Fat Lady Sings. K2 Buys Ride

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 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. 

 

 

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.

 

 

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.