Kohl’s New Retail Experiment

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My family has a beach house on Long Beach Island, New Jersey.   I’ve been going there since I was a kid and still try to get back most summers. It’s where I learned to surf (I know- New Jersey surf? We work with what we’ve got).

Anyway, I was back there in September and as my wife and I headed back to the airport, Diane said, “Pull in there.” So I did. It was something called “Off Aisle” by Kohl’s and I gather this is their first store using this concept.

The store is a 30,000 square foot box with a cement floor. It’s filled mostly with racks on which apparel hangs, though they also offered some shoes, kitchen ware and bedding. Kind of like a Ross store.

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Not Much Happened But That’s Not So Bad; The Buckle’s Quarter

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In the retail and economic environment we’ve got right now and given the results of some of its competitors it’s kind of hard to complain about a company that put 10% of revenue to the net income line in the quarter that ended August 1st.

Revenues were pretty much the same as in last year’s quarter at $236 million. The cost of sales was more or less constant at $141 million. Gross profit stayed at $95 million as did selling expense at $46 million. Okay, here’s a dramatic change! General and administrative expenses actually rose from $10 to $11 million. That took income from operations down $1.5 million to $37.2 million and net income was down a million from $24.5 to $23.5 million.

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Another Industry Turnaround Continues; Abercrombie & Fitch’s Quarter

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It was last December when A&F’s long time CEO was “resigned” by its board of directors. I posted a link last winter to an article about how that came to happen. Here’s that link.

That’s not to say he had complete responsibility for what went wrong at A&F. But, as the article made clear, it’s fair to say that his presence and management style delayed A&F acknowledging and dealing with its issues.

They are still looking for a new CEO. I agree with them when they say they want to do it right- not fast.

Sales in the quarter ended August 1 fell 8.2% to $818 million from $891 million in the same quarter last year. Abercrombie sales were down 9.5% from $421 to $381 million. Hollister fell 5.9% from $465 to $437 million. In the U.S., revenues fell 5.9% from$546 to $515 million. Europe, due partly to a strengthening dollar, fell 19.3% from $248 to $200 million. What they call “other” was up from $96 to $103 million, or by 7.4%.

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PacSun’s August 1 Quarter; Expense Cuts and Debt Restructuring Doesn’t Create Customers

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For the quarter ended August 1, PacSun’s revenues fell 7.6% to $195.6 million from $211.7 million in the same quarter last year. Comparable store sales, including ecommerce, were down 6%. The gross margin fell from 29.1% to 25.8%.

1.1% of the gross margin decline was due to a decrease in their merchandise margin. 2.1% was the result of spreading occupancy costs over a lower sales base.

“Selling, general and administrative (“SG&A”) expenses were $53.9 million for the second quarter of fiscal 2015 compared to $60.6 million for the second quarter of fiscal 2014. As a percentage of net sales, these expenses decreased to 27.5% in the second quarter of fiscal 2015 from 28.6% in the second quarter of fiscal 2014.”

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Zumiez’s Quarterly Report and Retail Market Conditions

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By their standards, Zumiez didn’t have much of a quarter in the three months ended August 1. Revenue rose just 1.76% from $176.7 million in last year’s quarter to $179.8 million in this year’s. Net income fell from $7.46 to $3.21 million. Here what CEO Rick Brooks says happened.

“For the second quarter and back-to-school season reported today, we believe our results were heavily impacted by four key factors; a lackluster consumer traffic driven by the absence of a clear fashion trend that we can capitalize on; weakness in our spring and summer seasonal product; the impact of foreign exchange, particularly in our border and more tourism-oriented locations; and the shift of the Labor Day holiday back one week from the prior year.”

A quarter is only a quarter and, maybe more importantly, he noted, “…we continue to believe the industry is going through an immense share consolidation cycle with the winners and losers separating themselves by who can provide a unique brand experience that gives the consumer what they want, whenever they want, however they want it.”

I agree with his point about consolidation. There are too many retail stores, too many brands, too much product that’s the same as all the other product, too many customers without enough disposable income and a level of information that makes differentiating a brand in the long term difficult. Mostly great for consumers. Not so great if you’re a retailer. Or a brand.

Zumiez, I think, has one other strategic issue. They’ve always described themselves as an action sports retailer. It was/is an important point of differentiation. I’ve suggested previously that such a description might not always remain adequate to describe their market position. We’re there.

Look, this has been evolving for a long time. As I’ve been putting it for some years talking about brands, the further you get away from your core market, the more likely it is that they may know your name but not your story. And the harder it gets to compete. Zumiez has to deal with that as well. They firmly and successfully planted their flag in the action sports market, but now they have to compete in the broader market of active outdoor or youth culture or whatever it is.

Zumiez tells us that they’d be doing better in shoes except that kids want basketball shoes, but Zumiez doesn’t sell them and won’t because it doesn’t fit their image and market. And I’ve previously agreed with that. Yet those kids are buying those shoes somewhere and it’s not Zumiez. But Zumiez is cautious about being like the stores where such shoes are sold. How have other products or categories evolved so that they are being bought places besides Zumiez and that Zumiez can’t act like?

What does Zumiez do? Do they stick to the action sports focus and, in my judgment, limit their growth opportunities (hard for a public company) or do they dip a toe in this broader market, whatever it is, and risk some dilution of the market position? I’d love to be a fly on the wall in the meeting where they discuss their competitive position.

Zumiez has a couple of things going for it in this market. First, they have a balance sheet that allows them to be patient but to take some risks. All other things being equal, there’s no reason they shouldn’t be one of the successful players left staying as this consolidation works its way through the market.

Second, they’ve invested and are investing a lot of money in systems to identify what product should be sold where and when and to give their customers choices as to when and how to buy. That costs money and takes us back to how nice it is to have a strong balance sheet.

Third, they’ve got a strong program to identify and nurture new brands. They tell us they turn over between 20% and 30% of their brands each year, so perhaps nurture is a lousy word. Ensure the survival of the fittest is probably a better way to think about it.

I don’t know about you, but I’ve noticed that the term “fast fashion” seems to have disappeared from our lexicon. That’s because it’s no longer a trend, but a condition of business.  That’s how Rick Brooks seems to see it:

“With the evolving nature of the empowered consumer through the use of technology, the business is subject more than ever to trend cycles that develop faster and end faster. Our business has always been driven by a combination of trend-right items, fashion cycles and our deep vendor base of emerging and growing brands to provide unique product that resonates with our consumers. And all of these cycles are moving faster in response to the need of today’s technology empowered consumer.”

As you can see, their systems and new brand program are necessary to respond to these market conditions.

Fourth, Zumiez has always trumpeted the quality of their employees and their selection and training processes. I agree that’s a big strength. But I wonder how it changes with the market. Once again, I’d love to be a fly on the wall and hear how they discuss the employee attributes they want as the market they compete in evolves.

Points three and four particularly intrigue me. Their employees and their awareness of brands coming and going at the granular level has the potential to give them the information they need to figure out what products to compete with in which markets against whom. I make that sound so simple. I’ll have to nag them a little and see if they’ll tell me if I’m on the right track.

Fifth and last, I’m wondering how the number of stores they have and the layout and size of those stores may change in response to these conditions. Zumiez has 578 stores in the U.S. at the end of the quarter (640 total including 40 in Canada and 22 in Europe) and has talked about capping the U. S. store count at somewhere between 600 and 700. I wonder if that’s still valid given the conditions I’ve described and the consolidation Rick Brooks and I seem to agree is going on.

Okay, back to the numbers. The revenue increase was the result of adding 58 net new stores since a year ago offset by a $7.9 million decline in comparative store sales (4.5%) and a $4.4 million decline due to a weaker Canadian dollar and Euro. So the number of stores went up by 9.1%, but they still had a revenue decline for the quarter.

The gross margin fell from 34.5% to 32.1% or by 240 basis points (2.4%). “The decrease was primarily driven by a 130 basis point decrease due to the deleveraging of our store occupancy costs [that is, they had less sales to spread them over], 70 basis points due to a decrease in our product margin, and 20 basis points due to higher distribution costs.” CFO Chris work says there was, “…downward pressure on product margins as a result of the increased promotional activity to clear out seasonal inventory.”

SG&A expense rose from 27.9% of revenue to 29.2%. “The increase was primarily driven by an increase of 160 basis points due to the deleveraging of our store operating expenses, partially offset by a decrease of 30 basis points decrease in incentive compensation.”

As already mentioned, the balance sheet is strong. I will note that cash provided by operating activities for the six month ended August 2, 2014 was $30.5 million. For the six months ended August 1, 2015, it was $977,000.

On the one hand, Zumiez has the same issues that all retailers in our space have. They are probably better positioned and ahead of the curve in dealing with them. On the other hand, being “the action sports retailer in the mall,” while a defendable position, may be hard to grow from. We’ll see.

They noted in the conference call that typically, among their top brands, a couple break out and provide a trend that means a big revenue boost. This hasn’t happened the way it happened last year. Rick Brooks told the analysts that he sees this as just part of a typical cycle that will run its course.

I’m considering the possibility that the changes and challenges of retail are of a longer term nature. The difficulties of retail (and the opportunities!) are so profound in this country that I see it taking some years to work through. We just don’t need 80 square feet of retail space for every man, woman, and child. Zumiez should be okay, but that doesn’t mean it will be easy.

Globe’s Results for the Year; Good, but What’s Going on in North America?

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I’m kind of late writing about this, but Quiksilver inconveniently filed for bankruptcy right before I went on vacation and I was focused there. The headline is that Globe improved its performance. However, there isn’t much to analyze. Basically they tell us, “We did good and think we can do better.”

Hope so. Anyway, here’s a brief presentation and discussion of the numbers. Just to remind you, Globe is Australian and all the numbers are in Australian dollars.

Revenue rose 32.7% from $104 to $138 million for the years ended June 30 2014 and 2015. Revenue from all their brands rose. Globe was up 24% and Dwindle 34%. 4Front was up 36%. That’s their licensing and distribution business for Australia and New Zealand. The brands they manage are Stussy, Obey, Vision Streetwear, and Komono. Hardcore, “…the largest distributor of leading brand skateboard products, both owned and third party international brands, in Australia and New Zealand,” rose 39%. Its brands include Girl, Lakai, Thrasher, Chocolate, Flip and others you would recognize.

Finally FXD, which sells “carefully designed and styled work wear,” was up more than 100%. This brand, I recall, is pretty new and I imagine that growth is from a small base.

How did they accomplish this growth? “Past diversification strategies and brand investments driving growth.” Well, that certainly explains it. You can see why this might be a short article.

Revenue in the Australasia segment rose 32.6% from $37.7 to $50 million. Sales in Australia rose 30.5% from $34.9 to $45.5 million. Clearly, most of the segment’s growth was in Australia, which represented 91% of segment revenue.

All the divisions reported growth in the segment. “Improvement in performance [was] due to strategic diversification of brands, categories and new distribution channels.” Moan. Come on guys. Give me something at least a little specific to work with here so I can explain your good results to people.

North American revenue was up 26.3% from $39.2 to $49.5 million, with U.S. revenues up 16.4% from $20.8 to $24.2 million. Hmmm. Wait a minute. Those segment numbers are from note three, paragraph b of their filed report. But the slides they provided as part of their presentation says North American net sales grew by 14% as does the discussion of the results in the financial filing. I don’t know- 26.3% seems better than 14%.

Somebody at Globe help me out. Is the 14% constant currency maybe? Or have I lost the ability to read or work my calculator? Anyway, I’m giving you the numbers as reported in that footnote. The increases I calculated from the financial report is the same for the other two segments as what’s reported in the presentation, so I’m thoroughly confused.

European revenues rose 41.5% from $26.6 to $37.6 million.

The Australasia segment EBITDA rose from $3.34 to $5.65 million. The North American loss worsened from $1.03 to $1.67 million. Losses aren’t supposed to rise when revenues goes up 26.3%. Or even 14%. Wonder what’s going on there. Europe’s EBITDA was up from $3.60 to $6.97 million. That’s quite an increase.

Let’s move a little further down the income statement. Globe’s income statement doesn’t show a gross profit line. But in a note they do show something called “Cost of sales.” I’m going to use that (perhaps not correctly) as what we’d call cost of goods sold to calculate a gross margin. When I do that, I get 46.1% in 2015 compared to 46.4% in 2014.

Net income in 2014 was a loss of $12.3 million. In 2015, Globe reported a profit of $3.72 million. There are a couple of items you need to be aware of in evaluating these comparative results.

Last year, there was a $17.1 million charge for impairment of assets. In 2015, there was no such charge. Due, I think, at least partly to that charge there was tax benefit in 2014 of $3.3 million where 2015 shows a tax expense of 1.7 million. That’s a $5 million difference.

If we look at the pretax numbers and take out the impairment charge, you’ll see that Globe would have earned $1.45 million last year compared to $5.42 this year on a pretax basis.

The balance sheet is pretty solid with no borrowings or long term debt. Equity grew consistent with the net income. The current ratio is solid.

As I’ve already complained, we’re not getting a lot of specifics. Basically, after some tough years, Globe is running its business better. As they put it, “This revenue and profitability improvement was a consequence of the recent investments and diversification into new markets and brands and as such, growth came from multiple brands, product categories and geographic regions.”

As usual, I’m pretty sure there was no magic bullet. Just hard work, some difficult lessons, and management discipline. North America still seems to have some issues with the loss increasing even with a solid sales increase.

Quiksilver’s 10Q; Not Really a Surprise

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In the aftermath of Quik’s bankruptcy filing, the 10Q feels like an afterthought. Still, it’s worth a brief review. There was no conference call. Hell, what’s left to say?

In the quarter ended July 31, revenues fell 11.1% to $336 million from $378 million in the same quarter last year. Gross margin didn’t do much of anything, rising from 47.9% to 48%. Below are the comparative sales and gross profit for both quarters.

Quik 7-31 10q 9-15 #1Revenues as reported for the Americas, EMEA and APAC were down, respectively, 15.3%, 8.7% and 4.1%. Talking about revenues, Quik tells us, “Year-over-year net revenue and gross margin comparisons continuing to be unfavorable due primarily to the impact of currency exchange rates and licensing. We also expect our net revenues and margins to be unfavorably impacted by late deliveries in the short term and an evolving distribution channel strategy, particularly in North America.”

I don’t know what they mean by the “evolving distribution channel strategy.” I hope they mean they are pulling back from some questionable channels.

By channel, wholesale revenue fell 15% from $233 to $198 million. Retail was down 9% from $123 to $112 million. E-commerce rose from $20 to $21 million, or by 5%. Licensing revenue was $5 million, compared to $2 million in last year’s quarter.

They note that the drop in wholesale revenue includes $21 million “…from licensed product categories.” Instead of getting that $21 million, they received $5 million in revenue, but of course they received it without any cost or effort. Ignoring for a moment the impact on the brands of where and how that product was sold, it seems like a pretty good deal if for no other reason than the positive impact on cash flow.

By brand, Quiksilver was down 6% from $141 to $132 million, Roxy by 18% from $118 to $97 million, and DC by 11% from $108 to $96 million.

We’ve got a 19.2% reduction in SG&A expense from $205 to $166 million. These numbers include asset impairment charges of $17.4 million in this year’s quarter compared to only $180,000 in last years. $16 million represented “…the write-down of the carrying value of the Quiksilver trademark…”

“The decrease in Americas segment SG&A was primarily due to reductions in employee compensation, advertising, and bad debt expenses. The decrease in EMEA and APAC segment SG&A was almost entirely due to changes in foreign currency exchange rates.” Remember that a stronger dollar makes things cheaper when translated into US dollars.

When we’ve got a goodwill impairment charge of $80 million, down from $178 million in last year’s quarter. We’ve got an operating loss that’s fallen from $203 to $102 million, but you can see that’s pretty much just the result of the impairment charge being $100 million lower. Interest expense at $18 million is a big lower than the $18.7 million in last year’s quarter and foreign currency produced a gain of $4.7 million compared to a loss of $2.3 million last year.

So the net loss fell from $223 to $125 million. Depending how you think about the goodwill impairment charge, you might conclude that this year’s quarter was pretty much the same as last year’s.

The key thing to note on the balance sheet is that the long term debt has been classified as a current liability due to the bankruptcy filing. That interesting, because obviously the September 9 bankruptcy filing occurred after the July 31 date of the financial statements. Quik says the reclassification is what’s required by generally accepted accounting principles. They also tell us, “As of July 31, 2015, the estimated fair value of the Company’s borrowings under lines of credit and long-term debt was $583 million, compared to a carrying value of $822 million.”

At the end of the day, the balance sheet as presented isn’t of much interest right now, as all the unsecured creditors have made a contribution to Quik’s equity by virtue of the filing. That is, they can’t get paid unless the court approves payment or until a plan is confirmed. Some will get more, some less and a lot nothing.

That’s pretty much the end of the shortest analysis of a Quik filing I’ve ever done. My two major concerns as we watch the current restructuring process move forward continue to be 1) where will the sales growth come from and 2) is existing, long term management the right ones to pull this off.

Quiksilver’s Bankruptcy Filing: And the Beat Goes On

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As pretty much everybody knows, Quiksilver filed for Chapter 11 Bankruptcy on September 9th. This is another step in a long process that’s been going on for years now and that we’ve followed together on these pages and in other places.

This will not be an explanation of bankruptcy or a discussion of why companies get into trouble. I’ve written those articles years ago (not specific to Quiksilver) and have posted them at the bottom of my home page under Classic Market Watch Columns. I sent that same link and information out last week. That’s probably the first time most of you have seen the bottom of my home page. Hell, I haven’t seen it in a while.

Before we get into some of the specifics of the filing and the plan, let’s briefly talk about what I think matters most.

In every report from Quiksilver I’ve analyzed in recent years, I’ve asked, “Where’s the sales growth going to come from?” No amount of bankruptcy filing, restructuring, store closings, downsizing and rejection of contracts resolves that issue.

That doesn’t make the filing unimportant. As I wrote before the filing, some form of restructuring had to happen because the existing balance sheet and implied cash flow did not support continued operations. As a result of the filing, and assuming the plan is approved, debt and interest expense will decline and so will other expenses. For example, Quiksilver reported it had north of 700 stores at April 30. Lease contracts for unprofitable stores will be rejected in bankruptcy and the store count will decline. That will reduce expenses further.

But it will also reduce sales once the liquidation of excess inventory that results from the closings is done. I’m fine with that. The Quiksilver, Roxy and DC brands could all stand to be a little less broadly distributed from a brand building point of view. As you know, however, I believe there’s a potential conflict between building brands with hard to differentiate products and being a public company.

My point is that none of this restructuring stuff matters unless consumers want to buy products with the Quiksilver, Roxy and DC names on them. The good news in that regard is that consumers typically don’t notice a bankruptcy filing. With that in the back of our minds, let’s look at what’s happened.

Who Filed for Bankruptcy?

While it’s easy to say, “Quiksilver filed for bankruptcy,” that’s not an description adequate for our discussion. Quik’s U.S. operations filed. Here’s a list of the legal entities included in the filing.

Quik bk filing 1 9-15

 

 

 

 

 

 

 

 

 

And here’s Quik’s complete organizational structure from one of the filing documents. I know the picture is too small to really read, but I just wanted you to have a sense of the scope of the legal entities composing what we think of as Quiksilver. The shaded boxes are the ones filing for bankruptcy, and correspond to the list above. The legend at the bottom right of the chart refers to the shaded boxes as “Non-Debtor.” I think that’s a mistake.

quik bk filing 2 9-15

Now, why do you care?

A “Prepackaged” Filing and the Role of Secured Creditors

Without getting into too much detail (like I’m going to be able to avoid that), you are probably aware that Quik has various pieces of long term debt. Around one-third of it is secured. That is, if Quik doesn’t perform under the terms of the deal under which they borrowed the money, the secured debtholders can seize the collateral securing the loans. Collateral can include various classes of assets including inventory, receivables, cash, trademarks, buildings, etc. It just depends what’s in the agreement.

That doesn’t change in bankruptcy. The secure creditors still have the right to the assets if Quik doesn’t perform under the loan agreement. But if the secured creditors take their collateral, Quik ends up selling its assets for the benefit of its creditors, the company goes away, and the secured creditors get less than if they can somehow restructure the debt and keep Quik operating. Or at least so they’ve apparently calculated. Knowing what I know about what happens to asset values in liquidation scenarios, I suspect they are right.

So a secured creditor has some leverage, and you can’t do a chapter 11 bankruptcy, prepackaged or otherwise, without their cooperation. Quik has played “Let’s Make a Deal” with that creditor in advance, and the plan is effectively part of the filing.

The press release tells us the filing “…is supported by 73% of the Company’s senior most class of debt…” It further tells us that “…holders of the Company’s Eurobonds sufficient to waive any technical default arising from the filing have agreed to allow the Company to reorganize its U.S. operations in Chapter 11.”

The rights and remedies of the secured creditors are no doubt carefully spelled out in documents, and you may all feel free to go find and read those documents to your heart’s content, because I’m not going to. My hope is that whichever, if any, secured creditors may not have agreed to this deal don’t have the ability to slow it down. The whole purpose of a prepackaged deal is to get the company in and out of bankruptcy quickly.

Here’s a list of the three biggest chunk of Quik’s debt included in the filing. The first one is the notes denominated in Euros.

Quik bk filing 3 9-15

You’ll note the $279 million in secured notes in the middle. You may also notice that none of this is due to be repaid farther away than 2020, and the first notes (the ones denominated in Euros) are due in 2017.

Who’s Getting Treated How and Just What’s the Deal?

 The thirty largest unsecured creditors are listed in the original filing. The biggest by far is US Bank as trustee for $225 million of unsecured notes. That’s the third item on the chart above. The next largest is, I think, a supplier and it’s for $7.3 million. Most of the rest are for merchandise, but there is a couple for “real estate” that I take to be store leases. Don’t know for sure. There are a few individuals for severance. As you are aware, Quik already stop paying under its severance agreements (35 people I think), but most of those amounts aren’t big enough to make the top 30. The smallest amount on this list is $931,000.

Unsecured creditors don’t typically do well in a chapter 11 filing, but in this case it sounds like some will do better than others. What I’ve typically seen is that they have to be dealt as a single class and treated equally. They can’t be paid until the case is settled, though they can continue to sell to the filing company (in this case Quik) if they want to.

Quik, however, has petitioned the court to pay some or all of what they owe to “critical suppliers.” The court has approved those payments up to some specific limits. That makes some sense to me because they need these suppliers to get product. If these suppliers start messing with production or the supply chain, Quik could be in a world of hurt quickly. Okay, they already are, but even more hurt.

I wonder- if I were one of those critical suppliers, I’d be thrilled to get paid but I’m not clear how excited I’d be to continue to give Quik terms on new products. Those must be interesting discussions.

It would be great if some lawyer reading this would explain what I don’t understand. I know bankruptcy judges have a lot of discretion (they should), but I’m surprised you can treat some unsecured creditors differently from others.

The rest of the unsecured creditors are not going to do quite so well as the critical suppliers. They would “…receive cash in an amount equal to its pro rata share of the Unsecured Creditor Recovery.” The total of that Unsecured Creditor Recovery is $7.5 million. We haven’t yet seen the schedule that shows us all the unsecured creditors, but I’m thinking this will mean pennies on the dollar.

Then there are the holders of the common stock. There’s a 60 page list of those people. Interestingly, there seem to be an awful lot of people who own one share. Last time I saw, Quik stock was trading between $0.08 and $0.10 a share. As currently structured, those shareholders are going to end up holding common stock that’s worth exactly and specifically zero. Just to be clear, here’s how Quik put it in an SEC filing. “All of the Company’s existing equity securities, including its shares of common stock and warrants, will be cancelled and extinguished, without holders receiving any distribution.”

Like the people with severance agreements, some store landlords can expect their leases to be rejected in bankruptcy. Quik will close the stores where they choose to do that, though they would have the option of renegotiating the leases with the landlord to get more favorable terms.

So far, there are 27 stores to be closed and, in fact, that process started before the filing when Quik made a deal with a liquidator to sell the inventory and fixtures in those stores. The process is to be completed by the end of December.

Quik has also opened some “pop up” locations to dispose of obsolete or distressed inventory. I don’t quite know if that refers only to the inventory from the stores being closed or not.

Product from all three brands is involved in the store closing and liquidation. This can’t be good for the brand’s market perception.

The happiest people in this deal have to be the ones who hold the Euro notes. Basically, if they keep quiet and don’t cause trouble, the non-debtor foreign subsidiaries will continue to pay principal and interest as it comes due during bankruptcy, and the claims of the Euro holders will be unchanged when Quik exits bankruptcy. And if they want, they can get 25% of their notes paid down if they agree to extend the maturity by three years. Quik would like those notes not to have to be paid in 2017.

The other two sets of notes, totaling about $500 million, will go away. That will result in a big improvement in the balance sheet and reduction in interest expense. However, the 2018 notes can be converted into common stock. The 2020 notes will be in the unsecured creditor pile and get not much as I described above. Boy, are they screwed.

Oaktree Capital, as you know, will provide part of the “debtor in possession” (DIP) financing. Some lenders like to do DIP financing because it has a priority in bankruptcy over just about everything. As I recall, it’s senior to all claims except taxing authorities and the professionals (lawyers, accountants, etc.) who work on the case. Oaktree will provide $115 million in DIP financing. Bank of America will provide another $60 million, essentially continuing their asset based lending facility through the bankruptcy process.

By definition, asset based lending facilities are secured. But you don’t see it in the debt list above because it’s short term borrowing. There was $33 million outstanding under that line at April 30. I’m guessing that maybe there was $60 million outstanding at the time of the filing.

When they exit bankruptcy, Bank of America will replace its existing ABL line with a new $75 million line. As a secured creditor, it appears they will more or less come out of this whole. Asset based lenders usually do.

“Upon consummation of the Proposed Restructuring, the new Company will be funded by two separate rights offerings of up to $122.5 million and €50.0 million, respectively. Both rights offerings will be backstopped by the Plan Sponsor [Oaktree]. It’s the owners of the $279 million of notes due in 2018 and of the Euro notes that will have the chance to participate in these offerings. And if they don’t participate, Oaktree will take the whole amount. That’s what’s meant by “backstop.”

This will apparently involve some combination of new debt and common stock at a discount price. We don’t’ yet know what the new price will be. The proceeds from those two offerings will be used to repay Oaktree it’s DIP financing (yes, they may end up partly repaying themselves), paying the unsecured creditors, buying back the 25% of the holders of the Euro debt from those who want to extent their notes for three years, and for “general corporate purposes.”

What Does This All Mean?

As I started off telling you, no amount of restructuring addresses in any way the attractiveness, or lack of attractiveness, of Quiksilver’s brands in the market. But, hopefully, it gives them another chance to focus on that.

That was the whole idea when they got out from under the Rossignol debacle and brought in financing from Rhone, but here we are with a bankruptcy filing. In the words of Quik CEO Pierre Agnes in the press release, “Our fresh capital structure, with a very low level of debt for our industry, will enable us to invest in and reinvigorate our brands and products. We are confident we will emerge a stronger business, better positioned to grow and prosper into the future.”

This restructuring does a lot more for the balance sheet than the prior one. But I bet if I went back and looked at the press release for that deal, I’d find similar words.

The next thing I’m focused on is the roll of Oaktree. As you know, they are a major investor in Billabong, and now in Quiksilver. All over the summary plan document is the recurring phrase, “…which shall be in form and substance acceptable to Oaktree.” How is this going to work exactly? How much control will Oaktree exert? Their representatives resigned from the Billabong board right before the filing, but I’d be pretty surprised if somewhere, somehow, Oaktree people hadn’t thought about some kind of coordinated strategy or consolidation or sharing of functions or something. I doubt the legal and ownership structure would permit that right now, but everybody wants to be the next VF.

Quiksilver stock, as you probably know, has been delisted from the New York Stock Exchange. As of September 10th, it was traded on the over the counter market under the symbol ZQKSQ. Large chunks of stock are going to be owned by Oaktree and others. Someday, it’s possible they may want that stock to go up in value so they can sell it and make money.

I’m guessing that if things go well for Quik, we’ll see a secondary offering a year or three down the road so that the current shareholders can have some liquidity for their holdings. But we don’t have to worry about that right now.

Meanwhile, somebody sent me a copy of a letter than Quiksilver President Greg Healy sent out to dealers more or less when the filing occurred. I’m not going to reproduce the whole letter, but I want to quote one sentence.

“The challenges we face today stem from poor decisions made by previous management, which saddled the Company with a burdensome debt load.”

I’m kind of wondering what they mean by “previous management.” Not Andy Mooney. The debt was there before anybody at Quik had ever heard his name. It’s true that Andy didn’t understand the market, but he was also responsible for initiating a bunch of operational changes that should have been implemented, in some cases, years sooner.

This statement really bothers me, because it suggests not being completely in touch with reality. There is nothing worse in a turnaround. And the longer a turnaround lasts, the more the pressure builds and the harder it gets to be in touch with reality. Andy Mooney may have been the wrong outsider, but my experience is that an outsider is a good idea. I am wondering just how much leverage Oaktree will exercise in this area. Remember, they brought Neil Fiske into Billabong.

I’m going to urge you all again to go to the bottom of my home page under Classic Market Watch Columns, and read the one about why companies get in trouble.

The next court hearing is scheduled for October 6th. I’ll watch for new documents and try to keep you up to date. In the meantime, keep in mind that this necessary step doesn’t solve all Quiksilver’s problems- it just gives them another chance to address them.

What’s “Bankruptcy” and How Does it Work?

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What exactly is a Chapter 11 bankruptcy filing and how does the process work?

A Chapter 11 is a “reorganization” bankruptcy. That is, it is filed with the assumption that the filer will use the protection of the court to reorganize its finances so that it can continue as a going concern.  That doesn’t always happen, but it’s the intention going in.

There are a number of schedules you have to file with the court when the bankruptcy occurs.  These included assets and liabilities, income and costs, a schedule of existing contracts and some others.  Typically, the owner of the business becomes the “debtor in possession” and is responsible for the continued management of the business and control of the associated assets.  He is in a position of fiduciary responsibility with the same powers and obligations as if a Trustee had been appointed to manage the business. He’s required to file the monthly reports, can hire attorneys, accountants, appraisers or other professionals to help with the case, and file tax returns.

Note that a corporation has standing as a separate entity, so an owner’s personal assets are not at risk in a corporate filing, except to the extent of his equity in the business (or if he has given a personal guarantee, though that’s an issue outside of bankruptcy).  A sole proprietor filling a chapter 11, on the other hand, will find his personal assets are part of the bankruptcy.  Something to think about.

All You Need Is Cash- and a Bankruptcy Attorney

With the filing of the bankruptcy petition, all collection efforts by creditors are required to cease.  In fact, the company is not permitted to pay any unsecured debts incurred prior to the date of the bankruptcy filing.
Actually, it’s worse than that. The debtor in possession has the right and maybe the obligation to recover certain payments or transfers of property made prior to the bankruptcy filing so they can be equally divided among creditors. You can understand how the bankruptcy judge and creditors might insist on that if the owner used corporate assets to buy a Caribbean island a week prior to the filing when he wasn’t paying his creditors. Giving stuff to relatives or other insiders in anticipation of the filing is also a no-no.

Generally, this does not apply to payments made in the ordinary course of doing business, so one thing you make sure you do is pay your employees everything you owe them up to the day of the filing.  Remember you’re trying to restructure the business and it can be kind of hard if the employees have been stiffed right along with the other unsecured creditors.

You’re also going to need cash for a retainer for your friendly bankruptcy attorney, who knows he won’t get paid for 120 days or so after the filing and wants some money to bill against.  The phone company and other utilities will probably want a deposit to continue providing service, and some of your suppliers you haven’t paid and now can’t pay by law may be reluctant to ship you more merchandise on credit (though their chances of getting paid on new shipments may actually have improved).

It takes some cash to file a successful chapter 11.  Any company thinking about it should be hoarding some in advance.

Cash Collateral

If there’s a bank or other financing source involved, chances are they have security in the company’s assets.  If you don’t pay them, they have the right to the inventory, receivables, trade name, furniture and fixtures, patents, copy machine, and your lunch in the office refrigerator.  But of course, if they take all that and try to liquidate it to get themselves paid, there’s no business.

The debtor in possession can’t use that cash collateral, as it’s called, without permission of the secured creditor or authorization of the court. The court is required to make sure the collateral belonging to the secured party is adequately protected on a continuing basis. So typically there will be a cash collateral hearing where the secured creditors, the judge, and the debtor in possession, along with appropriate attorneys, will figure this all out.

The secured creditors’ interest is in ultimately collecting their money.  They know things were going to hell before the filing.  They also know that if they had to sell the debtor’s inventory and collect his receivables themselves, it might not go too well.  So, if they believe they can continue to be adequately secured and that the debtor in possession has a fighting chance to turn the business around, they will often not oppose the debtor’s use of cash collateral.  And even if they do the bankruptcy judge, who has quite a bit of discretion in the whole bankruptcy process, can require them to allow it as long as they have “adequate protection.”

The debtor needs use of the cash collateral to continue to operate the business, but there’s a chance he also needs some additional financing.  There is a class of lender who provide “debtor in possession” financing.  Remember that as a result of the filing, all the unsecured creditors have made an involuntary and hopefully temporary contribution to the debtor’s capital, immediately strengthening the balance sheet.  A lender supplying debtor in possession financing often has priority over existing unsecured debt, so their risk is reduced.

I don’t know what the debtor in possession financing market is like right now given current economic conditions.  It will be interesting to find out.

Now What?

Well, the immediate pressure is off the debtor in possession, and he can try and restructure his business.  He’s no longer spending all his day shucking and jiving with creditors and figuring out how to make payroll.  He has an exclusive period of 120 days in which to file a plan of reorganization. Nobody else can do it during that time. The 120 day can be extended, but not past 18 months.  Knowing that somebody else (like the creditors’ committee) might be allowed to file one can motivate the debtor to get it done.

There’s probably been a creditors’ committee formed which typically consists of the 7 largest unsecured creditors. They can be more or less active, but typically consult with the debtor in possession on running the business and developing the plan.  It can be useful to have the committee looking over the debtor’s shoulder.

There may be various legal proceedings going on where, for example, certain creditors try to get relief from the stay that keeps them from trying to collect their money.

The debtor has the right to reject contracts and leases he does not believe are in his interest.  He’ll be busily using that leverage to restructure his business.

He’ll also be working to convince customers, suppliers (who have not been paid but can be paid for new work in bankruptcy), and employees that the business is viable and that they should continue to deal with him.  What fun.

The Plan

At the core of the plan eventually filed with the courts is the issue of who gets paid how much. As the business and its assets are the source of that repayment, how the business is going to operate and how much cash it flows off are critical.  It would be typical for the plan to classify those who are owed money as secured creditors, unsecured creditors, and equity security holders, though there can be others. The further down the list you are, the lower your priority.  The tax authorities and the lawyers and other professionals who worked with the firm during the bankruptcy are at the top of the list.

Typically, there’s not going to be enough to give everybody 100 cents on the dollar, so there’s some negotiations involved in getting the plan approved. If I remember this right, a whole class of claims is said to accept the plan if the creditors in that class who do accept it represent at least two-thirds in amount and more than one half of the numbers of claims in the class. One of the things that’s sometimes done to simplify the approval process is to agree to pay all the smallest claims 100% of their claim when the plan is approved. That tends to get them on your side.

I’ve described in about 1,500 words a process and set of circumstances on which many books have been written. There can be a lot of permutations and combinations, but I hope this gives you the general picture.  The process of getting a company through a bankruptcy is interesting and challenging – though not so much if you’re the debtor or a creditor.
Read more at http://business.transworld.net/features/market-watch-chapter-11-bankruptcy-what-does-that-mean-exactly/#0zv6LhGGjHbcbx60.99

 

The Quiksilver Conundrum; There Has to be a Deal

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I’ve resisted writing this, but with the recent article in Bloomberg highlighted by Boardistan and Shop-Eat-Surf reporting, also based on a Bloomberg, that Quik had hired a restructuring firm, I guess there’s no reason not to.

What I want to do is take you through Quik’s circumstances and choices based on their most recent balance sheet dated April 30, 2015 We’ll seeing another one shortly, but I doubt that’s going to change my analysis. I also want to consider with you what a “restructuring” might mean and how it impacts the industry.

Quik’s most recent balance sheet states there are 174,642,124 shares of common stock issues and outstanding. That’s not a fully diluted number, but let’s work with it. As I write this (September 4) Quik’s stock is trading at $0.46 a share. Multiplying that price by the number of shares outstanding gives us a market capitalization of $80.3 million.

Now let’s suppose that all the shareholders of Quik’s common stock- every last one of them- offered to give me their shares for free. And let’s further assume that somehow when I got all those shares for free I wouldn’t have to pay income tax on $80.3 million in income.

How would I respond to the offer? Very, very carefully. If I accepted, I would become the owner of all of Quik’s assets- and its liabilities.

The liabilities total $1.153 billion, and I can guarantee that they are mostly very, very real. The largest is $785 million of long term debt. Total assets of $1.139 billion are less than liabilities. Hence the negative equity on the balance sheet.

In any kind of restructuring, we’d have to take a hard look at those asset values. Okay, I believe the $48 million in cash on the balance sheet is probably worth $48 million no matter what. I’m not so sure what the fixed assets of $190 million, the intangibles of $138 million and the goodwill of $80 million would be worth.

There’s also inventory of $291 million and receivables of $252 million. In any sort of a messy restructuring, would those be worth 100 cents on the dollar? My experience is that they would not, but it depends on just how things come down.

So were I to accept the offer, I’d own a company that wasn’t making any money and, realistically speaking, had assets that were significantly less than its liabilities. Sounds like a bad deal.

That’s why I am not expecting, and have not been expecting, any kind of offer to buy the equity. You’d just have a new shareholder with the same problem the current shareholders have.

Unless you think that the three brands- Quiksilver, Roxy and DC- have value well in excess of what they are carried for on the balance sheet.

Whoops- as I sit here writing this Shop-Eat-Surf has just published a story that says, “Quiksilver cuts jobs, stops severance payments.” To me, that’s further indication of their cash flow issues (not new) but also may have to do with ongoing negotiations.

Anyway where was I? Oh yeah- the value of the three brands. What I’ve said in the past is that all three brands have value, but that it would be easier to recognize that value as a private company. I’m pretty confident there’s no reasonable valuation that generates a sales price of a brand that solves Quik’s balance sheet problem. The sale price goes to pay down debt and leaves the company proportionally with the same problem on a smaller scale.

There are buyers for all three brands, but probably not at a price that does Quik any good. I’d love to be wrong and think we’ll find out if I am pretty soon.

You can see what’s going on. Quik has continuing and worsening cash flow issues. It’s in a lousy negotiating position. What I assume are ongoing negotiations and analysis is dealing with exactly the valuation assets I’ve raised for both the balance sheet accounts and the brands under different scenarios.

My best guess is that there’s no reasonable valuation a buyer will accept that can work without a restructuring of the debt, through whatever vehicle and in whatever form that might take. Quik management and the restructuring firm will be negotiating not just with potential buyers but with the secured creditors to try and put such a deal together.

As an industry, we have to be concerned about what happens to Quik’s three brands. We’d like them to end up where they could be nurtured a little to recognize their value, rather than blown up in distribution. It’s already been disconcerting for me to walk into Fred Meyers and see Quik and DC kids’ stuff on the racks and discounted in the Sunday newspaper ads.

I’ve highlighted for some time now what I see as a conflict between building a brand and being a public company. The way you rebuild brands in our current environment- like Billabong and Skullcandy are trying to do as public companies- is to pull back on distribution to better position the brand and improve margin while reducing expenses. But this requires some patience and I don’t think it lends itself to valuations that solve Quik’s problem.

Quik’s last financial statement reporting was in early June, so we should be seeing the next one any time. There’s going to be some kind of deal, and I don’t see how it can avoid involving some restructuring of debt. Let’s hope that whatever form it takes, the brands are still positioned to be supportive of the industry.