Billabong’s Half Yearly Report: Starting Over

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Billabong reported their financial results for the six months ended December 31, 2013 last Thursday. I’ve been diving into a hoard of details they posted. After all of that, I think I’m going to end up spending a lot less time than usual on some of those details. 

That’s because I largely agree with a couple of comments from Billabong management in their conference call. I’d like to start by sharing those with you. 
 
Early in his comments, CEO Neil Fiske said, “…18 months of leadership distraction and organizational turmoil, which impacted all our brands. It is important to recognize that the company’s protracted transactions process hit the Americas region particularly hard. First, by creating a long gap in leadership and subsequently, a significant loss of talent.” 
 
He goes on to describe the people they have hired, are hiring and have still to hire. Later on he notes, “During the next six months we expect to complete our portfolio review, looking at each brand’s growth plan and fit with our longer term strategy. We will also initiate work on the brand books as guiding documents that are the cornerstone of a new brand management system.” 
 
Then CFO Pete Meyers, talking about the six months results, says, “Overall a mixed result as Neil has outlined, but somewhat ancient history in the context of the opportunity to reform this business in the years ahead. By the way, you’ll notice that my slides are in the old format and that’s symbolic as they deal almost exclusively with the old Billabong and that the results today predate any impact of the turnaround plans that we’ve shared with you and next time they’ll be in the same style as Neil’s.”
 
Meanwhile, there will be a major (that is not a strong enough word) and really intriguing reorganization of the company. The Billabong, Element and RVCA brands will each get a global head responsible for global merchandising and marketing. They will each report to the CEO and be responsible for the brand’s income statement. 
 
However, says CEO Fiske, “…we are not centralizing design or merchandising into any one region. Rather, we are leaving design, merchandise and marketing teams in each region to be close to the market, fast and highly responsive to local customer needs.” 
 
There will also be regional presidents for each of the Americas, Asia Pacific, and Europe to“…drive sales distribution and channel development in their respective geographies, while providing critical input on customer needs back to the brand teams. They will drive the go to market model for each country based on a newly defined tiering system. Regional leaders will also take responsibility for growing the smaller emerging brands, for example Tigerlily in Asia Pacific or VonZipper in the Americas.”
 
The third piece of the organization contains the global functions. These will include the CFO, a chief operating office, somebody in charge of human resources and, most interestingly to me, “…a turnaround office leader focused on cost takeout and accelerating the impact of key initiatives.” 
 
The gentleman they’ve hired in that role (Bennett Nussbaum) has an impressive background in turnaround management and clearly doesn’t need a job. It will be interesting to see how he interfaces with the organization to keep it turnaround focused and how long this job lasts. I’d be curious to know if he reports to Neil Fiske or directly to the Board of Directors. I can imagine him ranging all over the company with quite a degree of discretion. I don’t recall ever hearing about a company hiring a turnaround manager who wasn’t the person in charge, but I think it’s a great idea in these circumstances. 
 
“The objective of the global support functions is to build global scale capability and efficiency, driving our cost down so we can reinvest in the brands. We can no longer afford to have three regional supply chains, three regional IT structures with different systems, five different direct consumer technology platforms, high cost logistics in fulfilment and underdeveloped human resource management.”
  
They are going to rely on these cost reductions to fund expanded brand marketing. Finding those cost reductions is part of the responsibility of the Turnaround Office. Their balance sheet doesn’t really give them another choice.
 
When I was in business school (which is beginning to feel like it was shortly after the second Crusade), they described this kind of organization as a matrix. Which I think is a great way to describe it, because there are definitely going to be some people who wake up and find out they’ve been living in a dream world. 
 
The positive thing about a matrix organization is that it can facilitate good communications and group the right people to work on an issue. The potential problem is that roles and relationship are sometimes not completely clear. What happens when what the head of the brand wants to do conflicts with the ideas of the regional president? Every organizational structure has its strengths and weaknesses. A matrix structure can be less efficient at decision making. You manage that through constant communication and developing mutual respect and trust. As was noted somewhere in the conference call, I’d love to have the frequent flyer miles these people are going to rack up. 
 
There are additional changes and reevaluations going on across the company at various levels. You can see why I’m not as focused on the historical financial statements as I might usually be. The company that is going to emerge over the next year or three isn’t going to look like the one that produced these six months results. Lots of different people. A new organization and reporting relationships. A focus on “…fewer, bigger, better stories that cut through the clutter and better align to our key merchandising programs.” Probably fewer brands in total. A reorganization of the marketing function. Fewer SKUs, fewer factories. There’s a lot more. With every month that passes, it’s going to resemble less and less the company who’s financials I’m discussing here. 
 
But it’s not in my nature to ignore those results, so let’s move on to them now. Remember the numbers are in Australian dollars. 
 
First, let’s look at the numbers as reported on the financial statements. These include brands that were sold during the year (Nixon, Dakine) as well as a bunch of expenses Billabong characterizes as “significant,” meaning they had to do with the refinancing and restructuring and the big general mess they had to manage. As I’ve said before, I don’t believe that just because you screw up you get to exclude certain expenses from your operating results on, I guess, the promise that you’ll never screw up again. 
 
Sales from continuing operations rose 3.2% from $563 million in the prior calendar period (pcp) to $580 million. Gross profit margin fell from 54.9% to 53.6%. The pretax loss from continuing operations was $40 million compared to $439 million in the pcp. Operating expenses were up a bit, but what stands out is that last year’s income statement had Other Expenses of $513 million largely from the write down of the brands and goodwill. The number this year was $61 million in charges. Last year’s finance costs, however, were just $10.3 million compared to $57.3 million in the current period. After discontinued operations, we have a bottom line, after tax loss of $126 million compared to a loss of $537 million in the pcp.
 
Here’s how that breaks down by region as reported, including discontinued operations and significant items. 
 
 
 
Let me point out that the segment EBTDAIs excludes the impairment charges. That’s the “I” on the end. The reason I’m telling you that is because the numbers from the presentation that came with the conference call, which I refer to below, talk about EBITDA. There ain’t no “I” on the end. I’m going to assume that’s a typo, because the segment numbers are the same in both places. 
 
The big problem, you can see, was in the Americas. “The result,” they tell us, “…reflects weakness in the Canadian market, smaller brands & South America.” We’re specifically told that Sector 9’s revenues were down 20% in the Americas. They also point to what they call “operational instability” in the region due to personnel changes and general uncertainty. “…we believe,” says CEO Fiske, “the decline in the Americas result has much more to do with the organizational turmoil and loss of talent associated with the 18 months of protracted deal related distraction than any underlying issues with the strengths of the brand.” 
 
There was an as reported EBITDAI margin of negative 5.7% compared to a positive 4.2% in the pcp. For their continuing business, EBITDAI margin fell from a positive 8.7% to 4.7%. 
 
Things look better in the Australasia region, where the reported EBITDAI margin rose from 5.3% to 6%. For the continuing businesses it was up from 11.8% to 12.6%. They closed some stores, but took out some costs to get the improvement. Comparable store sales were up 3.2% including online sales. 
 
In Europe, the reported EBITDAI margin deteriorated from (0.5%) to (8%). For the continuing business, it fell from (2.5%) to (3.5%). They point, like everybody else, to the lousy macro-economic situation in Europe and the expected startup losses of Surfstitch. Brick and mortar comps in Europe were up over 5%.  They still see some softness in the Billabong brand. 
 
At December 31, excluding the West 49 stores, Billabong had a North American store count of 66. There were 112 in Europe and 252 in Australia.
  
Next, from their presentation, is the chart that includes the “as reported” results and then removes significant items and discontinued businesses and gets us to the continuing businesses results they’d like us to focus on. 
 
 
 
As long time readers know, I tend to prefer the as reported numbers (statutory results as they call them in Australia) because they don’t allow for finagling. In this case, because the refinancing has gone on so long, cost so damn much, and had such a destructive impact, I think maybe looking at the continuing business is the right thing to do. 
 
Except for some of the significant items where it looks to me like finagling happened. Here’s the list of significant items. 
 
 
 
You can look at the list and decide for yourself which it is or is not okay to exclude. My point of view is that things like “inventory clearance below cost,” “redundancy costs,” maybe part of the financing costs and perhaps part of others are hard to justify excluding. You’ll note that by excluding them they managed to show a small profit from continuing businesses of $3.9 million. If I were a suspicious person, I could conceivably think they figured they might as well exclude stuff until a profit appeared. And honestly, I might have done the same thing. 
 
Over on the balance sheet, equity has fallen to $194 million from $618 million a year ago. Cash is up, and inventory and receivables are both down. How much of the declines are the result of the sale of brands and how much from better management is hard to tell. The current ratio has improved, but that’s because the refinancing transferred current liabilities for borrowings to non-current liabilities. Current borrowings were at $9.5 million, down from $280 million at the end of the prior calendar period. Total liabilities, however, rose from $674 million to $765 million. 
 
Cash generated from operating activities went from a positive $29 million in the pcp to a negative $27 million in the six months ended December 31, 2013. That’s almost completely due to the costs of the refinancing they tell us.
 
As you are probably aware, Billabong is in the middle of a rights offering which, if successful, will improve their balance sheet. 
 
So much for not spending too much time on the financials. Let’s start to wrap up with a comment by CEO Neil Fiske in response to an analyst’s question. 
 
“So what is important, I think, to all of our brands is that they have authenticity with the core of the market. It is a little bit of a paradox in the sense that when we focus on the core of the market and we grow relevance, share and aspiration with that core the brands become more widely appealing. So really our strategy is to focus narrowly, but create brand positions that are so well-defined and aspirational that inherently they have broad appeal.” 
 
A week or ten days ago, I wrote about some similarities between Billabong and Quiksilver. I suggested that what we had to watch for were clues to what products they were going to sell to which customers. Neil’s put it more eloquently than I did. And he’s focused exactly on the correct and most difficult management task. 
 
Long time readers will know I’ve asked the question, “Can you stay credible as you broaden your distribution?” I’ve suggested that the further away you get from the core, the harder it is to stay credible and compete because the more likely it is that the customer may know your brand, but not your story. And the story is the brand’s single most important point of differentiation. 
 
Goldman Sachs analyst Phillip Kimber asked a related question I really liked. 
 
“One of the key things in managing a brand is being very tight on the distribution in which it’s released to. I’m just wondering if that’s an issue that will be part of this turnaround –i.e. you may have to drop sales materially because you choose not to service them because you’re looking to strengthen the brand as a result. Is that part of this turnaround? 
 
Here’s Neil’s answer: 
 
“One of the things I think that we do have in our positive column is that we’ve really focused on quality of distribution, over the last couple of years in particular. As you recall we got a little sideways a couple of years ago in the US in particular with sales to the Closeout Channel. We’ve cleaned up a lot of that distribution and we are really focused on quality distribution channels. I think within the trade we are seen as having not over extended the brand and have kept our distribution quite clean and brand appropriate.”
  
He didn’t exactly answer the question, except to say he thinks they’ve done a good job with distribution recently. But it’s a big part of the what do you sell to which customer question. Right now, in the middle of a turnaround where cash flow and brand building are probably more important than sales growth, and where public market expectations may be lower, is a great time to be cautious in distribution and build the brands for the future.

 

 

Billabong and Quiksilver; Two Peas in a Pod

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Billabong’s announcement last week that it was, among other things, conducting a strategic review of SurfStitch and Swell caused me to focus on the similarities of its situation to Quiksilver’s. It also made me realize that most of what has been discussed publically by both companies is what I’ll call mechanical issues. I want to remind you what those are and then move on to the way more important and difficult to manage strategic issue they both face but, understandably, don’t spend a lot of time talking about in public. 

We all know that both Billabong and Quiksilver got into trouble due to some acquisitions they paid too much for, their aggressive forays into retail and their tendency to allow units to operate independently, resulting in an unsustainable cost structure.
 
I think those things would have come back and bit them in the butt even if the economy hadn’t cratered, but the teeth marks wouldn’t have required as many stitches. With their balance sheets out of whack, both had to sell assets, raise expensive capital, change management, cut costs, push for revenue in ways they would (I hope) have preferred not to, rationalize their sourcing and reduce SKUs, consolidate and coordinate design and marketing, and revise and upgrade their information systems.
 
Now, I call those things mechanical. That’s not to suggest they were easy to do, or that exactly what to do was always obvious. But nobody doubted they had to happen (and outside stakeholders didn’t give them a choice anyway). That gives you the refreshing liberty to say, “Let’s get at it!” and start without too much analysis. There was, to use one of my favorite phrases, some low hanging fruit.
 
The process isn’t complete (it’s never really complete- it’s a long term way of thinking), but it’s well underway. Both companies will see significant improvement in their bottom lines as a result.
 
So let’s move on to the hard part. What brands should sell what product to which consumer? I’m sure I could figure out a more erudite way to say that, but why bother. They had to start to address the mechanical stuff before they could really focus on market segmentation (there- that’s a more erudite term) because some of it represented survival issues. It’s hard to care which way you’re rowing when there’s a big hole in the bottom of the boat.
 
Part of the process of keeping the boat floating through the restructuring was to press for sales in places and in ways they didn’t want to do. I assume it helped in the short run- perhaps not so much in the long run. Both companies have some recovering to do from distribution decisions they made while managing those short term survival issues.
 
In the long term, the ONLY THING THAT MATTERS competitively is their ability to figure out the market segmentation thing. The mechanical stuff is necessary but not sufficient. The what product to sell to which customer issue is existential. If they don’t do that well, they’ve got no business or at best a dramatically different business. “Dramatically different” is code for a brand that doesn’t do this well and finds itself milking its market credibility with cheaper product in broader distribution until there’s nothing left.
 
Both companies want to grow the top as well as the bottom line. (What?! Public companies focused on top line growth?!  Shocked! I’m shocked!) If they could, at least for a while, just worry about improving the bottom line (and the balance sheet) their jobs would be a whole lot easier. The mechanical issues, as I so blithely call them, are simpler to manage. And as I’ve written, market segmentation takes care of itself initially though distribution management which builds brand strength for future growth.
 
But you can’t do that for too long. You risk finding yourself stuck in a niche you can’t get out of. For some brands, that wouldn’t necessarily be a bad result. It’s difficult for Quik and Billabong because that market niche might tend to be a predominantly older customer group that has been loyal to the brand for a long time but will inevitably buy less.
 
Their challenge over the longer term is to continue to appeal to their traditional customer groups (if only for the cash flow) while also reaching the younger demographic they have to evolve towards. Not easy.
 
So that’s why I perked right up way back when Launa Inman became Billabong’s CEO and, in her initial presentation of her strategy, talked about the need to figure out what the brands stood for and how the customers and potential customers perceived them. Billabong proceeded to spend a lot of money on that issue. We never heard the results, but why would we? You can tell all your competitors that you’re cutting costs, improving systems, reducing SKUs and consolidating certain function. They’re doing it themselves and are probably wondering why you didn’t get on with it sooner. But I can’t think of any good reason (outside of a brain tumor or psychotic episode) why’d you’d share findings about what customers think of your brands, why they buy them, and how you’re planning to position those brands.
 
Part of that evaluation will determine product direction. It’s fair to say that when you’re trying to keep a company alive, you aren’t likely to take a lot of product risk if only because you can’t afford things that don’t work. But armed with their evaluations of who’s buying what product and why, I would expect to see both companies be more aggressive with product development and introductions. The consolidation of those functions from regional to worldwide should make that easier by making it more cost effective. It’s time to take some risks.         
 
Most of us think it’s important that Billabong and Quik do well because they are positioned to represent the surf industry in the broader market. It seems to be an industry article of faith, practically a mantra, but it has the ring of truth to it.
 
I’m not sure any more what “the surf industry” means. Don’t feel bad surf people. I feel the same way about other segments of action sports and, by the way, am not quite sure what exactly the action sports market is either.
 
But recognize that neither Billabong nor Quik is a pure surf company in the way they were years ago.   The “core” surf market is way too small to support much growth for either company. Anyway, that seahorse left the barn years ago when they both acquired non surf brands that represent significant percentages of total revenue.
 
I will always look at the numbers (I can’t help myself). But the numbers, by the time we see them, only tell you what has already happened. As I try and figure out how Quik and Billabong are going to do, I’ll be looking for clues to their product and market segmentations decisions, because at the end of the day, that’s mostly what’s going to matter. And not, you might consider, just for Quiksilver and Billabong.

 

 

Intrawest Officially Trading as a Public Company. What’s the Impact?

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As many of you know, Intrawest, the owner of Steamboat, Winter Park, Tremblant, Stratton, Snowshoe, Mammoth, and half of Blue Mountain, started trading as a public company on January 31. The initial offering price for the stock was supposed to be $15 to $17, but it ended up going public at $12 in a soft stock market where fear of the Fed tapering and its impact on certain developing countries is taking its toll. As I write this Monday morning, the stock is at $11.78 at 9:40 AM Pacific time with the whole market taking another drubbing. The trading symbol is SNOW, which kind of makes sense.

I explained the rationale for the public offering a couple of weeks ago in this article. To summarize, they are great at running resorts, but the real estate crunch did them in. It left them with an untenable debt burden and they are resolving the problem by having most of the creditors agree to convert their debt to common stock. I guess I think they would have preferred another solution, but didn’t have one.
 
When I wrote my initial article, I did it based on an SEC filed S1 which didn’t have all the numbers filled in. That’s standard procedure. Now, with the company actually public, there’s a final prospectus with all those numbers, and I thought I’d point out a few things. You can see that document here.
 
The selling price is $12.00 a share, but the underwriting discount is $0.78 a share, so the selling shareholders get $11.22 a share before the costs of doing the deal.
 
With the deal done, the “initial shareholders” control 65.3% of the common stock. Those shareholders are all controlled by the Fortress Investment Group. For this discussion, you can pretty much think of Fortress as the seller of most of the shares.
 
As part of the deal, Fortress converted about $1.4 billion in debt to equity. Intrawest itself sold 3.125 million shares and will receive about $32 million. The initial shareholders sold 12.5 million shares and are receiving (probably on February 5th) about $140 million. To be clear, that $140 million is not available to Intrawest for operations. It goes to the entities who converted their debt to equity.
 
Let’s see what Intrawest has accomplished financially by doing this deal, starting with the income statement.
 
For the years ended June 30, 2011, 2012 and 2013, Intrawest reported net losses of $499 million, $336 million, and $296 million respectively. Yet in those same years, they had positive cash flow from operations of $21 million, $43 million and $42 million respectively.
 
If you look at the expenses for those years, you’ll see all kinds of noncash expenses for losses on sale of assets and impairments of goodwill, real estate, and long-lived assets. They are particularly big in 2011, and decline thereafter. The loss from operations is $197 million in 2011. It falls to $19 million in 2012 and is a positive $3.5 million in 2013.
 
But below the operating line is interest expense. Here’s the numbers for the three years in millions of dollars.
 
Interest expense on third party debt                     (143,463)             (135,929)             (98,437)
Interest expense on notes payable to affiliates    (160,943)              (195,842)             (236,598)
Total Interest                                                      (304,406)             (331,771)             (335,035)
 
That, I think, can be characterized as a lot of interest and the bottom line, as indicated above, reflected it. What’s the impact of getting rid of it which, after all, is the purpose of Intrawest going public?
 
In a pro forma income statement they provided, which assumes the deal is done (it is done now), interest expense in the year ended June 30, 2013 falls from the $335 million shown above to $48 million. Net income goes from a loss of $296 million to a profit of $5.4 million. Quite a difference.
 
With the assets all written down to a reasonable value and interest expense reduced dramatically, Intrawest can now go about making money running resorts. That’s not a slam dunk, but it’s lower risk than mountain real estate right now. And who knows, maybe there will be a time in the future when those now low valued assets will be worth a bunch again.

   

A Sustainable Competitive Advantage: The Zumiez 100K

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I have written before about the value of Zumiez’s hiring, training, and promotion process. They take kids with a passion for the activities and brands their stores sell, train them, support them, make them compete with their peers, and promote the ones who succeed. The average age of store managers is something like 23 and pretty much all their district and regional managers started out as sales people in a store. 

This approach to culture and staffing is so important to them that it’s been allowed to impede their growth plans when they couldn’t identify enough good people to staff new stores. In hindsight, I imagine they are thrilled that happened given the way the environment for brick and mortar is evolving.
 
Anyway, it’s easy to read SEC filings and intellectualize about this, but when you walk into the annual 100K party at Keystone, where the company’s best sales people are celebrated, you look up and see a sustainable competitive advantage staring you right in the face. That’s never happened to me.  The fact that I was afraid I was the oldest person in a room of 1,300 only dampened my enthusiasm a bit.
 
A competitive advantage is only sustainable if none of your competitors can duplicate it. I suppose somebody else could do what Zumiez does, but they’d better get started. They’re 30 plus years behind.
 
I’m guessing most of the Zumiez sales people don’t read my column. If they wrote one I’d sure as hell read it to find out what brands were succeeding. If they did read it, I’d tell them how lucky they are to have jobs involved with something they love (hell, maybe just to have jobs), solid support and training, the opportunity to advance based on performance and, if they want it, a career.
 
And finally, I’d tell them what a great thing it is to be part of something that can support and validate them. Without getting too deep into generational history (read this book if you are curious what I’m talking about), let’s just say that this is a group of young people who are going to have to pull together to solve some big problems not of their making. I’m seeing it with my own kids (they don’t work at Zumiez) as they form groups and relationships outside of the immediate family that involve strong personal bonds. I see it where I went to college, where the number of students who return for reunions are much larger than they ever were in my generation.
 
So the environment Zumiez has created not only works for these young people, but for Zumiez as well and is consistent with the way generations turn over and repeat themselves in our society over decades. And it has significant implications for how any brand markets itself today.
 
But, as usual, I digress. Back at the 100K, the introduction of brand founders was particularly interesting. In groups (there’s a lot of them), they march founders out on stage and give each one a chance to say a few words. Somebody told me they’d meant to bring a decibel meter to measure the applause each brand got (or didn’t get). That would have been brilliant. I would love to publish that list with the noise levels listed.
 
Among the brands that got the loudest cheers were brands that are urban, or youth culture, or whatever word you want to use. But they were definitely not action sports brands. Not to say that some action sports brands weren’t well received, but I thought the reception of the various brands was a good indication of how the industry is evolving.

It is true that a deeply imbedded, successful culture can be destructive to a company if the culture resists evolving with the competitive and economic environment. I can’t say for certain that Zumiez (or any other company) won’t someday have that problem.  But Zumiez can minimize that potential by just letting the young sales force that is part of its target demographic drive brand selection and be the arbiter of what’s “cool.”  If they do that I think this competitive advantage can continue to be sustainable.  That’s a hell of thing and unusual in our industry.

 

 

Tilly’s Quarter and the Retail Environment

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Tilly’s quarter ended November 2, though the 10Q didn’t come out until later. I’m late writing this, but I thought there were a few things in it you might want to think about, especially given the holiday results and warnings from industry retailers.

Just to be clear, I believe the country was over retailed even before ecommerce. With its explosion, it’s even more over retailed. Every retailer has to be thinking about where or if they should be opening (or closing) stores. Store sizes probably have to shrink. Inventory has to be managed differently as the coordination between brick and mortar and ecommerce becomes tighter.
 
Let’s start with some of Tilly’s President and CEO Dan Griesemer conference call comments. This first one sounds a lot like other CEOs.
 
“During the quarter, we experienced a continuation of the weak traffic trends that have affected many retailers, leading to lower than expected comparable store sales. Consistent with the past several quarters, consumers continue to focus their shopping into compressed peak periods and pullback during non-peak periods. This trend was consistent across all product categories, real estate formats and store vintages, as well as in our e-Commerce channel; affirming our view that our sales results were primarily driven by external factors.”
 
He seems to be implying that disappointing results are okay because they were caused by things outside of their control. I know a conference call has a high marketing content, but wouldn’t it be better if such results were caused by things they could fix?
 
“While acknowledging that teen unemployment remains high, and that other categories such as electronics and entertainment compete for teen dollars, we know that Tilly’s remains the top destination for the most relevant merchandise and brands important to our action sports inspired customers.”
 
You know if you aren’t a new reader that I don’t think that “action sports” is an adequate description of the market our retailers are in. More importantly, I’ve got a bit of a problem with the idea that Tilly’s is “the top destination.” If he’d said Amazon, well, maybe.
 
“Despite the challenging external environment, we continue to adhere to the proven business strategies that have guided Tilly’s success for over 30 years, including our differentiated business model and our sharp focus on evolving preferences and needs of our customer.”
 
Focus on customer requirements is a good thing and something all retailers are doing. Or should be doing. But I think Mr. Griesemer would agree the competitive environment has changed a bit in 30 years, and I hope Tilly’s business strategies have changed to reflect that. I don’t think any of us are using the same package of strategies we were using 30 years ago.
 
Finally, in response to an analyst’s question CEO Griesemer says, “…we recognize that we have a unique business, a unique business model.” Unique is a pretty strong word. Of course no analyst asked just what he meant by that. I don’t see Tilly’s as unique, and would have loved to hear why he’s comfortable using the term.
 
He talks about a lot of good things they are doing. They are “relentless” in pursuing the brands and styles their customers want. They are keeping the business and inventory clean, with inventory per square foot down 16% from a year ago. That’s a great result. They also talk about having “newness” in their stores multiple times a week. That certainly means with product, but it felt like he meant more, though he wasn’t specific.
 
Those are all good things, but I don’t see them rising to unique. But perhaps some of the discussion below will help us understand what Tilly’s thinks does.
 
Tilly’s balance sheet is solid, and doesn’t require any discussion.
 
Sales for the quarter fell very slightly, from $124.9 to $123.8 million. CFO Jennifer Ehrhardt reminds us that “This reflects approximately $8 million in back-to-school period sales that shifted into the second quarter from the third quarter this year, when compared to the 2012 fiscal calendar.” Ecommerce sales were $13.3 million, up from $12.9 million in last year’s quarter.  Gross margin fell from 33.5% to 30.9%. 2.4% of that decline was due to occupancy costs from new stores. Product margin improved by 0.2%.
 
Selling, general and administrative expense rose from $27.9 to $28 million. Net income was down 33.9% from $9.3 to $6.1 million.
 
They closed the quarter with 189 stores, up from 168 stores at the end of last year’s quarter. They expect to grow their store count by 15% in each of the next several years. “The stores are located in malls, lifestyle centers, ‘power’ centers, community centers, outlet centers and street-front locations.” That’s an interesting mix. If I had to guess, it might be that getting a good deal on the rent was an especially important factor in choosing locations.
 
Comparable store sales fell 2.4%. That includes a 1% increase contributed by ecommerce sales. The average store size at the end of the quarter was 7,788 square feet, but average sales per store were $592,000, down 16% from 705,000 in last year’s quarter. Picture each of their stores being a square that’s about 88 feet on a side. My gut tells me those are low sales for stores that size, and makes me think I’m right about their negotiating well with landlords.
 
I’m wondering if CEO Griesemer would tell me that what was unique about their business model was their ability to make money on lower store sales volumes because of their lower occupancy costs. I’d still have a hard time with “unique,” but I might be okay with calling it a competitive advantage.
 
Tilly’s is facing the same uncontrollable, external, headwinds all retailers in our industry are facing. My expectation is that those will last a while. In addition, rapid change driven by ecommerce has to be managed- maybe harnessed is a better term. The look and roll of brick and mortar is going to be different as a result.
 
Yet most retailers seem to go along opening (more cautiously, I admit) new stores that, from a macro point of view, we don’t need. The assumption, I guess, is that all the bad stuff will happen to their competitors.
 
I would remind you all that unique doesn’t necessarily mean good. Even if your evaluation of your own market advantages doesn’t rise to “unique,” be careful that your confirmation bias* doesn’t have its way with you.
 
* Confirmation bias is the tendency of people to favor information that confirms their beliefs or hypotheses. People display this bias when they gather or remember information selectively, or when they interpret it in a biased way. The effect is stronger for emotionally charged issues and for deeply entrenched beliefs. People also tend to interpret ambiguous evidence as supporting their existing position.

   

Quiksilver’s 10K: It’s Results for the Year and Some Issues of Strategy

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If you haven’t noticed, I’ve been working to not just report the numbers (it’s hard to grab readers attention with the drama of a changing current ratio) but to draw some larger business lessons from company reports and make us all think about the issues. You can think I’m wrong, or you can think I’m right (I’m not always sure). I just ask that you pause and think. 

Quiksilver is giving us the chance to pause and think. I’ll get to the numbers of course, but let’s dive right into some more strategic issues, starting with this quote from their discussion of distribution channels in the 10K (which you can see here).
 
“We believe that the integrity and success of our brands is dependent, in part, upon our careful selection of appropriate retailers to support our brands in the wholesale sales channel.”
 
No kidding. I suspect I’d define “careful selection” differently from Quik management, but then I don’t have to answer to the stock market. As I’ve said, it’s hard to be public and do the right thing for a brand in our space.
 
“A foundation of our business is the distribution of our products through surf shops, skateboard shops, snowboard shops, sporting goods stores, and our own proprietary retail concept stores, where the environment communicates our brand and culture.  Our distribution channels serve as a base of legitimacy and long-term loyalty for our brands. Most of our wholesale accounts stand alone or are part of small chains.”
 
I’m all for communicating brand and culture. But outside of its own stores and certain core shops, it’s tough for any brand to do. Damned near impossible once your distribution gets past a certain point. Perhaps, I’ve argued, even a detriment as some of those further removed customers may know your brand, but not know or care about your story. And then, how are you competing? I’d also love to hear what Quik’s definition of a “small chain” is. 
 
Next, here are some comments CEO Andy Mooney made in the conference call. They are in the order I came to them.
 
“… retail brick-and-mortar sales were very steady and e-commerce sales continued to show robust double-digit gains. And…we continue to see very slow erosion in the specialty core surf and skate chain worldwide, offset by pretty robust growth in emerging markets, particularly for us, Russia, Brazil, Mexico and Southeast Asia, and even Japan this quarter.” 
 
Okay, here’s the next one.   “In the case of Quiksilver, we believe there’s opportunities to take share within the core channel, particularly when we see the current weakness of some of our competitors in the marketplace.”
 
Subject to definitional clarity, I’m wondering just how big the core market is. I’ve suggested it’s not really that large a market overall. I’d be curious what percentage of its total revenues Quik sees as coming from the core market. And if it’s “slowly eroding” how significant to revenue growth can taking share be? It was years ago I first pointed out that even robust growth in the core channel (if by “core” we mean specialty shops) doesn’t really move the revenue and profit needle much once a company is larger.
 
And third from CEO Mooney, talking about their Board Rider stores. “These are very exciting stores that have within them restaurants, bars, barbershops. We offer in those stores a broad range — array of our own products, but also other products that would be relevant to our consumer. So products like GoPro or mophie, the battery charge — battery packs for iPhone, headphones, that type of thing. We think that makes for an interesting environment for consumers that cut across all 3 brands. Those stores are performing very well for us. We’d like to experiment with a few of those stores here in North America in 2014…”
 
A couple of weeks ago, I wrote about Zumiez’s quarter and asked if it really mattered how we defined our industry or if maybe it was up to our customers to define us and our job was just to give them the product they wanted where and when they wanted it. It sounds like that’s how Andy Mooney looks at things given his description of the Board Rider stores. Interesting implications for branding however. Will any of these products carry a Quiksilver brand? How much and what kind of product can you carry before these stores no longer “communicate the brand and culture?”
 
And next: “Well, one of the things that we’ve been doing because we can is we’ve been doing product injections into our retail stores ahead of the calendar that’s required to introduce new product for the wholesale channel…So we’ve got some of the products, the newer products that we want to have in retail in the stores quicker. One of the other kind of really important changes that we’re going through, which again gives us the level of confidence that we can actually go deeper in SKU reductions is that, as an organization, historically, we have designed for wholesale, and retail has been an afterthought. Increasingly, what we’re seeing is, we’re going to design primarily for our own retail stores, our own website and our own key wholesale partners.”
 
I guess I just have to wonder what actual core retailers, which Quik says are a foundation of their business, think when they read this. I am not saying I wouldn’t do the same thing if I were in Andy Mooney’s place. But as a core retailer, it might make me think about my commitment to Quik’s brands. 
 
And finally, just to put the cherry on the whipped cream, Andy notes:
 
“I think our wholesale business is in transition, in that we’re seeing a rotation out of the small independent mom-and-pop operators in surf, skate and snow into other — in some cases, other wholesale players. That could be, in the case of Europe, it could be large multi-outdoor players like Decathlon or it could be pure play e-commerce players like Surfdome in their own stable in Europe, or Amazon, even here in the U.S., or eBay. There’s a lot of activity happening on web for pure-play retailers that clearly didn’t exist before. So you’ve got a rotation out. Definitely, the small independent operators are much more challenged than they’ve ever been, today. And we’re seeing, I’d say, some modest contraction in that channel, but it’s rotating into other channels.”
 
Once again, I think Andy’s perception may be accurate. But where does it leave Quiksilver (and other industry brands and retailers) who get their credibility and legitimacy from having their roots in a sport and lifestyle that, with revenue growth, is less important to a bigger percentage of their customers? How can Quik’s “…distribution channels serve as a base of legitimacy and long-term loyalty for our brands” under these circumstances? 
 
Now, here’s how Quik defines its strategy in the 10K:
 
“In our efforts to increase shareholder value, we have adopted three fundamental strategies: 1) strengthening our brands; 2) growing sales; and 3) driving operational efficiencies.”
 
Those strategies (if they are strategies, and I don’t think they are) offer no competitive advantage or point of differentiation. Everybody who owns a brand is striving to do those three things all the time. Always have been, always will. Granted, they’ve become more important since the economy went to hell. I suppose I expect too much from the information provided in a 10K.
 
We’ll move onto the numbers now.
 
The Numbers
 
Revenue for the year fell 6.8% from $1.942 billion to $1.811 billion “…due to the expected decrease in DC sales.” Argh. Some of you may remember that several years ago I expressed concern that Quik might push the DC brand too hard in a search for revenue. They did. It’s the public market pressure again. You’ll note some more indications of this below where I present more data on DC.
 
Wholesale fell from 74% to 71% of the total. Retail rose from 23% to 25% and ecommerce from 3% to 4%. Apparel was 62% of the total. Footwear and accessories were 25% and 13% of revenues from continuing operations respectively. The Quiksilver brand was 40% of revenues from continuing operations (unchanged from the previous year). DC represented 30%, down one percent and Roxy 28%, up 1%. Other brands were 2%.
 
The Quiksilver brand’s year over year revenue fell 8% as reported from $784 to $721 million. DC was down 9% from $588 to $542 million. Roxy fell 4% from $530 to $511 million. Total wholesale revenues were down 9% to $1.294 million. Retail was down 2% to $447 million and ecommerce rose 25% to $69 million.   
 
I’d note that revenues from continuing operations are surprisingly even over the quarters, with the 1st quarter being lowest at 23% of the total, and the 3rd and 4th highest at 26%. As a finance guy, I love that.
 
38% of this revenue was generated in the U.S. The next biggest single country is France at 12% with Australia/New Zealand coming in at 7% and Canada at 6%. Below is the table that shows net revenues and gross profit by operating segments. Note that revenues were down in all three segments for both the quarter and the year.
 
 
 
For the quarter ended October 31, the Quiksilver brand had flat revenues of $190 million. Roxy stayed the same at $137 million but DC was down $47 million to $139 million. That is a 25% decline. Wholesale revenue fell 12% to $353 million. Same store sales in company owned stores were flat and ecommerce revenues grew 22% to $16 million. The gross margin for the quarter rose 1.4% to 47%. It would have risen 1.9% except for $2 million in restructure related costs.    
 
The gross profit margin for the year was down from 48.5% to 48.2%. The decline was “…primarily due to increased discounting associated with DC brand net revenues within our wholesale channel. We entered fiscal 2013 with a higher level of DC inventory in the wholesale channel than we planned, which resulted in higher discounting to clear this product.”
 
SG&A expenses declined from $227 to $200 million. “The decrease in SG&A was primarily due to reduced employee compensation expenses and event related marketing expenses, partially offset by higher severance and early lease termination costs as well as increased e-commerce expenses associated with the expansion of our online business.” As a percentage of revenue, SG&A rose 1.7% from 45.7% to 47.4% “…primarily due to net revenue declines outpacing any SG&A reductions in fiscal 2013.”
 
Quik spent $93 million on promotion and advertising during the year, down from $118 million the prior year.
 
Asset impairment charges (noncash) were $1.7 million compared to $6.7 million last year. Interest expense rose from $15.3 to $20 million and the loss before taxes and discontinued operations (businesses they are selling) rose from $11.2 to $18.7 million.
 
And then, there was a provision for income taxes of $157.5 million compared to a benefit of $9.7 million the prior year. That left Quik with a net loss from continuing operations of $176.2 million compared to a loss of $1.5 million the previous year. After then taking into account the discontinued operations, we’ve got a net loss of $171 million compared to a profit of $4.4 million last year.
 
I usually stay away from income tax issues, but a charge of $157 million (it’s noncash) requires some respect and a little attention. Here’s how CFO Richard Shields explains it:
 
“The Q4 tax provision includes a noncash charge of $157 million related to taking allowances on the net operating loss carry forward deferred tax assets in France. We have NOLs of EUR 356 million in France, which were created in the Rossignol disposition in 2009. These deferred tax assets were carried on the balance sheet, tax effected, at $157 million. Based upon the cumulative losses we have incurred in France in recent years, we took valuation and reserves against those deferred tax assets. This does not preclude our future use of those NOLs, and those NOLs do not expire.”
 
I’m sure you all understand that as well as I do. My take is that they don’t expect French results to be good enough to let them utilize those assets in the near future, so they might as well write them off now while nobody is expecting much from them on the bottom line. I think that, having written them off, they will have more value if they can be used. One of you CPAs out there want to explain this to us on my web site?
 
The balance sheet requires a little attention. Trade accounts receivable are up like $1 million to $412 million, but with the sales decline, you might have liked to see them go down. I see their allowance for doubtful accounts has increased from $57.6 to $60.9 million. Deductions for bad debts were $2.38 million compared to $7.81 and $9.26 million respectively in the prior two years. The average number of days it took them to collect receivables rose from 85 days to 97 days or by 14%. We can’t tell if that’s because they extended longer terms or had trouble collecting.
 
Total inventories rose slightly from $327 to $338 million. Again, with a decline in sales, you’d like to see that fall. They tell us that, “As of October 31, 2013, aged inventory was approximately 6% of total inventory, a reduction of 100 basis points versus October 31, 2012,” and it was 15% lower than a year ago.   CFO Richard Shields tells us in the conference call that they added $8 million in U.S. retail inventories because they thought they were too thinly stocked.
 
It is, of course, good to see aged inventory falling. But what, exactly, does 6% represent? Is that a good number or a bad number? Is “aged inventory” anything older than three months or three years? Not knowing that, I have no idea how to react to that number. It wasn’t available during the conference call, so nobody could ask. I’ve emailed Quik to ask that question and will let you know if I get an answer.
 
By the way, the receivable and inventory numbers exclude the assets associated with the businesses being sold. Total assets fell from $1.72 to $1.62 billion, largely due to the write off of the tax assets.
 
Current liabilities are up from $357 to $367 million. However, long term debt, net of current portion, rose 12% from $721 million to $808 million. Mostly due to that increase, total liabilities increased from $1.116 billion to $1.233 billion.
 
As a result, stockholders’ equity fell 35.6% from $583 million to $370 million. Total liabilities to equity rose from 1.85 times to 3.18 times.
 
The Profit Improvement Plan     
 
You remember that last May, Quiksilver introduced its Profit Improvement Plan (PIP). Here’s how they describe it.
 
“Important elements of the PIP include:”
 
“• clarifying the positioning of our three core brands ( Quiksilver , Roxy and DC );
• divesting or exiting certain non-core brands;
• globalizing product design and merchandising;
• licensing of secondary or peripheral product categories;
• reprioritization of marketing investments to emphasize in-store and print marketing along with digital and social media;
• continued investment in emerging markets and e-commerce;
• improving sales execution;
• optimizing our supply chain;
• reducing product styles;
• centralizing global responsibility for key functions, including product design, supply chain, marketing, retail stores, licensing and administrative functions; and
• closing underperforming retail stores, reorganizing wholesale sales operations, implementing greater pricing disciplines, and improving product segmentation.”
 
CEO Mooney notes in the conference call that the fall and holiday SKU count is 47% lower than last year. That’s progress. Remember that licensing agreement like the one for children’s apparel and the sale of Mervin and other assets helps with the SKU reduction.  
 
I pretty much agree with all of this and wish Quiksilver, as a company, had started it sooner. I’m sure we all realize that some of these things make sense whether times are good or times are hard.
 
They go on to say:
 
“We expect that the PIP, when fully implemented by the end of fiscal 2016, will improve Adjusted EBITDA by approximately $150 million over fiscal 2012 Adjusted EBITDA, of which approximately one-half is expected to come from supply chain optimization and the rest is expected to be primarily comprised of corporate overhead reductions, licensing opportunities and improved pricing management, along with modest net revenue growth compared with fiscal 2012 results.”
 
I wish they’d tell us what “modest net revenue growth” means. I’m seeing in Quiksilver what we’re seeing in a lot of other companies- not just in our industry. Bottom line improvement is coming largely from expense reduction driven by layoffs and improved efficiency. Top line growth with a solid gross margin is harder to come by. Trouble is, you can’t cut expense and become more efficient forever.
 
The Retail Footprint
 
Quik ended the year with 631 owned retail stores. They had an additional 243 stores licensed to independent retailers around the world for a total of 874 retail locations. Here’s how the owned stores break down by type and location.
 
 
Quik closed 17 retail stores during the last quarter of the year. They see a chance to add “…a few more full-priced stores in developed markets…” and believe “…there’s tremendous opportunity to open stores in emerging markets.” They believe they’ve got a big opportunity in ecommerce, where they “…received 30 million visitors to our own branded sites last year.” But they “…only converted, on average, 1.5% to 2.0% of them.” Part of the PIP is the consolidation of their three independent ecommerce platforms. Good idea.
 
I applaud what Quik is going as part of its profit improvement plan. But I’m going to ask the same question I’ve been asking about Quik for years now. Where will revenue growth come from? Like most public companies with roots in traditional action sports, they are ultimately conflicted by the need to grow revenues but also to manage distribution carefully to differentiate products that don’t have meaningful competitive advantages. You can see that conflict highlighted in some of the quotes and the discussion at the start of this article.
 
Why might Quiksilver be more successful than its competitors? There are three possible reasons. Better management, better brands, and/or a stronger balance sheet. Actually, you need some of all three.

 

 

Does it Matter What Industry We Think We’re In? Zumiez’s Quarter

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For many of us, “action sports” doesn’t really describe our target market anymore. We struggle (or at least I struggle) with words like “youth culture” or “fashion” or “outdoor” to describe it. None of them work very well. They are all correct, but not adequate or complete. 

Maybe Zumiez has helped me figure out why. During the conference call, CEO Rick Brooks said, “…it’s really not about e-commerce, it’s really not about stores, it’s about meeting whatever our customers want and whatever channel they want it, anyway they want to get the product. That’s where we’re trying to play and we’re trying to dominate the market in that arena of integrated multichannel selling.”
 
He’s also talked about the fact that they had reduced their North American store projection over the years from 800 to between 600 and 700, but with no decline in revenue from what they would have expected with 800. That is due to the growth of ecommerce and integrated multichannel selling (also known as the now ubiquitous omni channel).
 
The thought that popped into my head was that Rick probably didn’t care quite as much as he used to whether the customer was best classified as action sports, youth culture, fashion, outdoor, or something else. What he cares about was that Zumiez carried the apparel, accessory, footwear, and limited hard goods brands (because that’s a point of differentiation- for now- for Zumiez) that his teen to young adult customers want.
 
At some level Zumiez, or any other retailer for that matter, isn’t going to define itself quite as rigorously as it used to. Its customer is going to define it. That will happen at least partly through Zumiez’s rigorous and ongoing process of identifying and assisting new brands and integrating them into Zumiez’s selling channels at whatever level they can succeed. They discuss the process of identifying and supporting new brands in the conference call. Here’s part of what CEO Brooks say on the subject:
 
“…we are just laser-focused on trying to be supportive and a really good partner for our small retail brands. And again, we have hundreds of brands today that we’re doing business with, just like we always have. And some of them are just in a few doors, and we want to be the right way for that young brand, and we want to do everything we can to help see them be successful. Maybe it’s just those 10 doors, but we’re hoping that over time — and they have to do their job well, too, of making sure that they have great products. They have to have a great marketing, and product and marketing have to be completely aligned with the unique brand positioning. And then they have to have great retail partners that believe in full price selling.”
 
It occurs to me we’re already seeing the customer define the brand happen in the decline of traditional print and media advertising. Why bother spending money (whose impact was already unclear) to define yourself to a certain customer group when the omnipotent, endlessly connected customer with near perfect information is going to decide for themselves what you stand for? 
 
It certainly changes the roll of the marketing department. It doesn’t have to explain what the company is about. It has to listen to the customer to evolve with them but not, it occurs to me, let that customer pull the company too fast or in a direction which will ultimately be wrong.
 
And yet, in response to analyst’s question, Rick talks about their Ultimate Gift Guide that they are mailing to selected control groups to see what kind of response they get. Maybe the role of print is changing in ways we don’t quite understand yet. I’d love more details on how they see the guide tying into their ecommerce channel.  
 
Zumiez may also have an advantage in this environment in the way they identify store managers and give them a high level of management discretion.
 
So I think I’m going to stop stressing out about what to call our industry. I’ve concluded not only that it’s less important, but that it might be a mistake to worry about it as it could lead to resistance to inevitable change.
 
Meanwhile, back in the financial statements, Zumiez’s revenues rose 6.2% to $191.1 million in the quarter ended November compared to the quarter ended October 27 last year. Ecommerce sales were 11% of the total (10.7% in last year’s quarter). They had a net of 55 more stores open in this year’s quarter (541 in North America at the end of the quarter). Comparable store sales increased 1.5%, “…partially offset by the negative impact of the calendar shift, which moved a week of the back-to-school season into the second fiscal quarter of fiscal 2013 and out of the three months ended November 2, 2013 compared to the prior year quarter.” The impact was $7 million.
 
Comparable store sales include ecommerce sales. They rose 7.9% while brick and mortar sales were up only 0.7%. 
 
The gross margin declined slightly from 37.3% to 37%. “The decrease was primarily driven by the deleveraging of our store occupancy costs and an increase in ecommerce related costs due to ecommerce sales increasing as a percent of total sales. This decrease was partially offset by an 80 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.”
 
Without the Blue Tomato inventory step-up, then, the gross margin would have been 36.2%.
 
SG&A expense as a percentage of sales rose from 25.4% to 26.2% or from $45.7 to $50.1 million. Part of the increase was from “…deleveraging of our store operating expenses.” I might have expected the opposite result with 55 more stores open. No detailed explanation is offered.
 
There was a charge of $1.3 million for settling litigation included, and some additional investments in their ecommerce business. There was a benefit of 0.6% because they reduced the expected earnout payments for the Blue Tomato acquisition. That happens because Blue Tomato isn’t performing as well as they had previously expected. That does not necessarily mean it’s performing badly. Total charge for the Blue Tomato acquisition this quarter was $1.7 million.
 
Operating profit fell from $21.4 to $20.7 million and net income was down from $12.7 to $11.9 million. The balance sheet is fine, and there’s no big change from last year. Inventory is up, but it’s consistent with having 55 more stores. In North America, inventory per square foot was basically flat.
 
I guess I’ll have Rick Brooks help me end this. 
 
“I just view retail in America as over-stored. I think, in particular, teen retail is way over-stored. And that is one of the reasons that there’s such tremendous promotional pressure in the teen retail world. One of the reasons, not all of them. But it is a significant reason, I think, that we see the level of promotional cadence in the teen world that we’re seeing today.”
 
That’s a problem for everybody in this space- not just Zumiez. And it’s a reason why you have to operate well. Sales and margin increases are hard to come by. The winners, I think, will be letting their customers help them determine their market position. I think Zumiez’s management would agree with that.

 

 

Billabong: Light at the End of the Tunnel

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At the annual meeting on December 10, Billabong’s Chairman, Ian Pollard, and new CEO Neil Fiske talked to shareholders. Ian talked about what the last year plus had been like and Neil outlined his ideas and strategies for Billabong going forward. You can see their presentations here if you want to. At the moment, it’s the first item under “Recent News.” 

Though I’ll get to it, it wasn’t Neil’s strategic presentation and plan going forward that I found most interesting. Honestly, there wasn’t much in it that hadn’t been mentioned before or that was, at least to me, unexpected.
 
But in both presentations there was an honesty, a focus, a clarity of purpose that has been missing from Billabong presentations over the last year or two as they’ve struggled to stabilize the company and deal with competing proposals.
 
There was a palpable sense of relief in Ian’s remarks. As he put it, “It is also the first time in at least 12 months where the company’s future success will be firmly in the hands of management and their ability to achieve their business goals – rather than the Company’s need to respond to change of control or refinancing proposals.”
 
He went on to say:
 
“These proposals inhibited reform in two ways:
·         First by dominating the attention of both the Board and management.
·         Secondly, potential bidders would only remain engaged if major strategic changes were put on hold.”
 
“The consequent delays in strategic change impacted the Company’s overall financial
performance.”
 
I have previously expressed some surprise that more of former CEO Inman’s plan hadn’t been implemented while she was there and since she left. Chairman Pollard is telling us why that is. The bidders didn’t want it happening until they were on board because, I guess, they didn’t want what they were investing in to change without their involvement. Fair enough, but it seems like some of her proposals (a number of which are also in Neil’s plan) were going to make sense no matter who was in charge, and I’m sorry they couldn’t make some progress sooner.
 
So are Billabong’s board and management I’m sure. Must have been frustrating as hell to know what you needed to do, have a plan to do it, be ready to do it, and not be able to do it. As Ian put it, “Throughout this period a brand that has been built on some of the simplest joys of life has been mired in high profile corporate transactions of extreme complexity.”
 
“Mired.”  Yup, pretty much sums it up.
 
CEO Neil Fiske practically had me sold as soon as he stopped going through his background and said:
 
“A good turnaround has three components:
·         A clear strategy
·         A management team that can execute on that strategy
·         A capital structure that provides stability and room to reshape the business.”
 
He’s right. Or at least that’s been my experience as well. It’s important for you to realize that having two out of three isn’t enough; it doesn’t let you get two thirds of the work done. There’s damned little you can do without all three.
 
This attitude- that the worst is behind them, they can focus on building the business, work on positive things, maybe even have some fun- is as important as Neil’s three components. Don’t worry, I haven’t gone completely touchy feely on you. We’ll get into the strategy next. There’s a lot of work to do and no guarantee of success. It’s a turnaround. Still, I can’t over emphasize the importance of this apparent attitude adjustment (which needs to permeate the whole organization) if they are going to succeed.
 
They are going to focus and simplify. As Neil puts it:
 
“We have been trying to do too many things – and none of them particularly well. Building global brands takes one skill set. Running regional multi-brand retail is something totally different. And being a pure play multi-brand e-commerce business is another thing altogether. Then multiply that complexity by a regionalized organization structure with independent decision making and different operating infrastructures. As complexity grew, we lost focus. We confused the organization.”
 
You’ll notice similarities to what Quiksilver is doing. And to K2’s reorganization a couple of years ago. And for that matter to Microsoft’s “One Microsoft” strategy they announced this past July.
 
When sales increases are harder to come by, operating in independent silos is just too expensive. If you want sales increases, you better put your best foot forward. “Fewer, bigger, better” is how Neil puts it.
 
Neil and his team have determined that Billabong is about “building powerful global brands.” They are going to divide all their brands into the big three (Billabong, Element and RVCA) and the other “emerging” brands. There will be specific strategies for each brand based on its potential and market position. It sound like there may be some brands among the emerging brands sold if they don’t see a strong competitive position and bright future for them.
 
They will differentiate brands partly by using “the creativity and uniqueness of the brand Founders” and will “focus on the authentic core youth consumer.”
 
To me, that implies a certain period of retrenchment where they will “…push the uniqueness of each brand by fostering creative and cultural environments with distinctive brand DNA and vivid personalities.” I wonder (and I’ve said this before, oh, dozens of times at this point) if that focus is consistent with the requirements of being a public company. Where and how do they grow each brand, but retain its uniqueness- its competitive strength if you will. I guess they’re figuring that out.
 
As he moves on to talk about a product, Neil says we can expect at least a 25% reduction in the number of styles. He notes that Billabong “…lacks clear merchandising strategies. We have great design and terrific products. But we don’t have great merchandise planning, buying, allocating and inventory management.” Obviously, there are some systems issues there that need to be addressed. It will be made easier both by simplifying the organization and cutting the number of styles.
 
What was most interesting in the discussion of marketing was that Billabong had tended to fund each brand at the same level (by which I think they mean a similar percentage of sales). They are changing that and will put more resources towards brands where they think they can get a better return. Imagine that.
 
It makes it seem even more likely to me that some additional brands might be sold. Weaker brands are not going to perform better when their marketing spend is reduced.
 
I also like the idea that they are going to “…have an integrated marketing calendar that lays out the major story and key items each month – and then aligning all our marketing and our depth of buy against those big stories. Windows. Print ads. Digital media. Front Tables. Everything converges on and amplifies the big story.”
 
That seems kind of obvious when you read it, but it’s damned hard to do when you have “…a regionalized organization structure with independent decision making and different operating infrastructures.” That’s part of why the structure is changing.
 
The marketing “war chest” is going to be funded by cuts in other G&A expenses.
 
These days, no discussion of marketing strategy is complete if you don’t work in the term “Omni-Channel” and low and behold, here it is as point IV in Neil’s presentation. He notes that “The best customers shop in all our channels – digital, our own retail stores, and wholesale. And they are worth 3-4 times the value of a traditional single channel customer.” I haven’t heard that stat before, but it’s pretty compelling.
 
He goes on, “One of our priority initiatives, therefore, is to build our mono-brand direct to consumer platform – which integrates digital, retail, and CRM. That Direct to Consumer segment should grow to a substantial part of our sales over the next five years. Again, we believe this can be done in a way that grows consumption and market share – and is complementary to our wholesale strategy.”
 
Every company wants to do this. And if you can’t, all you end up with is a really expensive digital presence that potentially cannibalizes your brick and mortar stores. Why is Billabong going to be better at this than its competitors? I think Neil would say because of the quality of their brands, the unique focus each brand is going to have, and the simplification of the organization. Billabong’s multiple ecommerce platforms around the world are going to be unified.
 
You’re going to see a supply chain with fewer, bigger, suppliers. Neil hopes to increase inventory turns from 2.4 to 4.0 times. That will take a couple of years, but will free up a bunch of cash and reduce other costs. That includes distribution and logistics costs, which Neil sees as being 50 to 100 basis points higher than they should be.
 
We are going to see a companywide reorganization rolled out at the end of January or early February. Hardly a surprise given what’s been described above. There will also be some improvements in financial discipline- also not much of a surprise. I can guarantee you won’t increase your inventory turns from 2.4 to 4 without some.
 
What we have here is a series of solid initiatives that are similar to what a lot of other companies in a lot of other industries are doing given the economy we’re all operating in. Wish Billabong could have gotten started sooner, but they’ve told us why they couldn’t.
 
I think we’ll see sales of some additional brands because of the focus on prioritizing the brands with the most potential (and some limits on financial resources). Reading between the lines, we’re also going to see continuing deemphasize on retail, because Billabong’s focus is on “building powerful global brands.” West 49 is about to be gone. My guess is that every store decision will now be based on how it supports brand building. If it doesn’t make money and it doesn’t make the brands look good, it will be closed. How does the omni-channel strategy change how many stores they need and where they need them? Probably a good question for any brand.
 
As Neil says, this is going to take some time. One of the first signs of success I’ll be looking for is an improvement in the gross margin and operating income even if sales don’t rise much, or even decline. I’ll also be curious to see how he recruits for the management team. Remember when Gary Schoenfeld came in as PacSun’s CEO he essentially rebuilt the whole senior management? It was months to accomplish and longer to get them working well with the organization.
 
Feels like a good start. Now all they have to do is implement.

 

 

PacSun’s Quarter: The Transition Continues

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I have been writing for a while now, without having a really good answer, about just what market we are in as action sports doesn’t, for most of our companies, adequately describe the customer base or competitive environment. Outdoor, youth culture, fashion are all words bandied about to describe it. It’s probably some of all of those. 

Pacific Sunwear has figured this out. It’s recognized that action sports isn’t a big enough market to support its plans. As a public company it has to seek some growth and it needs the broader market to find that. It’s choice of brands and positioning as a southern California lifestyle company is indicative of this. I think they’ve made the right choice (in fact the only choice they could make) even though it puts them in a position to have to compete against other fashion focused retailers like Forever 21 that Zumiez, for example, with its action sports positioning and focus doesn’t compete against quite so directly.
 
Reported sales for the quarter ended November 2nd fell 4% from $215.5 million to $206.6 million. However, due to the retail calendar shift, fiscal 2012 had an extra week in it. 
 
“Due to the inclusion of a 53rd week in fiscal 2012, there is a one-week calendar shift in the comparison of the third quarter of fiscal 2013 ended November 2, 2013, to the third quarter of fiscal 2012 ended October 27, 2012. The third quarter of fiscal 2012 included a higher volume back-to-school week as a result of the 53rd week retail calendar shift compared to the third quarter of fiscal 2013. This resulted in a decrease in net sales of approximately $11 million, a 1.9% decrease in gross margin…”
 
So there would have been higher margins and sales if not for the shift in the calendar. Gross margin fell from 28.1% during the quarter to 25% in the same quarter last year. It was basically all due to the calendar shift. 1.9% of the decline was due to lower merchandise margins. The rest of the gross margin decline was also due to the calendar shift because it caused an “Increase in occupancy, distribution costs and all other non-merchandise margin costs…”
In the conference call they tell us, “The decline in gross margin in the third quarter was the result of a challenging and competitive back-to-school landscape, leading to a higher promotional activity.” I wish somebody had asked them to compare what the 10Q says about gross margin with that statement from the conference call.
Selling, general and administrative expenses as a percentage of sales fell from 27.5% to 26.1%. Half the decline was due to a reduction in depreciation that resulted from store closings. The rest was from lower expenses. PacSun reported an operating loss of $2.24 million compared to an operating profit of $1.15 million in last year’s quarter. For the nine months ended November 2nd, the operating loss fell to $8.1 million compared to $22.8 million in the comparable nine months the previous year.
 
 Net income for the quarter rose from $948,000 to $17.2 million. Obviously, when you have an operating loss but a positive net income, there has to be something interesting going on between the middle of the income statement and the bottom- and there is.
 
There’s a gain on derivative liability of $23.4 million. In last year’s quarter the gain was $5.6 million. That is a non cash item associated with some of their financing activities that I’ve described before. You may read the footnotes in the 10Q if you have a compelling urge to know the details.
 
If we remove that non cash item from both quarters, we find that the loss in last year’s quarter before taxes and discontinued operations would have been $2.01 million. In this year’s quarter, it would have been $5.8 million.
 
In the cash flow, we see PacSun continues to use, rather than generate cash in operations. They used a bit over $21 million in both this fiscal year’s 9 months and last year’s. On the balance sheet, the current ratio has fallen from 1.38 to 1.21 and total liabilities to equity rose from 3.18 to 6.99 times compared to a year ago. Current liabilities in this quarter include a separate line item for derivative liability of $27.1 million. It was not broken out in last year’s quarter. I assume it was included in other current liabilities.
 
Merchandise inventories were almost constant at $137 million. They ended the quarter with 635 stores compared to 722 stores a year ago. They are, by the way, going to close another 15 to 20 stores during this quarter.
 
I might have expected a 12% decline in store count to result in some inventory reduction. They note in the conference call that “Adjusting for the timing of the 53rd week calendar shift, total inventory was down approximately 3% on a comparable store basis,” but I don’t think that takes closed stores into effect.
 
If I were running PacSun I think I’d have done basically what they’ve done. Because I don’t see a second viable choice. The balance sheet is still weakening. What PacSun (not to mention a host of other retailers) needs is some improvement in consumer spending.

 

 

Intrawest Files for Initial Public Offering. Will it Happen?

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On November 12, Intrawest Resort Holdings, Inc. filed the first draft of a form S1 with the SEC for an initial public offering. Like all first drafts, there’s some significant information missing, including the proposed price of the stock and how much they want to raise. But at 400 pages as a PDF, there’s also a lot of interesting information that I thought you’d want to hear about. Here’s the link if you want to skim it yourself. 

Intrawest, to refresh your memories, owns and operates Steamboat, Winter Park, Mont Tremblant, Stratton Mountain, and Snowshoe. It also owns 50% of Blue Mountain. In the year ended June 30, 2013, Intrawest had total revenue of $517 million. 65.5%, or $339 million, came from the mountain and lodging operations at those resorts. 22%, or $114 million, came from their adventure segment. Mostly that’s Canadian Mountain Holidays that provides heli-skiing trips. The remainder of the revenue, 12.5% or $64 million, came from real estate. That includes real estate development as well as real estate management, except there isn’t any real estate development going on right now.
 
Now, some of you will recall that back in the good old days of “The Best Economy Ever” Intrawest and other resorts made a whole bunch of money developing and selling real estate in coordination with the improvement of the mountain experience. The real estate market has changed a bit since 2007.
 
Intrawest tell us they have 1,150 acres of “core development parcels” surrounding or adjacent to their resorts. They also say, “While we do not have any specific plans for the development of our core entitled land, we are focused on designing strategies for future development of this land in concert with planning for on-mountain and base village improvement.”
 
Sounds like there’s a lot of planning going on, but not much else. When might it move past planning?
 
“As the economy continues to improve, we expect consumers will have more disposable income and a greater inclination to engage in and spend on leisure activities. We also expect recreational adventure and experiential travel to continue to gain in popularity as individuals, including the important “baby boomer” generation, live longer, healthier lives. We believe that our business is well positioned to capitalize on these favorable trends…”
 
I don’t know when consumer spending is going to improve, or how much improvement Intrawest requires before they might put some of these plans into action. But if they’re waiting for consumers to start partying like it’s 1999 again, I suspect they’re in for a long wait. The focus on the baby boomers isn’t new for resorts, and I’ve previously questioned whether that’s an adequate strategy. The focus has to be on people with high disposable incomes, boomers or not, though obviously there’s a big overlap there.
 
But I digress. I do that sometimes. Let’s get back to the impact that resort real estate development had on Intrawest. It will lead us to why they are going public.
 
Here’s what they say the real estate collapse that started in 2007 did to them:
 
“Prior to the collapse in the housing markets in late 2007 and the global financial crisis that followed, we were actively engaged in large scale development and sales of resort real estate, primarily in North America. In light of the then prevailing market conditions, we ceased new development activities in late 2009. As a result, we were left with a portfolio of real estate assets, high leverage levels and litigation initiated by purchasers of resort real estate seeking to rescind their purchase obligations or otherwise mitigate their losses. This confluence of factors had a material impact on our consolidated financial results for the fiscal years presented below.”
 
Material impact indeed. Here’s some summary numbers from their income statement for the last three years ended June 30 (In $000s).
 
       
2011
2012
2013
Total Revenues
    
$559,523
$513,447
$524,407
(Loss) Income From Operations
  
(196,516)
(19,332)
3,478
Interest Expense on 3rd Party Debt
(143,463)
(135,929)
(98,437)
Interest Expense on Notes Payable to Partners
(160,943)
(195,842)
(236,598)
Net Loss
      
(498,506)
(336,063)
(296,714)
             
2011 had almost $150 million in impairment charges for goodwill, real estate, and long lived assets. There was also a $26 million loss on the sale of some assets. These all impacted operating income. The total of such charges fell to about $21 million in 2012 and to almost nothing in 2013, permitting Intrawest to show an operating profit.
 
But now look at the interest expense numbers. This is interest on loans that was going to be paid, and the loans paid off, through the development and sale of real estate. And said real estate is no longer being developed or sold. If we visit the June 30, 2013 balance sheet, we see long term debt of $581 million and notes due to partners of $1.359 billion. With a “B.” What they call partners’ deficit (basically equity) is a negative $1.02 billion, having worsened from a negative $724 billion a year ago. 
 
The people to whom all this money is owed seem to have recognized that there is no imaginable combination of economic improvement, perfect snow conditions, and growing visitor days that will let them get out from under this debt. I’d say they’re right. Shades of American Skiing Company- though they didn’t have the issue of an imploding real estate market.
 
Their solution is to take Intrawest public. But what fool would buy shares in a company with this kind of balance sheet losing this much money? The answer is none, or at least not enough.
 
The partners’ solution is to convert their $1.359 billion in notes to equity, moving it out of liabilities. That includes the accrued, but unpaid, interest of $761.7 million as of June 30, 2013.   The restructuring reduces total liabilities from $2.14 billion to $756 million, producing a much cleaner balance sheet. How clean exactly we don’t know yet because the proforma balance sheet in the S1 is incomplete- no surprise since we don’t know how much money they will be raising.
 
But we do have a proforma income statement for the year ended June 30, 2013 prepared as if the deal had been done a year earlier. It shows net income of $8.5 million instead of a loss of $297 million.
 
Why, you might ask, don’t the partners just restructure the balance sheet without going public? Well, if you’re a shareholder (especially if you didn’t really want to be a shareholder) you might want to be able to sell your stock someday. That’s a lot easier if the stock is publically traded. It may also be the case that Intrawest needs the cash that will be raised in the public offering.
 
Intrawest, you may recall, was acquired by Fortress Investment Group in a leveraged buyout. Wikipedia tells us that “Three weeks before the opening of the 2010 Olympics, Fortress failed to make payment on its loan used to buy out Intrawest. This caused its creditors to force Intrawest to divest itself of several of its resort holdings in 2009 and 2010 which includes Whistler Blackcomb, in order to reduce its debt load.”
 
As part of the restructuring for the IPO, which is a bit more complicated than I’ve bothered to describe in this article, a subsidiary of Fortress is “contributing” $50 million to Intrawest. Why would they do that?
 
“As of June 30, 2013, Cayman L.P. [the legal entity that owns Intrawest’s resorts until this deal happens] had loans due to affiliates of Fortress, consisting of notes payable to partners with a principal balance of approximately $597.0 million and accrued interest of approximately $761.7 million. Pursuant to the applicable loan agreements, Cayman L.P. currently accrues interest at rates ranging between 15.6% and 20.0% per annum on the notes payable to partners.” 
 
There are two more things I want you to know. The first is that after the offering is completed, if it is completed, an affiliate of Fortress will own enough of the equity to be able to appoint a majority of the board of directors. Hardly a surprise as it’s their debt that’s being converted.
 
The second is that somehow Intrawest can be classified as an Emerging Growth Company under the Jumpstart Our Business Startups Act of 2012. No, I don’t really understand that either and find it kind of amusing. But what it means is that they don’t, among other things I guess, have to provide five years of financial statements (which they don’t), have the auditor give an opinion over their financial controls, or disclose as much about compensation as usual.
 
We know that Intrawest management knows how to run resorts. And it’s correct to say that they got hammered by the collapse of the real estate market and, if this deal gets done, the impact of that will have been financially flushed out. But they are planning to succeed doing the same things they did before under very different economic circumstances. The question a potential buyer of this common stock has to ask is if they think that’s a reasonable expectation.