Zumiez Buys Blue Tomato

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Well, this one caught me by surprise, though I guess it was supposed to. No, not that Zumiez bought Blue Tomato, though that caught me by surprise too. What surprised me is that Zumiez has a “…strategic plan to build the leading global action sports retail business.” And, according to the press release, this acquisition is the “next step” in that plan, so I guess it’s not new.

 Zumiez CEO Rick Brooks noted, “The similarities between each organization’s culture and operating philosophies give us great confidence we can successfully leverage our combined expertise to selectively expand Blue Tomato’s European footprint and strengthen our foundation to support future international development.”

I knew about the Canadian expansion, and I knew Zumiez is planning something like 600 U.S. stores, but I didn’t know about these global plans. I don’t recall any specific discussion in any SEC filings or in a conference call. Maybe I just missed it.
 
All the currency figures I’m going to give you are in euros. The current exchange rate is 1.265 euros to the dollar. To hear Zumiez’s announcement and discussion of the transaction, you can call (877) 523-5612 and enter passcode 16847. The press release and SEC filing is available here.
 
Blue Tomato was founded in 1988 by Gerfried Schuller and has five stores in Austria. It’s got a 10,000 square foot flagship store, two smaller stores, and two other snow focused store that are seasonal. It sells “…an extensive and diverse mix of branded snow and skate hard goods, apparel, footwear, and accessories across Europe.” Its sales in the year ended April 30, 2012 was EUR 29.4 million. That’s a 27% increase over the previous year, and Zumiez says their EBITDA has grown at a compound rate of 42% over the last three years. Their net income for the April 30, 2012 year was EUR 3.5 million under Austrian accounting standards. No idea how Austrian accounting standards are different from the U.S.
 
75% of Blue Tomato’s business, or EUR 22 million in the last complete fiscal year, is done on the internet. They operate in 14 languages and sell to 60 countries, though those sales are concentrated in Europe.
 
Zumiez is paying EUR 59.5 million plus contingent payments of EUR 22.1 million over the next three years that will depend on management achieving certain performance objectives. We aren’t told the specifics, but the contingent payments will depend partly on achieving a certain EBITDA in the 2015 fiscal year and, interestingly, “…the opening of certain defined incremental stores in the European market by the end of the fiscal year ending 2015.” 
 
 Up to EUR 5 million of the contingent payment will be in Zumiez stock. The purchase price will be paid from Zumiez existing cash balances. Existing management will continue to run Blue Tomato.
 
Even ignoring the earn out, the purchase price is more than twice the last complete year’s sales. Shades of Decker’s purchase of Sanuk. I’m really wishing I knew something about Austrian accounting.
 
Zumiez paid what I take to be a big price for Blue Tomato, but they expect it to improve their earnings in the second half of their fiscal year (assuming the deal closes by July 1 as planned). But given the growth Blue Tomato has experienced in what is generally conceded to be a soft and deteriorating European economy, I can imagine why that price might be justified. And, happily for Zumiez, the Euro has weakened in the last couple of months. I wonder if Blue Tomato’s decision to sell now wasn’t based, at least in part, on the overall financial and economic situation in Europe. My hat’s off to them for deciding to sell when things were going well.
 
So Zumiez is going to open some stores in Europe, but we don’t know if they will be Zumiez or Blue Tomato stores, or both. We also have another example of a retailer whose brick and mortar stores, though important for building the brand, are a smaller part of the overall business’ revenues and profits compared to ecommerce. This is not a new trend.
 
I will look forward to watching how the Zumiez’s culture translates to Europe, seeing how and where they open stores, how they integrate inventory management, and how their respective web presences evolve to work with each other.

 

 

PacSun’s Quarterly Results: The Financial Statements Show Progress

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The strategic issue hasn’t changed. As CEO Gary Schoenfeld put it in the conference call, “Regrettably, over the past several years, PacSun lost some of its identity as a brand and its relevance among target consumers…” If they can fix that, they can succeed. Gary Schoenfeld took the job because he thinks they can. 

You can see their 10Q here. The headline is that they cut their operating loss by 34%, from $27.8 million in the quarter ended April 28th to $18.3 million in the same quarter last year.
 
Their net loss fell by even more, from $31.5 million to $15.6 million. But last year in the quarter there was a $2.8 million loss on discontinued operations (none this year- see below). And this year they had a $6.3 million gain on derivative liability associated with the Golden Gate Capital loan and $3.3 million in other expenses below the operating line that didn’t show up in the quarter last year. That’s why I started with the operating numbers.   
 
Sales grew only slightly from $171.9 million to $173.8 million. Remember they are working with 729 stores at the end of the quarter compared to 827 a year ago.
 
They had a 1% increase in comparable store sales in both men’s and women’s. It’s the first time they’ve done that in a quarter since fiscal 2005, they reported.
 
Mostly, they improved their results by increasing their gross margin from 19.3% to 23.6%. 1.6% of the increase was from higher initial markups and a decrease in promotions. 2.2% was from leveraging occupancy costs over higher comparable store sales.
 
When you close 98 stores, you get rid of a lot of costs. But of course you also lose the sales associated with those stores. CEO Schoenfeld talked a bit about these stores during PacSun’s presentation at the Piper Jaffray Consumer Conference on June 6. He noted that many of these closed stores were low volume stores and that there was simply no way to fix them. You can click through from PacSun’s web site to listen to that presentation.
 
You can see the impact of these stores from a 10Q footnote on discontinued operations (number 12 if anybody cares). As defined, they didn’t have discontinued operations for the quarter ended this April (they only closed 5 stores and the cash flow implications weren’t “significant”).
 
But in the quarter ended April 30, 2011 they closed 25 stores. Those stores had revenue of $13.9 million and generated a net loss of $2.8 million on a gross profit margin of only 16.6%. Boy, you can really hear those dogs barking. PacSun will close another 100 stores this year- mostly after the holiday season, which makes sense, and you can imagine the positive impact that will have if their numbers are similar.
 
PacSun reduced its selling, general and administrative expenses from $61 million to $59.3 million. As a percent of sales it fell from 35.5% to 34.1%.
 
The balance sheet weakened, as you would expect with continuing losses and the loan from Golden Gate. But inventories were down a bit over 10%, which you’d expect with the store closings. They pointed out in the conference call that inventories fell 3% on a comparable store basis.
 
Implicit in some of the discussion in the conference call and the presentation was the way PacSun was thinking about brands and its mix of purchased and proprietary brands. What I heard was that they were being a little more thoughtful- maybe more purposeful is a good way to put it- about how the two work with each other. Proprietary brands are no longer just what you use to make some extra gross margin to the extent your store merchandising can stand it. They are being used in coordination with purchased brands to offer customers the best assortment of pricing, design, features, and merchandising they can. PacSun isn’t the only retailer thinking that way of course, but it’s an important change nevertheless.
 
Sitting in my ivory tower, I can make various pronouncements that PacSun needs to make its stores “cool” and a destination again. At the Piper Jaffray conference, Gary Schoenfeld reminded the audience (and me) that accomplishing that involves “…doing lots of blocking and tackling…” every day. “Cool” is the results is thousands of individual actions over an extended period of time. It’s a lot of work and takes a solid management team. In the case of PacSun, the management team underwent an almost complete change after Schoenfeld came in.
 
Making that change and then getting new ideas, processes, and attitudes to filter down to the rest of the organization takes a while. You can hear it’s getting some traction now.
 
It will also be interesting to see how PacSun performs a year or so from now when those last 100 stores are closed. You don’t celebrate having to do that, but the cost, management focus, perception of the company, and just having that hanging over you isn’t good. No positive energy there.
 
Hopefully, getting that done along with the impact of the new management team will do a lot for PacSun’s performance.      
 

 

 

Zumiez’s Quarter; Ho Hum, Another Good One. How Do They Keep Doing It?

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If it wasn’t so intriguing, it would be getting boring. Zumiez’s sales for the quarter ended April 28, 2012 grew 22.7% to $129.9 million from $105.9 million in the same quarter the previous year. Comparable store sales were up 12.9%. Ecommerce sales rose 7.7% and were 6.2% of the quarter’s total sales. They think ecommerce may eventually be 10% of their sales. They had 47 more stores than they had at quarter’s end a year ago (445 in total).

You can see their complete 10Q here.

Their gross profit margin rose to 32.4% up from 31.3 in last year’s quarter. Mostly, the increase is due to leveraging their costs across more stores. That is, they have 47 more stores but didn’t have to buy another accounting system to support them, so the accounting system cost per store, to use one example, declined.

Selling, General and Administrative expenses as a percentage of sales fell by 210 basis points (2.1%). Three-quarters of that was due to operating efficiencies from having more stores, and one-quarter from a decrease in corporate costs.
 
Net income rose from $1.9 million to $4.5 million. The balance sheet is solid with no bank or other borrowing. Inventory was up of course, but it was essentially flat on a per square foot basis they tell us.
 
How does Zumiez’s do so well when others are struggling? We can get some insights from the conference call discussion. I also want to remind you of some advantages that aren’t mentioned there.
 
First, Zumiez is at a “sweet spot” in their growth curve. Their goal, you may remember, is 600 stores and right now, at 445 stores and growing, they are still able to find good places to open stores. It’s not like that’s an easy thing to do. Management reminds us of their disciplined application of a strategy they’ve followed since the company was founded, their employee development program, their commitment to infrastructure and systems, and their marketing approach of “…offering highly differentiated assortments of merchandise and delivering best-in-class service.” In other words, they run the business well.
 
Secondly, as I’ve written before, they were the first in the malls and are still the only ones, as far as I know, to offer hard goods. Actually, Billabong stores sell Sector 9 Longboards so I guess it’s not strictly true that they are the only ones anymore.
 
With so many independent specialty retailers closing due to the recession, and with all the brands opening stores in malls, Zumiez’s strategy has been validated by everybody else, but they are still the leaders in executing that strategy.
 
Now, on to some things they said in the conference call. One analyst asks the question I’m asking; “I guess I think probably the question we could ask the most is what is Zumiez doing, I mean that your sales trend is so good?” Here’s management’s answer in part.
 
CFO Marc Stolzman says, “…one of the real strengths…is our merchant’s ability to micro merchandise the product assortment. As a multi-branded retailer, that really is trying to capture each of the micro trends as they are occurring, it really takes a dedicated, very hard focus on the data, and really trying to keep everyone of those hot products in stock. Unlike a lot of our competition, we have purchase orders going back and forth with our vendors on a constant basis, and product coming into our warehouse constantly, instead of having more of an upfront purchase and then working through that inventory or replenishing it.”
 
CEO Richard Brooks adds, “…the benefit of our whole system is what you see is taking place here. With great job by our product team, great job by our sales teams on the web and in stores. And what you’re seeing is, us being able to rack quickly, move to what customers want, still being incredibly well diversified in our brands. I think last year our largest brand was about 6% of sales.”
 
Let’s consider the implications of that. If they have the systems and people to identify the micro trends, as they call them, in each store and the systems to react so they can stock according to those trends, my hat’s off to them. But how might this be impacting the brands Zumiez carries?
 
Note that no brand they carry was more than 6% of sales last June (their private label brands account for about 18% of total revenue for the year). If that’s generally true over the whole year, it limits the leverage any single brand has in negotiating with Zumiez. This is compounded by the fact that Zumiez is becoming a brand by itself and, in my judgment at least, is the most credible of the action sports retailers of any size. It’s good to have your brand in Zumiez. I’ve been saying for years that the best retailers give credibility to the brands they carry.
 
I wonder how Zumiez’s search for micro trends translates into individual store manager’s authority to select inventory and merchandise their stores. CFO Stolzman has told us, ‘…we have purchase orders going back and forth with our vendors on a constant basis…”
 
I can see how this translates into a good thing for Zumiez, and I’d love to talk with them about the algorithms they use in their system to manage their open to buy. But there’s some potential extra work, and therefore costs, for brands selling to Zumiez with, it sounds like, more, smaller purchase orders and potential frequent changes in those orders.
 
Apparently there are few brands that Zumiez absolutely has to carry, and part of their formula for success likely puts some extra demands on brands. That must make for interesting negotiations. If I had that kind of leverage I’d certainly use it.
 
Zumiez management refers to working closely with brands, and I hope part of that relationship is teaching some brands techniques that Zumiez uses to project demand and manage inventory. I can imagine that might be of benefit to everybody.

 

 

VF’s Quarter and some Broader Considerations

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As I’ve told you, I’m not so much interested in analyzing the financial statements of big multi-brand corporations like VF (or Nike, or PPR, or Jarden, etc.) but of seeing, to the extent we can, what they are doing in the action sports/youth culture space (or whatever industry we’re in). Mostly I don’t think you want to hear about Footnote F on pension plan contributions but might be interested in any strategic implications or trends I can glean.

To be honest, I do actually want to mention Footnote F briefly. VF noted one of the reasons their operating expenses as a percentage of sales rose was due to an increased pension expense. Companies with pension plans (as opposed to 401Ks) have to fund those plans based on complex actuarial calculations. When returns don’t meet what they project, they have to put more money into the pension plan, and that’s an expense. 

Continuing to do what I said I wasn’t going to do, VF noted that their gross margin for the March 31 quarter benefitted by 0.4% by a “…change in inventory accounting policy that did not recur in 2012.”
 
You’ll be pleased to learn I’m not going to go into that in detail. The point is that this arcane accounting stuff does matter. As much as we’d like it to go away, it’s hard to evaluate results without considering it.
 
VF’s sales for the quarter were $2.53 billion, up 31% from $1.94 billion in the same quarter last year. 12% of that growth was organic (from brands they already owned) and the rest was from the acquisition of Timberland. Direct to consumer business is 19% of the total, and international is 45%.
 
Net income for the quarter was $215 million, up from $201 million last year. Their balance sheet is just fine and I think with that we can move on to discussing their outdoor and action sports coalition (“the coalition”) where Vans, The North Face, Reef, and now Timberland reside.
 
The big news is that we got an actual number on Reef! Its revenues grew by 11% during the quarter. It’s not like that’s momentous or anything, but as it’s been many quarters since VF has offered any number on Reef at all, I take it as a sign that revenues were not necessarily increasing in prior quarters and now they are.
 
For the quarter, the coalition had revenues of $1.26 billion and generated an operating profit of $201 million. That’s 49.4% of the quarter’s revenues and 55.5% of its operating income. In the quarter last year the coalition’s revenue was $788 million. Of that growth of $472 million, $356 million came from the Timberland acquisition and $134.5 million was organic.
 
VF’s overall gross margin was down 1.5% during the quarter, but we’re told it was up in the coalition, though we aren’t told how much. The North Face and Vans revenues grew 14% and 25% respectively. Their direct to consumer business rose 18% and 21% respectively. The North Face’s annual sales are approaching $2 billion. Vans has passed $1 billion.
 
In the Americas, the coalition’s revenues grew 41%, with 29% of that being from Timberland. International revenues rose 84% in the quarter, with 65% of that increase from the Timberland acquisition. Ignoring the Timberland acquisition, the coalition’s operating margin grew from 18.3% in the quarter last year to 20.3% in this year’s quarter. You can see why they like this piece of their business.
With those numbers in mind, let’s list VF’s overall strategies. According to CEO Eric Wiseman, they are:
 
-Building lifestyle brands.
 
-Growing internationally.
 
-Serving consumers directly through our growing base of retail and online stores.
 
-Win with winning retailers. 80% of VF’s business is wholesale. They expect direct to consumer to top out at about 22%.
 
-Enable VF’s future. They “…recognize the importance of consistent investments behind a best-in-class infrastructure, including talent development, supply chain capabilities and technology.” The company’s capital expenditures in 2012 are expected to be $375 million.
 
-Lead in innovation. Their definition of innovation is “…something new that creates value.”
 
 With that as background, let’s consider the specific strategies for The North Face and Vans. Consistent with what CEO Wiseman said, coalition President Steve Rendle describes The North Face strategy as follows:
 
“The North Face key strategies in 2012 include delivering the most important, innovative outdoor products in the industry, leveraging our brand authenticity to connect more deeply with active consumers, providing a premium retail experience both in our owned stores and wholesale partner’s locations and growing our international business.”
 
He goes on to discuss how they connect with consumers:
 
“Centered on bold, athlete-tested, expedition-proven storytelling campaigns, we continue to invest in expeditions and events that define our brand through the eyes of the hard core user.”
 
Gee, some of these strategies sound vaguely familiar. If I were to summarize, I’d say that VF is busily turning The North Face into a $2 billion and growing action sports brand. 
 
Just one other thing on The North Face. They also note they are “…implementing a global product line rationalization program with the goal of reducing SKUS by 15% by fall of 2013.” I think every brand and retailer can benefit by reviewing their stocking units and figuring out which ones they can really do without.
 
Essentially they are pursuing the same strategies with Vans, though of course it’s already a solid action sports brand.
 
Timberland is apparently introducing apparel next year. It will be interesting to see how that’s positioned.
 
At some level, I’m starting to ask what the difference between “outdoor” and “action sports” is. Core action sports brands have often had trouble growing out into the broader market because they didn’t understand fashion or didn’t have the financial resources or infrastructure. But those brands expanded distribution enough that brands like The North Face (and maybe Timberland?) can approach it from the outside.
 
Maybe the thought for today is that it’s necessary for you to spend some time carefully defining what market you’re in. That’s hardly a new idea. But there was a time when you could say “action sports” and kind of know who your customers and competitors were. I’m not sure that’s true anymore.

 

 

Decker’s Quarter and Sanuk’s Role in it.

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I’m looking at Decker’s filings not because of a general interest in Deckers, but because they purchased Sanuk last July. Unlike Reef as part of VF Corporation, Sanuk is a significant part of Decker’s sales and profits so we can find out way more about how it’s doing as part of Deckers than we can find out about Reef as part of VF, just to use one industry example.

Maybe more importantly, we can get some insight into how Decker views Sanuk and what its plans for it are. As more and larger corporations acquire action sports/youth culture brands as a means to learn about and penetrate that market, it’s increasingly important we think that way.

Before I start, here’s the link to the 10Q in case anybody wants to see it.
 
Deckers owns Ugg, Teva, Sanuk, and a few other small brands that generated only $6 million of their March 31 quarter revenue of $246.3 million. That’s up 20.2% from $204.9 million in the same quarter last year. But they didn’t own Sanuk in last year’s quarter, and Sanuk accounted for $32.4 million of their sales in this year’s quarter, or 13.2% of the total. That $32.4 million represents 78% of Decker’s $41.5 million increase. The rest came from the Ugg brand.   Without Sanuk, sales were up 5%.
 
Decker’s overall gross margin fell from 50% to 46% mostly due to a whopping increase in the price of sheep skin used in the Ugg products. Selling, general and administrative expenses grew from $74 million to $101 million. $9 million of that was due to the acquisition of Sanuk. Decker’s net income for the quarter fell from $19.8 million to $8 million. The balance sheet is in good shape, though inventory has grown quite a bit with the largest factor being the increase in the cost of sheep skin. 
 
Deckers reduced its guidance for the year. They now expect sales to grow 14% rather than 15%. Earnings per share are expected to decline 9% to 10% rather than be flat. The company is under a bit of pressure and that was reflected in some of the analyst’s questions.
 
With that as background, where does Sanuk fit in? Obviously, given the price Deckers paid for Sanuk, expectations are high. That price was $120 million plus an earn out. As of March 31, 2012, the “contingent consideration for acquisition of business” (the expected remaining earn out) was $62.8 million. A year earlier it was $91.6 million. Deckers has already paid $30 million to the former owners of Sanuk.
 
In calculating that contingent consideration, Deckers used sales forecasts that “…include a compound annual growth rate of 17% through 2015.” Note 10 of the 10Q tells us that the earn out, without any limit on amount, is 51.8% of Sanuk’s gross profit in 2012, 36% in 2013 and 40% in 2015. No, it doesn’t say anything about 2014.
 
For that price, Deckers is expecting big things from Sanuk.
 
“We believe that the Sanuk brand is an ideal addition to the Deckers family of brands and that each of our brands can leverage off each other’s distribution channels. The Sanuk business is a profitable business that we believe provides for substantial growth opportunities within the action sports market, as well as other markets and channels in which Deckers is already established, including retailers such as Dillard’s, Journey’s, Nordstrom, Zappos.com, and REI.”
 
One wonders if Sanuk will fit as well in some of those retailers as other Decker brands. Well, that’s what you pay management to figure out; keeping a brand authentic while growing its recognition and penetration. “The product,” they say, “is resonating very well with a broader cross-section of consumers and we’re also excited about the rapid growth trajectory.” Sanuk’s margins, they tell us, are “…ahead of expectations.”
 
Before Decker’s unallocated overhead costs of $41.4 million, Decker’s income from operations for the quarter was $53.3 million. Of that, Sanuk accounted for $10.6 million, or 19.9% of the total, even though it’s only 13% of sales. After those unallocated overhead costs, Decker’s income from operations was $11.9 million.
 
By way of comparison Ugg, Decker’s largest brand, generated $91.9 million of wholesale business in the quarter (37% of the total) and operating income of $28.4 million. That’s 31% of sales compared to 33% for Sanuk. Wow- imagine what Ugg can do when the winter isn’t lousy (unless you like warm winters) and the price of sheep skin isn’t through the roof.
 
Deckers did $46.2 million in retail revenue during the quarter, almost all with the Ugg brand. They have 46 stores of their own worldwide and expect to continue opening stores in 2012 and beyond. There’s a chart on page 19 of the 10Q that breaks down brand sales between wholesale, retail and ecommerce. Except for $107,000 of ecommerce sales, all of Sanuk’s sales are wholesale.
 
When you buy a brand as a public company, you need performance from that brand commensurate with the price you paid. Inevitably and appropriately, the purchasing management pushes the acquired brand into expanded distribution utilizing the channels, expertise and beliefs about the market that lead it to acquire the brand. As an industry, that’s our reality. Successful brands reach a level beyond which they can’t go without help and the owners want their pay day.
 
If that’s what’s happening, and if it’s the future, how does it impact your company? There’s a longer article coming up on this article I think.     

 

 

SPY Optic’s Quarter: Sales and Loss Both Grow

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SPY’s sales for the quarter ended March 31 increased 22% during the quarter to $8.1 million compared to $6.7 million in the same quarter last year. The company had a net loss of $2.58 million compared to $1.52 million in the quarter last year.

Sale of SPY branded products were also up 22% to $7.9 million. The remaining sales represented close out product from the licensed brands (O’Neill, Melodies by MJB, Margaritaville). Apparently those sales represent the last of the licensed brand inventory and that’s really good news.

Though gross profit grew from $3.4 to $3.8 million, the gross profit percentage fell from 50.9% to 46.5%. Most of this decline came from blowing out the remaining inventory of the licensed brands, but there were also “…modest increases in close-out sales related to our SPY products…” SPY closeout sales were $600,000 (7.6% of SPY brand sales) during the quarter compared to $500,000 in the same quarter last year.
 
Total operating expenses rose from $4.75 million to $5.95 million. As a percentage of sales, they grew from 70.9% to 73.1%. Almost all of that came from growth in sales and marketing and general and administrative expenses. The 10Q (which you can review here) says that most of this is related to staffing for growth and marketing the SPY brand.
 
This is a good place to pause and remind you of where SPY is and how it got here. Or, you can read my earlier reports on SPY as long as you’re on my web site.
 
SPY is in business and independent only because its largest shareholder has been in a position to put a whole lot of money into SPY. The balance sheet shows $13.7 million of subordinated stockholder long-term debt. Aside from the same problems with the economy we’ve all had, SPY has had the issue (and cost) of the licensed brands, the purchase, then the sale and ongoing liability of its Italian factory, endless (and hopefully now ended) management changes, The No Fear lawsuit, and has generally been through a whole bunch of chaos- self-inflicted and otherwise.
 
But through it all somehow the SPY brand itself is still here and now growing. But to justify the expense structure they’ve put in place, it needs to grow a lot more. There’s light at the end of the tunnel, and if they can just finally get out from under all these non-operating expenses and distractions (which they are closer to) and keep growing the brand, they’ll have a viable business. But it’s going to be a long time before the major shareholder has a return on his investment.
 
Okay, back to the analysis. 
 
Interest expense has approximately doubled to $505,000 for the quarter. This reflects the increase in debt from a year ago.
 
Speaking of cash, though the company had a loss of $2.6 million, they only used $0.4 million in operating activities. That’s because they had $800,000 of noncash expenses (much of their interest, depreciation, amortization, stuff like that) and they generated $1.5 million from their “…working capital, which relates primarily to cash generated from significantly higher accounts payable and accrued expenses primarily associated with the timing of inventory purchases…” They note that paying these will require the use of cash in the second quarter.
 
Accounts payable are up almost $1.4 million since December 31, 2011. Increasing liabilities is a way to generate cash. Simply put, you have the money because you haven’t paid the other guy. Not that it would ever happen in this industry. Likewise, decreasing assets increases cash; like collecting a receivable for example. Cash flow represents the changes in balance sheet accounts. You can be making an accounting profit but be in trouble because you aren’t generating enough cash.
 
There must be a finance professor in me struggling to break out. Let’s move on to SPY’s balance sheet.
 
The balance sheet has deteriorated since a year ago, but in some ways it doesn’t matter as long as there’s willingness on the part of somebody to continue to lend to the company. Equity has declined from $840,000 to a negative $9.8 million. Total liabilities have risen from $13.3 million to $22.8 million.
 
Net inventory has risen over the year from $3.4 million to $6.3 million. Even with the sales increases, that seems like a lot. We know the March 31, 2012 inventory is clean of the licensed brand inventory because they say it is. And that number is net of a $900,000 reserve for obsolete inventory. There was a note that they had purchased some inventory during the year for anticipated sales that did not materialize, so maybe they are still working through that and perhaps it’s part of the $900,000 reserve. I would love to have more detail on the quality of that $6.3 million of inventory.
 
Gross trade receivables are $6.7 million. There’s an allowance for doubtful accounts of $300,000 then an allowance for returns of $1.4 million. The net account receivable number of $5.011 million is what’s on the balance sheet. This, I think, is related to the licensed brands. Since the reserve is already established, and the income statement hit taken, any product that comes back can just be sold without an income statement impact but will generate cash.
    
However, “The Company anticipates that it will continue to have requirements for additional cash to finance its working capital requirements and to invest in marketing and sales activities deemed necessary to achieve its desired business growth.”
 
They discuss that they have borrowed the maximum allowed under the arrangement with Costa Brava (owned by the major shareholder), though they will continue to accrue rather than pay the interest in cash. They say they intend to borrow more under their line with BFI, but as it’s an asset based line, it’s hard to know how much will be available. BFI can also yank it any time they want if they get nervous.
 
Then the company says, “However, the Company believes that it will have sufficient cash on hand and cash available under existing credit facilities to enable the Company to meet its operating requirements for at least the next twelve months without having to raise additional capital if the Company is able to achieve some or a combination of the following factors: (i) achieve desired net sales growth, (ii) improve its management of working capital, (iii) decrease its current and anticipated inventory to lower levels, (iv) manage properly the increase in sales and marketing expenditures required to achieve the desired level of business growth, and (v) achieve and maintain the anticipated increases in the available portion of its BFI credit facilities.”
 
So they are going to need additional cash. They think they’ll have enough for the year if things go well, if Costa Brava lets them continue to not pay interest in cash and if BFI lends them more money. Lots of ifs.
 
The brand seems to be performing, the impact of the licensing deals is apparently a thing of the past and they’ve got, as far as I can tell, a good team in place. There still appear to be some inventory issues and commitments to their former Italian factory that may continue to cost them money. And then there’s the acknowledgement that more cash will be required and at least some uncertainty of where it will come from if things don’t go really well.
 
At the end of the day, though, the brand seems strong enough to justify the effort, though more and higher margin sales are needed to support the infrastructure and make a profit.   

 

 

The Management Changes at Billabong

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Let’s review what’s happened. Over a few years, Billabong transformed itself from a wholesaler with a group of strong brands with some retail to a 600 store retailer that owns brands. The retail growth, I’ve written, probably took place a little faster than they had planned, but if what you think is the right opportunity appears, sometimes you just have to take a leap.

For the brand and retail strategy to work together, they have to get as much of their owned brand product as possible into owned retailers. That maximizes the gross margin dollars they earn.

Accomplishing that is tricky. Here’s how I framed the issue.
 
“How much of your owned brands can you put in a retailer before it’s perceived as a Billabong store regardless of the name on the front? How do you handle the other brands those owned stores carry when you’re trying to make room for your own higher margins brands?   How do they feel, as one of those non-owned brands, about being in those stores and the way their brand may be merchandised? I am sure Billabong management spent, and is spending, time on those issues every day.”
 
How are they doing on this core issue? All we know are their overall financial results. It hasn’t been a good three years. Mostly recently, they raised capital by selling off half of Nixon and announced a program to close stores and cut expenses. I wrote about that in detail.
 
As you know, the plot thickened on May 9 when former Target Australia executive Launa Inman was appointed Managing Director and CEO of Billabong effective May 14. Former CEO Derek O’Neill left the company on the day of the announcement. North American head Paul Naude was promoted to President of the Americas.
 
The company held a conference call that day to discuss the transition, and I’ve read the transcript. Ms. Inman had been consulting with the board for two months, but had only been focusing on the Australian operations. Throughout the call, both she and Chairman Ted Kunkel declined to discuss her long term plans for Billabong, as she hadn’t had the time to do a complete review.
 
The conversation was framed around Ted Kunkel’s statement that “…we need new leadership and we need new skill sets.” Ms. Inman’s appointment is meant to give the company the retail experience it needs given how important retail has become to Billabong. Though Ms. Inman talked about her previous experience with brands, it sounds like Billabong will rely on Paul Naude for his knowledge of brands, branding and the surf industry. Ms. Inman says Paul is going to be working very closely with her. Makes sense.
 
Ms. Inman said, “My real priority is going to have to be focusing on the greater value that we need to extract from the retail network and the strengthening supply chain. “ That’s consistent with how I framed the issue (see the quote above) in my earlier article.
 
We also learned on the call that Derek O’Neill left the company without a consulting arrangement. One analyst noted his strong connections with suppliers, customers and athletes and asked if there were any risks for Billabong in that area. Part of Chairman Kunkel’s response was to say he was “…absolutely convinced that he [Derek O’Neill] will act appropriately.”
 
Another analyst asked, “Has the Board got the necessary leadership, talent and skills to execute this future successfully?” A third, referring to Ted Kunkel, said “…a lot of your very large shareholders are telling me that you’re the guy that should be held accountable and resign,…” Mr. Kunkel didn’t think so. There’s a shocker.
 
One thing that didn’t come up in the call was that Billabong has pinned a chunk of its problems on the poor economy worldwide, the recession in Australia and the strong Australian dollar. No matter how good Launa Inman is, I doubt she can do any more about those factors than Derek O’Neill could.
 
There’s a lot of uncertainty here, and it was reflected in the conference call. Ms. Inman hasn’t had enough time to really figure out what she really wants to do. But, as came up in the call, her choices may be limited as Chairman Kunkel makes it clear that the board believes in the integrated brand and retail strategy. And, he points out they’ve got 600 stores they can’t just ignore.
 
 The issue, I guess, goes back to the ability to maximize gross profit dollars by putting owned brands into owned retail. It will be interesting to watch and see how she approaches that and whether she can do it better. 

 

 

Skullcandy’s March Quarter: Great Sales Growth. Where’s the Income?

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There’s a lot of interesting information in this10Q and the conference call. Let’s start with the income statement to see where we want to focus.  You can see the whole 10Q here.

First, we see a 47.9% growth in sales from $36 million in the quarter ended March 31, 2011 to $53.3 million in the same quarter this year. But net income rose only 4.4% from $1.07 million to $1.117 million. As a percentage of revenue, it fell from 3% to 2.1%. There was actually a $103,000 operating loss in North America. Europe’s operating income was $1.587 million. 

The gross profit margin fell from 50.8% to 48.8%. Selling, general and administrative expenses rose 70% from $14.4 million to $24.5 million. There was no related party interest expense this quarter compared to $1.72 million of such expense in the same quarter last year.
 
Okay, so those are the big numbers from the income statement. Let’s see what’s behind them.
 
International sales (meaning mostly Canada and Europe) increased 44.1% or $3.3 million to $10.9 million and represented 20.5% of sales. It was $7.6 million or 21.1% of sales in the quarter last year. Of that increase, $2.2 million was the result of the acquisition of their European distributor. 
 
Online sales were 9.7% of sales or $5.2 million, an increase of 69.4%. Management notes that the increase was mostly the result of the acquisition of Astro Gaming.
 
Domestic sales were up 46.5% to $37.2 million and were 69.8% of total sales. Management comments, “This increase primarily reflects increased volume to existing retailers.” That comment takes me to the 10Q footnote on concentration of credit risk note.
 
Skull mentioned unidentified customers A, B, and C. Customer A was 15% of the quarter’s sale. In the same quarter the previous year, A was less than 10%. Customer B fell from 14% of sales in the quarter last year to less than 10% in this year’s quarter. We don’t know how much less than 10%. Customer C was 14% in last year’s quarter and 13% in this year’s.  Sales to their top ten domestic customers accounted for 51% of sales during the quarter compared to 48% in last year’s quarter.
 
Accounts receivable owed by A, B, and C combined accounted for 36% of total receivables of $39 million, or $14 million at the end of the quarter. 
 
To me, this is a pretty significant concentration. Either customer A or C is Best Buy and the other one is Target. Best Buy has been having some problems and announced in April they were closing 50 stores this year. It had 1,103 U.S. Best Buy stores at the end of fiscal 2012.
 
Currently, Skullcandy sells in Best Buy, Target, Dick’s, Fred Meyer, Sports Authority, and Walgreens, as well as the usual specialty channels and no doubt in some others I don’t know about. I’ll get back to this when we discuss strategy.
 
The organic sales increase then (the increase ignoring acquisitions) came mostly from the U.S. but didn’t generate any profits.
 
Okay, the gross margin. Skull says “The decrease in gross margin was due primarily to lower margin sales to the closeout channel in connection with our transition to an updated product and packaging collection…” They also note that they “…are experiencing higher product costs due to increasing labor and other costs in China. If we are unable to pass along these costs to our retailers and distributors or shift our sales mix to higher margin products, our gross profit as a percentage of net sales, or gross margin, may decrease.”
 
In their prepared remarks, management noted that both unit volume and the average selling price increased double digits in the first quarter. The price increase was driven by a move towards higher priced, over the ear headphones. But the over the ear headphones have lower gross margins than the in the ear product, so that’s another reason for downward pressure on the gross margin. 
 
There was also an interesting disclosure and discussion related to gross margin in the conference call that said the following:
 
“Late in the quarter we made the decision to clear out a sizable amount of miscellaneous older products in our warehouse. This was an assortment of older odd lot products that had accumulated over the past several years. This revenue transact (sic) at margins lower than is typical for the close out channel which impacted overall gross margins by 150 basis points. While this resulted in downward pressure to our gross margins that we had not planned for in the quarter, it improved the quality of our remaining inventory on hand.”
 
This closed out inventory represented “a couple of million dollars” in incremental revenue.
 
I understand managing quarterly earnings as a public company and that inventory is part of that. But anybody in this industry who has any inventory that has “…accumulated over the past several years” and has increased in value should let me know so I can tell everybody your secret. I’ve never seen a good reason not to get rid of old inventory sooner rather than later. Well, aside from a systems issue that made it hard to identify the obsolete inventory or not wanting to take the earnings hit I mean. Still, it doesn’t sound like it’s enough to be concerned with, though it did lead to a couple of questions from the analysts.
 
Three quarters of the gross margin percentage decline, then, was the result of the closeout sale of old inventory and more current inventory in old packaging. All else being equal, we can expect margin to recover by that 1.5% in the next quarter though, as I’ve mentioned, they do point to some other potential margin pressures.
 
The increase in selling, general and administrative expense (sg&a) was “…primarily the result of $4.1 million in additional payroll related expenses, $1.8 million in additional marketing and advertising expenses and $1.0 million in additional depreciation and amortization based on increased investments in property and equipment and the acquisition of certain intangible assets in August 2011.”
 
As a percentage of revenue, sg&a increased from 40% to 46%. They refer to the growth as “critical” spending to support long-term growth, and I can see why they need to do it given the stage of the company’s development and its revenue growth. In response to a question during the conference call, they tell us that sg&a spending will be lower during the rest of the year’s quarters, and use trade show spending as an example of why the first quarter was higher. That makes sense to me, but obviously this spending can’t continue to increase as a percentage of sales. Getting that percentage to decline is a way to pull some bucks to the bottom line.
 
I don’t have much to say about the balance sheet. A year ago it kind of sucked (negative equity) because of $63 million in related party long term debt. That went away with the public offering. The March 31 balance sheet shows $11 million in cash, $110 million in equity, no long term debt and a solid current ratio. Acquisitions also make balance sheet comparisons a bit difficult.
 
Due to online price competition, Skullcandy revamped their web site and, more importantly I think, reduced by more than 60% the number of retailers approved to resell product online. The remaining retailers have agreed to follow minimum advertised pricing policies, and Skull has implemented online product tracking to enforce their policies.
 
Another thing that’s going on is the rollout of their new packaging. This of course leads to questions about what happens to the product in the old packaging. Do retailers transition gradually or all at once? How do they price and sell the old product? Skull says they “… worked with all of our retailers to map out a transition strategy that varies from linking old and new skews for a period of time to a complete reset on a certain day. In this transition we’ve anticipated the certain level of returns of the old package items and will look to steadily sell through most of this over the next several quarters.”
 
 Fair enough. It’s kind of an inevitable pain in the ass that is going to happen when you make this kind of change. It has some costs but comes under the heading of ordinary course of business.
 
If you follow Skull’s stock, you know that the market wasn’t happy with these results and management’s explanation even though Skull characterized the net income as in line with expectations. I’ve discussed above some of the things that might have given some holders of the stock pause.
 
In the past, I’ve characterized Skull’s strategy as trying to be cool in the very broad market. I’d add that it’s trying to bring coolness to some of its non-core retailers and convince those retailers that can be an asset. That’s kind of an oversimplification, but I like oversimplification when discussing broad strategies. Other industry brands, of course, are broadening their distribution, but I don’t expect to see most of them in Fred Meyer.   
 
Whether or not Skull can do that is really the bet you place when you buy Skull’s stock (I don’t own stock in any company I write about). Skullcandy management knows that keeping a first mover advantage in any market is a hard thing to do. Not only are they growing sales quickly, but they are investing in people and infrastructure, bringing product development in house, making changes in packaging, trying to merchandise differently in mass market retailers, and generally spending a whole bunch of money trying to secure and strengthen their position. They hope/believe that there is some combination of branding and technology that minimizes the extent to which headphones become commoditized. 
 
Even if they are making all the right decisions, that kind of change and growth (positive chaos maybe is a good term) has some costs and consequences, and we saw them in this review of their quarterly results. I had to spend way longer than usual trying to interpret what Skullcandy was saying in their quarterly report and conference call and it makes my Spidey senses tingle. Hopefully, for no good reason.   

 

 

What Can We Learn From Vail’s Metrics?

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Vail Resorts released some metrics today on their season through April 22nd that I thought were worth a quick review because of some of the lessons it teaches any business about market positioning. I also want to discuss briefly accounting for season passes (try and contain your excitement). You can see the complete press release here. The numbers exclude Kirkwood, which was acquired by Vail only on April 12th.

Lift ticket revenue was down just 0.3%, in spite of a 12.6% decline in skier visits. Ski school revenue rose 0.3% while dining revenue fell  4.0% and rental/retail was down 0.3%. These numbers are compared to last year’s season through April 24th.

However, revenue per skier visit from ski school, dining and rental/retail combined rose 13.4%. I commented on Vail’s January 31st quarterly results back in March and said, in the title, “If You’re a Winter Resort, Be a Big One. With Rich Customers. And Great Facilities.” These numbers don’t do anything to make me reconsider that.
 
Lift ticket revenue benefits from season pass sales. Vail CEO Rob Katz referred the strength of that program in discussing these results.   You get the money early and don’t have to give it back if it doesn’t snow or the buyers don’t come as often (Hmmm…. Some resort should look into offering a more expensive season pass with some kind of insurance feature that gave you back some amount of money if it didn’t snow a certain amount. Or maybe offered you a discount on next year’s pass.).
 
Since season passes have become more important as a revenue source for a lot of resorts, let’s talk about accounting for those revenues. The first issue is whether or not a resort is set up to scan passes. That is, do they specifically know how many times a season pass holder uses their pass?
 
Somebody I talked to who knows way more about this than I do estimated that between 50% and 65% of resorts now scan passes and I’ll bet that all the big, sophisticated ones do. Vail does.
 
Let’s assume first the case where you scan passes. If somebody paid $100 for a pass and they only come once, the resorts lift ticket revenue from that pass is $100 per visit. If they came ten times, it’s $10 per visit.   Note that when Vail talks above about revenue per skier visit increasing 13.4%, they are not including lift ticket revenue.
 
Now that $100 is in the bank. And you’re not getting any more lift ticket revenue from that pass purchaser. But if they come a lot, they may bring friends and they’ll spend money at all those other places at your mountain. And the incremental operating costs of having that customer come more often are almost nothing. So a resort at the end of the season should hope that their lift ticket per visit from the person who bought the $100 season pass is about $1.00 a visit. Because the lower the lift ticket revenue per visit from that customer, the higher the total revenue for the season.
 
What the resort would really like is for that same customer to come 100 times but not buy the season pass. That could get us into an interesting discussion about how to price season passes and how customers perceive the utility of those passes, but maybe another time.
 
What if you don’t scan? Then I guess you just estimate a certain number of days based on conditions, past experience, anecdotal evidence and maybe activity at restaurants or the ski schools or something. Hopefully, that doesn’t translate into the “wing and a prayer” approach. If the number they use is higher than it actually was, then reported skier visits are over reported. But reported revenue per visit would be too low.  
 
The person I spoke with suggested that in a season such as the one just ended, there might be a smaller percentage of visits on season passes and more on single tickets. If a resort that scans treats season passes in the oversimplified way I suggested for the $100 pass that would increase ticket revenue per visit. If resorts accurately track season pass usage, they probably saw a smaller percentage of visits on passes, more on single tickets. That should increase ticket revenue per visit.
 
The first conclusion, I guess, is that scanning is good. Without it, your financial statements can be fine (not necessarily good, but accurate), but your management information will, at best, be inconsistent from year to year. You’d want to not just scan your season passes, but every lift ticket every time it’s used.
 
I know scanning equipment costs money and takes training, but in this competitive, cost sensitive, weak economy environment it doesn’t seem like a luxury. To the 35% plus of you who are getting along without it, I’m forced to ask how much better you could do with it.
 
And if anybody out there things I’m nuts, let me know and I’ll be pleased to write about how you succeed without it.
 
The lesson is that good management information matters. I suppose I could write thousands of words on ways to account for season pass revenue (I’m actually getting kind of intrigued by it). When I was finished with what would probably be a really boring accounting discussion, I would have no doubt concluded that there were a few ways to do it that make sense. And I would further conclude that it wouldn’t matter which one you used as long as you applied it consistently and understood its strengths and weaknesses. That’s the way it is with management accounting.
 
Meanwhile, speaking of other lessons from Vail’s metrics, CEO Katz noted that cumulative snowfall was down 50% over Vail’s six resorts compared to last year. He credits a few things with their results in spite of that. They include “…increased yields from luxury and international guests.” He also points to their snowmaking capabilities, level of service, quality of facilities and available activities.
 
Now, you never expect to read these press releases and learn about how a company really, really, screwed up (Anybody who has been in business more than a few years and hasn’t really screwed up, please call me. I want to invest in whatever you’re doing). Still if, like Vail, you’ve correctly identified your customers, figured out what they want, and provide it to them, things are likely to go well.      

 

 

PPR Earnings Release and Volcom- Exit Strategies for Core Brands

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This article was occasioned by PPR’s release of its quarterly results, but that’s not really what it’s about. When PPR, or Decker’s or VF or Jarden releases earnings we’re interested in what happened mostly because we’d like to know what’s going on with Volcom, or Sanuk, or Reef, or K2/Ride. We never find out very much. 

Volcom is in PPR’s Sports & Lifestyle Division which includes Puma and Volcom (including Electric). Puma did 821 million Euro in the March 31 quarter and “other” brands in that division, which means Volcom, did 65.6 million Euro. That’s about $87 million at the March 31 exchange rate.
 
Maybe ten days ago, I wrote about Nike’s quarter, indicating it was kind of a waste of time for me to analyze Nike’s financials. Instead, I tried to focus on some comments Nike’s CEO made about sources of product innovation. The goal was to try and provide a little perspective that maybe helped smaller companies in action sports (or maybe it should be called active lifestyles?) think about how to compete and succeed in the eight hundred pound gorilla era. I think that approach is valid not just for NIKE, but for all the large companies that have bought up companies in our industry.
 
PPR management made clear in the conference call that they were disappointed in Puma’s results, and that they were working hard to improve them. At the time of PPR’s acquisition, there was speculation that Volcom might help Puma become “cool” and that we could see a Volcom shoe line created with Puma’s help.
 
At the time of the acquisition by PPR, Volcom was a company that was very strong in its market niche but, in my analysis, didn’t have anywhere to go. It was so closely identified with its niche it didn’t have the strength to break out of it. PPR, with about 4 billion Euros of revenue in the recently completed quarter, and the owner of such luxury brands as Gucci, Bottega Veneta and Yves Saint Laurent, didn’t buy Volcom for its 65 million Euros of revenue (1.6% of PPR’s total) and its growth potential in the “core” market. They didn’t buy it just to help Puma or to do Volcom shoes.
 
What do they have in mind? What do any of these behemoths have in mind?
 
At the most obvious level, PPR saw what VF has done with Vans and The North Face in its action sports segment and the associated growth rates and said, “We want a piece of that too.” If nothing else, you might expect that PPR will be interested in additional acquisitions in the space, perhaps in competition with VF.
 
Neither Nike, nor PPR, nor VF is interested in a brand that has no potential beyond the “core” market. It would just be too small to temp them. When the PPR/Volcom deal went down, I suggested, only partly in jest, that maybe PPR would expand Volcom into upper end boutiques. I (probably) don’t see any product collaboration between Volcom and Gucci. But I’ve watched brands like Nixon get some traction in that upper end market with some of their higher priced product, and I just wonder what’s possible. With PPR’s help, could Volcom open some stores that carried some new classes of Volcom product? Go and see what WESC is doing. 
 
A brand, like Volcom, that’s secure in its niche and roots has the potential to grow out of that niche without confusing its customers and destroying its market. It’s not a sure thing, and it’s not easy. It’s management’s challenge every day.
 
For better or worse, we created that opportunity when we chose to pursue growth across markets and expand distribution. We created a much larger market, but one we couldn’t take advantage of on our own.
 
Large, successful companies in action sports are small, inexperienced players in the broader fashion business. As Volcom discovered, even going public and shoring up your balance sheet doesn’t solve that problem.
 
I’m sitting here trying to think of companies who have smashed through that barrier without help. I’m not doing very well. Everybody who is thought to have the potential to go from core to fashion seems to be acquired.
 
That, I guess, is the strategic point I started to think about as I read PPR’s quarterly report and looked for information on Volcom. A successful exit strategy for an action sports brand owner, in general, will require a revenue size that is proof of concept and is big enough to be interesting to a possible buyer. There also has to be an indication that you can hope, with the right support, to move past the core market and into the much larger fashion space. You can see that’s an issue for hard goods brands.
 
In the future, then, when I review the reports of Nike, VF, Decker, Jarden, VF and any other big companies involved in our industry,  I’ll try and pull our trends and ideas that are more interesting than the change in the current ratio. More fun for me to write. Hopefully, more valuable for you to read.