More of the Same: Tilly’s Annual Report

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There is getting to be a certain sameness to all the reports I read from the retailers in our space. It’s not that Tilly’s has done anything bad, though their results aren’t good. It’s just that we seem to be in an environment where it’s hard to do something really distinguishing as a retailer. 

Tilly’s store numbers have grown from 111 at January 30, 2010 to 195 when the latest fiscal year ended- February 1, 2014. Revenues over the same period have risen from $283 to $486 million, up 6% from $467 million the prior year, though comparable store sales fell 1.9% during the year after rising 2.2% the previous year. Average sales per store were $2.396 million, down $2.676 million the prior year. They opened a net of 27 stores during the year. 
 
E-commerce sales were $57.8 million, up from $53 million the prior year.
 
Gross margin peaked in the year ended January 28, 2012 at 32.2%. It fell slightly to 32.1% last year and was down to 30.7% for the most recently ended year. One thing that contributed to the decline was markdowns:
 
“Total markdowns, including permanent and promotional markdowns, on a cost basis were $35.7 million, $32.2 million and $23.2 million and represented 7.2%, 6.9% and 5.8% of net sales in fiscal years 2013, 2012 and 2011, respectively. We accrued $0.9 million and $0.5 million for planned but unexecuted markdowns, including markdowns related to slow-moving merchandise, as of February 1, 2014 and February 2, 2013, respectively.” 
 
They had the smallest increase in SG&A expenses in dollar terms they’ve had in the last five year. They rose by just 3.16% from $118.8 to $122.6 million. As a percentage of sales, they fell from 25.4% to 24.7%.  Operating income was down from $31.4 to $29.7 million.
 
Net income fell pretty dramatically from $23.9 to $18.1 million due to a big jump in income tax expense from $7.4 to $11.6 million. However, it would still have fallen by $1.5 million if the tax provision had been unchanged.
 
Fourth quarter sales fell from $140.7 to $139.9 million. Operating income took a big hit, falling from $14.8 to $8.4 million during the quarter. 
 
The balance sheet is solid and I’d note particularly a minor decline in inventories even as Tilly’s increased its store count by 10%. They note in the conference call that inventory on a square foot basis was down 13.5% over a year ago. That is such an improvement that combined with the markdown expense described above I think they were probably over inventoried before. Cash generated by operations rose a bit from $41.7 to $43.8 million.
 
Now we get to the sameness part. They list four growth strategies; 1) Expand our store base, 2) Drive comparable store sales, 3) Grow our e-commerce platform and 4) Increase our operating margins.
 
In the first place, I don’t see those as strategies, but as metrics against which you measure your strategy. Essentially, however, there isn’t a retailer in our space that isn’t trying to accomplish those same four things and they are certainly not points of differentiation for Tilly’s (or for any other retailer).
 
Their strengths they list as; 1) Destination retailer with broad relevant assortment, 2) Dynamic merchandise model, 3) Flexible real estate strategy across real estate venues and geographies, 4) Multipronged marketing approach, 5) Sophisticated systems and distribution/fulfillment infrastructure to support growth and 6) Experienced management team.
 
Once again, you can see that these are things a lot of larger industry retailers might, and do, claim as strengths. As to whether Tilly’s, or another retailer, is meaningfully better at any of these than the competition, I have no idea. They talk about these in some detail in their 10K (which you can see here). I recommend you take a minute to read pages 3-6 and see if you feel differently about this than I do.
 
They sum it up like this on page 6:
 
“We seek to be viewed by our customers as the destination for West Coast and action sports inspired apparel, footwear and accessories. We believe we offer an unparalleled selection of relevant brands, styles, colors, sizes and price points to ensure we have what our customers want every time they visit our stores. Our extensive selection of third-party and proprietary merchandise allows us to identify and address trends more quickly, offer a greater range of price points and manage our inventories more dynamically. We offer a balanced mix of merchandise across the guys and juniors categories, with additional merchandise in the boys, girls, footwear and accessories categories. We believe this category mix contributes to our broad demographic appeal.”
 
I think we can all imagine other retailers, and brands with significant retail components, saying something similar. Tilly’s own brands, by the way, were 28% of revenues, down from 30% the prior year. Their largest brand accounted for just 4% of sales during the year.
 
Tilly’s President and CEO Daniel Griesemer, consistent with what they say in the 10K, describes how they are trying to improve their performance and notes, “We have reduced our expectations for annual net store growth in the near-term to low double digits compared to our prior targets of mid-teen growth.” He thinks e-commerce can represent a larger percentage of their total revenues. “We just recognized that given all of the initiatives we have in place, our customers engagement and activity online and in mobile really indicates that there is a significantly greater opportunity than just 15% that we recognized that also as we continue to grow out store footprint.” 
 
The more interesting issue, which I’ve raised before, is how you expand e-commerce revenues without cannibalizing brick and mortar and, maybe even more importantly, how you get mobile influenced brick and mortar sales. That’s not just interesting for Tilly’s.
 
Like others, Tilly’s is pursuing an omni-channel strategy and tell us they “…recently completed the implementation of our fully integrated digital platform” with the goal of “…giving our customers seamless access and increased ease of shopping.” 
 
He also expects new stores to be about 10% smaller. I see that as tied to the e-commerce strategy. They are also going to focus on outlet stores, and expects 30% of new stores this year to be outlet.
 
The issue of the outlet stores was one that attracted a lot of analyst attention. They were particularly unsure how that related to Tilly’s differentiated merchandising strategy. CEO Griesemer said Tilly’s was “…increasing the number of brands and increasing the number of products that are new or unique or exclusive…And then we’re using both our digital capability and our catalog capability and in-store capability to communicate that newness more effectively. That includes newness and exclusivity from very large and well-established brands…like Volcom and RVCA and Nike and all kinds. So I’m not just referring to adding on a few small new brands, it’s really across the board.”
 
Now, I don’t completely know what “newness” means in this context, and I wasn’t the only one uncertain. The next question was:
 
“So talking about having more differentiated exclusive merchandise in the stores and then talking about outlet strategy seem to be a bit diametrically opposed. So if you could talk about, when you’re thinking about the Volcom and some on of the world? And how you’re going to get more exclusive product from them? How are you sourcing and what kind of product will be expected to be seeing in the outlets? And are your channel partners, your brand partners comfortable with the idea of you pursuing both strategies?”
 
Mr. Griesemer’s answer was as follows:
 
“They are and they really are diametrically opposed that and they’re not really related. We’ve got a real great team of merchants that are driving the most relevant product for this action sports inspired customer across the broad range of brands and our own private label product in the full-line stores, which remains huge, the majority of the business. And we are launching an outlet specific format that gets us access to true outlet venues. And so that product will be uniquely sourced from our brands and from our own private label product.”
 
“It’s special purchases and things that are relevant and appropriate for the season and for the price point strategy and really don’t get in the way of the full price execution that we have in the majority of the stores.”
 
Another analyst didn’t find that answer completely satisfying (neither did I) and asked if there would be overlap between the products and brands in the outlet and full priced stores. The answer was yes.
 
We’re all sitting here in an economy where there are way too many retailers and our target consumers have a higher unemployment rate than the overall economy and less disposable income than they used to have. Meanwhile, our products are over distributed and differentiation is hard to come by.
 
We’ll be looking at some more retailers and will find they all have similar issues. Tilly’s can do everything well and find it still isn’t really differentiated from its competitors. A tough retail market and lack of a real competitive advantage is a hard place for any retailer to be.

 

 

PacSun’s Annual Report and Quarter: Improvement, But More Needed

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PacSun’s 2013 fiscal year ended February 1, 2014, and that’s the year we’re discussing here. You can review the 10K yourself here. I’d like to start with CEO Gary Schoenfeld’s mention in the conference call of the “…four key pillars of our overall strategy.” They are, he says: 

“…our commitment to showcasing distinct brand identities derived from the best of brands that are inspired by the streets, the beaches, the skate parks, music, art, and culture that lives across the state of California. Second is to be a leader in anticipating and recognizing the fashion trends that emerges from our backyard and translate them to the marketplace with the expediency that today’s digital world now requires.”
 
“Third is to bring the creativity, diversity and optimism that is quintessentially California to every consumer touch point through our Golden State of Mind platform. Fourth is to continue to build the top talent organization across the country that similarly thrives on creativity, fashion, and a relentless desire to be the best.”
 
I’m in favor of all of those but especially like number three- the Golden State of Mind- because it’s the only one of the four that might offer a point of differentiation from other retailers. The other three are what all retailers in this space are trying to achieve. Maybe PacSun will do them better than their competitors.
 
PacSun ended its fiscal year with 618 stores. It increased its sales for the year from $785 to $798 million. That’s up from $759 million and $756 million in the two years before that. The fact that there was one less week in fiscal 2013 compared to fiscal 2012 meant that they had $8 million less in revenue than they would otherwise have had.
 
Remember that over recent years their sales results were achieved while closing nearly three hundred stores. They closed 30 during the just completed fiscal year. At the end of the 2009 fiscal year they had 894 stores. They think they will close another 10-20 during this fiscal year. 
 
Comparable store sales were up 2% as they were the prior year and accounted for almost all of the sales increase. That number includes PacSun’s internet sales, which were 7% of total sales during each of the last two years. Men’s apparel fell from 48% to 46% of revenues. Women’s rose from 37% to 39% and footwear and accessories remained at 15%. As for most retailers, the denim category is tough. It fell from 17% to 13% of revenues during the year.
 
Nike, including Hurley, represented 10% of revenues during the year. More interesting to me was that their proprietary brands represented 49% of total net sales, up from 47% the previous year. There was a time some years ago when I would have said (did say) that was too big a percentage to get from their own brands. But times change, and some brands don’t have the pull they used to have with PacSun’s target customers. In addition, as PacSun notes, proprietary brands allow them to offer better value to the customers who are looking for that (there’s a lot of that going around), manage their inventory better and respond to fashion trends more promptly. And hopefully PacSun makes a few more points of margin.
 
The gross profit margin at 25% was the same as the prior year. SG&A expense as a percentage of sales fell from 29.9% to 27.7%. In dollars it fell from $235 to $221 million. Most of the decrease in SG&A was the result of lower depreciation and a decline in payroll and payroll related expenses.
 
The operating loss improved from $38.4 to $21.4 million. The net loss was $48.7 million compared to $52.1 million last year. I should point out that they booked a loss on their derivative liability of $10.6 million compared to almost nothing last year.
 
Sales for the fourth quarter were $218.6 million with a net loss of $22.5 million. In last year’s fourth quarter, sales were $222.9 million and the loss was $19.9 million. Remember that fourth quarter ended February 1.
 
The balance sheet continues to deteriorate, which is what can happen when you lose money. Total equity fell from $64.4 to $18.1 million. As a result, total liabilities to equity increased dramatically from 1.88 to 14 times. The current ratio declined from 1.37 to 1.14. Cash at year end fell from $48.7 to $27.8 million and we see on the cash flow that operations used $7.7 million in cash compared to generating $6.4 million the prior year.
 
I’m not prepared to blame all of PacSun’s problems on the economy but, like many retailers, their numbers have yet to recover from the economy cratering in 2007-8. Economic conditions still aren’t favorable, especially for the target customers of PacSun and similar retailers.
 
CEO Schoenfeld, responding to an analyst question talked about “…the reality of PacSun being I think pretty unique from just about any other retailer in the mall today.” I hope it’s true, because that kind of distinctiveness is what they need. Unfortunately, the analyst didn’t follow up and ask him to clarify that comment.
 
As I’ve said before, the balance sheet places some urgency under PacSun’s need to at least cut their losses significantly and pretty quickly. I agree with most of what they are doing but what they really need is for the youth employment situation to improve. I would not be surprised to see some kind of new financing arrangement in the fairly near future unless PacSun’s results improve dramatically.  

 

 

Intrawest’s First Quarterly Report

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Intrawest recently filed their first public report since going public. You’ll remember that they did an initial public offering (IPO) as a way to restructure their balance sheet after the real estate market for mountain properties collapsed. I wrote about that here and here. Fortress was the company that owned most of Intrawest’s debt. Now that the debt has been converted to equity as part of the IPO, “Fortress beneficially owns 60.1% of the voting and economic equity interests of the company.” 

The company’s second quarter ended December 31, 2013. They acknowledged being late getting this report done due to the pressures of the public offering. I’m going to briefly review the numbers they reported, but remember that these numbers are before the conversion of their debt to equity and completion of the IPO that happened in the first quarter of 2014.
 
Revenue for the quarter fell slightly from $104.3 to $102.1 million. Operating expenses dropped from $109 to $106.7 million. Operating income improved slightly from a loss of $19.6 million to a loss of $18.6 million. They recorded a net loss of $122.2 million compared to a loss of $109.4 million in last year’s quarter. Last year’s quarter included interest expense of $89.6 million compared to $70 million for the quarter ended December 31, 2013. As I discussed in my earlier articles most of that interest expense goes away once the IPO is done because the debt becomes equity.
 
Let me also show you some other income statement numbers below operating income.
 
 
The numbers are in thousands of dollars. The first column is the 2012 quarter and the second for 2013. I’m pretty sure those are all related to restructuring the company and have damned little to do with running a winter resort. But you can see they generate some significant distortions in the income statements and in the year over year comparison.
 
I don’t spend much time discussing the balance sheets of winter resorts. It’s more about cash flow than the balance sheet at a particular point in time. For example, only on winter resort balance sheets have I seen negative current ratios that don’t seem to bother anybody. Hell, they don’t even bother me much anymore. What they do (and what I’d do) is borrow on their lines of credit when they need to pay expenses not covered by cash flow. No reason to incur interest expense until you have to.
 
Revenue from Intrawest’s Mountain segment was $76 million during the quarter, up from $72 million in the same quarter last year. “The Mountain segment includes the operations of the Company’s mountain resorts and related ancillary activities, comprising Steamboat, Winter Park, Tremblant, Stratton, Snowshoe, as well as a 50% interest in Blue Mountain.”
 
Here’s some further information on the Mountain segment. ETP is effective ticket price. RevPar is revenue per available room, and ADR is average daily room rate. They note that the decline in ETP was due to selling more season passes, so that decline is kind of in a good cause. It’s nice to get money up front. They got one-third of their list revenue from season passes or frequency products in fiscal 2013 and the percentage is increasing. 
 
 
The Adventure segment revenue fell from $13.1 to $11.5 million. The Adventure segment comprises CMH, which provides heliskiing, mountaineering and hiking adventures, and ancillary aviation services, which include fire suppression, maintenance and repair of aircraft.”
 
“The Real Estate segment includes a vacation club business, management of condominium hotel properties, real estate management, including marketing and sales activities, as well as ongoing real estate development activities.” Its revenue fell from $17.1 to $13.9 million.”
 
They also provide what they call “adjusted EBITDA” for each segment. Here are those numbers below the revenue per segment.
 
 
I’m not going to spend much time analyzing this report. There’s a lot of noise in the numbers caused by the restructuring and IPO. The key fact is that starting with the June 30 quarter, we’ll start to see how Intrawest can do financially without all the interest and some associated expenses and managerially without the distractions associated with having your balance sheet upside down and having to do an IPO you didn’t really want to do.

 

 

SPY’s Year: Sales and Margin Up, Expenses Down

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When I review SPY’s results, we get to see what a smaller specialty brand is doing. They would prefer, I imagine, that they weren’t public and that we didn’t get to look over their shoulder. But for the time being anyway, we do.

I suppose I need to confess that they are doing most of the things I think, and have written, that smaller specialty brands should do, so I’m likely to approve. Let’s see what those are. 

I’m going to start with the cash flow and note that in the year ended December 31, 2013, they generated positive cash from operating activities of $683,000. Not a huge number, but last year they used $5.2 million in operations. To me, getting to positive operating cash flow is more important than making a profit for a company like SPY that’s recently out from under a few tough years.
 
Sales for the year were up $2.2 million or 6% to $37.8 million. All but $100,000 was SPY branded product. They sold $32.6 million of the total in the U.S. and Canada.
 
Gross profit margin increased to 50% from 46% the previous year because they sold higher margin product, made more product in China (instead of Italy) and earned higher margins on closeout product. They also said it was higher because they had “…lower overhead as a percentage of sales partially due to the consolidation of our European distribution center to North America.” I don’t really understand that last one because I don’t know how it impacts product cost.
 
Sales and marketing expense was down 18% from $13.8 to $11.3 million. Advertising was reduced from $819,000 to $394,000. That’s because, well, they spent less. They also reduced SG&A expense from $0.2 million to $6.1 million. They did that in spite of $0.1 million spent in relation to two board of director resignations and $0.3 million related to an officer resignation. Shipping and warehouse expense was also down $300,000.
 
So if you increase your sales, improve your gross margin and reduce your expense guess what happens? SPY had a positive income from operations of $399,000 compared to an operating loss of $5 million last year. We learn in the conference call that it’s the first operating profit since they went public in 2004.
 
They still had a bottom line loss of $2.86 million, down from a loss of $7.24 million last year. But that is almost completely the result of $2.97 million in interest expense, up from $2.39 million last year. This is because  of the $21.5 million due to shareholder we see on the balance sheet, up from $19.1 million at the end of last year. There’s also a line of credit outstanding of $4 million due to an asset based lender.
 
If it wasn’t for the shareholder debt, the balance sheet would be okay, though I do note an increase in receivables of 16.6%, way in excess of sales growth. On the other hand, I love the 6.4% reduction in inventory even with the increase in sales. SPY has had some inventory problems in the past, and we can hope this reduction suggests that’s coming to an end.
 
Next, let’s talk about strategy and tie it to the financial results. Here’s where you can see the 10K if you want to follow along.
 
On page nine, talking about product development, they note, “Our products are designed for individuals who embrace the action sports, performance and lifestyle markets.” To me, that correctly sets some limitations on where their distribution can go, and is typical and appropriate for a niche brand.
 
In the conference call, management noted that they had run out of snow goggles by the end of 2013 and that it was their first year of running out of inventory. They also noted that they had strong orders for next season. The one questioner expressed some concern that, as a result, they might have left some sales on the table. CEO Michael Marckx allowed as how they probably had.
 
I was waiting and hoping he’d suggest to the questioner that running out of inventory had something to do with next season’s strong orders, but he didn’t.
 
SPY expects its revenues in 2014 to be in the $39 to $40 million range with a “modest improvement” in gross profit. I was also interested to learn that they will start paying interest on the shareholders debt in cash, rather than accruing it as more debt.
 
It is interesting what you can do with your expenses when you are a bit cautious with your distribution. I am reluctant to draw too straight a line between controlling distribution and reducing marketing expenses (and SG&A, and inventory, and reducing working capital investment) but I’m pretty sure there’s something to it. Retailers seem to favor product that sells through at full margin for some reason, and that makes business easier and more profitable for everybody.
 
I am pretty sure SPY has also benefitted from the brand refocusing and related company reorganization. As they describe it, “…to sustain the relevancy of our brand to our target market and beyond, we reorganized our entire company, realigned our branding efforts in order to better reflect the original intent of our brand, and have continued to make improvements since then.” Sharing a focus, direction, sense of purpose matters. Sorry if that sounds a little mystical, but I suspect it’s part of the reason they could increase sales and cut expenses.
 
SPY’s business strategies in some cases don’t sound much different from their much larger and better resourced competitors and that could be a problem. I also noticed there wasn’t a word about online or direct to consumer in the whole 10K, and that’s certainly different from most brands. Finally, if they haven’t already, they are going to run out of ways to cut expenses, and bottom line improvement this year may have to come from growing sales.
 
But for now, let’s just note the continued improvement and see what happens next.

Zumiez’s Annual Report: Growth, but Constrained by the Economy.

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Zumiez reported top and bottom line growth even as they acknowledged and were impacted by the economic headwinds in Europe and the U.S. As they put it, “…teen retail in general experienced a challenging sales environment, with many mall based teen retailers seeing significant sales declines. Zumiez was not immune to the declines in traffic; however…our sales results held strong relative to the teen retail sector, with comparable stores sales down slightly while product margins remained essentially flat.” 

As always, I’ll get to the details. If they are a bit more resistant to these headwinds than other retailers, it’s because they’ve been pursuing the same strategy for 35 years. The caveat, of course, is that you have to pursue the right strategy. Just to review, they list their competitive strengths as:
 
·         Attractive lifestyle retailing concept
·         Differentiated merchandising strategy
·         Deep-rooted culture
·         Distinctive customer experience
·         Disciplined operating philosophy
·         High-impact integrated marketing approach
 
You can read about each of these on pages four and five of their 10K.
 
We’ve reviewed together similar claims of competitive strengths for other companies and I’ve sometimes concluded that their claims were more aspirational than actual, noting that’s what every company in the industry wants to do. Zumiez is more credible simply because they’ve been doing it longer with some success.
 
Zumiez ended their fiscal year (February 1) with 551 stores including 28 in Canada and 12 in Europe under the Blue Tomato name (six opened during the year). They plan to open 55 additional stores worldwide in this fiscal year including five in Europe. Net sales grew 8.2% from $669 to $724 million. The fiscal year had one less week than the prior year.  Comparable store sales were down 0.3%. That includes a 0.1% decline in brick and mortar and a 5.4% increase in ecommerce sales.
 
Obviously, new store openings were responsible for most of the sales growth. Average sales per store were $1.2 million, down from $1.24 million last year.
 
Ecommerce sales were 12.3% of sales for the year compared to 11.2% the previous year. What I imagine they are thinking about, but aren’t talking about yet, is how much of their brick and mortar sales are influenced by online. That would be a good question for an analyst to ask.
 
Here’s a table from their 10K that shows their revenue by category. 
 
 
Revenue in the U.S. accounted for 89% of Zumiez’s total revenue. 
 
The gross margin rose from 36% to 36.1%. “The increase was primarily driven by a 40 basis points benefit due to prior year costs related to a step-up in inventory to estimated fair value in conjunction with our acquisition of Blue Tomato and a 40 basis points impact of the correction of an error related to our calculation to account for rent expense on a straight-line basis. These increases were partially offset by a 50 basis points impact due to the deleveraging of our store occupancy costs and a 50 basis points impact of the increase in ecommerce related costs due to ecommerce sales increasing as a percent of total sales.”
 
So it increased by 0.8% due to some one-time accounting changes. Then it decreased by 0.5% because of deleveraging of store occupancy costs. Don’t quite understand that and would love some detail. Finally, if the 0.5% impact from ecommerce related costs is part of implementing their omni channel strategy, I’m fine with that.   
 
Selling, general and administrative expenses were up from $172.7 to $188.9 million. As a percentage of sales, it was up just 0.2% to 26%.
 
“The increase [as a percentage of sales] was primarily driven by a 60 basis points impact of the increase in ecommerce corporate costs… a 40 basis points impact due to the deleveraging of our store operating expenses, a 20 basis points impact due to the deleveraging of our corporate costs and a 20 basis points impact of a litigation settlement charge…These increases were partially offset by a 70 basis points impact of the reversal of the previously recorded expense associated with the future incentive payments to be paid in conjunction with our acquisition of Blue Tomato, a 30 basis points benefit due to prior year costs related to transaction costs incurred in conjunction with our acquisition of Blue Tomato and a 20 basis point impact due to a decrease in incentive compensation.”
 
The key thing I pull out of there is that Blue Tomato is obviously not performing as they had hoped when they bought it. Here’s how they describe it in the conference call:
 
“…we continue to be optimistic about our long-term prospects in Europe. However, the reality is the operating environment in the region just as in North America has been challenging since we completed the acquisition in 2012. While the sales in Europe comp positive in Q4 and for the year, we are estimating our sales and earnings results to be below the thresholds that a contingent earn-out is based upon and the likelihood that we will now achieve those minimum levels required for a payout is low.”
 
Operating income rose 6.3% from $68.5 to $72.8 million, but the operating margin fell very slightly from 10.2% to 10.1%. Net income grew from $42.1 to $45.9 million.
 
Fourth quarter sales were $227 million, up 1%, with comparable store sales (which includes ecommerce) down 2.2%. North American revenue was down $1.6 million even with the new stores. Europe increased by $4 million probably because of the new stores.   It was the fourth quarter in the previous year that had the extra week I mentioned before. That accounted for $8.9 million in revenues last year.
 
The quarter was positively benefited by $5.8 million from the reversal of the Blue Tomato projected earnout and by $3.3 million for correcting a lease accounting error, which I am sure neither you nor I want to discuss in detail. 
 
The balance sheet continues to be strong, allowing them to continue to pursue certain of their strategies in an uncertain environment. There’s very little long term debt. Cash generated by operations was about $67 million, consistent with the last couple of years.
 
It’s just a tough environment to be a retailer in right now. As CEO Rick Brooks put it, “In this world there are too many stores and as retailers are forced to reduce their capacity, share consolidation will continue.” That probably makes Zumiez’s strategy and points of differentiation more valid than ever, but there are a few things they need to be and, I imagine, are thinking about.
 
The first, as I’ve suggested before, is what business they are in. If they are truly limited to the action sports business, it may constrain their growth. As an example, they acknowledge that it was a lousy season for snowboard hard goods. But one of the things they do to distinguish themselves as an action sports retailer, especially in the mall, is to carry them. Drop snowboards? Add twin tipped skis? I don’t know. Is the target market action sports participants or youth culture? Both? Is the competitive space as broad as branded consumer products, which somebody recently suggested to me? If so, what the hell does that mean?
 
I suspect that Zumiez’s (and other company’s) omni-channel efforts will help them figure that out. I didn’t bother to describe the 48 or so mentions of what they are doing in this area, but let’s just say they’re all over it. It’s going to impact when and where they open stores, what those stores look like and, I expect, how big they are. And it’s going to influence their product selection as their customers and potential customers engage with them and have more control over what they buy and where.
 
The relationship between systems, technology and what you sell to whom is only going to get stronger. Neither Zumiez nor anybody else knows how it’s all going to work out, but they seem as well positioned as anybody to figure it out. Now if only the economy would improve.

 

 

Skullcandy’s Year and Quarter: Still Comes Down to Whether They Can Be Cool at Fred Meyer

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My dilemma is that I like almost all of what Skull is doing. But it’s hard to pull it off as a public company. Either they are pursuing a niche strategy where it will be hard to get acceptable public market kind of growth, or they are competing in a much larger market against players that have them outgunned. My take on the conference call and 10K (which you can see here), is that they are trying to straddle the two. Here’s how they put it. 

“We have a sales and distribution strategy that allows us to build relevant and exclusive products for our specialty retailers while giving us a runway to build demand creation and scale production before launching into large format retailers. This builds our brand authenticity with our specialty retailers while creating a robust product pipeline for the future.”
 
I have written way too many times that the further you get beyond the “core” market, the more likely it is that the consumer may know your name but not your story. I think they need to not just know, but embrace your story if your competitors are way bigger than you are and have you out resourced. That’s Skullcandy’s challenge.
 
Financial Results
 
Let’s start with the December 31 balance sheet. Over all, it’s not dramatically different from a year ago. The current ratio is strong and hasn’t changed much. Neither have total liabilities to equity. Cash has increased from $19 to $39 million as cash generated by operations rose from $13.5 to $23.5 million. I like cash. There’s still no bank or long term debt. Receivables have fallen from $76 to $58 million, consistent with the decline in sales of 29.5%, from $298 to $210 million.
 
North American sales fell 30.4% from $222.6 to $155 million due to “Increased competition in the audio and gaming headphone markets and…our continued scaling back of sales to the off-price channel, which were down approximately 48.9% compared with 2012, contributed to the decrease in North America net sales. In addition, and to a lesser extent, the decrease in net sales was the result of the transition to a direct distribution model in Canada, our decision to stop selling products to certain retailers and distributors that were violating our policies on minimum advertised prices and our significant decrease of discounted online sales at www.skullcandy.com.”
 
International sales, including those sold in the United States with “ship to” locations outside of North America, decreased from $75.1 to $55.1 million. Non-U.S. sales decreased 27%, falling from $28.5 to $20.8 million. “The decline was primarily attributable to lower sales in Europe, which continued to be a challenging retail environment and our desire to carefully control inventory with retail customers in our international set of distributor partners. The softness, though, in Europe was offset to a lesser extent by gains in Japan, Mexico and Canada…”
 
In explaining the sales decline above, you’ll notice they start with “increased competition” and then mention the reduced off-price channel sales. I wonder what percentage of the total decline resulted from increased competition. It would be useful if they explained exactly what sales channels “off-price” referred to and how many dollars the cut backs represented.
 
Back on the balance sheet again, we see that inventories have decreased only very slightly, from $41.6 to $40.3 million. I would have expected a much large decline given the fall in revenue. The 10K doesn’t tell us anything about the quality of inventory. We learn in the conference call that they have $3.1 million in additional inventory in a warehouse in Canada that didn’t exist a year ago. One of the analysts asked how comfortable there are with their inventory and got told by CEO Hoby Darling that “…overall, we have really clean inventory.” Nothing they said really explained to me why it wasn’t down more given the revenue decline.
 
Switching back to the income statement, we find a gross profit margin that declined from 46.8% in 2012 to 44.3% in 2013. The 10Q says, “The decrease in gross margin was primarily attributable to increased sales returns and allowance expense due to increased returns rates to the Company’s retail customers and a shift to a lower margin product mix.”
 
Like with the inventory, I’d like a lot more information about that. With the sales decline, they lead by talking about increased compensation. Then they tell us in the conference call that sales returns and allowance expense was 11% of revenue in 2013, up from 6.4% in 2012. And remember they are reducing their off-price sales. I don’t quite know what that term means or how many dollars of sales we’re talking about, but I guess I might have expected that reducing those off-price sales would have tended to improve the gross margin if the number is significant.
 
Selling, general and administrative expenses were approximately level at $98 million. As a percentage of sales they rose from 32.9% to 46.7%. There are $8.2 million in “nonrecurring expenses,” as they like to refer to them, included in that number. These include a big customer bankruptcy filing, moving their offices, severance for the former CEO, and a write down for some “end-of-life” products. 
 
It isn’t just with Skullcandy that I get a smile on my face when I see the list of what they call nonrecurring. There always seems to be something next year that’s nonrecurring. I think companies should establish a reserve for nonrecurring expenses like they do with bad debt. Course, if you reserve for them it means you expect them, and then I suppose they can’t be classified as nonrecurring. But, damn it, something nonrecurring seems to occur every year.
 
Demand creation expense increased by $1.1 million to $27.1 million. Given their strategy, I think that’s appropriate, and I’d even like to see more. I like their 4-city takeover concept, “…based around Crusher and our NBA All-Star in Chicago with Derrick Rose, Oklahoma City with Kevin Durant, Houston with James Harden, and Minneapolis, where we featured the product and athletes on billboards, buses wrap with Crusher and exploding windows, athlete product and brand images projected onto buildings and other out-of-home media during the holidays and into the beginning of this year.” It’s coordinated with a big social media component.
 
Their operating income for the year declined from a positive $41.5 million to a loss of $5 million. The net loss was $3 million compared to a profit of $25.8 million last year. That includes an income tax expense of $14.6 million last year compared to a tax credit of $2.9 million in 2013.
 
Sales for the last quarter of the year fell from $101 to $72.2 million. Gross margin was down from 44.5% to 43.5%. They had net income during the quarter of $3.7 million compared to $11.4 million in the same quarter last year.
 
Walmart, Other Customers and Strategy
 
Skul’s two biggest customers during the year were Target and Best Buy. One of them was 10% of sales and one 14%. Don’t know which was which. They accounted for 28% and 25% of the company’s accounts receivable at the end of the year.
 
In the conference call, we learn from CEO Darling that Skullcandy will “…test the segmented product line that focuses on our entry level price points with Walmart in mid-Q2. Some people will ask whether Walmart is right for the brand.” Indeed. 
 
Here’s how he says they think about distribution in general:
 
“When we think about adding distribution, we think about 5 key questions: First, does our consumer shop at the location? Second, does our consumer expect to find us there because our competitors are there? Third, can we position the brand at retail point-of-sale in a way that is fun, young and irreverent and does not dilute the brand? Fourth, can we serve a customer that otherwise has limited access to our products at brick-and-mortar from a geographic perspective? And fifth, whether we can create segmentation throughout our distribution pyramid from pinnacle on down?”
 
Here’s how he answers those questions with regards to Walmart:
 
“First, we know our consumer shops at Walmart. Second, each of our competitors, including Beats, Apple, Sony, Bose, Yurbuds and Monster are all already sold at Walmart and have been there for multiple seasons. Third, we have negotiated POS that we believe will look and feel right so that our consumer has a good experience with our brand. Fourth, Walmart is the store in many towns, where there’s no other or very limited Skullcandy distribution, especially throughout the South and Midwest. Lastly, we’ll segment Walmart during this test to only the price points and designs that we believe are most attractive to the Walmart customer and are different than most of our other accounts.”
 
At Walmart, they are going to be focusing on buds under $20 and headphones under $35. They indicate this is a “…different assortment than almost all of our other retailers have.” 
 
I started this analysis talking about the difficulty of being a niche brand while meeting the expectations of Wall Street. You can almost feel the dilemma this causes when Hoby says, “As part of opening Walmart, we are also doubling down our core and influencer retail partners…We have to keep specialty special.” When he notes above that their competitors are already at Walmart I can’t quite figure out if, as he says, that’s a reason to be there or a reason not to be there. They talk about how they are going to manage the brand at Walmart and insure sell through (though they aren’t specific as to how). But if the Walmart order gets significant (remember something like 6,000 stores in the U.S. and 10,000 worldwide) and Walmart wants a different mix or better pricing, how easy will it be to say no?
 
When Skull went public, I characterized their challenge as “being cool at Fred Meyer.” They are certainly more focused, thoughtful and cautious about how they go about doing that, but the challenge hasn’t really changed and the competitive landscape has gotten tougher.

 

 

Quiksilver’s Quarterly Results: Still a Work in Progress

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It’s not usual that I’m happy to see a decline in year over year revenues during a quarter, but in the case of Quiksilver, I think I’ll make an exception. Their revenues for the quarter ended January 31 fell by 4.8% from $412 to $396 million. But at least some of that decline is from cleaning up distribution and I love that. In fact, I think it’s where Quiksilver needs to start. 

As most of you know, their earlier financial problems led them to push brands for revenue in ways that weren’t good for those brands even if it was what the company had to do. To build their brands now, they have to exercise some caution with distribution.
 
Here are their results by segment from the 10Q. EMEA is basically the European area and APAC is Asia and the Pacific.
 
 
Here’s the operating income for each region:
 
 
You can see that revenue was down in each segment, but so was SG&A expense. In constant currency, revenue fell 2%. Below are the revenue numbers by brand as reported in the 10Q.
 
 
They only discuss the individual brands’ performance by region in constant currency. Quiksilver and DC revenues were off in the high single digit percentage in the Americas. Roxy was up by a similar amount. “The net revenue decrease in the Americas wholesale channel was focused within North America where net revenues decreased by a high single-digit percentage due primarily to three factors: 1) lower sales of DC brand products of approximately $6 million as a result of improved management of channel inventory to better align sell-in with sell-through; 2) a reduction of net revenues of approximately $2 million as a result of the discontinuation of the Quiksilver women’s product line in fiscal 2013; and 3) a reduction in net revenues of approximately $2 million as a result of lower shipments into Venezuela due to the economic instability occurring there.” They note that the decrease in the Americas was focused in North America and expect continued “negative impact” on the North American wholesale business “in the near future.”
 
I love that DC fell because they were controlling distribution. Staying far, far away from Venezuela right now is a good idea.
 
In EMEA the Quiksilver brand was down a low double digit percentage. DC fell by high single digits and Roxy was flat. “The decrease in EMEA wholesale channel net revenues was primarily due to lower net revenues with clearance customers due to improved inventory management, and increased returns and markdowns to aid inventory sell-through versus the prior year period.”
 
In APAC “…segment net revenues increased across all three core brands (Quiksilver, Roxy and DC) and all three distribution channels (wholesale, retail and e-commerce). A significant portion of the net revenue increases was driven by promotional activity and clearance sales.” APAC revenues rose 11% in constant currency but were down 4% as reported, and they expect currency to continue to be an issue in that region “in the near future.”
 
As reported, here’s how Quiksilver did during the quarter by distribution channel.
 
 
Talking about the wholesale business, they note, “Our wholesale net revenues have declined for the last several quarters, particularly within the Americas and EMEA segments due to various economic and competitive challenges. We believe it is likely that such difficulties will continue in the near future, resulting in further net revenue declines within this channel.” Ecommerce revenues in the Americas were down slightly. CEO Andy Mooney noted in the conference call that they expect more fallout in the “smaller wholesale accounts.”   
 
Gross margin in the Americas rose from 42.8% to 43.4%. In EMEA it was up barely from 58.7% to 58.8%. In APAC, it fell from 54.0% to 52.7%. The overall gross profit margin remained the same at 50.9. 
 
Selling, general and administrative expense (SG&A) declined by 5.6% from $216 to $204 million. These expenses include $2.6 million this quarter and $3.1 million in last year’s quarter as part of the profit improvement plan (PIP). There’s another $2 million in expense during the quarter “…related to certain non-core brands that have been discontinued, but I don’t know if that’s part of SG&A or cost of goods sold. As a percentage of sales, SG&A declined from 52.5% to 51.9%.
 
They point out that, “Depending on the pacing and nature of further restructuring activities, we may not be able to maintain the same pace of SG&A savings in future quarters that we have achieved in recent quarters.” There’s no “may not” about it. A company’s ability to improve the bottom line through expense cuts doesn’t last forever. Employees won’t work for free and landlords will want their rent. 
 
Remember, the PIP is supposed to improve adjusted EBITDA by $150 million by the end of fiscal 2016. “Approximately one-half of this improvement is expected to come from supply chain optimization and the rest is expected to be primarily driven by corporate overhead reductions, licensing opportunities and improved pricing management, along with net revenue growth.” They aren’t specific about which part will provide how much. 
 
The operating loss fell from $9.7 to $4.8 million, but a chunk of that ($2.3 million) is because of a decline in the asset impairment charges from $3.2 million to $883,000. It’s good to see those noncash, but indicative of expected future cash flow, charges going away.
 
Interest expense rose from $15.5 to $19.4 million, and the loss from continuing operations after taxes declined from $31.2 to $22.7 million. However, they had a tax benefit of $4.4 million instead of a tax expense of $2.9 million, a $7.3 million improvement.
 
Net income went from a loss of $30.6 million to a profit of $14.9 million, but that’s only because they had a one-time $37.6 million gain from discontinued operations after taxes.
 
I’d characterize the balance sheet as weaker than a year ago. Equity has fallen from $590 to $380 million while total liabilities are up from $1.158 to $1.221 billion. Total borrowings rose over the year from $788 to $865 million. There’s a decline in inventory from $419 to $360 million, but it’s hard to evaluate that as some of the reduction came from the sale of assets or elimination of brands. CFO Shields tells us in the conference call that inventory days on hand decreased by 11 days. He also says, “The quality of our inventory improved as we continued to liquidate aged inventory.” Aged inventory as a percentage of total inventory was down. That, I suppose, is good, but some specifics would sure be nice. When will that excess aged inventory be gone and how much are we talking about?
 
Receivables are pretty much unchanged at $339 million. I might have expected some reduction there given the sales decline and asset sales.
 
Okay, having dragged you through the numbers, let’s have some fun and talk strategy. At various points in the 10Q and the conference call, we’re reminded that margins at wholesale were down, that the number of smaller wholesale accounts is shrinking and that they expect it to continue to shrink. That’s just a market reality faced by all brands. CEO Mooney notes, “The smaller accounts are absolutely important to us. I just think there’s going to be fewer of them." In the U.S., we learn, small wholesale retail accounts are just 19% of Quiksilver’s revenue. In Europe, it’s 40% to 45%.
 
If that channel is going to continue to shrink, Quik can’t rely on it for growth. What’s the solution? One answer, they believe, is more retail stores. They ended the year with 645 company owned stores and expect to open around 40 more this year.
 
A second thing they are doing is adding entry-level price point products for DC. I don’t know what kind of revenue that might generate.  I’m mostly just surprised they weren’t selling there before. So was Andy Mooney I think. He notes that DC has never participated in the “…$45 to $55 retail price segment for canvas vulcanized footwear…” Worldwide, he estimates the market is 120 million pairs. You can see why he’d like DC to get a piece of it. I can’t think of any reason they shouldn’t.
 
Third, we find out that Quiksilver has already reduced product SKUs by 40%, but that their own retail stores can still only showcase half the company’s products. He thinks they might be able to cuts SKUs by another 40%. Think of the magnitude of those cuts. It’s stunning that they could have had so many SKUs in the first place.
Cutting SKUs that much has huge implications for inventory investment and supply chain management. It will let them pull a chunk of working capital out of the company. But maybe more important is the impact on their competitive positioning when retailers have some chance to actually get theirs heads around a brand’s line and merchandise more of it well. As they cut SKUs and manage distribution better, there is an opportunity to differentiate the brands.
 
But my antenna really went up when Andy said early in his remarks, “…we also believe that we have opportunities to increase sales to the larger wholesale accounts in these markets by focusing on appropriately segmented product collections.”
 
Later, in response to an analyst question, he expanded on his thinking:
 
“…I think increasingly, the larger retailers aren’t really interested in what our line is. What they’re interested in is what their line is. Each of those retailers is increasingly looking for custom-design lines that appeal to both their unique consumer as they see it, and certainly their business objective.”
 
He goes on:
 
“Every retailer in the mall is looking down the mall to see what the competitor has from the same brand. And if they have something similar, they’re not particularly interested in carrying that brand. So that requires an organizational setup, people who are adept to doing footwear under [indiscernible] and that’s a particular breed of cat. You need a supply chain that can get both in printed goods and cut and sold goods to market on a quicker pace than you would do for the traditional channel.”
 
Okay readers, help me out here. I read that and hear “fast fashion in big chains.” I’m not prepared to characterize this as a good idea or a bad idea, but I do have questions. Just to be clear, I don’t have any problem with Quik’s brands being in large chains (the right one, merchandised correctly, with the right product). Everybody else is there and, as Andy Mooney says, this is where the market is going.
 
Question one is does Quik have the systems and infrastructure to pull this off? CEO Mooney says they do. The company will have to develop a new internal attitude about how they operate.
 
Question two: Does this imply selling to some different retailers than they are already selling to? If so, which ones?
 
Question three: What exactly does it mean to produce different products for different retailers? How different are the products? How many products how often? Is it for the whole line that the chain carries or just some coordinating product around the edges?
 
Question four: If retailers are interested in what their line is, not what your line is, what does that say about brand positioning? Do you just make what they want? I think this might say something important about how you compete. How much influence does a chain that places a big order have over the product you make before you aren’t managing your own brands anymore?
 
Question five: Who is Quik competing with in this market with these customers? What’s the value of their brand’s heritage in these circumstances?
 
I’ve wondered a few times now if distribution won’t begin to become less important as you allow consumers to connect with your brand whenever they want and however they want on whichever device they are using or in the store, where the devices are also used. I suspect that’s part of the answer to making this work.
 
At the end of the day, I’m on board with the operational steps Quik is taking to cut costs and improve efficiencies and expect it to have a positive impact on the bottom line. I think I mostly agree with their ideas about how the market is evolving. But figuring out how heritage brands fit in this market and grow in it is the challenge they have. 
 
Not for the last time, and not just for Quiksilver, I wish they were a private company.

 

 

Deckers’ Full Year Results and Some Insights on Sanuk

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We’ve all been interested in Deckers since they bought Sanuk. I want to start by pulling what we can on Sanuk out of the 10K and conference call. But Deckers also said some interesting things about direct to consumer business and how brick and mortar integrates with online. Finally, of course, I’ll look at their numbers for the quarter and the year.

Sanuk’s Results
 
Let’s go right to this chart from the bowels of the 10K (which you can see here) for Sanuk’s numbers for the year ended December 31, 2013 (in millions of dollars).   The first column is 2013, the second 2012, the third the amount of the change ($ millions) and the fourth the percent change.
 
 
Still not the kind of increases they were hoping for when they bought the brand I imagine. Now, somewhere else in the middle of the 10K we are reminded that the earnout for Sanuk was, without any limit, “…36.0% of the Sanuk brand gross profit in 2013, which was approximately $18,600…” That’s $18.6 million, just to be clear.
 
If $18.6 million is 36% of the gross profit, then 100% of the gross profit is $51.7 million. Sanuk’s gross profit percentage, then, was 50.8%. Here’s what they say about Sanuk’s wholesale business. Ecommerce and retail margins would be higher I assume.
 
“Wholesale net sales of our Sanuk brand increased primarily due to an increase in the volume of pairs sold, partially offset by a decrease in the weighted-average wholesale selling price per pair. The decrease in average selling price was primarily due to an increased impact of closeout sales. For Sanuk wholesale net sales, the increase in volume had an estimated impact of approximately $10,000 and the decrease in average selling price had an estimated impact of approximately $5,000.”
 
Those numbers are in millions of dollars as well.
 
The next thing they tell us is that Sanuk’s operating income on its wholesale business only was $20.6 million, up from $14.4 million the previous year. That’s an increase of 43% and is 21.8% of wholesale revenues, up from 16% a year ago. By way of comparison, the UGG operating income on its wholesale business as a percentage of revenue in 2013 was 27.5%.
 
But there’s a catch. A pretty big catch, actually. I’ll let the folks at Deckers explain it to you.
 
“The increase in income from operations of Sanuk brand wholesale was primarily the result of decreased expense related to the fair value of the Sanuk contingent consideration liability of approximately $8,000, which was primarily due to changes made during 2012 to the brand’s forecast of sales and gross profit through 2015, which increased the expense in 2012 without a comparable increase in 2013. In addition income from operations increased due to the increase in net sales, partially offset by a 1.4 percentage point decrease in gross margin due to increased closeout sales as well as an increase in sales expenses of approximately $2,000.” That’s $2 million.
 
So they’d booked $8 million as an expense for the contingent payout they expected to have to make. But the brand didn’t perform as projected, so they don’t have to pay that. Without that $8 million they got to add back in in 2013, I guess operating income would actually have fallen on rising sales. Meanwhile, the gross margin fell and they had higher closeout sales. One wonders to what extent the sales increase was due just to closeout sales. And they had to spend an extra $2 million to do this.
 
Granted, Sanuk is only 8.9% of Deckers’ total revenues for the year, but it still annoys me when they make it this hard to figure out what’s actually going on. If I’d paid as much for the brand as they paid and it was performing like this, I’d probably do the same thing.
 
The Omni Channel
 
We’re all speculating about the integration and evolution of online and brick and mortar. Deckers has David Powers as the President of Omni-Channel for them. He had some interesting things to say about what they’re doing.
 
He says they are starting to open stores that are a couple of hundred square feet smaller than usual. This is driven by the realization that ecommerce and quicker delivery is going to start to reduce the need for as much square footage, if only because one third of a store’s footprint won’t be needed to hold inventory. I think they are right about that.
 
I’ve raised the issue that ecommerce has to generate enough incremental sales to offset the cost of the ecommerce function or it will reduce the bottom line. But that isn’t necessarily true if direct to consumer sales evolve in such a way that your expense in brick and mortar declines due to technology reducing staffing costs, lease costs falling because you need fewer square feet, and reduced inventory due to more flexibility in your inventory systems.
 
Dave Powers put it this way:
 
“We will continue to leverage technology to transform the shopping experience into one that is personalized and efficient for our customers driving conversion and long-term growth for Deckers. We need to continue to strengthen our understanding of who our customers are and use that information to develop deeper relationships with them. We are actively working on a unified system to connect and communicate to our customers as they move between our stores and E-Commerce sites.”
 
He goes on to describe their first multi-brand retail store:
 
“The store will serve as the showcase for our expression of Omni-Channel retail and a test lab for new concepts, utilizing the latest technology combined with compelling merchandising to elevate the customer experience. Our customers have the ability to shop in-store using digital touch screens, customize their products, and order online, ship direct to their home free of charge or to pick up in stores.”
 
In general, this feels like exactly the right approach. They are going to learn a lot of interesting things and I look forward to hearing about what works and what doesn’t and how the concept evolves.
 
The Numbers
 
Total sales for the year rose 10% from $1.41 to $1.57 billion. The sales are broken down in the table below by brand at wholesale and for other channels. The left column is 2013, the right 2012.
 
 
You can see that UGG represents about 53% of total revenues, and fell very slightly  at wholesale for the year, though it was up 10% overall. Direct to consumer is 32% of revenues. At the end of the year, they had 117 retail stores worldwide, 40 of which were opened during the year. U.S. sales for the year were $1.04 billion, up 7.1% for the year. International sales grew 16.5%. 
 
The gross profit margin rose from 44.7% to 47.3%. “Gross profit increased by approximately 1.5 percentage points due to reduced sheepskin costs and increased use of UGG Pure, real wool woven into a durable backing used as an alternative to table grade sheepskin in select linings and foot beds, as well as an increased mix of retail and E-Commerce sales, which generally carry higher margins than our wholesale segments, of approximately 1.2 percentage points.”
 
You may remember that Deckers got hit pretty hard when sheepskin prices rocketed and they tried, but weren’t able to push the price increases through to consumers. Those prices have come down some, but what I like is the UGG Pure idea. It’s allowed them to respond in a realistic way to market forces and general economic conditions by continuing to offer a quality product but at some lower price points. As CEO Angel Martinez put it, UGG Pure allowed them “…to offer our consumers luxurious quality at appropriate price points and extend into new categories.” 
 
I’d also like you to notice that the gross margin on the direct to consumer sales is only about 1.2% higher than wholesale. That’s additional margin worth having, but it’s nowhere near what people used to think it would be. It costs a lot to run direct to consumer operations. But remember that gross margin in direct to consumer operations is after a bunch of operating expenses. That is, it’s not just product gross margin.
 
Selling, general and administrative expense was up from $446 to $529 million. As a percentage of sales, it rose from 31.5% to 33.9%. The biggest piece of this increase ($53 million) came from the opening of new stores. SG&A expense includes $86.5 million in advertising, marketing, and promotion costs. That’s up from $78.5 million the previous year.    
 
Net income was up from $129 to $146 million.
The balance sheet is in good shape and strengthened over the year. I particularly note an increase in cash from $110 to $237 million (I like cash) and a reduction in inventory from $300 to $261 million even as sales rose. The decrease is mostly due to a decline of 18% in UGG inventory.
 
Deckers’ financial results are improving, and it looks like they might be taking the lemons the higher sheepskin prices gave them and turning them into lemonade through the UGG Pure and some other things they are doing. I also like their approach to DTC.
 
They are expanding the UGG brand into outerwear and a home fashion line starting this fall. Men’s’ and women’s lounge wear tops and bottoms are part of the line. Omni-Channel President David Powers noted in the conference call, “I think the real win here is the combination of loungewear and slippers and home together as a full lifestyle expression, and I think we’re learning what the best way to showcase that in our stores is.” We’ll see how that goes.
 
To end where we started, Deckers still seems to have some work to do with Sanuk, but perhaps their recent hiring is an indication that things are going to start improving if those people are allowed to run the brand.

 

 

VF’s Quarter and Results for the Year: One Sentence Caught my Attention

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Okay, strong balance sheet, revenue growth, profitable, blah, blah, blah. I’ll get to all that. But on page 22 of the conference call an analyst asked about their interest in potential acquisitions. The answer from CFO Bob Shearer, in part, was “…how we think about acquisition targets, and we think about it a lot, and yes, we have a list. But we think about brands that are complementary to our brand portfolio that help us reach customers/consumers.” 

I added the italics and bold type. You wouldn’t think that their having a list would get me quite this interested, but it does. Consider what it means. They have a list of companies they might want to buy. I assume they didn’t create this list by throwing darts or rolling die. Maybe there’s a drinking game! Probably not. They had a process whereby they looked at the brands they own, with whom and how they compete, and their customer segmentation. Then they surveyed the universe of competitors and analyzed and selected the ones they thought might be good fits.
 
Okay, I don’t want to make VF sound too omnipotent here. Maybe they aren’t as rigorous as I’m suggesting. Acquisitions in this industry, in my experience, have a large element of serendipity to them. Still, such a process would be consistent with the management rigor I think I hear in their public information. And it would be important managing their portfolio of brands.
 
Just so you see how important, here’s a list of the brands they own and the markets those brands are in.
 
 
That’s a lot of brands, a lot of markets, and quite a bit of market overlap. Randomly buying brands because they were “a good deal” and increased revenue would result in an unmanageable behemoth pretty quickly. That, I assume, is where the rigor of developing the list comes in. Deals they make will be supportive of markets where they already participate and have expertise.
 
Their management rigor also shows up in their operations. VF makes around 500 million units of product a year for 35 brands. They own 28 of their own factories and work with 1,800 contract manufacturers in 60 countries. They’ve got 29 distribution centers and 1,246 retail stores under various brands.
 
In what is probably an understatement, they say in the 10K (you can see it here), “Managing this complexity is made possible by the use of a network of information systems for product development, forecasting, order management and warehouse management, attached to our core enterprise resource management platforms.”
 
Why is this a good thing? Here’s another quote from the 10K.
 
“We believe that we will be able to remain cost competitive in 2014 due to our scale and significance to our suppliers. Absent any material changes, VF believes it would be able to largely offset any increases in product costs through: (i) the continuing shift in the mix of its business to higher margin brands, geographies and channels of distribution; (ii) increases in the prices of its products; and (iii) cost reduction opportunities. The loss of any one supplier or contractor would not have a significant adverse effect on our business.”
 
Not sexy maybe, but I’d characterize all this boring operations stuff as a critical competitive advantage. It’s particularly important for integrating and realizing value from an acquisition. Anybody can buy a company. It takes good management and hard work to integrate it effectively into an existing organization. And careful selection of the acquisition target, which brings us back to their list of company’s they watch. Having tied that together, we can now move on to the numbers.
 
Fourth quarter revenues were $3.29 billion, with a net profit of $368 million, or 11.2%. Outdoor & Action Sports revenues were up 12% for the quarter. The North Face rose by 12% and Vans by 14%. “Vans was up at a low-double-digit rate in the Americas, up 20% in Europe and up at nearly the same rate in Asia.”
 
For the year, VF’s revenues rose 5% from $10.77 to $11.3 billion. The growth was all organic. That is, there were no acquisitions in 2013.
 
38% of revenue was from outside the U.S. Direct to consumer, which includes retail stores, outlet stores and online represented 22% of revenue compared to 21% a year ago. Ecommerce by itself was $327 million, or 2.9% of total revenue. Of their 1,246 retail stores, 1,166 carry only a single VF brand. The other 80 are VF outlet stores. The plan is to open another 150 stores in 2014 focused mostly on Vans, The North Face, Timberland and Splendid.
 
They also note, “In addition to our direct-to-consumer operations, our licensees, distributors and other independent parties own and operate over 3,000 partnership stores…”
 
The Outdoor & Action Sports segment grew from $5.866 to $6.379 billion and represents almost 56% of total revenue for the year. It generated an operating profit of $1.106 billion, representing 57.3% of VF’s total operating profit for the year of $1.93 billion.
 
“The Outdoor & Action Sports Coalition revenues increased 9% in 2013 over 2012 primarily due to an increase in unit volume. The North Face, Vans, and Timberland brands achieved global revenue growth of 7%, 17% and 5%, respectively. U.S. revenues increased 7% in 2013 and international revenues increased 10% with balanced growth in Europe and Asia Pacific. Direct-to-consumer revenues rose 15% in 2013 driven by increases of 28% and 15% for The North Face and Vans brands, respectively. New store openings, comp store growth and an expanding e-commerce business all contributed to the direct-to-consumer revenue growth.”
 
The North Face grew its revenues by 20% in Asia and at a “mid-single digit” rate in Europe. They don’t tell us what happened in the U.S. but given those numbers it seems to imply that things weren’t that good.
 
One analyst, referring to The North Face, asked if they’d seen any changes in the competitive environment. Steve Rendle, Group President of Outdoor and Action Sports Americas answered, “The competitive set in the outdoor industry remains the same. As North Face transcends that outdoor space it takes on a whole lot of new competitors.”
 
Those new competitors a brand encounters as it extends its reach is something I’ve talked about often. It’s a whole new competitive environment and we can all think of brands that haven’t done well trying to extend themselves. But they weren’t VF’s size with its management processes and balance sheet. Part of how they expect to succeed, Steve Rendle says in response to another question, is because The North Face “…is very much a pre-booked business model…we will buy to that order book and that order book is about 90% to 95% of our total revenue.”
 
They don’t, in other words, risk making too much product and over distributing. As you know, I like that a lot. It’s important to building a brand.    
 
Vans, we learn, passed $1 billion in the Americas in 2013. They highlight that Vans is no longer just a footwear brand and is having success moving into apparel. They note that, “According to data from more than 160 US board shops, Vans is a top 10 brand in almost all of our men’s apparel and accessory categories.”
 
Okay, that has to be data from Action Watch. I’m wondering just what it means to be in the top 10. How many brands of men’s apparel or accessories does a specialty shop carry? Wish some analyst had asked for a more detailed explanation.
 
Van’s international business was up 23% for the year. There was a mid-20% increase in Europe and a “high-teen” increase in Asia. I’d like a bit more specific information. Given the overall increase of 17% and the increases they mention for Europe and Asia, what should I assume for the U.S? It’s interesting that they provide percentage growth numbers for the other areas, but not the U.S. or at least the Americas.
 
Gross margin rose from 46.5% to 48.1%. “The increase in gross margin reflects lower product costs and the continued shift in the revenue mix towards higher margin businesses, including Outdoor & Action Sports, international and direct-to-consumer,” management said.
 
Selling, general and administrative expenses rose from $3.597 to $3.841 billion. As a percentage of total revenues it rose from 33.1% to 33.6%. This was partly because they choose to make some additional marketing expenditures “…to support future growth for our largest and fastest growing businesses.” Kind of nice to have a balance sheet that supports that kind of decision making. It was also higher because Timberland was included for a whole year for the first time. Advertising and promotion expense alone was $671.3 million, or 5.9% of revenue.
 
Interest expense was $80.6 million for the year. The weighted average interest rate was 4.5%. I just mention that because I wonder about the impact on VF, and lots of other companies, when interest rates rise substantially. That is going to happen, and if I knew when I’d get very, very rich.
 
Net income was $1.21 billion, up from $1.09 billion last year.
 
The balance sheet is strong, with a current ratio of 2.5 and a debt to total capital ratio of only 19.3%. Inventory was up a bit, but less than you’d expect given the revenue growth. Receivables were up 11.3%- more than twice the revenue growth.
 
If I could ask a couple of balance sheet related questions just because I have an inquiring mind, the first would be about the accrued liabilities. They total $905 million, and are mostly broken down in Note J. But the biggest single entry, for $209 million, is “other.” It’s not that it’s a big number for VF, but I’m curious what’s in it. Oh well, guess we’ll never know.
 
The second would focus on Note M on their retirement and savings benefit plans. Not much a question as a comment. I note that their expected rate of return on plans assets in 2013 was 5.7%. Obviously, the higher your expected return, the less you have to put into the plans each year to meet the obligations. VF’s 5.7% may still, in my opinion, turn out to be a bit high, but it’s certainly reasonable. Good for them for being realistic. When you see a company (or a municipality, or a state) claim their pension plan is “fully funded,” that’s based on certain assumptions about how long people are going to live and how much the plan assets are going to earn. If those assumptions aren’t reasonable, then the plan is probably not fully funded. Ask the pension holders in Detroit.
 
Okay, I know nobody wants to hear any more about that, so I’ll move on.
 
VF’s four growth drivers are leading in innovation, connecting with consumers, serving consumers directly wherever and however they want to engage the company’s brands, and continuing to expand geographically from the Americas to Europe and Asia in mature and emerging markets. Those might sound a bit like platitudes taken in isolation. But in conjunction with the strategies and management processes we’ve highlighted here, they seem credible.

   

Sport Chalet and Ideas on the Retail Environment

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I don’t follow Sport Chalet closely. But they said something in their 10Q for the December 29th quarter that related to some other ideas I’d seen on how the retail market is changing. I thought they might be worth talking about together.

Sport Chalet’s Dilemma
 
Sport Chalet operates 52 stores, 34 of which are in Southern California. “These stores,” we’re told, “average approximately 41,000 square feet in size. Our stores offer over 50 specialty services for the Sport enthusiast, including online same day delivery, climbing, backcountry skiing, ski mountaineering, avalanche education, and mountain trekking instruction, car rack installation, snowboard and ski rental and repair, Scuba training and certification, Scuba boat charters, team sales, gait analysis, baseball/softball glove steaming and lacing, racquet stringing, and bicycle tune-up and repair.”
 
Founded in 1959, Sport Chalet was to have “A focus on providing quality merchandise with outstanding customer service…The goal was: to ‘see things through the eyes of the customer;’ to ‘do a thousand things a little bit better;’ to focus on ‘not being the biggest, but the best;’ to ‘be the image of an athlete;’ and to ‘create ease of shopping.’”
 
Well, if that was their goal in 1959 they were ahead of their time. I’m sure you’ve recognized that what they describe fits very well with the conventional wisdom of what a specialty retailer has to do today to compete.
 
 When the economy went south in 2007, things got tough for Sport Chalet, especially since most of their business was in Southern California.
 
“As a result, our sales, which are largely dependent on the level of consumer spending in the geographic regions surrounding our stores, declined and we incurred substantial losses. In response, we modified our business model to make the Company more efficient, improved our liquidity and reduced operating expenses during the downturn. Additionally, we reinforced our commitment to be first to market with performance, technology and lifestyle merchandise by expanding our specialty brands and continuing to emphasize the availability and proficiency of our sales staff while many of our competitors emphasized value pricing and severely reduced store staffing.”
 
You can see that they tried what I’ve characterized in other articles as “more of the same.” Again, it’s all the things that are supposed to let the specialty retailer compete. It seemed to start to work, and then it didn’t. For the nine months ended December 29, 2013, Sport Chalet lost $4.4 million on revenue of $264 million.
 
So they are “…renewing our focus on reducing costs and refining our inventory position and store strategy. We are reducing our costs by decreasing store and corporate office labor expense to align with current sales trends, cutting IT maintenance expenses in non-critical areas, switching to a more cost effective logistics provider, negotiating rent reductions and honing our customer satisfaction initiatives. Through the closure of underperforming stores, selected staff reductions, and the renegotiation of logistics and software contracts, we have reduced our annualized operating expenses by approximately $3.2 million.”
 
But things are still tough. They blame poor early season winter weather and are working with vendors to manage inventory levels (something every vendor loves to hear) and closing four stores.
 
As I see it, the strategy they have historically based their competitive strategy on requires high spending levels and high prices. They are trying some new strategies; next generation store format, online store growth, leveraging technology and data, mobile and digital leadership, and local marketing programs. They just list those in the 10Q- there are no specifics provided.
 
On the surface, none of those sound like bad ideas, but I’m not sure they can expect to have the financial ability to carry them through if consumer spending trends continue. Too many of their customers can’t afford to buy what they want to sell or, if they can afford it, can’t see any reason to pay the Sport Chalet price for it.
 
In spite of a business strategy we’d all tend to agree seems right for the independent specialty retailer, they are caught between a rock and a hard place. What’s going on?
 
Nordstrom’s Bar
 
Here’s a picture of the new bar they’ve opened at Nordstrom’s in the local mall. Notice the crowd at it
.
 
 
 
It’s big and takes up a lot of space. Space where I wonder if they wouldn’t be better off having merchandise. I don’t quite know what their concept is. Maybe it’s for husbands whose wives are shopping. That won’t work for me because my wife considers me a huge downer to have along when she’s shopping. I’m sort of like a six year old in the back seat of a car during a long trip constantly saying, “Are we done yet?” My mere presence in the vicinity ruins the experience.
 
I am all for retailers taking risks and trying new things. Some work, some don’t and you always learn something. I’m sure Nordstrom’s thought it out carefully and, perhaps unlike Sport Chalet, they can afford to experiment. But there’s almost a sense to it of not knowing what else to do as the retail environment changes faster than we can keep up.
 
That’s not completely a surprise. This country was well over retailed even before the internet came along. However, increasing debt and leverage managed to masquerade as real economic growth until 2007 and covered that up. Now, retailers are struggling to hold on to their piece of the pie.
 
How Big Is Online?
 
I was sent a Wall Street Journal article I can’t seem to get access to called “Online Shopping is Big. It’s Also Tiny.” It points out that among the major consumer segments, online sales are no more than 25% of the total. It only gets to 25% in the computers, electronics and appliances sector. That sector, in total (store and online combined) is $272 billion annually. Making the online part $68 billion. In toys and sporting goods online is “only” 12% of $128 billion in annual sales. It’s just 1% of the $884 billion food and alcohol market.
 
Still it’s gotten there in a little less than 20 years and while figuring out the future isn’t my strong point, I’m pretty sure we can expect some more online sales growth in most, and probably all, categories.
 
But what exactly does “online shopping” mean? Are you only shopping online if you research, select and order the product on a computer or some mobile device? If you go to a store but then order online from the retailer you visited, is that online? What about if you go to the store and the sales person orders it online for you after you’ve chosen and has it delivered to your house the next day?
 
The data from the Wall Street Journal isn’t broken down that way, but I know retailers are pondering the issue. How online relates to brick in mortar is something we’d all like to know more about.
 
What Does Walmart Think?
 
The Atlantic magazine, in its current issue, features a short interview with Walmart’s Senior Vice President for Mobile and Digital, Gibu Thomas. It’s called “Get Ready to Roboshop” and you can read it here.
 
Mr. Thomas has 1,500 people trying to figure out just exactly how on line and in store retailing are going to fit together. He projects U.S. on lines sales to be around $345 billion by 2016. But he thinks “mobile influenced offline sales,” as he calls them, will be $700 billion. Walmart apparently has a smart phone app that, if you allow it, will help guide your shopping experience in Walmart. He says that more than 75% of their customers under 35 have a smart phone. During the past holiday season, more than half the traffic to Walmart.com came from mobile devices.
 
So go read the interview. There was certainly some learning here for me. It seems like we shouldn’t worry about on line sales. They are here to stay, are going to grow, and there’s nothing we can do about it. Where retailers’ attention should apparently be focused is on integrating the brick and mortar and mobile device experience. I knew that, but seeing some numbers attached to it gives me some focus and sense of urgency. It appears I’d better get my web site working better with mobile devices.
 
My sense is that this approach might be particularly beneficial to Sport Chalet as a high end chain with fairly well to do customers (you aren’t poor if you’re planning a scuba trip). There may be an app in every retailer’s future. I think I’ll download the Walmart app and walk through one of their stores.