accounts.” Finally, there were some higher freight costs because of more air freight shipments. Having to pay for air freight sucks I can say from personal experience.
 
These higher costs were offset, they say, by some increased purchases of lower cost product from China and the higher margins they got from sale of the old licensed product after they wrote it down last year.
 
Let’s focus on that last one for a minute. If you carry product in inventory at $50 and sell it for $100, you have a 50% gross margin. Assume you figure out you have way too much of that product and it’s not worth anything, so you write it off, charging the $50 to expense. Next year, to your surprise, you figure out how to sell it for $25. You carry it in inventory for nothing, so that $25, from an accounting point of view, is all gross profit. That will boost your gross profit margin nicely. We don’t know how much of that Spy had.
 
Sales and marketing expense rose 43.3% from $2.6 million to $3.8 million. The increase was “…driven primarily by increased marketing efforts to promote our SPY brand and our new SPY products…” The biggest piece of the increase was $500,000 for marketing costs. There was also $300,000 spent on product displays and $200,000 on compensation. For all of 2012, Spy has minimum annual payments to sponsored athletes of $919,000. They are betting on the Spy brand, so where else would the money go.
 
General and administrative expenses were down $900,000, or 33.8%, to $1.73 million. That reduction is largely related to the one time management restructuring costs from April 2011. 
 
As reported, total operating expenses fell 22.4% from $7.5 million to $5.8 million and the operating loss for the quarter fell from $2.64 million last year to $1.07 million in this year’s quarter. The net loss for the quarter was $1.63 million, down 45% from a loss of $2.95 million in the same quarter last year.
 
But in the quarter last year, there were the one-time charges of $1.95 million associated with getting out from under the deals for the licensed brands and the $900,000 for the management restructuring.
 
Ignoring those two charges, operating income in last year’s June 30 quarter on a proforma basis was a positive $214,000 and the reported operating income can be viewed as a decline compared to last year’s quarter caused by the fall in gross margin and the marketing spend to build the brand.
 
As you already know, Spy has financed its continuing losses mostly through loans from Costa Brava, an entity controlled by Spy’s largest shareholder. As of June 30, 2012, those loans totaled $15.1 million. A year ago, they were about $9.5 million. In a year then, Costa Brava put an additional $5.6 million into Spy. In August 2012, the amount of the line of credit from Costa Brava was increased from $7 to $10 million. Spy borrowed an additional $1 million on August 3.
 
Spy says in its 10Q, “The Company anticipates that it will continue to have requirements for significant additional cash to finance its ongoing working capital requirements and net losses, which have included increased spending and marketing and sales activities deemed necessary to achieve its desired business growth.” This seems to indicate that they expect continued losses. There’s no information on how much those losses might be or how long they might continue.
 
You may recall that Spy announced on July 2 that it was planning to raise some additional capital by the end of August. I am writing this on August 24th, but nothing has happened as far as I know.
 
With the accumulated losses and shareholder debt, the balance sheet shows a stockholders’ deficit of $11.2 million.
 
Accounts receivables have grown 16.4% over the year, from $5.5 to $6.4 million. That number is net of an allowance for doubtful accounts of $277,000 and a $1.665 million allowance for returns.   Total sales, as you recall, were up 5.3%. Inventories fell 9.5% from $8.5 million to $7.7 million. That’s good to see, though I have no idea how much of that is better inventory management as opposed to write downs of overvalued product. The inventory number is “…net of an allowance for excess and obsolete inventories of approximately $0.9 million…”
 
I think Spy is doing the right things. Certainly focusing on the brand, and spending money to build it, is what they have to do. And the management team seems stabilized, strong, and focused. As long as Costa Brava is willing to fund them, they can continue to pursue their strategy. To justify the investment that’s been made in the company, however, Spy requires a faster rate of growth and, obviously, to make a profit. Next quarter, I hope to see real improvement in their operating performance.
 

 

 

VF’s Quarterly Results and Strategy: They Do Love Outdoor and Action Sports

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VF’s reported revenues rising 16.4% in the quarter ended June 30 compared to the same quarter last year. Net income was up 20% from $129.4 million to $155.3 million. As you look at those headline numbers, there are a couple of things to keep in mind.

 
First, the Timberland acquisition closed on September 13, 2011 so this is the first June quarter where it’s been included, and it was the largest acquisition VF has made. They paid $2.3 billion for Timberland. It’s part of VF’s outdoor and action sports group. During the quarter ended June 30, it contributed revenue of $239.4 million and reported a loss (as expected- apparently that’s just how the second quarter is for Timberland) of $37.2 million.
 
Second, on April 30th VF sold the John Varvatos brand and generated a pretax gain on the sale of $41.7 million. The sale of that brand reduced revenues in the quarter by $14.4 million.
 
Organic revenue growth (growth from brands they already owned) was $125.1 million, or 3%. International business grew 33%, representing about a third of total revenues. 26% of that growth came from Timberland. Direct to consumer revenues were up 37% in the quarter (29% from Timberland) and are 21% of total revenue. VF has opened 58 new stores so far this year, and expects to have opened 130 by year end. Comparable store sales in the stores VF operates were up mid-single digits in the second quarter.
 
Without the Timberland related acquisition expenses of $3.4 million and the gain on the sale of John Varvatos, net income would have been $122.9 million instead of the $155 million reported. Operating income, without the Timberland loss and related acquisition costs, would have been $193.7 million instead of the reported $164 million. By the way, my thanks to whoever it is at VF that presents this information in a fairly easy to figure out format. Oh- and here’s the link to the 10Q.
 
Before we delve deeper into those numbers, I want to remind everybody that back in the middle of June, VF did an investors’ day presentation just on Vans.   You can listen to the whole presentation here, and I suggest you do if you haven’t already.
 
When I wrote about Nike’s annual report a couple of weeks ago, I related it to a book called The New Rules of Retail. VF is discussed in that book as an example of a company that is creating neurological connectivity with its customers, using preemptive distribution, and controlling its value chain to compete as called for and explained in the book. You can see that all over the Vans presentation.
 
So why does VF love its outdoor and action sports segment? It has something to do with the fact that it generated 49% of its total revenues, including Timberland, during the quarter. Its next largest segment is jeanswear, which generated $594 million, down from $613 million in the quarter last year. Those two segments, then, were 76.3% of the quarter’s revenues and they generated 76.4% of operating profit.
 
VF’s overall operating margin was 7.9%, down from 10.3% in last year’s second quarter. 2.3% of that decline was the result of Timberland’s loss in the quarter.   
 
Of the $125 million in organic growth in the quarter referred to above, $113.4 million came from outdoor and action sports. That’s a 12% increase; 16% in constant dollars. Organic growth in operating profit for the whole company during the quarter was $18.4 million. In the outdoor and action sports segment alone it was $25.5 million, so that segment made up for the poorer performance of some others.
 
The North Face is part of outdoor and action sports. Its revenues in the quarter were up 14% (16% in constant currency) and it’s direct to consumer (DC) grew 9%. For the whole year, they expect The North Face to approach $2 billion in revenue.
 
VF is targeting Vans revenue of $2.2 billion by 2016. Revenues in the quarter were up 25% (29% in constant currency). Its DC business rose 18%.
 
Timberland revenues were up “…slightly on a constant dollar basis…” However, VF management sounds positively giddy as they talk about the opportunities in product, operations, and marketing they have with Timberland. It will be rolling out an apparel line in the near future.
 
One analyst asked about the impact of cleaning up Timberland’s distribution. Group President of Outdoor and Action Sports Steve Rendle answered it this way:
 
“As we look to right size that business, we are closing some of the distribution. Simultaneously, we’re rightsizing the product segmentation strategy, getting the right products in the right channels.”
 
Read that again and go listen to their plans for Vans. Read about what they are doing with The North Face in the conference call. You can detect in the conference call (see it here) a certain consistency across Vans, The North Face, and Timberland in terms of product development and the approach to the consumer. I would think there might be some real opportunities there as the brands come at overlapping customer groups from different perspectives.
 
Okay, let’s get back to VF’s overall financial results. Gross margin increased to 46.1% from 45.9% in last year’s quarter. This was “…due to a greater percentage of revenues from higher gross margin businesses, including the Outdoor & Action Sports, international and retail businesses, as well as an improvement of gross margin in our Jeanswear Americas business which reflects increased pricing compared to the prior period.”
 
Marketing, administrative and general expenses as a percent of sales rose from 35.7% in last year’s quarter to 38.4% this year. 2.4% of that increase was the result of the Timberland acquisition as it had higher expense ratios than the rest of VF. I won’t be surprised to see those Timberland ratios come down.
 
0.4% of the increase came from higher domestic pension expense. VF has a defined benefit plan. Those have to be funded based on an actuarial assessment of the number of people who will retire, when they will retire, how long they will live and what the assets in the plan are projected to earn. These days, it’s a bit hard to assume your pension assets will earn 7% and this is requiring some corporations (not just VF) to contribute more to their plans. That reduces net income.
 
Interest expense rose $7.6 million in the quarter because they borrowed money to pay for part of the Timberland acquisition.
 
The balance sheet was inevitably a bit weaker compared to a year ago after they borrowed money to buy Timberland. Long term debt is up $900 million. The current ratio fell from 3 to 1 to 1.9 to one and debt to total capital rose from 18.7% to 35.7%. Inventories rose 22.2% from $1.286 billion to $1.57 billion year over year. However, $246 million of that increase is the result of the Timberland acquisition. Excluding that, the increase was just 3%.
 
Receivables rose from $889 million to $1.03 billion over the year, but $121.7 million of that increase was Timberland. I should note that VF has an agreement with a financial institution to sell certain of its receivables on a nonrecourse basis. VF still manages and collects the sold receivables, but if they are ultimately uncollectable, it’s not VF’s problem. This sale of receivables reduced the accounts receivable on VF’s balance sheet by $135.5 million at June 30, 2012.
 
VF is the third company I’ve written about recently (Skullcandy and Nike being the other two) who seem to be responding to the changing retail/wholesale dynamic in ways that have some similarities. Those responses are consistent with the conditions described in The New Rules of Retail and that book’s prescription for success.
 
I expect VF to do some good things with Timberland. And I’ll be interested to see how VF manages the other brands in its portfolio if outdoor and action sports continues to grow and perform at such a high level. 

 

 

Skullcandy’s June 30 Quarter; Focus on the Strategy

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Skull had a strong quarter, and we’ll review the numbers. But what intrigues me more are the investments Skull is making and the steps they are taking to implement their strategy. That’s where I want to spend most of our time. In what was, and continues to be, an oversimplification I’ve written that the bet Skull was placing was that they could be cool in retailers like Fred Meyer. We’re going to dig a little deeper now and talk about some things they are doing that are consistent with the requirements for success in what we all know is a dramatically changing retail environment.

 
Sales for the quarter ended June 30 were up 38.2% to $72.4 million from $52.4 million in the same quarter last year. Domestic sales rose 34.1% to $50.6 million from $37.7 million in last year’s quarter. International sales rose $6.2 million or 59.9% to $16.5 million and represented 22.8% of total sales for the quarter. Skull acquired their European distributor in August of last year, and that increased its international sales.
 
As a reminder, each of Target and Best by accounted for more than 10% of Skull’s net sales during the first six months of 2012.   
 
Online sales increased $1.0 million to $5.3 million. That 22.8% increase is almost entirely the result of their acquisition of Astro Gaming in April, 2011. As a percentage of total sales, online sales declined from 8.3% to 7.4%. Skull says this was because they stopped using their web site to sell clearance product “…in order to better preserve the integrity of the brand.” Good decision.
 
Gross margin percentage fell from 51.1% to 49.2% in this quarter. As reported in the 10Q, “The decrease in gross margin is mostly due to a shift in sales mix to higher price point products with lower gross margin structures.”
 
It would appeal to my sense of organization to just review the financials then move on to the strategic issues but, unsurprisingly, it’s hard to separate them. It was many years ago that I first suggested that it might be a good idea to focus not just on your gross margin percentage but on the total gross margin dollars you earn, as that was what you paid your bills with. A few years after that, Cary Allington at Action Watch pointed me at the idea of Gross Margin Return on Inventory Investment. It was a more formal approach to what I’d already been saying and I urged the adoption of the idea in some presentations and in a Market Watch column. It’s a particularly valuable concept in a weak economy.
 
Skull’s management is apparently all over this. They noted that their average selling price increased by double digits in the quarter. One of the analysts asked how they should think the “…margin dynamics between these on-ear and over-the-ear versus buds?”
 
Skull VP of Finance Ronald Ross had already noted that Skull was continuing “…to see a mix shift toward over-ear styles and higher-priced product.” Responding to the analyst, CEO Jeremy Andrus indicated they viewed these trends very favorably. He acknowledged buds had less technology and materials in them, so were cheaper to produce. But he thought the trends would “…increase our revenue and the dollar share of gross margin.” Another executive noted that they saw the trend as positive not just financially, but for the brand as well.
 
So Skullcandy, though of course they would love a higher gross margin, is arguing that they end up with more gross margin dollars with a higher priced product even if the gross margin is a bit lower, and that’s okay with them. I agree.
 
Selling, General and Administrative Expenses (SG&A) rose from $17.2 million to $24 million. As a percentage of sales, it went from 32.9% to 33.1%. They note that “Approximately half of the increase was related to strategic investments in our direct international and gaming platforms, including expansion of personnel.” The areas they are investing in include, “…an in-house product design model, fixtures and point of purchase displays developed to improve our in-store presentation, property and equipment to support operational growth and the purchase of certain intangible assets related to our acquisition of the distribution rights in Europe.”
 
Another argument I’ve made from time to time is that a weak economy and tough competitive conditions offer opportunities to well positioned companies with strong balance sheets. I’m not going to spend a lot of time on Skull’s balance sheet, but since their public offering it’s been strong enough to allow them to pursue their strategy with few, if any, financial constraints. I mostly like where they are spending their money.
 
One of the facts of our new retail environment, whether you’re a brand or a retailer (and assuming we can still tell the difference), is that doing all the operational and back office stuff right is no longer a source of competitive advantage. It’s a minimum bar to have a chance to compete. Doing all that stuff right costs money and requires, I’ll say again, a strong balance sheet.
 
Also due to its public offering, Skull’s interest expense fell from $2.3 million in last year’s quarter to $147,000 in this year’s. Net income rose from $4.3 to $6.8 million, and you can see that without that decline in interest expense, the growth of net income would have been a lot lower.
 
With the financials reviewed, let’s move on to other strategic considerations. Skullcandy rather eloquently expresses the connection between action sports and its target market as follows:
 
“Our brand also benefits from the increasing popularity of action sports, particularly within the youth culture. Our consumer influencers are teens and young adults that associate themselves with skateboarding, snowboarding, surfing and other action sports. These consumers influence a broader consumer base that identifies with authentic action sports lifestyle brands. In addition, music is an integral part of the youth action sports lifestyle, and headphones have become an accessory worn to express individuality.”
 
That action sports brands try and use their involvement with the core to reach a much broader customer base is hardly a new idea.   But Skullcandy draws the smaller core towards the much broader consumer market using the commonality of music and the actual product- the headphones. I’m sitting here trying to think of another company that has a product that can do this quite so well but I’m coming up blank. Maybe Nixon is another example. Perhaps this is the bedrock of Skullcandy’s success.
 
You’ll also note in the quote the term “consumer influencers.” We’re all aware of the declining role of traditional advertising and the importance of engaging with your customers. You do that, I think, by controlling as much of your value chain as you can. It’s especially important that you control it at the point of contact with the consumer, and Skull is trying to do that in various ways.
 
They are “…rolling out new point-of-sale fixtures and powered listening stations globally. By the end of the year, we plan to have over 5,000 in place.” About half of these are powered listening stations where you can listen to your own music on Skullcandy headphones as you make purchase decisions.  Some of them have video as well.
 
Their thinking is that higher price point products especially require a listening experience for the consumer at the point of sale. Where they’ve installed them, they’ve seen it “…impact sell-through from sort of low-double digits up to significantly higher than that, depending on the retailer or the fixture type.”
 
They have a retail education group within Skullcandy which is going into retailers and educating sales people on the Astro brand. I can’t see any reason you wouldn’t do that for the high end Skullcandy product as well.
 
They’ve been auditing all their retail customers in Europe since acquiring their distributor and it’s apparently leading to some changes in what they sell to whom; even at the initial cost of some sales.
 
They’ve launched the 2XL brand as a price point product they can sell to places like Walgreens and Rite Aid without damaging the Skullcandy brand. I guess I’m not quite certain why you can sell Skullcandy to Fred Meyers but not to Walgreens, but what do I know.
 
During the conference call, they were asked about selling to Walmart and the answer was along the lines of there’s no current active conversation or commitment, but we’re watching them and it’s kind of hard to ignore the biggest retailer in the world.
 
This goes back to the ability to control your value chain at the point at which it contacts the customer. If you can manage the experience the consumer has with your product so that it’s a positive one and represents the brand in the way you want, does it matter if you’re showing the product in a core shop or in Walmart? That’s an important point, and not just for Skullcandy. The breakdown of the traditional retail/wholesale distribution system requires that brands think about it.
 
Skullcandy’s financial results are good, and their balance sheet is solid. But what I really like is first, the way they are reaching their market using the commonality of music and headphones to draw together the action sports core and the broader market and, second, their strategic initiatives that seem to address the rapidly changing and emerging retail environment.

 

 

Speculation on Billabong

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Walking around a really good Agenda show last week, the question I kept getting asked was, “What’s going to happen to Billabong?”  As I told everyone who asked, I only had access to the same public information they had. Given that information, my best guess is that Billabong will be sold.  Here’s my reasoning. 

As you know, TPG offered, on July 23rd, to buy Billabong for AUD $1.45 a share subject to due diligence and other conditions. They already have an agreement from two Billabong shareholders who together control over 24% of the outstanding shares to sell if there is a deal. Billabong announced on July 27 that “TPG will be granted the opportunity to conduct non-exclusive due diligence in order to reduce the conditionality of its proposal and to improve its understanding and valuation of Billabong.”  
 
Notice it’s nonexclusive, so it’s not impossible for another buyer to pop up. But TPG has 24% of the shares already tied up with deals that give them some upside if higher price is negotiated. TPG also has agreed to allow “…Billabong’s founding shareholder, Gordon Merchant, and Collette Paull to roll over all or part of their respective shareholdings in the company into the TPG proposal.” There seems to be at this point a certain momentum, though a lot can happen between the start of due diligence and the closing of a deal; including an adjustment in the price.
 
The other reason I think a deal will happen is because of the process by which we got to where we are. Back on February 17th Billabong announced the deal to sell half of Nixon to TCP (not to be confused with TPG) for net proceeds of US $285 million. The deal closed on April 12th. That US $285 million, along with other action take to reduce expenses and close some retail stores, was supposed to address Billabong’s capital structure issues. That is, it strengthened their balance sheet.
 
 In the conference call at the time the Nixon transaction was announced, Silvia Spadea, a Merrill Lynch analyst, said, “I guess there’s no question that that will provide you with a short term reprieve with respect to your balance sheet issues. But, in my mind, it doesn’t really do much to address the fact that – you know to improve your current structural issues or stem the current deterioration in your earnings. I guess I’m just wondering how confident you are that the initiatives that you’ve outlined today are going to be enough to permanently fix that balance sheet issue, so that we don’t have this problem a year down the track.”
 
 An excellent question, I thought. In their answers, Billabong CEO Derek O’Neill and CFO Craig White never said anything like “You bet- problem solved,” and you actually wouldn’t expect them to be that definitive. But what they did do was indicate they had confidence in their projections. And my common sense told me that if they had even an inkling that the short term problem wasn’t  well and truly solved, they’d have taken more drastic steps and the Board of Directors would not been quite so cavalier about turning down an offer of AUD $3.30 a share for the company.
 
So imagine my surprise (Yours too, I expect) when Billabong management  announced on June 21st  (Former CEO Derek O’Neill departed the company on May 9th) that they were raising AUD $225 million at $1.02 a share, 44% below the previous closing price.
 
What the hell is going on in there? Had business conditions just fallen off a cliff and Billabong management hadn’t seen it coming?   Almost seems like it couldn’t happen that fast. Had they known it was worse, but had another solution in mind? In the U.S. such a failure to disclose would probably lead to shareholder lawsuits and a flogging from the Security and Exchange Commission. I don’t know what happens in Australia.
  
I suspect it’s not quite as black and white as either of those choices. In doing turnaround work, I’ve noticed a lot of denial and perseverance during periods of change even among highly competent managers/owners and I suspect there might have been some of that in this case.
 
When management has credibility issues, things appear to be going south much faster than anybody (including said management?) knew, and the shareholders take it on the chin and have a stock valued at AUD $1.39 a share they think they could have sold for AUS $3.30 just a couple of months ago, companies find themselves in play.
 
When will we know the outcome? Billabong is scheduled to report their full year earnings on August 27th. That is also the date new CEO Launa Inman is scheduled to present her plan to turn around the company. Due diligence takes some weeks typically, and I wouldn’t be surprised if an announcement coincided with the earnings report.   
 
I wonder what TPG would have found had they commenced due diligence under their previous offer of AUD $3.30? I think maybe there’s an untold story here. Anybody want to tell it to me?