Billabong’s Year and New Plan; I Wish They’d Done This Sooner

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Billabong’s fiscal year ended June 30. On August 27, they released their full year results and presented their promised strategic plan. The financial results were poor but not unexpected, coming in at the low end of their guidance. The good news is that it looks like they wrote off, wrote down, reserved for or expensed every item they could find that might possibly represent a problem or stand in the way of their new strategic plan. 

I refer to this as the “big bath” approach. That is, if things look bad and your audience is going to hate what you tell them anyway, might as well get all the bad news you can identify behind you. This is good because not only does it mean fewer negative influences going forward (both financially and in terms of management focus) but there’s a reasonable chance that some of these assets you’ve written down will turn out to have some value that will go right to the bottom line in future periods.
 
A really good time to do this is when you have a new Managing Director and CEO coming in and, as you’re aware, Launa Inman joined Billabong on May 9th, coming from Target Australia (no relationship t Target in the U.S. except that they license the name.
 
CEO Inman presented her strategic plan for the company, and I’ll get into the details below. Much of her approach is what I’d call blocking and tackling. That, by the way, is a very, very good thing. It’s fundamental, but it’s critical. Those of you who have followed my suggestions for how companies should be approaching a lower growth, consumer centric environment won’t be surprised that I like what she proposes for Billabong.
 
Housekeeping
 
Here are a few things to keep in mind as we go through this. First, all the numbers are in Australian Dollars unless I say otherwise. Second, “pcp” means prior calendar period.   Third, The Australian Dollar is worth US$ 1.03 today (August 31). On June 30, it was worth US$ 1.016. Fourth, if you want to review the financial report, conference call transcript, or the slides for the fiscal year review or new strategic plan, you can find them here.
 
The TPG Offer
 
I imagine most of you were hoping to find out what’s going on with the July 23rd offer from TPG International to buy Billabong for $1.45 a share. Me too. But all we found out on the conference call was that the confidentiality agreement had been signed and the due diligence commenced. However, in footnote 41 on page 123 of the financial report, I did find the following:
 
“There is no guarantee that, following the due diligence process, a transaction will be agreed or that the Board will recommend an offer at the current proposed offer price. In fact, the Board does not believe that the proposal reflects the fundamental value of the Group in the context of a change of control transaction.”
 
Billabong’s board of directors doesn’t think $1.45 is enough. As you’ve probably noticed, there’s some speculation that other buyers might be out there lurking in the lichens. This will be interesting to watch.
 
The Year’s Results
 
Here’s the broad brush. Billabong lost $276 million on revenue of $1.44 billion. Last year, they earned $119 million on revenue of $1.56 billion. Cost of goods sold rose from $728 million to $765 million. Gross margin fell from 53.3% to 47%.
 
I’m going to go ahead and present some of the other income statement numbers, but starting with sales, I’m going to go back to clarify and explain a bit.
Selling, general and administrative expenses (SG&A) rose 14.2% from $564.7 million to $645 million. Other expenses rose 275% from $144.8 million to $544 million. Last year’s pretax profit was $88.7 million. This year’s pretax loss was $522 million. There was an income tax benefit of $40 million this year and you have to then add in the $206 million gain on the sale of 48% of Nixon to get to the net income number.
 
Billabong operates in three segments. Australasia includes Australia, New Zealand, Japan, South Africa, Singapore, Malaysia, Indonesia, Thailand, South Korea and Hong Kong. The Americas is the U.S., Canada, Brazil, Peru and Chile. Europe is Austria, Belgium, the Czech Republic, England, France, Germany, Italy, Luxembourg, the Netherlands and Spain.
 
The Rest of the World “…relates to royalty receipts from third party operations.” I conclude that the countries listed in the three segments are where Billabong has its own operations. The royalties were $2.6 million during the year.
 
Here’s the revenues and EBITDAI for the three segments for the last two years. 
 
 
I know most of you know this, but EBITDAI is earnings before interest, taxes, depreciation, amortization and impairment charges. Call it the operating result. The impairment charges total $343 million. We’ll discuss them below.
 
Now, the plot thickens. Billabong adjusts the numbers above to “…exclude significant and exceptional items…” These are “…items associated with the strategic capital structure review…” 
 
“Significant income and cost items associated with the strategic capital structure review includes
but is not limited to, doubtful debts, inventory write downs and redundancies partially offset by the gain on sale of 51.5% of the Nixon business (significant items). Exceptional items include other costs and charges associated with certain initiatives outside the ordinary course of operations (exceptional items) (collectively significant and exceptional items).”
 
Here’s the numbers for the recent year with those items removed. 
 
 
It’s a miracle. Instead of an EBITDAI loss in its three main segments of $74 million, Billabong shows an EBITDAI profit of $118 million and a net income of $33.5 million instead of a loss of $275 million.
 
There is justification for making some of these adjustments, and I’m not against trying to show a true picture of operating results. But I’m not quite certain how bad debts and inventory can be removed from operating results. I mean, if some of the inventory ain’t worth much, and you can’t collect the receivables, that’s pretty much about how you operated I think. 
 
I guess the argument is that they identified and took these write downs because of their strategic review, and are starting fresh, have a new CEO, and just want to clear the decks (see “the Big Bath” discussion at the start of the article).
 
In the Australasia segment, they note that “Sales…increased over the pcp principally as a result of the inclusion of a full year of trading for the prior year acquisitions of SDS/Jetty Surf and Rush Surf in Australia.” I conclude revenues would have been at best even without that acquisition related revenue. They mention as factors reduced June shipments and a highly promotional environment. Australia represented 65% of the total segment revenues.   
 
In the Americas, they point to wholesale and retail performance in Canada as a major reason for the reduction in EBITDAI margins. They note issues with West 49 on a couple of occasions. The U. S. was 59% of this segment’s total revenue.    
 
They talk about the impact of sovereign debt issues in Europe having “… a significant adverse impact on consumer confidence and demand, especially in southern European territories…” The result was delays in shipments, weak in-season repeat business, and soft trading conditions in their owned retail. CEO Inman noted that Billabong has historically been very strong in Southern Europe. Unless you live under a rock somewhere, you know that things are pretty bad there. The comment in the conference call  that about 25% of their accounts in Europe having closed was indicative of the situation. France, interestingly, is 83% of the European segment’s total revenue for the year ended June 30, 2012 which further illustrates how bad Southern Europe must be if it can have the impact.
 
Wholesale revenues were $1.07 billion. However, that includes sales to owned retail. If you eliminate sales to owned retail, you get down to wholesale revenue for the year of $831 million. Retail revenues were $719.6 million. Billabong had 634 company owned stores at year end. Same store sales grew 1.4% in the U.S., but fell 10.4% in Canada, 1.9% in Europe, and 3.7% in Australia.  
 
Let’s move on now and look at expenses.
 
The cost of goods sold amount includes $73.5 million of the “significant” items. This includes both a loss on inventory already sold as well as an allowance for writing down inventory that is “realizable below cost.” Total June 30 inventory was $293 million, so that’s a pretty big number. It also goes a long way towards explaining the decline in the gross margin.
 
There’s a pretty long list of “significant” items included in the general and administrative expenses. I thought the best thing to do was just pull the list from the financial report.
 
 
There was another $6.5 million as well, bringing the total to $117 million.
 
As noted above, SG&A totaled $645 million for the year including this $117 million. The $33 million doubtful account expense is a result of their decision to stop working with certain wholesale accounts. That decision, Billabong believes, means the receivables are less likely to be collected and so they’ve taken a provision for them.
 
Billabong closed 58 stores during the year ended June 30, and expects to close an additional 82 during this year. That explains the early termination expense of $58 million.
 
Just to remind everybody, most of these large expenses (and the inventory charges) ultimately free up working capital and reduces annual expenses. So while it hurts in the period you take these charges, it’s a continuing benefit in future periods.
 
Down in other expenses there’s a $343 million charge mostly for impairment of goodwill, brands and intangibles. This is a noncash charge, but it is a real indication of declining expected cash flow and value of the assets.   Along these, lines we see in other income a credit of $22 million for a reduction in already booked earn outs for acquisitions.
 
Equity on the balance sheet fell as a result of the loss from $1.196 billion to $1.027 billion in spite of the gain on the sale of Nixon and the equity raised. But total liabilities fell by 47% from $834 million to $441 million. The total liabilities to equity ratio stayed constant at 1.02 times.
 
Cash rose from $145 million to $317 million but the current ratio deteriorated, going from 2.34 times to 1.47 times. However, that’s mostly because current borrowings rose from $15 million to $229 million, while longer term borrowings fell from $597 million to $249 billion.
 
Receivables fell by 34.5% reflecting in part the elimination of Nixon receivables as well the write down of $33 million for doubtful accounts. Impaired receivables rose from $21 million to $52 million over the year. Just because it is classified as impaired doesn’t mean all or part of a receivable won’t be collected. Billabong increased the provision for its impaired receivables from $20 to $40 million.
 
I guess the way to look at the financials- and especially all the write downs and impairment charges- is to say that they represent an acknowledgement of some mistakes made and opportunities to do some things better.  The question then becomes if they have identified the mistakes and what are they going to do differently. That takes us to CEO Launa Inman’s strategic presentation.
 
What’s the Plan?
 
I thought the meat of the presentation started when she looked at Billabong’s challenges. Externally, these were the “unprecedented macroeconomic environment,” the impact on the Billabong brand of the shrinking account base, and the strength of the Australian dollar.
 
Internally, the challenges she focused on included the organization’s inability to keep pace with its global expansion, the poor performance of the Billabong brand, problems in implementing the retail strategy, and issues with the supply chain costs and responsiveness. That last one includes not just where you have stuff made, but how you move it and how you manage your inventory. It has a lot to do with information systems, or the lack of them. 
 
I want to make two points here. The first is that the internal challenges would have been, and were, challenges even if the external ones hadn’t been as severe. Cash flow and fast growth, I’ve said a time or two, covers up a lot of problems. When the good times ended, the problems became harder to ignore and got meaningful quickly.
 
Second, Billabong had tended (before West 49) to acquire strong brands with solid management and, I’m told, let them run pretty independently. I liked that approach, but you can see how it could create some inefficiencies a company can’t afford when times aren’t quite so good even if the management teams at each company ran their brands well. CEO Inman noted, “One of the things we as an organization have is great entrepreneurs who really understand the customer in many ways but yet at the same time we’ve never really analyzed the data to ensure that everything we do going forward has facts and is fact based so that we can make clear and concise decisions. “      
 
They started to address their challenges by collecting some information. They spent $20 million on consultants doing it. I like the sound of that.   They measured the size of their markets. They did extensive customer research in the U.S., Australia, and France. They did it for all their brands and for snow, skate, and surf. Who are our customers, how do they perceive us, and why do they buy from us Billabong wanted to know. CEO Inman noted, “This was in fact the first time that this research has ever been actually done.”
 
Part of their work with consultants was “… to have a real deep dive into the profitability of the brands, of the actual retail outlets, the supply chain and also even look at the opportunities of e-commerce.”
 
How you can run a business without that information (as best you can get it) is beyond me, and I think it’s great they started with this research even at a time when money was tight. You can’t fix it if you don’t know what’s broken, and an objective, outside, opinion not based on anecdotal evidence is a good place to start.
 
Billabong, as part of its research, benchmarked itself against leading brands (not just in action sports) to see where it stood. Among the things they found out was that “…We had the highest awareness within the board sport market but yet for all that we weren’t really differentiated.”
 
So what are they going to do? They’ve got short, medium and long term plans and you really ought to review the presentation yourself at the Billabong web site. This damned article is already 2,500 words and I’m not done yet. I hope somebody actually reads this far.
 

 

 

Billabong is going to measure, measure, measure. Launa Inman thinks if you don’t measure stuff, it doesn’t get done and that’s certainly my experience. I’m guessing this might be a new experience for some of the brand managers at the level I expect it to happen.
 
They are going to be consumer centric in everything they do. I hope that means they are going to work very hard to control the consumers’ experience at every point where Billabong touches them.  That’s just the environment we’re in. The consumer has perfect information and endless choices. They don’t need you- you need them. Consumers take for granted the product. What you have to give them is a good experience.
 
They are going to focus particular attention on RVCA, DaKine and Element. These are the three brands identified by their research as having the greatest growth opportunities. That doesn’t mean there aren’t opportunities in other brands, but you if you focus everywhere, you focus nowhere.
 
They also talked about simplification. Billabong has 25,239 unique styles, 500 suppliers, something like 13,000 wholesale customers, and 625 stores (we know this number is going down). Those stores are under 15 names and they have 35 web sites. Aside from the customer confusion, imagine the costs savings from rationalizing this a bit. 
 
Billabong has imagined. They found, during their research, that 34% of their styles give them 1% of their sales. They must have just fallen off their chairs when they saw that. I don’t think I would have believed it the first time I heard it. They are going to cut the number of styles by 15% this year. When they see how that works out, they’re going to look to cut it another 15% next year. It cuts costs, but it also “…enables us to concentrate on delivering the correct proposition to the consumer.”
 
Years and years ago, I commented on the snowboard industry’s tendency to increase the number of styles they offered as a response to what their competitors were doing, rather than focusing on what their customers wanted. I guess Billabong is figuring that out too.
 
Moving right along on simplification, they noted that that 85% of product purchases come from 19% (that’s 95 out of 500) of suppliers. What do you think is going to happen to their number of suppliers? I’d be really curious to know how many suppliers go away just from cutting the 34% of styles that give them 1% of sales.
 
Speaking of interesting statistics, Billabong found that 80% of their sales came from 11% of their customers. You can hardly go wrong by focusing on what that 11% want from you. I’d go so far as to say that will probably solidify brand positioning and perception by focusing there. Here are a couple of quotes from Launa Inman that are related to this.
 
“This is all about the experience. It’s all about making them [the customer] feel part of the tribe, and that what we need to work on.”
 
“When we analyzed the issues that have faced the retail, there were some stand-outs, and the most important one is the ability of the organization to integrate the brands as they bought them. The second thing is we were not consumer- and customer-centric enough, but that is changing. In our quest to try and increase profitability, we’ve started to push our own family brands and without understanding whether that was right for the customer, and those are the things that we are now going to be doing.”
 
One of the things that’s going to be required to do all this is better systems. “That means that we need to have organizational design and structure. We need to relook at our IT systems. No strategy can be carried out today unless it is underpinned by good IT.”
 
As I pass 3,000 words, I find myself desiring to figure out how to end this. I haven’t covered everything I’d like to cover, but let’s try and summarize and reach some conclusions.
 
Let’s start with something CFO Craig White said during the question and answer part of the conference call.
 
“Essentially, if you look at the next four years, what you should expect to see is reasonably modest revenue growth, but real margin expansion as we get leverage through improvements in the supply chain and so on…”
 
I think he’s saying, and I agree, that revenue growth isn’t going to be easy to come by as difficult economic conditions persist, but that there are a lot of opportunities to bring more dollars to the operating profit line by running the business better. In Billabong’s case, it may represent the best way to improve profitability in the next year or two.
 
As I’ve written, operating efficiently can no longer provide a strategic advantage. It’s a minimum bar that gives you the opportunity to compete. Companies like VF and Nike, and now Billabong, have figured this out. And as I said in the title, I wish they’d figured it out sooner.
 
But it isn’t just about operating efficiently. Operating well saves you a lot of money. Just as importantly, it gets the right product in front of the right potential customers with the right presentation in a coordinated way at the right time. You have to be consumer centric, and good operations are a critical part of that.
 
When brands started becoming retailers, and retailers brands, it seemed to be focused on generating a little more gross margin (less than most people think- running retail is expensive) and responding to your competitors. What really mattered, however, was that it allowed better control of distribution, and the ability to manage the points of contact with your consumer and the quality of the experience you offered them.
 
Billabong is saying they’ve figured that out and have a strategy to achieve it based on solid data they worked hard to get. It’s kind of conceptually simple, but not quite so easy to implement. As they acknowledge, it’s a multiyear process.
 
It’s also going to require an evolution of their culture. How do you balance entrepreneurial people with the intention to “…totally integrate, in time, our single brands as well as our pure play e-commerce, and also our bricks and mortar.” That may prove to be the most challenging part of the whole plan.

  

 

 

 

Spy’s June 30 Quarter. Brand Sales Up, But Gross Margin Falls. What to do About the Balance Sheet?

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In the conference call discussion of their results Michael Marckx, Spy’s President and CEO, emphasized two things. The first was the total focus on the Spy brand. The second was that they had a solid and complete management team that was in agreement on the company’s strategy and direction.

Those are good things. In spite of the sales increase, however, the company continues to lose money, and can only pursue its strategy with the help of continuing loans from its largest shareholder. Here are the details.     
 
Sales for the quarter rose from about $9 million to $9.5 million, or by 5.3% compared to the same quarter last year. Sales of Spy products were up $1.1 million, or 13%, to $9.3 million. That number includes $300,000 of Spy brand closeouts. There was also $200,000 in closeout sales of the licensed brands (O’Neill, Melodies by MJB, and Margaritaville) that they no longer sell. I’d note that the licensed brands closeout sales were down from $800,000 in the same quarter last year, so hopefully we’re coming to the end of that. Sunglasses represented 94% of revenue during the quarter.
 
 
Total gross profit fell from $4.88 million to $4.75 million even with the sales increase. Gross profit margin was down from 54.3% to 50.3%. They give four reasons for the decline.
 
The first is reduced gross margin on international business due to poor European economic conditions (International sales in the quarter were $790,000). Second, some of the product they sold that they bought from LEM (the Italian factory they used to own) has gotten more expensive, but they’ve got a deal that requires them to continue to buy some product there. Third, there was an increased level of discounting which they say is “…primarily due to increased levels of sales to major accounts.” Finally, there were some higher freight costs because of more air freight shipments. Having to pay for air freight sucks I can say from personal experience.
 
These higher costs were offset, they say, by some increased purchases of lower cost product from China and the higher margins they got from sale of the old licensed product after they wrote it down last year.
 
Let’s focus on that last one for a minute. If you carry product in inventory at $50 and sell it for $100, you have a 50% gross margin. Assume you figure out you have way too much of that product and it’s not worth anything, so you write it off, charging the $50 to expense. Next year, to your surprise, you figure out how to sell it for $25. You carry it in inventory for nothing, so that $25, from an accounting point of view, is all gross profit. That will boost your gross profit margin nicely. We don’t know how much of that Spy had.
 
Sales and marketing expense rose 43.3% from $2.6 million to $3.8 million. The increase was “…driven primarily by increased marketing efforts to promote our SPY brand and our new SPY products…” The biggest piece of the increase was $500,000 for marketing costs. There was also $300,000 spent on product displays and $200,000 on compensation. For all of 2012, Spy has minimum annual payments to sponsored athletes of $919,000. They are betting on the Spy brand, so where else would the money go.
 
General and administrative expenses were down $900,000, or 33.8%, to $1.73 million. That reduction is largely related to the one time management restructuring costs from April 2011. 
 
As reported, total operating expenses fell 22.4% from $7.5 million to $5.8 million and the operating loss for the quarter fell from $2.64 million last year to $1.07 million in this year’s quarter. The net loss for the quarter was $1.63 million, down 45% from a loss of $2.95 million in the same quarter last year.
 
But in the quarter last year, there were the one-time charges of $1.95 million associated with getting out from under the deals for the licensed brands and the $900,000 for the management restructuring.
 
Ignoring those two charges, operating income in last year’s June 30 quarter on a proforma basis was a positive $214,000 and the reported operating income can be viewed as a decline compared to last year’s quarter caused by the fall in gross margin and the marketing spend to build the brand.
 
As you already know, Spy has financed its continuing losses mostly through loans from Costa Brava, an entity controlled by Spy’s largest shareholder. As of June 30, 2012, those loans totaled $15.1 million. A year ago, they were about $9.5 million. In a year then, Costa Brava put an additional $5.6 million into Spy. In August 2012, the amount of the line of credit from Costa Brava was increased from $7 to $10 million. Spy borrowed an additional $1 million on August 3.
 
Spy says in its 10Q, “The Company anticipates that it will continue to have requirements for significant additional cash to finance its ongoing working capital requirements and net losses, which have included increased spending and marketing and sales activities deemed necessary to achieve its desired business growth.” This seems to indicate that they expect continued losses. There’s no information on how much those losses might be or how long they might continue.
 
You may recall that Spy announced on July 2 that it was planning to raise some additional capital by the end of August. I am writing this on August 24th, but nothing has happened as far as I know.
 
With the accumulated losses and shareholder debt, the balance sheet shows a stockholders’ deficit of $11.2 million.
 
Accounts receivables have grown 16.4% over the year, from $5.5 to $6.4 million. That number is net of an allowance for doubtful accounts of $277,000 and a $1.665 million allowance for returns.   Total sales, as you recall, were up 5.3%. Inventories fell 9.5% from $8.5 million to $7.7 million. That’s good to see, though I have no idea how much of that is better inventory management as opposed to write downs of overvalued product. The inventory number is “…net of an allowance for excess and obsolete inventories of approximately $0.9 million…”
 
I think Spy is doing the right things. Certainly focusing on the brand, and spending money to build it, is what they have to do. And the management team seems stabilized, strong, and focused. As long as Costa Brava is willing to fund them, they can continue to pursue their strategy. To justify the investment that’s been made in the company, however, Spy requires a faster rate of growth and, obviously, to make a profit. Next quarter, I hope to see real improvement in their operating performance.
 

 

 

VF’s Quarterly Results and Strategy: They Do Love Outdoor and Action Sports

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VF’s reported revenues rising 16.4% in the quarter ended June 30 compared to the same quarter last year. Net income was up 20% from $129.4 million to $155.3 million. As you look at those headline numbers, there are a couple of things to keep in mind.

 
First, the Timberland acquisition closed on September 13, 2011 so this is the first June quarter where it’s been included, and it was the largest acquisition VF has made. They paid $2.3 billion for Timberland. It’s part of VF’s outdoor and action sports group. During the quarter ended June 30, it contributed revenue of $239.4 million and reported a loss (as expected- apparently that’s just how the second quarter is for Timberland) of $37.2 million.
 
Second, on April 30th VF sold the John Varvatos brand and generated a pretax gain on the sale of $41.7 million. The sale of that brand reduced revenues in the quarter by $14.4 million.
 
Organic revenue growth (growth from brands they already owned) was $125.1 million, or 3%. International business grew 33%, representing about a third of total revenues. 26% of that growth came from Timberland. Direct to consumer revenues were up 37% in the quarter (29% from Timberland) and are 21% of total revenue. VF has opened 58 new stores so far this year, and expects to have opened 130 by year end. Comparable store sales in the stores VF operates were up mid-single digits in the second quarter.
 
Without the Timberland related acquisition expenses of $3.4 million and the gain on the sale of John Varvatos, net income would have been $122.9 million instead of the $155 million reported. Operating income, without the Timberland loss and related acquisition costs, would have been $193.7 million instead of the reported $164 million. By the way, my thanks to whoever it is at VF that presents this information in a fairly easy to figure out format. Oh- and here’s the link to the 10Q.
 
Before we delve deeper into those numbers, I want to remind everybody that back in the middle of June, VF did an investors’ day presentation just on Vans.   You can listen to the whole presentation here, and I suggest you do if you haven’t already.
 
When I wrote about Nike’s annual report a couple of weeks ago, I related it to a book called The New Rules of Retail. VF is discussed in that book as an example of a company that is creating neurological connectivity with its customers, using preemptive distribution, and controlling its value chain to compete as called for and explained in the book. You can see that all over the Vans presentation.
 
So why does VF love its outdoor and action sports segment? It has something to do with the fact that it generated 49% of its total revenues, including Timberland, during the quarter. Its next largest segment is jeanswear, which generated $594 million, down from $613 million in the quarter last year. Those two segments, then, were 76.3% of the quarter’s revenues and they generated 76.4% of operating profit.
 
VF’s overall operating margin was 7.9%, down from 10.3% in last year’s second quarter. 2.3% of that decline was the result of Timberland’s loss in the quarter.   
 
Of the $125 million in organic growth in the quarter referred to above, $113.4 million came from outdoor and action sports. That’s a 12% increase; 16% in constant dollars. Organic growth in operating profit for the whole company during the quarter was $18.4 million. In the outdoor and action sports segment alone it was $25.5 million, so that segment made up for the poorer performance of some others.
 
The North Face is part of outdoor and action sports. Its revenues in the quarter were up 14% (16% in constant currency) and it’s direct to consumer (DC) grew 9%. For the whole year, they expect The North Face to approach $2 billion in revenue.
 
VF is targeting Vans revenue of $2.2 billion by 2016. Revenues in the quarter were up 25% (29% in constant currency). Its DC business rose 18%.
 
Timberland revenues were up “…slightly on a constant dollar basis…” However, VF management sounds positively giddy as they talk about the opportunities in product, operations, and marketing they have with Timberland. It will be rolling out an apparel line in the near future.
 
One analyst asked about the impact of cleaning up Timberland’s distribution. Group President of Outdoor and Action Sports Steve Rendle answered it this way:
 
“As we look to right size that business, we are closing some of the distribution. Simultaneously, we’re rightsizing the product segmentation strategy, getting the right products in the right channels.”
 
Read that again and go listen to their plans for Vans. Read about what they are doing with The North Face in the conference call. You can detect in the conference call (see it here) a certain consistency across Vans, The North Face, and Timberland in terms of product development and the approach to the consumer. I would think there might be some real opportunities there as the brands come at overlapping customer groups from different perspectives.
 
Okay, let’s get back to VF’s overall financial results. Gross margin increased to 46.1% from 45.9% in last year’s quarter. This was “…due to a greater percentage of revenues from higher gross margin businesses, including the Outdoor & Action Sports, international and retail businesses, as well as an improvement of gross margin in our Jeanswear Americas business which reflects increased pricing compared to the prior period.”
 
Marketing, administrative and general expenses as a percent of sales rose from 35.7% in last year’s quarter to 38.4% this year. 2.4% of that increase was the result of the Timberland acquisition as it had higher expense ratios than the rest of VF. I won’t be surprised to see those Timberland ratios come down.
 
0.4% of the increase came from higher domestic pension expense. VF has a defined benefit plan. Those have to be funded based on an actuarial assessment of the number of people who will retire, when they will retire, how long they will live and what the assets in the plan are projected to earn. These days, it’s a bit hard to assume your pension assets will earn 7% and this is requiring some corporations (not just VF) to contribute more to their plans. That reduces net income.
 
Interest expense rose $7.6 million in the quarter because they borrowed money to pay for part of the Timberland acquisition.
 
The balance sheet was inevitably a bit weaker compared to a year ago after they borrowed money to buy Timberland. Long term debt is up $900 million. The current ratio fell from 3 to 1 to 1.9 to one and debt to total capital rose from 18.7% to 35.7%. Inventories rose 22.2% from $1.286 billion to $1.57 billion year over year. However, $246 million of that increase is the result of the Timberland acquisition. Excluding that, the increase was just 3%.
 
Receivables rose from $889 million to $1.03 billion over the year, but $121.7 million of that increase was Timberland. I should note that VF has an agreement with a financial institution to sell certain of its receivables on a nonrecourse basis. VF still manages and collects the sold receivables, but if they are ultimately uncollectable, it’s not VF’s problem. This sale of receivables reduced the accounts receivable on VF’s balance sheet by $135.5 million at June 30, 2012.
 
VF is the third company I’ve written about recently (Skullcandy and Nike being the other two) who seem to be responding to the changing retail/wholesale dynamic in ways that have some similarities. Those responses are consistent with the conditions described in The New Rules of Retail and that book’s prescription for success.
 
I expect VF to do some good things with Timberland. And I’ll be interested to see how VF manages the other brands in its portfolio if outdoor and action sports continues to grow and perform at such a high level. 

 

 

Skullcandy’s June 30 Quarter; Focus on the Strategy

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Skull had a strong quarter, and we’ll review the numbers. But what intrigues me more are the investments Skull is making and the steps they are taking to implement their strategy. That’s where I want to spend most of our time. In what was, and continues to be, an oversimplification I’ve written that the bet Skull was placing was that they could be cool in retailers like Fred Meyer. We’re going to dig a little deeper now and talk about some things they are doing that are consistent with the requirements for success in what we all know is a dramatically changing retail environment.

 
Sales for the quarter ended June 30 were up 38.2% to $72.4 million from $52.4 million in the same quarter last year. Domestic sales rose 34.1% to $50.6 million from $37.7 million in last year’s quarter. International sales rose $6.2 million or 59.9% to $16.5 million and represented 22.8% of total sales for the quarter. Skull acquired their European distributor in August of last year, and that increased its international sales.
 
As a reminder, each of Target and Best by accounted for more than 10% of Skull’s net sales during the first six months of 2012.   
 
Online sales increased $1.0 million to $5.3 million. That 22.8% increase is almost entirely the result of their acquisition of Astro Gaming in April, 2011. As a percentage of total sales, online sales declined from 8.3% to 7.4%. Skull says this was because they stopped using their web site to sell clearance product “…in order to better preserve the integrity of the brand.” Good decision.
 
Gross margin percentage fell from 51.1% to 49.2% in this quarter. As reported in the 10Q, “The decrease in gross margin is mostly due to a shift in sales mix to higher price point products with lower gross margin structures.”
 
It would appeal to my sense of organization to just review the financials then move on to the strategic issues but, unsurprisingly, it’s hard to separate them. It was many years ago that I first suggested that it might be a good idea to focus not just on your gross margin percentage but on the total gross margin dollars you earn, as that was what you paid your bills with. A few years after that, Cary Allington at Action Watch pointed me at the idea of Gross Margin Return on Inventory Investment. It was a more formal approach to what I’d already been saying and I urged the adoption of the idea in some presentations and in a Market Watch column. It’s a particularly valuable concept in a weak economy.
 
Skull’s management is apparently all over this. They noted that their average selling price increased by double digits in the quarter. One of the analysts asked how they should think the “…margin dynamics between these on-ear and over-the-ear versus buds?”
 
Skull VP of Finance Ronald Ross had already noted that Skull was continuing “…to see a mix shift toward over-ear styles and higher-priced product.” Responding to the analyst, CEO Jeremy Andrus indicated they viewed these trends very favorably. He acknowledged buds had less technology and materials in them, so were cheaper to produce. But he thought the trends would “…increase our revenue and the dollar share of gross margin.” Another executive noted that they saw the trend as positive not just financially, but for the brand as well.
 
So Skullcandy, though of course they would love a higher gross margin, is arguing that they end up with more gross margin dollars with a higher priced product even if the gross margin is a bit lower, and that’s okay with them. I agree.
 
Selling, General and Administrative Expenses (SG&A) rose from $17.2 million to $24 million. As a percentage of sales, it went from 32.9% to 33.1%. They note that “Approximately half of the increase was related to strategic investments in our direct international and gaming platforms, including expansion of personnel.” The areas they are investing in include, “…an in-house product design model, fixtures and point of purchase displays developed to improve our in-store presentation, property and equipment to support operational growth and the purchase of certain intangible assets related to our acquisition of the distribution rights in Europe.”
 
Another argument I’ve made from time to time is that a weak economy and tough competitive conditions offer opportunities to well positioned companies with strong balance sheets. I’m not going to spend a lot of time on Skull’s balance sheet, but since their public offering it’s been strong enough to allow them to pursue their strategy with few, if any, financial constraints. I mostly like where they are spending their money.
 
One of the facts of our new retail environment, whether you’re a brand or a retailer (and assuming we can still tell the difference), is that doing all the operational and back office stuff right is no longer a source of competitive advantage. It’s a minimum bar to have a chance to compete. Doing all that stuff right costs money and requires, I’ll say again, a strong balance sheet.
 
Also due to its public offering, Skull’s interest expense fell from $2.3 million in last year’s quarter to $147,000 in this year’s. Net income rose from $4.3 to $6.8 million, and you can see that without that decline in interest expense, the growth of net income would have been a lot lower.
 
With the financials reviewed, let’s move on to other strategic considerations. Skullcandy rather eloquently expresses the connection between action sports and its target market as follows:
 
“Our brand also benefits from the increasing popularity of action sports, particularly within the youth culture. Our consumer influencers are teens and young adults that associate themselves with skateboarding, snowboarding, surfing and other action sports. These consumers influence a broader consumer base that identifies with authentic action sports lifestyle brands. In addition, music is an integral part of the youth action sports lifestyle, and headphones have become an accessory worn to express individuality.”
 
That action sports brands try and use their involvement with the core to reach a much broader customer base is hardly a new idea.   But Skullcandy draws the smaller core towards the much broader consumer market using the commonality of music and the actual product- the headphones. I’m sitting here trying to think of another company that has a product that can do this quite so well but I’m coming up blank. Maybe Nixon is another example. Perhaps this is the bedrock of Skullcandy’s success.
 
You’ll also note in the quote the term “consumer influencers.” We’re all aware of the declining role of traditional advertising and the importance of engaging with your customers. You do that, I think, by controlling as much of your value chain as you can. It’s especially important that you control it at the point of contact with the consumer, and Skull is trying to do that in various ways.
 
They are “…rolling out new point-of-sale fixtures and powered listening stations globally. By the end of the year, we plan to have over 5,000 in place.” About half of these are powered listening stations where you can listen to your own music on Skullcandy headphones as you make purchase decisions.  Some of them have video as well.
 
Their thinking is that higher price point products especially require a listening experience for the consumer at the point of sale. Where they’ve installed them, they’ve seen it “…impact sell-through from sort of low-double digits up to significantly higher than that, depending on the retailer or the fixture type.”
 
They have a retail education group within Skullcandy which is going into retailers and educating sales people on the Astro brand. I can’t see any reason you wouldn’t do that for the high end Skullcandy product as well.
 
They’ve been auditing all their retail customers in Europe since acquiring their distributor and it’s apparently leading to some changes in what they sell to whom; even at the initial cost of some sales.
 
They’ve launched the 2XL brand as a price point product they can sell to places like Walgreens and Rite Aid without damaging the Skullcandy brand. I guess I’m not quite certain why you can sell Skullcandy to Fred Meyers but not to Walgreens, but what do I know.
 
During the conference call, they were asked about selling to Walmart and the answer was along the lines of there’s no current active conversation or commitment, but we’re watching them and it’s kind of hard to ignore the biggest retailer in the world.
 
This goes back to the ability to control your value chain at the point at which it contacts the customer. If you can manage the experience the consumer has with your product so that it’s a positive one and represents the brand in the way you want, does it matter if you’re showing the product in a core shop or in Walmart? That’s an important point, and not just for Skullcandy. The breakdown of the traditional retail/wholesale distribution system requires that brands think about it.
 
Skullcandy’s financial results are good, and their balance sheet is solid. But what I really like is first, the way they are reaching their market using the commonality of music and headphones to draw together the action sports core and the broader market and, second, their strategic initiatives that seem to address the rapidly changing and emerging retail environment.

 

 

Speculation on Billabong

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Walking around a really good Agenda show last week, the question I kept getting asked was, “What’s going to happen to Billabong?”  As I told everyone who asked, I only had access to the same public information they had. Given that information, my best guess is that Billabong will be sold.  Here’s my reasoning. 

As you know, TPG offered, on July 23rd, to buy Billabong for AUD $1.45 a share subject to due diligence and other conditions. They already have an agreement from two Billabong shareholders who together control over 24% of the outstanding shares to sell if there is a deal. Billabong announced on July 27 that “TPG will be granted the opportunity to conduct non-exclusive due diligence in order to reduce the conditionality of its proposal and to improve its understanding and valuation of Billabong.”  
 
Notice it’s nonexclusive, so it’s not impossible for another buyer to pop up. But TPG has 24% of the shares already tied up with deals that give them some upside if higher price is negotiated. TPG also has agreed to allow “…Billabong’s founding shareholder, Gordon Merchant, and Collette Paull to roll over all or part of their respective shareholdings in the company into the TPG proposal.” There seems to be at this point a certain momentum, though a lot can happen between the start of due diligence and the closing of a deal; including an adjustment in the price.
 
The other reason I think a deal will happen is because of the process by which we got to where we are. Back on February 17th Billabong announced the deal to sell half of Nixon to TCP (not to be confused with TPG) for net proceeds of US $285 million. The deal closed on April 12th. That US $285 million, along with other action take to reduce expenses and close some retail stores, was supposed to address Billabong’s capital structure issues. That is, it strengthened their balance sheet.
 
 In the conference call at the time the Nixon transaction was announced, Silvia Spadea, a Merrill Lynch analyst, said, “I guess there’s no question that that will provide you with a short term reprieve with respect to your balance sheet issues. But, in my mind, it doesn’t really do much to address the fact that – you know to improve your current structural issues or stem the current deterioration in your earnings. I guess I’m just wondering how confident you are that the initiatives that you’ve outlined today are going to be enough to permanently fix that balance sheet issue, so that we don’t have this problem a year down the track.”
 
 An excellent question, I thought. In their answers, Billabong CEO Derek O’Neill and CFO Craig White never said anything like “You bet- problem solved,” and you actually wouldn’t expect them to be that definitive. But what they did do was indicate they had confidence in their projections. And my common sense told me that if they had even an inkling that the short term problem wasn’t  well and truly solved, they’d have taken more drastic steps and the Board of Directors would not been quite so cavalier about turning down an offer of AUD $3.30 a share for the company.
 
So imagine my surprise (Yours too, I expect) when Billabong management  announced on June 21st  (Former CEO Derek O’Neill departed the company on May 9th) that they were raising AUD $225 million at $1.02 a share, 44% below the previous closing price.
 
What the hell is going on in there? Had business conditions just fallen off a cliff and Billabong management hadn’t seen it coming?   Almost seems like it couldn’t happen that fast. Had they known it was worse, but had another solution in mind? In the U.S. such a failure to disclose would probably lead to shareholder lawsuits and a flogging from the Security and Exchange Commission. I don’t know what happens in Australia.
  
I suspect it’s not quite as black and white as either of those choices. In doing turnaround work, I’ve noticed a lot of denial and perseverance during periods of change even among highly competent managers/owners and I suspect there might have been some of that in this case.
 
When management has credibility issues, things appear to be going south much faster than anybody (including said management?) knew, and the shareholders take it on the chin and have a stock valued at AUD $1.39 a share they think they could have sold for AUS $3.30 just a couple of months ago, companies find themselves in play.
 
When will we know the outcome? Billabong is scheduled to report their full year earnings on August 27th. That is also the date new CEO Launa Inman is scheduled to present her plan to turn around the company. Due diligence takes some weeks typically, and I wouldn’t be surprised if an announcement coincided with the earnings report.   
 
I wonder what TPG would have found had they commenced due diligence under their previous offer of AUD $3.30? I think maybe there’s an untold story here. Anybody want to tell it to me? 

Nike’s Annual Report and Some Suggested Reading

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Two days ago, Nike filed its 10K annual report with the SEC and I’ve been through it. I’m not going to spend a bunch of time doing a detailed analysis of their already reported results if only because there wouldn’t be a lot of insight to be gained. But there were a few comments in the fine print of the report and in the conference call that I thought were relevant to thinking about the business environment.

As part of that process, I want to point you to a book called The New Rules of Retail, by Robin Lewis and Michael Dart that Roy Turner at Surf Expo turned me on to. It’s also available for Kindle. Let me make the connection between the book and Nike by starting with a quote from Nike Brand President Charlie Denson talking about how the Nike brand achieved a 21% increase in revenues during the year.

“We did it on the strength of our product innovation, the power of the brand, and the differentiation we create through distribution,” he said. Nike Inc. President and CEO Mike Parker notes, “There’s a strong appetite for authentic brands and genuine innovation. Digital technology is just beginning to show what’s possible in products, services and at retail. And new partnerships continue to advance how products are manufactured and distributed.”
 
You might be tempted to say, “Well, no kidding” but having just finished the book, I heard more in that statement than I otherwise might have.
 
The New Rules of Retail (published in 2010) makes a number of predictions we can already see coming true. It says that just to be in the game, you have to do all the operational stuff well. Not just well- really well. And you have to keep improving. That’s no longer a strategic advantage, but the price of entry. I’ve been saying that for a few years, though not with such strategic eloquence, so you can begin to see why I like this book. Like all of us, I’m partial to people who confirm what I think.
 
They also say that “The ultimate collapse of the traditional retail/wholesale business model is now clearly visible.” I’ve said retailers are becoming brands and brands are becoming retailers.  I’m liking the book more and more.
 
They think that as much as 80% to 90% of traditional department store revenues will be generated by their own or exclusive brands. They suggest that retail stores “…will become hybrid enclosed ‘mini-malls’ for increased traffic and higher productivity.” They think Amazon will open stores. They expect preemptive strategies like pop-up stores to “…become proactive strategies as opposed to marketing opportunities.” They expect big retailers “…will accelerate the roll out of their smaller free-standing ‘localized’ neighborhood stores.”
 
They say some other intriguing (or maybe scary?) things too, but I’ll let you read them for yourself and look at the examples they provide.
Why is this happening? Because the consumer has near perfect information and an almost endless number of choices. What to do?
 
The authors suggest that successful companies will do three things. First, and as a condition for accomplishing the other two, they will control their value chain; especially at points of contact with the consumer. This does not mean owning your whole value chain.
 
Second, with consumers expecting more and better all the time and to get things the way they want them, companies have to far exceed the consumers’ expectation. They will accomplish this by creating a “neurological connectivity” with their customers. I know that sounds a bit like voodoo, but the book explains it very well. Think Starbucks or Trader Joes. Or Vans, though that’s my point of view.
 
Third, they will have “…to gain access to consumers ahead of the multiplicity of equally compelling products or services, and precisely where, when and how the consumer wants it.” They call this preemptive distribution.
 
Now, with those three actions in mind, go back and read the quotes from the Nike conference call I started with. The book’s authors note that in all the companies they interviewed, none used their exact words, but the successful ones were doing what they suggested. By the way, they spend quite a bit of time talking about VF and how it’s following their prescription. That’s an interesting read.
 
My immediate reaction on finishing the book was that doing what they say is required was damned expensive and required a strong balance sheet; especially in a lousy economy. Though they don’t address the financial cost of their strategy, I suspect they would agree as they believe “50 percent of retailers and brands will disappear.”
 
They don’t talk about a time frame, so it’s hard to know what to think about that prediction. And they don’t say anything about new brands being created. If their prediction is over three years, it’s pretty harsh. If it’s over 40, it’s probably a low estimate given normal brand cycles.
 
So probably you’re not as big as Nike and might not have their balance sheet. The message isn’t, “If you’re not big you’re doomed.” The message is, first, business was way more fun and easier in the 90s and I really miss that. Second, rapid disruptive change is never something any of us really like, but it’s full of opportunities for the people it doesn’t paralyze.   Some of that opportunity comes from the fact that your competitors may be paralyzed.
 
Third, Lewis and Dart wouldn’t disagree that you still need to know your customers and give them what they want. It’s harder than it used to be, but you also have some technology tools you didn’t have before. In that sense at least, nothing has changed.
Okay, wasn’t this supposed to be about Nike or something?
 
Nike’s revenues for the year were up for almost all categories and brands to $24.1 billion (including Cole Haan and Umbro which they are selling). Sales at Hurley fell from $252 million to $248 million. Nike reports total action sports sales at $499 million, up from $470 million the previous year. That’s 2.1% of Nike’s total sales for the year. I guess “action sports sales” means Hurley plus Nike Skate. Maybe it includes some Converse sales.
 
We know that Hurley lost money, though they don’t say how much. Lower gross margins as well as higher selling and administrative expenses as a percentage of sales contributed to Hurley’s loss. But they are still confident in Hurley’s future. Mike Parker noted in the conference call, “…we’re confident our NIKE, Converse, Jordan and Hurley brands have virtually unlimited growth potential.”
 
Nike’s gross profit margin fell from 45.6% in 2011 to 43.4% in the year ended May 31, 2012. The decline was “…primarily driven by higher product input costs, including materials and labor, across most businesses. Also contributing to the decrease in gross margin were higher customs duty charges, discounts on close-out sales and an increase in investments in our digital business and infrastructure.”
 
I found the mention of higher customs duties interesting. They note in the 10K, “The global economic recession resulted in a significant slow-down in international trade and a sharp rise in protectionist actions around the world. These trends are affecting many global manufacturing and service sectors, and the footwear and apparel industries, as a whole, are not immune. Companies in our industry are facing trade protectionist challenges in many different regions…”
 
On pages four and five, they talk about issues with importing into the European Union, Brazil, Argentina and Turkey and about trade relations with China. Among the reasons the Great Depression lasted so long was the imposition of various “beggar thy neighbor” trade policies (including the Smoot-Hawley tariff act in this country) that reduced worldwide economic activity.
 
Looks like all the world’s helpful and friendly politicians are at it again. You know, I knew they would, but I really hoped they wouldn’t. I better move on. Oh- 58% of Nike’s revenues are from outside the U.S.
 
Well, this is interesting. I’m looking at an income statement with no restructuring charges, goodwill impairment, or intangible and other asset impairment. There’s no “adjusted earnings” offered as an explanation for something or other. No EBITDA reconciliation to GAP. No discontinued operations (There will be next quarter because of the plan to sell Cole Haan and Umbro). There’s hardly any interest or “other” expense. Just net income that rose for the year from $2.13 to $2.22 billion, or by 4.2%. That decline in gross margin really hit them hard.
 
Okay, I’m worried. If too many companies start just reporting what they earned without resorting to various explanations, reconciliations, and obfuscations, who’s going to need me to figure it all out? Where will I be if we have straight forward, easy to read financial statements? I sure hope this isn’t a trend.
 
Revenue in North America rose from $7.58 to $8.84 billion, or by 16.6%. Earnings before interest and taxes were $2.01 billion, up from $1.74 billion the previous year. Revenue from Western Europe was up 7.1% to $4.14 billion, but earnings fell 18.2% from $730 million to $597 million. China sales rose from $2.01 billion to $2.54 billion and earnings rose 17.3% to $911 million.
 
Nike ended the year with 384 retail stores in the U.S., but 109 of those are Cole Haan which will go away when they sell the brand. Hurley had 29 stores. Non-U.S. retail stores totaled 442 including 69 Cole Haan. Direct to consumer revenues totaled 17% of total Nike brand revenue (not Nike, Inc.) And comparable store sales grew 13%.
 
If Nike starts renting space in a Macy’s and stocks and manages the inventory itself, will they call that a “store?” For all I know, they are already doing that. The distinction between brand and retailer just keeps blurring.
  
Nike’s balance sheet is more than solid, with $3.7 billion in cash, a current ratio of 3.0, almost no long term debt and $10.4 billion in equity against $5.1 billion in total liabilities.
 
Nike’s doing well given economic conditions not even they can shrug off. Most importantly, I think they have a clear vision of where brands and retail are going.

 

 

Spy to Raise Capital by End of August- But That’s All We Know

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Spy filed an 8K on July 2 that announced they had increased the amount of the note due to Costa Brava from $6 million to $7 million, and that the full amount of $7 million was already outstanding. They also said they expected to raise some form of equity by August 31. As you may recall, Costa Brava owns 48.4% of Spy’s common stock (52.1% on an as converted basis). Mr. Seth Hamot is the Chairman of the Board of Spy, and “…sole member of the sole general partner of Costa Brava.”

You may also recall, or you may not, that interest on the loan to Costa Brava was being accrued as additional debt by Spy rather than paid in cash. That’s at least part of the reason why the loan amount had to be increased.

We also learn that, “SPY North America must prepay $1 million of the principal amount outstanding under the line of credit within five business days of our proposed sale of equity (preferred stock, common stock, warrants to purchase common stock, or any combination thereof) with proceeds to us of at least $4 million prior to payment of any transaction expenses. The amount so paid will reduce dollar-for-dollar Costa Brava’s commitment to make advances under the line of credit. We expect to sell such amount of equity by August 31, 2012.”
 
That Spy would want to raise equity is hardly a surprise. Their filings have noted the potential need for additional working capital, and Mr. Hamot, understandably, doesn’t want to continue to lend money to Spy.
 
But that suggests he expects the money to come from somewhere besides Costa Brava. We don’t, however, know what form the equity will take or how much it will be though the deal is supposed to be done by August 31. That makes me think the discussions are already ongoing if only because they felt obligated to mention it in this filing.
 
Spy’s stock closed on July 3 at $1.40 a share. But it doesn’t trade much volume and there’s a big bid/ask spread so that doesn’t mean all that much. It’s only averaged 2,457 shares a day over the last 90 trading days and some days there are no trades at all.
 
You will also note from the quote above that Spy has to pay back a chunk of any money it raises to Costs Brava to reduce the loan outstanding. While that improves the balance sheet by reducing debt and increasing equity (depending on the form of the capital raise), it doesn’t generate any working capital for Spy unless the amount raised is more than what’s paid back to Costa Brava.
 
Well, that’s not quite true. It reduces interest expense. But interest expense to Costa Brava hasn’t been paid in cash anyway.  It’s also made clear that the line of credit available from Costa Brava will be reduced by the amount of the repayment. That is, they can’t borrow it again.
 
So who exactly, is going to step in and invest money in Spy and at what price that goes right out the door to Costa Brava and Mr. Hamot? Other existing shareholders?
 
It should be interesting to watch. Hope you have a long and pleasant holiday weekend.

 

 

Quik’s April 30 Quarter: Adjusted EBITDA Falls 39%

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Quik had a 3% sales increase in the quarter, growing to $492 million from $478 million in the same quarter last year but, as I define and discuss below, their adjusted EBITDA fell by 39%.

 The gross margin percentage fell from 54.8% to 49.2%. That rather significant decline, they say in the 10Q, “…was primarily the result of higher levels of clearance business, the timing of certain royalties, higher input costs and the impact of fluctuations in foreign currency exchange rates.” The higher level of clearance represented 36% of the decline, we learn in the conference call.

In constant currency (ignoring the impact of foreign currency fluctuations), the wholesale business was up 2%, retail revenues increased 9%, and ecommerce was up 131%. Also in constant currency, Quiksilver brand revenues rose 4%. Roxy was up 5% and DC, 13%. As reported, Quiksilver brand revenues were $209 million, up 1%. Roxy revenues were up 3% as reported to $135 million, and DC had revenues of $131 million, up 11%.

According to GAAP (Generally Accepted Accounting Principles) Quik had a net loss in the quarter of $5.1 million compared to a loss of $83.3 million in the same quarter the previous year. The loss in the quarter last year included an asset impairment charge of $74.6 million for goodwill in the Asia/Pacific segment. The asset impairment charge in this year’s quarter was $415,000. Those are both non-cash charges and don’t have anything to do with how much product they sold at what prices and margins.
 
The net loss in last year’s quarter also included an income tax provision of $39.7 million “… to establish a valuation allowance against deferred tax assets in our Asia/Pacific segment. As a result of this valuation allowance and the valuation allowance previously established in the United States, no tax benefits were recognized for losses in those tax jurisdictions.”
 
My eyes glaze over when it comes to accounting for income taxes, but I think that relates the big asset impairment charge. The tax provision in this year’s quarter was $7.2 million.
 
If you ignore the asset impairment charges, then Quik had pretax income in last year’s quarter of $32.6 million. The comparable number for this year’s quarter is a loss of $4 million.
 
On page 28 of their 10Q, (see the whole 10Q here) Quik reports their adjusted EBITDA. That’s earnings before interest, taxes depreciation, amortization, asset impairment, and non-cash stock based compensation expense. In last year’s quarter that number was $62.1 million. In this year’s April 30 quarter, it had fallen to $37.6 million.
 
As reported, revenues were up in the Americas from $211 million to $221 million. Gross profit percent fell from 49.1% to 44.2% and total gross profit was down from $104 million to $98 million. 
 
Europe’s sales fell 5.5% from $207 million to $196 million as reported. In constant currency, they remained more or less the same. Gross profit fell 15% from $128 million to $109 million. The gross margin was down from 62% to 55.7%.
 
CFO Richard Shields made an interesting comment about their financial strategy in Europe during the conference call. He said, “We’re trying to make sure that we repatriate cash in Europe back to U.S. dollars so we’re not at risk there.”
 
Let me loosely translate that for you a bit. He’s saying that if he wakes up one morning (it would probably be a Monday) and the Euro has gone to hell and capital controls are in place and the capital markets have frozen up again because Greece has left the Euro zone or some Spanish banks have collapsed or whatever, he doesn’t want to be stuck with money he can’t get out of Europe that’s going to be worth half of what it was in U.S. dollars when he can finally get it. I hope you’re all thinking about that.
 
Asia/Pacific sales rose from $58 million to $74 million, or by 27.3% as reported. It was a 24% increase in constant currency. Note that this improvement was “…primarily driven by improved performance in Japan, where net revenues in the three months ended April 30, 2011 were significantly impacted by the earthquake and related tsunamis in the region.”
 
So they’re saying that the growth only looks good because of the natural disaster in Japan last year and that there wasn’t much growth in the rest of the region.
 
Gross profit in the Asia/Pacific segment rose 16.5% from $30.9 million to $36 million. The gross margin fell from 53.1% to 48.6%.
 
Operating income fell in all three segments. In the Americas, it was down from $17.9 million to $8.9 million. In Europe, it declined from $43.8 million to $25.9 million. Asia/Pacific fell from a loss of $81.1 million to a loss of $4 million, but remember the $74.6 asset impairment charge in the quarter last year.
 
As you think about how Quik did this quarter compared to last year, you need to  isolate the funky tax charge, the asset impairment and the Japanese earthquake/tsunami in last year’s quarter. If you do that, it’s hard to see progress in the income statement.
 
On the balance sheet, equity has risen from a year ago to $591 million from $535 million. The current ratio is a healthy 2.61 times, very slightly down from a year ago. Total liabilities have barely changed, so the total liabilities to capital ratio has improved with the increase in equity.
 
In the current assets, cash has fallen from $139 million to $79 million. And inventory rose 24% from $290 million to $359 million. That’s a bigger increase than you’d like to see given the associated sales increase. However, Quik notes that, “The increase in consolidated inventories was primarily the result of higher input costs and the early receipt of goods in comparison to the prior year. “ They think that higher product costs were responsible for 10% to 15% of the inventory increase.
 
Accounts receivable rose 8.5% from a year ago. They were up 17% in the Americas (with only a 4.7% sales increase), down 3% in Europe, and increased 22% in the Asia/Pacific segment due mostly, I assume, to the recovery in Japan. In constant currency, they were up 15% overall. 
 
So those are the numbers and they reflect not only Quik’s difficulty in finding places to grow (I’ve mentioned that before), but just how hard the whole economic environment is for everybody.
 
In the conference call CEO Bob McKnight mentions product for NFL teams as being shipped. He also says, “NBA board shorts will follow with some teams introduced this summer…” There will also be National Hockey League product, and they are “…expanding the program into Australian football leagues.”
 
They also talk about taking DC into JC Penney for back to school, and CFO Richard Shields says, “So DC continues to expand distribution as [there is] demand in a lot of channels where we don’t currently sell. And our overall global segmentation strategy, I think, positions us well to succeed in those channels. So we are going to continue to roll out distribution globally.”
 
And here, I guess, we get to the crux of the matter. What is Quik’s global segmentation strategy exactly? When I first heard about Quik’s selling NFL board shorts, I said something like, “You know just because you can sell something somewhere doesn’t mean you should. Not all product extensions are good.” I recognize the need, especially as a public company, to grow. But in the conference call discussion about growing sales, there’s a sense of selling a brand somewhere because you can and you haven’t yet. I hope Quik is careful with that. I hope all brands are.
 
Quiksilver’s operating performance declined rather precipitously from the same quarter a year ago even with the recovery in the Asia/Pacific segment. I still think it’s better to focus on generating more gross margin dollars with strong, brand supporting, sell through and clean inventories than it is to struggle for that incremental sale, but then I don’t have to meet with the analysts every quarter. 

 

 

News From Billabong

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I just listened to a Billabong conference call where new CEO Launa Inman announced they were raising more capital, downgrading earnings expectations, and undertaking a top to bottom review of all Billabong operations with the goals of reducing expenses, identifying efficiencies and improving the competitive positioning of Billabong and its brands.

They want to raise 225 million Australian dollars (about $229 million U.S. dollars) by selling shares to existing shareholders at $1.02 for each new share, a 44% discount from the 1.83 Australian dollar share price before the trading halt. The offer is fully underwritten by Goldman Sachs and Deutsche Bank, which means that Billabong will get the money. 

Apparently, business conditions weakened significantly in May and into June. There was weaker in season business and some wholesale accounts delayed shipments. The European, Canadian and Australian markets have deteriorated. The U.S. has some signs of improvement, but it’s too soon to call it a recovery, they said.
 
You’ll remember that Billabong sold half of Nixon and turned down a AUD 3.00 per share for the company not very long ago, saying that it couldn’t justify raising equity at that price. Now, apparently it can and then some, which says something about how conditions have deteriorated. 
 
CEO Inman announced that they were starting a “deep dive” complete review of all Billabong operations, expenses, procedures, market positioning, supply chain, and pretty much anything else you can think of. Nothing is off limit. The goal is not just to cut expenses, but to rationalize systems and procedures. That will be completed and the actions announced August 24th when they present their full year results.
 
My sense from the comments is that there are some inefficiencies and system overlaps/incompatibilities left over from acquisitions that haven’t been fully addressed.
 
The company is already in the process of closing 140 stores and expects that to be completed by the end of fiscal 2013. They had previously announced AUD 30 million in expense cuts, and that is proceeding. I think they expect to find more as a result of the business review.
 
But it’s not just about reducing expenses. They want to improve the retail experience, do more with ecommerce (which is 4% of retail sales and growing), define the customer base, look at perceptions of the brands and positioning, and define their customer base. They seem particularly concerned with the Billabong brand which, they acknowledged, has weakened in recent years.
 
Right now, of course, that’s all just a statement of intentions and they are asking shareholders to pony up more money with no plan in place. I guess that’s an indication of how badly they needed the money. The most important thing, they noted, was “…to stabilize the balance sheet.”
 
They are also hiring a global retail manager. The new executive will be introduced next week.
 
I have no doubt that Billabong will be able to do some things better and make itself more competitive. And I’d note that it usually takes a new CEO with a fresh perspective and no hesitation about questioning everything to make that happen quickly. That was always my experience doing turnarounds. There’s a certain element of ruthlessness required.
 
But the real question, and not just for Billabong, continues to be what happens to the world economy? I think that’s the same point I made when I reviewed their half yearly results. CEO Inman was adamant that they were raising enough money, but then the proceeds from the sale of half of Nixon were supposed to solve the problem too. PacSun and Quiksilver have had a hard time implementing their restructurings and turnarounds swimming upstream against the economic current. Billabong won’t be different.         

 

 

Tilly’s First Quarterly Report

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As you know, Tilly’s went public recently. They’ve just released their first quarterly 10Q report and held their first conference call as a public company. The report is for the quarter ended April 28. Their public offering was May 4, so the balance sheet doesn’t reflect the results of that offering yet, and I don’t have access to a balance sheet from a year ago, so I can’t compare the two. However, the balance sheet is just fine.

Tilly’s describes itself as “…a fast-growing destination specialty retailer of West Coast inspired apparel, footwear and accessories. We believe we bring together an unparalleled selection of the most sought-after brands rooted in action sports, music, art and fashion.” I’d be interested in chatting with them about what exactly makes a selection of brands “unparalleled.”

Sales in the quarter were $96.5 million, up 16% from $83.1 million in the same quarter the previous year. $9.9 million of that $13.4 million increase was from stores that weren’t opened in last year’s quarter.   Tilly’s ended the quarter with 145 stores in 19 states. A year ago, they had 126 stores. They opened five stores during the quarter and expect to open an additional 16 by the end of the year. They think they can expand to 500 locations over the next ten years.
 
The gross profit margin stayed the same at 31.5%. Selling, general and administrative expenses as a percent of sales fell a bit from 25.5% to 25.3%. You expect to see that decline with growth in the number of stores. Net income rose 21.7% from $4.86 million to $5.91 million.
 
We’ve got to talk about how income taxes impact those net income numbers. Reported income tax in this quarter was only $68,000. It was $56,000 in the same quarter last year. Historically, Tilly’s has been an S corporation, where taxable income flowed through to the shareholders and they paid the taxes. So the income taxes mostly showed on the shareholders’ income tax returns and not on the company’s income statement.
 
As part of the public offering, the company converted to a C corporation. If it had been a C corporation in this April 28 quarter, reported income taxes, assuming a 40% rate, would have been $2.39 million and net income would have dropped to $3.59 million. That’s more typical of what we’ll see in future quarters with Tilly’s as a C corporation and public company. 
 
Ecommerce sales were $10.9 million, up from $8.3 million in the same quarter last year and represented 11% of total revenue in this quarter. They think it can grow to represent 15% of revenues over time. I’m kind of wondering if some retailers won’t find it representing a lot more than that eventually.
 
Their comparable store sales grew by 4.3% and we learn in a footnote that the ecommerce sales were responsible for 2.8% of that. That’s 65% of the total comparable store sales growth.
 
Their brick and mortar comparable store sales, then, grew by just 1.5%. This is interesting. Do we say, “Wow, that’s not much of a brick and mortar increase.  Is there something wrong?” Or do we focus on the 4.6% and, acknowledging the increasing interdependence of ecommerce and brick and mortar, say that just fine. What does that imply about opening additional stores? What’s the multiplier between brick and mortar and ecommerce? I wrote yesterday (twice unfortunately) about Blue Tomato being acquired by Zumiez and doing 75% of their business on line. We all know there are other retailers that have a store or more, but do most of their business on line.
 
I expect most multi store retailers would agree you need fewer stores in the internet age. How many fewer? How do you think about site selection in terms of the impact on internet sales? Intriguing issue. 
        
Tilly’s describes its stores as located in “…malls, lifestyle centers, “power” centers, community centers, outlet centers and street-front locations.” I find this an interesting description, if only because I’m not certain I know what some of the terms mean. All they say about their location selection process is “…we are modeling long term a balance between mall and off-mall. So the chain today is roughly half mall, half off-mall and our long-term targets are to have the chain reflect that. We don’t manage specifically to that, it is really a function of where is the best location in the venue where we want to be, in a trade area where we know we have an opportunity.”
 
 I’d like to hear them describe that in more detail. I am wondering if stores in different kinds of locations are of different sizes and/or carry different kinds of inventory based on the type of location they’re in.
 
As you may recall, Tilly’s, as a public company, has two classes of stock and the founding shareholders are the only ones with voting stock. I also noticed from footnote eight (Related Parties) that Tilly’s leases its corporate headquarters, distribution center, some warehouse space, another office with warehouse space, and yet another building it will use as its ecommerce distribution center, from one of the co-founders.
 
But before they signed each of those leases, “…the Company received an independent market analysis regarding the property and therefore believes that the terms of each lease are reasonable and are not materially different than terms the Company would have obtained from an unaffiliated third party.”
 
So I guess it’s okay.
 
Tilly’s had a good quarter. I’ve found their 10Q and conference call lacking information in some areas, and I’ve highlighted those areas above. Partly, of course, that’s a function of the questions the analysts ask. Maybe next time they’ll ask some of mine.