Billabong Has a Meeting

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Billabong held its annual shareholders meeting October 25th.  Chairman Ted Kunkel and CEO Derek O’Neill made short speeches you can read here that contained a few pieces of interesting information. Looking over the longer term, however, I am more interested in an issue they discussed and acknowledged as being important, but didn’t really get into at the level I would have liked.

That issue is the question of what percentage of sales can be represented, in the retail they own, by the brands they own.
 
To be honest, I would have managed it exactly the way they did because I wouldn’t have been in hurry to give my competitors any more information than I needed to. And because I’m guessing the shareholders wouldn’t have wanted a two hour speech.
 
I discussed this when I wrote about their annual report for the year ended last June 30th. To summarize, when you buy retail, you do it partly to get the higher margin. But you don’t get that higher margin right away. First, you have to sell the existing inventory at normal retail margins. Second, you have to stock the stores with new inventory, but you only get higher margin when the product sells at retail- not when it goes into the store, which is when you would have gotten it before you owned the store. Third, you have to replace brands you don’t own with brands you do own. The more you do that, the more money you make.
 
Retail represented 38% of Billabong’s revenues in their last complete year, and they didn’t own all of their retail for the whole year. In a perfect world, they’d like to sell only Billabong and Billabong owned brands in their retail stores. But a West 49 store can’t be all Billabong brands and still be a West 49 store. Can it?
 
No, and Billabong knows that. Certainly it can be 30%. How about 75%? At what point does stocking a store with owned brands impact the store’s image and market position? When do the non-owned brands you carry in stores begin to feel like they aren’t getting enough space to be merchandised well and that all they are doing is helping Billabong build its competitive position against them?
 
I don’t think either Billabong or I have a solid answer to that. It probably varies according to brand and retail location. But I bet they are thinking about it every day and I wish they’d talked more about it though, as I said, I didn’t expect them to. This may be the single most important issue, among those they can control, that impacts their future results.
 
CEO O’Neill pointed out that “…the family brand share in all of the Group’s acquired retail operations has been lifting and this is leading to better profitability for the business,” so they are starting to get the promised benefits. 
 
Chairman Kunkel gave us some specific data for West 49. Before the acquisition, Billabong had an EBIDTA of about $5 million from West 49 and “…a store penetration level of 15% company owned product.” For the year that will end June 30, 2012, they expect an EBITDA of $15 million and a penetration level of 35%. Notice that the EBITDA contribution tripled but the penetration level didn’t. That’s the higher margins at work I assume.
 
Just to carry this a bit further, we see that the ratio of EBITDA to store penetration last year was 0.33. In the current fiscal year, they expect it to be 0.43. Now, I don’t quite know what to call that calculation, because I just made it up, but higher is better. If I were Billabong, I’d have a graph that tried to project it as owned brands retail sales grew. I say “tried” because I’m not sure it’s completely a linear relationship as there are other factors involved I’m not sure how to include.
 
Ted Kunkel also said some interesting things in describing the company’s rationale for its increased retail focus. He said the two key groups in the industry were the brand owners and the specialty retailers, with the brand owners being the product innovators and the retailers the “…important interface through which the brands connect with the consumers.” I wouldn’t make quite such a clear distinction. Specialty retailers have a role in product innovation- or at least in trend identification and communication that leads to product innovation.
 
He goes on to say: “One particular trend among the larger mall-based retailers has been a transition to vertical product, thereby reducing the floorspace available to authentic boardsport brands and, in many instances, watering down the appeal of the stores to the core boardsports consumer  demographic.”
 
Certainly this is a valid reason for Billabong, and other brands, to move into the retail space. But if accurate it seems to imply declining importance to the specialty retailer. Or maybe it makes the ones who are left even more important.   
 
Derek O’Neill started his presentation by reminding the audience of some of the challenges they had faced last year even beyond the ones involved in integrating new acquisitions. These included earthquakes in Japan, floods in Australia, weak economies, and a rapidly gyrating Australian dollar. I thought he made an important comment when he noted that it wasn’t the level of the Australian dollar that was a problem, but the volatility. Obviously, Billabong wasn’t the only company affected by these.
 
He also gave us information on what’s happened in the quarter that ended September 30. Total sales were up 24.7% in constant currency. Excluding acquisitions, they rose 6%. In their owned retail in the U.S. same store sales rose 6.4%. Without providing any numbers, he describes their U.S. wholesale business as “stable.” I guess that’s an improvement.
 
No numbers on the Australian wholesale business either, though he indicated that specialty account base was performing “quite well.” Their owned retail business in Australia had positive comps of three to four percent. He described Europe as having “solid revenue growth year to date” but with slightly lower margins due to higher product costs.
 
The year seems to be starting out better for Billabong, with some of the promised improvements in owned retail coming on line and more to follow. Sounds like the wholesale business is a bit more problematic.  Lacking financial statements with a bottom line, we have to be a bit cautious in reaching conclusions about their first quarter performance. My focus will continue to be on the extent to which they can push their owned brands into their retail.       

 

 

Billabong’s Annual Report; The Relationship between Strategy and Operating Environment

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Billabong’s annual documents (which you can see here and here) provides us with a superlative opportunity to look at the nexus of a company’s strategy and its operating environment. The conference call transcript was also worth reading, but it seems to have disappeared from their web site. I can send anybody who wants it a copy.

Of course I’ll spew forth all sorts of numbers (in Australian dollars). But I want to look at those numbers in terms of the evolution of Billabong’s strategy, the impact of external factors, and some operational initiatives which, given the operating environment, are going to have a lot to do with Billabong’s future performance.

I’m sorry I’m so late getting this done, but I’ve been back on the East coast helping my mother and her husband move. Family has to come first.
 
A Transition Year
 
The year ended June 30, 2011 was a transition year. Billabong told us it would be and has been telling us that since last year.
 
Reported revenue rose 13.6% to $1.68 billion. Net profit was down 18.4% to $119.1 million. In constant currency terms, revenues were up 23.8% and net profit fell 6.9%. The currency fluctuations cost Billabong $123 million in revenues and $18 million in net profit. 
 
I will point out that Billabong had taxable income of $126.9 million and paid only $8.86 million in taxes. That’s a tax rate of 7%. Last year, they paid $57.9 million in taxes on $203 million of taxable income and had a rate of 28.5%. If this year’s tax rate had approximated last year’s rate, their net profit would obviously been a lot lower. Billabong tells us to expect a rate of 23% to 24% in the current year.
 
Here, then, is the income statement headline. Net profit fell in spite of higher sales and a very low and not to be repeated tax rate. That’s not good.    
 
Now, why was this a transition year? Mostly because of acquisitions. They closed the acquisitions of retailers West 49 in Canada, and Surf Dive ‘n’ Ski, Jetty Surf, and Rush Surf in Australia. As a result, the number of company owned stores rose from 380 at the end of the last fiscal year to 639 at the end of this one.
 
They bought the RVCA brand in the U.S. Inevitably, they ended up with a lot more inventory and took on some debt to finance all these deals. I’ll get to that when I talk about the balance sheet.
 
The retail acquisitions took their direct to consumer share of revenue from 24% of total revenue at the end of last year to 38% at the end of this one. Now that’s a transition and we’ll talk about the impact when we look at the evolution of their strategy.
 
Operationally, acquisitions leave you with a lot to do. Here’s how Billabong puts it.
 
“A range of initiatives have been pursued within the business to reflect the change in mix between wholesale and retail. The standardization of various IT systems and sales intelligence software is underway, overhead has been adjusted, management within key retail divisions has been enhanced, design teams to build faster‐to‐market product have been established and greater investment has been made into the Group’s fast‐growing and profitable online operations. The strategy to build a more robust business model in response to the changing consumer environment is on track.”
 
They also closed 65 stores during the year due mostly to high occupancy costs. Many of these were stores acquired during the year.
 
The retail acquisitions caused some initial margin dilution and, maybe more importantly, it delayed some sales revenue because once you own the retailer, you have to wait to book a sale until the product is sold to the consumer. Before they bought them, Billabong got to book the revenue when product was shipped to the retailer. 
 
It takes time and costs money before you realize the benefits of these kinds of actions. They had $12.3 million in pre-tax one-time merger and restructuring costs. As you know if you read me regularly, I find the so called nonrecurring costs a bit problematic in evaluating a company’s results. While it’s true that these exact costs won’t recur next year, there always seem to be new non-recurring costs at some level every year.
 
There’s a lot going on. Billabong expects to see more of the benefits in the current year. I’d go so far as to say they’re counting on it.
 
External Factors
 
As you saw above from the difference between as reported and constant currency numbers, Billabong got hammered by the strength of the Australian dollar (At June 30, one Australian dollar was about $1.06 U. S.). The Australian economy going into recession and getting hit with floods in Queensland didn’t help either. And, speaking of natural disasters, remember the earthquakes and tsunami in New Zealand and Japan.  Like every other industry company, they had to deal with higher product costs as the price of cotton rose. The good news is that the price has now fallen and that should start to benefit Billabong next calendar year.
 
Meanwhile, consumers worldwide are just not cooperating. “With the exception of the USA and some Asian territories, global trading conditions have generally deteriorated significantly,” is how they put it. They noted they’d seen some deteriorating in conditions in Europe during the last two months of the year.
 
Damn those pesky consumers!
 
It is, in short a tough operating environment (not just for Billabong) with a continuing high level of uncertainty. As a result, Billabong is not going to offer any earnings per share guidance until things calm down.
 
Operational Initiatives
 
 I quoted Billabong above in describing the operational initiatives they are pursuing.   Some are the direct result of acquisition, but none are bad ideas in and of themselves regardless of any acquisitions. I’ve been writing for a few years now that it was time to stop over-focusing on the top line, where revenue increases are continuing to prove tough to come by. Look instead to generate more gross and operating margin dollars through better operations.
 
I’d like to believe Billabong took my advice, but I’m afraid they probably figured it out on their own. As reported, their gross margin fell only slightly from 54.4% to 53.8%. In a promotional, higher cost environment, that seems like a good result. Even with the turn towards retail, their long term strategy implies the kind of cost management focus I advocate.
 
The initiatives they describe are not inclusive of everything they’re doing. And I wonder, as a public company, if they would have taken on quite all of it if they’d known what the year was going to be like. Still, as they get through all this stuff, assuming it goes well, on budget and on schedule, the impact on the bottom line should be substantial. 
 
Strategy
 
Early on, Billabong recognized the limits of long term growth if you’ve only got one brand. They decided to grow by paying full price for established brands with growth potential and good management in place. I suspect there won’t be any more significant acquisitions for a while. Their balance sheet wouldn’t really support them, and they’ve got more than enough on their plate.
 
Part of their strategy has always been to protect their brand names by being cautious about inventory, distribution, and promotions. Even when the recession started, they choose to lose some sales rather than devaluing their brands by discounting. As noted above, their gross margin last of year of 53.8% fell only slightly from the previous year even in a difficult environment.
 
The strategy of growing retail (hardly unique to Billabong) had, in my opinion, a number of sources. First, it was the same desire for growth that lead them to buy other brands. Second, it was the knowledge that the number of solid brands they owned made a retail strategy more viable because they had the ability to stock their owned retail with these brands and generate extra margin dollars. Third, it was their analysis of the difficulties facing the independent specialty retailers worldwide. Things go a lot smoother when you don’t have to get orders from independent retailers and then collect from them.
 
The change in strategy, if you want to call it that, was the speed of growth in retail. I doubt they planned to have 38% of revenues coming from retail at the end of the year. And remember when these retailers have been owned for a full year, the percentage will probably be higher.
 
I suspect the accelerated growth was opportunistic. They could hardly ask West 49, or any of the other retail acquisitions, to wait and be for sale next year.
 
Finally, I want to remind you of some Billabong policies and procedures that some might not call strategic, but I see as the most strategic things they do. Look at the remuneration report starting on page 12 of Appendix 4E (the second link in the second paragraph of the article).   Then check out the eight governing principals starting on page 43.
 
The remuneration report shows how Billabong works very hard to align company and employee interests. The governing principals simplify managing by making it clear what’s most important. When you sit at the desk of the senior executive, you are constantly inundated with stuff crying for attention. These principals make it easier to not waste time on the wrong stuff. Even more powerfully, they can help do the same thing for every employee in the organization if they are communicated effectively. Wonder how much time and money that can save.
 
I also noted that all directors attended all nine scheduled board meetings and three unscheduled ones as well. I love to see that level of commitment.
 
Oh Yeah- Forgot the Financial Statements
 
The first thing I want to know if what the sales would have been without the acquisitions. We know that U.S. wholesale was flat excluding RVCA. I also see that trade receivables fell from $389 million to $341 million suggesting an overall decline in wholesale sales. But I don’t have a way to isolate any currency or timing impacts so I can’t be sure. All of last year’s acquisitions occurred between July and November of 2010, so their impact on sales in the year ended June 30, 2011 is substantial.  I think I’ll call a friend.
 
The friend got back to me and tells me I didn’t read footnote 35 closely enough.  My friend is right.  Acquisitions contributed $313.3 million to revenue during the year ended June 30, 2011.  Without the acquisitions, Billabong’s revenue would have been $1.374 billion, down 7.6% from the previous year.   
 
As you may recall, Billabong operates and reports its business in four segments; Australasia, Americas, Europe, and Rest of the World. I’ll ignore the rest of the world as it only represents $2.2 million in revenue.
 
Revenues in all three regions were up significantly in constant currency but, again, I can’t isolate the impact of the acquisitions. The Americas had revenue of $844 million, up 32.5% (18.4% as reported). Europe grew by 11.5% to $338 million (it was down 1.9% as reported). Australasia grew 19.5% to $502 million.
 
As reported, EBITDA (earnings before interest, taxes, depreciation and amortization) fell in all three regions. It fell from $89 million to $55 million in the Australasia. It was down from $92 million to $80 million in the Americas and from $70 million to $54 million in Europe. Consolidated EBITDA was $192 million, down 24.3% in reported terms and 16.2% in constant currency. The reported EBITDA margin was 11.4%, down from 17.1% the previous year.
 
Without the inventory impact of the acquisitions (projected to be temporary) it would only have fallen to 13.1%. Other factors include the merger and restructuring costs of $12.3 million already mentioned and foreign exchange losses. There was also $4.5 million associated with restructuring and rolling over the company’s syndicated debt facility and some accounts payable timing issues that dragged payments into the year.
 
We’ve already talked about the external factors that influenced this.
 
Overall, selling, general and administrative expenses rose 27.5% to $599 million. That includes employee expense that rose from $226 million to $283 million. Obviously, a chunk of this increase is the result of the acquisitions. There are people working in all those places and they inconveniently want to be paid.
 
The balance sheet took a hit. Remember a couple of years ago when Billabong raised some capital even though they didn’t really need to? It’s a good thing they did because I don’t think some of the acquisitions they did would have happened without it.
 
The current ratio fell from 2.48 top 2.33. Total liabilities to equity rose from 0.82 to 1.02. Net borrowings were up from $217 million to $468 million. Their interest coverage ratio fell from 12.6 times to 6.1 times. Some of the analysts were concerned about that.
 
Inventories rose 45% from $240 million to $349 million. This includes the inventory of all the acquired companies so naturally inventory rose. But there’s more to it than that. All the inventory in the acquired stores is at full wholesale cost. Even the Billabong and Billabong owned brand inventory. Once Billabong is stocking those stores directly, the owned brand product will go into the store inventory at Billabong’s cost- not full wholesale. Branded inventory from other companies will still come in at full wholesale cost, but I’m sure Billabong hopes to make some better deals based on its larger retail purchasing power and we know they expect to increase the percentage of owned brand inventory in those stores.
 
In other words, some of that inventory increase should go away over the next year as the owned brand inventory turns over, and its share of total inventory in these stores expands. The inventory increase is partly, but not completely, a one time event.
 
There is also some excess inventory they bought in anticipation of sales that didn’t occur and some they bought and received early because of concern about possible supply constraints that didn’t emerge. In total, they see $60 to $65 million of existing current assets turning into cash during the year.
 
Net cash flow from operating activities fell from $187.2 million to $24.3 million. That’s a big drop. There are also about $86 million in acquisition payments scheduled for this year.
 
There was some wailing and gnashing of teeth from some of the analysts about the weakening of the balance sheet and the decline in operating cash flow. They should be concerned. It’s rather critical to Billabong that these operational and margin improvements kick in this year because we continue to be in an environment where sales increases may be harder to come by. Europe is weakening and, at least in my mind, it’s not certain that the U.S. will strengthen much.
 
But I also think some of the analysts were caught by surprise by the size of the increase in retail business. Rather than focusing on the strategic impact, they were concerned with the short term financial impact. I guess that’s their job. That’s why there are quarterly conference calls.
 
At the end of the day, a stock goes up in the long run because of increases in earnings. Nothing else matters. I imagine there were discussions around Billabong as to whether they should do quite so many acquisitions last year. They knew the economic environment was iffy, and they could more or less calculate the balance sheet impact. Still, if you look at their strategy you can conclude the concepts of the deal made sense even if the timing wasn’t quite what they might have preferred. It was the best path they could see to improved, long term profitability given the environment they have to operate in.
 
But they’ve taken on some additional risk to do it. The balance sheet shows it. And, like the rest of us, they can no longer count on automatically higher revenues generated by strong consumer demand.         
 
I think we can assume that the world economy is not going to miraculously rise up during the next 12 months. So what we’ll be doing is watching to see how well Billabong executes its operational strategies internally to improve its earnings and strengthen the balance sheet. 

 

 

Billabong Reduces Guidance Due to Japanese Disaster.

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Billabong announced yesterday that its Net Profit after Taxes in constant currency would be lower this fiscal year than last year by 2% to 6% due to the problems in Japan. Previously, as announced on February 18, they had expected it to be flat. The announcement describes their position in Japan and the disaster’s impact on it. Happily, none of their employees were seriously hurt.

I expect we’ll see similar announcements from other companies, and I think Billabong gets credit for stepping up and announcing it quickly even though the precise impact is somewhere between difficult and impossible to estimate right now. There is no company or person with any experience in dealing with 8.9 level earthquakes, tsunamis, and possible radiation releases all at the same time.

Obviously, earning less money rather than more money isn’t generally a good thing.  But this has no impact on Billabong’s longer term market positioning or the validity of its strategy except to the extent that events in Japan impact the global economy. That’s a potential problem for all of us.

 

 

Billabong Purchase of West 49 and Implications for the Industry- Questions, Questions, Questions

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Billabong’s acquisition of West 49 was the biggest retail expansion by a brand so far. We’ll see more brands buying more retailers and opening more stores. This article is about why. What are the motivations and the industry impacts? And what are some of the conflicts and contradictions companies will face as they pursue this strategy? Some of this is a bit repetitive of stuff I’ve written before, but we’re really talking strategy and industry evolution at the highest level. I want to tie it all together.

A Little History

Years ago we all knew, and I and lots of others wrote, that we didn’t need any more retailers (not just in action sports). Especially as the internet came into its own, consumers had more choices of product and place to buy than could possibly be useful. That didn’t mean a new store by brand x couldn’t succeed- we were all giddy with rising income and asset values after all- but if it wasn’t opened, no consumer was likely to care.
 
Then came the recession. If things are improving, we’re hardly out of the woods yet. U.S. Unemployment is 9.6% (a lot higher if you count people who have given up looking). The creation of 150,000 jobs in October was hailed as a big success, but that’s not much more than the number we need to keep up with population growth. Foreclosures and housing prices are still a major burden. Banks are cautious about their lending (we want them to be, I think- isn’t not being cautious part of what got us into this mess in the first place?), and consumers are still paying down debt and saving (again, hard to say that’s a bad thing).
 
Wish we were doing as well in the U.S. as in Canada. Well, this is for a Canadian publication after all and there’s nothing like a little ass kissing directed at the editor to minimize requests for rewrites.
 
Anyway, retailers across the whole economy closed when the recession hit, and the process is still continuing. We are all intimately familiar with the impact on action sports core stores. I’m sure everybody reading this knows a favorite store that’s gone away or is struggling. West 49’s public financials made it very clear it had some issues before it was acquired, and I expect its problems were part of the motivation for the deal.
 
Point one, then, is that if the economy is improving, we’re still struggling, at least south of the border.
 
Point two is that the role and numbers of “core” retailers is changing. Use to be that we thought anybody who was an independent retailer and carried hard goods was a “core” shop. Turns out we were wrong. A real core shop caters to participants and serious lifestylers who are not so price sensitive, carries the newest and best product, and is owned and staffed by people who are part of the culture and are participants themselves.
 
What does a core shop have to do to be successful?   My list is below.
 
Attributes of a Successful Core Retailer
 
By the way, I first created this list (slightly modified here) so long ago that I can’t even find it on my web site.
 
·         Good management accounting systems that they actually maintain and use
·         A quality internet presence
·         Active participant in its community
·         Sales volume high enough to make their shop financially viable (duh!)
·         A career path that helps them keep good employees for at least a while
·         Willingness to carry and promote new brands
·         They excel at selling and servicing hard goods.
 
The Rationale for More Stores
 
Things are better in Canada, so maybe it’s easier to justify new retailers there than in the U.S. Still, looking at the overall economic picture, and what I’d characterize as the apparent lack of consistent, real, growth in skate/snow/surf participation, one has to wonder why more stores make sense.
 
Answer? They probably don’t overall. But of course each company does what it perceives to be in its own best interest at the time. Especially as a public company, you’ve got to find ways to grow and become more profitable. Your choices of how you might grow haven’t changed in a long, long time.
 
You can sell more to existing independent retailers. Well, the action sports market doesn’t quite offer the organic growth potential it used to. There are fewer of those retailers, and the growth you can expect from them becomes less and less significant as a company gets bigger and bigger.
 
You can expand your distribution. I think at this point we all understand that there are limits to that unless you’re fundamentally changing your brand’s positioning- not an easy thing to do.
 
You can make acquisitions, and we’ve seen a lot of that from Billabong and others. I expect we’ll see more.
 
You can try and expand your brand franchise into other product areas. Quiksilver’s women’s brand comes to mind. You can add product under an existing brand like Electric (owned by Volcom) is doing with apparel. You can start a new brand. All of these have costs and risks as well as potential that aren’t the subject of this article.
 
You can run your business better, trying to improve your inventory management and controlling expenses in hopes of improving the bottom line even with limited sales increases. Pretty much everybody who’s made it through the recession has done and is doing this.
 
And finally, you can go vertical and, as part of that, open or acquire retail stores. Why does that appear to be so attractive right now? That question brings us to the list below. The points on the list are not of my creation. They are taken from conference calls, publications, and conversations.
 
Why Retail Locations?
·         Capture the middleman’s margin dollars.
·         Better control of our brand and image. Improving the consumer experience with the brand.
·         As a response to fast fashion; we can get new product into retail faster and we don’t have to convince some buyer to order it.
·         Collection issues and uncertainty as to the future of small, independent retailers.
·         We don’t see better growth opportunities (okay, nobody exactly said it quite that directly).
·         Ability to merchandise their offerings better across the complete product line.
·         Leverage with landlords, infrastructure and vendors.
·         As a competitive response.
 
I am not saying these points are all valid for any brand that opens retail stores- only that they have the potential to be. Or that brands going into retail believe they are. One of the things I wrote when the Billabong/West 49 deal was announced was that I thought Billabong might find integrating a 130 or so chain with some apparent financial difficulties more challenging than integrating a brand (like their previous acquisitions) that was growing, profitable, and well managed. As far as I can tell, Billabong really has left their acquired brands more or less alone. I wonder if they can do that with West 49.
 
The Strategic Conundrum
 
I’ll get to the tactical issues for brands building its retail base below. Right now, I want to take a few paragraphs to talk about how this retail focus might fit into the industry’s general evolution. It’s possible I’ve got more questions than answers, but it’s clearly something anybody running a brand or a retailer needs to be thinking about.
 
And maybe the distinction between brand and retailer is a good place to start.  Action sports began as brands selling to core retailers. Those sales expanded into broader distribution. Now brands are also selling their own (and other) brands direct to consumer through both the internet and their own stores. I expect this to continue to grow.  Brands becoming retailers, retailers becoming brands. The impact?
 
If you’re a small independent retailer, go back and read the box with attributes of a successful core retailer. If you read between the lines, you have figured out that you have to be a brand too- but a local brand in your community, not a national one.
 
But maybe I’ve spoken too quickly. There’s the internet after all. Think of a shop like Evo in Seattle. It’s got a successful retail store, but just one. Where it seems to be growing is with its internet presence. And it’s not the only one. As a brick and mortar retailer, it’s a local brand. With its internet sales exceeding its store sales is it a national brand? Can it be? Will it start selling Evo branded product to other retailers?
 
Next, it seems clear that the brand retail explosion is pretty much ending any stigma there was to being in a mall. This is working particularly well for Zumiez which, with its hard goods and action sports lifestyle committed employees, looks and tries to act an awful lot like a core shop. It’s almost like brands open retail locations in malls are validating Zumiez’s business model, but can’t match Zumiez’s history and focus. Maybe Billabong thinks West 49 can have a similar positioning and advantages in Canada.   It will be interesting to watch Zumiez does in Canada now that West 49 is part of Billabong.
 
Now, let’s talk about the action sports business. What is that exactly? For one thing, it’s a term that’s been thrown around out of habit even as the industry has evolved almost beyond recognition. Try this: The action sports industry is that group of brands and retailers who develop and sell product to participants in the sports of snowboarding, skateboarding, surfing, and wakeboarding, (arguments can be made to add others) and to a close circle of non-participants actively involved in the sports and lifestyles.
 
If you accept my definition, it becomes pretty clear that retail building brands aren’t just after the action sports market. It’s just not a big enough market given their existing size and objectives. I came up with the “lifestyle sports fashion business,” as a description of the market they are focused on growing in, but I’m not sure that captures it either. Maybe that’s why we keep using terms like “action sports” and “core.” We have no idea what to replace them with. Maybe youth culture is the correct term.
 
It’s no secret that this growth and industry evolution means we’re more fashion and non-participant oriented in our sales. I don’t say that critically- it’s kind of inevitable. The retail blossoming we’re experiencing puts companies like Billabong into a whole new market. I’ll say it again- it’s where they have to go to grow, and they face a whole new set of competitors as they go there.
 
What Will Billabong Do?
 
There are a number of issues Billabong will have to address as they integrate West 49. But I hasten to mention that any company with multiple brands and a retail presence will face similar issues.
 
How much of their owned brands will they sell in West 49 stores? Billabong’s Paul Naude suggested it might get up to 60% eventually. West 49, of course, was already a customer of Billabong’s. But given the higher margins and the leverage they get, Billabong would like to increase it. Go back and review my “Why Retail Locations” list.   In a perfect world, where it wouldn’t cost them any sales, they’d probably love to make West 49 stores all Billabong and its owned brands. With brands including Nixon, Element, Sector 9, Dakine, Von Zipper. Xcel and others, they certainly have the product to increase the proportion sold in West 49.
 
Assuming for a minute that Billabong wants to keep essentially the same levels of total inventory in West 49 stores (subject to any changes in sales levels), do they bring in more Dakine backpacks and reduce or eliminate Hurley, just to pick a brand? There are also Element backpacks. And Billabong backpacks. And Vans. Etc.
 
Billabong’s strict financial and operational bias will be to replace Vans, Hurley and other backpacks with its own brands. They can’t, however, make that decision without reference to West 49s customers and its market position. Do customers come in asking for Hurley backpacks and will they care if they end up with an Element one instead?
 
Would Billabong be okay with selling a bit less at West 49 stores if they got higher margins because of their owner brands?
If Billabong sells more of its owned brands in these stores, it will have to carry and sell less of somebody’s brand. Who’s? How much less? Will the customers care?
 
Billabong believes it can better merchandise it product and position its brands through its own retail because it can present the whole line the way it wants. Doesn’t Hurley, to continue with the same example, feel the same way?
 
When Billabong, or another brand, begins to control how much of which product is carried in a retail store, what happens to the manager/owner’s ability to change product/brands in response to changing local conditions?
 
So, if you’re Hurley and Billabong is cutting back its purchases of backpacks for the West 49 stores, how far do they have to cut it back before you begin to feel like your product is an afterthought and that there’s not enough product and selection of product to represent the brand well?
 
Might not Hurley (owned by Nike) take a look at the situation not just in terms of backpacks, but strategically in terms of the overall impact of brand owned retailers on its brand? One conclusion they could reach is that the distinction between brands and retail is disappearing and that competitive conditions require them to control more of their own retail. Go look at the list of reasons a brand might want to be in retail again. Given the advantages listed there, how can a big brand not do some of its own retail?
 
How about the implications for retail chains? If you’re going to have to compete with vertical brands with the advantages I’ve outlined. You’d better have a hell of a market position. I wouldn’t be surprised to see some more chains up for sale as this all evolves. And I wouldn’t be surprised to see some competition for buying them. The economics are very compelling. They might be equally compelling when it comes to buying a brand that would fit into your retail.
 
What would I do if I were Billabong? I’ve be crunching my numbers, looking at margins and sell through for various brands in West 49. I’d be talking about Billabong owned brands and what are possible substitutes for other brands. I think I’d probably conclude that I don’t want to carry brands that I can’t merchandise correctly. My bias would be to eliminate some brands rather than to inefficiently cut back on a lot of them.
 
Conclusion
 
Billabong’s purchase of West 49 feels like it might be the formal announcement of a new industry consolidation based on vertical integration. The competitive dynamics associated with this out in the larger world of sports fashion lifestyle product are driving it. As I said, I don’t like that term. But I don’t have a better one and I have to draw a distinction between the action sports market as I defined it above and this much, much larger market that the big, public, multi-brand companies are focused on.
 
The break between the two seems so fundamental that I can almost see a big gap between them. Maybe that’s where the “youth culture market” fits in. If you are in what I’ve defined as the action sports market, forget about what vertical brands are doing. If you are one of those vertical brands, you aren’t going to ignore the “core” market, but you are going to get a declining piece of your revenue and profitability from it and you will focus accordingly.

 

 

Billabong’s Half Yearly Report; A Consistent Strategic Approach

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Billabong management told us at least six months ago that 2011 would be a “transition year” and it is. But the strategy they started to tell us about a few years ago remains intact and they continue to pursue it. As I’ve written before, I generally agree with that strategy and my experience is that companies that pursue a solid strategy over the long term succeed- unless the market environment changes and the strategy doesn’t.

Let’s set the stage a little. All the documents on which this analysis is based can be found here.

First, Billabong has always been protective of its brands. You’ll remember that when the recession hit, they resisted the urge to discount more than most other brands with the goal of maintaining their brand equity. Probably cost them some sales, but gave them better gross margins. My readers know that, in the current economic environment (which I expect we’ll be in for years) I believe in generating gross margin dollars even at the cost of some sales.
 
Second, they are probably done with acquisitions for now. They won’t say never or none, but they aren’t looking and think they have enough opportunities integrating what they’ve bought. Indeed, much of the reason Billabong describes 2011 as a transition year is because of the need to complete that integration and the positive impact they expect it to have.
 
Third, the nature and structure of Billabong has changed as their retail component and owned brands have increased. At December 31, 2010 they had 635 company owned stores. These stores represented about 40% of group revenue for the half year and all that new retail wasn’t owned for the whole six months. The core Billabong brand represents, for the first time, just under 50% of revenues. So Billabong is heavily focused on retail and is a portfolio of brands that needs to be managed. But due to the retail component, they can’t be managed completely in isolation of each other.
 
The final point I want to raise before getting to the analysis is not specific to Billabong and concerns the issues that are mostly of our control, though of course we try our best to manage them. I guess this relates to consistently pursuing your strategy unless the market changes.
 
Everybody who makes anything from cotton knows that cotton prices are at record highs. Billabong CEO Derek O’Neill points out in the conference call that cotton typically represents something like 40% of the FOB price of a garment and that some price increases are inevitable for all companies. It’s in the supply chain where he sees the biggest downside risk to their business. But inflation isn’t just in cotton, and it’s not just in China. With a soft economy, you wonder just how much of those increases you will be able to pass along. I’m pretty clear on what people with stagnant incomes, no jobs, or too much debt who have to choose from more expensive food, gas, or board shorts will tend to pick.
 
Which gets us to the subject of economic recovery, because a little inflation can be irrelevant if the world is growing, jobs are being created and customers are happy. Billabong, like most other companies I think, is assuming some improvement. Or at least they need that improvement to achieve their projected results. Here’s how they put it:
 
“…the Group expects NPAT to be flat in constant currency terms for the full financial year ending 30 June 2011 and, thereafter, assuming global trading conditions gradually improve, in particular in the Australian consumer environment, the Group expects to return to more historic EPS growth rates in excess of 10% per annum in constant currency terms.”
 
Finally, there’s the uncontrollable issue of exchange rates. This is a good time to remind you that the numbers in here are in Australian dollars (AUD) unless I say otherwise.  Between July 1 and December 31, 2010 the AUD strengthened from $US 0.85 to $US 1.02. That’s 20%. So revenues earned in US dollars were worth a lot fewer AUD at the end of the period than at the beginning. The Euro strengthened by about 11.6% over the same period against the AUD. I always felt that if you’re an investor, what you care about is your return in the currency you invested in and expect to get paid in.   But looking at constant currency provides a valuable perspective, and I’ll refer to it in this discussion.
 
Quick Look at the Balance Sheet
 
Let’s do the easy part first. Billabong has always been ahead of the curve in managing their balance sheet in anticipation of their cash flow, acquisition and expected growth requirements. In August, it increased its bank line from US$483.5 million to US$790 million and extended the two segments of the facility by one year to July 1, 2013 and July 1, 2014 respectively. This provided some flexibility, ability to fund acquisitions, lower costs, and general breathing room so opportunities and surprises could be managed.
 
Between December 31, 2009 and December 31, 2010, long term borrowings rose from $397 million to $571 million (remember those are Australian dollars). The number at June 30, 2010 was $405 million so most of the increase came in the six month period. 
The largest was West 49, acquired on September 1, 2010. There were four other acquisitions between July 2 and November 8. Note six to the financial statements reports that the “Outflow of cash to acquire subsidiary, net of cash acquired” was $203.6 million. $94 million was for West 49.
 
Inevitably, borrowing money has an impact on the balance sheet. Comparing last December 31 with the prior year, we find the current ratio has fallen from 3.81 to 2.27. Higher is usually better. Total liabilities to equity over the same period rose from 0.67 to 1.03. In this case, lower is generally better.
 
I feel obligated to report the change, but the balance sheet is still strong and it’s not like there’s an issue here. We know why it happened, that it was deliberate, and that they adjusted their lines of credit to give them the flexibility to manage it. Balance sheets can never be looked at in isolation from cash flow management. Well managed balance sheets give me a warm, fuzzy feeling.
 
Digging Into the Income Statement
 
Here are the summary numbers as reported. Half year revenues rose 15.7% to $837.1 million compared to the same period the prior year. The gross profit margin fell from 55.7% to 54.4%. Selling, general and administrative expenses rose 20% from $239 million to $287 million. Other expenses were up $33 million to $87 million. Interest expense rose from $12.2 million to $19.9 million.
Profit before tax dropped from $98.4 million to $62.3 million, or 36.7%. After tax income fell 17.9% from $69.7 million to $57.2 million. The income tax provision was down from $28.7 million to $5.1 million. The lower tax rate was largely the result of several one-time events. Without those, the tax rate would have been 24%. 
 
EBITDA (earnings before interest, taxes, depreciation and amortization) fell by 23.4% as reported. Billabong says five factors were responsible for the decline:
 
1)      The very weak retail environment in Australia.
2)      The strength of the AUD against the US$ and the Euro.
3)      The impact of the recent acquisition of retailers (see discussion below).
4)      M & A and restructuring costs of $10.3 million.
5)      An increase in global overhead costs.
 
In constant currency, revenue was up 24.4%, EBITDA fell by 17.3% and after tax profit fell 9.8%.   Revenues would have been $49 million higher. Net income would have been up $6 million. Big currency impact.
 
Billabong reports its business in three segments; Americas, European, and Australasian. Sales in the Americas were up 28.6% as reported and 38.2% in constant currency. In Europe, they fell 4.1% as reported and rose 14.3 in constant currency. In Australasia, it was 12.4% and 13%.
 
As reported, EBITDA in the Americas fell from 13.7% during the period from $33.7 million to $29.1 million. The EBITDA margin was down from 10.6% to 7.1%. In constant currency it fell 5.8% from $30.9 million to $29.1 million and, as a percent, from 10.4% to 7.1%. It was noted that conditions in the wholesale accounts were showing some improvement, but that retailers were still cautious about holding inventory. Good for them. During the conference call it was noted there were “significant declines” in sales to Pac Sun during the six months, with orders for the Billabong and Element brands down 50%.   
 
Reported European EBITDA fell 17.4% from $29.1 million to $24.1 million. The margin dropped from 17.8% to 15.3%. In constant currency, it rose 3.9% from $23.2 million to $24.1 million but the EBITDA margin declined from 16.8% to 15.3%. Growth in this segment was led by the Element, Nixon and DaKine brands.
 
For the Australasian segment, it was reported to decline 32.5% from $59.7 million to $40.3 million. The EBITDA margin fell from 24.9% to 15%. In constant currency, the numbers in this segment were almost the same as reported.           
 
The Impact and Management Challenge of Acquisitions
 
The other expenses line in the income statement includes $7.4 million in acquisition related expenses. West 49 contributed $82 million in revenue and $1.7 in after tax profit to the group for the six months ended December 31, 2010. The other acquisitions (which aren’t broken out separately because, I assume, of their smaller size) contributed revenue of $66.5 million and after tax profit of $6.2 million during the same period. If you take that $148.5 in acquisition related revenue out of the total for the period, total revenue from existing brands was $688.6 million, down 4.5% from the same period the prior year. CEO O’Neill says in the conference call that “…once we strip out the acquisitions, there was revenue growth in the underlying business…”  Strangely enough, I’m guessing both statements may be correct. The difference, which is discussed in some detail during the conference call and below, may come from how you categorize between wholesale and retail during the transition period following acquisitions. 
 
Now, let’s talk about the impact on sales and margins when a brand acquires a retailer that was a customer before it was acquired. First, revenues no longer get recognized when the brand ships its product to the retailer. The retailer has to sell that new inventory before it’s recognized as revenue by the consolidated entity. On the other hand, Billabong immediately starts recognizing sales of inventory held by the retailer as of the closing date. But if Billabong has previously sold some Billabong branded product to, say, West 49 and the product’s still in the West 49 store after the closing date, what happens? Billabong has already recognized the sale of that merchandise and taken it out of their inventory. It comes back into their inventory at the acquisition date, but at what cost? You can’t go back and adjust your financial statements based on an acquisition that occurs the next period. I guess you bring it in at the acquired company’s cost. Okay, I’ll stop. I don’t want to go all debit and credit on you. But you can see that there’s some delay in recognizing sales and the increasing gross margin.
 
And these retail acquisitions start out with lower margins than Billabong is use to earning. Before they can really influence that, according to CEO O’Neill, “…we have to sell the inventory on the floor, the inventory in the warehouse and also the inventory on order by the previous owners before we get the opportunity to affect the mix of product on the floor and generate additional wholesale margin through the sale of company owned product to the stores. So that means we have to get through one or two inventory turns of existing product from third party suppliers before we can start to realize the benefits of owning retail.”
 
Changing the product mix on the floor and getting better margins sounds so simple, but it’s pretty complex as I’ve pointed out previously. Billabong has to decide how much of which of its owned brands it can carry in the stores. Obviously, they make more money on those brands. Are they going to reduce the footprint of the brands their retail carries that they don’t own? By how much? How will those other brands react to that? CEO O’Neill says, “As far as the third-party brands go, I think we are still having a lot of discussions in terms of who’s coming with us over the medium term.” I’ll bet they are.
 
You can see why these acquisitions have a lot to do with why management calls 2011 a transition year.
 
Critical Factors
 
As you think about the things that will influence Billabong’s success, where should you focus? First, on the economy. Billabong appears to be counting on some improvement there to meet its goals. Well, why should they be different from the rest of us? I hope we get that improvement, but I’m not certain it will come quickly.
 
Second, as I discussed above, they’ve got some non-trivial work to do to realize the benefits of their retail acquisitions. It’s easy to buy a company. It’s hard work to achieve the benefits you projected when you bought it. We’ll get a better sense of how it’s going in six months or so. I was glad to see the discussion in the conference call about the progress they are making in consolidating four computer systems, warehouses, and back office functions into one. I don’t know the details, but there’s typically some money to be saved and efficiencies to be gained there.
 
Some of those efficiencies come in getting product to market a little faster and having to hold less in inventory, and I suspect that requires those integrated systems. That was also a subject of the call, but this isn’t the first time Billabong management has focused on it.
 
Accomplishing that requires that things go smoothly in the supply chain. Billabong has some concerns not just about the price of cotton, but about labor shortages and shipment delays.  Once again, this is a concern we all share.
 
Finally, with no acquisitions expected in the near future and the economy improving slowly at best, you have to ask where growth will come from. Every company that protects its brands through control of distribution eventually runs up against this. Where can you sell without diluting your brand equity?
 

My sense is that Billabong, while they wouldn’t trumpet it from the roof tops, knows sales increases are harder to come by than they’d like. But they believe that can accept slower top line growth in exchange for vertical margin, system efficiency, and certain savings you can sometimes achieve when your brands are well positioned and cautiously distributed. If they do think that, well, I agree with them

 

Billabong’s Announcement and the Industry Strategic Issues Underlying It.

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On December 15th, Billabong revised its projected results for the six months ending December 31, 2010. Here’s what they said:

“The Company’s previous guidance….indicated net profit after tax (NPAT) for the first half year ended December 31 2010 would be slightly lower than the prior year in constant currency terms. The Company now anticipates that first half NPAT will be 8% to 13% lower than the prior year in constant currency terms.”

You can read the press release and the transcript of the conference call they held here. It’s the “trading update” and “trading update transcript.”
 
In Australia, they pointed to cool wet weather, lower than expected wholesale repeat business, and weaker than expected consumer retail spending. In the US it was a shift in seasonal orders pushing delivery into the second half of the year, partially offset by strong retail performance in their owned stores. In both Australia and Canada, slower sell through of existing product in newly acquired retail has meant a delay in getting their owned product into this retail. To a lesser extent, Europe and Japan were also just a little soft.
 
Well, every year shit happens. To all of us. It can be weather, or product delays or a soft economy somewhere (or everywhere) or a container I put on a train from the East coast because it would be faster than a ship and then a blizzard stops the train and they “lose” the railroad car (true story) or lots of other things. They will always happen.
 
What I would like to do is get out from under the tactical issues and the uncontrollable stuff for a minute and talk about market evolution and strategy. If it sounds like I’m saying, “I told you so,” and am being a bit insufferable well, I probably am. But I’m going to enjoy it. You can trash me on my web site if it gets too bad.
 
This isn’t by the way, just about Billabong, though I’m using them as an example and their announcement was motivation to write this.
 
As attractive as all that extra margin is to brands, successfully integrating retail with your existing owned brands isn’t easy or straightforward. How much of which brand to put where, what brands to cut, whether you require a retailer to carry your owned brands even if they aren’t selling, etc. are not trivial issues. About 40% of Billabong’s revenue is from retail now.
 
Oh wait- I already wrote about that like just last week. See it here.
 
West 49 is the biggest retail acquisition (maybe the biggest acquisition?) Billabong has made. And, as far as I know, it’s the first one they made that had some elements of a turnaround to it, requiring more management time and attention I suspect.
 
Oh wait- I already wrote about that when Billabong bought West 49. See it here. Look towards the bottom of the article in the section called Nuts and Bolts.
 
Though the short term issues Billabong is facing are certainly real, I think there’s more to it than that. At the end of the day, both retailers and brands have to expect that sales increases will be harder to come by for a while. Anybody expecting a strong economic recovery in the short term is fooling themselves. Retailers and brands are (correctly in my judgment) focusing on expense and inventory control, and generating gross margin dollars. It’s not that they don’t want to grow, but they aren’t expecting it like they use to.
 
Oh wait- I already wrote about that. See it here back in 2009. And here. Okay, I guess I’ve been insufferable enough.
 
Of course if you’re a public company, you’re kind of reluctant to tell the analysts, “We don’t think we can grow much for a while!” Just wouldn’t be well received, though I doubt I’m saying anything here the analysts aren’t thinking. They are smart people.
 
Look at Billabong’s announcement as representative of issues we all face.

 

 

Billabong’s Annual General Meeting

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On October 26th, Billabong Chairman Ted Kunkel and CEO Derek O’Neill made speeches at the company’s annual meeting.  Together they only run to to seven pages of big, easy to read, type.  You should read them, and you can read them here.  There’s a lot of good, succinct information on why fiscal 2011 is a transition year, the performance of their acquisitions, the evolution of their retail business (now almost 40% of their revenue), the impact of currency fluctuations, market conditions, and their continued focus on operating efficiency.

In a lot of ways, it’s a convenient, easy to ready, summary of the annual report that came out a couple of months ago.  It lays out their results, strategies, and issues without being too detailed and dense.

I did a detailed analysis of their annual report when it first came out and if you’re curious, and haven’t seen it before, it’s here.

 

 

 

 

Billabong’s Annual Report; Why Their Retail Strategy is a Match to the Economic and Industry Environment

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Billabong’s annual report and associated documents released around it contain a wealth of information. Some of the questions asked by the analysts in the conference call, and the answers provided, were particularly interesting. But equally important, there are some insights into general market conditions, the evolution of the retail environment and issues with Chinese production. It’s a lot to cover. Let’s get started.

Strictly By the Numbers

First, let’s set the foreign exchange stage since all the numbers I use are in Australian Dollars (AUD) and Billabong’s management talks a lot about the impact of currency fluctuations. On June 30, 2010 one US dollar was worth 1.167 Australian dollars. A year earlier, on June 30, 2009, one US dollar got you 1.24 Australian dollars. That’s a 5.9% strengthening of the Australian currency over 12 months. It wasn’t a regular change. The strengthening was greater during the first six months than the second.
 
Currency fluctuations (it happened with the Euro as well) mean that reported results become harder to interpret. You can sell, for example, more in a country, but because your home currency strengthens against that country’s currency, you show lower revenue in your home currency.
 
Some people, including me, have made the argument that, as an investor in Australia, who invests in AUDs and spends AUD, all you care about is the AUD result. I still believe that, but looking at constant currency (as Billabong and other companies do) can help you evaluate comparative performance between periods.
 
Okay, enough. If you’re curious about the impact of exchange rates, the first Market Watch column I ever wrote in 1995 was on the subject. You can read it here. http://jeffharbaugh.com/1995/06/13/foreign-exchange-management-whats-all-this-brouhaha/.
But you probably don’t care and wish I would get back to Billabong, so I will.
 
Revenue fell 11.2% for the year ended June 30, 2010 (they were flat in constant currency) to $1.488 billion (In Australian dollars, remember). “European sales of $344.0 million were up 5.2% in constant currency terms, but down 11.3% in reported terms. Sales of $712.6 million in the Americas were down 1.2% in constant currency terms, or down 14.8% I reported terms. Australasian sales of $425.7 million were down 1.9% in constant currency terms, or down 4.2% in reported terms.”
 
“Gross margins strengthened to 54.4% from 53.3% in the prior year, reflecting a less promotional retail environment, primarily in the USA.”
 
Cost of goods fell 13.4% to $676 million. Selling, general and administrative expenses were down 10.6% to $470 million. Other Expenses were down from $125 to $121 million. If I’m reading my footnote 7 on page 69 of their Appendix 4E right, that includes amortization and depreciation, rental expenses, and minor impairment charges. That’s enough time spent on that.
 
Finance charges were down from $38.6 to $25.2 million, mostly as a result of the reduction in borrowing that the capital raise in May 2009 permitted. Pretax profit was off slightly from $206 to $203 million and net income was $145.2 million, down from $152.8 million.
 
Profit, if they didn’t have all that pesky exchange rate movement (in constant currency that is) would have been up 8.1% over the previous year. If they excluded last year’s impairment charge expense of $7.4 million, it would have been up 3.1% in constant currency terms. And if they hadn’t had to expense $2.7 million of post-tax acquisition costs under new accounting rules that last year they could have capitalized, their net profit after tax growth in constant currency would have been 5%.
 
So how much did they make? Every year companies have “stuff” that isn’t consistent with last year. Hey, I’ve got an idea! How about we stick with the $145.2 million Australian dollars at the bottom of their income statement? That seems like a reasonable thing to do, though maybe a little old fashioned. There can come a point where explanations don’t lend clarity, because none of them are “right.” And none of them are “wrong.”   And there are new explanations every year. If I had my way, I’d like to see five years of summary financial statements under the current year’s accounting standards. Then meaningful comparisons would be easier.
 
Billabong sees 2010/11 as a “transition year.” We’ll talk about what they mean later. They expect NPAT (net profit after taxes) to grow from 2% to 8% in constant currency terms. I completely agree with them forecasting in constant currency, by the way, because nobody has any idea what exchange rates are going to do. They expect an improving outlook in the Americas, continued strength in Europe, but a challenging market in Australia. In fact, Australian forward orders are down 20%, and Billabong is expecting a 20% reduction in sales there in fiscal year 2011.
 
EBIT (earnings before interest and taxes) is expected to be flat. They don’t say if that’s in constant currency or not. I think it is. They also expect higher interest costs and a lower tax rate. So if all this is in constant currency, and EBIT is flat and interest higher, that seems to suggest that all their NPAT growth will be due to a lower tax rate.
 
Over on the balance sheet, things are pretty much fine. My hat’s off to Billabong for raising capital in 2009 under not the most favorable conditions. It gave them the balance sheet to consistently pursue their strategy even during tougher economic times. The current ratio fell over the year from 3.3 to 2.45, but that’s plenty strong. Total liabilities to equity improved a bit from 0.89 to 0.82. In August of 2010, they refinanced and increased their bank lines to give them lower margins and more availability. The line went from US$ 483 million to US$ 790 million.
 
The increase in the line isn’t necessarily targeted on further acquisitions, but they won’t rule one out. One other use of the line will be to pay certain of their acquired companies’ bonus payments that are coming due.
 
I am a little curious about their inventory and trade receivable numbers. As you remember, total revenue was down 11.2%. Inventory fell 5.2% to $240 million and trade and other receivable was down only 1.7% to $398.4 million. It’s not that I’d expect inventory and receivables to fall in lock step with revenue, but I’m curious enough to read a few foot notes.
 
The first thing I notice in Note 1, paragraph k is that “All trade receivables…are principally on 30 day terms. Boy, good for them. I know a lot of brands who’d love to have mostly 30 day terms. They had a reserve for bad debt of $23 million at the end of last year. It’s down to $21.5 million at June 30, 2010. Billabong thinks they have problem receivables of $26.1 million, but expect to collect some part of that which I’d expect too. Of those, $14.4 million are over six months old. $26.1 million represents 6.36% of total receivables. “The individually impaired receivables mainly relate to retailers encountering difficult economic conditions.” What a surprise.
 
Note 10, paragraph b then goes on to discuss trade and other receivables that are “past due but not impaired.” They’ve got $82.8 million of these which I guess is in addition to the $26.1 impaired receivables discussed in the paragraph above.
 
I’m a bit unclear on what “past due but not impaired” means. Of this $82 million, $17 million is more than 6 months past due. That sounds pretty impaired to me. All they say is that “These relate to a number of independent customers for whom there is no recent history of default.” If they’re six months past due, I’d tend to characterize them as having a very recent history of default.
 
This number is up from $68.5 million at the end of the last fiscal year. It can’t be that there are $82 million of additional problems accounts because that would be a huge number and nobody asked about it in the conference call. So could you ladies and gentlemen at Billabong please help us stupid Americans who don’t understand Australian accounting and provide some more detail?
 
The Remuneration Report
 
This report, part of the Appendix 4E, lays out who gets paid what and how. But what impressed me were the remuneration principles on page 15. Here they are:
 
“Our remuneration principles
 Provide a market competitive reward opportunity;
 Apply performance targets that take into consideration the Group’s strategic objectives, business plan performance expectations and deliver rewards commensurate for achieving these objectives and targets;
 Ensure executives are able to have an impact on the achievement of performance targets;
 Align executive remuneration with the creation of shareholder value through providing a portion of the reward package as equity and using performance hurdles linked to shareholder return;
 Encourage the retention of executives and senior management who are critical to the future success of the Group; and
 Consider market practice and shareholder views in relation to executive remuneration, whilst ensuring that executive remuneration meets the commercial requirements of the Group.”  
    
Remuneration is divided into three parts; fixed, short term, and long term. The short and long term parts are both “at risk” and, in fact, parts of them haven’t been paid this year or last because certain agreed upon performance objectives weren’t achieve. The “at risk” portion varies by executive, but it’s not less than 20% of compensation for anybody and is typically higher.
 
This is very powerful stuff and I think goes a long ways to explain Billabong’s long term success. It aligns shareholders with management and doesn’t over emphasize short term results. Somebody’s put a lot of work in to developing and implementing this system, and I hope they got a lot of remuneration for it.
 
China, Production, Supply and Prices
 
Every company is talking about issues with labor availability, costs, and supply in China.  Billabong is no exception. Approximately 50% of their world production is in China. CEO O’Neill mentions a conversation he had with one supplier who was struggling to get workers. He also noted that the minimum wage went up 20% in May and that the currency has strengthened slightly. He points to cotton prices as being at a 13 or 14 year high and that there’s almost a shortage of it. Shipping container prices being triple what they were 12 to 15 months ago and freight prices are up as well.
 
He states, “I think that every apparel company you talk to would say that at some point over the next six to nine months that some apparel prices will have to rise.” I agree.
 
They are responding by looking for other production opportunities. Currently, they produce in approximately 27 countries. He mentions more production in South America and that “Europe’s actually began producing some items, fast turnaround items, back in places like Portugal.”
 
The Retail Environment
 
Company owned retail stores (380 at year end) contributed 24% of global sales for the year. “…in growth terms, our company-owned retail outperformed wholesale. This shows the benefit of having the extra opportunity to get the right product in front of the consumer.”
Billabong’s focus on retail isn’t new. They said many of the same things in their half year report. You can see what they said in the analysis I did at that time: http://jeffharbaugh.com/2010/02/25/billabongs-semi-annual-report/.
 
In North America, revenue from the 111 company owned stores was up 9.2% in constant currency terms. In Europe, the 103 stores were up 18.2%, again in constant currency. The number was 5.9% in Australasia with 166 stores. EBITDA for all retail stores improved from 10.2% to 10.9%. As you would expect, EBITDA margins for stores open two years or longer was even stronger, growing from 11.8% to 14.6%.
 
In talking about Billabong’s motivations for retail, they note how they’ve seen an increase in house brands by retailers in recent years, and how that ends up “…eroding the amount of space that’s available for premium brands…” and usually not working for the retailer. Though they don’t come right out and name it, I think they were thinking about PacSun, where their sales last year were down 40%.
 
There is also a general concern about the overall wholesale base. In Australia, they estimate their account base has declined 5% in the last 12 to 15 months. In addition, they have “quite a few” on credit hold and “may not continue selling to those accounts.”
 
In Europe, the decline has been between two and three percent of accounts. They had around 1,400 accounts in the US a couple of years ago, and it’s now fallen to an estimated 1,200. “What is clear is that, in real terms, there is not a lot of people opening new board sports space. So it’s not like currently there is any real new business coming online into the industry.”
 
They further note the tendency of many accounts to buy not based on what they think they can sell and best merchandise, but on the quality of the deal they can get, and expect further fallout in the retail space because of reduced consumer spending and tight credit.
With few new outlets for their products, a decline in the number of accounts and concern about the financial viability of some existing ones, and a retail base that’s cautious in their purchasing and more interesting in a deal than in merchandising high end product, you can see why Billabong is focusing on their own retail. They believe, and have said before, that they can better merchandise and sell their product in their own stores.
 
They are also interested in being more market responsive and creating new product in short time lines outside of the normal product cycle. They can do this with their own stores. An independent retailer, however, is often not prepared to buy sight unseen when Billabong asks them how much of a new product they want for delivery in four weeks. Maybe they should be if they believe in the brand.
In the short term, retail acquisitions have an interesting impact, and this is partly why Billabong refers to fiscal 2011 as a “transition year.” When Billabong sold product, for example, to West 49, they booked the sale when the product shipped. But the moment they own West 49, that sale doesn’t happen until the retail customer buys the product in the store. Revenue recognition, then, is delayed during the transition period.
 
Conference Call Questions
 
You haven’t read this far without figuring out that Billabong has some challenges to deal with, and the analysts on the conference call picked up on that. Here was a question that the JP Morgan analyst asked:
 
“You’ve highlighted higher sourcing cost, and that actually looks like a more enduring problem rather than sort of like a temporary sort of blip. You have a consumer that is seeking value and you’ve got channel base that’s sort of declining, well it has declined, and you’ve got mixed shift to lower margin regions like Brazil. I mean haven’t you got a lot of factors there that are actually negatively impacting your EBITDA margins in the US?”
 
CFO Craig White’s answer was, in part, that it depended on your time frame but he agreed there were other issues as well. “I mean we’re talking about 2010/11 as a transition year and implicit in the [mid-term] guidance we’re providing … of EPS growth in excess of 10% is a whole mix of things happening including overall gradual macroeconomic recovery; growing share of Billabong brands in retail which will improve existing margins in retail, be it West 49 or other stores; you know there is a whole range of things in there.”
 
But the analyst doesn’t seem quite satisfied with the answer: “I mean how can you give medium term 10% year on year growth guidance with a lot of confidence because in my mind it seems extraordinarily difficult to do that?”
 
I’ve summarized the exchange here.  The entire transcript, and all the reports I’ve referenced are on Billabong’s corporate web site if you want to dig in a little.
 
Billabong decided, when the recession started, that they would not be as promotional as other brands because they wanted to preserve brand equity. I thought that was a good decision. The question is how you make that work in a continuing weak economy under the circumstances the analyst outlined. At least part of the answer is by expanding your retail presence where you can better merchandise your brands, drop in new product quickly outside of the traditional product cycle, and get the margin and volume you are, to some extent, losing in your traditional retail channels. That’s what I might have told the analyst in CFO White’s place. Of course, I’ve had a couple of days to think about it and who knows what I would have said at the time.
 
There were also questions about whether or not the Billabong brand was losing market share, about whether more global styles and reduced range sizes reduced entry barriers for competitors, and on the company’s ability to manage all the owned and licensed brands. For a conference call, this was a lot of fun!
 
In difficult operating environments (this one qualifies) managers of public companies are often in no win situations. They can be cautious- and raise concerns that they aren’t acting aggressively enough in an obviously rapidly changing environment. Or they can act aggressively- and have people concerned they’re moving too quickly in too many new directions.
 
I’ve argued that the biggest risk of all is to not take a risk when things are changing and I think I’ll stand by that. Billabong does seem to be relying to some extent on a continuing US economic recovery and I’m not sure they should be. All the risks the analysts pointed out are very real ones. But business is a risk.
 
You minimize those risks by having an experienced management team, building agreement on goals and objectives among the team members, and by not sitting on your ass when you become aware that things are changing- for better or worse. I’m sure that one or more of the actions Billabong is taking won’t work out. That’s life. But in light of fast fashion, a declining wholesale base, a difficult economy, and the retail opportunity they have with the brands they’ve assembled, their strategy seems largely correct to me.    

 

 

Billabong Acquiring West 49

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Or Maybe Zumiez is Going to Buy Them
 
Oh, and Billabong Bought RVCA
 
Okay, Zumiez is Out of the Picture
 
Anyway, This is All Really Interesting- and Related
 
As you know, Billabong made an offer on June 30 to acquire the Canadian action sports retailer West 49. Only July 9th, Zumiez said that, subject to a satisfactory due diligence review, it would be prepared to make a higher offer. On the 14th, they said, “Never mind.” What we’ve got work with here are some of Billabong’s comments about retail in its last half yearly review conference call, it’s conference call and presentation on the proposed West 49 acquisition, West 49’s financial results for the quarter ended May 1 and the associated conference call, Zumiez’s announcement that they were prepared to beat Billabong’s offer (and then that they weren’t) and their announcement that they were opening some stores in Canada. Meanwhile as I was writing this, Billabong announced it had bought RVCA, which fits nicely in the discussion below on Billabong’s strategy and retail positioning.
 
Damn, I feel like a kid in a candy store. Although I have to admit that having Zumiez come and go and RVCA bought since I started researching this article has made for an interesting editorial challenge.
 
This analysis will be strategic in nature. Though obviously we’ll discuss the numbers and specifics of the offer what’s more interesting to me is what this says about the retail environment, the evolution of the industry and the shape that larger, successful industry companies are going to take as they continue to expand into the broader market. Let’s start by looking at the players.
 
West 49
The chain is a Canadian action sport retailer founded in 1995 by current CEO Sam Baio. They’ve got 138 mostly mall based stores (not unlike Zumiez- the plot thickens). There are 81 West 49 stores. They also have five Billabong stores.
 
The remaining 52 stores include 19 under the D-Tox label, 16 Off the Wall Stores, and 17 Amnesia store. Billabong’s presentation on this deal has some info on page describing how these other brands are positioned. You can see the complete presentation here and I suggest you take a minute to do that. It’s just 12 Power Point slides long and won’t take long.
 
Many of these other brands (Most? I’m not sure.) were acquired by acquisition. More brands, of course, means more marketing expense and some complexities in operating around, for example, inventory purchasing and management. Keep that in mind as we review briefly West 49’s recent financial results, which include all 138 stores. I wonder if Billabong would keep all those other store brands. Would Zumiez have renamed all 138 stores as Zumiez?
 
In the quarter ended May 1, 2010 West 49 lost $2.6 million Canadian on sales of $40.9 million. This was very close to the same sales and loss they experienced in the same quarter one year ago. Comparable store sales were down $2.6% (3% for West 49 branded stores). CEO Baio cited pressures on margins as a result of the competitive landscape and said they were still waiting for consumer confidence to return. As you’ve probably noted, other retailers and brands have shown some almost inevitable rebound in their quarterly results as the very difficult conditions of a year ago have eased. West 49 did not and that was some cause for concern.
 
The balance showed $0.00 in cash and cash equivalents compared to $7.9 million on January 30, 2010. Obviously, no business operates without some cash to pay its ongoing bills. For all I know, the day after this balance sheet they drew down an available line of credit in the ordinary course of business and the balance showed some cash again. But I’d note that the current ratio at 1.05 was barely over one.
 
We didn’t get any more information on their financial condition because at the end of the conference call, there were no questions. That’s because the stock is pretty closely held (note that Billabong already has 56% of the voting shares agreeing to the transaction) and I guess the analysts don’t follow it. I certainly don’t have the information to conclude that West 49 has serious financial or liquidity issues.  But the information I do have makes me think that concerns in those areas could be a factor in their being prepared to sell the business now.
 
Billabong’s Retail Strategy
This isn’t a new topic for me. I wrote about their half yearly review and spend a lot of time on their retail strategy. See that here. http://jeffharbaugh.com/2010/02/25/billabongs-semi-annual-report/. At least scan through it and read the quotes about their retail strategy. Here’s what I said early in that article.
 
“Billabong CEO Derek O’Neill is clear in the conference call that we shouldn’t ‘…expect for retail to suddenly become a huge component of our business but it’s clear we will continue to identify opportunities to get our product to market where required.’ I read a little bit of ambiguity as to Billabong’s retail strategy into that statement, or maybe a little understandable reluctance to state what they really think of the retail situation.”
 
Billabong has described its acquisition approach as “opportunistic.” At the same time, they’ve discussed the tendency of independent retailers to purchase lower and mid price point product and to often not be able to merchandise the complete Billabong line well. They have noted that their own retail had outperformed their wholesale business and expressed some concern about tight credit conditions and the health of independent retailers. The company is also looking for ways to short cut its product cycle so it can have product sooner that it will just drop in its own stores before it gets to the independents.
 
You really need to go read the complete quotes in that article. Billabong’s strategy may be opportunistic with regards to timing (anybody’s acquisition strategy is) but I don’t think there’s any doubt that they have been planning to make retail a bigger part of their business. The presentation on West 49 says, in part, “Billabong has a long track record of successfully acquiring and integrating ‘bolt-on’ acquisitions consistent with its key strategic objectives of growing its brand portfolio and expanding its retail distribution network.”  (Emphasis added) And their store count has grown from 49 in 2004 to 510 this year assuming they complete the West 49 deal.
 
An acquisition strategy, of course, supports a general business strategy and can be the tool a company uses to transform itself. You might go look at what VF Industries, Collective Brands, and Genesco have done by selectively buying (and selling) brands to grow their companies and reposition themselves in markets they found attractive. It wouldn’t completely surprise me to find that those company’s strategies are a subject for discussion around Billabong’s executive offices from time to time.
 
Nuts and Bolts
 Billabong has offered to buy West 49 for $99 million Canadian. That’s about $96 million US. The deal is supposed to close in September, and will be funded using Billabong’s existing credit lines. Remember a year or two ago when Billabong raised some capital to improve its balance sheet? It wasn’t really a necessary thing to do, and the timing could have been more favorable. But without it, Billabong wouldn’t be able to do this deal without a financing contingency. This is one of the things I really like about Billabong. They always have consensus on what their strategy is and they have their eye on the long term ball as they pursue it.
 
Presently, “…across West 49’s portfolio Billabong has a brand share of approximately 15%.” They will be looking to increase that over time, but will leave the stores multi branded. CEO Derek O’Neill indicated in the conference call on the deal that the share of Billabong product in the West 49 stores might reach 45% over a couple of years.
 
If the West 49 stores go from 15% to 45% Billabong and Billabong owned brand products, obviously some other brands are likely to be unhappy with their share. There is, as we all know and no longer try to dispute, an inevitable tension between retailers and brands when the brand becomes a retailer.
 
In the past, when Billabong bought Nixon, Sector 9 and Dakine they paid high (fair might be a better term) prices for profitable companies with clear growth potential that Billabong could support, but that could more or less run on their own. I applauded that strategy because my experience is that buying a company is easy. Integrating a company and fixing it if it’s broken is much harder.
 
This deal isn’t quite the same judging from the data on West 49’s performance we reviewed at the start of this article.    In addition, just from going from 15% to 45% of Billabong brand product in its stores implies a transition that Billabong didn’t have to manage with those other three acquisitions. Of course, they have managed it with other retailers they’ve acquired, but none of those had 138 stores.
 
The analysts expressed some concern in the conference call. Though they didn’t come right out and say it (analysts never do) they seem to have some concerns that Billabong might be overpaying for this one.
 
As an example, Craig Woolford, and analyst with Citigroup, asked, “…even if I look back to ’08, it looks like it’s [West 49] been a very low margin business at an EBITDA level. Can you comment as to some reasons why it’s had such low profit margins?
 
CEO O’Neill’s basic response was that they had a plan to increase those margins over time, and that they’d talked to West 49 CEO Sam Baio who had a credible plan to get those margins up to “mid to high single digit EBITDA.”   I should note that Billabong’s last quarter results had its EBITDA retail margins at 14%.
 
Analyst Woolford continued, “Forgive me if I sound cynical but why would the shareholders of West 49 sell — I mean on a sales multiple, it’s 0.5 times sales, surely they would feel that they can then improve margins themselves before selling out to Billabong?”  Other analysts had questions that focused on the multiple being paid and how the deal would improve Billabong’s earnings per share during fiscal 2011.
 
Billabong’s answer to why margins would improve and why it would turn out to be a good deal was three fold; synergies, elimination of the costs of being a public company, and the higher margins they get when they put their own product in the stores in place of another brand’s products. They also think there’s potential to open some more stores in Canada.
 
Those are all good answers, but only eliminating the costs of being a public company is a slam dunk. Synergies can be surprisingly elusive and take time and cost money to realize. Billabong, to be fair, has just announced an agreement in principal- not a closed deal. So they can’t necessarily talk about exactly what they’d do and how they’d do it. But with other acquisitions of similar size, the issues just didn’t come up in quite the same way.
 
Partly, they didn’t come up because Nixon, Sector 9 and Dakine weren’t public companies. There was no public stock price. But this is also a different kind of deal that will require Billabong not just to support its new brand behind the scenes, but to take a very active role in helping it evolve. As a result I thought, when they first announced their interest, there was a reasonable chance that Zumiez would end up owning West 49. 
 
The Zumiez Offer
On July 9th, Zumiez came out and announced that they’d like to buy West 49 too. They had previously announced an interest in opening stores in Canada. Like Billabong’s, Zumiez offer would not have been contingent on financing. It “…would be prepared to make an offer, that would not be subject to a financing condition, to acquire all of the outstanding common shares and preferred shares of West 49 for a cash price in excess of $1.30 Canadian per share [what Billabong offered]” The offer would be contingent on Zumiez’s satisfactory completion of a due diligence review.
 
If an offer had been made, Billabong would have had five days to decide whether or not to match it.
 
West 49 already had a deal with Billabong but, as a public company, they have a fiduciary responsibility to act in the best interest of their shareholders. If two deals are equally likely to close, shareholders tend to like the one with the higher price per share.
 
West 49, of course, would love a higher offer, but isn’t all that thrilled at the idea of telling a retail competitor who’s just announced it’s entering West 49’s market everything about itself as would happen during a typical due diligence review. I’ll be interested to see how the two parties finesse that.
 
I’m happy to tell you that I wrote the sentences above before Zumiez’s July 13 announcement that they couldn’t reach an agreement with West 49 on how to conduct a due diligence review. I’m not completely surprised by that result, but I am a little disappointed. I think it would have been great fun to have a good old fashioned bidding contest for a company in our industry.
 
As has been discussed above, Billabong has some work to do to realize the value of a West 49 acquisition. This is a bit different from some of its other larger deals, and has some stakeholders nervous about the price being paid and the sources of the improved performance.
 
Zumiez is exclusively a retailer with a proven model. Like West 49, its stores are largely mall based. Like Billabong, it could have eliminated the West 49 public company expenses and no doubt realize some synergies itself in a combination. It wouldn’t have gotten the benefit of higher margins that Billabong gets when it places more of its owned brand product into its retail, but maybe it would have gotten some better terms from suppliers due to higher volume, though it probably gets pretty good deals already.
 
The argument that Zumiez could have made was that it just has to transplant its existing systems and management programs onto the West 49 stores to achieve results comparable to what it gets in the US. That sounds conceptually simple, but would not have been in practice. For one thing, Zumiez has always prided itself (rightfully so I think) on its management training and the fact that everybody works their way up from being a sales associate. I have to believe that finding and/or training enough people to turn West 49 stores into Zumiez stores (which I assume would be the long term goal) would have been a challenge. And I’m assuming a lot of similarity between the US and Canadian markets, which may not be the case.
 
I don’t know if the $1.30 Canadian that Billabong is prepared to pay is a fair price or not, but my immediate take is that Zumiez could have justified paying a little more than Billabong. Guess we won’t find out now. 
 
RVCA Deal 
And as if there wasn’t enough going on, Billabong has announced the long anticipated acquisition of RVCA. It’s a comparatively small deal, so not many details were announced, but we know that RVCA will add about $30 million to Billabong’s annual revenues at its current size.
 
And it’s an easy deal to explain. Like they typically have in the past Billabong is buying a solid brand that they will support, but leave management to run from a marketing and product development point of view. They will benefit not only from the growth of the brand’s sales to non-owned retail, but from putting RVCA into Billabong’s retail distribution. Pretty much the same concept they had for Nixon, Dakine, Sector 9 and most of their other acquisitions.
 
It’s pretty simple to explain, and it’s worked before. As we’ve spent parts of this way too long article discussing, it’s an interesting comparison to a West 49 deal that I see as more complex for Billabong and not quite fitting their historical approach. At the end of the day, that’s why I think Zumiez might have ended up as the successful bidder if they had been able to get past the due diligence issue with West 49.
 
In the economic environment we have now and, I think, will have for a few more years, brands are uncertain of the viability of core shops and unsure how much growth they can expect from them. As they and their lines get larger, they are also finding they can merchandise better and make more money through their own retail. Vertical integration, fast fashion, the imperative for cost control, market expansion into the mainstream, and the need for growth if you’re a public company all will push companies in the direction Billabong is taking as they get larger.

 

 

Billabong’s Semi-Annual Report

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Billabong released its numbers for the six month ended December 31, 2009 last week and held a conference call. Though clearly not immune to a tough economy, the company’s raising of capital to strengthen the balance sheet, long term focus on brand equity, willingness to lose some sales rather than become too promotional, realism as to the operating environment, and nuts and bolts management of costs and inventory has left them in a pretty good position.

But what really caught my attention was the discussion of retailing during the conference call. I’d like to spend some time on that before I get to the financial results.
Billabong’s Retail Perspective
Billabong closed the year with 360 company owned retail outlets, up from 335 June 30th. 90 of those are in the European segment, 157 in Australasia, and 94 in the Americas. Retail now represents just a little more than 25% of the company’s sales.
No, I don’t know why those three numbers don’t add up to 360. I’ve emailed Billabong to ask.
Billabong CEO Derek O’Neill is clear in the conference call that we shouldn’t “…expect for retail to suddenly become a huge component of our business but it’s clear we will continue to identify opportunities to get our product to market where required.” I read a little bit of ambiguity as to Billabong’s retail strategy into that statement, or maybe a little understandable reluctance to state what they really think of the retail situation. Later conference call comments provided more insight into their thinking and created an intriguing picture of the retail market as Billabong sees it and how they may approach it.
They start by noting that there is still some softness in prebooks (though things have improved) both in terms of the size of the orders and the numbers of retailers they have received orders from for summer. CEO O’Neill indicates that 80% of the account base (referring, I think to the US) had orders in, where it would have been 90% two years ago. There is still “…a little bit of an apprehension to actually placing forward orders, and some customers preferring to do a little bit of business in season.” “I’d say that’s a trend that’s probably going to be there for a little while,” he continues.
I’d be curious to know just what he means by “a little while.”
Next, he talks about tight credit conditions and the health of independent retailers. “I can’t sit here at all and say that all the accounts that we are currently dealing with will still be there in three months time,” is how he puts it. He also thinks they may have to tighten credit by the end of the current six months.
Finally, he says, “If you look at the wholesale level, most of the business going on, the buyers are focused on your price point category and up to your mid price print category.”
Any brand talking about the US market (and some other countries as well) might say the same thing. We’ve got a new set of economic conditions that look to be long lasting where independent retailers are falling out, the survivors are ordering more cautiously, consumer spending is down and focused on low to middle price points.
No surprise there, but now the plot thickens. “…in our own retail, which has definitely outperformed our wholesale side in this period, in our own retail we can showcase and merchandise a product across all the price points and we’re doing really well right across the board.”
“The cycles with our own retailers, we are beginning to drop product into our own retail even faster than wholesale channel. We are beginning to, on certain key styles…build product that may go into our own retail before even the wholesale consumer sees it in an indent (sic) process. But we’re beginning to utilize our own retail to test product a lot more and we’re just becoming a little more focused on that shortening of the whole supply side.”
And then, just to make this even more interesting, he says, “If you look at the big retail brands out there, they don’t have a buyer to get past, they just decide what they’re going to make and they put it in their own stores and therefore they could have a very short cycle.…we are looking more and more at some of our own retail stores where we can looking at touching on a more vertical model. And not having that delay with going out and having an eight week ordering pattern and then go away and ordering product, we’ll just go straight to retail.”
What percentage of total revenues could retail represent?” somebody asked. “It’s probably going to depend on what happens with the wholesale account base,” O’Neill responded.
There’s more, but I think that’s enough quotes. You can see the report and the conference call here. http://www.billabongbiz.com/news-business.php
In summary, given foreseeable economic conditions, Billabong isn’t sure what level of growth and profitability it can rely on from its independent retailers. Right now, it believes it can merchandise and sell its product better in its own stores because of the independents’ reluctance to order and tendency to order the lower to mid priced items, and its results bear that out. It’s also looking for ways to short cut its product cycle so it can have product sooner that it will just drop in its own stores before it gets to the independents. This is also, in part, a response to the branded retailers. Dare I say Forever 21? Seems like they are the poster child for product cycle blues these days.
Not to belabor the point, and certainly not to put words in Billabong’s mouth, but if a well managed company like Billabong is unsure of the role and importance of independent retailers going forward, and thinks they can do better business in their own stores, how will the role of those independents evolve? It’s always been an industry article of faith that core retailers were the bedrock of the business but that might be changing as companies get large and we become increasingly fashion based and fashion competitive.
By the Numbers
I have to begin by reminding you that Billabong’s functional currency is the Australian Dollar, and the numbers here are in that currency. Just for reference, at the moment one U.S. dollars equals 1.12 Australian dollar. A year ago a U.S. dollar cost 1.55 Australian dollars. That’s a 28% change over the year and that can wreak havoc on your financial planning and reporting. In this case, it did so I’m going to report some constant currency results along with reported results. Management notes that each one cent movement in the average monthly exchange rate between the Australian and the US dollar for the five months of the year that are left above or below the 0.90 rate they are planning will change reported net profit after taxes by $500,000 from their projection. 
Revenues fell 10.8% in reported terms from $810 million in the half year ended December 31, 2008 compared to the half year ended December 31, 2009. They were only down 2.8% in constant currency.
In the Americas, reported sales were 17.6 lower, but only down 6.2% in constant currency. They point out that “…direct comparisons to the prior year are somewhat misleading. The latest result includes a full six months of trading from DaKine versus three months in the prior year. The prior corresponding period also included three months of trading in the period that preceded the global financial crisis.”
They also note that sales to PacSun were down about 50% for the half year. Billabong anticipates that “…the retailer’s percentage contribution to the Group’s overall North American sales will decline to the single-digit level across the full financial year.”
Given Billabong’s focus on brand equity and interest in selling higher end product, I have to agree with their approach, though I don’t know how they easily replace those sales.
European sales were $164 million, down 7.6% in reported terms but up 2.6% in constant currency. Billabong reports strong momentum in Europe. Australasia revenue fell 2.5% in reported terms but only 1.4% in constant currency.
With sales down, cost of goods fell 14.2% as reported from $373 to $321 million. Gross margin percentage actually strengthened from 53.8% to 55.5%.   Selling general and administrative expenses were down 7.7% from $260 to $239 million. Finance costs fell 40.8% from $20.6 to $12.2 million due to the repayment of debt following the May 2009 raising of capital.
Reported net profit was down 15.4% from $82.4 to $69.7 million. They blame that almost entirely on unfavorable movements in exchange rates.
Much of the strengthened balance sheet is the result of the capital they raised in 2009. Between December 2008 and December 2009 cash increased from $169 to $213 million. Receivables fell 15% from $394 to $334 million and they reduced inventories 23.8% to $247 million. Total current assets were down 10.6% and noncurrent assets fell 11.3% from $1,317 to $1,168 million.
Trade and other payables were down 34.5% from $273 to $178 million. That explains most of the drop in current liabilities from $302 to $215 million. The current ratio improved from 3.04 to 3.81.\
By far the biggest change in the non-current liabilities is in borrowings which, as a result of the capital raised, were reduced by half from $810 to $397 million. Deferred payments also fell significantly from $161 to $107 million, reflecting a $34 million payment to the former owners of Dakine and other payments as well.
Between earnings and the equity raised, total equity grew 34% to $1,190 million. Total liabilities to equity plunged from 1.51 to 0.67. This is my kind of balance sheet!
Billabong is confident, but a bit cautious about the rest of the year.
“Retail markets remain extremely volatile and difficult to predict, consumer spending patterns remain erratic and global economic concerns continue to weigh on general sentiment. Against this backdrop, the Group’s North American business continues to experience challenging conditions. While there is some stability emerging within the independent specialty channel, there is no recovery evident amongst the Group’s larger mall-based customers. Australasia is showing mixed performances, with South Africa, Japan and New Zealand expected to remain soft but the balance of the region remaining steady. Europe, a highlight in the first half, is expected to remain relatively buoyant.”
They expect better foreign exchange hedge rates and the impact of previous expense reductions to help their results. The most intriguing thing to me, however, is still their perspective on and approach to the retail business. It will be interesting to see if other action sports brands share their perspective and if any take a similar approach.