Quiksilver’s Decision to License Children’s Apparel

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On November 26, when Quik announced that LF USA  (a subsidiary of Hong Kong headquartered Li & Fung, a multinational consumer goods sourcing, logistics and distribution group) would “…design, manufacture and market children’s apparel bearing the Quiksilver and DC brand trademarks in the Americas…” I tried to ignore it. It was a short press release and, on the surface, consistent with Quik’s announced strategy of focusing “…our energies and resources on our core apparel business and significantly reduce product styles and SKUs in our supply chain,” as CEO Andy Mooney put it in the press release. 

Then one of my readers inconveniently messed with my comfortable mind set and asked, more or less, “Hey Jeff, if kids aren’t part of Quik’s core business, what is?” I thought that was a good enough question to require some discussion.
 
I’ve talked before about brands aging out. That is, the customers who grew up with them (and with whom the brand grew up) get older and decidedly less cool. The brand may retain those customers. They may even sell them new products.
 
I’d like to pause for a moment and tell you just how hard it is to move on here without stopping to have some fun imagining what those products might be. Send me your ideas. I’ll put them on my web site (anonymously of course).
 
But the future of a business can’t be only with those existing customers because they are going to start buying less and eventually buy nothing at all. New demographic groups have to discover the brand as they grow up and, with luck, make it their own.
 
Quik’s management team knows that kids matter. My reader is implying that Quik is somehow making a mistake by licensing the kid products because of its critical importance to the company’s future. Maybe, but maybe not.
 
Let’s recall that Quiksilver has been losing money. They’re working hard to turn that around by reducing expenses, improving operational efficiency, and focusing their limited resources where they think they can get the most bang for the buck. Remember in recent years they’ve tried selling bathing suits in vending machines at resorts, board shorts with NFL logos, etc. I sense perhaps they’ve learned a lesson.
 
A royalty revenue stream, no operating expenses and, as CEO Mooney points out, fewer SKUs, may be the right way to go operationally and financially given their resource constraints. I’m guessing this is as much a financial as a marketing decision.
 
More important is what’s in the license agreement and how LF USA will handle this. We know nothing about that. What products, exactly, will they sell? Through what distribution in what quantities? At what prices? How will product quality be? Does Quik have any input into design or any of these other issues?
 
The devil is always in the details in any licensing agreement I’ve seen. Obviously, poorly made products only tangentially related to Quiksilver’s market showing up in schlocky distribution would bad no matter how much royalty income it generated. Quik knows this and I am sure it’s managed in the agreement.
 
Do I wish Quik was doing and completely controlling its own kid’s products? Sure. They probably wish that too. Do they recognize the importance of the kid’s market to their future? Of course. Is it a mistake to license the product? Not if they know they need to be in the kid’s market and don’t’ have the resources to do it the right way themselves.
 
The product will hit retail in 2014, and I guess we’ll start to find out then what kind of deal they made with LF USA.

 

 

Some Additional Financial Information on Mervin

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For some reason, following the November 7th sale of Mervin, Quiksilver had to file an 8K that showed Quik’s proforma financial statements as if the sale of Mervin had already occurred. To do that, Quik shows us the adjustments they have to make to represent their balance sheet as if Mervin had been sold at the beginning of the 9 months ended July 31, 2013 and to the income statement to show what the Quik income statement would have looked like for the year ended October 31, 2012 if Mervin had been sold at the beginning of that year. 

They do that by inserting a column between Quik’s historical and proforma financial statements that shows the Mervin numbers that have to be subtracted to get to how Quik would have looked without Mervin. Below is the part of the income statement that shows Mervin’s numbers (center column).
 
 
Quik points out in the 8K that this is subject to certain assumptions and doesn’t necessarily reflect what the results would have been if the split had actually happened October 31, 2011. Don’t be confused by the brackets around the Mervin numbers in the middle column. That just shows they are being subtracted to get to Quik’s proforma numbers without Mervin, as shown in the third column.
 
You can see, then, that Mervin’s revenue for that full year was $33.5 million, and they had a gross margin of 52.7%. Seems impressive to me given they make lots of hard goods and much of it, as far as I know, is made in the U.S. Down at the bottom, you can see Mervin had net income of $6.79 million while Quik, including Mervin, lost $10.76 million. Mervin, then, made a big contribution to Quik’s bottom line in that year.
 
I want to emphasize again that these Mervin numbers aren’t necessarily what Mervin would look like on a stand-alone basis. I’d think the revenue would be the same, but issues of taxes, interest expense, allocation of corporate expenses, etc. would probably mean a different result. Still, you can see why Altamont was prepared to pay $51.5 million for Mervin. Actually, if they could rely on Mervin, as a stand-alone company, to earn $6.8 million after taxes on revenue of $33.5 million (20.3%!), they would probably have been prepared to pay more.
 
I had been prepared to see the Mervin revenue number be higher on the assumption that Quik had really pushed them for sales while they were working through their issues. As regular readers know, my point of view is that the bottom line looks so good, and the gross margin is so high, exactly because they didn’t push revenues too hard.
 
The July 31, 2013 balance sheet shows Mervin with accounts receivable of $7.2 million. That’s higher than you’d want to see a snowboard company of this size have at July 31 of any year. I suppose that’s just a reflection of snow conditions the prior season. Mervin inventory was $13.8 million, which doesn’t seem out of line going into the shipping season.
 
Anyway, that’s all there is. Just thought you might be curious.

 

 

How’s Sanuk Doing? Decker’s Quarterly Results

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So I guess I’ll start by telling you what Deckers says about Sanuk. In the 10Q for the quarter ended March 31, 2013 they provide this Sanuk Brand Overview (page 17). I’ve highlighted the phrase I want you to pay attention to. 

“The Sanuk brand was founded 15 years ago, and from its origins in the Southern California surf culture, has grown into a global presence. The Sanuk brand’s use of unexpected materials and unconventional constructions has contributed to the brand’s identity and growth since its inception, and led to successful products such as the Yoga Mat sandal collection and the patented SIDEWALK SURFERS®. We believe that the Sanuk brand provides substantial growth opportunities within the action sports market, as well as other domestic and global markets and channels in which Deckers is already established.”
 
In the June 30, 2013 10Q the Sanuk Brand Overview (page 17 again) says exactly the same thing, but they’ve added the following sentence at the end (which I’ve highlighted): 
 
“However, we cannot assure investors that our efforts to grow the brand will be successful.”
 
They say exactly the same thing in the current 10Q (September 30 quarter). I’m kind of embarrassed I was a quarter late noticing it. But I’m also kind of concerned I noticed it at all. I have so got to get a life. 
 
Why did they think they had to add it?
 
Decker’s management paid $120 million in cash for Sanuk (subject to adjustments at closing) plus earn outs. The deal closed in July of 2011. In its last complete year as an independent company, Sanuk did $43 million in sales. I don’t recall what Deckers has paid out so far for the earnout, but as of September 30, 2013, they estimate the discounted value of the remaining required payout at $47 million (page 7 of the 10Q which you can see here). That payout assumes a “compound annual growth rate” of 16.9%.  They used 17.3% last quarter.
 
Below, from the 10Q, is a table showing Sanuk’s sales by channel and the change from last year’s quarter. Column one is this year’s quarter, and column two last year’s. The last two columns are the dollar and percentage changes (dollars in 000’s). You can see that total sales were up by just $85,000, and they fell in the wholesale channel. 
 
 
And here are the numbers for the 9 months ended September 30 compared to last year. 
 
 
With 9 month revenue of $79.4 million, Deckers has certainly gotten some good growth out of Sanuk in a bit over two years, though growth has now slowed. 
 
Sanuk’s income from operations from its wholesale business rose from $2.86 million to $3.66 million during the quarter and from $16.2 million to $19.5 million for the nine months. Here’s what they say about why the operating income increased in the quarter:
 
“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 and decreased marketing and promotional expenses. The decrease in expenses was partially offset by the decrease in net sales and resulting gross profit.”
 
Let me translate- We cut expenses and, because the brand isn’t performing as well, didn’t have to book at much for the earn out. That helped, but with sales and gross margin down, not as much as we would have liked.
 
We aren’t provided with operating income for the direct to consumer sales. Here’s what they have to say about Sanuk’s wholesale results for the quarter.
 
“Wholesale net sales… decreased primarily due to a decrease in the average selling price, partially offset by an increase in the volume of pairs sold. The decrease in average selling price was primarily due to increased closeout sales in the US, partially offset by increased average selling prices outside the US primarily due to the addition of international wholesale sales, which generally carry higher price points than distributor sales. The increase in volume of pairs sold was primarily due to our wholesale customers in the US and UK, as well as our distributors throughout Europe and wholesale customers in France, Japan and Benelux. These increases in volume were partially offset by a decrease in volume to our distributors throughout Asia. For Sanuk wholesale net sales, the decrease in average selling price had an impact of approximately $2,500 and the overall increase in volume had an impact of approximately $2,000.”
 
Go back and read that carefully. Note that when they talk about the decrease in average selling price in the US, they say it’s “partially offset” by increased prices outside the US. But that’s because they apparently changed some distribution from distributor to wholesale. I mean, it’s true that you get higher margins selling at wholesale than through a distributor, but you also incur more expenses in getting the sale.
 
Net, is this a good thing? Well, we don’t really know, though obviously they think it made sense to change the distribution or they wouldn’t have done it. But they try and spin it as a counterbalance to lower prices due to closeouts in the US, though I don’t think it is. Everything they say is no doubt true, accurate, and complete as interpreted by a squad of lawyers.
 
Here endeth the daily lesson on the care you have to take when reading SEC filings (and press releases and conference calls even more) for any company. Especially when they have to share some bad news.
 
One symptom of the problems Deckers seem to be having with Sanuk is that “…Sanuk brand inventory increased $3.9 million to $12.5 million.” That’s a 45% increase from $8.6 million a year ago. 
 
Deckers, as you know, also own UGGs and Teva, as well as some smaller brands. Total company sales rose 2.75% during the quarter compared to last year’s quarter from $376.4 million to $386.7 million. The gross profit rose from 42.3% to 43.2%. This increase was “…primarily attributable to a shift in the mix of channel revenue with a greater contribution coming from our Direct to Consumer division…”
 
Once again, I feel obligated to point out that you get higher margins from direct to consumer business but also incur higher expenses. The question for any company is whether there’s any of that extra gross margin left after you cover those higher costs.
 
Deckers reported an increase in selling, general and administrative expenses of 20.8% from $99.7 to $120.4 million. About $12 million of the increase was for 37 new retail stores that weren’t open a year ago. Operating income from retail stores for the quarter fell from $321,000 to a loss of $2.26 million. Same store sales revenues rose 1.9% for the quarter. For nine months, operating income from retail fell from $8.5 million in 2012 to a loss of $1.6 million in 2013.  
 
Largely as a result of that SG&A increase, Decker’s income from operations for the quarter declined from $59.6 to $46.5 million. Net income was down from $43 million $33 million.
 
Overall, Deckers is suffering from the same worldwide economic problems that are afflicting everybody else. They also got hammered when their UGG brand, which accounted for 87% of total revenues during the quarter, was hit by spiking sheepskin prices over the last couple of years. My perception is that they’ve managed that pretty well after initially trying to push through more of the cost increase than the consumer would accept.
 
But they are having trouble with Sanuk, and I’m starting to believe that some of that trouble is of their own making. Growth has slowed, they’re having to close out some excess inventory and, probably inevitably, gross margin is down. They’ve cut spending in response.   
 
I’d remind Deckers management of Nike’s various attempts to enter the action sports business some years ago. They were pretty certain of their success, thought they could buy their way in and that they understood the business. As I’ve noted, we went to their parties, ate their food, drank their beer, but for a long time didn’t buy their product.
 
Then Nike figured out that they didn’t understand this business after all. They got humble (or maybe just more determined), developed some patience, hired a few people who knew what was up, and left them alone. They backed them up with their balance sheet and logistic resources even when they weren’t quite sure what the hell those guys were doing and it worked.
 
The situation isn’t the same, and the market has changed. Still, there’s a lesson there somewhere for Deckers and how they might consider managing Sanuk.

 

 

SPY’s Quarter: More of the Same. That’s Good and Bad

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To sum it all up, the good news is that sales for the quarter ended September 30.2013 rose 2.7% compared to the same quarter last year from $9.89 to $10.15 million and the net loss declined from $1.78 million to $302,000. The bad news continues to be the balance sheet, where the long term debt to stockholders is $20.86 million, up from $17.53 million a year ago. Here’s the link to the 10Q for those who might be interested, though I’m pretty sure most of you read my stuff specifically to avoid having to look at the 10Q. 

I suppose I could stop here and have the shortest article ever. But there are a few financial points that need highlighting and a big strategic issue.
 
The sales amounts are pretty much all SPY branded product except for $100,000 in last year’s quarter. However they note that there was $600,000 in SPY sales this quarter “…which were considered to be closeouts, defined as (a) older styles not in the current product offering or (b) the sales of certain excess inventory of current products sold at reduced pricing levels.” The amount in last year’s quarter was $800,000 and it’s good to see it declining. It’s about 6% of sales. Apparently, they are still clearing up some inventory issues.
 
Sunglasses and optical were 56% of sales. Goggles were 43%. The numbers in last year’s quarter were 64% and 35% respectively. North American sales were 80% of the total compared to 84% last year.
 
The reduction in the net loss was driven by two things. First was a monster improvement in the gross profit margin from 43.5% to 48.5%. 
 
“The increase in our gross profit as a percent of net sales during the three months ended September 30, 2013 compared to the same period in 2012 was primarily due to: (i) improved overall sales mix of our higher margin products; (ii) a higher percentage of lower cost inventory purchases from China; (iii) lower overhead as a percentage of sales partially due to the consolidation of our European distribution center to North America; and (iv) lower sales of closeout products at reduced price levels.”
 
I would be very interested to know what their margin was on the $600,000 in closeout sales.
 
The second was a 19% decline in operating expenses from $5.53 to $4.47 million resulting in an operating profit of $454,000 compared to an operating loss of $1.22 million a year ago. Most of this was the result of a $900,000 decline in sales and marketing expense to $3 million due to “…(i) a $0.3 million decrease in advertising, public relations, marketing events, and related marketing costs; (ii) a $0.6 million decrease in sales and marketing salary and travel related expenses primarily for reductions in headcount.”
 
I’d also note that cash provided by operations over the nine months of the year so far was a positive $2.49 million compared to a negative $4.13 million in last year’s first nine months. Keep in mind that the interest on the shareholder debt is not being paid in cash but being added to principal and that has something to do with the improvement.
 
Enough on the numbers. Let’s talk about the brand’s positioning. Here’s how they describe it in the 10Q:
 
“…the Company believes it has captured the imagination of the action sports market with authentic, distinctive, performance-driven products under the SPY ® brand. Today, the Company believes the SPY ® brand, symbolized by the distinct “cross” logo, is a well-recognized eyewear brand in its segment of the action sports industry, with a reputation for its high quality products, style and innovation.”
 
Fair enough. Now, here’s some branding discussion from the press release:
 
“We have a HAPPY disrespect for the usual way of looking (at life). This mindset helps drive us to design, market and distribute premium products for people who "live" to be outdoors, doing intense action sports, motorsports, snow sports, cycling and multi-sports-the things that make them HAPPY. We actively support the lifestyle subcultures that surround these pursuits, and as a result our products serve the broader fashion, music and entertainment markets of the youth culture.”
 
I think the happy disrespect approach is great as long as they can keep it up. It really can supply some differentiation. Irreverence works in this industry. But note that the second quote talks about the broader youth culture market, and the first does not.
 
Maybe I’m reading too much into this. It seems symptomatic of a problem I’ve been highlighting for a while. How does a company maintain its positioning in the historical action sports industry while expanding into the broader youth culture business? It’s proven to be difficult (Burton? Volcom? Skullcandy? Sanuk?).
 
Long term, SPY’s challenge is exactly to do that. I think it has to if it’s going to find enough growth and profitability to get out from under its debt to shareholders. Strategically, that’s what I’ll be watching for.

 

 

VF’s Quarter; Outdoor and Action Sports Continue to Lead, But…

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There are, to my way of thinking, three main points to be made about VF’s September 30 quarter. The first is that the Outdoor & Action Sports (OAS) segment revenues as reported rose 6.43%. Excluding a $32 million foreign exchange gain, the increase was 4.7%. Jeanswear was up 3.89% as reported and the other segments (Imagewear, Sportswear, Contemporary Brands, and Other) were basically flat for the quarter.  Excluding foreign currency changes, OAS reported an operating loss of $1.7 million.  There are good, even positive, reasons why, and I’ll discuss them below.  But I still don’t like it.

OAS includes, as you know, Vans, The North Face, Timberland and Reef. Don’t forget it also includes Jansport, Kipling, Smartwool, Eastpak, Eagle Creek, Lucy and Napapijri. I’d suggest you take a minute to check out VF’s web site and see where those other brands are positioned. I found it kind of interesting as I continue to think about the junction of action sports, youth culture, outdoor and fashion.
 
The second point is the wonderfulness of a strong balance sheet. VF spends some time in their conference call discussing some additional investments they are going to make. As CEO Eric Wiseman puts it, “…we think a challenging environment is the ideal time to upshift and hit the gas pedal a bit harder on marketing and product initiatives, supporting and helping to drive traffic to our wholesale partners, and of course, our own Direct-to-Consumer business by strengthening our connection with consumers, and creating even more meaningful engagement with our brands is key to our long-term success.”
 
He goes on to discuss how they’ve done this before, and that they are going to spend an additional $30 million in the fourth quarter and a total of $40 million extra in the second half, 80% on OAS and most of that focused on Vans, The North Face and Timberland. It’s also “…about 70% positioned outside the U.S. and heavily D2C weighted…”   He acknowledges that’s $0.25 a share, but that they will still be on plan. One of VF’s strengths, to my way of thinking, is their capacity (and financial ability) to take the longer term view while accommodating the quarterly requirements of a public company.
 
Third, VF projects a rigorous, consistent, but flexible management approach to running their businesses. That’s not to say that things don’t go wrong and they don’t make mistakes (though you generally don’t read about them in the earnings press release or conference call unless they’re whoopers). But it sounds like (and it’s sounded this way for a while) there’s a consensus as to goals and objectives among the management team and hopefully the employees that creates efficiencies. There is, at the risk of oversimplifying, institutional knowledge off what’s “right” and what’s “wrong” for the brands and the company. That is a powerful competitive advantage not easily come by.  I see this discipline, for example, in a balance sheet where inventory actually dropped a bit in spite of the sales increase.
 
The problem comes when that institutional consensus and momentum needs to be changed but is so stubbornly imbedded it won’t change. Then you become JC Penney. That’s just a general comment- not an expectation for VF.
 
Total revenues for the quarter rose 4.7% from $3.15 to $3.3 billion.  Net income rose from $381 million to $434 million.  Across all segments, international rose 7% to represent 40% of the total, and direct to consumer was up 14% to 40% of the total. $32 million of the revenue increase came from foreign currency translation. OAS, at $1.97 billion, represented 60% of the total. Jeans wear was an additional 23% of the total.
 
The gross margin increased 0.9% during the quarter from 46.7% to 47.6%. “The higher gross margins…reflect lower product costs and the continued shift in our revenue mix towards higher margin businesses, including Outdoor & Action Sports, international and direct-to-consumer.”
 
“Selling, general and administrative expenses as a percentage of total revenues increased 40 basis points during the third quarter…primarily resulting from increased investments in marketing and direct-to-consumer, partially offset by the leverage of operating expenses on higher revenues.”
 
OAS’s operating profit for the quarter was $421 million or 21% of revenues. It grew 1.94%. In last year’s quarter it was $413 million. Of that increase of $8.2 million, there was actually a $9.9 million currency translation gain. Ignoring the currency gain, OAS had an operating loss of $1.7 million for a quarter. Hmmmm.
 
They provide the following additional detail on the OAS results;
 
“The North Face ®, Vans ® and Timberland ® brands achieved global revenue growth of 3%, 16% and 2%, respectively. U.S. revenues for the third quarter increased 5% and were negatively impacted by retailer caution and a calendar shift for key retailers, which pushed approximately $40 million of shipments [mostly the North Face] from the third quarter into the fourth quarter of 2013. International revenues rose 8%, reflecting growth in Europe, Asia Pacific and the Americas (non-U.S.).”
 
The additional demand generation expenses and calendar shift had a meaningful impact and OAS results for the quarter would look better without them.
 
It would be particularly interesting to see what kind of revenues and operating income other brands in VF’s OAS segment were generating, but I guess there’s no chance of that. I’d settle for just a little information on Reef.
 
VF has growth in OAS and jeans, but its other segments are flat on a quarter over quarter basis. One quarter, of course, doesn’t mean much. It looks like OAS is running into some headwinds that have to do with a difficult economy, but then so are most other companies. There’s also the fact that their success with Vans, just as one example, means that the percentage increases they could generate in the past will be harder to come by. That’s just the law of large numbers.
 
Even given the reasonable and even positive explanations, I find the operating loss in OAS, excluding foreign exchange, interesting and I’ll be watching that in future quarters.

   

Skullcandy’s Quarter; Consolidating to Grow

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Skullcandy’s 10Q for its September 30 quarter came out yesterday. I’ve been through it and the conference call. They are continuing to apply the tactics they’ve adopted as part of their turnaround strategy. That means, in the words of CEO Hoby Darling, “…as we go into Q4, we’re going to do the exact same things that we did in Q3 that are working. And that is we’re going to continue to edit off-price, we’re going to continue to cut accounts that are brand-dilutive. We’re going to continue to cut accounts that break map pricing and don’t allow us to control our brand online.” 

As you know, I like these things. Well, let’s not say I like them so much as I don’t think brands like Skull have much choice. Given their competitors and the nature of the product, what else can they do but start by trying to stake out a market niche they can be a leader in and, hopefully, grow from? If they watch their distribution, and are the leading brand in the youth culture “cool” niche, I suspect they can improve their margins, reduce operating expenses, and bring more money to the bottom line. I’ve described in various articles how I think that works in general.
 
And that would be a fine result if they weren’t a public company. But they are, and the markets want to see regular revenue growth. Skull management thinks they can resume their growth (though they aren’t specific about how much growth) in the second half of 2014. But they are preparing for that growth by hunkering down in a niche where they see the brand as having a competitive advantage.  Ask Burton or Volcom, just to name a couple of brands, how easy it is to grow out of a niche you are strong in when the competitors are big and well resourced.
 
Okay, hold that thought while we take a look at the numbers.
 
I’m going to start with the balance sheet just to get it out of the way. There’s not much to say. It’s pretty strong. Cash has risen to $34.7 million from $1.9 million a year ago. Receivables are down from $60 to $41 million, consistent with the decline in revenue. Inventory has fallen from $55.4 to $48.7 million.
 
Given the sales decline, I might have expected more of a year over year inventory decline. Part of the reason it isn’t down more is that they’ve got $2.5 million of inventory newly tied up in direct distribution in Canada that they started in the September 30 quarter. But they acknowledge that they’ve got some current inventory of high end product that isn’t selling well, and they are working to get rid of it.
 
Notice that the lawyers made them add “Our business could be harmed if we fail to maintain proper inventory levels” as a risk factor in the 10Q. Now, lawyers take an abundance of caution approach to risk factors, but it wasn’t included before and now it is. I conclude that whatever the level of excess inventory is, it’s not completely insignificant. An analyst might have asked about this in the conference call, but the call is before the 10Q is released so they didn’t know about it.
 
Aside from a few bucks in deferred taxes, there’s no long term debt, and equity has risen from $129 to $136 million. The current ratio and total debt to equity are solid.
 
Revenue fell from $71 million in last year’s quarter to $50 million this year. They’ve got two customers who represented $21.4 million of total revenues for the quarter, or 43%. They don’t say this, but I suspect they are Target and Best Buy. That’s kind of a serious concentration.
 
North American sales, which include Canada and Mexico, were $34.8 million down from $57.4 million in last year’s quarter. That’s a decline of 39.4%. International sales rose from $13.6 to $15.2 million, or by 11.8%. They point out that, “Included in the North American segment for the three months ended September 30, 2013 and 2012 are international net sales of $932,000 and $2,976,000, respectively, that were sold from the United States to customers with a “ship to” location outside of North America.”
 
They talk a lot about the tactics I highlighted at the beginning of this article. Get out of off price, enforcing pricing, etc. Good stuff. But when we get to the 10Q and they talk about the reasons for the sales decline, here’s what they say:
 
“Contributing to the decrease in net sales is increased competition in the audio and gaming headphone markets. Additionally contributing to the decrease, and consistent with the strategy stated in previous quarters, we continued to scale back our sales to the off-price channel, which were down approximately $4.4 million, or 74.6%, compared with the three months ended September 30, 2012. We expect sales to the off-price channel to continue to be down more than 50% in the fourth quarter of 2013. There was also a decrease in net sales of $2.2 million as a result of the transition to a direct distribution model in Canada. We also actively stopped selling products to certain retailers and distributors that were violating our policies on minimum advertised prices which further contributed to the decrease in net sales.”
 
Long quote. But what I noticed was that they started the explanation by talking about increased competition, not their distribution and pricing tactics. Does that imply that increased competition is more of a factor than intentionally reduced tactics? I don’t know and no analyst had an opportunity to asking in the conference call. 
 
Gross margin fell from 47.4% to 44.9%. As reported, it was 43.4% in North America, down from 46.6% in last year’s quarter. For the international segment, it was 48.1%, down from 51%. Eventually, they’d like to grow the international business to 50% of their total from 25% right now. I am sure the better margin has something to do with that.
 
The theory is that if you tighten up distribution and enforce pricing agreements, your gross margin is supposed to improve as you cut off price sales. Interesting that we’re not seeing that. Maybe it’s too soon. “The decrease in gross margin was primarily attributable to increased allowances to the Company’s retail customers and a shift to a lower margin product mix,” they tell us.
 
The “allowances” are from 1% to 1.5% that they are giving certain retailers who have inventory of the high end product I mention above. The “shift to lower margin product mix” I’m a bit confused about. Some of you may recall that under Hoby Darling’s predecessor, they were pursuing higher priced, over the ear product that had lower margin, but generated more gross margin dollars. Now, we’re told, they are going to focus on the $100 and under market where they have a strong market position but which apparently has a lower margin than the higher price products, which I thought had lower margins and they are moving away from. That’s another clarification I’d be asking for if I were an analyst and had the 10Q before the conference call. Yes, I’m kind of on a “Conference calls are useless unless you have the actual filing and time to look at it,” rant. Just ignore me.
 
In the conference call they refer to difficult conditions in Europe, an expectation of a highly promotional holiday season, and the ongoing industry consolidation. Those things are not usually good for margins.
 
Selling, general and administrative expenses (SG&A) fell from $23.1 to $22.4 million, or by 3%. There was $1 million in expense associated with closing the San Clemente office. Without that, the decline would have been 7.4%. As a percentage of net sales SG&A rose from 11.3% to 43.8%.
 
In discussing these expenses, they note they invested an additional $300,000 in “marketing and demand creation efforts” and there is discussion about how Skull is continuing to “…leverage our powerful portfolio of brand ambassadors and roster of athletes in fun and compelling ways that generated consumer excitement and demand.” In case anybody hasn’t figured it out, this is a youth culture and fashion brand- not an action sports brand in spite of its roots there.
 
Operating income fell from $10.6 million to $514,000. It went from $7.4 million in North America to a loss of $2.2 million. In international, operating income fell from $3.2 million to $2.7 million. Net income declined from $6.5 million to $1.1 million. Net income was higher than operating income during the quarter due to an $842,000 tax credit.
 
Over on the cash flow, we see that they’ve generated $18.8 million in cash from operating activities during the nine months ended September 30. During the same period last year they used $11.3 million. That’s quite an improvement. You’d expect it given the balance sheet.
 
In 2014, Skullcandy “…plans to selectively add new distribution in the U.S. in underserved geographic areas and where our consumer expects to find us based on where our competition sells.” They are also going to open their first outlet store in Park City before the end of this year. They will be looking to open some additional ones during next year. As you’re all aware, outlet stores have evolved way past where they are just a place to get rid of slow moving merchandise.
 
They are also launching this quarter a blue tooth speaker called Air Raid that will retail for $149. This is their first non-headphone technology product and it’s probably a place they need to go to get the revenue growth they require. As CEO Darling puts it, “…expanding into new adjacent audio categories is an important part of our growth strategy.”
 
Skullcandy is tightening its distribution and pricing with the goal of solidifying its brand positioning. They are trying to lead in the youth culture “cool” headphone space in the $100 and under price range and also offer distinctive product, both in terms of performance and branding, to their customers. If they can do that in what they characterize as a highly competitive, consolidating market, then they have to figure out how to grow out of that niche while maintaining the positioning they are working so hard to achieve.
 
In the action sports business, that’s been damned difficult. We’ll watch to see if their different positioning, even though they are action sports based, makes it any easier.

 

 

Billabong: Restructuring News and Sale of West 49

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I got four pieces of information for you. If you’d prefer, you can read Billabong’s announcement which came out Monday their time. It’s the first item under “Recent News.” 

The most interesting, which they leave for last, is the pending sale of West 49 to YM Inc., “a leading fashion retailer with a number of highly successful stores including Stitches, Urban Planet, Sirens, Siblings, Suzy Shier and Bluenotes.” They are buying 92 stores for a total of between $9 and $11 million Canadian dollars. Billabong will keep six Billabong and two Element stores in Canada.
 
I recommend you take a few minutes and look over YM’s web site. They say what I think are a number of insightful things about operating and their target market. 
 
YM and Billabong also signed “…an initial two year supply agreement” under which Billabong brands will continue to be sold in West 49 stores. We don’t get any specifics about which brands or how much. At the end of the day, I assume that YM, like any retailer, will choose to carry the brands that sell best at good margins.
 
You will remember that Billabong bought West 49 in the summer of 2010 for $83 million Canadian dollars. At the time, West 49 had 140 store fronts. I can’t tell what the West 49 assets are presently carried at on Billabong’s balance sheet, so I don’t know what the accounting impact of this deal on the income statement will be. But its cash positive and, most importantly, it gets Billabong out from under the lease obligations of those 92 stores. West 49 will now be strictly a wholesale customer, so some margin and revenue goes away, but so do all the operating expenses.
 
We also learn that US$300 million of the previously announced US$360 million 6 year senior secured term loan was received and used pay off the US$294 million term loan and associated interest and fees previously received from Altamont. That gets Altamont out of the picture. 
 
Third, we learn that the seven person board of directors will consist of independent directors Sally Pitkin, Ian Pollard and Howard Mowlem. “The other directors are founder and substantial shareholder Gordon Merchant, Jason Mozingo (nominated by Centerbridge), Matt Wilson (nominated by Oaktree), and CEO Neil Fiske.” The two directors who had represented Altamont are out of there.
 
Finally, we’re told that “Billabong continues to work with GE Capital to provide an asset-based multi-currency revolving credit facility of up to US$100 million. This has been reduced from up to US$140 million in part due to the sale of West 49.”
 
That it’s being reduced because the sale of West 49 reduces their needs make sense. But that’s only “part” of the reason it’s being reduced and we don’t know what the other reason or reasons might be. I’m kind of interested to see that it isn’t done yet and would love to ask why.
 
Billabong’s restructuring and refinancing continues. I’m happy to see it moving forward, but I’m still waiting to understand the results of the customer and brand positioning analysis that started under former CEO Launa Inman. They can restructure and cut expenses till the cows come home, but customers still have to like the brands.

 

 

Kering tells us Almost Nothing about Volcom’s Results

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Kering reported its earnings for the September 30 quarter last week. We learned very little about Volcom and Electric. It’s like trying to find out what’s going on with Ride when we review Jarden’s financials or Reef when we look at VF’s. They just aren’t big enough to require much disclosure. What I do believe is when there’s good news, more time is spent on the smaller brand’s results. To me, the lack of information speaks volumes. Let’s see what we can find out.

Remember that Kering (then PPR) announced the acquisition of Volcom back in May 2011 and paid $608 million. The last time Volcom, as a public company, reported a quarter ended September 30 it was in 2010. Their revenue in that quarter was $105 million. 
 
Volcom is part of Kering’s Sports & Lifestyle Division. That division includes, in addition to Volcom, Puma, Cobra, Tretorn and Electric (acquired with Volcom). That entire division reported revenue of 896 million Euros for the quarter. (If we use the exchange rate at September 30 2013, that’s about $1.21 billion). But Puma represented 825 million Euros, or 92% of the total. So, according to my careful calculations, Volcom, Electric, Tretorn and Cobra together for the quarter had revenue of 71 million Euros. That’s $96 million at the September 30 exchange rate.  That represents a decline of 7.9% from 77.5 million Euros in the same quarter last year for the entire division. 
 
So what do we know?  We know that Volcom, Electric, Cobra and Tretorn together had about $9 million less in revenue than Volcom (including electric) reported during the quarter than ended September 30, 2010.   I have no idea what revenues Tretorn and Cobra had and whether those revenues grew or shrank. Do your own guessing, but by way of example, let’s say they are just $5 million each during the quarter.  That would leave Volcom and Electric combined at $86 million. 
 
We are told in the conference call that Volcom’s revenues were up 2% compared to the same quarter last year so that suggests that Cobra and Tretorn were down. 2% if probably not quite the kind of growth Kering had in mind when they spent $608 million. Kering says Volcom benefitted from the introduction of shoes and “resilience” in apparel. Its sales were “solid” in the North American market. Electric, they say, is “refocusing” on accessories and that impacted its results. Resilience and refocusing are the kinds of words you use when things aren’t going all that well, though how a 2% increase represents resilience beats the hell out of me. 
 
I don’t know if Volcom’s 2% growth includes Electric or not. I think not, but remember that the $102 million Volcom reported in its last September 30 quarter before being acquired does. 
 
When Volcom was acquired I wrote an article that congratulated Richard Woolcott and the Volcom board of directors for selling at the right time and for the right reasons. There’s a lesson there for anybody building a company, and at least one of you is now going to get a call from me this week suggesting it’s time to sell. 
 
The Kering press release does not even include complete financial statements, and many of the numbers are adjusted to reflect a “constant group structure and exchange rates.”   It’s bad enough that in the U.S. they do the conference call before the analysts really have time to analyze the press release and before they see the 10Q. That Kering can get away with doing it before they’ve released complete financial statements at all just amazes me. You won’t be surprised to learn that most of the questions are “strategic,” which in this case means there’s not much else you can ask about. I have no idea why the analysts tolerate it. Conference calls are starting to feel like Kabuki theater. 
 
It looks like Volcom (including Electric) isn’t doing very well based on the few numbers we are provided. Interesting that nobody else has even raised the issue. Certainly they are nowhere near performing up to expectations at the time they were acquired. What happened? Don’t know. I imagine that Kering’s expectations didn’t help things. But I also think, as I wrote at the time, that Volcom had gone a long way towards filling the niche they had positioned themselves in, and growing beyond that has proven difficult.
 
 

 

 

Market Evolution; Things to Think About from Quik CEO Mooney and My Spin on Them

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I wrote about Quiksilver’s quarter maybe a month ago. In the conference call, CEO Andy Mooney had some really interesting things to say about how the market is changing. I set them aside to think about. I felt they were comments that were appropriate to a general discussion of market evolution, rather than the particulars of Quik’s situation, though obviously they apply there as well.

The first thing he says, talking about Europe, is that we’re seeing “…a transition from smaller independent operators to larger big-box formats.” He went on to explain that their management team in Europe saw the decline in the number of independent specialty retailers as normal during a down economy, and that they expected a recovery in their numbers as the economy improves.
But CEO Mooney doesn’t share that expectation. “I’m a little less optimistic than they are because of the impact of – largely of e-comm because I think e-comm in some ways is creating systemic pressure on those smaller independent retailers, which for us is actually somewhat of a blessing because it’s actually less expensive for us to service e-comm retailers – pure play e-comm retailers – than it is to service remote onesie, twosies sub-specialty shops, particularly ones that by definition are kind of undercapitalized, have problems paying their bills, et cetera, et cetera.”
He expects some rebound in the number of specialty shops, but not as much as in past cycles. I also think his analysis for Europe is relevant in much of the rest of the world as well and certainly in the U.S.
However, I don’t think pressure on specialty shops has come only from ecommerce, though certainly that’s a big issue. I’d remind you all of the (apparent) strength of the economy up to 2007 and of the length and depth of the (continuing) recession that followed. Because the good times were as good as we’ve ever seen them, a lot of independent specialty retailers opened that would probably never have gotten off the ground in less favorable economic conditions. That they’ve closed in historically bad economic times and won’t reopen unless things get fabulous again is hardly a surprise and isn’t only about the internet.
One analyst asks if he thinks the action sports market is shrinking globally. Mooney responds, “…It’s not necessarily a contracting market; it’s a transitioning market.” He talks about the impact of ecommerce again, and then goes on to discuss another piece of the transition.
“You’re seeing,” he says, “…fewer more professional players who are allocating their open-to-buy to fewer more professional brands…my viewpoint is that there will be consolidation both in the retail theater, but I think there’ll also be consolidation in the branded theater. It’s that the stronger, more professionally-run companies will continue to gain share in what has historically been a very fragmented industry…what occurs when you’re going through this type of phase is you’ll end up with 4 to 5 major players who will have significant footprints in the specialty channel, and we absolutely intend to be one of those players.”
I assume if he thought it was a contracting market and that Quik wasn’t capable of being one of those four or five major players, he wouldn’t have taken the job in the first place. And, of course, what else is he going to say?
Still, I find his answer incomplete as it ignores a couple of elephant in the room issues that impact all the larger brands in our industry.
First, as I’ve written, the real action sports market is a pretty small market and has always been a pretty small market. Right now, judging from the evidence I have in terms of participation, it is shrinking. So Quiksilver, and any other brand with its roots in action sports of any size, is already competing way outside of action sports in fashion, youth culture, urban or whatever we want to label it as.
The second is that I don’t know what he means by specialty channel. Can‘t believe some analyst didn’t ask that. My assumption is that it includes not just independent specialty shops, but chains up to and including Intersport, Zumiez, Journeys, Tilly’s, etc. It used to be so clear and now it’s not. Is Intersport really “specialty?” I am not sure PacSun is with its new positioning. Maybe it’s correct to say it’s specialty, but in a much broader market. How broad does a market have to get before retailers who serve it are no longer “specialty” retailers?
Andy doesn’t seem to be that concerned about the independent specialty retailers and I don’t entirely blame him from a strict operating and revenue point of view. But some of those shops would say, “Right back at you, Andy.” Quik’s brands are widely enough distributed that I’m not sure shops can really compete with them and certainly they won’t help differentiate shops.
But Quiksilver is certainly a surf based brand. Can you be a “surf based brand” and not be in core surf shops? Can DC not be in core skate shops? Maybe they need to have product in those channels even if they aren’t the fastest growing, most profitable, easiest to work with accounts in the world. It’s not, of course, that Quiksilver isn’t in those shops, but it doesn’t feel like an area of emphasis and it’s fewer than it used to be.
Meanwhile, even if a big action sports brand kills it in the specialty market up to and including the chains I’ve mentioned and their ilk, it’s not going to be enough- especially as a public company. Macy’s, Nordstrom’s, Dick’s, Sports Authority- you can’t decide not to be in them. You can only decide when, with what product, and try to make sure they present you well.
I think Quiksilver, Billabong, and Skullcandy, just to name three, would be much better off if they were private. They’d be able to be more discriminating in their distribution in ways that would benefit their brands and, as a result, I think they’d be more profitable.
From their public discussions, we already know that these three companies are taking steps to improve their operations and become more efficient. Good for them. I have no doubt it will improve their bottom lines. But that doesn’t impact brand positioning (unless it changes distribution?) and leads us to the next elephant in the room.
Who’s the customer? It wasn’t discussed in the conference call.   Brands, we all know, have life cycles. As they grow and succeed, they resonate with a group of customers. If they are lucky enough to be around long enough – not an easy thing to accomplish – they age right along with that customer group. The customers’ lifestyle, shopping habits, priorities and lifestyle evolves. The company evolves with them.
As those customers shop differently, the brand distributes differently. I won’t bore you with specifics you already know, but distribution tends to become broader as brands age. And broader. And broader.
How do you accommodate those customers but be relevant and “cool” enough to attract new ones? Look at the winter resort business. They’ve built facilities and created experiences that appeal to their older, aging customers. But that customer group is only one who can afford that experience. Given the economy and existing resort cost/price structure, who do they replace current customers with as they age out?
When Andy Mooney says it’s “something of a blessing” that they don’t have to deal with so many small shops, I knows what he means. But if a brand doesn’t have product that those stores want to carry and can sell for margin, what does that say about its ability to attract new customers as the old ones “age out?” How, in short, do you follow your customers along their lifestyle curve while still attracting new ones?
CEO Mooney also talks about the product review the company is undergoing and how they are trying to focus on those products where they can differentiate and be a leader. We won’t see the results until 2014, which I’d say is about as fast as we could see the results. I’d expect that is part of their answer to my question.
At some level Vans is the poster child for a brand that seems to be accomplishing this transition. They’ve made their heritage a foundation of growth with new customer groups without, as far as I can tell, alienating the old ones.
It’s important to remember, however, that Vans didn’t manage that without some bumps in the road. They were a $400 million public company in trouble before they were acquired by VF in 2004.
Having the kind of success Vans is now having requires a steady hand, objectivity, and money. The “who’s the customer?” issue has to be addressed early and realistically before pressures from the inevitable market evolution lead to product and distribution decisions that compound the difficulty of making the required changes. This is particularly difficult in public companies, where the correct decisions don’t typically contribute to immediately improving quarterly results. This is why I’m such a fan of what Skullcandy is doing. I think they are doing the right things in spite of the short term impact on quarterly results.
Then there’s the whole ecommerce thing which is changing the playing field in ways we don’t understand yet. At least I don’t. I’ll just say here that I wonder if ecommerce accelerates the traditional brand life cycle- or, alternatively, maybe makes it irrelevant? Can it be that distribution will become less important, replaced by how you connect with your customers at all your touch points with them? Will it still matter if you’re in “specialty” distribution? We’ll all be finding out.
Finally, and still on the issue of who the customer is, Andy Mooney talked, as I noted above, about consolidation in the brands and ending up “with 4 to 5 major players who will have significant footprints in the specialty channel, and we absolutely intend to be one of those players.”
We’ve had a few conversations about consolidation over the years and the path he describes is certainly a familiar one. Snowboarding comes to mind when you think about consolidation. How’s that worked out as far as keeping customers and attracting new ones goes?
Operationally, I understand why CEO Mooney would expect the kind of consolidation he describes. But for me the strategic issue is how a company like Quiksilver, if it becomes one of four or five major players with broad and broadening distribution, positions its brands so that many of the specialty retailers want and need to carry them.
I don’t perceive that has been accomplished very often in the past. I hope in future conference calls (Not just Quiksilver’s) companies explain how they are going to do it with particular attention to who their customer is.

 

 

Abercrombie & Fitch Quarter: Trends Impacting Us All

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Consistent with other retailers, A&F’s numbers for their August 3 quarter were not so good. Let’s look at those numbers and then talk about the general trends I think are impacting most retailers in our space.

The Numbers
 
Net sales fell about 1% from $951 to $946 million. U.S. sales were down 8% compared to last year’s quarter, while international rose 15%. The impact of foreign currency rates benefited this quarter’s sales by about $3.4 million.
 
Direct from the 10Q, here’s how the sales number break down:
 
 
You might take a look at sales by brand in dollars and then at the comparable store sales change below that. You’ll note that overall comparable store sales fell 10% even though total sales were down just 1%. Including direct to consumer, they were down 11% in the U.S. and 7% internationally. Hollister comparable store sales fell 13%.
 
The comparable store sales decline was “…partially off-set by new international stores and the impact of the calendar shift, that resulted from the 53-week fiscal year in Fiscal 2012.”
 
Let’s talk about this calendar shift stuff. The retail calendar is divided into 52 weeks of seven days each. Simple enough. But that’s only 364 days and leaves an extra day each year to be accounted for. So every five to six years a week is added to the fiscal calendar.
 
In the words of VP of Finance Brian Logan, “…due to the calendar shift from the 53rd week in fiscal 2012, the prior year comparable 13-week period ended August 4, 2012, had approximately $44 million of additional sales versus the reported 13-week period ended July 28, 2012, which provided a benefit to second quarter year-over-year sales and earnings.” The point is that this quarter looks, comparatively speaking, better than it would have if the extra week hadn’t dragged sales from one quarter to another last year.
 
As you may have noticed, all the retailers are talking about it this year. Thank god we won’t have to deal with it again for another six years now.
 
Okay, still on sales, let’s look at how A&F did by region. Here’s another chart from the 10Q.
 
 
You can see the U.S. took a big hit. I’ve included the 26 week results as well just so you can see  the 5% sales decline over that period.
 
Saving their bacon for the quarter was an increase in gross margin from 62.3% to 63.9%. They tell us the improvement was “…primarily driven by lower product costs.” What they don’t tell us is whether the lower product was the result of epic, creative, insightful management efforts or pure dumb luck. If they’d done some good management things to make that happen, you’d expect they’d tell us. On the other hand, they are in the middle of a profit improvement plan that’s supposed to generate in excess of $100 million annually. But much of that isn’t supposed to be realized until 2014. Okay, let’s say it’s the profit improvement plan. May well be.
 
Store and distribution expense rose from $592 to $604 million. As percentage of sales, it increased from 48.1% to 49.9% quarter over quarter. We aren’t really told why. Marketing, general and administrative expenses rose from $458 to $471 million and from 11.7% of sales to 12.4%. The increase was “…primarily driven by increases in consulting and other services.” It includes “…$2.6 million related to the implementation of the ongoing profit improvement initiative.”
 
During the quarter, and reflective of some of this expense, A&F opened four international Hollister chain stores and two A&F outlet stores- one in the U.S. and one in the U.K. So far this fiscal year, they’ve closed seven stores in the U.S. and one in Canada. They expect that by the end of the year they will have closed a total of 40 to 50 U.S. stores. The remainder of the closures will all happen at the end of the year as leases expire.
 
Net income for the quarter was $11.4 million, down from $17.1 million in last year’s quarter. For the fiscal year to date, they’ve got a profit of $4.2 million compared to a loss of $4.3 million in last year’s first half.
 
Net cash used for operating activities for the year to date is $209 million, compared to $24.3 million in the prior year. About $98 million of that increase is for shares repurchased. Inventory was down by 9% compared to last year’s quarter. They’d expected it to be down by more.
 
Trends and Strategies
 
A&F didn’t give any guidance as to future results beyond the current quarter “Due to the lack of visibility given the recent traffic trends…” CEO Mike Jeffries talked about the market this way:
 
“The reasons for the weak traffic we’ve seen in the U.S. are not entirely clear. Our best theory is that while consumers in general are feeling better about the overall economic environment, it is less the case for the young consumer. In addition, we believe youth spending has likely diverted to other categories. We assume that these effects will abate at some point, but until we have seen clear evidence of that, we are planning sales, inventory and expense levels on a conservative basis.”
 
He goes on to discuss their profit improvement plan (mentioned above) and ongoing long term strategic review. He notes, “…the plan emerging from this review will map out clear strategies covering our assortment, our real estate plans, direct-to-consumer, omni channel, technology, marketing and CRM and sourcing. We are confident that these plans will give us a clear roadmap for sustainable growth in sales, profitability and return on invested capital.”
 
To me, the most amazing part of his presentation is where he says, “We assume these effects will abate at some point” to which I respond, “Why?” If he really believed that- if he didn’t think things were changing dramatically- why is the long term strategic review necessary?
 
At one point an analyst asks, “I’m just wondering if you could maybe comment on the potential for maybe non-traditional competition within the teen space potentially driving some of the weakness that you’re seeing across the entire industry from you and some of your competitors. Is there perhaps a structural change that’s occurred? And is that what we’re seeing within the teen category?”
 
Mr. Jeffries answer is, “…I think you’re right on in terms of the potential for non-traditional competition. It’s happening and we’re — we want to be in the forefront of that. I think what we own is very powerful brands. And owning those brands, we think we’re going to be able to be in the forefront of the non-traditional brick-and-mortar part of the business.”
 
CFO Jonathan Ramsden, responding to a question about what won’t change in the business model, says “…the core aesthetic and what the brands stand for.”
 
There’s an understandable limit as to what I expect management to disclose in a conference call. And it’s certainly not a problem that’s unique to A&F. But assuming things will go back to the way they were when “…youth spending has likely diverted to other categories” and stating that the ”core aesthetics and what the brands stand for” won’t change seem like they could be incompatible statements.
 
In his excellent book The Black Swan, Nassim Taleb talks about the life cycle of the turkey. From the day it’s born, everybody takes really good care of him. They feed him, give him medicine, keep him warm and don’t ask him to do anything. If you asked the turkey what tomorrow is going to be like he’ll say, “Why just as good as today.” The turkey doesn’t know tomorrow is Thanksgiving.
 
We’re in a market where where you need to be particularly careful in examining your assumptions.