Billabong’s Half Yearly Report; A Consistent Strategic Approach

/0 Comments/in /by

Billabong management told us at least six months ago that 2011 would be a “transition year” and it is. But the strategy they started to tell us about a few years ago remains intact and they continue to pursue it. As I’ve written before, I generally agree with that strategy and my experience is that companies that pursue a solid strategy over the long term succeed- unless the market environment changes and the strategy doesn’t.

Let’s set the stage a little. All the documents on which this analysis is based can be found here.

First, Billabong has always been protective of its brands. You’ll remember that when the recession hit, they resisted the urge to discount more than most other brands with the goal of maintaining their brand equity. Probably cost them some sales, but gave them better gross margins. My readers know that, in the current economic environment (which I expect we’ll be in for years) I believe in generating gross margin dollars even at the cost of some sales.
 
Second, they are probably done with acquisitions for now. They won’t say never or none, but they aren’t looking and think they have enough opportunities integrating what they’ve bought. Indeed, much of the reason Billabong describes 2011 as a transition year is because of the need to complete that integration and the positive impact they expect it to have.
 
Third, the nature and structure of Billabong has changed as their retail component and owned brands have increased. At December 31, 2010 they had 635 company owned stores. These stores represented about 40% of group revenue for the half year and all that new retail wasn’t owned for the whole six months. The core Billabong brand represents, for the first time, just under 50% of revenues. So Billabong is heavily focused on retail and is a portfolio of brands that needs to be managed. But due to the retail component, they can’t be managed completely in isolation of each other.
 
The final point I want to raise before getting to the analysis is not specific to Billabong and concerns the issues that are mostly of our control, though of course we try our best to manage them. I guess this relates to consistently pursuing your strategy unless the market changes.
 
Everybody who makes anything from cotton knows that cotton prices are at record highs. Billabong CEO Derek O’Neill points out in the conference call that cotton typically represents something like 40% of the FOB price of a garment and that some price increases are inevitable for all companies. It’s in the supply chain where he sees the biggest downside risk to their business. But inflation isn’t just in cotton, and it’s not just in China. With a soft economy, you wonder just how much of those increases you will be able to pass along. I’m pretty clear on what people with stagnant incomes, no jobs, or too much debt who have to choose from more expensive food, gas, or board shorts will tend to pick.
 
Which gets us to the subject of economic recovery, because a little inflation can be irrelevant if the world is growing, jobs are being created and customers are happy. Billabong, like most other companies I think, is assuming some improvement. Or at least they need that improvement to achieve their projected results. Here’s how they put it:
 
“…the Group expects NPAT to be flat in constant currency terms for the full financial year ending 30 June 2011 and, thereafter, assuming global trading conditions gradually improve, in particular in the Australian consumer environment, the Group expects to return to more historic EPS growth rates in excess of 10% per annum in constant currency terms.”
 
Finally, there’s the uncontrollable issue of exchange rates. This is a good time to remind you that the numbers in here are in Australian dollars (AUD) unless I say otherwise.  Between July 1 and December 31, 2010 the AUD strengthened from $US 0.85 to $US 1.02. That’s 20%. So revenues earned in US dollars were worth a lot fewer AUD at the end of the period than at the beginning. The Euro strengthened by about 11.6% over the same period against the AUD. I always felt that if you’re an investor, what you care about is your return in the currency you invested in and expect to get paid in.   But looking at constant currency provides a valuable perspective, and I’ll refer to it in this discussion.
 
Quick Look at the Balance Sheet
 
Let’s do the easy part first. Billabong has always been ahead of the curve in managing their balance sheet in anticipation of their cash flow, acquisition and expected growth requirements. In August, it increased its bank line from US$483.5 million to US$790 million and extended the two segments of the facility by one year to July 1, 2013 and July 1, 2014 respectively. This provided some flexibility, ability to fund acquisitions, lower costs, and general breathing room so opportunities and surprises could be managed.
 
Between December 31, 2009 and December 31, 2010, long term borrowings rose from $397 million to $571 million (remember those are Australian dollars). The number at June 30, 2010 was $405 million so most of the increase came in the six month period. 
The largest was West 49, acquired on September 1, 2010. There were four other acquisitions between July 2 and November 8. Note six to the financial statements reports that the “Outflow of cash to acquire subsidiary, net of cash acquired” was $203.6 million. $94 million was for West 49.
 
Inevitably, borrowing money has an impact on the balance sheet. Comparing last December 31 with the prior year, we find the current ratio has fallen from 3.81 to 2.27. Higher is usually better. Total liabilities to equity over the same period rose from 0.67 to 1.03. In this case, lower is generally better.
 
I feel obligated to report the change, but the balance sheet is still strong and it’s not like there’s an issue here. We know why it happened, that it was deliberate, and that they adjusted their lines of credit to give them the flexibility to manage it. Balance sheets can never be looked at in isolation from cash flow management. Well managed balance sheets give me a warm, fuzzy feeling.
 
Digging Into the Income Statement
 
Here are the summary numbers as reported. Half year revenues rose 15.7% to $837.1 million compared to the same period the prior year. The gross profit margin fell from 55.7% to 54.4%. Selling, general and administrative expenses rose 20% from $239 million to $287 million. Other expenses were up $33 million to $87 million. Interest expense rose from $12.2 million to $19.9 million.
Profit before tax dropped from $98.4 million to $62.3 million, or 36.7%. After tax income fell 17.9% from $69.7 million to $57.2 million. The income tax provision was down from $28.7 million to $5.1 million. The lower tax rate was largely the result of several one-time events. Without those, the tax rate would have been 24%. 
 
EBITDA (earnings before interest, taxes, depreciation and amortization) fell by 23.4% as reported. Billabong says five factors were responsible for the decline:
 
1)      The very weak retail environment in Australia.
2)      The strength of the AUD against the US$ and the Euro.
3)      The impact of the recent acquisition of retailers (see discussion below).
4)      M & A and restructuring costs of $10.3 million.
5)      An increase in global overhead costs.
 
In constant currency, revenue was up 24.4%, EBITDA fell by 17.3% and after tax profit fell 9.8%.   Revenues would have been $49 million higher. Net income would have been up $6 million. Big currency impact.
 
Billabong reports its business in three segments; Americas, European, and Australasian. Sales in the Americas were up 28.6% as reported and 38.2% in constant currency. In Europe, they fell 4.1% as reported and rose 14.3 in constant currency. In Australasia, it was 12.4% and 13%.
 
As reported, EBITDA in the Americas fell from 13.7% during the period from $33.7 million to $29.1 million. The EBITDA margin was down from 10.6% to 7.1%. In constant currency it fell 5.8% from $30.9 million to $29.1 million and, as a percent, from 10.4% to 7.1%. It was noted that conditions in the wholesale accounts were showing some improvement, but that retailers were still cautious about holding inventory. Good for them. During the conference call it was noted there were “significant declines” in sales to Pac Sun during the six months, with orders for the Billabong and Element brands down 50%.   
 
Reported European EBITDA fell 17.4% from $29.1 million to $24.1 million. The margin dropped from 17.8% to 15.3%. In constant currency, it rose 3.9% from $23.2 million to $24.1 million but the EBITDA margin declined from 16.8% to 15.3%. Growth in this segment was led by the Element, Nixon and DaKine brands.
 
For the Australasian segment, it was reported to decline 32.5% from $59.7 million to $40.3 million. The EBITDA margin fell from 24.9% to 15%. In constant currency, the numbers in this segment were almost the same as reported.           
 
The Impact and Management Challenge of Acquisitions
 
The other expenses line in the income statement includes $7.4 million in acquisition related expenses. West 49 contributed $82 million in revenue and $1.7 in after tax profit to the group for the six months ended December 31, 2010. The other acquisitions (which aren’t broken out separately because, I assume, of their smaller size) contributed revenue of $66.5 million and after tax profit of $6.2 million during the same period. If you take that $148.5 in acquisition related revenue out of the total for the period, total revenue from existing brands was $688.6 million, down 4.5% from the same period the prior year. CEO O’Neill says in the conference call that “…once we strip out the acquisitions, there was revenue growth in the underlying business…”  Strangely enough, I’m guessing both statements may be correct. The difference, which is discussed in some detail during the conference call and below, may come from how you categorize between wholesale and retail during the transition period following acquisitions. 
 
Now, let’s talk about the impact on sales and margins when a brand acquires a retailer that was a customer before it was acquired. First, revenues no longer get recognized when the brand ships its product to the retailer. The retailer has to sell that new inventory before it’s recognized as revenue by the consolidated entity. On the other hand, Billabong immediately starts recognizing sales of inventory held by the retailer as of the closing date. But if Billabong has previously sold some Billabong branded product to, say, West 49 and the product’s still in the West 49 store after the closing date, what happens? Billabong has already recognized the sale of that merchandise and taken it out of their inventory. It comes back into their inventory at the acquisition date, but at what cost? You can’t go back and adjust your financial statements based on an acquisition that occurs the next period. I guess you bring it in at the acquired company’s cost. Okay, I’ll stop. I don’t want to go all debit and credit on you. But you can see that there’s some delay in recognizing sales and the increasing gross margin.
 
And these retail acquisitions start out with lower margins than Billabong is use to earning. Before they can really influence that, according to CEO O’Neill, “…we have to sell the inventory on the floor, the inventory in the warehouse and also the inventory on order by the previous owners before we get the opportunity to affect the mix of product on the floor and generate additional wholesale margin through the sale of company owned product to the stores. So that means we have to get through one or two inventory turns of existing product from third party suppliers before we can start to realize the benefits of owning retail.”
 
Changing the product mix on the floor and getting better margins sounds so simple, but it’s pretty complex as I’ve pointed out previously. Billabong has to decide how much of which of its owned brands it can carry in the stores. Obviously, they make more money on those brands. Are they going to reduce the footprint of the brands their retail carries that they don’t own? By how much? How will those other brands react to that? CEO O’Neill says, “As far as the third-party brands go, I think we are still having a lot of discussions in terms of who’s coming with us over the medium term.” I’ll bet they are.
 
You can see why these acquisitions have a lot to do with why management calls 2011 a transition year.
 
Critical Factors
 
As you think about the things that will influence Billabong’s success, where should you focus? First, on the economy. Billabong appears to be counting on some improvement there to meet its goals. Well, why should they be different from the rest of us? I hope we get that improvement, but I’m not certain it will come quickly.
 
Second, as I discussed above, they’ve got some non-trivial work to do to realize the benefits of their retail acquisitions. It’s easy to buy a company. It’s hard work to achieve the benefits you projected when you bought it. We’ll get a better sense of how it’s going in six months or so. I was glad to see the discussion in the conference call about the progress they are making in consolidating four computer systems, warehouses, and back office functions into one. I don’t know the details, but there’s typically some money to be saved and efficiencies to be gained there.
 
Some of those efficiencies come in getting product to market a little faster and having to hold less in inventory, and I suspect that requires those integrated systems. That was also a subject of the call, but this isn’t the first time Billabong management has focused on it.
 
Accomplishing that requires that things go smoothly in the supply chain. Billabong has some concerns not just about the price of cotton, but about labor shortages and shipment delays.  Once again, this is a concern we all share.
 
Finally, with no acquisitions expected in the near future and the economy improving slowly at best, you have to ask where growth will come from. Every company that protects its brands through control of distribution eventually runs up against this. Where can you sell without diluting your brand equity?
 

My sense is that Billabong, while they wouldn’t trumpet it from the roof tops, knows sales increases are harder to come by than they’d like. But they believe that can accept slower top line growth in exchange for vertical margin, system efficiency, and certain savings you can sometimes achieve when your brands are well positioned and cautiously distributed. If they do think that, well, I agree with them

 

Skullcandy Going Public; What We Can Learn From Their SEC Filing

/0 Comments/in /by

It’s always interesting when a company in the industry decides to go public. They’ve got to drop their drawers and provide you, in their S1 filing, with information you could only speculate about previously. If you want to see it, the whole thing is here.

As of last week, Skullcandy’s drawers are well and truly dropped. Since I returned from the excellent SIA show in Denver, I’ve been through the complete filing. I’ll review the numbers with you, but what’s more interesting to me is their market positioning and strategy.

They’ve grown quickly by recognizing and exploiting the “…increasing pervasiveness, portability and personalization of music.” They stylized what had been a commodity product and connected action sports, youth culture and music in a way it hadn’t been done before. Rick Alden and his team get all the credit in the world for recognizing and capitalizing on an opportunity that was staring us all in the face.

The question for me is whether Skullcandy can retain its “first mover” advantage against companies like Sony and Nike as they inevitably expand their distribution to grow, which they will have to do as a public company. That’s the intriguing part of the discussion, but let’s go over the numbers first.
 
Historical Financial Results
In 2005, Skullcandy (hereafter known as SC) had revenue of $1.33 million. Over the next four years, its revenues were $9.1, $35.3, $80.4, and $118.3 million for the years ended December 31. Its 9 month revenues for 2009 were $70.7 million compared to $95.9 million in the first 9 months of 2010. Domestic sales represented 72.5% and 81.1% of revenue for 2009 and the first 9 months of 2010 respectively. During both these periods, Target and Best Buy each represented more than 10% of their net sales. SC products are also sold in Radio Shack, Fred Meyer, Dicks, and The Sports Authority in additional to independent retailers and specialty chains.
 
Their gross profit percentage has been north of 48.5% for 2007-2009. It was 48.2% for the first 9 months of 2009 and 51.4% for the same period in 2010. That increase in 2010 was largely the result of domestic sales, with higher margins, growing compared to a temporary decline in lower margin international sales. They had a now resolved dispute with their European distributor that cost them a few million in revenues.
 
Selling, general and administrative expenses, as a percentage of sales, have risen every period. They were 20.8% in 2007. They rose to 22.4% in 2008 and 22.9% in 2009. In the first 9 months of 2009 they were 26.4%. The number was 31.5% in the first 9 months of 2010.
 
Typically, you might see that percentage decline with growth after a certain point. I’m thinking (and I can’t ask SC because they are in what’s called the “quiet period” that follows this kind of SEC filing) that they recognize that first mover advantage doesn’t last forever and they are trying to maximize their market penetration before players with a lot more resources than they have start to catch on and catch up. They state that of the $11.5 million increase for the first 9 months of 2010, $4.1 million was for advertising and marketing. Advertising costs by themselves for the years ended December 31 2007 through 2009 were $922,000, $3.55 million, and $3.1 million respectively. Interesting to see that decline in 2009. 
 
When they talk about their athlete and musician sponsorships, they list snow, ski, skate, surf, moto, wakeboarding, BMX and Bike teams totaling 83 athletes. There is also a five member NBA crew, a 21 plus music family, and 24 members of the DJ family. But they go on to note that, “The majority of the individuals and groups listed above do not have contractual relationships with us but support our brand by wearing our products and participating in Skullcandy events and marketing activities.” I guess that means that the majority are people they flow product to and hope that product shows up being used by the personality.
 
Income from operations has risen each year. There was an operating loss of $274,000 in 2005. There were operating profits of $954,000, $9.8 million, $21.2 million and $30.4 million from 2006 through 2009. But as a percentage of revenues operating income has declined. It was 27.8% in 2007, 26.4% in 2008 and 25.7% in 2009. For the first 9 months of 2009 and 2010, it fell from 21.7% to 19.9%. With the rise in selling, general and administrative expenses and the sales to more price sensitive customers, I suppose that’s not a surprise. Given their distribution and apparent growth plans, I’d expect some further decline in that percentage. 
 
Interest expense was fairly low the first three years of SC’s life. It rose to $586,000 in 2008 and to $8.9 million in 2009. During the first 9 months of 2010 it was $6.6 million compared to $6.5 million in the same period of 2009. Well, growth takes capital and SC raised some pretty expensive money. Notes payable to related parties totaled $27.5 million at the end of 2008 and $52 million at the end of 2009. Stockholders’ equity was $20.7 million at the end of 2008 and fell to negative $18.6 million at the end of 2009. Cash was $19.4 million at the end of 2008 but only $1.7 million at the end of 2009.
 
You can see the rationale for going public. It will clean up the balance sheet, get rid of most of the interest expense, and give them growth capital. It was probably either that or sell the company.
 
Net income was $13 million in 2008, up from $6.3 million the prior year. In 2009, net income was $13.5 million, only slightly above the prior year in spite of increasing revenue from $80.4 to $118.3 million. You can see the impact of the rise in interest expense there.
 
Market Positioning and Strategy
Here it is in a nutshell: “We believe the increasing use of portable media devices and smartphones, and the growing popularity of action sports, support our anticipated long-term sales growth.”
 
Now let’s look at what they see as their competitive strengths as they describe them and, as possible, talk about each. These competitive strength statements are quotes from SC’s filing.
 
Leading, Authentic Lifestyle Brand. Skullcandy fuses music, fashion and action sports, all of which permeate youth culture. We believe the power of our brand has driven our strong market share.
 
Fair enough. Their success to date would suggest they’re right about that. But of course somewhere between lots to all successful brands in our industry would make more or less the same statement. And all those companies, at some point in their growth, have run into difficulties (not necessarily insurmountable) associated with distribution and the size and resources of their competitors as they’ve stepped away from action sports and into fashion. Why might SC be different?
 
They would probably make two arguments. First, that with each of Best Buy and Target accounting for over 10% of their sales, they’ve leaped over the distribution issue without damaging their brand and have placed SC in those channels before their hugely larger and stronger competitors could get there with comparable offerings. Second, they’d point (they do point!) to the continuing growth in portability they are taking advantage of.
 
My perception is that all products in our industry that have pushed their distribution have ended up with some competitive pressure on their prices and the extent of that pressure has been dependent on the speed and extent of their distribution.   At some point, growth requires that you end up selling to customers who are more utilitarian and price conscious and less concerned with “cool.”
 
The bigger the market, and the more attractive the opportunity, the sooner you attract competitors and the stronger they are. Nike stumbled around in action sports for a while before they got it right, but they did get it right. Skate brands will tell you what happened when the Chinese decided they could make skateboards and the market was big enough to warrant the effort. 
 
Are headphones somehow different because they’re an electronic product even though SC has positioned itself as an action sports company? At the end of the day, there’s no easy answer and it’s a question of SC’s ability to implement its strategy. It always is. How do they stay an “authentic lifestyle brand” as they grow?
 
Brand Authenticity Reinforced Through High Impact Sponsorships. We believe we were the first headphone brand to sponsor leading athletes, DJs, musicians, artists and events within action sports and the indie and hip-hop music genres. We believe this has increased our brand awareness and reinforced our credibility with our target consumers.
 
It’s an element of faith in our industry that sponsorships matter and SC seems to have done a hell of a job here. But there’s nothing stopping Sony or Nike from doing the same thing in SC’s market. Nike in particular does know a few things about sponsorship.
 
Track Record of Innovative Product Design. Our company was founded on innovation, and we employ innovative materials, technologies and processes in the design and development of our products.
 
One of the things that particularly impressed me was their focus on getting product to market quickly. I think that’s key. The company has gone from one SKU in 2003 to over 1,200 as of September 30, 2010. Note that 1,200 SKUs translate into basically 20 models with various colors and graphics. Headphone represented 87% of gross sales for the 9 months ended September 30, 2010. It was 90% in 2009.   SC talks about having utility patents on certain features and technologies and about having filed for others. They aren’t specific and I suppose they shouldn’t be. But I’d love to know if any of these offers a proprietary advantage in the market.
 
Talking about their product, they note that, “…Two of our manufacturers together accounted for 72% of our cost of goods sold in 2009 and 73% of our cost of goods sold for the nine months ended September 30, 2010. Each of these manufacturers is the sole source supplier for the products that it produces.” They have 19 independent manufacturers in total. They are working on developing some more sourcing flexibility and have opened an office in Southern China. Good idea.
 
Targeted Distribution Model. We control the distribution and mix of our products to protect our brand and enhance its authenticity.
 
Now wait a minute. I know what works and doesn’t work in distributing a product has changed, and I know the company’s been around since 2004, but as they describe it, it sounds like SC’s distribution is being targeted with a blunderbuss. They could explain it in a much more positive way.
 
Essentially, I think SC management believes, due to the nature of the product and the market, that they can be “cool” in Best Buy and that some of the distribution constraints that would apply to other action sports products don’t apply to head phones. They may be on to something. Not to get the lawyers in an uproar, but I suggest you say that in the S1 if it isn’t too late. The assumption, or the hope at least, may be that SC can eventually be almost anywhere headphone are sold without damaging the brand. This isn’t really targeted distribution as we think about it in our industry. But that doesn’t mean it isn’t carefully thought out.
 
Growth is not just anticipated to be through domestic retail. They expect to increase their international penetration, which was slowed by a dispute with a distributor in Europe (now resolved) and sell more on line. Current on line sales are 4% of revenues. They have started to add premium products selling well above the $10 to $70 retail prices of existing product. Finally, they expect to branch out in to complementary products such as cases and speaker dock models. The first of these will be out this summer.
 
Proven Management Team and Deep-Rooted Company Culture.
 
From what I’ve read and know, I’d have a hard time saying anything but, “Yes, they do.”
 
When the public offering is complete, they hope to have raised up to $125 million.  SC will use about $45 million of the proceeds to pay down debt. The balance will be “for working capital and other general corporate purposes,” which is what these things always say.
As I said when I started, Rick Alden and the Skullcandy team have done a great job identifying and taking advantage of a market opportunity that, in hindsight, looks obvious. Hell, they all look obvious in hindsight. I think the key to being able to continue their growth while keeping their profitability up is as simple, and as difficult, as keeping SC cool in Best Buy and other places as their distribution grows.
 
They are going to run into some heavy duty competition and I’m not aware that they can make a technically superior product. Or at least they don’t talk about it in the S1. But you know what? If you’re successful in business you run into competition, and that’s just the way it is. Skullcandy has done about the best job I’ve ever seen of using their first mover advantage and I look forward to watching this play out.

 

 

Quiksilver Files Its 10-K for the Year

/4 Comments/in /by

Last week, Quik filed its’ annual 10-K report with the SEC covering the quarter and year ended October 31, 2010. They announced their earnings by press release and held a conference call back in December. I’m not going to reanalyze their financials. I did that last month and you can read it here. But the north of 100 pages annual 10-K has a few additional details I thought might interest you. They aren’t presented in any particular order, except sort of from front to back in the 10-K.

Here’s a paragraph where Quik describes its average retail prices:

"We believe that retail prices for our U.S. apparel products range from approximately $20 for a t-shirt and $43 for a typical short to $190 for a typical snowboard jacket. For our European products, in euros, retail prices range from approximately €22 for a t-shirt and about €50 for a typical short to €162 for a basic snowboard jacket. In Australian dollars, our Asia/Pacific t-shirts sell for approximately $39, while our shorts sell for approximately $60 and a basic snowboard jacket sells for approximately $250. Retail prices for our typical skate shoe are approximately $60 in the U.S. and approximately €67 in Europe."
 
I don’t know that there’s anything of great import to deduce from that, but I thought some of you might like to see how it compares to what you know about retail prices. On to the next random piece of information.
 
Quiksilver branded products are sold in the Americas through about 11,500 store fronts. The Americas includes Canada, and South and Central America. Roxy is in 11,300 store fronts. The number for DC is 12,000. All three brands together are in a total of 10,800 locations in Europe and 3,360 in Asia/Pacific.
 
About 40% of revenue worldwide comes from what Quik calls “core market shops.” Interestingly, that number is lowest in the Americas at 28%. It’s 41% for Europe and 77% for Asia/Pacific. I’d love to know what their definition of “core market shop” is.
 
18% of consolidated revenues from continuing operations were from their ten largest customers. The largest single customer accounted for less than 3%.
 
Quiksilver has pretty much gotten away from seasonality, which is a good thing (take it from somebody who has had to manage cash in a snowboard company). Their biggest quarter last year was 27% of revenues and their smallest 24%.
 
At the end of the year, Quik had 540 stores worldwide. 116 are company owned outlet stores and 6 are licensed outlet stores. Quik had a total of 224 of what they call licensed stores. In these stores they “…do not receive royalty income from these licensed stores. Rather, we provide the independent retailer with our retail expertise and store design concepts in exchange for the independent retailer agreeing to maintain our brands at a minimum of 80% of the store’s inventory. Certain minimum purchase obligations are also required.”
 
I wonder what happens if those Quik brands aren’t the ones selling well, what flexibility they have with regards to that 80%, and what the purchase terms for that merchandise are.
 
Future season orders: $478 million as of November 2010 compared to $535 million at the same time the previous year. That’s a decline of 10.65%.
 
Number of employees: 6,200 full time equivalent; 2,600 in the Americas, 2,200 in Europe and 1,400 in Asia/Pacific.
 
Advertising and promotion budget: $106.9 million in 2010. It was $101.8 million in 2009 and $122.1 in 2008.
 
Allowance for doubtful accounts: It has risen from $31.3 million at the end of fiscal 2008, to $47.2 million at the end of fiscal 2009 to $48 million at the end of fiscal 2010.
 
I’ve got no great analysis to lay on you. I did that, to the best of my ability, when they announced their earnings. But I am very aware that a number of you heave a sigh of relief when I go through these somewhat arcane documents so you don’t have to. Anyway, I hope this was useful.   

 

 

Quiksilver’s Focus Goes From Balance Sheet to Income Statement; Their Quarterly and Annual Results

/0 Comments/in /by

Quiksilver continued to improve its balance sheet over the year and quarter, and this conference call is the first in a while where I’ve gotten a sense of where some growth might really come from. We’ll talk about that. 

But first, I thought some of you might actually want to know how much Quiksilver earned for the quarter and year ended October 31, 2010. Amazingly enough, if all you did was read the three pages of text in the press release and listen to the conference call, you wouldn’t know. You could finally see the actual, bottom line number on the financial statement on page four of the release.

For the quarter, Quik lost $22.1 million on revenues of $495.1 million. In the same quarter the previous year, they reported a loss of $1.78 million on revenues of $538.7 million. For the fiscal year, they lost $9.68 million on revenue of $1.837 billion. For the previous year, they had a loss of $192 million on revenue of $1.978 billion.
 
There. That wasn’t so hard. It’s not operating income. It’s not EBITDA. It’s not proforma. It’s not in constant currency. It’s just the bottom line results according to good old fashioned Generally Accepted Accounting Principles. A lot of really smart people worked really hard to give us GAAP. Couldn’t we just start with that and then provide the explanations and adjustments?
 
And we do need some of those explanations. We want to know that $119 million of last year’s loss was due to the Rossignol debacle and there’s value in being able to compare the company’s results without that impact by looking at continuing operations. But I wouldn’t want to act like that didn’t happen or that it somehow wasn’t a real loss.
 
Our industry’s popular press essentially reproduced the press release. The exception was Boardistan, who actually showed the quarterly loss in their headline.
 
On To the Numbers
 
With my rant now completed, let’s look a little harder at some of the numbers. Gross margin percentage in the quarter rose nicely from 47.6% to 53.5% compared to the same quarter last year on the decline in revenue noted above. With some help from a 3.6% reduction in selling, general and administrative expenses, this allowed them to increase their operating income from $15.1 to $34.3 million. But interest expense, not unexpectedly, jumped from $20.9 to $50.6 million. All but $16 million of that was the write down of debt issuance costs that had been capitalized and that went away when they paid off debt. The loss from continuing operations grew from $13.8 to $22 million.
 
The year ended October 31 looked a lot like the quarter. The gross profit percentage rose from 47.8% to 52.6% on the sales decline shown above. Selling, general and administrative expense fell 2.3%. Operating income was up 80% to $123.5 million. As in the quarter, interest expense rose as expected from $63.9 to $114 million, more than offsetting a reduction in income taxes from $66.7 to $23.4 million. The continuing operations result improved from a loss of $70.3 million to a loss of $8.1 million.
 
Quik’s reported business segments are the Americas, Europe, and Asia/Pacific. In the quarter, sales fell in all three, but the gross margin percentage was up in all, though gross profit dollars rose only in the Americas. All the gross profit increase, obviously, came from the Americas though it has the lowest gross margin percentage of the three segments at 48.1%. Gross profit percentage was 60.2% in Europe and 54.8% for Asia/Pacific. 
 
The big turnaround in operating income for the quarter was in the Americas, where it went from a loss of $9.3 million to a profit of $12.7 million. Europe’s operating income was up about $4 million to $20.9 million. Asia’s actually fell from $14.5 million to $8.6 million. I imagine Quik’s management would get positively giddy if they could get their Americas gross margins up to those of the other segments.
 
For the year, sales fell in the Americas and Europe and rose slightly in Asia/Pacific. Gross margin percentages were also up in all three segments, reaching 46.3% in the Americas, 59.8% in Europe, and 54.2% in Asia/Pacific. The Americas represented 46% of total revenue. Europe is 40% and Asia/Pacific 14%.
 
The trend in operating income for the year was much the same as in the quarter. The Americas went from a $25.3 million loss to a $56.9 million profit. Europe fell a bit from $104 to $94 million and Asia/Pacific was down from a profit of $23.2 million to a profit of $11.8 million.
 
The Quiksilver brand’s revenues were about $770 million during the year. Roxy and DC were each about $500 million in revenue for the year. DC is the brand where they see the most growth potential; especially outside of the Americas. They note that the juniors market is still impacted by fast fashion price point driven goods. As they put it, “Declines in the Roxy business are moderating, and it appears they will reach the bottom in fiscal 2011.”
 
The balance sheet, well, there is no balance sheet and I feel more ranting coming on. There are some balance sheet numbers (and to be fair, it’s most of the important ones) but we won’t see the complete balance sheet until the annual report. I’m actually writing this now rather than when that report comes out because at the end of the year, the SEC gives companies a lot longer to file.
 
Receivables, compared to a year ago, have fallen 14.5% to $368.4 million. They note in the conference call that days sales outstanding fell 5 days to 63 days. Inventories are essentially the same at $268 million, and they note in the conference call that it’s about where they expected inventories to be. I guess I would have expected some reduction with sales down, but given the increase in gross margin it’s hard to argue that inventories aren’t under control. Lines of credit and long term debt are down from $1.04 billion a year ago to $729 million. The debt reduction reduces their annual interest expense by $26 million. 
 
Sorry to disappoint those of you were looking forward to my scintillating discussion of the “GAAP to Pro-Forma Reconciliation” or the “Adjusted EBITDA and Pro-Forma Adjusted EBITDA Reconciliation” or even the ever popular “Supplemental Exchange Rate Information,” but I think I’ll move on to the conference call. You can view the complete press release here.     
 
Strategies for Growth
 
 CEO Bob McKnight said, “Our overriding strategic objective is to retain and remain the world’s number one action sports lifestyle company centered on boardriding. And boardriding for us has a broader connotation than just surfing, skating and snowboarding. It also includes the closely related interest of our growing global demographic. BMX, rally, moto, bike, hike, climb, paddle, mix martial arts, and many other growing action sports and activities.”
 
He identified four “primary initiatives” they would use to implement this objective. The first was to “…focus our energy and resources primarily on our three major brands.” Second is to “…focus on strategic core marketing initiatives and core athletes.”
 
The third is to “…expand through product line extensions, geographical reach, and further channel development.” This includes the Quiksilver Girls line, launching in spring. They also plan to expand DC into “…surf, snow, BMX, rally and moto.” They “… also believe we have a huge opportunity in mountain resorts and colder weather markets within the Americas and Asia-Pacific to replicate the success of our European winter outerwear business.” The geographic expansion will be where they already have a presence, but have underinvested in the past.
 
The fourth primary initiative “…is the development of incubator brand concepts that can potentially represent opportunities consistent with our culture and areas of expertise.” I don’t know quite what that means but he mentions Lib Tech and Gnu as examples, and that must have Mike and Pete reaching for their favorite adult beverage.
 
As is the case for every company of any size that wants to grow, the devil’s in the details. How do you focus on your three major brands and remain centered on boardriding but grow moto, bike, climb, paddle, mixed martial arts and others? How big a part of your business can those become before you’re no longer centered on boardriding? If you want to grow Lib Tech and Gnu “…consistent with our culture and areas of expertise,” that might be interpreted as putting some serious limits on their growth.
 
Quik’s ecommerce business is about $25 million, and they think it has the potential to be 10% of their business. They closed the year with 540 stores. They believe DC has the potential to be a billion dollar brand.
 
For 2011, they are looking for “…modest sort of growth” overall for the company. They’ve got cost pressures they estimate at five to ten percent, and expect to implement some selective price increases. They expect an overall gross margin for the year consistent with 2010. The price increase and some cost initiatives, along with favorable currency rates in some countries outside of the U.S., should allow them to achieve this in spite of costs going up.
 
What do they expect in terms of sales for 2011? “Quiksilver kind of low-single digit expectations for fiscal ’11; Roxy, down mid-singles, and DC, up somewhere in the high-single to low-double digit range. In terms of what we are expecting in regionally, much of the growth is focused on the Americas region in 2011. We are launching the Quiksilver Girls collection beginning on 2/25. Our first delivery is coming out.”   
 
It’s nice to see Quik more or less out from under their liquidity and debt problems and focused on brand building and the future. I can see that they have some possibilities for growth, but none of them feel easy and it sounds like real impact will be felt after 2011. I guess that’s just business for all of us these days. 

 

 

Billabong’s Announcement and the Industry Strategic Issues Underlying It.

/2 Comments/in /by

On December 15th, Billabong revised its projected results for the six months ending December 31, 2010. Here’s what they said:

“The Company’s previous guidance….indicated net profit after tax (NPAT) for the first half year ended December 31 2010 would be slightly lower than the prior year in constant currency terms. The Company now anticipates that first half NPAT will be 8% to 13% lower than the prior year in constant currency terms.”

You can read the press release and the transcript of the conference call they held here. It’s the “trading update” and “trading update transcript.”
 
In Australia, they pointed to cool wet weather, lower than expected wholesale repeat business, and weaker than expected consumer retail spending. In the US it was a shift in seasonal orders pushing delivery into the second half of the year, partially offset by strong retail performance in their owned stores. In both Australia and Canada, slower sell through of existing product in newly acquired retail has meant a delay in getting their owned product into this retail. To a lesser extent, Europe and Japan were also just a little soft.
 
Well, every year shit happens. To all of us. It can be weather, or product delays or a soft economy somewhere (or everywhere) or a container I put on a train from the East coast because it would be faster than a ship and then a blizzard stops the train and they “lose” the railroad car (true story) or lots of other things. They will always happen.
 
What I would like to do is get out from under the tactical issues and the uncontrollable stuff for a minute and talk about market evolution and strategy. If it sounds like I’m saying, “I told you so,” and am being a bit insufferable well, I probably am. But I’m going to enjoy it. You can trash me on my web site if it gets too bad.
 
This isn’t by the way, just about Billabong, though I’m using them as an example and their announcement was motivation to write this.
 
As attractive as all that extra margin is to brands, successfully integrating retail with your existing owned brands isn’t easy or straightforward. How much of which brand to put where, what brands to cut, whether you require a retailer to carry your owned brands even if they aren’t selling, etc. are not trivial issues. About 40% of Billabong’s revenue is from retail now.
 
Oh wait- I already wrote about that like just last week. See it here.
 
West 49 is the biggest retail acquisition (maybe the biggest acquisition?) Billabong has made. And, as far as I know, it’s the first one they made that had some elements of a turnaround to it, requiring more management time and attention I suspect.
 
Oh wait- I already wrote about that when Billabong bought West 49. See it here. Look towards the bottom of the article in the section called Nuts and Bolts.
 
Though the short term issues Billabong is facing are certainly real, I think there’s more to it than that. At the end of the day, both retailers and brands have to expect that sales increases will be harder to come by for a while. Anybody expecting a strong economic recovery in the short term is fooling themselves. Retailers and brands are (correctly in my judgment) focusing on expense and inventory control, and generating gross margin dollars. It’s not that they don’t want to grow, but they aren’t expecting it like they use to.
 
Oh wait- I already wrote about that. See it here back in 2009. And here. Okay, I guess I’ve been insufferable enough.
 
Of course if you’re a public company, you’re kind of reluctant to tell the analysts, “We don’t think we can grow much for a while!” Just wouldn’t be well received, though I doubt I’m saying anything here the analysts aren’t thinking. They are smart people.
 
Look at Billabong’s announcement as representative of issues we all face.

 

 

PacSun’s October 30 Quarter; Big Changes Take Time

/0 Comments/in /by

PacSun released their earnings and had a conference call on November 22nd. So why am I just getting around to writing about it? It’s because they didn’t file their 10Q until December 9th. I’m funny like that- I like to have the most complete information I can before doing much analysis.

What I was hoping for, but not expecting, was some detailed discussion of the company’s strategy. I didn’t really get it. The quarterly numbers are important, and I’m interested in hearing about cost pressures, and how various segments are doing. But what I really want to know is how Pacific Sunwear is going to make itself relevant to its target market again. We have the broad outlines of that strategy, but it’s too soon to know how it’s going to work out. Let’s take a short detour into the company’s recent history to understand what ‘s going on.

Recent History
 
Gary Schoenfeld took over as PacSun’s President and CEO on June 29, 2009, replacing Sally Frames Kasaks. Ms. Kasaks had a stellar background in retail, but it was never clear she quite “got it” in the action sports/youth culture space. Mr. Schoenfeld (former President and CEO of Vans) clearly does “get it” and is taking a different approach.
 
She had taken PacSun out of shoes, and he reversed that decision. Her merchandising strategy had the same assortment at all the stores. He’s moving to make it specific to location. He mentions in the conference call that he’s been cautious about rolling the localization strategy out and that the “…actual execution didn’t begin to materialize until towards back to school.” This is a critical strategy that should impact margins and sales. To some extent, the strategy had been delayed because they didn’t have somebody who could lead the execution, a problem now resolved. I talk below about their management transition and its impact.
 
Gary Schoenfeld talked about the need to reconnect with the customer and the culture in a way Sally Kasaks never did and he has rolled out some marketing initiatives to do that. As he put it in the conference call, “I talked [when he first took the job] about the importance of reestablishing our relationships with brands, improving our merchandising and selling culture within our stores, connecting with our customers, and reigniting a culture of passion and creativity within Pac Sun.” Zumiez could have written that.
 
He’s cut the number of stores from over 900 when he started to 877 at the end of October and expects to be at about 850 by the end of January 2011. Depending on how accommodating landlords are, we may see a further cut of over 100 stores in the next couple of years.
 
To me, the most telling thing he’s done is to hire eight new vice presidents and promote a ninth in the last 11 month. The most recent hires were in September and October. There were, obviously, some vice presidents who left the company as well. They’ve also changed their whole regional director team in the last 12 months.
 
The list of management on their web site only has 12 people, including Mr. Schoenfeld. So these changes represent a nearly complete turnover. My experience is it takes a minimum of at least a couple of months for a new senior manager to become fully effective.
So we’ve got a big management transition going on along with an attempt to change and reinvigorate the culture. That ought to keep them off the streets. And, like every other company, they are doing it in a difficult economy. Like other companies, they are concerned about sourcing and product costs hurting their margins. Also like other companies, they don’t expect to be able to pass these costs along to consumers. CEO Schoenfeld notes they “…are committed to working aggressively to try to maintain our gross margins next year through better product assortments, localization initiatives, detailed review of product specs, and refined pricing strategies.” I expect there will be some price increases as well.  
 
I have neither a crystal ball nor a level of arrogance that allows me to think I can predict whether they will succeed or not. With the level of change they’ve undertaken, it’s just too soon to tell. But I do know this; if PacSun had continued along the same path it was on, it would be in a world of hurt. Like I keep saying, the biggest risk is to take no risk at all.
 
And Now, the Numbers
 
I’ve got the balance sheet from a year ago to compare the October 30, 2010 one to. I feel more like I’m comparing apples to apples that way.
 
Current assets have actually grown a bit, but that’s mostly because they’ve got some more cash and that’s almost never a bad thing. In August, PacSun borrowed $28 million in term money secured by some of their facilities.
 
I was a bit surprised to see that their inventory was down only $2 million to $166 million. With lower sales, fewer stores, and the kind of tight inventory management we’re seeing from other companies, I expected more of a decline. CEO Schoenfeld said they “…were down modestly, and consistent with our expectations in terms of how were planning the quarter.” They don’t say this, but I wonder if it might have something to do with their decision to localize assortments. Maybe until they get that dialed in, it requires a little extra product.
 
Net property and equipment is down about $60 million.
 
Accounts payable rose from $63 million to $77 million. Long term liabilities were up due to the mortgage debt they took on in August. The current ratio is essentially the same, riding from 1.93 to 2.02 over the year. Total liabilities to equity is up from 0.57 to 0.89. This is mostly explained by the loss the company has incurred. At the end of the quarter, they had no direct borrowings under their line of credit and $95 million in availability.
 
Sales for the quarter fell 3.9% to $257.9 million. Comparable store sales were down 3%. That’s the smallest quarterly drop this fiscal year.  Gross profit fell from $73.4 million to $64.4 million. Gross profit margin was down from 27.4% to 25%. Most of that decline was due to a “Decrease in merchandise margin as a percentage of sales primarily due to a decrease in initial markups and increase in markdowns, particularly within denim and wovens.”
 
They cut their selling, general and administrative expenses by 20.5% to $71.1 million. As a percentage of sales, that’s down from 33.4% to 27.6%. 1.6% came from a decline in payroll expense. 2.8% was because their $2 million noncash charge in this category for underperforming stores was so much lower than the $9 million charge in the same quarter last year.
 
The reduction in expenses was what allowed them to cut their operating loss from $15.9 million in the third quarter last year to $7.1 million this year. Their net loss was about $7 million for the quarter compared to a loss of $10.9 million in the same quarter last year. Their income tax provision this quarter was only $173,000 compared to $5.04 million in the same quarter last year, so maybe we’re better off looking the pretax loss, which fell from $15.9 million to $7.1 million.
 
For nine months, the pretax loss was $53.2.0 million last year and rose to $61.1 million for the nine months ended October 30, 2010.
 
We need to give Pacific Sunwear some more time. The extent of the change they are undertaking requires it. I wish they didn’t have to climb the mountain of a lousy economy while they did it.           

 

 

What’s Up with Quiksilver? The Stock Was up Huge Today

/0 Comments/in , , /by

Quiksilver’s stock jumped 22.7% today (December 9th) from 4.75 to 5.68 on the biggest volume since last March. These kinds of moves don’t happen in a vacuum, so I thought I’d check around a bit. An investment banker I know was kind enough to alert me, and I found the following reported on Bloomberg:

“PPR SA has agreed the sale of its Conforama chain to Steinhoff International Holdings Ltd. for 1.625 billion euros, La Tribune reported, without saying where it got the information.”
“PPR Chief Executive Officer Francois-Henri Pinault is interested in buying Quiksilver Inc., La Tribune said. He has reestablished contact with the company, as well as with Rhone Capital, which holds a 19 percent stake in the California-based maker of clothing for skateboarders and surfers, according to the newspaper.”
The link is here, though I’m quoting the whole thing.
Who’s PPR SA? I didn’t know either, but here’s a blurb on them from Yahoo Finance.
PPR SA Company Profile
PPR has transformed itself from a conglomerate to the world’s third-largest luxury group (behind LVMH and Richemont). PPR’s stable of global luxury brands includes a 99% stake in Italian luxury goods company Gucci Group, and luxury brands Alexander McQueen, Balenciaga, Boucheron, Bottega Veneta, Stella McCartney, and Yves Saint Laurent, among others. The group’s other activities include the multichannel merchant Redcats, Fnac music and book stores, the Conforama chain of household furniture and appliance stores, and the German athletic shoemaker PUMA. More than half of PPR’s sales are generated outside of its home country. PPR is run by Fran�ois-Henri Pinault, the son of its founder Fran�ois Pinault.
Is this actually going to happen? Somebody thinks something is going to happen given the way the stock jumped.   I don’t know what the price might actually turn out to be, but Rhone Capital would sure make a nice return quickly.
Love to do more analysis of this, but the unfortunate fact is I don’t have any information.  Maybe soon!  Or maybe not.

 

 

Zumiez’s October 30 Quarter and Its Position in the Market

/2 Comments/in /by

This shouldn’t take long. The balance sheet has more cash than a year ago, no long term debt, and is solid. The inventory increase of 8.8% since a year ago is a lot less than the 20% sales increase for the quarter (but remember that inventory is at cost and revenue at retail price). Zumiez indicated in the conference call that efficiencies provided by the new Southern California warehouse had a lot to do with their ability to better control inventory. They expect to continue to increase inventory by less than sales.  You can see the complete filing here.

Sales grew from $113 million to $136 million. Gross profit margin rose from 35.4% to 39%. If that looks low, remember they include occupancy and certain other costs in their cost of goods sold calculations. Other companies don’t do that. They indicated the increase was about half product margin improvement and half a decrease in store occupancy costs. In 2007 it cost them around $440,000 to open a new store. Now those costs are down to about $340,000 due to better deals with landlords and their improved operations.

Ecommerce sales for the quarter were about 4.4% net sales for the quarter, or a bit less than $6 million. In the same quarter the previous year, they were 2% of net sales, or about $2.3 million. They expect that ecommerce will be “…substantially larger for us over the next five years,” but they weren’t specific.
 
Management indicated they were learning a lot from the ecommerce business. They can read trends faster and allocate inventory better. They noted that operating margins in stores and on the web were not very different. Those of you who have actually invested in the systems and people it takes to run a really responsive ecommerce site won’t be surprised at that.
 
Selling, general and administrative expenses were up 7.3% but fell as a percentage of sales from 28% to 25.1%. Of the 300 basis points decline, 140 came from “store operating expense efficiencies and the rest from accounting changes I won’t bore you with the details of. Net income rose 143% to $12.3 million. That’s 9.1% of net sales compared to 4.5% in the same quarter last year.
Now for some fun facts about Zumiez.
  • 400 stores in 37 states. They opened 27 in 2010. They expect to open “a handful” in Canada in 2011, but not enough to have a meaningful impact on revenue. You know, I wonder if they ever really thought they were going to buy West 49 or if they just hoped to get a peek at their numbers.
  • They’ve still got this 14.3% interest in a manufacturer of apparel and hard goods I reported last quarter. They still won’t tell me who it is or how they got it. Rats.
  • Unredeemed gift cards at October 30 were $1.83 million. They don’t count them as income until they are used, but after 24 months they take unused card balances as revenue because their experience is that they won’t ever be used after that. Got to love that free money.
  • Pages 29-38 of their 10Q are all risk factors. It’s the longest section of the report. I just find it interesting that a company that seems to be doing so well could feel the need to talk about so many things that might go wrong. Must be the lawyers.
  •  Private label represented 15.7% of net sales last year. That number will be higher for 2010, but they didn’t say what it will be.
  • Their long term goal is to have 600 to 700 stores. I imagine that’s based on their analysis of how many malls there are that can support their concept. But I wouldn’t be surprised if they’ve looked at what happened to PacSun and said to themselves, “Nobody need 900 Zumiez stores.”
  • They bought snow product cautiously and might be a little tight on inventory if the snow conditions are good. Good for them. Leftover snowboard inventory is a dagger in the heart. Okay, maybe I’m overdramatizing, but you know what I mean.
  • Back in 2006, their sales per square foot were about $500. They think they could reach their operating goals now with square foot sales of maybe $440 or $460 due to operating leverage, the web, and their new warehouse. 
CEO Brooks say they want to “Stay true to who we are and focus on things that distinguish Zumiez from the competition.” That means carrying hard to find brands, providing a unique shopping experience, and having the best in class customer service. My guess is that their growth will be constrained by their ability to staff stores with the kind of action sports enthusiasts they want, but I’d characterize that as happening in a good cause. They’d be crazy to grow faster than they are able to perpetuate their culture in new stores.
 
Zumiez, like everybody else, is concerned about the strength of the economic recovery, issues with certain product supply, and increasing product cost due to cotton costs, labor, shipping, and other factors. Yet they seem uniquely positioned as the only hard goods carrying mall shop with at least a feel of independent core shops. And the days of it being evil to be in mall are long gone based on the other brands that are there.   

 

 

Making Changes in a Difficult Market; Orange 21’s Sept. 30 Quarter and Nine Months

/4 Comments/in /by

Orange 21 (Spy Optic) is one of my favorite brands for a couple of reasons. First, over the last couple of years they’ve worked themselves through some really tough issues, making difficult decisions when required. And they’ve had to do it during the recession. Second, for better or worse they’re public. We get to see the numbers, actions, and management strategies of a smaller company in this industry. 

 Finally, they are representative of the issues that most smaller companies are facing right now, and we can learn a lot from how they are responding. Let’s get learning. I should make it clear that the following analysis is mine based strictly on their public documents. Nobody at Orange 21 has talked to me about it.   
 
Key Strategic Decision
 
Orange 21’s sales fell 6.3% for the quarter to $8.2 million compared to the same quarter the prior year. For nine months, they increased 2.8% to $26 million. Like almost every other company, they know that sales increases are harder to come by than they use to be and that there are some pressures on margins. I’d say the latter is especially true in the sun glass business and would be (though to a lesser extent) even if there was no recession. Sun glasses are (were?) a high margin product that inevitably attracted competition from many sources and put pressure on those margins.
 
Orange 21 is at that awkward stage of its life- too big to be small and too small to be big. There are margin pressures and fewer core retailers to sell product to. They’ve been disciplined in controlling expenses, but a brand needs advertising and promotional support, and you can only reduce expenses by so much for so long. Essentially, they need to grow but I don’t think they thought they could grow as much as they need to with their core product lines.
 
The last article I wrote was about Volcom. In that, I talked about how brands, and maybe our whole industry, was transitioning from action sports, to youth culture, to the fashion market. The markets are of course not as distinct as I make it sound, and moving from one to the other is in no sense linear or inevitable for all companies. But Orange 21 has decided they need to move towards the fashion market in order to find the growth they need.   
 
Enter their licensing agreements. In September of 2009, they signed a licensing agreement to develop and sell O’Neill branded eyewear. Along with Spy and Spy Optic, the O’Neill brand is targeted at the action sports market. In February 2010, they signed a licensing agreement with Jimmy Buffett and his Margaritaville brand for eyewear. They did the same with Mary J. Blige in May. Blige is pretty clearly the fashion business.  I don’t quite know if you’d characterize Buffett as fashion, but it’s sure not action sports or youth culture. Is “parrot head” a market segment?  
 
A few years ago, Orange 21 bought the factory that was making some of its product in Italy. At the time I thought maybe that was mistake. But since the purchase, they’ve worked hard to restructure, revamp and generally rejigger that factory so that it’s an asset. I’m guessing it will never compete on price with Chinese made glasses. But for the market Orange 21 is aiming at with the newly licensed brands, the factory may be just what they need. In fact, I’d bet that a desire to increase its throughput was a factor in the licensing decisions.
 
So Orange 21’s key strategic decision was to recognize their need for growth and that the amount they needed couldn’t come from their traditional sales channels. Hence the licensing agreements.
 
The downside is that the licensing agreements come with certain design, development and marketing expenses before they generate the first dollar of revenue. They spent about $400,000 in license related operating expenses during the quarter. There are also various minimum payments under the licensing agreements that total $479,000 for the year ending December 31, 2010. For the next three years, those minimums are $1.4 million, $1.1 million, and $0.8 million.    The Blige product started to sell in September. The Buffett product was to have hit markets in November. It better sell well.
 
The company’s decision to seek its growth outside of its traditional channels had a financial impact that we’ll now examine.
 
The Balance Sheet- Inventory is What I’ll Be Watching
 
Back in March, Orange 21 borrowed $3 million from Costa Brava Partnership. Costa Brava and its general partner own 46% of the company’s stock. $2.6 million of the $3 million was used to pay down its asset based line of credit from BFI. We can tell from the current balance sheet that they later drew down part of that line of credit again. At September 30, their line of credit outstanding was at $2.6 million. Subsequent to the September 30 balance sheet date, the company borrowed an additional $2 million from Costa Brava in two loans for $1 million each dated October 5 and November 1. What are they doing with this $5 million?
 
The first thing we notice is that in the nine months ending Sept. 30 2010, inventory has increased 41% from $7.76 million to $10.9 million, so there’s over $3 million in additional cash  tied up there. As noted above, sales over the same period were up only 2.8%. I expect part of this increase is for the holiday season. But some, I assume, is also to meet expected sales from the newly licensed brands that have launched or are launching now. They’ve are also funding, as noted, significant royalty payments and expenses for the new brands that are not yet generating income.
 
Income Statement- Improved Gross Margin and Expenses in a Good Cause
 
The gross margin for nine months rose from 42% to 50%. For the quarter, it was up from 33% to 47%. I’m glad to see those increases. Orange 21 had some problem inventory and if the problem isn’t solved, the increasing gross margin at least suggests they are getting it under control. They’ve got gross accounts receivable of $6.885 million. Their allowance for doubtful accounts is $720,000 (10.5%) and a further allowance for returns of $1.114 million. Subtracting those two gets us down to the balance sheet reported receivables number of $5.051 million. So some of the slow moving inventory may still be around, but it’s been written down or off and when they do sell it, the margin in big.
 
In spite of the small sales decline for the quarter, total operating expenses were up 17.8%. From what they said in their 10Q, I expect most of this is for the newly licensed brands. They’ve been too good at controlling their expenses to let them increase like that without a very strong justification.
 
I would note that in spite of these increased expenses and a decline in sales, their loss for the quarter fell from $1.136 to $932,000. Witness the power of an improved gross profit margin! What Orange 21 is really doing right now is investing in their new product lines. If we weren’t seeing those investments, they’d have no chance these new brands could succeed.
 
We can see that Orange 21 is getting hit by most of the problems that afflict other brands in this industry. A tough economy, a decline in the number of specialty retailers, smaller orders from the ones that are still standing, and some difficulty getting paid. The sunglass and goggle market is also very competitive and, as I’ve written before, brands with their own retail have a bias towards replacing other brands with their owned brands. Lousy West Coast summer weather also hit reorders during the sunglass season, and they had some vendor delays on snow goggle product.
 
All about par for the course. What seems to me to be different at Orange 21 is that they didn’t limit their response to struggling with those issues on a day to day basis, though they have certainly had to do some struggling. They said, “Hey! Doing more of the same isn’t going to cut it. What can we do differently?” They came up with the licensing.
 

These licensing deals are a risk.   But business is a risk and my personal opinion is that if they hadn’t tried something new, their longer term future might be problematic. I wrote years ago that when things change, the biggest risk is to do nothing. I wish I could take credit for Orange 21’s decisions, but I think they figured it out all by themselves.

 

Volcom’s Quarter Ended Sept. 30 and Some Strategic Industry Issues

/2 Comments/in /by

Those of you who read my stuff know I never try to be the first published. When Volcom did their press release I reviewed it. I listened to the conference call and read its transcript and thought about it. Then I reviewed their 10Q when it was finally released. Then I thought about it some more.

Now, I’ve thought enough. What I was thinking about as I reviewed Volcom’s material was the distinctions (and similarities) between the action sports, youth culture, and fashion markets. You see, I’m not sure just what market we are any more. Action sports, to me, is that fairly small market composed of consumers who are participants in the sports and maybe the first level of nonparticipants who are closely interested in the sports and the lifestyle. Fashion is by far the largest market. If the people in that market want a surf brand, they may be as content with Hollister as with Quiksilver. Or they may just like a plaid shirt style they saw somewhere and are happy to buy it at JC Penney. They may not even know that isn’t cool.

I see Volcom as being in the youth culture market, but holding on to its action sports roots and trying to reach up into fashion as a condition of growing. That could leave Volcom (or any other brand) stretched a bit thin in terms of market positioning.
So let’s look at Volcom’s results and discussion around those results in term of the changes that are going on in our industry and market and see if we can draw broader conclusions that go beyond Volcom.
 
The Balance Sheet and Issues of Strategy
 
Volcom’s balance sheet at September 30 remains very strong, if not quite as strong as a year ago. But it’s strong enough for them to pay a $1.00 a share cash dividend to shareholders of record at November 8th at a cost of $24.4 million. Even though it’s strong, I want to spend time on the receivable and inventory numbers, as this might get us to some of the broader industry trends I want to focus on.
 
Consolidated accounts receivable were up 17% to $81.8 million at September 30, 2010 compared to one year ago. Days sales outstanding were up to 91 days from 88 days a year ago. So on average it’s taking them three days longer to collect.
 
Inventories over the year are up 65% from $22.4 million to $37 million. By comparison, sales grew 11%. Inventory turns over the year fell from 5.8 times to 4.6 times. The number of days it took them to turn their inventory, therefore, rose from 63 to 80 days. Higher is generally better than lower when you talk about inventory turns, though too high a turn rate can indicate you’re not keeping enough inventory on hand.
 
With those numbers as background, let’s look at their discussion of inventory. Here’s what Volcom said about their inventory situation in their 10Q. “We believe that as of September 30, 2010, we have excess inventory levels on hand and in order to align these inventory levels with current in-season demand, we anticipate that we will experience higher inventory liquidation sales during the fourth quarter of 2010.”
 
They talk about this at some length in the conference call and give more detail on how it happened and what they are doing about it. First, they note that their 2010 strategy “…has been to gain floor space and market share throughout our account base. Along with increased focus on marketing and promotions, these initiatives have included incentive programs to improve retailer margins in order to insure continued strong orders for Volcom products.”
 
They certainly aren’t the only company with a strong balance sheet that thought a recession was a good time to take some market share, and they are probably right about that. But they chose to do it partly with programs (including some pre-book discounts and a little more markdown allowance) that reduced their gross margin in their United States segment (that includes Japan and Canada but not the Electric results in any of those countries) from 49.9% in the same quarter last year to 45.4% in the same quarter this year. Overall, their gross profit margin fell from 51.6% to 49.6% in the quarter.
 
Moving into next year, they expect to curtail some of these incentive programs. “We believe this will help us recover some of the lost gross margin, while maintaining our market share gain.”
 
Will whatever market share gain they’ve achieved be maintained when they remove the incentives? Yup, that’s the big question. Billabong was concerned enough about this issue that they chose to limit their discounts and incentives during the recession even at the cost of some sales. I’ve argued pretty strongly that your focus in a period of slower sales growth needs to be on expense control and generating gross margin dollars even at the expense of sales growth. It’s an issue for every solid brand in the industry and we’ll find out over time what the right answer is. It is, of course, possible that there are different answers for different brands.
 
Meanwhile, speaking of issues everybody in the industry has to deal with, Volcom indicated they are seeing upward pressure on manufacturing, freight, and raw material costs in the area of 15% to 20% FOB.  That’s more than some other companies have suggested. But Volcom, and everybody else, has to ask how consumers will react in this economic environment as brands try and make up for some or all of these costs increase with higher prices. And Volcom will be dealing with that as they withdraw certain
of these incentives from their customers.
 
Just this morning, somebody sent me a short, article on these costs increases coming out of China. You can read it here.
 
We are, by the way, still talking about inventory. What I like about how this article is working out is that we’re tying balance sheet to income statement to global strategy. It’s important to understand those relationships.
 
Why did inventory get so high? Volcom chose to carry more inventory “…to capitalize on potential in-season business.” They did this because of “…the retailers’ general reluctance to pre-book at historic levels.” They also “…made earlier and bigger buys on select styles due to longer lead times in China, and to take advantage of volume pricing.” When they did that, they had higher expectations for the second half of the year which did not materialize.
 
I wonder if retailer’s reluctance to pre-book should be looked at as an opportunity to sell in season or as an indication that consumers are expected to remain cautious in their spending.
 
Some of this inventory is going to carry over to next year and was bought with that in mind. I think that carrying over some styles in certain basic product is a good idea as long as the market will accept it. But Volcom said they “…plan to get rid of…” about $3 million in inventory in the fourth quarter and that will impact their margins.
 
How exactly are they going to get rid of the excess inventory? They don’t exactly say, but they do note that they expect that sales to PacSun will increase 17% in the fourth quarter. In the third quarter, PacSun bought $6.9 million. 17% would be an increase of about $1.17 million, and I wouldn’t be surprised if a chunk of $3 million in inventory they want to get rid of is going there.
That certainly creates an opportunity to discuss PacSun’s strategy and place in the market and Volcom’s relationship with them, but this article is going to be long enough and I’d better move on.
 
Before I get off inventory, there’s one more industry strategy issue that relates to it I want to discuss. It’s the role of the department stores. In the conference call, Nordstrom’s is mentioned as having stopped carrying action sports last year. In their previous conference call, Volcom was describing the opportunity they had at Macy’s. In this call, we’re told, “Macy’s has been more difficult for us right now in terms of our door count has been reduced over the course of, I think, this year, kind of quarter to quarter.” Quite a change for one quarter. Now Volcom is saying that “…Bloomingdales is our bright spot for our department store business.” But they’re only in eleven stores.
 
Those of you who read my last article on Volcom know that I visited a handful of Macy’s stores to look for Volcom and other action sports brands. What I found was that Volcom and other brands were either miserably merchandised or not present at all. It seems kind of clear that there’s some work to be done before Volcom moves much of its inventory in those channels.
 
Volcom’s inventory numbers, then, span a bunch of industry strategic issues that are important to all the players in our industry. These include the strength of the economic recovery, increasing product cost, delivery issues, the impact of fast fashion, changes in the retail base and its willingness to place preseason orders, and the inevitable difficulties of growing into the fashion/department store market. Nobody’s business model works the same way forever.
 
And that is the end of the inventory discussion. Finally.
 
Income Statement
 
For the quarter, revenue rose 11.4% to $104.7 million. For nine months, the increase was 13% to $244.6 million. Electric was the best performing segment, with an increase of 29% to $8.9 million. That’s 8.5% of the quarter’s total revenues.
 
Gross profit rose from $48.5 million to $52.8 million in the quarter, but gross profit margin fell from 51.6% to 49.6%. Selling, general and administrative expense rose by 17.6% to $33.9 million.  As a percentage of revenues, they rose from 30.7% to 32.4%. Volcom states:
 
“The increase in absolute dollars was due primarily to increased payroll and payroll related costs of $1.5 million, incremental expenses of $1.1 million associated with our recently acquired Australian licensee, increased marketing and advertising costs of $1.0 million, and increased commissions expense of $0.6 million associated with an increase in revenues between periods. The net increase in various other expense categories was $0.9 million.”
 
Operating income was down 8.6% to $18 million. Net income fell slightly from $13.3 to $13 million. It would have fallen by another million if Volcom hadn’t had “other income” that was about $1 million higher than in the same quarter last year due to a foreign currency gain.
 
Conclusion
 
I hate calling a section “conclusion,” but I couldn’t come up with anything pithy and witty and wanted you to know the income statement part was over. What I hope you’ve gotten out of this is the importance of the inventory change and number and how it relates directly to a series of strategic issues that Volcom, and the rest of the industry, is managing. I wish I had more detail on their inventory. How they manage the issues around inventory will have a lot to do with how Volcom progresses as a company. That’s always true, but my point is that it’s particularly true in our current operating environment.
 
As I said at the start, Volcom is a youth culture company with its roots in action sports and reaching for fashion as a condition of continued growth. They seem to have arrived at that time in their growth and development (due partly to economic conditions) when their business model may have to evolve a bit. That’s not a criticism. Every company that starts small in this industry hopes that someday they have to deal with the issue.