Skullcandy’s Strong Quarter; It’s Amazing What an IPO Can Do for Your Balance Sheet

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My favorite footnote in Skullcandy’s 10Q for the quarter ended September 30 is footnote nine and specifically the table on long term debt (Yes, I know it’s kind of sad that I have favorite footnotes). It shows no long term debt at the quarter’s end compared to $73.4 million on December 31, 2010. They raised $77.5 million through the IPO, and you can see what they used it for. Equity is now $92 million compared to a deficit of $16 million a year ago. The current ratio improved slightly from 1.89 to 2.19. They’ve got $15 million in cash at the end of the quarter compared to $2.3 million a year ago. Their bank debt is up a bit from $11.2 million to $14.2 million. 

Sales rose 58% from $38.5 million to $60.6 million. But they said in the conference call that sales in the 3rd quarter last year were impacted by late deliveries, difficulties getting product made, and inventory shortages. They note as a result that “…our increased sales guidance implies second-half sales growth of 38%, this year, versus 29% last year.” International sales were up 75.9% to $14.6 million. They closed the acquisition of their European distributor on August 26th. Online sales were up 413% to $6.2 million. That growth includes $2.9 million of sales of Astro Gaming products which Skull acquired in May.

Skull notes that they “…rely on Target and Best Buy for a significant portion of our net sales.” Each accounted for more than 10% of sales in 2010. Best buy continues to account for more than 10% in the first three quarters of 2011. As I noted when I reviewed their initial public offering documents, the bet Skull is making is that they can be very widely distributed but still be cool and desirable to their target market.
 
The gross profit margin fell from 52% to 47.5% though gross profit rose from $20 million to $28.8 million. Like most companies, they are experiencing higher product prices in China and they rely on two manufacturers there for “substantially all” of their product line.
 
Selling, general and administrative expenses were up from $13.3 million to $20.6 million. As a percentage of sales, they declined slightly from 34.5% to 33.9%. There was an additional $1.3 million of marketing expenses during the quarter.   Interest expense to related parties was $2.77 million during the quarter. That’s gone with the IPO complete and will mean improved profitability in future quarters. Profit was $952,000 compared to a loss of $1.22 million in the same quarter last year.
 
I’ve laid out the numbers first so we could talk about Skull’s strategy and positioning a bit. Skull is the first mover in a market they identified. The brand reflects “…the collision of the music, fashion and action sports lifestyles.” They have stylized “…a previously commoditized product… The Skullcandy name and distinctive logo have rapidly become icons and contributed to our leading market position.”      
 
As you’ve probably noticed, many companies are jumping into the market Skull created. There are limited barriers to entry and, right now at least, not a lot of technological product differentiation. In those circumstances maintaining and improving its market position requires Skull to grow quickly and continue to spend freely on advertising and promotion because that’s what the product differentiation is based on. And they are.
 
But growing costs money. You need more people and more inventory and continued marketing. In the 10Q Skull notes that they “…typically receive the bulk of our orders from retailers about three weeks prior to the date the products are to be shipped and from distributors approximately six weeks prior to the date the products are to be shipped…Retailers regularly request reduced order lead-time, which puts pressure on our supply chain.”
 
It would really be interesting to know more about the order cycle so we had a better understanding of how much Skull has to build inventory with growth.
 
Skull’s management talked in the conference call about how they are addressing some of these competitive issues. They indicate they are transitioning to “…an in-house ODM model, where we originate and control more of the design and manufacturing process.” The goal is to help them create new, proprietary products. They’ve also hired a “very senior acoustics engineer” to work with the product development team. “Dual sourcing remains a key priority…” Approximately 10% of products were dual sourced at the end of the third quarter, and this is to increase over the next year.
 
Importantly, they refer to an increasing average selling price (ASP), though they don’t give any specifics. They say that was “…driven by growth in our own premium category along with mid-shift towards higher priced products across our entire line of headphones.” Domestically, their ASP was up double digits.   That’s great. When you spend a bunch of money on creating the brand, you’ve got to get higher product prices for the business model to make senses. That’s why you build a brand.
 
High end headphones feel a bit like a little luxury people can afford (and need) in a tough economy. Maybe that’s why there’s room to move up in price point. I really wish all the money from the public offering hadn’t gone right out the door to pay the investors. I’ll bet Skull could do even better things with some more working capital.                 

 

 

WeSC’s Annual Report; Numbers and Strategy

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I didn’t spot WeSC’s annual report until Shop-Eat-Surf did a story on it. Now, I’ve been through it. The Swedish approach is an interesting combination of a U.S. style annual report and our 10K SEC filings. I’ll start with a review of the numbers, but more interesting (I hope) will be a discussion of WeSC’s strategy and market position.

A Few Numbers

WeSC is a Swedish company, so their functional currency is the Krona. All numbers are in Swedish Krona unless I say otherwise. By way of reference, there were six Krona to the U.S. dollar at the end of the company’s April 30 fiscal year. A year earlier, it was 7.62.
 
WeSC’s revenues for the year ended April 30 were 408 million. At the end of fiscal year exchange rate, that’s about US$68 million, up 11.2% from 367 million the previous year. In constant currency, it grew by 20%. Gross profit margin was 45.9% down from 46.9% the previous year.
 
Pretax profit fell 28% from 56 million to 41 million. Net profit was down 40% from 48.8 million to 29.4 million. I should note that the income tax rate jumped from 13.1% to 27.7% and that pushed net income down more than you would have expected. Earnings per share fell from 6.6 to 3.98 Krona. The lower tax rate last year was due to booking a tax loss carry forward.   It was a one-time event (hopefully). 28% is a normal tax rate.
 
WeSC explains that “For the full-year 2010/2011 the dollar was an average of approximately 4.2 percent lower than in 2009/2010,” and “…the euro was an average of approximately 10.5 percent lower than in 2009/2010.”
 
“The lower dollar and euro exchange rates against the Swedish krona have had a positive effect on gross profit in the form of lower production expenses. At the same time the lower dollar and euro exchange rates against the Swedish krona have reduced revenue, because of which the total effect on gross profit was negative (the majority of purchases are in US dollar and the majority of sales are in euro).”
 
WeSC also notes that higher cotton and shipping prices had a negative impact, though they passed on some part of those increased costs as higher prices. 
 
WeSC’s lament about higher costs and exchange rates sounded an awfully lot like Billabong’s. At least WeSC didn’t have droughts and floods to worry about in their home market and isn’t as dependent there on owned retail as Billabong is. 
 
Only 18% of the company’s revenues are in the U.S. In U.S. dollars, it’s about $12.1 million at the April 30 exchange rate. Its next largest markets by revenue are Sweden, Germany, France and Italy with 16%, 10%, 9% and 9% of revenues respectively. The company reported it was in 2,410 retailers in 21 countries. 626 of those are in the U.S. The next largest is Italy with 320.
 
One of the things we’ve noticed in reviewing other company’s results is that they are focusing on growth outside of the U.S. due to better margins and growth opportunities. WeSC seems well positioned to take that approach as well. They’ve just started their program to enter China. U.S. sales for the April 30 year generated an operating loss of 2 million Krona.
 
57% of revenues come from distributors. 35% is through wholesale with the remaining 8% from direct retail sales. Like many other companies, WeSC is bringing its distribution in house as it grows. In the last fiscal year, it acquired its Danish distributor. Previously it had done the same in Germany and Austria. As of April 30, WeSC had 28 retail stores it calls concept stores. It owns eight of them directly. They plan to open more (don’t say how many) and I’m wondering how many you open before you’re seriously in the retail business and not just doing concept stores any more.
 
On the balance sheet, I noticed that inventory fell over the year from 28 million to 24.5 million. That’s interesting with the increase in sales and the acquisition of one distributor, which normally causes inventory to increase. I imagine some of it has to do with the strengthening of the Krona, which would reduce the cost of product bought in other currencies when translated back into Krona. It probably also reflects the brand exclusivity the company wants and an effort to make the distributors keep the inventory.
 
Accounts receivable rose 46% from 71.4 million to 104 million. Some or that would occur naturally with sales growth, but the strengthening of the Krona would reduce the value of receivables in other currencies, so I’m unclear as to the reason for the increase. WeSC notes the company has 57 million in overdue receivables (compared to 28 million at the end of the prior year). They have those “…without impairment losses being considered necessary.” Of this 56 million, 7.8 million is more than 91 days overdue and another 7.4 million is 61 to 90 days overdue.
 
The company’s “provisions for impaired accounts receivable at year-end” has fallen from 3.3 million to 2.6 million even as total receivables and total overdue receivables have grown significantly. I’ve seen language like this before (I think in Billabong’s financials) and it just doesn’t make sense to me that you can have a lower provision with that kind of increase in receivables. You can’t conclude that there is not an increased receivables risk, even if you assume you aren’t going to have to collect your Greek receivables in Drachmas.
 
The footnote goes on to explain that the company has 14 customers who owe the company more than a million Krona and together make up 80% of receivables. Five of those owe WeSC more than five million Krona each and account for 56% of receivable. I imagine some of those are independent distributors.
 
WeSC has no long term debt. Current liabilities rose from 52.9 million to 68.5 million as a result of a 22.3 million liabilities to credit institutions. This represents money they’ve borrowed that’s secured by receivables. The current ratio has fallen from 3.1 to 2.4, but is still more than adequate. Total debt to equity is 0.57, up from .40 a year at the end of the previous fiscal year.
 
Strategy and Some Interesting Comparisons
 
WeSC talks about its strategy as being more penetration of existing markets, entering new markets, launching new product groups, and opening more retail stores. That, of course, is more or less the same strategy that a whole bunch of other brands have. Why might WeSC succeed at it?
 
In a word, “street fashion.” It now seems like an obvious thing, but it was some time before 2000 when CEO Greger Hagelin thought of it. Or at least I think he thought of it. Reminds me of Skullcandy’s Rick Alden wandering around one day some years ago and thinking, “cool, stylish, earphones for the exploding portable electronics market.” Both seem obvious now, and I’m sure I’m not the only one who’s said, “Why didn’t I think of that?”
 
If you’re a street brand or an action sports brand, it’s hard to become a fashion brand. Ask Burton. Ask Volcom who, in my opinion, sold to PPR at least partly because they so solidly owned their own market niche that they couldn’t break out of it and continue growing without help from a fashion player.
 
But if you’re starting from scratch, selling “…streetwear with style, a cross between traditional streetwear and contemporary fashion…,” maybe you can have a foot in both markets. “Because of WeSC’s unique identify, other brands carried by retailers are seen more as complements than direct competitors.”
 
That might be a bit arrogant. But if it’s true, it’s pretty damned powerful.
 
The result, CEO Hagelin says, is that “We are one of the few brands that can sell our products in everything from action sports stores to fashion boutiques, to some of the world’s best department stores…” And they are able to “…broaden our distribution with watering down the brand…,” he goes on to say.
 
Street fashion does fit in a lot of places, and allows for product extensions, because of the brand’s positioning, that an action sports or street wear brand would have a hard time accomplishing. WeSC’s foray into high end headphones and luxury sneakers are two examples of such extensions. The company tries not to compete on price.
 
But I have to note that public companies pressured to grow seem to have an almost innate ability to screw up distribution eventually. It’s uncanny.
 
CEO Hagelin’s letter to shareholders also notes that, “The basis for our success, as well as our biggest challenge, is to continue to enlist skilled employees and outstanding WeActivists, who will help us strengthen and spread our brand and corporate culture.”
WeActivists are “…informal brand ambassadors.” They “… are strong-minded, successful individuals who are dedicated to their professions and to WeSC. WeActivists range from artists skaters and snowboarders to photographers, musicians, DJ’s and others who are extremely good at what they do, whether famous or totally unknown. WeActivists share a “street mentality,” and each one serves as an individual ambassador for their subculture.”
 
That sounds a lot like what Skullcandy does with its own extensive group of informal brand ambassadors. The focus on employees who can spread the brand and strengthen the culture sounds like Zumiez’s outstanding employee development program. There is no reason to reinvent the wheel.
 
The one thing I didn’t see in the annual report was a discussion of the competition. I hope that’s just an oversight. I’m intrigued as I think about who their competitors are, and I can’t really name them. Obviously, it’s not that they don’t have any. But if my observation that there are some barriers to being either street or fashion and moving into street fashion is accurate, then maybe WeSC has a head start.
 
But first movers, if that’s what WeSC is, aren’t always the ones who ultimately succeed in a market. It might be that WeSC is just now getting big enough to be noticed by the big fashion players, and that could force the company to pay more attention to competition. I have no knowledge of this, but perhaps the company’s longer term strategy is to get purchased by one of the very large players. I can imagine that WeSC’s positioning might attract some big multiples if those potential buyers consider it valid.   

 

 

Jarden’s September 30 Quarter And the K2 Rolling Stones’ Limited Edition Ski Collection

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As you know, Jarden is a big, multi brand company that did $6 billion in its last complete year. They’ve got over 100 brands including Crock Pot, First Alert, Coleman, and Mr. Coffee. They also own K2, Ride, 5150, Planet Earth, and Volkl and that’s pretty much why we are interested in the company, though I think I’ve got a toaster oven one of their brands made.

The brands we care about are part of their Outdoor Solutions segment that did $707 million during the quarter (the whole company did $1.8 billion) and aren’t broken out from the rest of the brands in that segment. So we’re reduced to scouring footnotes and the conference call to see if we can find anything interesting.

Here’s the link to the 10Q. I’m not going to do my standard analysis of the income statement and balance sheet because the company’s pretty solid and I can’t really pull out any specifics that are relevant to action sports and youth culture.
 
Hiding in plain sight is the fact that Jarden is another big corporation that’s in our space and has been for some years now. Guess we should be used to it. That size and the extent of their operations gives them a perspective on the on the economy and business conditions that can highlights some things we are also thinking about.
 
One of those is China. Jarden management noted in the conference call that they expect Chinese wages and benefits will “…continue to rise by 15% to 20% annually as the Chinese economy becomes more consumer oriented and that the long-term trend in shipping and transportation costs will continue upwards.” As a result, they are bringing certain products back to the U.S. for manufacture. Time Magazine wrote about it as an example of an expanding trend. No snowboards or skis yet, according to the article.
 
A second is their focus on “achieving greater efficiencies from working capital.” That’s the stuff we’ve all been working on since the economy got tough; controlling inventories, being careful with credit, watching expenses. You know- all the operating stuff you do to try and bring a few more bucks to the bottom line when sales growth is a bit harder to come by.
 
With regards to the winter sports business, we did get a few pieces of information. They note that K2, Volkl and Marker have had strong early orders, especially in Europe. They think retailers are trying to replenish record low inventory positions.
 
There’s also a note about there being a Seattle K2 concept store that’s open on a seasonal basis. I haven’t seen it, but will have to track it down. Jarden has Rawlings and Coleman outlet stores. They say they are interested in doing more retail, but don’t offer any specifics.
 
I also found out that Jarden has an investment in Rossignol (size not specified) though they aren’t involved in running it.
 
Finally there are, in fact, going to be Rolling Stone limited edition skis from K2. I really don’t know whether or not I like this idea. I’d love to talk to the marketing guys about their rationale. I was relieved to see that it’s apparently not on any snowboards. Maybe it was the threat of putting Rolling Stones graphics on Ride that made Robert Marcovitch leave town.
 
As you know, Robert was the CEO of Ride and stayed with the company when it was acquired by K2 and when K2 was acquired by Jarden. He was running (very successfully I heard) the entire Jarden winter sports business until a bit more than two months ago, when he was promoted to CEO of Coleman and sent to their headquarter in Wichita, Kansas from Seattle.
 
Now the plot thickens. We learn in the conference call that, “…Robert and his senior team have been looking at Coleman on a global basis, looking at where our customers are, and how we need to be able to respond to a growing global presence…”
 
Out of this review came a decision for Coleman to put a facility in Denver“…that puts us closer to an international airport, puts us closer to people to work in the outdoor industries in our core consumer group and we think it’s a move that is going to kind of reinvigorate Coleman and put us on its next leg of growth over the next 10 years.”
 
Nice work Robert!! I don’t actually know any of this, but it just feels like he took the job, got to Wichita, and decided he needed to be back near the mountains. I’d love to see the Power Point he used to convince senior management.
 
On a serious note, I suspect that part of his new job is to get Coleman out of Wichita figuratively as well as, I guess, literally. This is a well-known brand that I think of as reliable, workmanlike, and venerable. In some ways it feels like a utility; it always works and it’s always there when you need it, but it’s definitely not cool. Robert has the background to make it cool and expand its market reach and I’ll bet that’s part of the plan. I think there’s a lot of potential there.
 
Should be fun to watch.

 

 

Billabong Has a Meeting

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Billabong held its annual shareholders meeting October 25th.  Chairman Ted Kunkel and CEO Derek O’Neill made short speeches you can read here that contained a few pieces of interesting information. Looking over the longer term, however, I am more interested in an issue they discussed and acknowledged as being important, but didn’t really get into at the level I would have liked.

That issue is the question of what percentage of sales can be represented, in the retail they own, by the brands they own.
 
To be honest, I would have managed it exactly the way they did because I wouldn’t have been in hurry to give my competitors any more information than I needed to. And because I’m guessing the shareholders wouldn’t have wanted a two hour speech.
 
I discussed this when I wrote about their annual report for the year ended last June 30th. To summarize, when you buy retail, you do it partly to get the higher margin. But you don’t get that higher margin right away. First, you have to sell the existing inventory at normal retail margins. Second, you have to stock the stores with new inventory, but you only get higher margin when the product sells at retail- not when it goes into the store, which is when you would have gotten it before you owned the store. Third, you have to replace brands you don’t own with brands you do own. The more you do that, the more money you make.
 
Retail represented 38% of Billabong’s revenues in their last complete year, and they didn’t own all of their retail for the whole year. In a perfect world, they’d like to sell only Billabong and Billabong owned brands in their retail stores. But a West 49 store can’t be all Billabong brands and still be a West 49 store. Can it?
 
No, and Billabong knows that. Certainly it can be 30%. How about 75%? At what point does stocking a store with owned brands impact the store’s image and market position? When do the non-owned brands you carry in stores begin to feel like they aren’t getting enough space to be merchandised well and that all they are doing is helping Billabong build its competitive position against them?
 
I don’t think either Billabong or I have a solid answer to that. It probably varies according to brand and retail location. But I bet they are thinking about it every day and I wish they’d talked more about it though, as I said, I didn’t expect them to. This may be the single most important issue, among those they can control, that impacts their future results.
 
CEO O’Neill pointed out that “…the family brand share in all of the Group’s acquired retail operations has been lifting and this is leading to better profitability for the business,” so they are starting to get the promised benefits. 
 
Chairman Kunkel gave us some specific data for West 49. Before the acquisition, Billabong had an EBIDTA of about $5 million from West 49 and “…a store penetration level of 15% company owned product.” For the year that will end June 30, 2012, they expect an EBITDA of $15 million and a penetration level of 35%. Notice that the EBITDA contribution tripled but the penetration level didn’t. That’s the higher margins at work I assume.
 
Just to carry this a bit further, we see that the ratio of EBITDA to store penetration last year was 0.33. In the current fiscal year, they expect it to be 0.43. Now, I don’t quite know what to call that calculation, because I just made it up, but higher is better. If I were Billabong, I’d have a graph that tried to project it as owned brands retail sales grew. I say “tried” because I’m not sure it’s completely a linear relationship as there are other factors involved I’m not sure how to include.
 
Ted Kunkel also said some interesting things in describing the company’s rationale for its increased retail focus. He said the two key groups in the industry were the brand owners and the specialty retailers, with the brand owners being the product innovators and the retailers the “…important interface through which the brands connect with the consumers.” I wouldn’t make quite such a clear distinction. Specialty retailers have a role in product innovation- or at least in trend identification and communication that leads to product innovation.
 
He goes on to say: “One particular trend among the larger mall-based retailers has been a transition to vertical product, thereby reducing the floorspace available to authentic boardsport brands and, in many instances, watering down the appeal of the stores to the core boardsports consumer  demographic.”
 
Certainly this is a valid reason for Billabong, and other brands, to move into the retail space. But if accurate it seems to imply declining importance to the specialty retailer. Or maybe it makes the ones who are left even more important.   
 
Derek O’Neill started his presentation by reminding the audience of some of the challenges they had faced last year even beyond the ones involved in integrating new acquisitions. These included earthquakes in Japan, floods in Australia, weak economies, and a rapidly gyrating Australian dollar. I thought he made an important comment when he noted that it wasn’t the level of the Australian dollar that was a problem, but the volatility. Obviously, Billabong wasn’t the only company affected by these.
 
He also gave us information on what’s happened in the quarter that ended September 30. Total sales were up 24.7% in constant currency. Excluding acquisitions, they rose 6%. In their owned retail in the U.S. same store sales rose 6.4%. Without providing any numbers, he describes their U.S. wholesale business as “stable.” I guess that’s an improvement.
 
No numbers on the Australian wholesale business either, though he indicated that specialty account base was performing “quite well.” Their owned retail business in Australia had positive comps of three to four percent. He described Europe as having “solid revenue growth year to date” but with slightly lower margins due to higher product costs.
 
The year seems to be starting out better for Billabong, with some of the promised improvements in owned retail coming on line and more to follow. Sounds like the wholesale business is a bit more problematic.  Lacking financial statements with a bottom line, we have to be a bit cautious in reaching conclusions about their first quarter performance. My focus will continue to be on the extent to which they can push their owned brands into their retail.       

 

 

Quik Grows its Sales and Profits; I Thought I Heard a New Attitude

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At the start of the quarterly conference call, Quiksilver founder and CEO Bob McKnight always makes a short speech highlighting the good things that are going on. After Rossignol, and through the balance sheet restructuring, they felt a bit like pep talks. He would highlight in a pretty nonspecific ways some things that were going well, and often they seemed like small things. It felt like he was offering reassurance where he could.

Suddenly that’s changed. Call me crazy and hell, maybe I’m imagining this, but his speech for the July 31 quarter didn’t sound like, “It’s going to get better.” It was more like, “It is better.” That was great to hear.

Reported sales were up 14% to $503 million from $441 million in the same quarter last year. They were up 11% in the Americas to $260.2 million, 16% in Europe to $176.4 million, and 20% in Asia/Pacific to $65.5 million. The percentages in constant currency were, respectively, 11%, 2%, and (3%). Quik’s largest customer accounts for about 3% of revenue. Comparative sales for company owned retail was up 21% in the quarter. Ecommerce business rose 65%, and they expect it will represent $25 million in revenue by year end. Overall for the quarter, “…Roxy was down just slightly in the quarter as a brand. Quik was up low single digits, and DC was way up. It’s in the range of 15% to 20% higher.”
 
 
I’ve previously expressed some concern that Quik might put too much pressure on DC for growth. I’ll look forward to seeing some revenue growth from Roxy and Quik and their new collections.  
 
The new Quiksilver Girls line and Quiksilver Women’s business are expected to generate revenues of $15 million. The Waterman collection, and its European equivalent, is now a $35 million business.  Quik needs some serious growth here.
 
One of the things that really caught my attention in CEO McKnight’s talk was the strategy for certain Roxy product to provide better quality and value at a higher price. Aside from generally just liking the strategy as a point of differentiation, it seemed positive, proactive, and confident.    
 
The growth in the Americas came “primarily” from the DC brand. The DC growth came “primarily” from footwear. The Quiksilver’s brand Americas growth was mostly in accessories and Roxy’s growth was from footwear and accessories. Roxy apparel declined.
In Europe in constant currency, DC and Quiksilver revenues rose, but Roxy was down. The 3% constant currency decline in Asia/Pacific came from the Quiksilver and Roxy brands, offset by strong growth in DC.
 
Gross margin percent fell from 52.3% to 50.7%. In the Americas, it fell from 46.7% to 44.2% mostly because of higher cost of goods, but also due to some mark downs. European gross margin fell from 60.6% to 60.3%. In Asia/Pacific it was down from 52.7% to 52.4%. I note again the attractiveness of sales outside of the Americas.
 
Selling, general and administrative expense jumped 14.5% to $221 million. It remained relatively constant as a percent of sales.
Operating income actually fell a bit from $35.4 million to $33.9 million even though they had no asset impairment charge this quarter compared to a charge of $3.2 million last year. It was down in the Americas from $27.7 million to $27.1 million. In Europe it rose 34.7% from $15.6 million to $21.0 million. Asia/Pacific, even with that big gross margin percent, reported an operating loss of $2.0 million up from $1.6 million in the quarter last year. For the whole company, operating income was 6.7% of sales compared to 7.8% in the quarter last year.
     
Interest expense fell from $20.6 million to $15.7 million due to reduction in their total debt. Net income rose from $8.6 million to $10.4 million.
 
The balance sheet has improved from a year ago, with the current ration rising from 2.26 to 2.45 and total liabilities to equity down from 2.45 to 2.14. Receivables are up consistent with sales. Days sales outstanding remained at about 65 from a year ago. In constant currency, inventory rose 24% compared to a year ago. This was required to support higher revenue levels. There were also some early receipts of fall season inventory.
 
I expect to see continuous, gradual, balance sheet improvement as long as the economy doesn’t worsen. And I’d like to see some growth out of the Quiksilver and Roxy brands. But you know what? If we could see those two brands grow slowly but be managed to generate a lot of gross profit dollars, if DC continued to grow but at a moderating pace, and some of the new initiatives began to generate some significant revenues I think we’d have a financial model that might make a lot of sense at the bottom line given the projected economy.        

 

 

Zumiez’s Quarterly Results; Their Computer Systems are a Competitive Advantage

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From a financial statement analysis point of view, this is kind of boring. The balance sheet is solid enough that I’ll pay it the ultimate compliment of not discussing it. No bank debt, and the inventory was more or less constant on a per square foot basis.

In the conference call, one of the analysts even wanted to know if they had any plans for dividends or acquisitions as a way to use up some cash. The answer was no. Zumiez like’s having cash when the economy sucks. Me too.

Sales for the quarter ended July 30 were $112.2 million, up 14.9% compared to the same quarter last year. Comparable store sales grew 7.5%. They opened a net of 31 stores during the fiscal year so far, bringing their total to 424 in 38 states and Canada. There are six stores in Canada and will be 10 by end of the year. Ecommerce sales were 5.3% of total sales for the quarter compared to 2.9% in the same quarter last year.
 
Gross profit rose 22.3% to $37.3 million. As a percentage of sales it was up from 31.2% to 33.2%. This improvement largely represents cost reductions and the ability to spread costs over a larger sales base rather than higher sale prices or lower product cost.  Remember that in the quarter last year they had a bunch of expense associated with the relocation of their distribution center that they don’t have this year. That represented 1% of the gross margin improvement.
 
Sales, general and administrative (SG&A) expenses rose about $1 million, but fell as a percentage of sales from 33.6% to 30%. 2.2% of that decline was due to last year’s payment of $2.1 million to settle a lawsuit. They didn’t have that expense this quarter. The rest was due to spreading costs over a bigger store base and reducing some expenses. Rent expense, in case you’re curious, was $16.7 million or not quite 50% of the SG&A total.
 
Net income improved to $2.59 million from a loss of $1.2 million in the same quarter last year.
 
That was easy. Now for the more intriguing stuff.
 
Zumiez still has a 14.3% equity investment “…in a manufacturer of apparel and hard goods.” And I still don’t know who it is or why they have it. It doesn’t actually matter particularly, but I’m just really curious about the circumstances behind it.
 
Zumiez’s 10Q (you can see it here) runs to 39 pages, which isn’t particularly long. But 10 pages of that- 25%- are taken up by a risk factors section that starts on page 22. PacSun doesn’t even include any risk factors, though they refer to the list in their last annual report. Zumiez must have more conservative lawyers.
 
The risk factor I focused on, as we work our way over to Zumiez’s strategy, was the one that said, “Our failure to meet our staffing needs could adversely affect our ability to implement our growth strategy and could have a material impact on our results of operations.”
This comes after, and is in addition, to the one about how they could be screwed if they lose key management, which is a risk factor most companies include.
 
Basically, they’re talking about getting enough of the people who work in the stores. You might think that in this economic environment it would be a little easier to get people. It is, but Zumiez doesn’t just want competent people. It wants competent people who are active action sports participants and who are committed to the life style. Unless they want to take some big risks with their business model, they can only grow as fast as they can recruit and train those people. They think they have the potential to open another 175 to 275 stores in the U.S.
 
Next, here’s CEO Rick Brooks talking about why Zumiez is successful:
 
“The foundation of our success and what will continue to strengthen our position as the leading branded action sports retailer is our product and our people. Our diverse mix of branded apparel, footwear, accessories, and hard goods, combined with a unique shopping experience, clearly distinguishes us from the competition. Our merchandise teams continue to do a great job fine-tuning our product assortments by mixing new hard-to-find brands with larger core brands that reflect current trends in demand.”
 
Then, after talking about the difficult economic conditions, he says the following:
 
“In this environment, the mall has become highly promotional. However, we believe that as a specialty retailer of product that’s hard to find elsewhere and with the in-store and Web experience that we provide, our concept reflects the quality of our strategies. We’ll benefit in the long run by staying true to this concept and will sustain our position as a quality destination lifestyle-driven retailer.”
 
They don’t much care, in other words, what others are doing. They are going to keep focused on doing what they do. CEO Brooks put it this way in response to an analyst’s question about Zumiez’s competitors. “It’s not that so much we’re concerned with what they’re doing, Jeff, from my perspective. It’s we’re concerned about what we need to do and what our plans are.”
 
And they have the balance sheet, cash flow, and marketing positioning as the core shop in the mall to back that up. To be fair, they also have the happy circumstance of not getting much of their revenue from the juniors business.
 
I guess I’ll let Rick Brooks continue to write this article for me.
 
“…we have a lot of brands you can’t find elsewhere. So, we are not inclined to discount brands that can sell at full price. In fact, again, I think we’ve been successful in being able to push through the price increases where there is demand for those brands.”
 
“We have been trying to assort — do local assortments in stores from virtually the very beginning of Zumiez under a very simple sales-driven philosophy that you should put things in stores that people want to buy. Now with scale, that gets to be tougher and tougher, so over the last number of years, going back 10 or 15 years, we have been instituting technology enhancements to allow — to provide better tools for our merchandise teams to assort — to do local store assortments.”
 
Well, I don’t know, I guess I can see some logic to putting stuff in stores people want to buy. How exactly do you know which stuff should be in what store?
 
As CEO Brooks says, they’ve been working on that for 10 to 15 years. Serious competitive advantages don’t just spring fully formed out of a planning meeting. They are still working on it, and are “…instituting new business intelligence reporting tools.”
 
In the longer term, “…we’ll be able to do all sorts of things that we’ve never be able to do at a much more detailed level. Better size optimization within that structure, right color size, getting more fine-tuned about what mix of products and categories and lifestyles go together in each store.”
 
“And ultimately, we would — give us a few years out, there will be another evolution in that relative to around planning rack capacity and building rack capacity into this model.”
 
You can see, as I said in the title, why Zumiez’s systems are a competitive advantage. Like their personnel and hiring policies. Like their core store positioning in the malls. They aren’t invulnerable to a poor economy and see their customers buying closer to need. But thanks to certain operational efficiencies developed over many years (which is the only way they can be developed) and a consistency in applying their business model they are as well positioned as any retailer in our industry to deal with it.

 

 

PacSun’s Quarter. Can the Strategy Work in this Economy?

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PacSun’s 10Q was filed two days ago. I’ve been through it and it offers a few tidbits of interesting information. But mostly, PacSun CEO Gary Schoenfeld said a lot of what needs to be said, at least strategically, in the conference call. Here are his most relevant comments:

“The economy is not getting better and competition remains fierce for a limited amount of discretionary spending. As a team, we remain committed to our turnaround strategy that includes a long-term focus on delivering trend-right products and creating a distinctive PacSun brand identity and experience tied to our unique California heritage.”

“But we also know our store gets shopped, but we’ve got to move up higher. There’s 8, 10, 12 good choices for her in the mall. And where you sit in that pecking order is pretty important.”
 
It’s hard to argue with the strategy, though it isn’t very distinctive and has elements of what most brands want to do. If a strategy lacks uniqueness, it can be expensive to implement. The question in my mind, which hasn’t changed much since the last time I took a look at PacSun, is whether there’s enough uniqueness so they can afford to implement it given the economy and the company’s financial circumstances.
 
Oh damn, I seem to have written the conclusion first. I guess I’ll just ignore that and move on to the numbers.
 
Sales for the quarter ended July 30 fell 1.6% to $214.9 million compared to the same quarter last year. I should point out they closed 31 stores during the first six months and expect to close 50 to 60 for the whole fiscal year.  Closing stores reduced sales by $8 million in the quarter. But stores not yet included in the comparable store calculation and a slight increase in comparable store sales increased sales $5 million, resulting in the net decline of $3 million. Women’s comparable store sales rose by 1%. Men’s were flat.
 
The gross margin fell from 23.2% to 23.0%. Merchandise margins fell by 1.3% but occupancy and buying and distribution costs fell so the decline in the gross margin was minimal.
 
Sales, general and administrative expenses fell 8% from $74 million to $68 million. As a percentage of sales it was down fro0m 33.9% to 31.6%. Most of the decline was payroll expense ($5 million) and depreciation ($4 million). You kind of wonder if their strategy doesn’t call for increasing certain of these expenses, but there’s that conflict between financial capability and the requirements of the strategy.
 
Inventory on the balance sheet fell from $174.8 million a year ago to $163.3 million at July 30, 2011. They have 59 less stores than they had a year ago. Total store count is now 821, down 59 from a year ago. Reported inventory is down 7%, but management indicated it would have been down 10% if they hadn’t taken some back to school deliveries early. There’s no discussion of the impact of any higher costs on inventory levels.
 
Cash was down from $25 million to $13.3 million. The current ratio fell from 1.61 to 1.44 over the year. Total debt to equity rose from 0.85 to 1.43. At least according to this cursory evaluation, the balance sheet has weakened a bit. They have nothing drawn on their line of credit, but indicate they might have to use it if current trends continue.
 
After the quarter ended, PacSun completed negotiations with some landlords. They are making payments of $1.3 million to buy out the leases on five stores which will be closed by the end of the year. They also made deals with 95 stores to reduce rents and extend leases at more favorable terms. They indicate this will save them $9.5 million over the lives of these leases (through most of fiscal 2012). They also issued 900,000 shares of stock (to the landlords I assume) as partial compensation for these lease changes.
One cool thing they did was to roll out Apple iPads in 300 stores. I’ve had the experience of shopping where clerks are equipped with them, and I like it a lot.
 
Along with other companies, PacSun has found the start of back to school difficult. As they describe it, “…the primary drivers included declining consumer confidence and a higher competitive promotional environment.” As a result, they are anticipating that same store sales “…will be in the mid to high negative single digits for the third quarter…”
 
I really miss the good, old fashioned reliable kind of recession where supply gets ahead of demand, companies pull back, we have a recession, then move forward as demand catches up. These debt excessive leverage recessions (of which this is my first one) are hard and very, very long because people paying down debt don’t buy stuff. It sucks to be a company- any company- trying to sell product to consumers that they can easily put off buying.
 
Okay, I’m done.  Like I said, I wrote the conclusion first so if you’re looking for closure, please read it again.

 

Billabong’s Annual Report; The Relationship between Strategy and Operating Environment

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Billabong’s annual documents (which you can see here and here) provides us with a superlative opportunity to look at the nexus of a company’s strategy and its operating environment. The conference call transcript was also worth reading, but it seems to have disappeared from their web site. I can send anybody who wants it a copy.

Of course I’ll spew forth all sorts of numbers (in Australian dollars). But I want to look at those numbers in terms of the evolution of Billabong’s strategy, the impact of external factors, and some operational initiatives which, given the operating environment, are going to have a lot to do with Billabong’s future performance.

I’m sorry I’m so late getting this done, but I’ve been back on the East coast helping my mother and her husband move. Family has to come first.
 
A Transition Year
 
The year ended June 30, 2011 was a transition year. Billabong told us it would be and has been telling us that since last year.
 
Reported revenue rose 13.6% to $1.68 billion. Net profit was down 18.4% to $119.1 million. In constant currency terms, revenues were up 23.8% and net profit fell 6.9%. The currency fluctuations cost Billabong $123 million in revenues and $18 million in net profit. 
 
I will point out that Billabong had taxable income of $126.9 million and paid only $8.86 million in taxes. That’s a tax rate of 7%. Last year, they paid $57.9 million in taxes on $203 million of taxable income and had a rate of 28.5%. If this year’s tax rate had approximated last year’s rate, their net profit would obviously been a lot lower. Billabong tells us to expect a rate of 23% to 24% in the current year.
 
Here, then, is the income statement headline. Net profit fell in spite of higher sales and a very low and not to be repeated tax rate. That’s not good.    
 
Now, why was this a transition year? Mostly because of acquisitions. They closed the acquisitions of retailers West 49 in Canada, and Surf Dive ‘n’ Ski, Jetty Surf, and Rush Surf in Australia. As a result, the number of company owned stores rose from 380 at the end of the last fiscal year to 639 at the end of this one.
 
They bought the RVCA brand in the U.S. Inevitably, they ended up with a lot more inventory and took on some debt to finance all these deals. I’ll get to that when I talk about the balance sheet.
 
The retail acquisitions took their direct to consumer share of revenue from 24% of total revenue at the end of last year to 38% at the end of this one. Now that’s a transition and we’ll talk about the impact when we look at the evolution of their strategy.
 
Operationally, acquisitions leave you with a lot to do. Here’s how Billabong puts it.
 
“A range of initiatives have been pursued within the business to reflect the change in mix between wholesale and retail. The standardization of various IT systems and sales intelligence software is underway, overhead has been adjusted, management within key retail divisions has been enhanced, design teams to build faster‐to‐market product have been established and greater investment has been made into the Group’s fast‐growing and profitable online operations. The strategy to build a more robust business model in response to the changing consumer environment is on track.”
 
They also closed 65 stores during the year due mostly to high occupancy costs. Many of these were stores acquired during the year.
 
The retail acquisitions caused some initial margin dilution and, maybe more importantly, it delayed some sales revenue because once you own the retailer, you have to wait to book a sale until the product is sold to the consumer. Before they bought them, Billabong got to book the revenue when product was shipped to the retailer. 
 
It takes time and costs money before you realize the benefits of these kinds of actions. They had $12.3 million in pre-tax one-time merger and restructuring costs. As you know if you read me regularly, I find the so called nonrecurring costs a bit problematic in evaluating a company’s results. While it’s true that these exact costs won’t recur next year, there always seem to be new non-recurring costs at some level every year.
 
There’s a lot going on. Billabong expects to see more of the benefits in the current year. I’d go so far as to say they’re counting on it.
 
External Factors
 
As you saw above from the difference between as reported and constant currency numbers, Billabong got hammered by the strength of the Australian dollar (At June 30, one Australian dollar was about $1.06 U. S.). The Australian economy going into recession and getting hit with floods in Queensland didn’t help either. And, speaking of natural disasters, remember the earthquakes and tsunami in New Zealand and Japan.  Like every other industry company, they had to deal with higher product costs as the price of cotton rose. The good news is that the price has now fallen and that should start to benefit Billabong next calendar year.
 
Meanwhile, consumers worldwide are just not cooperating. “With the exception of the USA and some Asian territories, global trading conditions have generally deteriorated significantly,” is how they put it. They noted they’d seen some deteriorating in conditions in Europe during the last two months of the year.
 
Damn those pesky consumers!
 
It is, in short a tough operating environment (not just for Billabong) with a continuing high level of uncertainty. As a result, Billabong is not going to offer any earnings per share guidance until things calm down.
 
Operational Initiatives
 
 I quoted Billabong above in describing the operational initiatives they are pursuing.   Some are the direct result of acquisition, but none are bad ideas in and of themselves regardless of any acquisitions. I’ve been writing for a few years now that it was time to stop over-focusing on the top line, where revenue increases are continuing to prove tough to come by. Look instead to generate more gross and operating margin dollars through better operations.
 
I’d like to believe Billabong took my advice, but I’m afraid they probably figured it out on their own. As reported, their gross margin fell only slightly from 54.4% to 53.8%. In a promotional, higher cost environment, that seems like a good result. Even with the turn towards retail, their long term strategy implies the kind of cost management focus I advocate.
 
The initiatives they describe are not inclusive of everything they’re doing. And I wonder, as a public company, if they would have taken on quite all of it if they’d known what the year was going to be like. Still, as they get through all this stuff, assuming it goes well, on budget and on schedule, the impact on the bottom line should be substantial. 
 
Strategy
 
Early on, Billabong recognized the limits of long term growth if you’ve only got one brand. They decided to grow by paying full price for established brands with growth potential and good management in place. I suspect there won’t be any more significant acquisitions for a while. Their balance sheet wouldn’t really support them, and they’ve got more than enough on their plate.
 
Part of their strategy has always been to protect their brand names by being cautious about inventory, distribution, and promotions. Even when the recession started, they choose to lose some sales rather than devaluing their brands by discounting. As noted above, their gross margin last of year of 53.8% fell only slightly from the previous year even in a difficult environment.
 
The strategy of growing retail (hardly unique to Billabong) had, in my opinion, a number of sources. First, it was the same desire for growth that lead them to buy other brands. Second, it was the knowledge that the number of solid brands they owned made a retail strategy more viable because they had the ability to stock their owned retail with these brands and generate extra margin dollars. Third, it was their analysis of the difficulties facing the independent specialty retailers worldwide. Things go a lot smoother when you don’t have to get orders from independent retailers and then collect from them.
 
The change in strategy, if you want to call it that, was the speed of growth in retail. I doubt they planned to have 38% of revenues coming from retail at the end of the year. And remember when these retailers have been owned for a full year, the percentage will probably be higher.
 
I suspect the accelerated growth was opportunistic. They could hardly ask West 49, or any of the other retail acquisitions, to wait and be for sale next year.
 
Finally, I want to remind you of some Billabong policies and procedures that some might not call strategic, but I see as the most strategic things they do. Look at the remuneration report starting on page 12 of Appendix 4E (the second link in the second paragraph of the article).   Then check out the eight governing principals starting on page 43.
 
The remuneration report shows how Billabong works very hard to align company and employee interests. The governing principals simplify managing by making it clear what’s most important. When you sit at the desk of the senior executive, you are constantly inundated with stuff crying for attention. These principals make it easier to not waste time on the wrong stuff. Even more powerfully, they can help do the same thing for every employee in the organization if they are communicated effectively. Wonder how much time and money that can save.
 
I also noted that all directors attended all nine scheduled board meetings and three unscheduled ones as well. I love to see that level of commitment.
 
Oh Yeah- Forgot the Financial Statements
 
The first thing I want to know if what the sales would have been without the acquisitions. We know that U.S. wholesale was flat excluding RVCA. I also see that trade receivables fell from $389 million to $341 million suggesting an overall decline in wholesale sales. But I don’t have a way to isolate any currency or timing impacts so I can’t be sure. All of last year’s acquisitions occurred between July and November of 2010, so their impact on sales in the year ended June 30, 2011 is substantial.  I think I’ll call a friend.
 
The friend got back to me and tells me I didn’t read footnote 35 closely enough.  My friend is right.  Acquisitions contributed $313.3 million to revenue during the year ended June 30, 2011.  Without the acquisitions, Billabong’s revenue would have been $1.374 billion, down 7.6% from the previous year.   
 
As you may recall, Billabong operates and reports its business in four segments; Australasia, Americas, Europe, and Rest of the World. I’ll ignore the rest of the world as it only represents $2.2 million in revenue.
 
Revenues in all three regions were up significantly in constant currency but, again, I can’t isolate the impact of the acquisitions. The Americas had revenue of $844 million, up 32.5% (18.4% as reported). Europe grew by 11.5% to $338 million (it was down 1.9% as reported). Australasia grew 19.5% to $502 million.
 
As reported, EBITDA (earnings before interest, taxes, depreciation and amortization) fell in all three regions. It fell from $89 million to $55 million in the Australasia. It was down from $92 million to $80 million in the Americas and from $70 million to $54 million in Europe. Consolidated EBITDA was $192 million, down 24.3% in reported terms and 16.2% in constant currency. The reported EBITDA margin was 11.4%, down from 17.1% the previous year.
 
Without the inventory impact of the acquisitions (projected to be temporary) it would only have fallen to 13.1%. Other factors include the merger and restructuring costs of $12.3 million already mentioned and foreign exchange losses. There was also $4.5 million associated with restructuring and rolling over the company’s syndicated debt facility and some accounts payable timing issues that dragged payments into the year.
 
We’ve already talked about the external factors that influenced this.
 
Overall, selling, general and administrative expenses rose 27.5% to $599 million. That includes employee expense that rose from $226 million to $283 million. Obviously, a chunk of this increase is the result of the acquisitions. There are people working in all those places and they inconveniently want to be paid.
 
The balance sheet took a hit. Remember a couple of years ago when Billabong raised some capital even though they didn’t really need to? It’s a good thing they did because I don’t think some of the acquisitions they did would have happened without it.
 
The current ratio fell from 2.48 top 2.33. Total liabilities to equity rose from 0.82 to 1.02. Net borrowings were up from $217 million to $468 million. Their interest coverage ratio fell from 12.6 times to 6.1 times. Some of the analysts were concerned about that.
 
Inventories rose 45% from $240 million to $349 million. This includes the inventory of all the acquired companies so naturally inventory rose. But there’s more to it than that. All the inventory in the acquired stores is at full wholesale cost. Even the Billabong and Billabong owned brand inventory. Once Billabong is stocking those stores directly, the owned brand product will go into the store inventory at Billabong’s cost- not full wholesale. Branded inventory from other companies will still come in at full wholesale cost, but I’m sure Billabong hopes to make some better deals based on its larger retail purchasing power and we know they expect to increase the percentage of owned brand inventory in those stores.
 
In other words, some of that inventory increase should go away over the next year as the owned brand inventory turns over, and its share of total inventory in these stores expands. The inventory increase is partly, but not completely, a one time event.
 
There is also some excess inventory they bought in anticipation of sales that didn’t occur and some they bought and received early because of concern about possible supply constraints that didn’t emerge. In total, they see $60 to $65 million of existing current assets turning into cash during the year.
 
Net cash flow from operating activities fell from $187.2 million to $24.3 million. That’s a big drop. There are also about $86 million in acquisition payments scheduled for this year.
 
There was some wailing and gnashing of teeth from some of the analysts about the weakening of the balance sheet and the decline in operating cash flow. They should be concerned. It’s rather critical to Billabong that these operational and margin improvements kick in this year because we continue to be in an environment where sales increases may be harder to come by. Europe is weakening and, at least in my mind, it’s not certain that the U.S. will strengthen much.
 
But I also think some of the analysts were caught by surprise by the size of the increase in retail business. Rather than focusing on the strategic impact, they were concerned with the short term financial impact. I guess that’s their job. That’s why there are quarterly conference calls.
 
At the end of the day, a stock goes up in the long run because of increases in earnings. Nothing else matters. I imagine there were discussions around Billabong as to whether they should do quite so many acquisitions last year. They knew the economic environment was iffy, and they could more or less calculate the balance sheet impact. Still, if you look at their strategy you can conclude the concepts of the deal made sense even if the timing wasn’t quite what they might have preferred. It was the best path they could see to improved, long term profitability given the environment they have to operate in.
 
But they’ve taken on some additional risk to do it. The balance sheet shows it. And, like the rest of us, they can no longer count on automatically higher revenues generated by strong consumer demand.         
 
I think we can assume that the world economy is not going to miraculously rise up during the next 12 months. So what we’ll be doing is watching to see how well Billabong executes its operational strategies internally to improve its earnings and strengthen the balance sheet. 

 

 

Globe’s Annual Report; Making a Profit Under Tough Conditions

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Globe’s annual report for the year ended June 30 showed up on their web site a couple of days ago. It doesn’t contain much in the way of a detailed analysis of results, but I’ll give you what’s there.   All the numbers are in Australian dollars.  You can read it yourself if you want to.

As reported, sales were down 3.5% from $91.7 million to $88.5 million. Net profit declined from $1.31 million to $1.09 million. Globe’s tax rate fell from 59.4% to 38.7%, keeping the profit decline from being higher.

At June 30, one Australian dollar was about $1.06 U. S.
 
In constant currency, ignoring changes in the exchange rate that is, sales rose 5%. In local currencies, North America and Europe were up 6% and 12% respectively. Australian sales fell 2% “…due to weak trading conditions in the retail sector throughout the year.”
Globe’s gross profit margin declined from 47.5% to 45.9%. Earnings before interest, taxes, depreciation and amortization (EBITDA) fell 47% from $5.5 to $2.9 million.  $735,000 of that decline resulted from an increase in corporate expenses not allocated to the geographic segments.   
 
As reported, sales in all three reporting segments fell during the year. In the Australian segment, they were down from $24.4 million to $24 million. North America went from $50.8 million to $49.3 million. Europe’s numbers dropped from $16.5 million to $15.0 million. The United States, by itself, fell from $34 million to $31.6 million.
 
Over on the balance sheet, current assets are down consistent with the fall in sales. Receivables fell by 13% to $12.2 million. Past due receivables rose a bit from $2.59 to $2.72 million. None of that is more than 91 days past due in either year. More than half is past due only zero to thirty days. In other words, past due doesn’t mean it won’t be collected though no doubt there will be a few problems accounts. There always are. 
 
Inventory rose by 12.7%. While you’d like not to see that with sales falling, we’ve got to remember that higher product costs translates to more dollars in inventory even if the number of units should be the same. Current liabilities were also down. The company has no long term debt and I guess no bank debt of any kind. The current ratio remains more or less unchanged from last year at 3.0. Total debt to equity is also more or less the same at about 35%.
 
Total equity fell from $51.1 million to $46.9 million. Total contributed equity is $144.2 million, but accrued losses of $86.8 million over the life of the company reduce the total equity number.      
 
The strong Australian dollar meant that sales in the U.S. and Europe translated into fewer Australian dollars. Globe had the same problem with higher product costs from China that everybody has. That explained a chunk of the gross margin percentage decline. And the Australian economy took it’s time about going into recession but once it started did a fine job of it.
 
Lower sales and profits, of course, are lower sales and profits no matter what the reasons are, and it doesn’t look like Globe is expecting much improvement next year. “All things being equal, the performance of the business [for fiscal 2012] is expected to be approximately in line with the 2011 financial year.”

 

 

Skullcandy has a Strong Quarter

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Skull’s sales for the quarter ended June 30 rose 46.4% to $52.4 million over the same quarter last year. Net income more than doubled from $2.1 to $4.3 million. This was helped by an income tax rate that fell from 56.6% to 41.6%. Gross margin essentially stayed the same, falling just one tenth of a percent to 51.1%. You can see the 10Q here.

Selling, general and administrative expenses rose $7.9 million or 84% to $17.2 million. There was a $3.7 million increase in payroll and $2.9 in marketing expenses. There were, obviously, also higher commission expenses on higher sales. As a percentage of sales, these expenses increased 6.8% to 32.9%.

Income from operations rose, but as a percentage of revenue it fell from 25% to 18.3%.
 
Skull is dependent on two Chinese manufacturers for their product. Like everybody else, they are experiencing higher costs from China and note that their gross margin might decline if they can’t pass these costs on to consumers.     
 
Remember that this quarter closed before they went public. As a result, we have $1.9 million in related party interest expense that wouldn’t be there if the offering had closed during the quarter. Also, I’m not going to spend any time on the balance sheet as it improved dramatically after the IPO. A bunch of cash has that impact on a balance sheet.
 
Just one balance sheet comment. Inventories grew 86% from $22.6 to $41.9 million. They discuss this in the conference call. Part of the growth was due to inventory levels being too low last year, and part is because of the acquisition of Astro Gaming. They also decided to increase their stock levels in 2011 to better service their retailers.
 
In discussing their outstanding orders, Skull says, “We typically receive the bulk of our orders from retailers about three weeks prior to the date the products are to be shipped and from distributors approximately six weeks prior to the date the products are to be shipped….As of June 30, 2011, our order backlog was $10.1 million, compared to $10.0 million as June 30, 2010. Retailers regularly request reduced order lead-time, which puts pressure on our supply chain.”
 
Obviously, they can’t wait for orders from retailers before placing orders with their factories. They say in the conference call inventory growth was roughly in line with sales if you ignore those three factors. But it looks to me like some of the inventory increase results, as Skull puts it, from “…pressure on our supply chain” that’s requiring some inventory growth in excess of sales growth.
 
Okay, one more balance sheet comment. There was a statement on the call about how, because they carried their inventory under FIFO, product margins had benefitted so far this year. In the second half of the year, as they start to sell the higher cost product, that benefit will go away. This inventory accounting stuff is going to start to matter with costs rising. I wrote about it in a bit more detail when I took my last look at VF Corporation.
 
The company’s net proceeds from the public offering in July were $77.5 million. Of that amount, $43.5 million, or 56.1% of the net proceeds, went right back out the door to pay accrued interest on convertible notes, unsecured subordinated promissory notes to existing shareholders, notes in connection with already accrued management incentive bonuses, and a bunch of other moneys due to existing stockholders. They used an additional $8.6 million to pay down their asset based line of credit in early August, and they may use a portion of the proceeds to buy back their European distribution rights. If that happened, that would leave them with $10.4 million of the offering proceeds, but they continue to have availability under their line of credit. 
 
If I had all the time in the world I’d like to go review and understand in detail how Skull financed its growth. It’s always hard to finance fast growth and it got harder when the economy went south. It must have been an interesting experience. Ah well, what doesn’t kill you makes you stronger.
 
In the conference call Skull management laid out its five major strategies. The first was to further penetrate the domestic retail channel. Skull is currently in Best Buy, Target, Dick’s and AT&T wireless. Domestic sales were about 80% of the total. During the quarter net sales to three customers totaled 27.4% of total sales and represented 44.4% of receivables at the end of the quarter.   That’s down from 33.2% of total sales and 46.9% of receivables at the end of the same quarter the previous year.
 
The second was to accelerate its international business, which is largely in Canada and Europe. It grew by 47.1% in the quarter and represented about 20% of total sales. A dispute with their European distributor had reduced 2010 sales, so part of the growth is catching up.
 
They sell in 70 countries and have 26 independent distributors. They want to distribute directly in key markets. This is a strategy most other companies in our industry have utilized.
 
57 North, their European distributor, represented more than 10% of their sales during the first half of 2011. In June, Skull entered into a non-binding letter of intent to buy those distribution rights back from 57 North for $15 million. As noted above, Skull has had a previous dispute with 57 North, and from the way they describe it in the 10Q, it sounds like there’s some uncertainty the deal will close. Maybe that’s just what they have to say because it’s a non-binding letter and negotiations are still ongoing. 
 
The third strategy is to expand their premium priced product category. The “vast majority” of their products are priced in the $20 to $70 range. They said they had premium products in the pipeline that could be released in the next 24 months. I’m pretty sure they said “could,” so unless they just used the wrong word, there seems to be some doubt as to the timing.
 
One of their existing premium products is the Aviator. They launched it in Apple stores and it was exclusively available there for six month. I like that distribution strategy but of course it may cost you some sales early on.
 
A fourth strategy is to expand complimentary product categories. This includes Astro Gaming’s head phones. They bought the company in April for $10.8 million. Astro sales are obviously included in the June 30 quarter. I don’t know exactly how much those sales were.
The fifth strategy is to increase online sales. Those sales were $4.3 million in the quarter, or 8.4% of net sales. In the quarter last year, online sales were 3.9% of total sales. $2.5 million was organic growth, which tells us that $1.8 million in online sales came from the Astro Gaming product. Organic online growth was 117% over the same quarter last year.
 
These are all fine strategies. In fact, they are so good that most companies are trying to implement them. What Skull says they have done is, “…revolutionized the headphone market by stylizing a previously-commoditized product and capitalizing on the increasing pervasiveness, portability and personalization of music.” I think they are right, but we’ll have to keep watching to see if they can continue to do it better than anybody else.