How Our Market is Changing: PacSun’s August 3 Quarter

We will, of course, get to the numbers. Among other things, we’ll talk about the impact of an extra week and their derivative liability.   But let’s start by jumping right to the conference call and noting some things CEO Gary Schoenfeld says.

He defines their core customer as “…the more fashion-savvy, older teen and early 20 consumer…” He does that in the context of discussing some of their new brands, “…which includes Kendall & Kylie and Brandy Melville.” Like me, you may not have wanted to know that Kendall and Kylie are the two youngest Kardashian sisters.  I’ve provided links to these two brands (Kendall & Kylie appears to be exclusive to PacSun) so you can get a look at the product if you aren’t already familiar with it. 
 
I note that one of the four key drivers of PacSun’s business is, “is to be a leader in anticipating and recognizing the fashion trends that emerge from our backyard and translate these to the marketplace with the expediency that today’s digital world now require…” I wonder the extent which that means “fast fashion.” The price points on the Kendall & Kylie product and the fact that a bunch is sold out suggests there’s an element of that. Go look at it yourself.    
 
Moving on to their men’s business, Gary notes “…emerging brands, footwear and accessories continued to perform well, yet this has been offset by softness in summer seasonal categories such as shorts and board shorts, resulting in a minus 2% comp for the second quarter.” He also notes that “Lack of newness in basic denim is similarly stifling the Men’s business as we transition to fall…” 
 
I’ve been increasingly thinking of denim as moving towards a commodity, and I haven’t seen anything recently to make myself change my mind. Gary says “…basic denim in both Men’s and Women’s has become somewhat of a commoditized category across the mall…” But he notes that their chino business is expanding.
 
I sit here considering the possibility that the highlighted trends in denim, shorts and board shorts are a longer term trend and wonder how t-shirts are selling. What business does that leave core action sports brands in? I’ll get back to you on that, but here’s what Gary thinks: 
 
“So the Men’s business is transitioning. The old PacSun was a short, board short, basic denim and T-shirt business, and I think we’re going through what I believe will ultimately be a healthy transition to a new group of brands, to further growth in footwear and accessories but also further recognition for us as a leader in style and again, taking our inspiration from what we see coming from our backyard here in California.” 
 
To be clear, I am not critical of what PacSun is doing. I may not be thrilled with Kendall & Kylie and Brandy Melville replacing some traditional action sports brands, but I think PacSun’s focus on new brands and fashion is appropriate and necessary. The “inspiration” they are taking from what they see in California has a lot less to do with action sports than it used to have. 
 
Zumiez must be viewing this with interest. On the one hand, they seem to own the core action sports space in the mall. On the other hand, what exactly is that space and what kind of comparable store growth can they expect from it? Their 10Q just come out this morning, and Quik is next. Also, I’m theoretically on vacation this week, so give me a break. 
 
Income Statement
 
We’ve made it to the numbers. Below is the summary income statement from the 10Q.
 
 
 
There’s a $17.9 million sales increase. However, there was a one week calendar shift in the quarter compared to last year. That means this year’s quarter included a peak back to school week instead of a not quite so good week in May. The 10Q says, “This resulted in an approximately $9 million increase in net sales, a 1.2% improvement in gross margin, and a $0.06 per share improvement to our loss from continuing operations per share for the second quarter of fiscal 2013, compared to the second quarter of fiscal 2012…” 
 
They also note that “…comparable store net sales increased 3%, average sales transactions increased 2% and total transactions increased 1%, as compared to the same period a year ago,” but of course that’s impacted by the extra $9 million in sales as well. Women’s were up 11% on a comparable basis, while men’s declined by 2%. 
 
The gross margin rose from 27.4% to 29.6% but, as already noted, a chunk of that was the result of the extra week. 
 
Selling, general and administrative expenses were down in total dollars and also fell as a percent of revenue from 30.5% to 27.1%. 1.7% of that decrease was the result lower payroll and related expenses. Probably from closing stores. 1.4% was the result of less depreciation mostly from store closures and 0.7% was from non-cash impairment charges declining from $2 million to $1 million. Other SG&A expenses increased by 0.4%. 
 
It looks to me like if we take into account the extra $9 million in sales and the impact of store closing, it’s hard to tell if these expenses increased or decreased as a percentage of sales. 
 
Anyway, that leaves us with an operating result which improved from a loss of $6.1 million to a profit of $5.3 million. I don’t know what it would have been without the $9 million of extra revenue. 
 
Now, I’m afraid, it’s time for fun with the derivative liabilities, which you can see as a separate line item in the statement above. I’ll keep this short. This is a noncash item, as they love to tell us. The convertible preferred stock issued to Golden Gate Capital has to be valued every year. The higher the stock price, the more it’s worth because the conversion price doesn’t change. While it’s not cash, it does represent a claim on income that will not be available to other shareholders, so it needs to be included as an expense. Okay, that’s it. 
 
We have, then, a loss that’s increased some. The comparison from last year’s quarter is negatively impacted by the increased derivative liability but positively impacted by the extra $9 million in sales. In the conference call, we learn that if we ignore the derivative liability, exclude the store closing charges and use an income tax rate of 37%, PacSun had income from continuing operations of about $1 million compared to a loss of $6 million. 
 
The company ended the quarter with 637 stores compared to 727 year ago. They plan to close 20 to 30 stores during fiscal 2013 as previously reported. 
 
Balance Sheet and Cash Flow 
 
The cash flow shows that operations used $17.1 million in cash during the first six months of the year compared to $13.5 million in last year’s six months. Someday, that needs to turn positive. The thing that catches my eye on the balance sheet is that shareholders’ equity is down to $22.5 million from $81.2 million a year ago. Total liabilities to equity have increased form 3.64 times a year ago to 13.9 times now. Cash is down from $34.8 to $26.9 million. 
 
Inventory has fallen only slightly from $144.8 to $140.3 million. Given that they have 90 less stores, I might have expected more of a decline. Perhaps this has to do with the transition of brands that’s going on. The current ratio has fallen from 1.27 to 1.05. That’s potentially kind of tight, though remember it’s just the number at one specific day. 
 
When PacSun mortgaged its real estate and made the deal with Golden Gate Capital, I said they’d bought themselves some time to implement their strategy. Even with the extra week thing, they’ve increased sales compared to last year’s quarter with 90 less stores. And I think their strategy and brand turnover is realistic and appropriate. 
 
Their balance sheet has my attention now. They haven’t drawn their line of credit and don’t think they will need to over the next 12 months if their forecasts are reasonable. But if their losses continue and they keep using (rather than generating) cash in operations, they may have to start.

   

Globe’s Annual Results

Globe reported a loss for the year ended June 30 of $6 million compared to a profit of $62,000 in the prior calendar period (pcp). That’s in Australian dollars, as are all the numbers in this article. Total revenues rose 2% from $83 to $84.1 million. The Globe brand was up 10%, but Dwindle fell 15%. Cost of sales rose from $45 to $47 million, with the gross margin falling from 45.9% to 44.1%. 

Employee benefit expense rose from $14 to $15.4 million, or by 10%. Sales and administrative expense was up 11% from $23.7 to $26.4 million. The loss before tax was $6.9 million compared to a pretax profit of $702,000 the prior year. They had a tax benefit of $990,000 compared to a tax expense last year of $640,000.
 
EBITDA, they tell us, was a loss of $4.7 million. They don’t seem to have included last year’s EBITDA, but by my calculation, it was a loss of $389,000.
 
So it wasn’t a great year compared to last year. What happened? They tell us they had one time costs of $4.25 million. These were composed of:
 
 
The restructuring costs related mostly to North America. There was an inventory charge of $600,000 and a charge for reduction of riders and employees of $500,000.
 
Those of you read my rant on Billabong’s showing its results without a whole laundry list of “significant costs” as they called them to show try and show a better operating performance probably already know what I think of this. There are reasons to present proforma results, but what I see here are a whole bunch of expenses incurred “in the ordinary course of business” as the saying goes. I’ll bet this isn’t the first time Globe has had to increase its doubtful accounts provision, had a late product shipment, or had set up costs of a new brand. Might not be the last either.
 
Any company can give us a proforma income statement at any time for any reason, but it seems like it only happens when there are big numbers they want to highlight so we’ll ignore them, if that makes any sense.
 
Let’s take a look at Globe’s results by segment. In Australasia, revenues rose from $25 million to $26.6 million, but EBITDA fell from $2.15 to $1.42 million. Revenues in Australia were up from $22 to $22.8 million. North American revenues were down from $41.8 to $39.3 million in spite of 14% growth in Globe brand revenues due to the decline in Dwindle. Its EBITDA crashed from a positive $1.71 million to a loss of $3.18 million. Revenues in the United States fell from $26.2 to $24.5 million. European revenues rose from $16.2 to $18.1 million due mostly to the Globe brand. EBITDA in that segment fell from $973,000 to a loss of $7,000.
 
If the balance sheet has weakened a little, it’s still okay. The current ratio fell from 2.88 to 2.33, and total liabilities to equity rose from 0.39 to 0.51.   But the longer term trend is worrisome. Contributed capital of $144 million has been reduced by losses of $96 million to $39 million. The company’s operations used $2.4 million in cash compared to generating $282,000 in the pcp. Cash fell from $10.2 to $6.4 million. Trade receivables rose from $9.4 to $10 million even after taking a doubtful accounts provision of $1.7 million ($911,000 in the pcp). Of course, there was a small sales increase which might result in higher receivables.
 
Inventories also rose from $14.5 to $17.7 million after provisions for write downs of $902,000 and $1.78 million respectively. Some of the growth may be due to new brands they are licensing and distributing in Australia and New Zealand as well as to the new brands they have started.
 
The statutory annual report Globe files is pretty short, and we don’t really find out much about their issues and opportunities. Partly, of course, that’s because their CEO is Matt Hill and two of their three directors are Peter Hill and Stephen Hill. Of the 41,463,818 ordinary shares outstanding at June 30, people named Hill owned 28.4 million of those shares, or 68.5%. I remember when Globe went public I wrote that I admired the Hills for getting the deal done and wondered why others invested.
 
Globe’s problems are pretty clear. They are a small company in two industries that are very competitive right now; skateboarding and shoes. We’ll find out in six months if any of their strategic initiatives help them turn things around.

 

 

Billabong’s Annual Report

Billabong released its results for the year ended June 30, 2013 a few days ago, and I’ve been plowing through the 200 or so pages of material and listening to the conference call.
 
My recent writings about public companies have been lamenting that they are public. Not just because they have to share their travails with us (though I kind of enjoy that), but because pursuing the strategy appropriate for our current market is in conflict with the growth requirements of a public company. It’s awfully hard to be an action sports based company and then have to grow, partly because you are public, into the broader youth culture and fashion market where the competitors have significant advantages and the new target customers may not value your story and brand.
 
We’ve seen this with Spy, Quiksilver, Skullcandy, and now Billabong. Reduce your growth targets (though don’t admit it), control distribution to build brand value, and be operationally efficient. The result, I’ve argued, is that you can improve the bottom line without big sales increases, but Wall Street doesn’t like that. It’s enough to make a company schizophrenic.
 
No doubt you’ve seen Billabong’s numbers. They reported a loss for the year of $863 million compared to a loss of $277 million in the pcp (prior calendar period). All numbers are in Australian dollars unless I say otherwise. Rather than go through the financial statement line items as I usually do, I’d like to highlight some issues that fall out of the data, but I’ll get back to the usual financial stuff later.
 
Status of the Refinancing Deal
 
As you know, Billabong had a deal with the Altamont group which the Oaktree/Centerbridge group, also interested in a deal with Billabong, asked the Australian government to review for fairness. The deal was revised so that the Australian government choose not to review it and Billabong is moving forward with documenting the Altamont deal. That’s to be completed in “weeks.” In the meantime, Dakine has been sold to Altamont and the short term bridge financing is in place. The Oaktree proposal is “…being considered in its entirety in the context of director’s fiduciary duties and in the best interests of shareholders.” My guess is that the Altamont deal will be completed.
 
But it isn’t done yet. And just in case you didn’t already know it, watching what Billabong has gone through should have convinced you that putting this kind of deal together is subject to various uncertainty and surprises.
 
Management told their auditor (PriceWaterhouseCoopers) that if for any reason they can’t get the Altamont deal to happen, the Oaktree proposal would. I can just imagine that negotiation with Oaktree if Altamont fell through.
 
Price said, “Okay, we believe you,” and gave them a clean opinion on their audit. But they felt it appropriate to note in their letter that if for any reason neither deal closed, Billabong’s ability to continue as a going concern might be jeopardized.
 
I mention that so you know that I’m not the only one who thinks a deal isn’t done until it’s done no matter how much we expect it to happen. If you want to read the language of the letter yourself, go to this page, click on “Preliminary Final Report & Full Year Statutory Accounts” under “Recent News,” open the PDF, and go to page 151 (153 as Adobe counts pages in a PDF). Can’t believe I was still awake when I got there. I will refer to this document a number of times in this article.
 
Management Structure
 
It seems like every time Billabong hits a bump in the road, a few more apples fall out of its management tree. They’ve lost some people I’d consider important and I’d note that CEO in waiting Scott Olivet hasn’t jumped to become CEO or invest his own money yet. Like me, and like the auditors, I suspect Scott knows a deal isn’t done until it’s done. And of course if the Altamont deal should not close and a deal with Oaktree happened, who would be CEO then?
 
I expect the deal with Altamont will close, Scott will become CEO and, hopefully, he’s already talking with people he’d like to bring in to build the management team. But getting the deal done just gets Billabong to the place where it gets a chance to compete. After the carnage it’s been through, one hopes good people are enthusiastic about joining the team. The documents are silent on this issue, but rebuilding management and making it effective (not just at the senior executive level) will take some time.
 
Billabong implemented a short term retention plan for six key executives (see page 28 of the report I referenced above) but that doesn’t address the resignations at lower levels.
 
The Brands and Operating Strategy
 
How are the individual brands doing? Literally the only thing we’re told is that “RVCA, Xcel and Von Zipper continue to perform well” In the Americas and Billabong and RVCA are doing well in Australasia. They have never broken out sales by brand and I would not expect them to start now. But that seems like a small list of brands doing well, and implies the others are not outperforming and no brand is performing well worldwide. In addition to those brands, at June 30 the company owned Element, Kustom, Palmers, Honolua, Beachculture, Amazon, Tigerlily, Sector 9 and Dakine.
 
Billabong also had 562 retail stores worldwide at June 30. There were 168 in North America, 113 in Europe, 126 in Australia, 37 in New Zealand, 47 in Japan, and 24 in South Africa. These stores operate under at least ten different names. They closed 93 stores during the year.
 
I find it interesting that they are operating at retail under ten or more names. They say on page 9 of the document that they will, “Consolidate store banners and optimize fitouts.” Good. The list of retail names will, of course, go down by at least one once they sell West 49. They tell us that the selling process is “advanced.” We learn in the conference call that West 49 is not profitable on a standalone basis, but is improving.
 
In broad brush, the operating strategy hasn’t changed much since former CEO Launa Inman presented it. They are rationalizing their supply chain and have reduced the number of suppliers from 275 to 50. Hard to know exactly what that means without further information on how much was produced at the ones they eliminated, but I’d expect to see the results in a reduced cost of goods sold and perhaps a reduction in certain administrative costs.
 
They are trying to differentiate their brands “…in key areas such as product, experience, service, convenience and innovative product design.” Isn’t everybody. One of the ways they are trying to do this is by managing their distribution better. Specifically, they note that they are reducing close out channel sales, particularly in the U.S. They characterize this as ongoing and well advanced. They call it “…a strategic shift in channel distribution away from close out/distressed sales channels towards more long term and profitable channels, such as e-commerce.”
 
I was a bit surprised to see that because I didn’t know that those channels were a significant part of their business. We don’t know how significant, but since they characterize the shift as “strategic” it can’t be small numbers.
 
This is a step towards managing distribution better to boost brand perception and, hopefully, gross margin. But it also reduces the top line (depending on the impact on each brand) and so is in conflict with the public company requirement of growing revenues.
 
They also are simplifying the business by reducing the number of styles. They were going to start with 15% and go from there. Other companies in our industry are doing that as well, and I’m all for it.
 
There are other items around developing e-commerce, executing at retail better (It’s still 50% of their total business), and trying to be more rigorous about deciding which brands to invest in where. All good stuff.
 
Running the business better with fewer suppliers, styles, and retail names and a more cautious approach to distribution has a favorable impact on the bottom line all by itself. But they are recognizing, I think, that operating well is closely tied to better brand building and competitive positioning.
 
“Significant” Items
 
Billabong choose to identify in their annual report $867.2 million in expense as “Significant” items. Most of it, they are at pains to point out, are intangibles and not cash. What Billabong does is exclude all these charges that are on their actual income statement and present “adjusted” results that show an after tax profit of $7.7 million instead of a loss of $863 million.
 
Below, from the presentation they made during their conference call, are the items they identified as significant. 
 
 
There was also an associated tax expense of $26.2 million, which is how they get to the $867.2 million.
 
Just how reasonable is this approach? 
 
The BIG Number
 
Let’s start with the $636.9 million number, $428 million of which was taken in the first half of the year. I apologize for this, but I don’t know how else to do it but to reproduce a couple of charts from their report. This first one below (page 104 in the report) shows how much they wrote off in 2012 and 2013 in both brand value and goodwill for each brand. The write-offs for countries and regions are associated with their retail operations and rationalization of their distribution operations.
 
 
 
This next chart (page 103) shows the carrying values with these write-offs completed.
 
 
 
Remember these are as of June 30 when Dakine was still owned by Billabong.
 
Definitely non-cash, but not without impact and implications. If you were enough of a glutton for punishment to continue reading on pages 104 and 105 about how they do the analysis to determine these write-downs, you’d find that the process was technical but also involved some assumptions (dare I say guesses?) about values and future cash flows. The bottom line is that they wrote down these assets because they aren’t worth what they once were and because their future cash flow is not going to be what they thought. It may not be cash now, but it’s sure an indication of cash they won’t get later.
 
You can see they wrote down the Billabong brand from $252 million to zero. They’ve also written Element down to zero. I guess those are the numbers the process led to, but obviously those brands are worth something more than zero. Brand write downs, by the way, are not something where your recover some value in the normal course of business like you would with written down inventory. But you would see a bigger gain if you sold the brand. We don’t know which, if any, additional brands Billabong might sell.
 
They don’t break out any write down for West 49, but I do see a $113 write down of good will in North America. Wonder if any of that is for West 49.
 
While taking these write down, they paid out during the year $69.7 million for “…purchase of subsidiaries and businesses, net of cash acquired.” An additional $10.5 million of deferred compensation is payable in the current fiscal year. Another $48 million is due in future periods. These numbers may decline to the extent they are associated with Dakine since it was subsequently sold, but we aren’t given that information. It would suck to still be paying for brands you’ve written down or off.
 
The Nixon Deal
 
That’s the $129.6 million on the significant Items list. Billabong has written its Nixon investment down to almost nothing.
 
We find out (page 100) that Billabong’s share of Nixon’s revenue in fiscal 2013 was $63.7 million. At June 30 Billabong owned 48.5% Nixon, so we can conclude that Nixon’s revenues during Billabong’s fiscal year were around $131 million. We’re also told that Billabong’s share of Nixon’s income was a loss of $5 million, so we can calculate that Nixon had a loss of just north of $10 million during that year.
 
Okay, here the reasons Billabong gives for writing down its Nixon investment. First, “the deterioration in the trading of Nixon…” and because they don’t expect it to do as well in the future as they thought it would. Second, it’s got $175 million in debt. Third, because of the terms of the joint venture they signed when they originally sold the equity stake. And finally, because they’ve renegotiated supply agreements with Nixon and this has reduced their interest in Nixon.
 
The first two are kind of self-explanatory, though I’d point out that the debt has existed since the deal was done. But the second two require some discussion. Let’s start with number three.
 
When they sold 48.5% of Nixon to Trilantic Capital Partners and 3% to Nixon management, Billabong got “Class A Common Units.” The buyers got “Class A Preferred Units.”
 
The commons only get paid when and if Nixon is sold after the preferreds get an unspecified return on their capital plus a “preferred return” of 12% on their capital.  Please read the following quote carefully.
 
“Hence in the event of poor performance and consequently lower sale proceeds, the returns to the Common Units will be less than those on the Preferred Units. In the event of significantly lower sale proceeds, the return to the Common Units could be zero. Conversely, in the event of very strong performance and consequently high sale proceeds, the returns to the Common Units can be greater than those to the Preferred Units.”
 
I guess right now it looks like strong performance and high sale proceeds are unlikely events.
 
On to the renegotiated supply agreement. When Billabong sold 48.5% of Nixon, they made an agreement with Nixon to buy a certain amount of product over four years. Don’t know exactly how much or when. On July 23, 2013, they made a deal with Trilantic to reduce these purchase commitments. Under the terms of that agreement, they now have to make payments totaling $14.2 million during the year ending June 30, 2014. They are going to get $9 million in product from Nixon during the year. 
 
In exchange for this Trilantic got enough Billabong units in the joint venture to reduce Billabong’s share of the Nixon joint venture to 4.85%. They are going to surrender those shares in December 2014 rather than make a final payment of $3 million at that time, and then Billabong’s share of Nixon will become zero.
 
So Billabong is going to pay $17.2 million and get out from under a supply contract in exchange for its 48.5% share of Nixon. Is Billabong no longer going to carry any Nixon product in its stores? Obviously, they are going to carry less because they are closing stores. Does the payment include the cost of purchasing the $9 million in product? Are they effectively paying $17.2 million for $9 million worth of product?
 
Billabong characterized their contract with the Nixon joint venture as “onerous” and at June 30, 2012 took a charge because they expected the required product purchases to be in excess of the group’s requirements.
 
But it was only in spring 2012 that Billabong sold the share in Nixon. And a month or two later they are finding out that the contract is “onerous” and taking a charge for it? I wonder what the product pricing in that contract was like. Meanwhile, Billabong retained 48.5% of Nixon, but given the difference between the common and preferred units, it’s hard to conclude that Billabong retained 48.5% of the projected earnings stream.
 
Billabong got cash it needed at the time they did the deal with Trilanatic, but I wonder (however Australian accounting works) if it was reasonable to characterize their stake as 48.5%. And I wonder if the terms of the supply contract didn’t favor Trilantic and the joint venture. Unfortunately, all I can do is wonder. 
 
All the Other “Significant” Charges  
 
Sometimes in accounting, when things are really, really bad, you decide that as long as the news is going to be god awful anyway, you might as well make it a little worse and write off absolutely everything you can to completely clean up the balance sheet. I’ve heard this called “The Big Bath Theory” and seen it in action.
 
Not all such write-offs generate income in subsequent accounting periods, but let’s look at one that does. Let’s you’ve got some lousy inventory. You think you can sell it, but for less than the cost you are carrying it at. When you sell it you will get cash, but recognize an accounting loss. But if you’re already writing off everything that isn’t nailed down and this lousy inventory is a small part of that, you say, “Oh the hell with it- let’s write that off too.” It’s now on the books at zero. You get the same cash when you sell it you got before you wrote it off, but you now recognize an accounting profit on it in the future period in which you sell it. And it’s a big profit, but you’ve effectively got a cost of goods sold of zero.
 
Not saying this is what Billabong did. Just want you to be aware of the concept. I hope they did do it.
 
It’s not just Billabong, of course, that adjusts for so-called one time charges in various forms in an attempt to make things look better- ah, I mean to try and present a better picture of the company’s operations. But when I see “inventory clearance below cost and receivables losses” of $32 million excluded, just as an example, I question it even as I understand the rationale. 
 
In the presentation during the conference call, management said that the significant items reflect, in part, “…charges arising from the difficult trading conditions experienced by the Group…” Just because times are tough doesn’t mean those charges aren’t part of real operating costs.
 
I’ve never seen a company say, “We got some breaks this year because of a strong economy, a favorable exchange rate and some lower commodity prices, so here’s a proforma that shows a worse result.”
 
In the conference call, Billabong noted that they were “learning to live with a lower Australian dollar.” That brought a smile to my face because it wasn’t too long ago that Billabong was blaming the strong Australian dollar for some of their problems. Apparently, weak or strong, the Australian dollar is just a problem.
 
There can be value in adjusted financial statements. And they don’t always favor the company. For example, Billabong’s adjusted EBITDA in its Australasia segment improved 120% as reported, but only 17.3% as adjusted. It’s up to you to figure out what the adjustments mean and whether they produce an adjusted financial statement that’s useful, and there’s no right answer. 
 
The Usual Financial Stuff
 
Billabong’s total revenue for the year was$1.34 billion, down 6.8%. As reported, they fell 15.1% to $637 million in the Americas, 16.5% in Europe to $232 million, and grew 9.7% to $472 million in Australasia.
 
EBITDA grew 151.6% in the Americas to $19.5 million from a loss of 37.8 million in the pcp.  In Europe, it declined 113% from a loss of $11.7 million to a loss of $25.1 million. In Australasia, it improved 120% from a loss of $21.5 million to a profit of $4.4 million. On a consolidated basis, EBITDA fell from $133 million to a loss of $1.9 million. Recognize that these numbers included Nixon in the pcp, but not in the year ended June 30, 2013. 
 
Australia was 67% of Australasia revenues and the U.S. was 56% of the Americas. France represented 86% of European revenues. That’s an interesting number, as I think things are going to get worse in France. As I mentioned earlier, retail was 50% of revenues. It was 71% of Australasia, 44% of the Americas, and 28% of Europe.
 
Revenues in the Americas was impacted by the 73 stores closed since February, 2012 and by comparable store sales that fell by 2.9% in the full price stores and 4.9% in outlets. Store closures and warehouse rationalization helped them reduce overhead.
 
In Europe, the macroeconomic environment pretty much stinks, and that required some store closings. There are fewer wholesale accounts and a lot of promotion. They reduced overhead by $9.3 million, but that wasn’t fast enough to keep up with revenue decline. SurfStitch startup losses were $7.6 million.
 
In Australasia, wholesale sales were softer, they closed some stores, and some wholesale accounts went out of business. The Billabong brand, as well as RVCA, is performing well. Their simplification programs are responsible for the improving EBITDA.
 
The gross margin fell to 51% from 52.7% in the pcp. There’s no discussion of the decline, but I assume it’s partly due to inventory write-downs ($31 million this year compared to $72 million in the pcp).
 
Selling, general and administrative (SG&A) expenses fell 16.3% from $645 to $540 million. They don’t give us a breakdown of what’s in here, but if you go to note 8 on page 90, they show the significant items that are included in the category. The interesting thing is that last year the total significant items were $117 million. This year, they were $49 million. That represents $68 million of the total $110 decline in SG&A. Using Billabong’s logic, and removing those significant from both year’s SG&A expense, we find they’ve fallen by 7% from $528 million to $491 million; not the 16.3% reported. And of course, there are no Nixon expenses in the 2013 SG&A and I can’t tell if they are part of the significant expenses or not (I’d expect not). So what should I conclude about Billabong’s efforts to reduce its SG&A operating expenses? Hard to tell.
 
Interest expense for the year was $13.4 million. Total interest and finance charges were $26.7 million (note 7, page 89). During the conference call we learn that interest costs under the Altamont deal will be between $43 and $48 million annually depending on the exchange rate. I don’t quite know which number to compare that to, but it’s quite an increase.
 
I suppose I should spend some time on the balance sheet, but with the Altamont financing hopefully imminent, it doesn’t seem like a good use of time. It would have been great if Billabong had, or would, provide a proforma balance sheet assuming the deal happens.
 
Final Thoughts
 
Sometimes Australian accounting leaves my head spinning and my sojourn through Billabong’s fine print hasn’t done anything to change that. I guess that’s my problem and I should move to Australia and study accounting.
 
Let’s move on to CEO Ian Pollard’s comments at the end of the press release. “We are nearing the end of a long process that has caused distraction, impacted on staff morale and has been very costly.” No argument there. One way or the other, it’s going to come to an end.
 
He goes on, “The Company looks forward to refocusing, reinvigorating its brands and rebuilding the business on a solid, long term financial footing.” I’d like to see that too.
 
To evaluate the possibilities, I’d like to see that proforma balance sheet I already referred to and, more importantly, I’d like to know more about the market position and potential of the company’s various brands. There are, I continue to believe, a host of cost reductions from operating better that won’t hurt any of the brands. In fact, they may help them and I applaud Billabong’s plan to reduce off price sales. But our market is changing madly. Legacy brands seem to be having a hard time getting traction and growing. You can read every word Billabong provided and not really get a better sense of where the brands stand. At the end of the day, that will be the most important thing.

 

 

Spy’s June 30 Quarter; Things Are Getting Happier

There are two things that really struck me in reading Spy’s June 30 10Q (which you can read here). You may not have seen them because, unlike you, I delight in reading small print and conference call transcripts. Perhaps “delight” is too strong a word. 

Anyway, the first thing I saw was that they had no (as in zero, zip, nada) sales of the “licensed products,” which, if you’ve been following the continuing adventures of Spy, you know was a distraction and cash flow problem for a couple of years. It hasn’t been a big deal for a quarter or so, but I look at this as the official end of all the crap Spy has had inflicted or has inflicted on itself in recent years. Now they just have to run the business.
 
Speaking of running the business, the second thing I noticed was that the cash flow from operations for the six months ended June 30 was a positive $1,077,000. In the first six months last year they used $3,860,000 in cash. I like positive operating cash flow. Sometimes, I like it more than an accounting profit because you can only pay your bills with cash- not with accounting based profit.
 
There’s still the small issue of the company not making any money, but the loss fell from $1.6 million in last year’s quarter to $574,000 in this year’s June 30 quarter. They accomplished that by increasing sales 5.6% to $9.96 million, improving the gross margin to 52.8% from 50.3% and reducing operation expenses by 15% from $5.83 million to $4.95 million.
 
Unsurprisingly, sunglass sales were 95% of total revenues during the quarter, with goggles being 4% and apparel 1%. North American sales (including Canada) were 88% of the total. What they define as closeouts of Spy product were $800,000 during the quarter compared to $500,000 last year. “A significant portion of the SPY ® sales growth was from sales of sunglasses into our North American optical and international channels, and from our optical frame product line and Happy Lens™ collection.”
 
The higher gross margin resulted from “(i) improved overall sales mix of our higher margin products partially due to increased levels of sales into optical channels; (ii) a higher percentage of lower cost inventory purchases from China; (iii) lower overhead as a percentage of sales partially due to the consolidation of our European distribution center to North America…” But they also had to increase inventory reserves, and that reduced the margin a bit. I’d really like more information on the composition of Spy’s inventory.
 
The reduction in operating expenses included sales and marketing that declined by 22% or $800,000 to $3 million. This came from “…(i) a $0.6 million decrease in advertising, public relations, marketing events, and related marketing costs; (ii) a $0.3 million decrease in sales and marketing salary and travel related expenses primarily for reductions in headcount. These decreases were partially offset by a $0.1 million increase in sales incentives and commissions…”
 
The balance sheet reflects both the improvement in operating performance and the continuing issue of too much debt. Over a year, cash rose from $821,000 to $948,000. Receivables were up from $6.39 to $6.45 million. Of course you expect some growth in receivables with sales growth, but I’d really need to see the composition of receivables last years and now to know how I feel about the change and current level. Specifically, I’d want to know how much was related to Spy brand product at both dates.
 
Inventory fell a bunch from $7.7 million to $5.5 million. That reduction is good to see, but some of that is due not only to liquidating the licensed brand product, but to getting rid of some old Spy inventory as well. Is the inventory now “right sized” for a more normally operating Spy business? I can’t tell, but it’s a lot closer than it used to be.
 
On the lower half of the balance sheet, we’ve got negative equity of $14.5 million, up from $13.8 million a year ago. Remember that the reason Spy has had a chance to try and pull off a turnaround is due to a major shareholder who’s been willing to pump in cash. Last June 30, long term debt to shareholder was $15.1 million. This June 30, the number is $23.2 million. However, current liabilities have fallen from $12.3 to $8.5 million, and total liabilities are up just 4.9% from $27.5 to $28.9 million.
 
In the conference call, CEO Michael Marckx talked about how Spy has “…become a much more effective organization, with the idea of Super Service at the heart of our company culture. This can be summed up with the ethos of being in service to our retail partners, the people who wear our products and to one another, inside and outside of the company. Our Super Service mantra is simple: How can we make people HAPPY? This mindset is not only evident in our customer service, it is apparent in how we market our brand…”
 
I know- that sounds a little like a big old platitude, but I don’t think it is. Let me finish quoting CEO Marckx before I explain why.
 
“…our efforts this half and moving forward stem from a focus and brand ethos that will help to further strengthen our unique positioning and product offering in ways that are mutually beneficial to our retailers. With a more diverse and unique selling proposition from SPY, our retailers are able to better serve their communities with higher quality, differentiated products from SPY, and do so knowing we bring an energy, strength and point of view that our competitors are not matching.”
 
What he’s doing is bringing continuity and clarity to the way the organization functions. Everybody knows how to spend their time. They don’t have to ask so often what to do and not do. They know how every stakeholder should feel after dealing with Spy- Happy.
 
They don’t focus so much on what the competition is doing as on how they can run their own business well. Without this focus I bet they couldn’t have increased sales and gross margin while cutting expenses.
 
Financially, Spy isn’t out of the woods. They are still losing money and their balance sheet, though showing operating improvement, is burdened with way too much debt. Solving that problem requires not just that they make a profit but that they grow that profit through increasing sales. I hope there isn’t pressure to grow sales faster than their market position permits. Our industry is littered with damaged brands who tried to pull that off.

 

 

A Quart of Paint

If you’re a homeowner, you know that you can never complete your project list. All you can do is try to keep it from getting longer. At our house, outside projects are my job and in the Northwest, that means get them done in the summer.

In the spirit of shortening the list, I stopped by a Sears yesterday to pick up a quart of exterior primer paint for one such job.
And found that Sears no longer sells paint. HOW IS THAT POSSIBLE!?
When we first moved up here from the Los Angeles area north of 20 years ago (Yes, I do appreciate the irony of my having found my way into action sports by moving from SoCal to Seattle), there was a chain of home stores called Ernst. It was obvious they were struggling, but when they started to carry furniture and all kinds of other stuff basically, in my view, desperately putting on the floor whatever they thought might possibly sell, I knew they were toast. Shortly thereafter, they were out of business.
It’s no secret Sears has been struggling. But when I saw they were no longer carrying paint I said, “Okay, that’s it.”
Tactically, I’m sure their carefully conducted analysis showed that paint was a money loser for Sears. So they got out of it.
But it’s way more than a financial decision. It’s a decision about who their customers are and what they expect from Sears. Truth is, I mostly go to Home Depot and Lowes now because I know that whatever I want for home repair, maintenance, or remodeling they are likely to have it. But Sears was convenient, and I had a residual affinity for it as a home store. But somehow their not having paint flipped a switch in my fontal lobe and what was clearly a delusion on my part is gone.
Sears used to be the place where you could get everything. If not in the stores then through the catalog. For certain items, it could be the only choice for people in parts of the country, and they were happy with Sears even if it took weeks to get the product. It’s way easier to be a retailer when your customers have no choices and love you anyway.
Sears has a hangover from the party it threw while selling almost everything to everybody. Now, why would you choose Sears? It sells hardware, home improvement, clothing, shoes, appliances, electronics, towels and bedding and probably some categories I’m forgetting. Oh yeah- auto repair. Is it your first choice for any of those? Can you think of anybody else that tries to compete in all those categories? To make it worse, we can all think of places with better selection, prices, and/or service in any of those categories.
Sears competes with everybody. Which is impossible and maybe means they are not very relevant as a competitor. I’d also note that the chains I consider the closest overall competitors to Sears (Walmart, Fred Meyers, Target, etc.) are also carrying food; the one thing Sears seems to have stayed away from.
Sears is a hodge podge of unrelated categories no longer connected by a defined consumer need and I don’t think they do any of the categories particularly well. It’s a bad place to be. And, as we all know, it’s made worse by an economy where sales increases are harder to come by.
I’m not writing about Sears because I’m worried about them leaping into the youth culture business (though, hell, everybody else has). They are a poster child for two business conditions. The first is owning a market niche (a damnably big one in Sear’s case) and having the market evolve away from you. Markets, of course, always change, so you have to expect that. I also expect you aren’t going to be able to predict how they change.
The second, said before but worth saying again, is that when you try to be meaningful to everybody, you can end up being meaningful to nobody.
It’s certainly an old story to us. Credible, successful brand tries to leap beyond its customer franchise alienating existing customers, never really distinguishing itself with the new target customers, and finding the competition from the whales in the new ocean overwhelming. Or credible, successful, brand just continues to do what it’s always done and ends up screwed as the market changes and it doesn’t.
It has, I think, always been true that you couldn’t just sit in your niche. Neither could you infinitely extend your brand. But cash flow, I’ve said, covers up a host of problems and it was easier to do nothing, or do the wrong thing, in the old economy and get away with it for a while.
In our competitive thinking, we used to be over focused on what our competitors were doing. It was way easier than really figuring out who your customers were and why they were buying from you- that’s hard work. That really didn’t work and certainly doesn’t now.
To over simplify, you probably have to grow, but not too much. “Not too much” is different for every brand or retailer. Every product you decide to carry, every distribution decision you make has to be based on what your customer is doing and what they want from you.
Create a process to help you make those decisions. If you don’t, they will be overwhelming and you’ll find yourself wallowing around like Sears. Don’t stop carrying paint if your customers expect you to have it.

 

 

What’s Up at Sanuk? Oh- And Decker’s June 30 Quarter

Deckers, as you know, owns UGG, Teva and some other smaller brands as well as Sanuk. At June 30, they had 89 retail stores as well. 

In the quarter ended June 30, Deckers reported sales that fell 2.5% to $170 million compared to last year’s June 30 quarter. The gross profit margin declined from 42.2% to 41.1%. Selling, general and administrative expenses rose 10.1% from$102.3 million to $112.6 million. There was a net loss of $29.3 million, up from a loss of $20.1 million in last year’s quarter.
 
With that cheery news behind us, let’s jump right to a breakdown of Decker’s revenue and operating income by segment taken right from their 10Q, which you can view, if you’d like, right here. The chart below is from page 9.
 
 
You can see that UGG wholesale business was down 20.7% and Teva wholesale fell 9.5%. Sanuk was up 4% at wholesale, ecommerce grew 34% and retail 29% due to new store openings since last year. Sanuk’s ecommerce sales rose from $1.26 million to $2.09 million. Their sales through Decker’s retail stores were up from $0 to $218,000. Total Sanuk sales in the quarter were $30.1 million.
 
It always intrigues me that there’s never a discussion of how, for better or worse, the direct to consumer business impacts wholesale business. It almost seems like there’s a conspiracy of assuming that it’s inevitably a good thing. I suppose, in the case of ecommerce, brands have no choice but to be involved in it, so you might as well assume that’s true. In the case of retail, I’m not quite so sure and never have been. I’d love to be a fly on the wall as companies try and decipher how their wholesale and direct to consumer businesses influence each other.
 
Back to the chart. In its bottom part, we see income from operations for each segment. Only ecommerce and Sanuk grew their operating profit. UGG actually lost a little money, and the retail stores more than tripled their operating loss. Opening more stores and losing more money doesn’t seem like a good plan.
 
But back to Sanuk’s wholesale results. You can see they grew operating profit during the quarter by 143% from $2.7 to $6.5 million even though sales were up only 4% or $1 million. How’d they do that?
 
Off to the fine print.
 
As background, Deckers acquired Sanuk in July 2011 for, uh, a lot of money. The contingency payments include 36% of Sanuk’s gross profit in 2013 and 40% in 2015 with no upside limit (no payment in 2014). Deckers has to estimate what these payments may be. They are included on the balance sheet in other accrued expenses and long term liabilities. At least some of the amount impacts the income statement. It’s interesting, given Sanuk’s recent results, that “The estimated sales forecast [for Sanuk] includes a compound annual growth rate (CAGR) of 17.3% from fiscal 2012 through fiscal 2015.”
 
Anyway, Sanuk’s big operating income improvement “…was partially the result of decreased expense related to the fair value of the Sanuk contingent consideration liability of approximately $5,000,000 partially offset by increased selling and marketing expenses of approximately $3,000,000. The increase in income from operations was also due to the increase in net sales and resulting gross profit.”
 
To some extent, then, Sanuk’s improved operating profit  from its wholesale business during the quarter is partly the result of Decker’s reduced expectations for the brand through 2015, resulting in a reduced accrual of the earn out. Isn’t accounting wonderful?
 
I’d also note that of the net goodwill of $128.7 million carried on Decker’s balance sheet, $113.9 million is related to Sanuk. At some point, if Sanuk’s performance doesn’t meet expectations, that will have to be written down. Don’t know how much. It would be a noncash charge, but still a hit to income.
 
We also learn that Sanuk’s wholesale sales “…increased primarily due to an increase in the volume of pairs sold, partially offset by a decrease in the average selling price. The decrease in average selling price was primarily due to increased closeout sales, as well as a change to the discount program for prebook and re-orders.” The volume increase was about $1.5 million, but the discounting cost them $500,000.
 
I’ve been writing and speaking lately about how hard it seems to be a public company in our space. I’m beginning to worry that Sanuk is another example of what happens when an excellent brand is acquired for a high price by a public company that has to meet Wall Street growth expectations, but doesn’t really understand our space.
 
Deckers CEO Angel Martinez, in the conference call, talks about Sanuk this way:
 
“…the Sanuk brand started off as a predominantly male one-season surf brand when we acquired them in 2011. Now we’re transitioning the Sanuk brand into a lifestyle brand that will be featured in department stores, sporting goods and outdoor retailers in 2014.”
 
He says that so easily. But as I think about why Sanuk succeeded and what the brand stands for, I think he may be surprised just how hard it is to accomplish that transition without damaging the brand. It’s not that it can’t be done; I am just not sure it can be done as quickly as a public company might require. I am sure that “department stores, sporting goods and outdoor retailers” is way too broad a definition of the target market to be useful, and I assume appropriate slicing and dicing is ongoing at Deckers. 
 
Deckers is taking Sanuk into new markets, they are taking it into new, broader distribution, they are trying, according to CEO Martinez, to “…allow our Sidewalk Surfer-loving customers the ability to wear their favorite styles deeper into the year [UGG by Sanuk?],” and, he says, they want to “transition the brand from primarily hanging footwear merchandise brand to a meaningful player on the footwear wall in our surf, outdoor and footwear specialty channels, during what has traditionally been the brand’s off season.”
 
I seem to remember a successful, fast growing, quirky, male surf brand called Sanuk. Whatever happened to that brand anyway?
 
It feels like Deckers is trying to change and grow Sanuk to meet Wall Street requirements and to justify the price they paid for the brand. But they now expect Sanuk sales during the year “…to grow approximately 5% versus our previous expectation of between 10% and 13%.” My hope is that they don’t see the reduced sales expectations as a reason to push some of these transitions even more quickly. I’d suggest they consider that some part of the lower sales is the result of what they’ve done already. Hope I’m wrong and that they listen to the people they’ve recently hired.

 

 

VF’s June 30 Quarter; Net Income Down, But Kind of Not Really.

VF’s net income fell 11% from $155.4 million in the quarter to $138.3 million in the same quarter last year. But last year’s quarter included a gain of $41.7 million from the sale of the John Varvatos brand that was booked under Other Income (Expense). In this year’s quarter, instead of a gain of $41.6 million, that line showed an expense of $1.5 million. Without that gain from the sale, net income would be up over last year’s quarter. 

Which is what you might expect with total revenues up 3.7% to $2.19 billion and the gross margin rising from 46.1% to 48.5%. As we’ve gotten used to, VF’s Outdoor & Action Sports segment (that includes Reef, Vans, The North Face and Timberland) led the way. Below is a table from the 10Q with the revenues and operating profit for each segment. And, while we’re at it, here’s the link to the 10Q for anybody who wants it. I always wonder if anybody but me ever looks at them.
 
 
As you can see, Outdoor & Action Sports (OAS) represented 49.7% of revenue and 37.3% of operating profit. The result in Jeanswear is impressive, delivering a bit more operating profit than OAS on only $612 million in revenue.
 
North Face revenue rose 5% in total. There was “…moderate growth in the wholesale sales, a 15% increase in the brand’s D2C [direct to consumer] business and a more than 20% increase in international sales.” In the Americas, wholesale revenue declined in the mid-single digit range. D2C there rose in the mid-teens.
 
Vans revenues grew 15%, with growth balanced between wholesale and D2C. Outside of the Americas, Van’s growth was over 20%. D2C growth was over 40%. They don’t tell us what Van’s growth was in the Americas, but obviously it was below 15% since outside of the Americas, it was 20%. I thought their take on Van’s apparel was interesting. “By taking classic action sports products the consumers are already connected to and adding performance benefits to them, such as weatherization, we’re equipping the Vans consumer with a whole new level of quality and technology in both warm and cold weather. This allows us to have more relevant, year-round offerings as we extend our reach into cold-weather months and cold-weather markets.”
 
We hear that Reef’s results were “solid,” but aren’t given any details. Timberland’s global revenues fell 3%. They were up low single digits in the Americas and down high single digits in the rest of the world. They expect revenue to be up for the year. We’re into VF’s second year of ownership of Timberland and to some extent it’s still a work in progress.
 
The 3.7% total revenue growth included 3% in the U.S. and 6% internationally including 10% in the Americas not counting the U.S. and 2% in Europe.
 
The gross margin improvement of 2.4% resulted from “…lower product costs and a favorable mix shift towards higher margin businesses.” Partly that’s due to growing D2C business. They don’t tell us anything about exactly how the lower product costs came to be. I wonder if there isn’t some benefit from the fall in cotton prices included there. I’d just like to know what part of it reflects good management and what reflects factors over which they have no control.
 
Inventory fell 3% even with the sales growth and certainly reflects good management. Inventory management is something they noted several times as an area of focus. They characterize their supply chain as a competitive weapon. “And as others are feeling the pinch of higher costs, we’re in many, many cases able to offset those costs through efficiencies in our own plants.”
 
They specifically connect inventory and supply chain management to marketing when they note that they are very satisfied with their retail inventories because it gives them “…the opportunity to really get our new product well positioned and upfront for the consumer as it starts to ship into our dealers…” That’s an important idea.
 
Marketing, administrative and general expenses rose 1% as a percentage of revenues. Half was for their D2C business and half for “…increased marketing investment in our brands.”
 
If VF has issues, and isn’t growing as fast as it used to, those issues are pretty much the same ones all retailers and brands in our industry have. Europe is weak, and VF especially calls out problems in Southern Europe. Hardly a surprise with unemployment rates north of 25%. The U.S. is recovering slowly, but consumers are cautious in their spending. “Retailers,” they note, “Are buying much closer to demand.”
 
But VF points out that their pension plans are almost fully funded (that’s a big deal, though you don’t hear about it much), they are paying down $400 million in Timberland related acquisition debt in the third quarter, and they will be out of the commercial paper market by year end. Their long term debt is down $400 million from a year ago. That leaves them with a balance sheet with which they can consistently pursue their strategy. Not everybody enjoys that. 

 

 

A Brief Update on Billabong

As you are probably aware, Billabong yesterday published a press release announcing the expected resignation of Launa Inman as CEO and of Paul Naude as a director and employee. It also said that, “Discussions with Scott Olivet regarding his appointment as CEO are continuing but have not been finalised as we await the outcome of the Takeovers Panel’s deliberations.” 

In the meantime, Scott is a consultant to Billabong and Peters Myers is acting CEO. You can see the press release here.  It’s the first item under “Recent News” called “Billabong Management Changes.”
 
Scott Olivet is the executive Altamont is bringing in as part of the overall deal with Billabong. One would assume that the deal with Scott was finalized before Altamont’s deal with Billabong was closed since Altamont wants Scott as CEO. You may also recall that Scott was investing a couple of millions of his own dollars in Billabong as part of the deal. I’m guessing here, but I can imagine that maybe Scott doesn’t want to commit his own funds until he knows what the Takeover Panel decides.
 
The investors who owned Billabong’s debt were paid off by Altamont when the deal with Billabong closed. They appealed to the Australian Takeover Panel because they didn’t like the deal. “Didn’t like” probably means they were hoping for a better deal themselves than just getting paid off.
 
Here’s a link to the Takeover Panel. When they publish a decision, we’ll be able to see it here. According to the site, “it takes a little over 2 weeks (16 days) for the Panel to make a decision on an application.” The average days from deciding to review to publishing their decision has been about 10 days in 2013. Billabong says it may be a week or more until we have that decision.
 
Meanwhile, Billabong has announced that their preliminary earnings presentation for the year ended June 30 will be released on August 27th. As I’ve said, I’ll be very interested to see their balance sheet.  Seems to me that in the past, they haven’t called it ‘preliminary." 
 
Okay, that’s it. I really wish this wasn’t all going on and that Billabong was just going about business, but it sure is interesting. 

 

 

Selling Less In a Good Cause; Skullcandy’s Strategy and Quarter

In the quarter ended June 30, Skull’s sales fell by 30% to $50.8 million from $72.4 million in the same quarter the previous year. Their gross margin fell from 48.6% to 44.9%. Selling, general and administrative expenses actually rose slightly from $23.5 to $24 million, but if you exclude the almost $1 million that’s included for the move from San Clemente to Park City, it fell a bit. Net income, not surprisingly, declined from a profit of $6.8 million to a loss of $689,000. 

It’s not that I’m thrilled to see these results, but I think they are indicative of Skull pursuing the only strategy they can reasonably pursue. Here’s how CEO Hoby Darling puts it:
 
“While I do not believe we will turn our sales trajectory positive this year, we’re decisively taking action based on learnings from some historical missteps and being more disciplined around distribution, retailer and product segmentation, discounting and importantly, the alignment of product, marketing and sales. These are necessary first steps to protect the brand and set us up for long-term healthy growth.”
 
You remember that last quarter Skull was cutting back on the sales through off price channels (year to date those sales are down 50%). Now we find out they’ve actually held back some product from some retailers to protect their brand position. As CEO Darling puts it, “We need a clear distribution channel and to have retailers and consumers seeking out our products.”
 
One more quote:
 
“We will continue to aggressively rebalance our distribution pyramid so that demand and supply are more closely matched. This includes minimizing the end-season product sales in the off-price channel, protecting our map pricing policy and supplying our retailers with the right amount of product to match healthy demand. We will continue to protect profitability, while investing in our most important growth initiatives in demand creation.”
 
Oh hell, just one more:
 
“As we think about our future, the main tenets of our strategy are based on the following: first, transforming the marketplace. This includes rebalancing and segmenting our distribution pyramid to amplify with winning retailers and match supply to market demand and clarifying our brand message, with a strong focus around digital and planned sale.”
 
Regular readers will know why I’m all a dither about this strategy. I’ve been pushing for some years the idea that with sales growth harder to come by, gross margin dollars and control of operating expenses was where you needed to focus to improve profitability. I’ve said that distribution and deciding who to sell to is way harder than it used to be. But I’ve also said that if you recognize the relationships between operations (especially inventory management) on the one hand and sales and marketing on the other, you can achieve better results while spending a lot less.
 
Like Quiksilver and Billabong have done and are doing, Skullcandy is also working to “…create a cohesive organization by removing the operating silos that were hampering communications, alignment and culture between different areas of the business." CEO Darling, by the way, thinks they can probably spend less on demand creation. He makes that comment in kind of an offhand way, but if the company approaches their customer segmentation, pricing, and distribution in the way he describes, it might be a lot less. Overall, what Skull is doing kind of reminds me of Spy’s strategy. And the bottom line is that Skull is going to have to reduce its SG & A spending as a percentage of sales unless sales grow way faster than they seem to expect.
 
There’s just one fly in the ointment. Like Billabong, Quiksilver and Spy, Skullcandy is public. These are four companies that would be better off if they were private and free to pursue brand strategies unconstrained by the need for regular, quarterly growth. Skull is purposefully restricting sales to defend and strengthen their brand and market position and, I’m expecting, greatly improving their overall profitability. Great decision.
 
But there’s that pesky Wall Street revenue growth bias out there. What to do? Skull expects that their current actions will increase their sales in their core market, though not until 2014. CEO Darling describes the brand as “…fun, young and irreverent, woven in with creative and active.” Good definition. “As small and creative company, we have the opportunity to be special and more unique than our larger competitors.” I agree. But that focus also limits growth because it limits your available customers.
 
What to do? Product extensions, which the analysts ask about every quarter, are one answer. Sell more to the same customer. The Air Raid Bluetooth speaker will be in retail in the fourth quarter. And you also look for growth by “…expanding beyond our core audio headphone market and partnering with other brand leaders and their respective consumer categories will assist in broadening our region appeal to give Skullcandy added legitimacy outside of our core market position.” They use a deal they are making with Lululemon as an example. Sell more to a new customer.
 
Let’s assume that as a result of implementing these strategies I like that Skullcandy solidifies its position in its core market, grows sales slowly (slower growth initially is implicit in its strategy), and improves its profitability on those sales significantly. As a private company, that might arguably be a great result. As a public one, not so much. So along come the brand extensions and the partner deals “to give Skullcandy added legitimacy outside of our core market position.”
 
How’s that worked out in this industry in the past for public companies? As I’ve pointed out, Zumiez is the only action sports based company that’s public and doing well. Others are all having difficulty or have been acquired.
 
Skull has the balance sheet to pursue its strategy. They’ve got no long term debt, $30 million in cash (up from $7 million a year ago) and a strong current ratio. Operations provided $12 million in cash flow during the first six months of the year compared to using $8 million in the first six months of last year. Inventory over the year fell 17% from $50.5 to $42 million. I might have expected a larger drop given the sales decline. They tell us the decline wasn’t greater “…due to higher gaming inventories support retail and the building of inventory in China to support our direct sales model there.” I’d be interested to know how much of their existing inventory is price point product they still need to move.
 
Much of the sales decline was due to a reduction in the off price sales, but they also mention “…lower sell-in at a key customer and a decline in sales to several of our specialty retailers.” They have one customer that represented 18.3% of sales during the quarter compared to 11.4% in last year’s quarter. While I imagine that increase is explained by their decision to reduce price point sales, it’s still quite a concentration.
 
They make the interesting comment that they see some market movement from over the ear product to in ear. They don’t tell us the extent of the change. That’s interesting because in their last call they talked about moving towards higher priced but lower margin (generating more margin dollars) product that was largely over the ear. I was surprised no analyst asked about that.
 
Skullcandy has a strategy I fully support, but wonder how it will be received in the public markets. They have some personnel, relocation, and operational changes going on that it’s just going to take a little time to work through. I will wait to see how their product extensions work out. I hope they aren’t too aggressive in that area.

 

 

Relaxed Fit

Maybe a month ago, I was walking through a local mall visiting all the usual retailers to see how things looked. I stopped at a PacSun store and was attracted to a table with some Volcom shorts on it in colors I really liked. There was a sticker on the shorts that said, “Relaxed Fit.” 

I paused for a moment, looked around the store to clear my head, and then read the sticker again. Yup, it said “Relaxed Fit.”
 
There was a moment of mental paralysis, then the thoughts all poured out at once. “This must be some sort of cool marketing trick I just don’t understand, the stickers are there by accident- some clerk is screwing around with my brain (and it’s working), is this really where our market is going, there’s some kind of new trend I don’t know about, yes, that must be it, maybe it means to be fit and relaxed, Kering (Volcom’s owner) is making them do this, no, wait, somebody slipped something in my soda…”
 
I walked out of the store determined to pretend this had never happened. But three weeks later, in another mall in another city I made the mistake of checking again and there the shorts were with that same diabolical sticker. My attempt at denial was foiled.
 
But happily I was saved by my ever vigilant research department that sent me this New York Times article called “Three’s a Trend | Men’s Shorts That Are Loose, but Refined.”
 
“Loose, but Refined” is conceivably a perfect (and hopeful) description of Volcom owned by mostly high end fashion company Kering. Grabbing at straws as I am, I’ve decided to believe that Volcom’s “Relaxed Fit” sticker is just a bow to this fashion trend shaped by their large corporate owner. See, I don’t know a lot of surfers, skaters and snow sliders that need relaxed fit clothing.
 
Okay, I’ve had a little fun with this, and I’m sure Volcom isn’t the only one doing it. I suppose I need to recognize that all our customers can’t be teenagers and that body shapes change with age (not mine of course). Yet in our push for growth, we get further and further from our roots. The ASC conference the day before the Agenda Show celebrated the importance of authenticity, but I wonder just what kinds of customers we can make product for before we begin to lose it.
 
I hope Volcom can stay loose.