Death By Purple Wrist Band; Reflections on The Surf Industry Conference

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I’m glad, I guess, that I’ve gotten to the age where I don’t feel completely compelled to take too much advantage of these “all inclusive, drink at much as you want of anything for free” conference packages. Because if I were so inclined, I suspect all the worrying going on at the conference might have driven me to strong drink.

I mean, here’s all these people who have been lucky enough to create a career and a life out of something they love and that’s fun. They have their industry conferences in Cabo San Lucas for god’s sake. Most people end up in Chicago in February.
But the surf industry is worried about skateboarding. And they’re worried about Hollister. And selling out (or not selling out). And being core (or not being core).    Having to change would be really inconvenient. Being worried makes it harder.
I just got back from the National Ski Areas Association convention in New Orleans. They’re worried too. About, oh, lots of shit. You know what I finally figured out? The problem is the worrying.
When industries succeed and get a little bigger, they become targets. When you’re in the fashion business, like surfing, trends change. Recessions happen. This recent recession wasn’t officially a recession as I understand it, but after ten or so years of growth, we’re perhaps a bit spoiled, and softening sales, which occasionally and inevitably happen, caused to us worry even more. There’s not much in the way of barriers to entry. Companies come and go. That’s life. Don’t like all these challenges that come with success? Go find a job in another industry.
But you know what? That industry is going to have challenges too. There will be lots of things to worry about over there as well. Guaranteed.
Where at the conference, by the way, was the discussion of actual surfboards and wet suits? You may remember them. I seem to recall that surfing can be a lot easier, and a lot more comfortable, if you have them. We talked about selling board shorts and shoes and t-shirts and which kinds of stores we should sell them in. Maybe if the surf industry was just the slightest bit hard goods driven, like the skateboard industry, we wouldn’t have so many worries. I don’t think we grow the surf industry when we sell more shoes and shirts and shorts. We have to sell surfboards to surfers.
Still, I mostly see those worries are just snares and delusions. Look, we’re in business. Business is a risk. It’s a risk whether you sit on your ass and do nothing or go out and attack your market, taking some risks along the way. If you sit on your ass, you’ll get fat and you may get steamrollered out of the way anyway. We can all make up a list of companies and brands that have come and gone.
It will be great if the surf industry can find its Tony Hawk. It will be great if there’s suddenly an easy way to create surf parks in Kansas. But in the meantime, I hope nobody is waiting for all our problems, real and perceived, to be miraculously solved.
It’s up to you. Go out and take some well thought out risks. Some of them will blow up in your face. So what!? At least when you fail you’ll learn something and people will notice. You’ll be in control and you’ll be leading.  You won’t be sitting on your ass waiting for the steamroller to skinny you up.
And some of your risks, if based on a good plan and knowledge of your customers, will succeed, and your company will be a leader instead of an ass sitter.
I just made this speech to the National Ski Areas Association. I just said the same thing to the skateboard industry for an upcoming Skateboarding Business article. You see, the skateboard industry has some issues and they’re worried, though not about the surf industry. Anybody catch the irony here?
I’d make the same speech to the snowboard industry, but it’s too late- it’s basically turned into the ski industry already.
Next year, when we all gather again with purple armbands in place, I hope we find some time to talk about good ways in which each individual company can support surfing to their own benefit. Let’s go out of our way to avoid speeches and panels focused on things we’re worried about.

 

 

Well, I Guess It’s a Recession; Perspective on an Economic Downturn.

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It has been a while—ten years actually—since we endured the lastr ecession back in ’90/91. But business cycles are pretty much immutable. 

What goes up must come down. “Regression to the mean” they call it in statistics.
 
Two things have me especially concerned about our current situation.  First, the economic rubber band is stretched tight after ten years of prosperity and growth. Second, this might be the first global recession since the early 70s.
 
Maybe our customers have enough net worth that there won’t be much impact on their spending. Maybe a kid’s ability to nag his parents into shelling out bucks for new shorts is more powerful than any concern over the family cash flow. Maybe people find money for things that are fun when everything looks bad. Maybe, but maybe not.
 
September 11th has had an unknown impact on consumer confidence andour nation’s psyche. It’s accelerated the decline of an already shaky economy. Any doubt about whether we were headed toward recession ended that awful day. The question is: how deep and how long will it be?
 
Obviously, I don’t know the answer to that. But since the surf industry is based on products that aren’t necessities (although we try to make the consumer feel they are), retailers and suppliers should be examining their business models and making adjustments now to deal with the impact of an economic downturn.
 
Maybe a short history lesson, a look at some current economic statistics, and a few conversations with people in the trenches will
give us all some insight on what we can expect in the months to come.
 
A History Lesson
 
In 1990, the economy started off pretty well. Gross Domestic Product (GDP) grew at a 5.1-percent rate during the first quarter. That declined to 0.9 percent in the second quarter and fell further to a negative 0.7 percent in the third. Fourth quarter GDP fell at a 3.2-percent rate.
 
For the year, we ended up with a real GDP growth rate of 1.2 percent. In 1991, it was a negative 0.6 percent. Officially, the 1990 recession started in July 1990 and ended in March, 1991—eight months later. A recession, by the way, is technically defined as a decline in GDP for two consecutive quarters, so they can’t get much shorter than that one was.
 
Iraq invaded Kuwait on August 2, 1990. The air war began January 17, 1991. The ground war followed on February 23 and lasted four days before President Bush declared a cease-fire. The first U.S. troops began to leave on March 8. We declared victory and went home.
 
Our current conflict began September 11. I’m sure none of us knows how long it will last or what exactly success will look like, but it’s not going to be as definitive as the Gulf War.
 
I’m told that the ’90/91 recession and the year or two that followed it was a tough time for the surf industry. Surfing was in the pits, and we had to reinvent ourselves. Of course, not all of the surf industry’s malaise back then was related to the economy. But the fact that a major change in fashion trends coincided with a recession meant the surf industry was hit hard.
 
Yet that was a relatively mild recession, because there was economic strength in much of the rest of the world. The last time Europe, Asia, and the U.S. all experienced economic weakness at the same time was during the 1973 to 1975 recession. It lasted sixteen months. Once again, I’m not certain of anything, but it’s possible that we may be facing that kind of global recession this time around.
 
The Current Situation
 
Parts of Asia haven’t gotten over the 1997 currency crisis, and Japan seems poised for its fourth recession in ten years. Germany and Britain, along with other parts of Europe, teeter on the edge of recession as well.
 
From a healthy 5.6-percent rate of growth in 2000’s second quarter, GDP in the U.S. has fallen each quarter. It ended the second quarter of this year with 0.2 percent growth. My guess is that the number we get at the end of October for the third quarter will be negative.
 
September retail sales were reported October 12. They showed a drop of 2.4 percent—the biggest in nine years. Economists had expected a drop of 0.7 percent. The September employment report showed the country lost 199,000 jobs during the month. That’s the largest decline in ten years.  Most of the fallout from the attack isn’t reflected yet. September was the twelfth month of declining industrial production. That ties a record that goes back to right after World War II.
 
But there’s also a bit of good economic news. Consumer spending had been holding up fairly well, though it had finally weakened a bit even before September 11. Housing has also held up well—probably due to declining interest rates.
 
The Federal Reserve has cut the discount rate from six to two percent this year. It was last that low in 1958. Typically, it takes six to nine
months for the benefit of rate cuts to work its way through the economy. The first rate cut was in January and the most recent October, so clearly we haven’t seen most of that impact yet.
 
Finally, the stock market looks like it may have put in a bottom after the worse bear market since the depression, and the market always turns around before the economy.
 
Among the public companies in the surf market, it was Quiksilver that made me first say to myself, “Okay, we’re having a recession.” That was back on September 6, the first day of the Action Sports Retailer show in San Diego. Quiksilver held an analyst’s conference call to announce that third quarter earnings were in line with expectations, but that fourth quarter earnings would be lower than projected. This was due to weaker than expected retail orders and too much inventory that would have to be closed out at reduced prices.
 
Quiksilver said that diluted earnings per share for fiscal year 2002 would be in the range of $1.50 to $1.55. The consensus analysts’
forecast had been for $1.85 per share.
 
Of course, Quik’s situation was hardly unique among surf-related manufacturers—they were just first to announce. On September 25, Vans beat analysts estimates for its first quarter ended September 1, but expected its second quarter to be flat or down five percent due to the impact of September 11. For fiscal 2002, Vans said its earnings per share would be near the level of a year ago on a forecast revenue increase of roughly ten percent.
 
Pacific Sunwear, on October 11, warned that its third and fourth quarter earnings would miss analysts’ consensus estimates, citing lower consumer confidence and spending. It now sees third quarter earnings of 25 to 27 cents per share, compared with a mean analysts estimate of 33 cents. It sees fourth-quarter earnings as being between 33 and 37 cents, compared with the previous mean analysts’ expectation of 41 cents.
 
But let’s not look at Quik, Vans, and PacSun as though they were unusual or had done something wrong. Tommy Hilfiger, Nautica, Kenneth Cole, Jones Apparel, VF Corp, Coach, Polo Ralph Lauren, Liz Claiborne, and Columbia have all either cut their earnings estimates or had them cut by the analysts—or both. Recession and terrorism are hitting pretty much everybody who sells apparel.
 
What Are They Doing About It?
 
Steve Price at Killer Dana has been reacting to the possibility of a recession for months now. By August, he’d already backed off on some of his projections and orders. He’s booking less going into spring, and scheduling it for delivery a little further out. He’s forecasting November and December sales will be off eight to ten percent from last year (which he described as being an incredible year), and is planning to be off ten percent through spring.
 
There were a few slow days after September 11, but overall September and October sales are up twenty-five percent for Price. Customers, he says, “Aren’t afraid to spend, but are paying more attention to what they get for their money.” He’s stocked up on a lot of rubber this fall, and it seems to be paying off for him. The best-selling wetsuit has been those around the relatively low 150-dollar pricepoint. Price says this is due to both consumer caution about spending, but also the good quality of even lower pricepoint wetsuits.
 
Killer Dana, it seems to me, has done two things that will get it through hard times. First, it started planning when the storm clouds
were first on the horizon—not when the floods came. Second, it has brand recognition and a market position that should keep it a shopping choice for its committed customers.
 
Jay Wilson, vice president of marketing at Vans, reports that the brand’s high-end and signature products are still experiencing good sell through and demand. West Coast sales, he says, have been harder hit than East Coast sales since September 11. Vans’ core customers are doing fine. “It’s the mainstream retailers who are affecting our business,” he reports. They’ve had some order cancellations and some shipping postponements.
 
In response, “Vans has reallocated dollars from branding to the store level,” says Wilson. The company is doing more demos at skate parks.  It’s revved up the rep force to spend more time with the customers and it’s making more shop calls to find out how they’re doing and to help fill in product. “We’ve got ten people calling shops one to two hours a day,” he says.
 
Vans has put a hold on new advertising or promotional commitments, and expects to maintain that through the middle or end of November. 
 
Dave Juan, one of the owners of Unsound Surf on Long Island, New York must be one of the guys Vans is calling more regularly. He’s now cut his orders for spring by 30 percent—though he wasn’t worried about a recession until September 11. “Sales were impacted, but are recovering,” he says.
 
He’s getting lots of calls from reps trying to get him to change his mind. Product is coming early and orders are complete—rather than a bit at a time as has been the case in the past. His interpretation is that brands don’t want to give him the chance to change his mind, and want to get their stuff into his store before the competition. He’s seen some loosening of credit terms and additional discounting. He’s ordered some extra Ocean Minded sandals, citing that brand’s commitment to donate part of its sales to the Red Cross relief effort.
 
Pat Fraley, president of Counter Culture, says sales aren’t going down, but buyers are more cautious. Some spring orders have been delayed, but he doesn’t see ship dates slipping yet. His perception is that companies with broader distribution are feeling it more than specialty shops. “It seems like most of our retailers are doing the right things,” he says.  “They have the right attitude.”
 
To help those retailers, Counter Culture has changed its pricing structure. “We’re shifting our entire [wholesale] price structure and
price points down two or three dollars,” says Fraley.
 
Fabrice Le Det, Asia and European sales manager for Reef, says he has some distributors who are very reluctant to travel, but that his
international prebooks for spring are still strong and fall product seems to be moving. “The big test,” he says, “will be once the spring
line hits the stores beginning in March and we see how the consumer behaves.”
 
He hasn’t seen many cancellations, though there have been some minor decreases in orders or delivery dates pushed out. Overall, sales are up from last year. He blames any minor softness in international sales on weak economic conditions and competition at the low end, rather than the events of September 11.
 
Mark Price, who’s handling international distribution for Tavarua apparel, says he’s not sure how much of the domestic retailing slowdown is due to the September 11 attacks, and how much is the result of recession. “The holiday season,” he says, “will be the acid test. It will create opportunities for those left standing.” Strong brands, he thinks, will be stronger next year.
 
“But what happens,” Price wonders, “when eighty percent of the floor space in specialty shops is taken up by brands that are also distributed nationally in larger stores?”
 
Hell of a good question. If the trend Price points to, accentuated by competition and economic conditions push margins down, but your onlypoint of differentiation comes from your expensive marketing program, how the hell are you going to make a buck? Lower margins and higher costs are not typically a recipe for financial success—especially if you are a small guy. Look what happened to the snowboard industry even without a recession. When brands are ubiquitous, how do we keep them exciting and special? A recession has the potential to accelerate the same trend in the surf industry.
 
Do Something!
 
My wife and I had dinner in an established Seattle restaurant about a week after the attack on the World Trade Center. Business was off about 30 percent, according to our waiter, who predicted: “There’s going to be a bunch of restaurants in Seattle closing down.”
 
He should be in a position to know. Which ones would close? The ones with either a poor balance sheet or no established clientele—or both. It’s the same situation for businesses around he country—including surf shops.
 
During a lot of the 90s, low interest rates, high personal expenditures, low inflation and unemployment, and big jumps in net worth meant a high growth rate for retail sales (averaging 6.55 percent annually between 1994 and 2000). That kind of growth and cash flow can cover up a lot of miscues and lack of a competitive advantage.
 
At the same time, retail competition is tough, to put it mildly. There have been a lot of store closings, but the United States is still over
retailed. All of you surf retailers who have ever had cause to complain about a brand opening your competitor in the next block understand this at a fundamental level. I’m still getting pretty regular e-mails from people who want to open shops and are looking for information.
 
Just like in the restaurant business, brands and retailers lacking a solid balance sheet and a viable market position are going to be
vulnerable in a recession.
 
You can either sit there and hope, or you can minimize your chances of being a casualty by taking action now. Examine your cash flow now. See what a ten-percent decline in revenues would do to your business and adjust your business model right now. I’ve gone out of my way to sound a little economically pessimistic. Hopefully I’m wrong—but plan as though I might be right.

 

 

Swell Raises $2 Million

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Almost as soon as my article on surf industry internet models was finished, Swell shut down its Crossrocket site and then, on May 3rd, announced it had raised $2 million in bridge financing. I hate it when that happens.

Rather than just throw up a press release that created more questions than it answered (see it below) Surf Biz asked me to track down new Swell Chairman and CEO Bob Allison and ask him what was up. It required a fairly impressive game of phone tag, but we manage to connect. Hopefully you’ll agree that the additional information was worth the wait.
 
The headline on the press release was about a $2 million bridge, so the first question was “Bridge to what?”
 
The $2 million is a loan convertible to equity. Mr. Allison confirmed that Swell had burned through most of the capital it had raised (most recently, $8 million raised last October). The $2 million “gives the investors time to evaluate how to move forward with the appropriate plan,” said Mr. Allison. He indicated that investors had committed to invest an additional $5 million in Swell consistent with the company demonstrating to them a viable business plan and revenue model.
 
So the additional $5 million is “committed” but not in the bank. It’s hardly surprising to learn that investors won’t throw money at a company until they understand the business model. 
 
The money raised towards the end of last October lasted six months or a little longer. That’s a burn rate of something like $1.3 million per month. Obviously, Swell has moved to reduce that. Part of that is the moving of the Swell media business to Huntington Beach, which Mr. Allison confirmed.
 
Swell’s actions in containing costs are consistent with what other surviving dot coms have had to do and, in any event, just make good business sense. But of course, no matter how much you reduce costs, you also have to grow revenue to demonstrate a viable business.
 
That business, according to Mr. Allison, will focus around the catalogue and ecommerce business. Brick and mortar may still be in the picture, but only in the longer term. Since launch, Swell had generated more than $1.5 million in revenue in spite of having essentially missed the Christmas season. $400,000 of that was in the last month, so it appears that revenue growth is accelerating. Their four catalogues have had a combined circulation of 1.6 million, and Swell has shipped more than 25,000 orders.
 
Still, they clearly have to grow revenue, reduce expenses and raise more money for the business model to succeed. The alternative is to make a deal.
 
Like with Surfing, for example.
 
Mr. Allison pointed out that Primedia, the owner of Surfing, had been an investor in Swell since its inception. He said that the two companies see significant potential synergies between what Swell is doing on line and what Surfing is doing off line. He acknowledged that there were discussions ongoing, but that no deal had been reached as of this time (May 11th). He expects a conclusion to those discussions in the next couple of weeks.

 

 

After the Gold Rush; The Internet’s Role in the Surf Industry, One Year Later

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Just about a year ago, I asked here in Surf Biz what it took to make money on the internet in the surf business. I said that if you were exclusively an etailer, and had to be both a merchant and journalist, it cost a lot of money just to operate, and you had the added expense of building a brand. I saw no financial advantage, and perhaps a disadvantage. Existing brands and retailers already had existing infrastructure and/or brand recognition. They would figure out how to use the internet to their advantage and it would become just another distribution channel, to be used or not depending on their strategy. Ultimately, they would realize that they were in control.

 
Internet e-commerce stocks were in the tank when I wrote that first article last May and things have been basically downhill since then. The Nasdaq has experienced a percentage decline that’s as bad as its worst decline ever, but it’s done it in half the time. There must be a bottom here somewhere.
 
Still moving forward with internet strategies in the surf industry are Becker, Swell, and Hub360. Becker, the four (about to be five) store Southern California surf retailer, is building its internet business based on a strong brand name and existing retail business. The retail business came first.
 
Swell is the leading (maybe the last?) combination etailer and content provider in the surf industry. It also owns and runs the Monster Skate and Cross Rocket web sites. It’s highly successful Surf Line, established in 1985 and purchased by Swell, is the genesis of the business.
 
Hub360, which has yet to launch its site, is positioning itself as a service provider to suppliers and retailers- a place where retailers and suppliers can place orders, check status, and see what’s in inventory.   Essentially, it sees itself as being able to make it easier and cheaper for suppliers to accomplish certain logistical activities and administrative activities that are important to do right, but don’t necessarily represent critical competences.
 
Three different business models. Three different ways to use the internet to build a successful company. Let’s look at each and see what we can learn, how the models might relate, and what the potential opportunities and sticky points are.
 
Becker
 
This is kind of the easiest one to talk about, because they aren’t an internet business, though they do business on the internet. They are a 20 year old, successful, core surf retailer with four (going on five) shops in Southern California.
 
And that brings us quickly to the first generalization we can make about successful internet businesses- in surf or anywhere else. There’s no such thing as a successful internet business- there are just successful businesses that can competitively provide a product or service to a defined customer base that happen to use the internet. The internet is not the source of their competitive advantage and is not their key differentiator, though it facilitates (or maybe makes possible) the delivery of their product or service.
 
Becker’s competitive advantage, according to CEO Dave Hollander, comes from the fact that they are a family of people and employees that sells the cool California culture without bastardizing it. To maintain what he sees as this key competitive advantage, they have intentionally limited their growth to preserve the company’s culture and market position.
 
Their internet site (www.beckersurf.com) first went up three and a half years ago. That’s practically back in the late Bronze Age in internet years. The brand was already credible when the internet presence was established. They didn’t have to begin with no brand recognition and spend lots and lots of time and money creating it. They didn’t have to work very hard to convince brands to allow their product on Becker’s web site due to the trust that long relationship brings. There are no discounted prices on the internet and never anything for sale, Hollander says. Some items end up selling for more than they sell for at a store.
 
They already own the inventory, and buy no inventory for the internet that they wouldn’t be buying for the stores anyway. “Well, no kidding,” I said the first time Dave told me that. But as we talked a little more, the significance hit me.
 
Dave (and, I imagine, any surf retailer who’s been in business twenty years) knows what will sell in his stores and what will not. That’s what he orders. On the internet, it’s a different story. He never knows what’s going to sell well, and where he’ll be shipping it. “The challenge of inventory management if you don’t have retail stores is overwhelming on the net,” states Hollander.
 
If you’re an internet only retailer, how do you choose and manage your inventory? If you never know who your customer is going to be or where they live, how do you order for them? If inventory selection is a crapshoot, what margin can you really expect to earn after discounting the stuff that doesn’t move? How will that discounting affect the perception of your site and brand?
 
A brick and mortar store gets its customers locally, and can learn about purchase patterns. The only thing Dave knows for sure about his internet purchasing patterns is that those U.S. accounts that are shipping to Indonesia always represent credit card fraud, and he won’t ship to them. Becker’s biggest internet problem is, in fact, credit card fraud, estimated to be ten to fifteen percent of orders received though, happily, not of orders shipped.
 
So here’s internet model number one- as an extension of an existing retail brand. With existing brand recognition and the infrastructure and inventory already in place, it’s an efficient, lower risk and cost strategy.
 
In most industries, we’re seeing existing brick and mortar retailers figure the internet out, using the same advantages Becker is using to make it work for them as an extension of their already successful brands.
 
Swell
 
Rumors about Swell being bought, running out of money, or going out of business are as common as fleas on a stray dog. Passing those rumors around seems like an industry obsession. But Swell is still here when most other internet companies aren’t and certainly at least some of the rumors are the result of the overall abysmal performance of the internet sector.
 
In response to all the rumors, Swell CEO Doug Palladini puts it this way: “Swell is not in imminent danger of running out of money. Funding was obtained consistent with a financial model showing profitability by the end of 2001
He didn’t seem inclined to answer questions like, “How much money do you have in the bank?” and “How much are you spending each month?” Well, I tried.
 
Enough of the fun stuff. Let’s get on to the business model.
 
The Swell internet site launched last October. According to Palladini, the business model, since its earliest presentation, wasn’t just about etailing- it always included the concept of brick and mortar retail. He isn’t prepared to be specific about how that will be accomplished or what the timing might be. Other revenue sources include advertising, catalogue sales (the second issue is out), and content syndication.
 
Although this is about surf, it’s a bit hard to talk about the Swell model without reminding everybody that the company includes the Monsterskate and Crossrocket sites for skate and snow boarding respectively. According to the Corporate Overview on the Swell website (www.swell.com), “Swell, Crossrocket and Monsterskate will be the definitive sources, regardless of medium, in the sports and cultures of surfing, snowboarding and skateboarding. Delivering rich content – news, information and entertainment – with extensive community applications and a robust etailing enterprises, Swell, Crossrocket and Monsterskate bring together action sports’ premier editorial talent to produce content of unparalleled quality and depth aimed at the core of each market, yet will appeal to the broader lifestyle audience as well.”
 
That’s a lofty goal. And expensive to achieve. Given the expense, how do you make money at it? Check out below the matrix of Swell’s existing or planned business opportunities.
 
Revenue
Source
                        Market>                                  Surf                Skate             Snow
                                                            Core/Lifestyle   Core/Lifestyle   Core/Lifestyle   
Etailing
Catalog
Retail Stores
Content Syndication
Surf Line
Advertising
 
Surf line only applies to surf obviously. The other revenue sources are potentially valid across the three markets. And they want to address both the core and the lifestyle markets as well. Five revenue sources times three markets is fifteen. Add Surf Line in the surf market. That’s sixteen. If you choose to look at core and lifestyle as related but distinct markets, that’s thirty-two possible market segments.
 
Not all these segments are really distinctive of course. There’s significant crossover and, Swell hopes, (oh god, here comes that word) synergies.
 
Here we are, I think, at internet business generalization number two. Few if any companies selling only to consumers will make it strictly by etailing. The internet is a tool- not a competitive advantage. Existing brick and mortar retailers have it all over etailers, especially if you’re selling fashion, and the brands control product supply.
 
Swell’s first challenge it to build its brand name. Or maybe three brand names, since they seem intent on doing the same with their skate and snow sites.
 
Its next challenge is to get customers. They are going to have to take them from somebody else, unless they believe that what they are doing creates new customers.
 
Time for internet business generalization number three. The internet does not create new customers. Okay, I know there was some kid in Northfield, Minnesota who stumbled on an etailer when he was checking out porn sites and bought something, but that doesn’t amount to a hill of beans, and I believe he probably would have bought it anyway at a traditional retailer.
 
Getting customers requires that Swell do etail as well or better than other etailers. I think they are doing surf content better than anybody, so I guess they might have a leg up there if you believe that people who come to look at content turn into etail customers. They have to do brick and mortar retail at least as well as existing retailers. They have to do catalog at least as well as existing cataloguers.
 
The third challenge is to get all this done. Somebody who’s in a position to know told me that opening a new surf shop requires between $180,000 and $225,000 in inventory plus $100,000 to $250,000 in up front expense. Just to pick the number in the middle, let’s say a total of $375,000 per store. They will have the same brick and mortar retail expense structure as any other brick and mortar retailer. They will have the same catalogue expense structure as any other catalogue retailer. They will have the same etail expense structure as any other etailer. And producing the killer content they have, which I agree is critical to their strategy, ain’t cheap.
 
To quote what I said a year ago, “Chaching! Chaching! Chachaching!”
 
Their final challenge is to make one and one equal three, or at least more than two. They are creating a brand and all these retail channels for the consumer (the same consumer everybody else has/wants) to choose from. Swell has to represent such a ubiquitous buying opportunity that the consumer who normally buys one hundred dollars of stuff buys more than that one hundred dollars. How much more? Don’t know. If that doesn’t happen, they are creating convenience for the consumer for sure but they’ve got a bigger expense structure that has to survive off the same dollar in sales.
 
But fundamentally, I like their “brand centric” concept. So do a number of important surf industry brands including Reef, Quiksilver, Billabong, Oakley and OP who have year long, not inexpensive, commitments to Swell. If they can get big enough fast enough, and create enough brand legitimacy, their different business pieces and revenue sources can feed off each other more than justifying the expense structure.
 
The idea is almost “Amazonian” in conception and I hope the market is large enough to support it. I wish Swell was doing this two years ago, when a recession didn’t seem imminent and money was easier to come by.
 
Hub360
 
When Hub’s business becomes active in the second quarter of the year Hub, as a business to business site, will allow retailers to browse catalogues on line, check inventory, place and track orders, access order history, and use online forecasting tools. Suppliers will be able to track retailer status. Hub President Dan McInerny describes it as a B2B marketplace for the action sports industry.
 
“It will bring together manufacturers, retailers, sales agents and industry organizations into one standard platform that allows them to better communicate, collaborate and conduct business,” he says.
 
Hubs customers will be the suppliers. There will be no charge for retailers to access the various supplier spaces once approved by the supplier. Hub will make its money the same way as somebody who runs a trade show. A company can have as big a presence on the web site as they want, and they will be charged accordingly.
 
Dan stresses that this is a service business that happens to do business on the internet. He’s helping suppliers by outsourcing certain tasks they have to perform, but that don’t represent critical competences to them. He believes Hub can do them better and cheaper.
 
Some suppliers seem to agree. Dan says he has letters of intent from over a dozen of the biggest companies in the industry representing apparel, footwear, optics, wetsuits and accessories. Their focus will be on surf and skate, because that’s the industry they know.   He hopes that once the concept has proven itself, they can license the idea and their proprietary software for use in other industries by people who know those industries.
 
Obviously, the suppliers won’t care if the retailers don’t come. Hub has signed letters from fifty top retailers saying they will use the site, giving the suppliers some assurance that the cash they pay Hub won’t be wasted. Dan indicated that Hub360 expects to be profitable in its first year if nothing happens except that the twelve suppliers sign on the dotted line.
 
Most suppliers may not have the time, energy, focus and/or money to develop their own site that can do everything the Hub site will do. The benefit to the retailer is that they won’t have to learn a different system and functionality for each supplier.
 
Of course, all the suppliers are already doing (well or not so well) what Hub will do for them. For better or worse, they have the systems and resources in place. Resistance to change can be a powerful force, and I’ll be interested to watch how retailers and suppliers adopt Hub’s system. Because the suppliers will still have to physically handle the product (that’s where much of the cost lies in the activities Hub will facilitate) I can imagine that the benefit from working with Hub will be from providing better customer service and having more accurate, timely information, rather than from overall cost reductions achieved.
 
At the end of the day will it work? The concept seems to make sense, but it’s a hell of a lot easier to evaluate an operating business model than it is a concept that has yet to see the light of day.
 
What’s New?
 
Well, I note that the internet stocks have gotten worse since I started writing this and several more companies have gone out of business. I guess I’m not inclined to change any of the conclusions I reached a year ago. Neither Becker, Swell, nor Hub360 are internet companies- they are just companies who use the internet. Their success depends, has always depended, and will continue to depend, on their ability to give their customers what they want- not on the internet.

 

 

The Dot Com Equation; What Does it Take to Make Money?

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In internet years, it seems like ancient history. But it really wasn’t long ago when it was taken for granted that on line retailing represented a new paradigm in selling to consumers. Maybe it still does- or will. But so far, making money as an online only retailer has proven illusive. How come? How many pairs of surf trunks do you have to move at a “normal” margin before you show a profit?

“It doesn’t matter!” One surf retailing dot com executive was heard to say. “These companies aren’t valued that way.” Of, course that was some weeks ago, and the world has changed. As of May 12th, internet e-commerce stocks, as a group, were rated 197 out of 197 industry groups followed for stock market performance by Investors Business Daily over six months. It wasn’t many months ago that they were among the leaders.   As a group, their stock prices have declined by 48% since January 1st.
 
Mr. Dot Com surf retailing executive, they’re valued that way now.
 
What have people figured out that’s made this happen?
 
Costs
 
It costs a lot of money to develop and maintain a quality web site. Instead of hiring $8.00 an hour sales people, you need $80,000 a year programmers and have a hard time finding them. Caching! You still have to carry inventory and take the associated inventory risk. Caching! You still have to get the product to the customer, and you can’t do that over the internet. Caching! You still have to provide customer service, including handling returns, and sometimes that means actually talking to the customer on the phone. It seems to be necessary, according to the conventional wisdom, to have not only product, but content. In other words, you’re not only an etailer, but also an ejournalist, and that adds some costs as well. Caching!! Caching!! Caching!! Oh, and of course you need to spend some money on marketing to establish your brand. CA-CA-CA-CHING!!
 
Lands End, the mainstream catalogue retailer with a great web site and killer customer service, earned $48 million on sales of $1.319 billion for the year ended January 28, 2000. Of course, they spent $190 million on producing, printing and mailing catalogues. But except for that expense, how is a dot.com retailer’s cost structure different from Land’s End? It isn’t.
 
Lands End internet based revenue totaled $138 million during the year, or 10.5% of total revenue. To put it bluntly, if they didn’t mail those catalogues, they wouldn’t have a viable business. Of course, Lands End isn’t exactly known as being cool, cutting edge, and appealing to the younger generation. Still, they’d have to do an awful lot of internet business before they could stop mailing those catalogues.
 
How much? Well, I guess more than $1.639 billion. That’s how much Amazon sold in the year ended December 31, 1999 and they lost $720 million for the year. It’s interesting to note that Amazon’s gross profit margin was only 18%. Lands End, cool or not, had a gross profit margin of 45%. That’s pretty cool to me. If Amazon had Lands End’s gross profit margin, they would still have lost a couple of hundred million, however.
 
Part of the difference in gross margins comes from the fact that Lands End is just better and more experienced in fulfillment and customer service than Amazon. But the biggest difference is that Lands End is selling product it makes itself with its own brand name on it. Amazon is selling stuff it buys from other brands. Lands End has cut out the middleman. Amazon is the middleman.
 
It looks like there’s more to making money in e-commerce than a cool website and building a community. The devil, as they say, (and the expense) is in the details. 
 
Competition
 
Quiksilver had $444 million in revenue for the fiscal year ended October 31, 1999. If, just to pick a number, Quik has 25% of the surf soft goods market, then we’re looking at an industry, at wholesale, that’s something less than $2 billion, though growing. If you’re a dot com in the surf industry, with the expense structure described above, how much business do you have to do before you can turn a profit? Where are the customers going to come from?
 
It doesn’t seem to me that the etailer is creating any new customers just by being an etailer. He’s fighting over existing customers, in an over retailed environment where he can only succeed largely by taking customers from competitors, of which there are a whole lot. And he’s trying to do it selling products that are probably differentiated from his competitors largely by marketing using a brand name that isn’t as well known.
 
Before the days of the internet, what percentage of total soft goods sales did catalogue companies do? If dot coms get that percentage of the surf industry soft goods market, can they make money? Are there any specific advantages conferred by the internet that will increase that percentage? I don’t know the answers to these questions, but that’s what I’d be asking if I was considering an investment in a dot com.
 
One statistic I saw a few years ago, which may or may not be relevant, was that catalogue and telephone sales of skis had never exceeded 5% of total sales in a given year.   Just for fun, let’s hypothesize that because of the cool factor, or their content, or technology, surf etailers can optimistically get twenty percent of total sales, or something less than $400 million. How many companies can that support? Given the implied size of those companies and their growth prospects, can they expect to attract adequate capital? PacSun and Quiksilver have both experienced some softness in their stock prices due to concerns about their ability to continue to grow quickly. They are both established companies that make money.
 
My personal opinion is that etailers of surf soft goods won’t even approach 20% of the total market. They may not get over five. But even if they can get to 20%, how does the financial model make sense to investors looking for fast growth, big returns, and a public offering?
 
Another competitive issue for dot coms is that established brands will ultimately figure out how to reconcile selling their product on line with supporting their brick and mortar retailers. Dot coms competing with retailers who already know how to handle customer service and fulfillment, have their infrastructure in place, and aren’t all that far behind in web development. Once the internet frenzy wears off, as it seems to be doing, I expect brands to recognize that it’s their product, they are in control and an etailer is just another retailer they may choose to sell too. Or not.
 
Community
 
The etailers’ answer, I expect, would resolve around “community.”   It has become the rallying cry for internet retailers who see creating a community as the focal point of their strategy for getting eyeballs and, hopefully, customers. It’s a good strategy. In all non-internet businesses, it’s called marketing- the process of identifying your customers and building a relationship with them.
 
On the internet, the concept of community implies it’s not adequate to look at the dot com’s revenue model just from the point of view of product sales. There are opportunities to generate revenue through advertisement, sale of content and information, and strategic alliances. How do you create these other sources of revenue? How much revenue can they generate? I don’t know. Neither does anybody else, though there are lots of theories.
 
Some of those theories will prove to be the correct ones, and those etailers may prosper. 
 
And So…….
 
At the end of the day, I wonder if the whole retail world, in the surf industry and in most other industries, won’t just be a fluid amalgamation of brick and mortar and on line. Whatever the successful model is, it’s going to change dramatically as broadband finds its way into more homes.
 
My bottom line on surf industry dot coms is that unless a lot of revenue comes from sources other than product sales, it’s hard to see a viable financial model. I suspect the inevitable result is that the need for sales volume will drive most of them to compete in the broader action sports market along the lines of Earthsports.com or FogDog.com. 

 

 

Fat Lady Sings. K2 Buys Ride

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K2’s purchase of Ride, announced on July 22 and expected to close within 100 days, is as close as we’ll ever get to a capstone on consolidation.

We all were intellectually aware of consolidation, but this makes you aware in your gut. Burton and K2 now control what I’d estimate to be 65 percent of the U. S. snowboard hard goods market. Add Salomon and Rossignol and the number jumps to north of 75 percent. The number two, independent, snowboard only brand in North America is now Sims
Three questions:
 
·         What the deal?
·         What does it mean for the industry?
·         How is K2 going to manage it?
 
The Deal
 
The only info we’ve got on the deal comes from the press release and Ride’s 8K filing with the Securities and Exchange Commission. K2 is buying the common stock of Ride. That is, it’s buying the whole company- not the assets like in the Morrow deal and so many other snowboard deals.
 
So K2 gets all the assets and all the liabilities, known and unknown. If a two-year-old Ride binding blows up, somebody is hurt, and Ride is sued, K2 will be responsible. In an asset deal, they typically would not be- which is one reason asset deals are often popular.
 
Ride’s stock will be acquired in exchange for K2 common stock. Ride shareholders will receive K2 shares “with an approximate value of $1.00 for each share of Ride stock owned.” Given the number of Ride shares outstanding, that means a purchase price of around $14.3 million. Both boards of directors have approved the deal. One of the reasons it will take so long to close is that Ride shareholders have to approve the deal as well.
 
The deal is being structured so it’s tax free to Ride’s shareholders. Ride’s directors have already agreed to vote their shares in favor of the deal.
 
To get Ride from the July 22 agreement date to closing, K2 has agreed to extend $2 million in interim financing to Ride in exchange of a promissory note that can be converted into Ride stock. The note’s initial interest rate is eight percent. That rate increases one percent every 180 days up to a maximum of eighteen percent on the unpaid portion of the note and any accrued interest, however the notes is payable in full on November 19, 1999.
 
The note is convertible by K2 at any time into Ride’s cumulative convertible preferred stock and is automatically converted under certain circumstances if the merger agreement between K2 and Ride is terminated. K2 would get one share of the convertible preferred stock for each dollar that is still owed from the principal and unpaid interest of the note.
If somebody else buys Ride, or agrees to buy ride, before the note is repaid or converted, K2 can demand to be paid in cash for up to a year based on the price of Ride’s stock (which could go up if a better deal comes along).
 
Ride, as a public company, has an obligation to consider any better offers that come along. This note is structured not only to give Ride working capital to get it through the period until closing, but to make it less likely that any such deal will come along. If the deal with K2 closes, there’s nothing but intercompany debt that gets eliminated in consolidation and doesn’t much matter.
 
As another step in keeping Ride operational until the deal closes, the two companies have agreed that K2 will acquire Ride bindings with an approximate cost of $700,000 and assume Ride’s obligations to ship Ride customer orders of approximately $8.4 million in bindings and apparel. K2 will purchase approximately $4 million in inventory from Ride’s vendors to fill these orders.
 
What’s it all mean? The two companies are getting so far into bed with each other before the deal closes that it’s unlikely it won’t close or that another buyer will come along.  
 
The transaction will be accounted for as a purchase rather than a pooling, and now I’ve put my foot in it because I have to explain the difference.
 
First, if you buy assets, you assign values to the assets based on what they are really worth. So is you’re buying accounts receivable for $100,000, but know that only 85 percent are collectible you’d “allocate” $85,000 of the purchase price to those receivables. After you’ve allocated as much of the purchase price as you can to the assets, the rest is allocated to goodwill. Goodwill sits on your balance sheet and has to be amortized (taken as an expense some at a time) over a period of many years, but isn’t deductible for tax purposes.   In addition, no bank ever thinks good will is worth anything when considering whether or not to lend you money.
 
Allocation of purchase price in an asset deal also has a major impact on who pays what tax when the deal closes, but since this isn’t an asset deal and I hate it when readers fall asleep, we’ll skip that. You’re welcome.
 
A pooling is a straight exchange of stock where the values on the two company’s balance sheets are added up. No goodwill is created. No assets are written up or down and there’s no allocation of purchase price. The only adjustments are the netting out of any inter-company debts (amounts the two companies owe each other).
 
K2 is buying Ride’s stock with its stock, but it’s not a pooling because Ride shareholders are getting a certain value per share- not just K2 shares with a value completely dependent on the market. It’s a purchase. That’s what the Financial Accounting Standards Board says, so that’s the way it is.
 
Once K2 knows exactly how many shares it’s exchanging for Ride, and the market price of those shares at closing, it will know how many dollars it paid for Ride by multiplying the market price of each share by the number of shares they are giving Ride shareholders. The accounting interpretation of the deal is that K2 is buying Ride’s equity, a balance sheet number. At March 31, that number was 16.1 million dollars. I’m sure it’s lower now. I wouldn’t be surprised if it’s around 14.3 million dollars.
 
To the extent that the purchase price is higher or lower than Ride’s actual equity at closing, other balance sheet items will be adjusted to reflect fair market values. For example, if the purchase price is $100,000 higher than the value of Ride’s equity at closing, the value of other Ride assets will have to be increased, to a maximum of $100,00 if what they are really worth justified such an increase. To the extent that those adjustments don’t account for the difference between Ride’s equity and K2’s purchase price, goodwill is adjusted. It looks in this case like the purchase price will end up being somewhere close to Ride’s equity, so adjustments should be minor.
 
That’s enough of that. This article is in serious danger of turning into a lecture on acquisition accounting.
 
So what’s the deal worth anyway? The easy answer is that it’s worth the approximately $14.3 million in K2 stock Ride shareholders are receiving. That’s not a bad answer, but let’s go a little further, keeping in mind that there’s rarely a right answer when you value companies.
 
Ride’s March 31 balance sheet showed thirty two million dollars in assets and sixteen million dollars in liabilities. K2 gets all those as part of the purchase. The assets include $8.5 million in goodwill and $5.4 million in net plant and equipment. If I were K2 trying to figure out the value of Ride, I’d call the goodwill zero. I’d write down the plant and equipment. How much would depend on what use I was going to make of the factory. Let’s say they cut it in half, making the realizable value of the Ride assets around $20 million. The liabilities, as usual, are all real.
 
Let’s say that K2 could liquidate the assets for $20 and pay off the liabilities for $16 million. It doesn’t work that way of course, but if it did K2 would have $4 million in the bank. So they would have paid stock worth $14.3 million less $4 million in net assets, or $10.3 million basically for Ride’s trade name and order book.
 
But you can’t realize the value of that trade name and order book unless you operate the business. To do that, you have to invest a certain amount of permanent working capital. Ride didn’t have the working capital it needed. In a nutshell, that’s why it had to sell. My guesstimate, depending on the expense reductions K2 can find to reduce overall operating costs, is that K2 is going to have to invest maybe more than$10 million in Ride in additional to the $4 million in net assets that’s already in there. My guess is that Ride’s bank (owed $8.5 million at March 31) is going to want to be paid off and certain unsecured creditors who have been waiting a long time for their money will also have to be paid. 
 
K2, therefore, may look at it’s cost to buy Ride as not only the value of the equity it gave up, but as the additional capital they have to invest to normalize the balance sheet- $24 million in total or maybe higher. If Ride had been capitalized normally, that whole amount, and probably more, would have accrued to Ride’s shareholders. But K2’s offer was based on what it would cost them not only to buy but to operate Ride regardless of whether it went to the shareholders or not.
 
Good deal or bad deal? K2 got a good deal. Did Ride shareholders get screwed? Not given the alternative. My sense is that Ride’s management found the buyer to whom Ride has the most value. Furthermore, Ride’s balance sheet and recent public information suggest that cash flow issues were severe enough that scenarios where shareholders got less than one dollar per share were possible. Like a whole lot less. Like the big goose egg.
 
All of the web whiners who are bitching and moaning about this deal ought to give Ride employees credit for performing some operational miracles under impossibly difficult circumstances not of their making.
 
If you want to blame somebody, check out the nearest mirror. The person you’re looking at bought an over priced stock in an industry facing an inevitable and predictable consolidation. 
 
Industry Impact
 
Ride and Morrow are gone as independent snowboard companies. Atlantis, Division 23 and Type A are, in my judgment, unlikely to resurface as strong specialty brands. To Forum, Sims, Palmer, Never Summer, Option and maybe a couple of other brands this could be an opportunity depending on retailers’ perception of the deal. One brand I’ve talked with is already getting calls from retailers who were prepared to buy Ride but are reluctant to buy “another K2 brand.”
 
The strategic line between the niche players and the big companies are as clearly drawn as you could ever expect to see. If any single action can be said to mark the end of snowboarding’s consolidation phase, this deal is it.
 
Specialty brands can exist in their niches and maybe grow a little. But it’s financially unlikely that anybody will start another one. Those niche brands that exist don’t have the economies of scale, distribution leverage, and marketing dollars they need to chase the big players. And as independent companies, they probably never will.
 
Then there’s Burton with something like forty five percent of the U.S. market. They are left standing alone with the cache of a niche brand, but on an international scale, and the leverage of a large company. Ain’t nothing to analyze there. My guess is that they are thrilled with this deal.
 
As I indicated, some retailers may have some resistance to putting more eggs in the K2 basket. But if the consumer wants Ride boards, and K2 offers good terms, prices, service, quality and promotion, the retailers will pretty much get over it. They have before.
 
I would expect the complete programs from Morrow and Ride to improve as a result of being part of a larger, financially stable organization. And the production of boards in China is going to produce some price points that retailers aren’t going to be able to live without.
 
Sean- I don’t really want to add here what you added. I think I ask and answer the question you raise in the next section.
 
K2’s Decisions
 
What I think was the opportunistic purchase of Morrow (it was too good a deal to turn down) seems to have transformed itself into a strategy with the purchase of Ride. Of course, we don’t know exactly what that strategy is yet. K2 now has five snowboard brands, with K2, Morrow, Ride, Liquid and 5150. How do they get positioned against each other? How many of those brands can you imagine one retailer buying? If I were doing it, I’d make K2 the ski shop brand. I’d retain Brad Steward (between movies, of course) to consult on repositioning Morrow as the quirky brand it use to be. Liquid would be for the mass-market channel, and Ride for specialty shops, but with a more mainstream profile and higher volume than Morrow. I’m fresh out of market positions and have no idea what I’d do with 5150. Whatever the positioning decisions are, I’ll be interested to see if all five are retained. I wonder what Cass would pay for Liquid? I’d really like to leave this in. Let’s talk.
 
Even excluding the distribution issues, managing five brands against each other in the same organization is tough. I’m reminded that one of Bob Hall’s first pronouncements on becoming CEO of Ride was that the company had too many brands.
 
Of course, some of the brands he eliminated didn’t have enough volume to justify the required advertising and promotional expenditures, and I don’t think K2 faces that. Still, there are some obvious conflicts as K2 works to restructure its organization to manage the five brands.
 
For instance, you just know that the financial guys at K2 are sharpening their knives to slice expenses and walking around muttering stuff about synergies. And certainly K2doesn’t need two warehouses, credit departments, computer systems, purchasing departments, etc.
 
Maybe they don’t need two factories. Yet maintaining brand integrity means keeping sales and marketing separate. Will they have separate customer service departments with people dedicated to brands or will the temptation to have one group that answers the phone “snowboard customer service!” win out? Will all the invoices the retailers receive look the same except for the brand name?   How many brands will be made in the same factory? Will the T-shirts and beanies all be the same but with different logos? In a thousand ways, none of which, by itself, probably matters, the identity of the brands can be subverted in the perfectly reasonable pursuit of operational efficiencies.
 
I’m not saying it will happen, but making sure it doesn’t is a hell of a challenge. It’s not easy to be passionate about five brands at once.
 
SIDEBAR
 
Things to Watch
 
1)             Who’s going to run what brands?
2)             What will happen to Ride’s factory?
3)             What will be the fate of the Device step-in system and the lawsuit with Vans (Switch)?
4)             How will be product development be managed among the different brands?
5)             I’m sure we’ll figure out some more to add.