SPY’s Year: Sales and Margin Up, Expenses Down

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When I review SPY’s results, we get to see what a smaller specialty brand is doing. They would prefer, I imagine, that they weren’t public and that we didn’t get to look over their shoulder. But for the time being anyway, we do.

I suppose I need to confess that they are doing most of the things I think, and have written, that smaller specialty brands should do, so I’m likely to approve. Let’s see what those are. 

I’m going to start with the cash flow and note that in the year ended December 31, 2013, they generated positive cash from operating activities of $683,000. Not a huge number, but last year they used $5.2 million in operations. To me, getting to positive operating cash flow is more important than making a profit for a company like SPY that’s recently out from under a few tough years.
 
Sales for the year were up $2.2 million or 6% to $37.8 million. All but $100,000 was SPY branded product. They sold $32.6 million of the total in the U.S. and Canada.
 
Gross profit margin increased to 50% from 46% the previous year because they sold higher margin product, made more product in China (instead of Italy) and earned higher margins on closeout product. They also said it was higher because they had “…lower overhead as a percentage of sales partially due to the consolidation of our European distribution center to North America.” I don’t really understand that last one because I don’t know how it impacts product cost.
 
Sales and marketing expense was down 18% from $13.8 to $11.3 million. Advertising was reduced from $819,000 to $394,000. That’s because, well, they spent less. They also reduced SG&A expense from $0.2 million to $6.1 million. They did that in spite of $0.1 million spent in relation to two board of director resignations and $0.3 million related to an officer resignation. Shipping and warehouse expense was also down $300,000.
 
So if you increase your sales, improve your gross margin and reduce your expense guess what happens? SPY had a positive income from operations of $399,000 compared to an operating loss of $5 million last year. We learn in the conference call that it’s the first operating profit since they went public in 2004.
 
They still had a bottom line loss of $2.86 million, down from a loss of $7.24 million last year. But that is almost completely the result of $2.97 million in interest expense, up from $2.39 million last year. This is because  of the $21.5 million due to shareholder we see on the balance sheet, up from $19.1 million at the end of last year. There’s also a line of credit outstanding of $4 million due to an asset based lender.
 
If it wasn’t for the shareholder debt, the balance sheet would be okay, though I do note an increase in receivables of 16.6%, way in excess of sales growth. On the other hand, I love the 6.4% reduction in inventory even with the increase in sales. SPY has had some inventory problems in the past, and we can hope this reduction suggests that’s coming to an end.
 
Next, let’s talk about strategy and tie it to the financial results. Here’s where you can see the 10K if you want to follow along.
 
On page nine, talking about product development, they note, “Our products are designed for individuals who embrace the action sports, performance and lifestyle markets.” To me, that correctly sets some limitations on where their distribution can go, and is typical and appropriate for a niche brand.
 
In the conference call, management noted that they had run out of snow goggles by the end of 2013 and that it was their first year of running out of inventory. They also noted that they had strong orders for next season. The one questioner expressed some concern that, as a result, they might have left some sales on the table. CEO Michael Marckx allowed as how they probably had.
 
I was waiting and hoping he’d suggest to the questioner that running out of inventory had something to do with next season’s strong orders, but he didn’t.
 
SPY expects its revenues in 2014 to be in the $39 to $40 million range with a “modest improvement” in gross profit. I was also interested to learn that they will start paying interest on the shareholders debt in cash, rather than accruing it as more debt.
 
It is interesting what you can do with your expenses when you are a bit cautious with your distribution. I am reluctant to draw too straight a line between controlling distribution and reducing marketing expenses (and SG&A, and inventory, and reducing working capital investment) but I’m pretty sure there’s something to it. Retailers seem to favor product that sells through at full margin for some reason, and that makes business easier and more profitable for everybody.
 
I am pretty sure SPY has also benefitted from the brand refocusing and related company reorganization. As they describe it, “…to sustain the relevancy of our brand to our target market and beyond, we reorganized our entire company, realigned our branding efforts in order to better reflect the original intent of our brand, and have continued to make improvements since then.” Sharing a focus, direction, sense of purpose matters. Sorry if that sounds a little mystical, but I suspect it’s part of the reason they could increase sales and cut expenses.
 
SPY’s business strategies in some cases don’t sound much different from their much larger and better resourced competitors and that could be a problem. I also noticed there wasn’t a word about online or direct to consumer in the whole 10K, and that’s certainly different from most brands. Finally, if they haven’t already, they are going to run out of ways to cut expenses, and bottom line improvement this year may have to come from growing sales.
 
But for now, let’s just note the continued improvement and see what happens next.

Zumiez’s Annual Report: Growth, but Constrained by the Economy.

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Zumiez reported top and bottom line growth even as they acknowledged and were impacted by the economic headwinds in Europe and the U.S. As they put it, “…teen retail in general experienced a challenging sales environment, with many mall based teen retailers seeing significant sales declines. Zumiez was not immune to the declines in traffic; however…our sales results held strong relative to the teen retail sector, with comparable stores sales down slightly while product margins remained essentially flat.” 

As always, I’ll get to the details. If they are a bit more resistant to these headwinds than other retailers, it’s because they’ve been pursuing the same strategy for 35 years. The caveat, of course, is that you have to pursue the right strategy. Just to review, they list their competitive strengths as:
 
·         Attractive lifestyle retailing concept
·         Differentiated merchandising strategy
·         Deep-rooted culture
·         Distinctive customer experience
·         Disciplined operating philosophy
·         High-impact integrated marketing approach
 
You can read about each of these on pages four and five of their 10K.
 
We’ve reviewed together similar claims of competitive strengths for other companies and I’ve sometimes concluded that their claims were more aspirational than actual, noting that’s what every company in the industry wants to do. Zumiez is more credible simply because they’ve been doing it longer with some success.
 
Zumiez ended their fiscal year (February 1) with 551 stores including 28 in Canada and 12 in Europe under the Blue Tomato name (six opened during the year). They plan to open 55 additional stores worldwide in this fiscal year including five in Europe. Net sales grew 8.2% from $669 to $724 million. The fiscal year had one less week than the prior year.  Comparable store sales were down 0.3%. That includes a 0.1% decline in brick and mortar and a 5.4% increase in ecommerce sales.
 
Obviously, new store openings were responsible for most of the sales growth. Average sales per store were $1.2 million, down from $1.24 million last year.
 
Ecommerce sales were 12.3% of sales for the year compared to 11.2% the previous year. What I imagine they are thinking about, but aren’t talking about yet, is how much of their brick and mortar sales are influenced by online. That would be a good question for an analyst to ask.
 
Here’s a table from their 10K that shows their revenue by category. 
 
 
Revenue in the U.S. accounted for 89% of Zumiez’s total revenue. 
 
The gross margin rose from 36% to 36.1%. “The increase was primarily driven by a 40 basis points benefit due to prior year costs related to a step-up in inventory to estimated fair value in conjunction with our acquisition of Blue Tomato and a 40 basis points impact of the correction of an error related to our calculation to account for rent expense on a straight-line basis. These increases were partially offset by a 50 basis points impact due to the deleveraging of our store occupancy costs and a 50 basis points impact of the increase in ecommerce related costs due to ecommerce sales increasing as a percent of total sales.”
 
So it increased by 0.8% due to some one-time accounting changes. Then it decreased by 0.5% because of deleveraging of store occupancy costs. Don’t quite understand that and would love some detail. Finally, if the 0.5% impact from ecommerce related costs is part of implementing their omni channel strategy, I’m fine with that.   
 
Selling, general and administrative expenses were up from $172.7 to $188.9 million. As a percentage of sales, it was up just 0.2% to 26%.
 
“The increase [as a percentage of sales] was primarily driven by a 60 basis points impact of the increase in ecommerce corporate costs… a 40 basis points impact due to the deleveraging of our store operating expenses, a 20 basis points impact due to the deleveraging of our corporate costs and a 20 basis points impact of a litigation settlement charge…These increases were partially offset by a 70 basis points impact of the reversal of the previously recorded expense associated with the future incentive payments to be paid in conjunction with our acquisition of Blue Tomato, a 30 basis points benefit due to prior year costs related to transaction costs incurred in conjunction with our acquisition of Blue Tomato and a 20 basis point impact due to a decrease in incentive compensation.”
 
The key thing I pull out of there is that Blue Tomato is obviously not performing as they had hoped when they bought it. Here’s how they describe it in the conference call:
 
“…we continue to be optimistic about our long-term prospects in Europe. However, the reality is the operating environment in the region just as in North America has been challenging since we completed the acquisition in 2012. While the sales in Europe comp positive in Q4 and for the year, we are estimating our sales and earnings results to be below the thresholds that a contingent earn-out is based upon and the likelihood that we will now achieve those minimum levels required for a payout is low.”
 
Operating income rose 6.3% from $68.5 to $72.8 million, but the operating margin fell very slightly from 10.2% to 10.1%. Net income grew from $42.1 to $45.9 million.
 
Fourth quarter sales were $227 million, up 1%, with comparable store sales (which includes ecommerce) down 2.2%. North American revenue was down $1.6 million even with the new stores. Europe increased by $4 million probably because of the new stores.   It was the fourth quarter in the previous year that had the extra week I mentioned before. That accounted for $8.9 million in revenues last year.
 
The quarter was positively benefited by $5.8 million from the reversal of the Blue Tomato projected earnout and by $3.3 million for correcting a lease accounting error, which I am sure neither you nor I want to discuss in detail. 
 
The balance sheet continues to be strong, allowing them to continue to pursue certain of their strategies in an uncertain environment. There’s very little long term debt. Cash generated by operations was about $67 million, consistent with the last couple of years.
 
It’s just a tough environment to be a retailer in right now. As CEO Rick Brooks put it, “In this world there are too many stores and as retailers are forced to reduce their capacity, share consolidation will continue.” That probably makes Zumiez’s strategy and points of differentiation more valid than ever, but there are a few things they need to be and, I imagine, are thinking about.
 
The first, as I’ve suggested before, is what business they are in. If they are truly limited to the action sports business, it may constrain their growth. As an example, they acknowledge that it was a lousy season for snowboard hard goods. But one of the things they do to distinguish themselves as an action sports retailer, especially in the mall, is to carry them. Drop snowboards? Add twin tipped skis? I don’t know. Is the target market action sports participants or youth culture? Both? Is the competitive space as broad as branded consumer products, which somebody recently suggested to me? If so, what the hell does that mean?
 
I suspect that Zumiez’s (and other company’s) omni-channel efforts will help them figure that out. I didn’t bother to describe the 48 or so mentions of what they are doing in this area, but let’s just say they’re all over it. It’s going to impact when and where they open stores, what those stores look like and, I expect, how big they are. And it’s going to influence their product selection as their customers and potential customers engage with them and have more control over what they buy and where.
 
The relationship between systems, technology and what you sell to whom is only going to get stronger. Neither Zumiez nor anybody else knows how it’s all going to work out, but they seem as well positioned as anybody to figure it out. Now if only the economy would improve.

 

 

Skullcandy’s Year and Quarter: Still Comes Down to Whether They Can Be Cool at Fred Meyer

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My dilemma is that I like almost all of what Skull is doing. But it’s hard to pull it off as a public company. Either they are pursuing a niche strategy where it will be hard to get acceptable public market kind of growth, or they are competing in a much larger market against players that have them outgunned. My take on the conference call and 10K (which you can see here), is that they are trying to straddle the two. Here’s how they put it. 

“We have a sales and distribution strategy that allows us to build relevant and exclusive products for our specialty retailers while giving us a runway to build demand creation and scale production before launching into large format retailers. This builds our brand authenticity with our specialty retailers while creating a robust product pipeline for the future.”
 
I have written way too many times that the further you get beyond the “core” market, the more likely it is that the consumer may know your name but not your story. I think they need to not just know, but embrace your story if your competitors are way bigger than you are and have you out resourced. That’s Skullcandy’s challenge.
 
Financial Results
 
Let’s start with the December 31 balance sheet. Over all, it’s not dramatically different from a year ago. The current ratio is strong and hasn’t changed much. Neither have total liabilities to equity. Cash has increased from $19 to $39 million as cash generated by operations rose from $13.5 to $23.5 million. I like cash. There’s still no bank or long term debt. Receivables have fallen from $76 to $58 million, consistent with the decline in sales of 29.5%, from $298 to $210 million.
 
North American sales fell 30.4% from $222.6 to $155 million due to “Increased competition in the audio and gaming headphone markets and…our continued scaling back of sales to the off-price channel, which were down approximately 48.9% compared with 2012, contributed to the decrease in North America net sales. In addition, and to a lesser extent, the decrease in net sales was the result of the transition to a direct distribution model in Canada, our decision to stop selling products to certain retailers and distributors that were violating our policies on minimum advertised prices and our significant decrease of discounted online sales at www.skullcandy.com.”
 
International sales, including those sold in the United States with “ship to” locations outside of North America, decreased from $75.1 to $55.1 million. Non-U.S. sales decreased 27%, falling from $28.5 to $20.8 million. “The decline was primarily attributable to lower sales in Europe, which continued to be a challenging retail environment and our desire to carefully control inventory with retail customers in our international set of distributor partners. The softness, though, in Europe was offset to a lesser extent by gains in Japan, Mexico and Canada…”
 
In explaining the sales decline above, you’ll notice they start with “increased competition” and then mention the reduced off-price channel sales. I wonder what percentage of the total decline resulted from increased competition. It would be useful if they explained exactly what sales channels “off-price” referred to and how many dollars the cut backs represented.
 
Back on the balance sheet again, we see that inventories have decreased only very slightly, from $41.6 to $40.3 million. I would have expected a much large decline given the fall in revenue. The 10K doesn’t tell us anything about the quality of inventory. We learn in the conference call that they have $3.1 million in additional inventory in a warehouse in Canada that didn’t exist a year ago. One of the analysts asked how comfortable there are with their inventory and got told by CEO Hoby Darling that “…overall, we have really clean inventory.” Nothing they said really explained to me why it wasn’t down more given the revenue decline.
 
Switching back to the income statement, we find a gross profit margin that declined from 46.8% in 2012 to 44.3% in 2013. The 10Q says, “The decrease in gross margin was primarily attributable to increased sales returns and allowance expense due to increased returns rates to the Company’s retail customers and a shift to a lower margin product mix.”
 
Like with the inventory, I’d like a lot more information about that. With the sales decline, they lead by talking about increased compensation. Then they tell us in the conference call that sales returns and allowance expense was 11% of revenue in 2013, up from 6.4% in 2012. And remember they are reducing their off-price sales. I don’t quite know what that term means or how many dollars of sales we’re talking about, but I guess I might have expected that reducing those off-price sales would have tended to improve the gross margin if the number is significant.
 
Selling, general and administrative expenses were approximately level at $98 million. As a percentage of sales they rose from 32.9% to 46.7%. There are $8.2 million in “nonrecurring expenses,” as they like to refer to them, included in that number. These include a big customer bankruptcy filing, moving their offices, severance for the former CEO, and a write down for some “end-of-life” products. 
 
It isn’t just with Skullcandy that I get a smile on my face when I see the list of what they call nonrecurring. There always seems to be something next year that’s nonrecurring. I think companies should establish a reserve for nonrecurring expenses like they do with bad debt. Course, if you reserve for them it means you expect them, and then I suppose they can’t be classified as nonrecurring. But, damn it, something nonrecurring seems to occur every year.
 
Demand creation expense increased by $1.1 million to $27.1 million. Given their strategy, I think that’s appropriate, and I’d even like to see more. I like their 4-city takeover concept, “…based around Crusher and our NBA All-Star in Chicago with Derrick Rose, Oklahoma City with Kevin Durant, Houston with James Harden, and Minneapolis, where we featured the product and athletes on billboards, buses wrap with Crusher and exploding windows, athlete product and brand images projected onto buildings and other out-of-home media during the holidays and into the beginning of this year.” It’s coordinated with a big social media component.
 
Their operating income for the year declined from a positive $41.5 million to a loss of $5 million. The net loss was $3 million compared to a profit of $25.8 million last year. That includes an income tax expense of $14.6 million last year compared to a tax credit of $2.9 million in 2013.
 
Sales for the last quarter of the year fell from $101 to $72.2 million. Gross margin was down from 44.5% to 43.5%. They had net income during the quarter of $3.7 million compared to $11.4 million in the same quarter last year.
 
Walmart, Other Customers and Strategy
 
Skul’s two biggest customers during the year were Target and Best Buy. One of them was 10% of sales and one 14%. Don’t know which was which. They accounted for 28% and 25% of the company’s accounts receivable at the end of the year.
 
In the conference call, we learn from CEO Darling that Skullcandy will “…test the segmented product line that focuses on our entry level price points with Walmart in mid-Q2. Some people will ask whether Walmart is right for the brand.” Indeed. 
 
Here’s how he says they think about distribution in general:
 
“When we think about adding distribution, we think about 5 key questions: First, does our consumer shop at the location? Second, does our consumer expect to find us there because our competitors are there? Third, can we position the brand at retail point-of-sale in a way that is fun, young and irreverent and does not dilute the brand? Fourth, can we serve a customer that otherwise has limited access to our products at brick-and-mortar from a geographic perspective? And fifth, whether we can create segmentation throughout our distribution pyramid from pinnacle on down?”
 
Here’s how he answers those questions with regards to Walmart:
 
“First, we know our consumer shops at Walmart. Second, each of our competitors, including Beats, Apple, Sony, Bose, Yurbuds and Monster are all already sold at Walmart and have been there for multiple seasons. Third, we have negotiated POS that we believe will look and feel right so that our consumer has a good experience with our brand. Fourth, Walmart is the store in many towns, where there’s no other or very limited Skullcandy distribution, especially throughout the South and Midwest. Lastly, we’ll segment Walmart during this test to only the price points and designs that we believe are most attractive to the Walmart customer and are different than most of our other accounts.”
 
At Walmart, they are going to be focusing on buds under $20 and headphones under $35. They indicate this is a “…different assortment than almost all of our other retailers have.” 
 
I started this analysis talking about the difficulty of being a niche brand while meeting the expectations of Wall Street. You can almost feel the dilemma this causes when Hoby says, “As part of opening Walmart, we are also doubling down our core and influencer retail partners…We have to keep specialty special.” When he notes above that their competitors are already at Walmart I can’t quite figure out if, as he says, that’s a reason to be there or a reason not to be there. They talk about how they are going to manage the brand at Walmart and insure sell through (though they aren’t specific as to how). But if the Walmart order gets significant (remember something like 6,000 stores in the U.S. and 10,000 worldwide) and Walmart wants a different mix or better pricing, how easy will it be to say no?
 
When Skull went public, I characterized their challenge as “being cool at Fred Meyer.” They are certainly more focused, thoughtful and cautious about how they go about doing that, but the challenge hasn’t really changed and the competitive landscape has gotten tougher.

 

 

Quiksilver’s Quarterly Results: Still a Work in Progress

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It’s not usual that I’m happy to see a decline in year over year revenues during a quarter, but in the case of Quiksilver, I think I’ll make an exception. Their revenues for the quarter ended January 31 fell by 4.8% from $412 to $396 million. But at least some of that decline is from cleaning up distribution and I love that. In fact, I think it’s where Quiksilver needs to start. 

As most of you know, their earlier financial problems led them to push brands for revenue in ways that weren’t good for those brands even if it was what the company had to do. To build their brands now, they have to exercise some caution with distribution.
 
Here are their results by segment from the 10Q. EMEA is basically the European area and APAC is Asia and the Pacific.
 
 
Here’s the operating income for each region:
 
 
You can see that revenue was down in each segment, but so was SG&A expense. In constant currency, revenue fell 2%. Below are the revenue numbers by brand as reported in the 10Q.
 
 
They only discuss the individual brands’ performance by region in constant currency. Quiksilver and DC revenues were off in the high single digit percentage in the Americas. Roxy was up by a similar amount. “The net revenue decrease in the Americas wholesale channel was focused within North America where net revenues decreased by a high single-digit percentage due primarily to three factors: 1) lower sales of DC brand products of approximately $6 million as a result of improved management of channel inventory to better align sell-in with sell-through; 2) a reduction of net revenues of approximately $2 million as a result of the discontinuation of the Quiksilver women’s product line in fiscal 2013; and 3) a reduction in net revenues of approximately $2 million as a result of lower shipments into Venezuela due to the economic instability occurring there.” They note that the decrease in the Americas was focused in North America and expect continued “negative impact” on the North American wholesale business “in the near future.”
 
I love that DC fell because they were controlling distribution. Staying far, far away from Venezuela right now is a good idea.
 
In EMEA the Quiksilver brand was down a low double digit percentage. DC fell by high single digits and Roxy was flat. “The decrease in EMEA wholesale channel net revenues was primarily due to lower net revenues with clearance customers due to improved inventory management, and increased returns and markdowns to aid inventory sell-through versus the prior year period.”
 
In APAC “…segment net revenues increased across all three core brands (Quiksilver, Roxy and DC) and all three distribution channels (wholesale, retail and e-commerce). A significant portion of the net revenue increases was driven by promotional activity and clearance sales.” APAC revenues rose 11% in constant currency but were down 4% as reported, and they expect currency to continue to be an issue in that region “in the near future.”
 
As reported, here’s how Quiksilver did during the quarter by distribution channel.
 
 
Talking about the wholesale business, they note, “Our wholesale net revenues have declined for the last several quarters, particularly within the Americas and EMEA segments due to various economic and competitive challenges. We believe it is likely that such difficulties will continue in the near future, resulting in further net revenue declines within this channel.” Ecommerce revenues in the Americas were down slightly. CEO Andy Mooney noted in the conference call that they expect more fallout in the “smaller wholesale accounts.”   
 
Gross margin in the Americas rose from 42.8% to 43.4%. In EMEA it was up barely from 58.7% to 58.8%. In APAC, it fell from 54.0% to 52.7%. The overall gross profit margin remained the same at 50.9. 
 
Selling, general and administrative expense (SG&A) declined by 5.6% from $216 to $204 million. These expenses include $2.6 million this quarter and $3.1 million in last year’s quarter as part of the profit improvement plan (PIP). There’s another $2 million in expense during the quarter “…related to certain non-core brands that have been discontinued, but I don’t know if that’s part of SG&A or cost of goods sold. As a percentage of sales, SG&A declined from 52.5% to 51.9%.
 
They point out that, “Depending on the pacing and nature of further restructuring activities, we may not be able to maintain the same pace of SG&A savings in future quarters that we have achieved in recent quarters.” There’s no “may not” about it. A company’s ability to improve the bottom line through expense cuts doesn’t last forever. Employees won’t work for free and landlords will want their rent. 
 
Remember, the PIP is supposed to improve adjusted EBITDA by $150 million by the end of fiscal 2016. “Approximately one-half of this improvement is expected to come from supply chain optimization and the rest is expected to be primarily driven by corporate overhead reductions, licensing opportunities and improved pricing management, along with net revenue growth.” They aren’t specific about which part will provide how much. 
 
The operating loss fell from $9.7 to $4.8 million, but a chunk of that ($2.3 million) is because of a decline in the asset impairment charges from $3.2 million to $883,000. It’s good to see those noncash, but indicative of expected future cash flow, charges going away.
 
Interest expense rose from $15.5 to $19.4 million, and the loss from continuing operations after taxes declined from $31.2 to $22.7 million. However, they had a tax benefit of $4.4 million instead of a tax expense of $2.9 million, a $7.3 million improvement.
 
Net income went from a loss of $30.6 million to a profit of $14.9 million, but that’s only because they had a one-time $37.6 million gain from discontinued operations after taxes.
 
I’d characterize the balance sheet as weaker than a year ago. Equity has fallen from $590 to $380 million while total liabilities are up from $1.158 to $1.221 billion. Total borrowings rose over the year from $788 to $865 million. There’s a decline in inventory from $419 to $360 million, but it’s hard to evaluate that as some of the reduction came from the sale of assets or elimination of brands. CFO Shields tells us in the conference call that inventory days on hand decreased by 11 days. He also says, “The quality of our inventory improved as we continued to liquidate aged inventory.” Aged inventory as a percentage of total inventory was down. That, I suppose, is good, but some specifics would sure be nice. When will that excess aged inventory be gone and how much are we talking about?
 
Receivables are pretty much unchanged at $339 million. I might have expected some reduction there given the sales decline and asset sales.
 
Okay, having dragged you through the numbers, let’s have some fun and talk strategy. At various points in the 10Q and the conference call, we’re reminded that margins at wholesale were down, that the number of smaller wholesale accounts is shrinking and that they expect it to continue to shrink. That’s just a market reality faced by all brands. CEO Mooney notes, “The smaller accounts are absolutely important to us. I just think there’s going to be fewer of them." In the U.S., we learn, small wholesale retail accounts are just 19% of Quiksilver’s revenue. In Europe, it’s 40% to 45%.
 
If that channel is going to continue to shrink, Quik can’t rely on it for growth. What’s the solution? One answer, they believe, is more retail stores. They ended the year with 645 company owned stores and expect to open around 40 more this year.
 
A second thing they are doing is adding entry-level price point products for DC. I don’t know what kind of revenue that might generate.  I’m mostly just surprised they weren’t selling there before. So was Andy Mooney I think. He notes that DC has never participated in the “…$45 to $55 retail price segment for canvas vulcanized footwear…” Worldwide, he estimates the market is 120 million pairs. You can see why he’d like DC to get a piece of it. I can’t think of any reason they shouldn’t.
 
Third, we find out that Quiksilver has already reduced product SKUs by 40%, but that their own retail stores can still only showcase half the company’s products. He thinks they might be able to cuts SKUs by another 40%. Think of the magnitude of those cuts. It’s stunning that they could have had so many SKUs in the first place.
Cutting SKUs that much has huge implications for inventory investment and supply chain management. It will let them pull a chunk of working capital out of the company. But maybe more important is the impact on their competitive positioning when retailers have some chance to actually get theirs heads around a brand’s line and merchandise more of it well. As they cut SKUs and manage distribution better, there is an opportunity to differentiate the brands.
 
But my antenna really went up when Andy said early in his remarks, “…we also believe that we have opportunities to increase sales to the larger wholesale accounts in these markets by focusing on appropriately segmented product collections.”
 
Later, in response to an analyst question, he expanded on his thinking:
 
“…I think increasingly, the larger retailers aren’t really interested in what our line is. What they’re interested in is what their line is. Each of those retailers is increasingly looking for custom-design lines that appeal to both their unique consumer as they see it, and certainly their business objective.”
 
He goes on:
 
“Every retailer in the mall is looking down the mall to see what the competitor has from the same brand. And if they have something similar, they’re not particularly interested in carrying that brand. So that requires an organizational setup, people who are adept to doing footwear under [indiscernible] and that’s a particular breed of cat. You need a supply chain that can get both in printed goods and cut and sold goods to market on a quicker pace than you would do for the traditional channel.”
 
Okay readers, help me out here. I read that and hear “fast fashion in big chains.” I’m not prepared to characterize this as a good idea or a bad idea, but I do have questions. Just to be clear, I don’t have any problem with Quik’s brands being in large chains (the right one, merchandised correctly, with the right product). Everybody else is there and, as Andy Mooney says, this is where the market is going.
 
Question one is does Quik have the systems and infrastructure to pull this off? CEO Mooney says they do. The company will have to develop a new internal attitude about how they operate.
 
Question two: Does this imply selling to some different retailers than they are already selling to? If so, which ones?
 
Question three: What exactly does it mean to produce different products for different retailers? How different are the products? How many products how often? Is it for the whole line that the chain carries or just some coordinating product around the edges?
 
Question four: If retailers are interested in what their line is, not what your line is, what does that say about brand positioning? Do you just make what they want? I think this might say something important about how you compete. How much influence does a chain that places a big order have over the product you make before you aren’t managing your own brands anymore?
 
Question five: Who is Quik competing with in this market with these customers? What’s the value of their brand’s heritage in these circumstances?
 
I’ve wondered a few times now if distribution won’t begin to become less important as you allow consumers to connect with your brand whenever they want and however they want on whichever device they are using or in the store, where the devices are also used. I suspect that’s part of the answer to making this work.
 
At the end of the day, I’m on board with the operational steps Quik is taking to cut costs and improve efficiencies and expect it to have a positive impact on the bottom line. I think I mostly agree with their ideas about how the market is evolving. But figuring out how heritage brands fit in this market and grow in it is the challenge they have. 
 
Not for the last time, and not just for Quiksilver, I wish they were a private company.

 

 

Deckers’ Full Year Results and Some Insights on Sanuk

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We’ve all been interested in Deckers since they bought Sanuk. I want to start by pulling what we can on Sanuk out of the 10K and conference call. But Deckers also said some interesting things about direct to consumer business and how brick and mortar integrates with online. Finally, of course, I’ll look at their numbers for the quarter and the year.

Sanuk’s Results
 
Let’s go right to this chart from the bowels of the 10K (which you can see here) for Sanuk’s numbers for the year ended December 31, 2013 (in millions of dollars).   The first column is 2013, the second 2012, the third the amount of the change ($ millions) and the fourth the percent change.
 
 
Still not the kind of increases they were hoping for when they bought the brand I imagine. Now, somewhere else in the middle of the 10K we are reminded that the earnout for Sanuk was, without any limit, “…36.0% of the Sanuk brand gross profit in 2013, which was approximately $18,600…” That’s $18.6 million, just to be clear.
 
If $18.6 million is 36% of the gross profit, then 100% of the gross profit is $51.7 million. Sanuk’s gross profit percentage, then, was 50.8%. Here’s what they say about Sanuk’s wholesale business. Ecommerce and retail margins would be higher I assume.
 
“Wholesale net sales of our Sanuk brand increased primarily due to an increase in the volume of pairs sold, partially offset by a decrease in the weighted-average wholesale selling price per pair. The decrease in average selling price was primarily due to an increased impact of closeout sales. For Sanuk wholesale net sales, the increase in volume had an estimated impact of approximately $10,000 and the decrease in average selling price had an estimated impact of approximately $5,000.”
 
Those numbers are in millions of dollars as well.
 
The next thing they tell us is that Sanuk’s operating income on its wholesale business only was $20.6 million, up from $14.4 million the previous year. That’s an increase of 43% and is 21.8% of wholesale revenues, up from 16% a year ago. By way of comparison, the UGG operating income on its wholesale business as a percentage of revenue in 2013 was 27.5%.
 
But there’s a catch. A pretty big catch, actually. I’ll let the folks at Deckers explain it to you.
 
“The increase in income from operations of Sanuk brand wholesale was primarily the result of decreased expense related to the fair value of the Sanuk contingent consideration liability of approximately $8,000, which was primarily due to changes made during 2012 to the brand’s forecast of sales and gross profit through 2015, which increased the expense in 2012 without a comparable increase in 2013. In addition income from operations increased due to the increase in net sales, partially offset by a 1.4 percentage point decrease in gross margin due to increased closeout sales as well as an increase in sales expenses of approximately $2,000.” That’s $2 million.
 
So they’d booked $8 million as an expense for the contingent payout they expected to have to make. But the brand didn’t perform as projected, so they don’t have to pay that. Without that $8 million they got to add back in in 2013, I guess operating income would actually have fallen on rising sales. Meanwhile, the gross margin fell and they had higher closeout sales. One wonders to what extent the sales increase was due just to closeout sales. And they had to spend an extra $2 million to do this.
 
Granted, Sanuk is only 8.9% of Deckers’ total revenues for the year, but it still annoys me when they make it this hard to figure out what’s actually going on. If I’d paid as much for the brand as they paid and it was performing like this, I’d probably do the same thing.
 
The Omni Channel
 
We’re all speculating about the integration and evolution of online and brick and mortar. Deckers has David Powers as the President of Omni-Channel for them. He had some interesting things to say about what they’re doing.
 
He says they are starting to open stores that are a couple of hundred square feet smaller than usual. This is driven by the realization that ecommerce and quicker delivery is going to start to reduce the need for as much square footage, if only because one third of a store’s footprint won’t be needed to hold inventory. I think they are right about that.
 
I’ve raised the issue that ecommerce has to generate enough incremental sales to offset the cost of the ecommerce function or it will reduce the bottom line. But that isn’t necessarily true if direct to consumer sales evolve in such a way that your expense in brick and mortar declines due to technology reducing staffing costs, lease costs falling because you need fewer square feet, and reduced inventory due to more flexibility in your inventory systems.
 
Dave Powers put it this way:
 
“We will continue to leverage technology to transform the shopping experience into one that is personalized and efficient for our customers driving conversion and long-term growth for Deckers. We need to continue to strengthen our understanding of who our customers are and use that information to develop deeper relationships with them. We are actively working on a unified system to connect and communicate to our customers as they move between our stores and E-Commerce sites.”
 
He goes on to describe their first multi-brand retail store:
 
“The store will serve as the showcase for our expression of Omni-Channel retail and a test lab for new concepts, utilizing the latest technology combined with compelling merchandising to elevate the customer experience. Our customers have the ability to shop in-store using digital touch screens, customize their products, and order online, ship direct to their home free of charge or to pick up in stores.”
 
In general, this feels like exactly the right approach. They are going to learn a lot of interesting things and I look forward to hearing about what works and what doesn’t and how the concept evolves.
 
The Numbers
 
Total sales for the year rose 10% from $1.41 to $1.57 billion. The sales are broken down in the table below by brand at wholesale and for other channels. The left column is 2013, the right 2012.
 
 
You can see that UGG represents about 53% of total revenues, and fell very slightly  at wholesale for the year, though it was up 10% overall. Direct to consumer is 32% of revenues. At the end of the year, they had 117 retail stores worldwide, 40 of which were opened during the year. U.S. sales for the year were $1.04 billion, up 7.1% for the year. International sales grew 16.5%. 
 
The gross profit margin rose from 44.7% to 47.3%. “Gross profit increased by approximately 1.5 percentage points due to reduced sheepskin costs and increased use of UGG Pure, real wool woven into a durable backing used as an alternative to table grade sheepskin in select linings and foot beds, as well as an increased mix of retail and E-Commerce sales, which generally carry higher margins than our wholesale segments, of approximately 1.2 percentage points.”
 
You may remember that Deckers got hit pretty hard when sheepskin prices rocketed and they tried, but weren’t able to push the price increases through to consumers. Those prices have come down some, but what I like is the UGG Pure idea. It’s allowed them to respond in a realistic way to market forces and general economic conditions by continuing to offer a quality product but at some lower price points. As CEO Angel Martinez put it, UGG Pure allowed them “…to offer our consumers luxurious quality at appropriate price points and extend into new categories.” 
 
I’d also like you to notice that the gross margin on the direct to consumer sales is only about 1.2% higher than wholesale. That’s additional margin worth having, but it’s nowhere near what people used to think it would be. It costs a lot to run direct to consumer operations. But remember that gross margin in direct to consumer operations is after a bunch of operating expenses. That is, it’s not just product gross margin.
 
Selling, general and administrative expense was up from $446 to $529 million. As a percentage of sales, it rose from 31.5% to 33.9%. The biggest piece of this increase ($53 million) came from the opening of new stores. SG&A expense includes $86.5 million in advertising, marketing, and promotion costs. That’s up from $78.5 million the previous year.    
 
Net income was up from $129 to $146 million.
The balance sheet is in good shape and strengthened over the year. I particularly note an increase in cash from $110 to $237 million (I like cash) and a reduction in inventory from $300 to $261 million even as sales rose. The decrease is mostly due to a decline of 18% in UGG inventory.
 
Deckers’ financial results are improving, and it looks like they might be taking the lemons the higher sheepskin prices gave them and turning them into lemonade through the UGG Pure and some other things they are doing. I also like their approach to DTC.
 
They are expanding the UGG brand into outerwear and a home fashion line starting this fall. Men’s’ and women’s lounge wear tops and bottoms are part of the line. Omni-Channel President David Powers noted in the conference call, “I think the real win here is the combination of loungewear and slippers and home together as a full lifestyle expression, and I think we’re learning what the best way to showcase that in our stores is.” We’ll see how that goes.
 
To end where we started, Deckers still seems to have some work to do with Sanuk, but perhaps their recent hiring is an indication that things are going to start improving if those people are allowed to run the brand.

 

 

VF’s Quarter and Results for the Year: One Sentence Caught my Attention

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Okay, strong balance sheet, revenue growth, profitable, blah, blah, blah. I’ll get to all that. But on page 22 of the conference call an analyst asked about their interest in potential acquisitions. The answer from CFO Bob Shearer, in part, was “…how we think about acquisition targets, and we think about it a lot, and yes, we have a list. But we think about brands that are complementary to our brand portfolio that help us reach customers/consumers.” 

I added the italics and bold type. You wouldn’t think that their having a list would get me quite this interested, but it does. Consider what it means. They have a list of companies they might want to buy. I assume they didn’t create this list by throwing darts or rolling die. Maybe there’s a drinking game! Probably not. They had a process whereby they looked at the brands they own, with whom and how they compete, and their customer segmentation. Then they surveyed the universe of competitors and analyzed and selected the ones they thought might be good fits.
 
Okay, I don’t want to make VF sound too omnipotent here. Maybe they aren’t as rigorous as I’m suggesting. Acquisitions in this industry, in my experience, have a large element of serendipity to them. Still, such a process would be consistent with the management rigor I think I hear in their public information. And it would be important managing their portfolio of brands.
 
Just so you see how important, here’s a list of the brands they own and the markets those brands are in.
 
 
That’s a lot of brands, a lot of markets, and quite a bit of market overlap. Randomly buying brands because they were “a good deal” and increased revenue would result in an unmanageable behemoth pretty quickly. That, I assume, is where the rigor of developing the list comes in. Deals they make will be supportive of markets where they already participate and have expertise.
 
Their management rigor also shows up in their operations. VF makes around 500 million units of product a year for 35 brands. They own 28 of their own factories and work with 1,800 contract manufacturers in 60 countries. They’ve got 29 distribution centers and 1,246 retail stores under various brands.
 
In what is probably an understatement, they say in the 10K (you can see it here), “Managing this complexity is made possible by the use of a network of information systems for product development, forecasting, order management and warehouse management, attached to our core enterprise resource management platforms.”
 
Why is this a good thing? Here’s another quote from the 10K.
 
“We believe that we will be able to remain cost competitive in 2014 due to our scale and significance to our suppliers. Absent any material changes, VF believes it would be able to largely offset any increases in product costs through: (i) the continuing shift in the mix of its business to higher margin brands, geographies and channels of distribution; (ii) increases in the prices of its products; and (iii) cost reduction opportunities. The loss of any one supplier or contractor would not have a significant adverse effect on our business.”
 
Not sexy maybe, but I’d characterize all this boring operations stuff as a critical competitive advantage. It’s particularly important for integrating and realizing value from an acquisition. Anybody can buy a company. It takes good management and hard work to integrate it effectively into an existing organization. And careful selection of the acquisition target, which brings us back to their list of company’s they watch. Having tied that together, we can now move on to the numbers.
 
Fourth quarter revenues were $3.29 billion, with a net profit of $368 million, or 11.2%. Outdoor & Action Sports revenues were up 12% for the quarter. The North Face rose by 12% and Vans by 14%. “Vans was up at a low-double-digit rate in the Americas, up 20% in Europe and up at nearly the same rate in Asia.”
 
For the year, VF’s revenues rose 5% from $10.77 to $11.3 billion. The growth was all organic. That is, there were no acquisitions in 2013.
 
38% of revenue was from outside the U.S. Direct to consumer, which includes retail stores, outlet stores and online represented 22% of revenue compared to 21% a year ago. Ecommerce by itself was $327 million, or 2.9% of total revenue. Of their 1,246 retail stores, 1,166 carry only a single VF brand. The other 80 are VF outlet stores. The plan is to open another 150 stores in 2014 focused mostly on Vans, The North Face, Timberland and Splendid.
 
They also note, “In addition to our direct-to-consumer operations, our licensees, distributors and other independent parties own and operate over 3,000 partnership stores…”
 
The Outdoor & Action Sports segment grew from $5.866 to $6.379 billion and represents almost 56% of total revenue for the year. It generated an operating profit of $1.106 billion, representing 57.3% of VF’s total operating profit for the year of $1.93 billion.
 
“The Outdoor & Action Sports Coalition revenues increased 9% in 2013 over 2012 primarily due to an increase in unit volume. The North Face, Vans, and Timberland brands achieved global revenue growth of 7%, 17% and 5%, respectively. U.S. revenues increased 7% in 2013 and international revenues increased 10% with balanced growth in Europe and Asia Pacific. Direct-to-consumer revenues rose 15% in 2013 driven by increases of 28% and 15% for The North Face and Vans brands, respectively. New store openings, comp store growth and an expanding e-commerce business all contributed to the direct-to-consumer revenue growth.”
 
The North Face grew its revenues by 20% in Asia and at a “mid-single digit” rate in Europe. They don’t tell us what happened in the U.S. but given those numbers it seems to imply that things weren’t that good.
 
One analyst, referring to The North Face, asked if they’d seen any changes in the competitive environment. Steve Rendle, Group President of Outdoor and Action Sports Americas answered, “The competitive set in the outdoor industry remains the same. As North Face transcends that outdoor space it takes on a whole lot of new competitors.”
 
Those new competitors a brand encounters as it extends its reach is something I’ve talked about often. It’s a whole new competitive environment and we can all think of brands that haven’t done well trying to extend themselves. But they weren’t VF’s size with its management processes and balance sheet. Part of how they expect to succeed, Steve Rendle says in response to another question, is because The North Face “…is very much a pre-booked business model…we will buy to that order book and that order book is about 90% to 95% of our total revenue.”
 
They don’t, in other words, risk making too much product and over distributing. As you know, I like that a lot. It’s important to building a brand.    
 
Vans, we learn, passed $1 billion in the Americas in 2013. They highlight that Vans is no longer just a footwear brand and is having success moving into apparel. They note that, “According to data from more than 160 US board shops, Vans is a top 10 brand in almost all of our men’s apparel and accessory categories.”
 
Okay, that has to be data from Action Watch. I’m wondering just what it means to be in the top 10. How many brands of men’s apparel or accessories does a specialty shop carry? Wish some analyst had asked for a more detailed explanation.
 
Van’s international business was up 23% for the year. There was a mid-20% increase in Europe and a “high-teen” increase in Asia. I’d like a bit more specific information. Given the overall increase of 17% and the increases they mention for Europe and Asia, what should I assume for the U.S? It’s interesting that they provide percentage growth numbers for the other areas, but not the U.S. or at least the Americas.
 
Gross margin rose from 46.5% to 48.1%. “The increase in gross margin reflects lower product costs and the continued shift in the revenue mix towards higher margin businesses, including Outdoor & Action Sports, international and direct-to-consumer,” management said.
 
Selling, general and administrative expenses rose from $3.597 to $3.841 billion. As a percentage of total revenues it rose from 33.1% to 33.6%. This was partly because they choose to make some additional marketing expenditures “…to support future growth for our largest and fastest growing businesses.” Kind of nice to have a balance sheet that supports that kind of decision making. It was also higher because Timberland was included for a whole year for the first time. Advertising and promotion expense alone was $671.3 million, or 5.9% of revenue.
 
Interest expense was $80.6 million for the year. The weighted average interest rate was 4.5%. I just mention that because I wonder about the impact on VF, and lots of other companies, when interest rates rise substantially. That is going to happen, and if I knew when I’d get very, very rich.
 
Net income was $1.21 billion, up from $1.09 billion last year.
 
The balance sheet is strong, with a current ratio of 2.5 and a debt to total capital ratio of only 19.3%. Inventory was up a bit, but less than you’d expect given the revenue growth. Receivables were up 11.3%- more than twice the revenue growth.
 
If I could ask a couple of balance sheet related questions just because I have an inquiring mind, the first would be about the accrued liabilities. They total $905 million, and are mostly broken down in Note J. But the biggest single entry, for $209 million, is “other.” It’s not that it’s a big number for VF, but I’m curious what’s in it. Oh well, guess we’ll never know.
 
The second would focus on Note M on their retirement and savings benefit plans. Not much a question as a comment. I note that their expected rate of return on plans assets in 2013 was 5.7%. Obviously, the higher your expected return, the less you have to put into the plans each year to meet the obligations. VF’s 5.7% may still, in my opinion, turn out to be a bit high, but it’s certainly reasonable. Good for them for being realistic. When you see a company (or a municipality, or a state) claim their pension plan is “fully funded,” that’s based on certain assumptions about how long people are going to live and how much the plan assets are going to earn. If those assumptions aren’t reasonable, then the plan is probably not fully funded. Ask the pension holders in Detroit.
 
Okay, I know nobody wants to hear any more about that, so I’ll move on.
 
VF’s four growth drivers are leading in innovation, connecting with consumers, serving consumers directly wherever and however they want to engage the company’s brands, and continuing to expand geographically from the Americas to Europe and Asia in mature and emerging markets. Those might sound a bit like platitudes taken in isolation. But in conjunction with the strategies and management processes we’ve highlighted here, they seem credible.

   

Sport Chalet and Ideas on the Retail Environment

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I don’t follow Sport Chalet closely. But they said something in their 10Q for the December 29th quarter that related to some other ideas I’d seen on how the retail market is changing. I thought they might be worth talking about together.

Sport Chalet’s Dilemma
 
Sport Chalet operates 52 stores, 34 of which are in Southern California. “These stores,” we’re told, “average approximately 41,000 square feet in size. Our stores offer over 50 specialty services for the Sport enthusiast, including online same day delivery, climbing, backcountry skiing, ski mountaineering, avalanche education, and mountain trekking instruction, car rack installation, snowboard and ski rental and repair, Scuba training and certification, Scuba boat charters, team sales, gait analysis, baseball/softball glove steaming and lacing, racquet stringing, and bicycle tune-up and repair.”
 
Founded in 1959, Sport Chalet was to have “A focus on providing quality merchandise with outstanding customer service…The goal was: to ‘see things through the eyes of the customer;’ to ‘do a thousand things a little bit better;’ to focus on ‘not being the biggest, but the best;’ to ‘be the image of an athlete;’ and to ‘create ease of shopping.’”
 
Well, if that was their goal in 1959 they were ahead of their time. I’m sure you’ve recognized that what they describe fits very well with the conventional wisdom of what a specialty retailer has to do today to compete.
 
 When the economy went south in 2007, things got tough for Sport Chalet, especially since most of their business was in Southern California.
 
“As a result, our sales, which are largely dependent on the level of consumer spending in the geographic regions surrounding our stores, declined and we incurred substantial losses. In response, we modified our business model to make the Company more efficient, improved our liquidity and reduced operating expenses during the downturn. Additionally, we reinforced our commitment to be first to market with performance, technology and lifestyle merchandise by expanding our specialty brands and continuing to emphasize the availability and proficiency of our sales staff while many of our competitors emphasized value pricing and severely reduced store staffing.”
 
You can see that they tried what I’ve characterized in other articles as “more of the same.” Again, it’s all the things that are supposed to let the specialty retailer compete. It seemed to start to work, and then it didn’t. For the nine months ended December 29, 2013, Sport Chalet lost $4.4 million on revenue of $264 million.
 
So they are “…renewing our focus on reducing costs and refining our inventory position and store strategy. We are reducing our costs by decreasing store and corporate office labor expense to align with current sales trends, cutting IT maintenance expenses in non-critical areas, switching to a more cost effective logistics provider, negotiating rent reductions and honing our customer satisfaction initiatives. Through the closure of underperforming stores, selected staff reductions, and the renegotiation of logistics and software contracts, we have reduced our annualized operating expenses by approximately $3.2 million.”
 
But things are still tough. They blame poor early season winter weather and are working with vendors to manage inventory levels (something every vendor loves to hear) and closing four stores.
 
As I see it, the strategy they have historically based their competitive strategy on requires high spending levels and high prices. They are trying some new strategies; next generation store format, online store growth, leveraging technology and data, mobile and digital leadership, and local marketing programs. They just list those in the 10Q- there are no specifics provided.
 
On the surface, none of those sound like bad ideas, but I’m not sure they can expect to have the financial ability to carry them through if consumer spending trends continue. Too many of their customers can’t afford to buy what they want to sell or, if they can afford it, can’t see any reason to pay the Sport Chalet price for it.
 
In spite of a business strategy we’d all tend to agree seems right for the independent specialty retailer, they are caught between a rock and a hard place. What’s going on?
 
Nordstrom’s Bar
 
Here’s a picture of the new bar they’ve opened at Nordstrom’s in the local mall. Notice the crowd at it
.
 
 
 
It’s big and takes up a lot of space. Space where I wonder if they wouldn’t be better off having merchandise. I don’t quite know what their concept is. Maybe it’s for husbands whose wives are shopping. That won’t work for me because my wife considers me a huge downer to have along when she’s shopping. I’m sort of like a six year old in the back seat of a car during a long trip constantly saying, “Are we done yet?” My mere presence in the vicinity ruins the experience.
 
I am all for retailers taking risks and trying new things. Some work, some don’t and you always learn something. I’m sure Nordstrom’s thought it out carefully and, perhaps unlike Sport Chalet, they can afford to experiment. But there’s almost a sense to it of not knowing what else to do as the retail environment changes faster than we can keep up.
 
That’s not completely a surprise. This country was well over retailed even before the internet came along. However, increasing debt and leverage managed to masquerade as real economic growth until 2007 and covered that up. Now, retailers are struggling to hold on to their piece of the pie.
 
How Big Is Online?
 
I was sent a Wall Street Journal article I can’t seem to get access to called “Online Shopping is Big. It’s Also Tiny.” It points out that among the major consumer segments, online sales are no more than 25% of the total. It only gets to 25% in the computers, electronics and appliances sector. That sector, in total (store and online combined) is $272 billion annually. Making the online part $68 billion. In toys and sporting goods online is “only” 12% of $128 billion in annual sales. It’s just 1% of the $884 billion food and alcohol market.
 
Still it’s gotten there in a little less than 20 years and while figuring out the future isn’t my strong point, I’m pretty sure we can expect some more online sales growth in most, and probably all, categories.
 
But what exactly does “online shopping” mean? Are you only shopping online if you research, select and order the product on a computer or some mobile device? If you go to a store but then order online from the retailer you visited, is that online? What about if you go to the store and the sales person orders it online for you after you’ve chosen and has it delivered to your house the next day?
 
The data from the Wall Street Journal isn’t broken down that way, but I know retailers are pondering the issue. How online relates to brick in mortar is something we’d all like to know more about.
 
What Does Walmart Think?
 
The Atlantic magazine, in its current issue, features a short interview with Walmart’s Senior Vice President for Mobile and Digital, Gibu Thomas. It’s called “Get Ready to Roboshop” and you can read it here.
 
Mr. Thomas has 1,500 people trying to figure out just exactly how on line and in store retailing are going to fit together. He projects U.S. on lines sales to be around $345 billion by 2016. But he thinks “mobile influenced offline sales,” as he calls them, will be $700 billion. Walmart apparently has a smart phone app that, if you allow it, will help guide your shopping experience in Walmart. He says that more than 75% of their customers under 35 have a smart phone. During the past holiday season, more than half the traffic to Walmart.com came from mobile devices.
 
So go read the interview. There was certainly some learning here for me. It seems like we shouldn’t worry about on line sales. They are here to stay, are going to grow, and there’s nothing we can do about it. Where retailers’ attention should apparently be focused is on integrating the brick and mortar and mobile device experience. I knew that, but seeing some numbers attached to it gives me some focus and sense of urgency. It appears I’d better get my web site working better with mobile devices.
 
My sense is that this approach might be particularly beneficial to Sport Chalet as a high end chain with fairly well to do customers (you aren’t poor if you’re planning a scuba trip). There may be an app in every retailer’s future. I think I’ll download the Walmart app and walk through one of their stores.

   

Billabong’s Half Yearly Report: Starting Over

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Billabong reported their financial results for the six months ended December 31, 2013 last Thursday. I’ve been diving into a hoard of details they posted. After all of that, I think I’m going to end up spending a lot less time than usual on some of those details. 

That’s because I largely agree with a couple of comments from Billabong management in their conference call. I’d like to start by sharing those with you. 
 
Early in his comments, CEO Neil Fiske said, “…18 months of leadership distraction and organizational turmoil, which impacted all our brands. It is important to recognize that the company’s protracted transactions process hit the Americas region particularly hard. First, by creating a long gap in leadership and subsequently, a significant loss of talent.” 
 
He goes on to describe the people they have hired, are hiring and have still to hire. Later on he notes, “During the next six months we expect to complete our portfolio review, looking at each brand’s growth plan and fit with our longer term strategy. We will also initiate work on the brand books as guiding documents that are the cornerstone of a new brand management system.” 
 
Then CFO Pete Meyers, talking about the six months results, says, “Overall a mixed result as Neil has outlined, but somewhat ancient history in the context of the opportunity to reform this business in the years ahead. By the way, you’ll notice that my slides are in the old format and that’s symbolic as they deal almost exclusively with the old Billabong and that the results today predate any impact of the turnaround plans that we’ve shared with you and next time they’ll be in the same style as Neil’s.”
 
Meanwhile, there will be a major (that is not a strong enough word) and really intriguing reorganization of the company. The Billabong, Element and RVCA brands will each get a global head responsible for global merchandising and marketing. They will each report to the CEO and be responsible for the brand’s income statement. 
 
However, says CEO Fiske, “…we are not centralizing design or merchandising into any one region. Rather, we are leaving design, merchandise and marketing teams in each region to be close to the market, fast and highly responsive to local customer needs.” 
 
There will also be regional presidents for each of the Americas, Asia Pacific, and Europe to“…drive sales distribution and channel development in their respective geographies, while providing critical input on customer needs back to the brand teams. They will drive the go to market model for each country based on a newly defined tiering system. Regional leaders will also take responsibility for growing the smaller emerging brands, for example Tigerlily in Asia Pacific or VonZipper in the Americas.”
 
The third piece of the organization contains the global functions. These will include the CFO, a chief operating office, somebody in charge of human resources and, most interestingly to me, “…a turnaround office leader focused on cost takeout and accelerating the impact of key initiatives.” 
 
The gentleman they’ve hired in that role (Bennett Nussbaum) has an impressive background in turnaround management and clearly doesn’t need a job. It will be interesting to see how he interfaces with the organization to keep it turnaround focused and how long this job lasts. I’d be curious to know if he reports to Neil Fiske or directly to the Board of Directors. I can imagine him ranging all over the company with quite a degree of discretion. I don’t recall ever hearing about a company hiring a turnaround manager who wasn’t the person in charge, but I think it’s a great idea in these circumstances. 
 
“The objective of the global support functions is to build global scale capability and efficiency, driving our cost down so we can reinvest in the brands. We can no longer afford to have three regional supply chains, three regional IT structures with different systems, five different direct consumer technology platforms, high cost logistics in fulfilment and underdeveloped human resource management.”
  
They are going to rely on these cost reductions to fund expanded brand marketing. Finding those cost reductions is part of the responsibility of the Turnaround Office. Their balance sheet doesn’t really give them another choice.
 
When I was in business school (which is beginning to feel like it was shortly after the second Crusade), they described this kind of organization as a matrix. Which I think is a great way to describe it, because there are definitely going to be some people who wake up and find out they’ve been living in a dream world. 
 
The positive thing about a matrix organization is that it can facilitate good communications and group the right people to work on an issue. The potential problem is that roles and relationship are sometimes not completely clear. What happens when what the head of the brand wants to do conflicts with the ideas of the regional president? Every organizational structure has its strengths and weaknesses. A matrix structure can be less efficient at decision making. You manage that through constant communication and developing mutual respect and trust. As was noted somewhere in the conference call, I’d love to have the frequent flyer miles these people are going to rack up. 
 
There are additional changes and reevaluations going on across the company at various levels. You can see why I’m not as focused on the historical financial statements as I might usually be. The company that is going to emerge over the next year or three isn’t going to look like the one that produced these six months results. Lots of different people. A new organization and reporting relationships. A focus on “…fewer, bigger, better stories that cut through the clutter and better align to our key merchandising programs.” Probably fewer brands in total. A reorganization of the marketing function. Fewer SKUs, fewer factories. There’s a lot more. With every month that passes, it’s going to resemble less and less the company who’s financials I’m discussing here. 
 
But it’s not in my nature to ignore those results, so let’s move on to them now. Remember the numbers are in Australian dollars. 
 
First, let’s look at the numbers as reported on the financial statements. These include brands that were sold during the year (Nixon, Dakine) as well as a bunch of expenses Billabong characterizes as “significant,” meaning they had to do with the refinancing and restructuring and the big general mess they had to manage. As I’ve said before, I don’t believe that just because you screw up you get to exclude certain expenses from your operating results on, I guess, the promise that you’ll never screw up again. 
 
Sales from continuing operations rose 3.2% from $563 million in the prior calendar period (pcp) to $580 million. Gross profit margin fell from 54.9% to 53.6%. The pretax loss from continuing operations was $40 million compared to $439 million in the pcp. Operating expenses were up a bit, but what stands out is that last year’s income statement had Other Expenses of $513 million largely from the write down of the brands and goodwill. The number this year was $61 million in charges. Last year’s finance costs, however, were just $10.3 million compared to $57.3 million in the current period. After discontinued operations, we have a bottom line, after tax loss of $126 million compared to a loss of $537 million in the pcp.
 
Here’s how that breaks down by region as reported, including discontinued operations and significant items. 
 
 
 
Let me point out that the segment EBTDAIs excludes the impairment charges. That’s the “I” on the end. The reason I’m telling you that is because the numbers from the presentation that came with the conference call, which I refer to below, talk about EBITDA. There ain’t no “I” on the end. I’m going to assume that’s a typo, because the segment numbers are the same in both places. 
 
The big problem, you can see, was in the Americas. “The result,” they tell us, “…reflects weakness in the Canadian market, smaller brands & South America.” We’re specifically told that Sector 9’s revenues were down 20% in the Americas. They also point to what they call “operational instability” in the region due to personnel changes and general uncertainty. “…we believe,” says CEO Fiske, “the decline in the Americas result has much more to do with the organizational turmoil and loss of talent associated with the 18 months of protracted deal related distraction than any underlying issues with the strengths of the brand.” 
 
There was an as reported EBITDAI margin of negative 5.7% compared to a positive 4.2% in the pcp. For their continuing business, EBITDAI margin fell from a positive 8.7% to 4.7%. 
 
Things look better in the Australasia region, where the reported EBITDAI margin rose from 5.3% to 6%. For the continuing businesses it was up from 11.8% to 12.6%. They closed some stores, but took out some costs to get the improvement. Comparable store sales were up 3.2% including online sales. 
 
In Europe, the reported EBITDAI margin deteriorated from (0.5%) to (8%). For the continuing business, it fell from (2.5%) to (3.5%). They point, like everybody else, to the lousy macro-economic situation in Europe and the expected startup losses of Surfstitch. Brick and mortar comps in Europe were up over 5%.  They still see some softness in the Billabong brand. 
 
At December 31, excluding the West 49 stores, Billabong had a North American store count of 66. There were 112 in Europe and 252 in Australia.
  
Next, from their presentation, is the chart that includes the “as reported” results and then removes significant items and discontinued businesses and gets us to the continuing businesses results they’d like us to focus on. 
 
 
 
As long time readers know, I tend to prefer the as reported numbers (statutory results as they call them in Australia) because they don’t allow for finagling. In this case, because the refinancing has gone on so long, cost so damn much, and had such a destructive impact, I think maybe looking at the continuing business is the right thing to do. 
 
Except for some of the significant items where it looks to me like finagling happened. Here’s the list of significant items. 
 
 
 
You can look at the list and decide for yourself which it is or is not okay to exclude. My point of view is that things like “inventory clearance below cost,” “redundancy costs,” maybe part of the financing costs and perhaps part of others are hard to justify excluding. You’ll note that by excluding them they managed to show a small profit from continuing businesses of $3.9 million. If I were a suspicious person, I could conceivably think they figured they might as well exclude stuff until a profit appeared. And honestly, I might have done the same thing. 
 
Over on the balance sheet, equity has fallen to $194 million from $618 million a year ago. Cash is up, and inventory and receivables are both down. How much of the declines are the result of the sale of brands and how much from better management is hard to tell. The current ratio has improved, but that’s because the refinancing transferred current liabilities for borrowings to non-current liabilities. Current borrowings were at $9.5 million, down from $280 million at the end of the prior calendar period. Total liabilities, however, rose from $674 million to $765 million. 
 
Cash generated from operating activities went from a positive $29 million in the pcp to a negative $27 million in the six months ended December 31, 2013. That’s almost completely due to the costs of the refinancing they tell us.
 
As you are probably aware, Billabong is in the middle of a rights offering which, if successful, will improve their balance sheet. 
 
So much for not spending too much time on the financials. Let’s start to wrap up with a comment by CEO Neil Fiske in response to an analyst’s question. 
 
“So what is important, I think, to all of our brands is that they have authenticity with the core of the market. It is a little bit of a paradox in the sense that when we focus on the core of the market and we grow relevance, share and aspiration with that core the brands become more widely appealing. So really our strategy is to focus narrowly, but create brand positions that are so well-defined and aspirational that inherently they have broad appeal.” 
 
A week or ten days ago, I wrote about some similarities between Billabong and Quiksilver. I suggested that what we had to watch for were clues to what products they were going to sell to which customers. Neil’s put it more eloquently than I did. And he’s focused exactly on the correct and most difficult management task. 
 
Long time readers will know I’ve asked the question, “Can you stay credible as you broaden your distribution?” I’ve suggested that the further away you get from the core, the harder it is to stay credible and compete because the more likely it is that the customer may know your brand, but not your story. And the story is the brand’s single most important point of differentiation. 
 
Goldman Sachs analyst Phillip Kimber asked a related question I really liked. 
 
“One of the key things in managing a brand is being very tight on the distribution in which it’s released to. I’m just wondering if that’s an issue that will be part of this turnaround –i.e. you may have to drop sales materially because you choose not to service them because you’re looking to strengthen the brand as a result. Is that part of this turnaround? 
 
Here’s Neil’s answer: 
 
“One of the things I think that we do have in our positive column is that we’ve really focused on quality of distribution, over the last couple of years in particular. As you recall we got a little sideways a couple of years ago in the US in particular with sales to the Closeout Channel. We’ve cleaned up a lot of that distribution and we are really focused on quality distribution channels. I think within the trade we are seen as having not over extended the brand and have kept our distribution quite clean and brand appropriate.”
  
He didn’t exactly answer the question, except to say he thinks they’ve done a good job with distribution recently. But it’s a big part of the what do you sell to which customer question. Right now, in the middle of a turnaround where cash flow and brand building are probably more important than sales growth, and where public market expectations may be lower, is a great time to be cautious in distribution and build the brands for the future.

 

 

Billabong and Quiksilver; Two Peas in a Pod

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Billabong’s announcement last week that it was, among other things, conducting a strategic review of SurfStitch and Swell caused me to focus on the similarities of its situation to Quiksilver’s. It also made me realize that most of what has been discussed publically by both companies is what I’ll call mechanical issues. I want to remind you what those are and then move on to the way more important and difficult to manage strategic issue they both face but, understandably, don’t spend a lot of time talking about in public. 

We all know that both Billabong and Quiksilver got into trouble due to some acquisitions they paid too much for, their aggressive forays into retail and their tendency to allow units to operate independently, resulting in an unsustainable cost structure.
 
I think those things would have come back and bit them in the butt even if the economy hadn’t cratered, but the teeth marks wouldn’t have required as many stitches. With their balance sheets out of whack, both had to sell assets, raise expensive capital, change management, cut costs, push for revenue in ways they would (I hope) have preferred not to, rationalize their sourcing and reduce SKUs, consolidate and coordinate design and marketing, and revise and upgrade their information systems.
 
Now, I call those things mechanical. That’s not to suggest they were easy to do, or that exactly what to do was always obvious. But nobody doubted they had to happen (and outside stakeholders didn’t give them a choice anyway). That gives you the refreshing liberty to say, “Let’s get at it!” and start without too much analysis. There was, to use one of my favorite phrases, some low hanging fruit.
 
The process isn’t complete (it’s never really complete- it’s a long term way of thinking), but it’s well underway. Both companies will see significant improvement in their bottom lines as a result.
 
So let’s move on to the hard part. What brands should sell what product to which consumer? I’m sure I could figure out a more erudite way to say that, but why bother. They had to start to address the mechanical stuff before they could really focus on market segmentation (there- that’s a more erudite term) because some of it represented survival issues. It’s hard to care which way you’re rowing when there’s a big hole in the bottom of the boat.
 
Part of the process of keeping the boat floating through the restructuring was to press for sales in places and in ways they didn’t want to do. I assume it helped in the short run- perhaps not so much in the long run. Both companies have some recovering to do from distribution decisions they made while managing those short term survival issues.
 
In the long term, the ONLY THING THAT MATTERS competitively is their ability to figure out the market segmentation thing. The mechanical stuff is necessary but not sufficient. The what product to sell to which customer issue is existential. If they don’t do that well, they’ve got no business or at best a dramatically different business. “Dramatically different” is code for a brand that doesn’t do this well and finds itself milking its market credibility with cheaper product in broader distribution until there’s nothing left.
 
Both companies want to grow the top as well as the bottom line. (What?! Public companies focused on top line growth?!  Shocked! I’m shocked!) If they could, at least for a while, just worry about improving the bottom line (and the balance sheet) their jobs would be a whole lot easier. The mechanical issues, as I so blithely call them, are simpler to manage. And as I’ve written, market segmentation takes care of itself initially though distribution management which builds brand strength for future growth.
 
But you can’t do that for too long. You risk finding yourself stuck in a niche you can’t get out of. For some brands, that wouldn’t necessarily be a bad result. It’s difficult for Quik and Billabong because that market niche might tend to be a predominantly older customer group that has been loyal to the brand for a long time but will inevitably buy less.
 
Their challenge over the longer term is to continue to appeal to their traditional customer groups (if only for the cash flow) while also reaching the younger demographic they have to evolve towards. Not easy.
 
So that’s why I perked right up way back when Launa Inman became Billabong’s CEO and, in her initial presentation of her strategy, talked about the need to figure out what the brands stood for and how the customers and potential customers perceived them. Billabong proceeded to spend a lot of money on that issue. We never heard the results, but why would we? You can tell all your competitors that you’re cutting costs, improving systems, reducing SKUs and consolidating certain function. They’re doing it themselves and are probably wondering why you didn’t get on with it sooner. But I can’t think of any good reason (outside of a brain tumor or psychotic episode) why’d you’d share findings about what customers think of your brands, why they buy them, and how you’re planning to position those brands.
 
Part of that evaluation will determine product direction. It’s fair to say that when you’re trying to keep a company alive, you aren’t likely to take a lot of product risk if only because you can’t afford things that don’t work. But armed with their evaluations of who’s buying what product and why, I would expect to see both companies be more aggressive with product development and introductions. The consolidation of those functions from regional to worldwide should make that easier by making it more cost effective. It’s time to take some risks.         
 
Most of us think it’s important that Billabong and Quik do well because they are positioned to represent the surf industry in the broader market. It seems to be an industry article of faith, practically a mantra, but it has the ring of truth to it.
 
I’m not sure any more what “the surf industry” means. Don’t feel bad surf people. I feel the same way about other segments of action sports and, by the way, am not quite sure what exactly the action sports market is either.
 
But recognize that neither Billabong nor Quik is a pure surf company in the way they were years ago.   The “core” surf market is way too small to support much growth for either company. Anyway, that seahorse left the barn years ago when they both acquired non surf brands that represent significant percentages of total revenue.
 
I will always look at the numbers (I can’t help myself). But the numbers, by the time we see them, only tell you what has already happened. As I try and figure out how Quik and Billabong are going to do, I’ll be looking for clues to their product and market segmentations decisions, because at the end of the day, that’s mostly what’s going to matter. And not, you might consider, just for Quiksilver and Billabong.

 

 

Thoughts from the SIA Show

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So I confess. I’m from Seattle and there was no way in hell I was going to be on a plane Sunday while the Super Bowl was on. I left Saturday. But in my two days wandering the show, I had some thoughts I wanted to share with you. 

There was a bit more of a somber attitude at the show then I’ve ever noticed. Everybody I talked to seemed to feel the same way. I particularly noted that the noise/crowd/enthusiasm difference between snowboarding and the rest of the show wasn’t as I was used to. That doesn’t mean there wasn’t a lot of business being done- my sense is that there was. I’d also note that the “core” (still hate that term) snowboard hard goods brands were interspersed with some large booth from brands I’d label as tangential to snowboarding and the snowboard ghetto, as we’ve come to call it, was more spread out. Perhaps that accounted for it. That’s probably a good thing. It recognizes market realities.
 
There were also business reasons why the mood was different. The apparent ongoing decline in snowboarding, a recovering, but still weak economy,  lack of California and Northwest snow, some negative publicity for snowboarding (deserved or not?) and issues of inventory may have had something to do with it.
 
Which brings me to distribution. Everything always seems to bring me to distribution in this industry. At the risk of oversimplifying (I get to do that because I don’t have to actually run a winter business any more), to make money in winter sports, you have to plan for what you think is an average winter in your market and produce/buy 10% (or 15% or 20%?) less than that. You make/buy only what you think you can sell at full margin during the season.
 
You do not wail and gnash your teeth when you run out of inventory and can’t fill reorders when it dumps late in the season. You just calmly remind the buyer to order more in preseason next year (or tell the customer to come in sooner if you’re a retailer) and thank your lucky starts that your inventory is clean.
 
Because the absolute best way to guarantee you don’t make money in winter sports is to have a bunch of left over inventory you have to close out. Not only do you make little to no money on that inventory, but it might have cost you a full margin sale at some point in the future.
 
That’s a particularly important point when all product is good and there’s no reason to replace it very often (On the plus side that reduces the cost to participate). There are fewer chances to make a sale than there used to be. I talked to a couple of industry types who had been offered free boards by brands and actually turned them down. They just didn’t need them and didn’t want to break in a new setup. Getting a new board for free was too much trouble, which sounds strange when I say it.
 
 My point of view on distribution and making money in this business seemed to be validated when I talked to three established snowboard brands who manage their production and distribution carefully. They’d all had issues with west coast retailers who couldn’t move product because of lack of snow. But the brand’s inventory was clean. So clean that they had trouble filling reorders from places with snow. Their solution, which worked because their inventory was clean, was to take the product from the first retailer and move it to the second.
 
Maybe the no snow retailer didn’t really want to give up the inventory even though they couldn’t pay. They just asked for big discounts to keep it. And maybe the product coming back doesn’t exactly match what the retailer with snow wants. Maybe the opportunity happens too late in the season to pull it off. Maybe some other stuff too. There is definitely friction in the process and some cost.
 
But at least these brands had the potential opportunity to take back some inventory and place it with somebody who could move it at full margin. They weren’t in a fight to be paid with a customer they wanted to keep for next season, and they’d made another customer very happy. Maybe there was some margin given up, but it was a lot less than if you had to close the stuff out.
 
This opportunity only existed because the brand was deliberate and cautious with inventory in the first place.
 
I also had occasion to talk with Jono Zacharias who, last time I updated my Outlook, was SVP for Global Sales at Westlife Distribution (686). He told me, speaking of distribution, something interesting. Apparently their best-selling pieces were the same in Europe, Canada and the U.S. this year. And their dogs- uh, I mean styles that didn’t sell quite so well- were the same in all three geographies.
 
I’m hypothesizing that says something about the internet and social networking. My sense is that wouldn’t have been the case a few years ago. Maybe it’s just a coincidence (it wasn’t true with Japan). If I were Jono, or a sales manager for another brand, I might go back a few years and check that out.
 
First, of course, you have to have the systems to do that. I’ve noted in my various articles all the companies spending money on systems to accumulate, integrate and analyze sales and inventory data. If there is some growing cohesiveness among styles and trends across geographies, then the implications for production, distribution and the numbers of SKUs you need could be significant. Just something to think about.
 
You know what? In spite of our industry’s macro problems, snow sliding is still FUN and SIA’s show does a great job reminding us of that. We’ve got something good to sell. The pace of change is disconcerting, but that usually means opportunity. Let me know if there’s a geographic convergence among your successful products. What can you do with that to run your business just a bit better?