A Brief Update on Billabong

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As you are probably aware, Billabong yesterday published a press release announcing the expected resignation of Launa Inman as CEO and of Paul Naude as a director and employee. It also said that, “Discussions with Scott Olivet regarding his appointment as CEO are continuing but have not been finalised as we await the outcome of the Takeovers Panel’s deliberations.” 

In the meantime, Scott is a consultant to Billabong and Peters Myers is acting CEO. You can see the press release here.  It’s the first item under “Recent News” called “Billabong Management Changes.”
 
Scott Olivet is the executive Altamont is bringing in as part of the overall deal with Billabong. One would assume that the deal with Scott was finalized before Altamont’s deal with Billabong was closed since Altamont wants Scott as CEO. You may also recall that Scott was investing a couple of millions of his own dollars in Billabong as part of the deal. I’m guessing here, but I can imagine that maybe Scott doesn’t want to commit his own funds until he knows what the Takeover Panel decides.
 
The investors who owned Billabong’s debt were paid off by Altamont when the deal with Billabong closed. They appealed to the Australian Takeover Panel because they didn’t like the deal. “Didn’t like” probably means they were hoping for a better deal themselves than just getting paid off.
 
Here’s a link to the Takeover Panel. When they publish a decision, we’ll be able to see it here. According to the site, “it takes a little over 2 weeks (16 days) for the Panel to make a decision on an application.” The average days from deciding to review to publishing their decision has been about 10 days in 2013. Billabong says it may be a week or more until we have that decision.
 
Meanwhile, Billabong has announced that their preliminary earnings presentation for the year ended June 30 will be released on August 27th. As I’ve said, I’ll be very interested to see their balance sheet.  Seems to me that in the past, they haven’t called it ‘preliminary." 
 
Okay, that’s it. I really wish this wasn’t all going on and that Billabong was just going about business, but it sure is interesting. 

 

 

Selling Less In a Good Cause; Skullcandy’s Strategy and Quarter

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In the quarter ended June 30, Skull’s sales fell by 30% to $50.8 million from $72.4 million in the same quarter the previous year. Their gross margin fell from 48.6% to 44.9%. Selling, general and administrative expenses actually rose slightly from $23.5 to $24 million, but if you exclude the almost $1 million that’s included for the move from San Clemente to Park City, it fell a bit. Net income, not surprisingly, declined from a profit of $6.8 million to a loss of $689,000. 

It’s not that I’m thrilled to see these results, but I think they are indicative of Skull pursuing the only strategy they can reasonably pursue. Here’s how CEO Hoby Darling puts it:
 
“While I do not believe we will turn our sales trajectory positive this year, we’re decisively taking action based on learnings from some historical missteps and being more disciplined around distribution, retailer and product segmentation, discounting and importantly, the alignment of product, marketing and sales. These are necessary first steps to protect the brand and set us up for long-term healthy growth.”
 
You remember that last quarter Skull was cutting back on the sales through off price channels (year to date those sales are down 50%). Now we find out they’ve actually held back some product from some retailers to protect their brand position. As CEO Darling puts it, “We need a clear distribution channel and to have retailers and consumers seeking out our products.”
 
One more quote:
 
“We will continue to aggressively rebalance our distribution pyramid so that demand and supply are more closely matched. This includes minimizing the end-season product sales in the off-price channel, protecting our map pricing policy and supplying our retailers with the right amount of product to match healthy demand. We will continue to protect profitability, while investing in our most important growth initiatives in demand creation.”
 
Oh hell, just one more:
 
“As we think about our future, the main tenets of our strategy are based on the following: first, transforming the marketplace. This includes rebalancing and segmenting our distribution pyramid to amplify with winning retailers and match supply to market demand and clarifying our brand message, with a strong focus around digital and planned sale.”
 
Regular readers will know why I’m all a dither about this strategy. I’ve been pushing for some years the idea that with sales growth harder to come by, gross margin dollars and control of operating expenses was where you needed to focus to improve profitability. I’ve said that distribution and deciding who to sell to is way harder than it used to be. But I’ve also said that if you recognize the relationships between operations (especially inventory management) on the one hand and sales and marketing on the other, you can achieve better results while spending a lot less.
 
Like Quiksilver and Billabong have done and are doing, Skullcandy is also working to “…create a cohesive organization by removing the operating silos that were hampering communications, alignment and culture between different areas of the business." CEO Darling, by the way, thinks they can probably spend less on demand creation. He makes that comment in kind of an offhand way, but if the company approaches their customer segmentation, pricing, and distribution in the way he describes, it might be a lot less. Overall, what Skull is doing kind of reminds me of Spy’s strategy. And the bottom line is that Skull is going to have to reduce its SG & A spending as a percentage of sales unless sales grow way faster than they seem to expect.
 
There’s just one fly in the ointment. Like Billabong, Quiksilver and Spy, Skullcandy is public. These are four companies that would be better off if they were private and free to pursue brand strategies unconstrained by the need for regular, quarterly growth. Skull is purposefully restricting sales to defend and strengthen their brand and market position and, I’m expecting, greatly improving their overall profitability. Great decision.
 
But there’s that pesky Wall Street revenue growth bias out there. What to do? Skull expects that their current actions will increase their sales in their core market, though not until 2014. CEO Darling describes the brand as “…fun, young and irreverent, woven in with creative and active.” Good definition. “As small and creative company, we have the opportunity to be special and more unique than our larger competitors.” I agree. But that focus also limits growth because it limits your available customers.
 
What to do? Product extensions, which the analysts ask about every quarter, are one answer. Sell more to the same customer. The Air Raid Bluetooth speaker will be in retail in the fourth quarter. And you also look for growth by “…expanding beyond our core audio headphone market and partnering with other brand leaders and their respective consumer categories will assist in broadening our region appeal to give Skullcandy added legitimacy outside of our core market position.” They use a deal they are making with Lululemon as an example. Sell more to a new customer.
 
Let’s assume that as a result of implementing these strategies I like that Skullcandy solidifies its position in its core market, grows sales slowly (slower growth initially is implicit in its strategy), and improves its profitability on those sales significantly. As a private company, that might arguably be a great result. As a public one, not so much. So along come the brand extensions and the partner deals “to give Skullcandy added legitimacy outside of our core market position.”
 
How’s that worked out in this industry in the past for public companies? As I’ve pointed out, Zumiez is the only action sports based company that’s public and doing well. Others are all having difficulty or have been acquired.
 
Skull has the balance sheet to pursue its strategy. They’ve got no long term debt, $30 million in cash (up from $7 million a year ago) and a strong current ratio. Operations provided $12 million in cash flow during the first six months of the year compared to using $8 million in the first six months of last year. Inventory over the year fell 17% from $50.5 to $42 million. I might have expected a larger drop given the sales decline. They tell us the decline wasn’t greater “…due to higher gaming inventories support retail and the building of inventory in China to support our direct sales model there.” I’d be interested to know how much of their existing inventory is price point product they still need to move.
 
Much of the sales decline was due to a reduction in the off price sales, but they also mention “…lower sell-in at a key customer and a decline in sales to several of our specialty retailers.” They have one customer that represented 18.3% of sales during the quarter compared to 11.4% in last year’s quarter. While I imagine that increase is explained by their decision to reduce price point sales, it’s still quite a concentration.
 
They make the interesting comment that they see some market movement from over the ear product to in ear. They don’t tell us the extent of the change. That’s interesting because in their last call they talked about moving towards higher priced but lower margin (generating more margin dollars) product that was largely over the ear. I was surprised no analyst asked about that.
 
Skullcandy has a strategy I fully support, but wonder how it will be received in the public markets. They have some personnel, relocation, and operational changes going on that it’s just going to take a little time to work through. I will wait to see how their product extensions work out. I hope they aren’t too aggressive in that area.

 

 

Relaxed Fit

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Maybe a month ago, I was walking through a local mall visiting all the usual retailers to see how things looked. I stopped at a PacSun store and was attracted to a table with some Volcom shorts on it in colors I really liked. There was a sticker on the shorts that said, “Relaxed Fit.” 

I paused for a moment, looked around the store to clear my head, and then read the sticker again. Yup, it said “Relaxed Fit.”
 
There was a moment of mental paralysis, then the thoughts all poured out at once. “This must be some sort of cool marketing trick I just don’t understand, the stickers are there by accident- some clerk is screwing around with my brain (and it’s working), is this really where our market is going, there’s some kind of new trend I don’t know about, yes, that must be it, maybe it means to be fit and relaxed, Kering (Volcom’s owner) is making them do this, no, wait, somebody slipped something in my soda…”
 
I walked out of the store determined to pretend this had never happened. But three weeks later, in another mall in another city I made the mistake of checking again and there the shorts were with that same diabolical sticker. My attempt at denial was foiled.
 
But happily I was saved by my ever vigilant research department that sent me this New York Times article called “Three’s a Trend | Men’s Shorts That Are Loose, but Refined.”
 
“Loose, but Refined” is conceivably a perfect (and hopeful) description of Volcom owned by mostly high end fashion company Kering. Grabbing at straws as I am, I’ve decided to believe that Volcom’s “Relaxed Fit” sticker is just a bow to this fashion trend shaped by their large corporate owner. See, I don’t know a lot of surfers, skaters and snow sliders that need relaxed fit clothing.
 
Okay, I’ve had a little fun with this, and I’m sure Volcom isn’t the only one doing it. I suppose I need to recognize that all our customers can’t be teenagers and that body shapes change with age (not mine of course). Yet in our push for growth, we get further and further from our roots. The ASC conference the day before the Agenda Show celebrated the importance of authenticity, but I wonder just what kinds of customers we can make product for before we begin to lose it.
 
I hope Volcom can stay loose.

 

 

Billabong Deal Completed

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Billabong announced today that the interim financial deal with Altamont and its partners and the sale of Dakine to the same group had been completed. They also announced that their syndicated debt liabilities had been paid off in full and that the two proposed Altamont directors would join the board. Here’s the announcement on the Billabong investors web site. It’s the first item under “Recent News.” 

Okay, so now what? Well, Scott Olivet is the new Managing Director and CEO, and Launa Inman is gone. The interim financing has to be turned into permanent financing by the end of the year when the interim loan from Altamont is due. I’m not quite clear on whether or not the asset based line from GE Capital is now in place or not. Billabong has to hold a shareholders meeting to approve various parts of the deal. I assume that will happen as quickly as possible so they can approve the options granted to Altamont and get the interest rate on the additional AUD $44 million convertible note down from 35% to 10%.
 
Questions include:
 
What additional brands, if any, will be sold?
 
Which parts of former CEO Inman’s plan will be retained? I’d expect that some of her operational rationalization will continue.
 
When will West 49 be sold? I assume it’s still for sale.
 
When will Billabong present their results for the year ended June 30? In the past, the date would have been announced by now. I really want a look at the balance sheet.
 
After this rather turbulent period, I hope Mr. Olivet can get employees refocused on running the business. Just like with Quiksilver, the industry needs Billabong to be strong and successful.

 

 

The Billabong Deal- A Second Offer Appears and is Rejected

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There are various articles flying around (and on Billabong’s web site) that tell us Oaktree Capital Management LP and Centerbridge Partners LP made an offer for Billabong yesterday (or the day before- I get confused about what day it is in Australia). As you know, the Altamont Consortium made, and Billabong accepted, an offer to buy Dakine, provide short term financing to pay off debt and, by the end of the year, roll that into a longer term loan. Here’s my article on that deal. 

In late June, Oaktree and Centerbridge, both distressed debt funds according to the articles, bought $289 million in Billabong loans at a discount from the original lenders. These are to be paid off by Altamont’s interim financing. According to this article from Bloomberg, Oaktree and Centerbridge “…“very much had a view that they were going to make money” through a debt-for-equity swap, Ben Clark, a portfolio manager at TMS Capital Pty., said by phone from Sydney. “They’ve been blindsided by Billabong’s intention to pay that debt back straight away” through the deal with Altamont.”
 
They bought the debt from Billabong’s banks at some discount, so are already positioned to make a profit when Altamont repaid it. But not being satisfied with that, they made their own offer for Billabong. That offer, according to the same article, “…would instead see A$189 million of the loans canceled in exchange for a 61 percent stake in Billabong, with the balance of A$100 million repaid using a six-year loan with an interest rate of 8 percent. The Australian company would retain its DaKine brand and the funds would seek a majority of board seats.”
 
This article says that Billabong has agreed to study this new proposal.  It further says that incoming CEO Scott Olivet would remain in that position. It’s not clear if he has agreed to that, or if it’s just an offer or assertion by Oaktree and Centerbridge.
 
 They also asked the Australian Takeover Panel to review the deal, saying it was “…anti-competitive and coercive.” The panel declined to stop the deal but said they could review it, as reported here. I don’t know what the possible outcomes of such a review are. Here’s what the panel actually said. “A sitting Panel has not been appointed at this stage and no decision has been made whether to conduct proceedings. The Panel makes no comment on the merits of the application.”
 
Meanwhile, we’re told in yet another article (you may not be able to access this unless you set up an account) that:
 
“Since Tuesday’s unveiling of the Altamont deal, Centerbridge and Oaktree have ramped up the pressure on Billabong, saying the company had refused to see their representatives despite a team of 10 or more flying in from the US to pitch a proposal.
 
Billabong chairman Ian Pollard has been intransigent.
 
He has said Centerbridge and Oaktree were invited many times last week to submit a proposal but refused on every occasion.
 
In the end, the chairman said Billabong had "executed the only executable transaction", which was the Altamont deal.
 
Despite Centerbridge and Oaktree claiming their proposal was superior and unconditional, Billabong said on Thursday it was subject to conditions that could not be satisfied, making any refinancing "far less certain" than the deal with Altamont.”
 
Here’s Billabong’s official response to these media reports from a release on their web site:
 
“The position is as follows:
1. The Company has received today a proposal from the Centerbridge/Oaktree Consortium.
2. This proposal was received by the Company after the Company had entered into the binding
bridge facility and DaKine sale agreement with the Altamont Consortium announced on 16
July 2013, which themselves followed an exhaustive process undertaken by the Company.
3. Prior to the Company entering into the transactions with the Altamont Consortium, the
Company made numerous requests to the Centerbridge/Oaktree Consortium to submit a
refinancing proposal. Despite those requests, the Centerbridge/Oaktree Consortium failed
to do so.
4. The proposal that has now been received from the Centerbridge/Oaktree Consortium is not
an offer that is capable of acceptance. The proposal is subject to conditions, a number of
which are incapable of satisfaction, and others which would make any refinancing far less
certain than under the Altamont Consortium transactions.”
 
What I think is going on here is that Centerbridge and Oaktree wanted to use the leverage from the debt they’d bought, which I believe was due and payable, as a way to get a chunk of equity in Billabong. Altamont’s offer to Billabong, which would have resulted in that debt being paid off next Tuesday or so, would keep that from happening, and they aren’t happy about that.
 
I guess what will be interesting to see is whether Centerbridge and Oaktree have created enough uncertainty on the part of Altamont and its partners to cause this transaction to be delayed. Remember, they have signed a deal with Billabong and I have no idea what that deal might or might not say about conditions under which the closing can be delayed. 
 
I kind of hope the deal just gets done so Billabong can get back to running its business.

 

 

The Billabong Deal

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As you have no doubt heard, Billabong has reached a deal with “…entities advised by Altamont and entities sub-advised by GSO Capital Partners1 (the credit arm of the Blackstone Group, and  together with Altamont, the “Altamont Consortium”)” to sell Dakine to Altamont, get bridge financing to pay off its existing syndicated bank debt, put together long term financing with Altamont and GE Capital, and to hire former Nike executive and Oakley CEO Scott Olivet as Managing Director and CEO of Billabong, replacing Launa Inman. 

Before we get into the all the gory details, here’s the link to the announcement on Billabong’s web site. It’s the first item under “Recent News.” And here’s what I wrote when we had an update from Billabong in early June.
 
I also want to remind you that it’s a little hard to evaluate the strategic significance of this deal because we don’t have Billabong financial statements, especially a balance sheet, to use. The fiscal year ended June 30, but we don’t yet know when the report will be released.
 
I’m going to use Australian dollars unless I say otherwise.
 
First, the Altamont Consortium is going to provide a bridge loan of $325 million. $289 million will go right out the door to pay off the banks. They are also going to buy the assets of Dakine for $70 million. That plus the part of the bridge loan not being used to pay off the banks means that Billabong gets $106 million in working capital.
 
Dakine was acquired by Billabong in August, 2009 for US$100 million. At the time, that was something like $120 million in Australian Dollars.  I’ll be curious to see what Altamont does with Dakine.  Wonder if they might not flip it to VF which, you remember, was a partner with Altamont early in the evaluation of Billabong.
 
The bridge loan and sale of Dakine are expected to be completed by this coming Monday, July 22. The loan expires on December 31, carries an interest rate of 12% and is to be replaced with the term loan discussed below. As part of the bridge financing, Billabong will issue 84.5 million options to the Consortium. That’s 15% of the company’s fully diluted capital. The option price will be $0.50 a share. The first tranche of options for 42.3 million shares was issued July 15th. The rest are part of the long term financing and each tranche will expire seven years after they are issued.
 
If the company is sold or makes a deal with somebody else before January 15, 2014, they’ve got to pay off the Consortium with a 20% principal premium. So I’m kind of guessing the deal will be with the Consortium. 
 
Okay, that wasn’t too bad. On to the long term financing.
 
Billabong has signed another commitment letter with the Consortium to provide a five year term loan of $281 million. This will include a “base commitment” $221 million and an “upsize” commitment of $60 million. The base commitment will carry an interest rate of 12%, but they can pay up to 5% of that “in kind.” That is, it can just be added to the loan principal rather than paid in cash. The upsize commitment carries an interest rate of 10% and has to be paid in cash. They will use this loan to pay off and replace the bridge loan.
 
The bridge loan, you will recall, is $325 million. The term loan is a total of $281 million so by itself it’s $44 million short of paying off the whole bridge loan. But wait! There’s more!
 
Billabong has also signed a commitment letter to issue a $44 million convertible note to the Consortium. There’s the rest of the money Billabong needs to pay off the bridge loan. The note will be convertible into “Redeemable Preference Shares” (RPS) once approved by Billabong’s shareholders. The interest rate on this note will be 12% and up to 5%, can be payment in kind. That is, it can just be added to the principal balance of the note.
 
Until the shareholders approve the RPS, the note will carry an interest rate of 35%, 25% of which may be payment in kind. With that kind of interest rate, we should expect to see Billabong scurrying to do a shareholders’ meeting for the approval. Once it’s approved, the RPS will be convertible into Billabong commons stock at $0.235 a share and will represent 25% of all shares outstanding (including options and the RPS). The RPS will pay a dividend of 12% of which up to 3% can be paid in common stock.
 
Of the 84.5 million options which are part of the overall deal, another 29.6 million will be granted on completion of the term loan with the balance of 12.7 million will be granted when the required shareholder approval is obtained.
 
The last piece of this is a Billabong commitment with GE Capital “for an asset-based multicurrency revolving credit facility of up to US$160m (A$177m) (“Revolving Facility”), subject to holding sufficient eligible accounts receivable and inventory as collateral.” I think that facility is available as quickly as they can get it into place, but it’s not quite clear.
 
My read on the change in Managing Director from Inman to Olivet is that the people providing the financing required an executive with extensive industry experience who would be immediately credible to everybody involved. In spite of Ms. Inman’s qualifications and significant accomplishments as an executive, it appears that what she accomplished during her tenure at Billabong wasn’t enough to create that perception. Altamont will also get two seats on Billabong’s Board of Directors.
 
Okay, so where does this leave us? If all this happens, the Consortium’s share in Billabong will be between 36.25% and 40.49%. That’s a lot of dilution for existing shareholders. We also know that Billabong will be paying a lot more interest expense. Working capital will increase by $106 million and they will have the asset based line from GE available.
 
None of this reduces the liabilities for store leases on the balance sheet, and I still expect West 49 to be sold. As to further asset sales, I have no idea. Ms. Inman had presented plans to streamline operations and reduce expenses substantially. From her description, I believe there’s money to be saved there, but we haven’t heard anything since the presentation of the plan.
 
Is all this “enough?” Altamont and the Consortium apparently think so and believe the debt load is manageable given their evaluation of the brands and their potential. But they are allowing some interest to be paid in kind just in case there are rough spots.
 
Of course, “the brands and their potential” is ultimately the only thing that matters. Perhaps we’ll learn something about that when they release their results for the June 30 year end.

 

 

Abercrombie & Fitch’s May 4th Quarter; There’s a Lot Going On

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I’ve gotten out of the habit of reviewing A&F’s results, but a cursory look at their 10Q intrigued me. You don’t typically see sales fall 9% while pretax income for the quarter improved (if that’s what you want to call it) from a loss of $30 million in last year’s quarter to a loss of $15 million. Most of this loss reduction is explained by a rather significant improvement in gross margin from 58.7% to 65.9%. 

At May 4, A&F had 1,053 retail stores. 909 were in the U.S. and 144 in other countries. 283 were Abercrombie & Fitch stores, 149 Abercrombie and 28 operated under the Gilly Hicks brand. The remaining 593, representing 56% of the total, is the ever popular Hollister. To be honest, while I don’t really like what Hollister represents to some of us, I admire what the company accomplished in building the brand and think there’s an object lesson there. Basically, it’s that authenticity (in the eyes of their target customer at least) can be manufactured by marketing. Whether it can be maintained is what we’re finding out.
 
Anyway, obviously things aren’t going all that well right now. Sales fell from $921 to $839 million. A&F store sales fell 13% to $325 million. Hollister was down 18% to $421 million. Interestingly, ecommerce sales fell 6% from $148 to $133 million. U.S. sales fell from $544 to $449 million while international rose from $229 to $258 million. Overall, comparable brick and mortar store sales fell by 17%. The international growth was the result of opening new stores. Looks like they expect to open 20 to 30 international stores during the year and close 40 to 50 in the U.S. 
 
The Stuff That’s Going On
 
Let’s start with an accounting change. How’s that for excitement? The company “…elected to change its method of accounting for inventory from the lower of cost or market utilizing the retail method to the weighted-average cost method effective February 2, 2013.”
 
They had to restate last year’s quarter ended April 28, 2012 to reflect the change. The numbers I’ve given you above include the impact of that restatement. Prior to the restatement, they showed a pretax profit of $5.2 million. The change reduced their pretax income by $35.3 million to the pretax loss of $30 million noted above.
 
That’s quite an accounting change. They did it because, “The Company believes that accounting under the weighted-average cost method is preferable as it better aligns with the Company’s focus on realized selling margin and improves the comparability of the Company’s financial results with those of its competitors. Additionally, it will improve the matching of cost of goods sold with the related net sales and reflect the acquisition cost of inventory outstanding at each balance sheet date.”
 
Any of you CPAs out there who want to chime in on this, please do. They make the explanation sound so benign and reasonable. But that’s a pretty big change in reported results and, as we’ll see, they’ve had some problems with inventory.
 
They tell us in the 10Q that “Sales for the quarter were lower than expected due to more significant inventory shortage issues than anticipated, added to by external pressures, including unseasonably cool weather conditions, and the macro-economic environment in Europe.” The gross margin improvement “…was driven by a mix benefit from selling a higher proportion of current season merchandise and lower product costs.”
 
I’m sitting here wondering how the inventory shortage impacted the gross margin. For the complete year, they expect the gross margin to be in the mid-60s and total dollar gross margin rose 2% in the quarter.   As you know, I’m a believer in controlling your distribution and inventory with the goal of improving sell through and perceived value. Very hard to do as a public company, however, when the market wants revenue growth. Still, I can’t help but note that A&F improved their bottom line performance on lower sales.
 
In the conference call, we find out from CEO Michael Jeffries that “…inventory accounted for approximately 10% of the comp sales decline due to both lower levels of fall carryover and delays in spring deliveries.”
The analysts were a bit uncertain how to think about the inventory as well. One asked, “… just trying to understand the connection between the lower inventory, the comp at Hollister and the gross margin. It sounds like, was it really a factor — you mean to say lower fall clearance inventory — or fall carryover. Does that mean lower clearance inventory? And really, you need that clearance inventory to drive the comp at Hollister, which is why the comp at Hollister was low, and that’s why gross margin was high. Is that an accurate statement?
 
CFO Jonathan Ramsden responded “Broadly, yes” and CEO Jeffries said, “Yes. Yes. I think that’s right on.”
 
Let me see if I’ve got this. They had problems getting the inventory they needed but if they’d had it, they would have had higher sales, but a lower grow profit margin? I’d love to know if total gross margin dollars earned would have been lower instead of 2% higher. But they are in the process of fixing this and are going to have a gross profit margin in the mid-60s for the whole year, they tell us.
 
The analyst, of course, is worried about sales comps at Hollister, because that’s kind of what analysts do. But I’m sitting here screaming, “But they earned more total gross margin dollars without those sales!” I’m not sure they should fix anything.
It needs to be pointed out that their store and distribution expenses as a percentage of sales rose from 49.5% to 53.5% and marketing and general and administrative expense went up from 12.7% to 14.2%. Still, they cut their loss in half selling less at higher margins.
 
Meanwhile, A&F is busy, like so many other companies these days, trying to cut costs and run more efficiently. Also from the 10Q: “We have also made progress on our profit improvement initiative, which includes a detailed review of our operational processes to identify investments that we have made in our business that may have had a return in the past but no longer do today. The initiative is divided into seven work-streams covering general non-merchandise expense, marketing, supply chain, merchandise planning and allocation, home office, store operations, and real estate and construction.”
 
They’ve identified annual savings of $35 to $55 million in general non-merchandise expense and marketing, but don’t expect most of that to be realized until next year. In the supply chain, home office and store operations work streams they have “…completed the diagnostic phase but still need to validate the process-driven savings opportunities through testing and further analysis.” They expect savings in those areas to be “substantial.” They are still in the diagnostic phases for the remaining work streams.
 
They are also involved in a “…cross-functional AUR [average unit retail] optimization initiative” where they “…have identified a number of specific opportunities to date that we anticipate will yield a meaningful gross margin benefit…” Those benefits should start to show up next year. They are also revisiting their overall strategy.
 
There’s not any part of their business they aren’t touching. If I may reiterate one of my favorite points of pontification, they’ve acknowledged the close connection between operations and competitive positioning.
 
Okay, I’m stopping here. A&F earned more gross margin dollars on lower sales and cut their loss in half. True, their operating expenses rose as a percent of sales, but they are in the middle of a top to bottom evaluation process to cut costs and increase operating efficiency including inventory management. If they can create a more cost effective and responsive company structure and keep their gross margin around 65% by managing product and distribution to improve brand perception, who cares if their sales don’t increase as fast as they used to? They’ll make more money.
 
The conference call and some of the discussion in the 10Q kind of waltzes around these issues. Maybe that’s because you can’t tell the analysts that revenue growth isn’t going to be as important as it was. But if they’ve bought into the same analysis as I’ve suggested, the company might do well regardless off what you think of Hollister.            

 

 

The Buckle May 4th Quarter

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There’s never time to write about everything I want to write about, and The Buckle is one that has often slipped through the cracks. And while there’s nothing dramatic to report, I thought it might be time to take a short look at their results. 

At the end of the quarter, The Buckle operated 443 stores in 43 states. They sell “…medium to better priced casual apparel, footwear, and accessories for fashion conscious young men and women.” Denim is about 45% of their business. Tops are 28.3%, sportswear/fashion 10.8%, accessories 7.5% and footwear 6.3%. 31% of their revenues for the quarter were from proprietary labels.
 
Sales grew 2.3% from $264 to $ 270 million. Comparable store sales rose 1.2% compared to the same quarter last year. Online sales, which aren’t part of comparable store sales, were up 6% to $20.9 million. For all companies that report comparable store sales, there’s some thinking to be done about how to manage online sales. Should they be part of comparable store sales? Everybody believes that online and brick and mortar sales have an impact on each other. Now if we could just figure out what, exactly, that impact was.
 
Gross profit margin stayed approximately the same, rising from 43.3% to 43.4%. Selling expenses as a percentage of revenue were constant at 17.5%. General and administrative expenses were, well, pretty much the same rising from 3.8% to 3.9% of sales. Operating income was- yeah, you guessed it- constant at 22% of revenue. Obviously, those expenses rose in total dollars commensurate with the sales growth.
 
Income tax provision was, uh, almost unchanged at $22 million. Wait, here’s something! Other income fell from $1.81 million to $350,000. The decline was due to “…the reduction related primarily to certain state economic development incentives received during the first quarter of fiscal 2012.”
 
Well, that’s exciting! Isn’t it? Okay, maybe not so much.         
 
Net income was down (you guessed it!) very slightly, from $37.8 to $37.6 million. So I’m beginning to get a sense of why I don’t write about the Buckle that much, though I’ve been intrigued by the merchandising in their stores.
 
Maybe there’s something exciting happening over on the balance sheet. Well, not really exciting. Cash and short term investments fell from $220 million on April 28 a year ago to $144 million on May 4. That’s a decline of 35%, but it hardly leaves them destitute. That pulled the current ratio down from 3.69 to 2.71, but it’s still in great shape. They note that “Capital spending for the corporate headquarters and distribution center during the first quarter of fiscal 2013 includes $5.4 million for the purchase of a new corporate airplane as a replacement for a plane that was sold by the Company in the fourth quarter of fiscal 2012.” Those expenses explain some of the decline in cash.
 
“…inventory on a comparable-store basis was up approximately 7%, and total markdown inventory was up compared to the end of the first quarter last year,” we’re told in the conference call. We don’t get any details on that mark down inventory.
 
Total liabilities to equity rose from 0.38 to 0.51 with the decline in shareholder’s equity from $398 to $320 million. There is no bank debt.
 
Well, that’s kind of it. I guess The Buckle headline for the quarter is that there’s nothing that’s particularly thought provoking or dramatically good- or bad- to write about.

 

 

Tilly’s Quarter; Income Down on Higher Sales.

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For the quarter ended May 4, Tilly’s sales were $109 million. In last year’s quarter ending April 28, 2012, sales were $96.5 million. That 13% sales growth. But further down the income statement, we find that income before taxes fell 35% from $5.9 to $2.3 million. What went on? 

NOTE: Net income fell even more, from $5.9 to $2.3 million. In last year’s quarter the company wasn’t public yet and, due to a different corporate structure, showed only $68,000 in income tax expense. In this year’s quarter, as a public company following the change in legal structure, income tax expense was $1.56 million. Now that’s a real expense, but it does sort of screw up the comparison. They provide some proforma numbers that show their net income last year would have been just $3.6 million with the same tax situation they have now. That’s a drop of 36%. 
 
Okay, back to what went on. $11.6 million of the sales increase came from opening new stores that weren’t open in the quarter last year. Comparable store sales were up 1.1%, or by $1 million. They rose 4.3% in last year’s quarter. Ecommerce sales rose 16% from $10.9 to $12.6 million.
 
They ended the quarter with 175 stores in 30 states compared to 145 at the end of last year’s quarter and expect to open at least 25 new stores in this fiscal year. They “…plan to continue opening new stores at an annual rate of approximately 15% for the next several years…”
 
Average net sales per store in the quarter fell from $605,000 to $565,000.  
 
The gross profit margin fell from 31.5% to 29.5%. “The decrease in gross profit margin was due to a 1.1% increase in product costs as a percentage of sales due to increased markdowns and a 0.9% increase in buying, distribution and occupancy costs as a percentage of sales due to costs increasing faster than the growth in net sales.” That doesn’t sound good.
 
 Selling, general and administrative expenses as a percent of sales rose from 25.3% to 25.9%. Within this increase of $3.9 million or 16%, store selling expenses accounted for $2.6 million of the increase. The specific causes were: 
 
“• store and regional payroll, payroll benefits and related personnel costs increased $2.3 million, or 0.7% as a percentage of net sales, as these costs increased at a higher rate than net sales due to a relatively small increase in comparable store sales and a greater proportion of the store base this year comprised of newer stores with immature sales volumes”
 
“• marketing costs, credit card processing, supplies and other costs increased $0.4 million, which represents a decrease of 0.2% as a percentage of net sales, due to these costs increasing at a lower rate than the net sales.”
 
The biggest chunk of the general and administrative expenses increase was stock-based compensation expense of $0.9 million, which they didn’t have last year because they weren’t yet public.
 
In the conference call, President and CEO Daniel Griesemer described the quarter’s results this way:
 
“…our business performance was better than expected as we achieved positive comparable store sales and net income of $0.08 per diluted share reflecting the strength of our business model and the diligent execution of our team in support of our growth initiatives.”
 
There are no balance sheet issues to discuss. The balance sheet improved markedly as a result of the public offering as you would expect. They went public on May 12, 2012. Of the $107 million raised, $84 million went to pay notes previously issued to the pre-offering shareholders.
 
Total inventory rose consistent with the opening of new stores but was down 6% on a per square foot basis. They note they “…have always committed to in season not carrying forward into future seasons. So you know we begin each quarter with inventory that’s clean and current and ready to do business for the forward season.” I like that policy, though of course it’s no substitute for picking the right inventory in the first place.
 
For the current quarter, Tilly’s expects “…comparable store sales growth in the range of flat to a positive low single digit increase…” This compares to a 5.1% increase in last year’s quarter. They tell us that “…the 2013 fiscal calendar shift will cause the first week peak week of the company’s back-to-school season to fall on the last week of the second quarter this year compared to being the first week of the third quarter last year. As a result we expect an estimated $8 million to $9 million in sales will shift into the company’s second quarter from the third quarter when compared to the 2012 fiscal calendar.”
 
So their second quarter prediction of comparable stores sales growth of “flat to a positive low single digit increase” includes that additional $8 or $9 million in revenue.
 
Tilly’s has a strong balance sheet and it’s great to see any comparable stores growth. But the increase in expenses, decline in gross margin and resulting drop in income (even adjusting for the impact of the public offering) tells me this is a work in progress.

 

 

PacSun’s May 4th Quarter; A Couple of Items to Discuss

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This, happily, won’t be like the short novel I had to write for Quiksilver. There are some interesting conference call comments and two income statement entries crying out for a brief discussion, but that’s pretty much it. Let’s get going. 

Sales rose 4.7% from $162.3 in the quarter last year ended April 28, 2012 to $169.8 million in the quarter ended May 4, 2013. Ecommerce sales were up 11%. Gross margin was up from $38.1 to $42.7 million. As a percent it rose from 23.5% to 25.1%. Selling, general and administrative expenses (SG&A) fell from $55.9 to $53.8 million. As a percentage of sales they fell from 34.5% to 31.6%. The operating loss fell from $17.8 to $11.1 million. They ended the quarter with 638 stores compared to 729 a year ago and expect to close 20 to 30 by the end of the fiscal year.
 
Okay here’s the first thing that needs to be discussed. The 2012 annual reporting period had an extra week in it. Here’s how Zumiez’s describes the impact:
 
“The first quarter of fiscal 2012 included a lower volume week and the first quarter of fiscal 2013 included a higher volume week as a result of the 53rd week retail calendar shift. This resulted in an approximately $6 million increase in net sales, 1.5% improvement in gross margin…”
 
Of the total sales increase of $7.5 million, $5.6 million, or 75%, resulted from the 53 week retail calendar. The reminder was the result of a 2.7% increase in comparable store sales offset by a 0.8% decline in non-comparable sales. The gross margin increased by 1.6% and you can see all that increase came from calendar shift. They also note that the merchandise margin rose from 51.4% to 53% and that 0.5% of that increase was from the calendar shift.
 
You can see you have to keep that shift in mind when comparing last year’s quarter with this year’s.
 
Right under the operating loss line is a $9.3 million loss on derivative liability. In last year’s quarter that was a gain of $6.3 million. That’s a $15.6 swing from one quarter to the next, so it requires a brief explanation. Here’s the link to the 10Q just in case you want to read a couple of footnotes with me.
 
Back in December 2011, PacSun got a $60 million term loan from Golden Gate Capital. The loan is due to be paid in December of 2016. As part of that deal, PacSun issued 1,000 shares of series B convertible preferred stock recorded as a derivative liability with a fair value of $15 million at the time it was issued. 
 
“The Series B Preferred shares are required to be measured at fair value each reporting period. The fair value of the Series B Preferred shares was estimated using an option pricing model that requires Level 3 inputs, which are highly subjective…”
 
Level three values are based on “unobservable inputs.” An amusing term, I’ve always thought. Anyway, this is noncash and goes up or down every quarter influencing the financial results as it does so.
 
The reported net loss for the quarter rose from $15.6 million to $24.2 million. Both the derivative liability and the calendar shift have significant impacts on how you look at PacSun’s results.
 
PacSun used about $30 million in cash for operating activities in the quarter. In last year’s quarter, it was $31 million. The current ratio has weakened from 1.53 to 1.21, and total debt to equity has jumped from 2.37 times to 6.13 times as losses have reduced equity from $98 million to $41 million. Long term liabilities are essentially unchanged.
 
On to the conference call. Let me start with a rather lengthy quote from CEO Gary Schoenfeld.
 
“We have spoken before about the decline in certain heritage brands that had become strongly associated with energy drink collaborations, which have largely gone away. Those brands will hopefully rebound over time, yet we continue to feel the effects of their decline, along with some of our other heritage brands as well. Within shorts and board shorts, Hurley continues to perform, as are our most — more basic Volcom and Modern Amusement shorts. Yet as our customer’s embracing more aggressive print and pattern trends in tops, it has been pretty much just the basic shorts that are selling and similarly, what we would consider to be the more fashion-forward board short ideas within our assortment, those are also underperforming compared to what we’ve seen in prior years.”
 
It isn’t just PacSun, of course, that’s reported some concern about heritage brands and that’s focusing on new and different brands. As I see it, it feels like they are favoring brands that are more fashion or youth culture and less action sports based. I also hypothesize that some of the older brands are aging up, and don’t hit PacSun’s target customers (17 to 24 in women’s) the way they used to.
 
Next, here’s a question that Berry Chen from Wedbush asked:
 
“…in terms of the Men’s heritage brands…is the team’s idea to continue to add some of these emerging brands that are doing well? And when do you expect some of that pressure from the heritage brands to kind of start to diminish?
 
Here’s Gary’s answer:
 
“…the shift to embracing the newer emerging brands and street wear as a trend has been critical. And if — had we not been successful in those efforts as well as expanding footwear and other accessory categories, our Men’s business would be in a much tougher position. There’s a lot of change happening within sort of the longer-standing brands. There have been significant executive changes at a number of key players. And so to answer your question, I can’t be specific in terms of exactly when that pressure lightens up. But obviously, we continue to focus on what we can control, which is continuing to work with the mix of brands that we have, both emerging and heritage, continuing to also bring the best that we can in terms of our proprietary design and in denim, in particular, to support changes in trends.”
 
Gary also noted “…the complete rethinking of design and development, as speed to market has become critical to sustainable performance.”
I’ve been reading that consumers are more willing to accept and trust new brands then they used to be. I’d expect this evolving consumer behavior coupled with the need to be quick to market to bias some retailers towards proprietary brands, and I think that’s happening.
 
It’s good to see the store closings finally tapering off. That’s a drain on resources PacSun could put to a better use. I agree with the market trends PacSun has identified and is focusing on. But as I asked back before Gary Schoenfeld even became CEO, can they make PacSun “cool” again and a place their target customers want to shop? There is certainly progress, but it’s still a work in progress and it needs to continue so the balance sheet doesn’t weaken further.