Speculation on Billabong

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Walking around a really good Agenda show last week, the question I kept getting asked was, “What’s going to happen to Billabong?”  As I told everyone who asked, I only had access to the same public information they had. Given that information, my best guess is that Billabong will be sold.  Here’s my reasoning. 

As you know, TPG offered, on July 23rd, to buy Billabong for AUD $1.45 a share subject to due diligence and other conditions. They already have an agreement from two Billabong shareholders who together control over 24% of the outstanding shares to sell if there is a deal. Billabong announced on July 27 that “TPG will be granted the opportunity to conduct non-exclusive due diligence in order to reduce the conditionality of its proposal and to improve its understanding and valuation of Billabong.”  
 
Notice it’s nonexclusive, so it’s not impossible for another buyer to pop up. But TPG has 24% of the shares already tied up with deals that give them some upside if higher price is negotiated. TPG also has agreed to allow “…Billabong’s founding shareholder, Gordon Merchant, and Collette Paull to roll over all or part of their respective shareholdings in the company into the TPG proposal.” There seems to be at this point a certain momentum, though a lot can happen between the start of due diligence and the closing of a deal; including an adjustment in the price.
 
The other reason I think a deal will happen is because of the process by which we got to where we are. Back on February 17th Billabong announced the deal to sell half of Nixon to TCP (not to be confused with TPG) for net proceeds of US $285 million. The deal closed on April 12th. That US $285 million, along with other action take to reduce expenses and close some retail stores, was supposed to address Billabong’s capital structure issues. That is, it strengthened their balance sheet.
 
 In the conference call at the time the Nixon transaction was announced, Silvia Spadea, a Merrill Lynch analyst, said, “I guess there’s no question that that will provide you with a short term reprieve with respect to your balance sheet issues. But, in my mind, it doesn’t really do much to address the fact that – you know to improve your current structural issues or stem the current deterioration in your earnings. I guess I’m just wondering how confident you are that the initiatives that you’ve outlined today are going to be enough to permanently fix that balance sheet issue, so that we don’t have this problem a year down the track.”
 
 An excellent question, I thought. In their answers, Billabong CEO Derek O’Neill and CFO Craig White never said anything like “You bet- problem solved,” and you actually wouldn’t expect them to be that definitive. But what they did do was indicate they had confidence in their projections. And my common sense told me that if they had even an inkling that the short term problem wasn’t  well and truly solved, they’d have taken more drastic steps and the Board of Directors would not been quite so cavalier about turning down an offer of AUD $3.30 a share for the company.
 
So imagine my surprise (Yours too, I expect) when Billabong management  announced on June 21st  (Former CEO Derek O’Neill departed the company on May 9th) that they were raising AUD $225 million at $1.02 a share, 44% below the previous closing price.
 
What the hell is going on in there? Had business conditions just fallen off a cliff and Billabong management hadn’t seen it coming?   Almost seems like it couldn’t happen that fast. Had they known it was worse, but had another solution in mind? In the U.S. such a failure to disclose would probably lead to shareholder lawsuits and a flogging from the Security and Exchange Commission. I don’t know what happens in Australia.
  
I suspect it’s not quite as black and white as either of those choices. In doing turnaround work, I’ve noticed a lot of denial and perseverance during periods of change even among highly competent managers/owners and I suspect there might have been some of that in this case.
 
When management has credibility issues, things appear to be going south much faster than anybody (including said management?) knew, and the shareholders take it on the chin and have a stock valued at AUD $1.39 a share they think they could have sold for AUS $3.30 just a couple of months ago, companies find themselves in play.
 
When will we know the outcome? Billabong is scheduled to report their full year earnings on August 27th. That is also the date new CEO Launa Inman is scheduled to present her plan to turn around the company. Due diligence takes some weeks typically, and I wouldn’t be surprised if an announcement coincided with the earnings report.   
 
I wonder what TPG would have found had they commenced due diligence under their previous offer of AUD $3.30? I think maybe there’s an untold story here. Anybody want to tell it to me? 

Nike’s Annual Report and Some Suggested Reading

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Two days ago, Nike filed its 10K annual report with the SEC and I’ve been through it. I’m not going to spend a bunch of time doing a detailed analysis of their already reported results if only because there wouldn’t be a lot of insight to be gained. But there were a few comments in the fine print of the report and in the conference call that I thought were relevant to thinking about the business environment.

As part of that process, I want to point you to a book called The New Rules of Retail, by Robin Lewis and Michael Dart that Roy Turner at Surf Expo turned me on to. It’s also available for Kindle. Let me make the connection between the book and Nike by starting with a quote from Nike Brand President Charlie Denson talking about how the Nike brand achieved a 21% increase in revenues during the year.

“We did it on the strength of our product innovation, the power of the brand, and the differentiation we create through distribution,” he said. Nike Inc. President and CEO Mike Parker notes, “There’s a strong appetite for authentic brands and genuine innovation. Digital technology is just beginning to show what’s possible in products, services and at retail. And new partnerships continue to advance how products are manufactured and distributed.”
 
You might be tempted to say, “Well, no kidding” but having just finished the book, I heard more in that statement than I otherwise might have.
 
The New Rules of Retail (published in 2010) makes a number of predictions we can already see coming true. It says that just to be in the game, you have to do all the operational stuff well. Not just well- really well. And you have to keep improving. That’s no longer a strategic advantage, but the price of entry. I’ve been saying that for a few years, though not with such strategic eloquence, so you can begin to see why I like this book. Like all of us, I’m partial to people who confirm what I think.
 
They also say that “The ultimate collapse of the traditional retail/wholesale business model is now clearly visible.” I’ve said retailers are becoming brands and brands are becoming retailers.  I’m liking the book more and more.
 
They think that as much as 80% to 90% of traditional department store revenues will be generated by their own or exclusive brands. They suggest that retail stores “…will become hybrid enclosed ‘mini-malls’ for increased traffic and higher productivity.” They think Amazon will open stores. They expect preemptive strategies like pop-up stores to “…become proactive strategies as opposed to marketing opportunities.” They expect big retailers “…will accelerate the roll out of their smaller free-standing ‘localized’ neighborhood stores.”
 
They say some other intriguing (or maybe scary?) things too, but I’ll let you read them for yourself and look at the examples they provide.
Why is this happening? Because the consumer has near perfect information and an almost endless number of choices. What to do?
 
The authors suggest that successful companies will do three things. First, and as a condition for accomplishing the other two, they will control their value chain; especially at points of contact with the consumer. This does not mean owning your whole value chain.
 
Second, with consumers expecting more and better all the time and to get things the way they want them, companies have to far exceed the consumers’ expectation. They will accomplish this by creating a “neurological connectivity” with their customers. I know that sounds a bit like voodoo, but the book explains it very well. Think Starbucks or Trader Joes. Or Vans, though that’s my point of view.
 
Third, they will have “…to gain access to consumers ahead of the multiplicity of equally compelling products or services, and precisely where, when and how the consumer wants it.” They call this preemptive distribution.
 
Now, with those three actions in mind, go back and read the quotes from the Nike conference call I started with. The book’s authors note that in all the companies they interviewed, none used their exact words, but the successful ones were doing what they suggested. By the way, they spend quite a bit of time talking about VF and how it’s following their prescription. That’s an interesting read.
 
My immediate reaction on finishing the book was that doing what they say is required was damned expensive and required a strong balance sheet; especially in a lousy economy. Though they don’t address the financial cost of their strategy, I suspect they would agree as they believe “50 percent of retailers and brands will disappear.”
 
They don’t talk about a time frame, so it’s hard to know what to think about that prediction. And they don’t say anything about new brands being created. If their prediction is over three years, it’s pretty harsh. If it’s over 40, it’s probably a low estimate given normal brand cycles.
 
So probably you’re not as big as Nike and might not have their balance sheet. The message isn’t, “If you’re not big you’re doomed.” The message is, first, business was way more fun and easier in the 90s and I really miss that. Second, rapid disruptive change is never something any of us really like, but it’s full of opportunities for the people it doesn’t paralyze.   Some of that opportunity comes from the fact that your competitors may be paralyzed.
 
Third, Lewis and Dart wouldn’t disagree that you still need to know your customers and give them what they want. It’s harder than it used to be, but you also have some technology tools you didn’t have before. In that sense at least, nothing has changed.
Okay, wasn’t this supposed to be about Nike or something?
 
Nike’s revenues for the year were up for almost all categories and brands to $24.1 billion (including Cole Haan and Umbro which they are selling). Sales at Hurley fell from $252 million to $248 million. Nike reports total action sports sales at $499 million, up from $470 million the previous year. That’s 2.1% of Nike’s total sales for the year. I guess “action sports sales” means Hurley plus Nike Skate. Maybe it includes some Converse sales.
 
We know that Hurley lost money, though they don’t say how much. Lower gross margins as well as higher selling and administrative expenses as a percentage of sales contributed to Hurley’s loss. But they are still confident in Hurley’s future. Mike Parker noted in the conference call, “…we’re confident our NIKE, Converse, Jordan and Hurley brands have virtually unlimited growth potential.”
 
Nike’s gross profit margin fell from 45.6% in 2011 to 43.4% in the year ended May 31, 2012. The decline was “…primarily driven by higher product input costs, including materials and labor, across most businesses. Also contributing to the decrease in gross margin were higher customs duty charges, discounts on close-out sales and an increase in investments in our digital business and infrastructure.”
 
I found the mention of higher customs duties interesting. They note in the 10K, “The global economic recession resulted in a significant slow-down in international trade and a sharp rise in protectionist actions around the world. These trends are affecting many global manufacturing and service sectors, and the footwear and apparel industries, as a whole, are not immune. Companies in our industry are facing trade protectionist challenges in many different regions…”
 
On pages four and five, they talk about issues with importing into the European Union, Brazil, Argentina and Turkey and about trade relations with China. Among the reasons the Great Depression lasted so long was the imposition of various “beggar thy neighbor” trade policies (including the Smoot-Hawley tariff act in this country) that reduced worldwide economic activity.
 
Looks like all the world’s helpful and friendly politicians are at it again. You know, I knew they would, but I really hoped they wouldn’t. I better move on. Oh- 58% of Nike’s revenues are from outside the U.S.
 
Well, this is interesting. I’m looking at an income statement with no restructuring charges, goodwill impairment, or intangible and other asset impairment. There’s no “adjusted earnings” offered as an explanation for something or other. No EBITDA reconciliation to GAP. No discontinued operations (There will be next quarter because of the plan to sell Cole Haan and Umbro). There’s hardly any interest or “other” expense. Just net income that rose for the year from $2.13 to $2.22 billion, or by 4.2%. That decline in gross margin really hit them hard.
 
Okay, I’m worried. If too many companies start just reporting what they earned without resorting to various explanations, reconciliations, and obfuscations, who’s going to need me to figure it all out? Where will I be if we have straight forward, easy to read financial statements? I sure hope this isn’t a trend.
 
Revenue in North America rose from $7.58 to $8.84 billion, or by 16.6%. Earnings before interest and taxes were $2.01 billion, up from $1.74 billion the previous year. Revenue from Western Europe was up 7.1% to $4.14 billion, but earnings fell 18.2% from $730 million to $597 million. China sales rose from $2.01 billion to $2.54 billion and earnings rose 17.3% to $911 million.
 
Nike ended the year with 384 retail stores in the U.S., but 109 of those are Cole Haan which will go away when they sell the brand. Hurley had 29 stores. Non-U.S. retail stores totaled 442 including 69 Cole Haan. Direct to consumer revenues totaled 17% of total Nike brand revenue (not Nike, Inc.) And comparable store sales grew 13%.
 
If Nike starts renting space in a Macy’s and stocks and manages the inventory itself, will they call that a “store?” For all I know, they are already doing that. The distinction between brand and retailer just keeps blurring.
  
Nike’s balance sheet is more than solid, with $3.7 billion in cash, a current ratio of 3.0, almost no long term debt and $10.4 billion in equity against $5.1 billion in total liabilities.
 
Nike’s doing well given economic conditions not even they can shrug off. Most importantly, I think they have a clear vision of where brands and retail are going.

 

 

Spy to Raise Capital by End of August- But That’s All We Know

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Spy filed an 8K on July 2 that announced they had increased the amount of the note due to Costa Brava from $6 million to $7 million, and that the full amount of $7 million was already outstanding. They also said they expected to raise some form of equity by August 31. As you may recall, Costa Brava owns 48.4% of Spy’s common stock (52.1% on an as converted basis). Mr. Seth Hamot is the Chairman of the Board of Spy, and “…sole member of the sole general partner of Costa Brava.”

You may also recall, or you may not, that interest on the loan to Costa Brava was being accrued as additional debt by Spy rather than paid in cash. That’s at least part of the reason why the loan amount had to be increased.

We also learn that, “SPY North America must prepay $1 million of the principal amount outstanding under the line of credit within five business days of our proposed sale of equity (preferred stock, common stock, warrants to purchase common stock, or any combination thereof) with proceeds to us of at least $4 million prior to payment of any transaction expenses. The amount so paid will reduce dollar-for-dollar Costa Brava’s commitment to make advances under the line of credit. We expect to sell such amount of equity by August 31, 2012.”
 
That Spy would want to raise equity is hardly a surprise. Their filings have noted the potential need for additional working capital, and Mr. Hamot, understandably, doesn’t want to continue to lend money to Spy.
 
But that suggests he expects the money to come from somewhere besides Costa Brava. We don’t, however, know what form the equity will take or how much it will be though the deal is supposed to be done by August 31. That makes me think the discussions are already ongoing if only because they felt obligated to mention it in this filing.
 
Spy’s stock closed on July 3 at $1.40 a share. But it doesn’t trade much volume and there’s a big bid/ask spread so that doesn’t mean all that much. It’s only averaged 2,457 shares a day over the last 90 trading days and some days there are no trades at all.
 
You will also note from the quote above that Spy has to pay back a chunk of any money it raises to Costs Brava to reduce the loan outstanding. While that improves the balance sheet by reducing debt and increasing equity (depending on the form of the capital raise), it doesn’t generate any working capital for Spy unless the amount raised is more than what’s paid back to Costa Brava.
 
Well, that’s not quite true. It reduces interest expense. But interest expense to Costa Brava hasn’t been paid in cash anyway.  It’s also made clear that the line of credit available from Costa Brava will be reduced by the amount of the repayment. That is, they can’t borrow it again.
 
So who exactly, is going to step in and invest money in Spy and at what price that goes right out the door to Costa Brava and Mr. Hamot? Other existing shareholders?
 
It should be interesting to watch. Hope you have a long and pleasant holiday weekend.

 

 

Quik’s April 30 Quarter: Adjusted EBITDA Falls 39%

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Quik had a 3% sales increase in the quarter, growing to $492 million from $478 million in the same quarter last year but, as I define and discuss below, their adjusted EBITDA fell by 39%.

 The gross margin percentage fell from 54.8% to 49.2%. That rather significant decline, they say in the 10Q, “…was primarily the result of higher levels of clearance business, the timing of certain royalties, higher input costs and the impact of fluctuations in foreign currency exchange rates.” The higher level of clearance represented 36% of the decline, we learn in the conference call.

In constant currency (ignoring the impact of foreign currency fluctuations), the wholesale business was up 2%, retail revenues increased 9%, and ecommerce was up 131%. Also in constant currency, Quiksilver brand revenues rose 4%. Roxy was up 5% and DC, 13%. As reported, Quiksilver brand revenues were $209 million, up 1%. Roxy revenues were up 3% as reported to $135 million, and DC had revenues of $131 million, up 11%.

According to GAAP (Generally Accepted Accounting Principles) Quik had a net loss in the quarter of $5.1 million compared to a loss of $83.3 million in the same quarter the previous year. The loss in the quarter last year included an asset impairment charge of $74.6 million for goodwill in the Asia/Pacific segment. The asset impairment charge in this year’s quarter was $415,000. Those are both non-cash charges and don’t have anything to do with how much product they sold at what prices and margins.
 
The net loss in last year’s quarter also included an income tax provision of $39.7 million “… to establish a valuation allowance against deferred tax assets in our Asia/Pacific segment. As a result of this valuation allowance and the valuation allowance previously established in the United States, no tax benefits were recognized for losses in those tax jurisdictions.”
 
My eyes glaze over when it comes to accounting for income taxes, but I think that relates the big asset impairment charge. The tax provision in this year’s quarter was $7.2 million.
 
If you ignore the asset impairment charges, then Quik had pretax income in last year’s quarter of $32.6 million. The comparable number for this year’s quarter is a loss of $4 million.
 
On page 28 of their 10Q, (see the whole 10Q here) Quik reports their adjusted EBITDA. That’s earnings before interest, taxes depreciation, amortization, asset impairment, and non-cash stock based compensation expense. In last year’s quarter that number was $62.1 million. In this year’s April 30 quarter, it had fallen to $37.6 million.
 
As reported, revenues were up in the Americas from $211 million to $221 million. Gross profit percent fell from 49.1% to 44.2% and total gross profit was down from $104 million to $98 million. 
 
Europe’s sales fell 5.5% from $207 million to $196 million as reported. In constant currency, they remained more or less the same. Gross profit fell 15% from $128 million to $109 million. The gross margin was down from 62% to 55.7%.
 
CFO Richard Shields made an interesting comment about their financial strategy in Europe during the conference call. He said, “We’re trying to make sure that we repatriate cash in Europe back to U.S. dollars so we’re not at risk there.”
 
Let me loosely translate that for you a bit. He’s saying that if he wakes up one morning (it would probably be a Monday) and the Euro has gone to hell and capital controls are in place and the capital markets have frozen up again because Greece has left the Euro zone or some Spanish banks have collapsed or whatever, he doesn’t want to be stuck with money he can’t get out of Europe that’s going to be worth half of what it was in U.S. dollars when he can finally get it. I hope you’re all thinking about that.
 
Asia/Pacific sales rose from $58 million to $74 million, or by 27.3% as reported. It was a 24% increase in constant currency. Note that this improvement was “…primarily driven by improved performance in Japan, where net revenues in the three months ended April 30, 2011 were significantly impacted by the earthquake and related tsunamis in the region.”
 
So they’re saying that the growth only looks good because of the natural disaster in Japan last year and that there wasn’t much growth in the rest of the region.
 
Gross profit in the Asia/Pacific segment rose 16.5% from $30.9 million to $36 million. The gross margin fell from 53.1% to 48.6%.
 
Operating income fell in all three segments. In the Americas, it was down from $17.9 million to $8.9 million. In Europe, it declined from $43.8 million to $25.9 million. Asia/Pacific fell from a loss of $81.1 million to a loss of $4 million, but remember the $74.6 asset impairment charge in the quarter last year.
 
As you think about how Quik did this quarter compared to last year, you need to  isolate the funky tax charge, the asset impairment and the Japanese earthquake/tsunami in last year’s quarter. If you do that, it’s hard to see progress in the income statement.
 
On the balance sheet, equity has risen from a year ago to $591 million from $535 million. The current ratio is a healthy 2.61 times, very slightly down from a year ago. Total liabilities have barely changed, so the total liabilities to capital ratio has improved with the increase in equity.
 
In the current assets, cash has fallen from $139 million to $79 million. And inventory rose 24% from $290 million to $359 million. That’s a bigger increase than you’d like to see given the associated sales increase. However, Quik notes that, “The increase in consolidated inventories was primarily the result of higher input costs and the early receipt of goods in comparison to the prior year. “ They think that higher product costs were responsible for 10% to 15% of the inventory increase.
 
Accounts receivable rose 8.5% from a year ago. They were up 17% in the Americas (with only a 4.7% sales increase), down 3% in Europe, and increased 22% in the Asia/Pacific segment due mostly, I assume, to the recovery in Japan. In constant currency, they were up 15% overall. 
 
So those are the numbers and they reflect not only Quik’s difficulty in finding places to grow (I’ve mentioned that before), but just how hard the whole economic environment is for everybody.
 
In the conference call CEO Bob McKnight mentions product for NFL teams as being shipped. He also says, “NBA board shorts will follow with some teams introduced this summer…” There will also be National Hockey League product, and they are “…expanding the program into Australian football leagues.”
 
They also talk about taking DC into JC Penney for back to school, and CFO Richard Shields says, “So DC continues to expand distribution as [there is] demand in a lot of channels where we don’t currently sell. And our overall global segmentation strategy, I think, positions us well to succeed in those channels. So we are going to continue to roll out distribution globally.”
 
And here, I guess, we get to the crux of the matter. What is Quik’s global segmentation strategy exactly? When I first heard about Quik’s selling NFL board shorts, I said something like, “You know just because you can sell something somewhere doesn’t mean you should. Not all product extensions are good.” I recognize the need, especially as a public company, to grow. But in the conference call discussion about growing sales, there’s a sense of selling a brand somewhere because you can and you haven’t yet. I hope Quik is careful with that. I hope all brands are.
 
Quiksilver’s operating performance declined rather precipitously from the same quarter a year ago even with the recovery in the Asia/Pacific segment. I still think it’s better to focus on generating more gross margin dollars with strong, brand supporting, sell through and clean inventories than it is to struggle for that incremental sale, but then I don’t have to meet with the analysts every quarter. 

 

 

News From Billabong

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I just listened to a Billabong conference call where new CEO Launa Inman announced they were raising more capital, downgrading earnings expectations, and undertaking a top to bottom review of all Billabong operations with the goals of reducing expenses, identifying efficiencies and improving the competitive positioning of Billabong and its brands.

They want to raise 225 million Australian dollars (about $229 million U.S. dollars) by selling shares to existing shareholders at $1.02 for each new share, a 44% discount from the 1.83 Australian dollar share price before the trading halt. The offer is fully underwritten by Goldman Sachs and Deutsche Bank, which means that Billabong will get the money. 

Apparently, business conditions weakened significantly in May and into June. There was weaker in season business and some wholesale accounts delayed shipments. The European, Canadian and Australian markets have deteriorated. The U.S. has some signs of improvement, but it’s too soon to call it a recovery, they said.
 
You’ll remember that Billabong sold half of Nixon and turned down a AUD 3.00 per share for the company not very long ago, saying that it couldn’t justify raising equity at that price. Now, apparently it can and then some, which says something about how conditions have deteriorated. 
 
CEO Inman announced that they were starting a “deep dive” complete review of all Billabong operations, expenses, procedures, market positioning, supply chain, and pretty much anything else you can think of. Nothing is off limit. The goal is not just to cut expenses, but to rationalize systems and procedures. That will be completed and the actions announced August 24th when they present their full year results.
 
My sense from the comments is that there are some inefficiencies and system overlaps/incompatibilities left over from acquisitions that haven’t been fully addressed.
 
The company is already in the process of closing 140 stores and expects that to be completed by the end of fiscal 2013. They had previously announced AUD 30 million in expense cuts, and that is proceeding. I think they expect to find more as a result of the business review.
 
But it’s not just about reducing expenses. They want to improve the retail experience, do more with ecommerce (which is 4% of retail sales and growing), define the customer base, look at perceptions of the brands and positioning, and define their customer base. They seem particularly concerned with the Billabong brand which, they acknowledged, has weakened in recent years.
 
Right now, of course, that’s all just a statement of intentions and they are asking shareholders to pony up more money with no plan in place. I guess that’s an indication of how badly they needed the money. The most important thing, they noted, was “…to stabilize the balance sheet.”
 
They are also hiring a global retail manager. The new executive will be introduced next week.
 
I have no doubt that Billabong will be able to do some things better and make itself more competitive. And I’d note that it usually takes a new CEO with a fresh perspective and no hesitation about questioning everything to make that happen quickly. That was always my experience doing turnarounds. There’s a certain element of ruthlessness required.
 
But the real question, and not just for Billabong, continues to be what happens to the world economy? I think that’s the same point I made when I reviewed their half yearly results. CEO Inman was adamant that they were raising enough money, but then the proceeds from the sale of half of Nixon were supposed to solve the problem too. PacSun and Quiksilver have had a hard time implementing their restructurings and turnarounds swimming upstream against the economic current. Billabong won’t be different.         

 

 

Tilly’s First Quarterly Report

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As you know, Tilly’s went public recently. They’ve just released their first quarterly 10Q report and held their first conference call as a public company. The report is for the quarter ended April 28. Their public offering was May 4, so the balance sheet doesn’t reflect the results of that offering yet, and I don’t have access to a balance sheet from a year ago, so I can’t compare the two. However, the balance sheet is just fine.

Tilly’s describes itself as “…a fast-growing destination specialty retailer of West Coast inspired apparel, footwear and accessories. We believe we bring together an unparalleled selection of the most sought-after brands rooted in action sports, music, art and fashion.” I’d be interested in chatting with them about what exactly makes a selection of brands “unparalleled.”

Sales in the quarter were $96.5 million, up 16% from $83.1 million in the same quarter the previous year. $9.9 million of that $13.4 million increase was from stores that weren’t opened in last year’s quarter.   Tilly’s ended the quarter with 145 stores in 19 states. A year ago, they had 126 stores. They opened five stores during the quarter and expect to open an additional 16 by the end of the year. They think they can expand to 500 locations over the next ten years.
 
The gross profit margin stayed the same at 31.5%. Selling, general and administrative expenses as a percent of sales fell a bit from 25.5% to 25.3%. You expect to see that decline with growth in the number of stores. Net income rose 21.7% from $4.86 million to $5.91 million.
 
We’ve got to talk about how income taxes impact those net income numbers. Reported income tax in this quarter was only $68,000. It was $56,000 in the same quarter last year. Historically, Tilly’s has been an S corporation, where taxable income flowed through to the shareholders and they paid the taxes. So the income taxes mostly showed on the shareholders’ income tax returns and not on the company’s income statement.
 
As part of the public offering, the company converted to a C corporation. If it had been a C corporation in this April 28 quarter, reported income taxes, assuming a 40% rate, would have been $2.39 million and net income would have dropped to $3.59 million. That’s more typical of what we’ll see in future quarters with Tilly’s as a C corporation and public company. 
 
Ecommerce sales were $10.9 million, up from $8.3 million in the same quarter last year and represented 11% of total revenue in this quarter. They think it can grow to represent 15% of revenues over time. I’m kind of wondering if some retailers won’t find it representing a lot more than that eventually.
 
Their comparable store sales grew by 4.3% and we learn in a footnote that the ecommerce sales were responsible for 2.8% of that. That’s 65% of the total comparable store sales growth.
 
Their brick and mortar comparable store sales, then, grew by just 1.5%. This is interesting. Do we say, “Wow, that’s not much of a brick and mortar increase.  Is there something wrong?” Or do we focus on the 4.6% and, acknowledging the increasing interdependence of ecommerce and brick and mortar, say that just fine. What does that imply about opening additional stores? What’s the multiplier between brick and mortar and ecommerce? I wrote yesterday (twice unfortunately) about Blue Tomato being acquired by Zumiez and doing 75% of their business on line. We all know there are other retailers that have a store or more, but do most of their business on line.
 
I expect most multi store retailers would agree you need fewer stores in the internet age. How many fewer? How do you think about site selection in terms of the impact on internet sales? Intriguing issue. 
        
Tilly’s describes its stores as located in “…malls, lifestyle centers, “power” centers, community centers, outlet centers and street-front locations.” I find this an interesting description, if only because I’m not certain I know what some of the terms mean. All they say about their location selection process is “…we are modeling long term a balance between mall and off-mall. So the chain today is roughly half mall, half off-mall and our long-term targets are to have the chain reflect that. We don’t manage specifically to that, it is really a function of where is the best location in the venue where we want to be, in a trade area where we know we have an opportunity.”
 
 I’d like to hear them describe that in more detail. I am wondering if stores in different kinds of locations are of different sizes and/or carry different kinds of inventory based on the type of location they’re in.
 
As you may recall, Tilly’s, as a public company, has two classes of stock and the founding shareholders are the only ones with voting stock. I also noticed from footnote eight (Related Parties) that Tilly’s leases its corporate headquarters, distribution center, some warehouse space, another office with warehouse space, and yet another building it will use as its ecommerce distribution center, from one of the co-founders.
 
But before they signed each of those leases, “…the Company received an independent market analysis regarding the property and therefore believes that the terms of each lease are reasonable and are not materially different than terms the Company would have obtained from an unaffiliated third party.”
 
So I guess it’s okay.
 
Tilly’s had a good quarter. I’ve found their 10Q and conference call lacking information in some areas, and I’ve highlighted those areas above. Partly, of course, that’s a function of the questions the analysts ask. Maybe next time they’ll ask some of mine.

 

 

Zumiez Buys Blue Tomato

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Well, this one caught me by surprise, though I guess it was supposed to. No, not that Zumiez bought Blue Tomato, though that caught me by surprise too. What surprised me is that Zumiez has a “…strategic plan to build the leading global action sports retail business.” And, according to the press release, this acquisition is the “next step” in that plan, so I guess it’s not new.

 Zumiez CEO Rick Brooks noted, “The similarities between each organization’s culture and operating philosophies give us great confidence we can successfully leverage our combined expertise to selectively expand Blue Tomato’s European footprint and strengthen our foundation to support future international development.”

I knew about the Canadian expansion, and I knew Zumiez is planning something like 600 U.S. stores, but I didn’t know about these global plans. I don’t recall any specific discussion in any SEC filings or in a conference call. Maybe I just missed it.
 
All the currency figures I’m going to give you are in euros. The current exchange rate is 1.265 euros to the dollar. To hear Zumiez’s announcement and discussion of the transaction, you can call (877) 523-5612 and enter passcode 16847. The press release and SEC filing is available here.
 
Blue Tomato was founded in 1988 by Gerfried Schuller and has five stores in Austria. It’s got a 10,000 square foot flagship store, two smaller stores, and two other snow focused store that are seasonal. It sells “…an extensive and diverse mix of branded snow and skate hard goods, apparel, footwear, and accessories across Europe.” Its sales in the year ended April 30, 2012 was EUR 29.4 million. That’s a 27% increase over the previous year, and Zumiez says their EBITDA has grown at a compound rate of 42% over the last three years. Their net income for the April 30, 2012 year was EUR 3.5 million under Austrian accounting standards. No idea how Austrian accounting standards are different from the U.S.
 
75% of Blue Tomato’s business, or EUR 22 million in the last complete fiscal year, is done on the internet. They operate in 14 languages and sell to 60 countries, though those sales are concentrated in Europe.
 
Zumiez is paying EUR 59.5 million plus contingent payments of EUR 22.1 million over the next three years that will depend on management achieving certain performance objectives. We aren’t told the specifics, but the contingent payments will depend partly on achieving a certain EBITDA in the 2015 fiscal year and, interestingly, “…the opening of certain defined incremental stores in the European market by the end of the fiscal year ending 2015.” 
 
 Up to EUR 5 million of the contingent payment will be in Zumiez stock. The purchase price will be paid from Zumiez existing cash balances. Existing management will continue to run Blue Tomato.
 
Even ignoring the earn out, the purchase price is more than twice the last complete year’s sales. Shades of Decker’s purchase of Sanuk. I’m really wishing I knew something about Austrian accounting.
 
Zumiez paid what I take to be a big price for Blue Tomato, but they expect it to improve their earnings in the second half of their fiscal year (assuming the deal closes by July 1 as planned). But given the growth Blue Tomato has experienced in what is generally conceded to be a soft and deteriorating European economy, I can imagine why that price might be justified. And, happily for Zumiez, the Euro has weakened in the last couple of months. I wonder if Blue Tomato’s decision to sell now wasn’t based, at least in part, on the overall financial and economic situation in Europe. My hat’s off to them for deciding to sell when things were going well.
 
So Zumiez is going to open some stores in Europe, but we don’t know if they will be Zumiez or Blue Tomato stores, or both. We also have another example of a retailer whose brick and mortar stores, though important for building the brand, are a smaller part of the overall business’ revenues and profits compared to ecommerce. This is not a new trend.
 
I will look forward to watching how the Zumiez’s culture translates to Europe, seeing how and where they open stores, how they integrate inventory management, and how their respective web presences evolve to work with each other.

 

 

PacSun’s Quarterly Results: The Financial Statements Show Progress

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The strategic issue hasn’t changed. As CEO Gary Schoenfeld put it in the conference call, “Regrettably, over the past several years, PacSun lost some of its identity as a brand and its relevance among target consumers…” If they can fix that, they can succeed. Gary Schoenfeld took the job because he thinks they can. 

You can see their 10Q here. The headline is that they cut their operating loss by 34%, from $27.8 million in the quarter ended April 28th to $18.3 million in the same quarter last year.
 
Their net loss fell by even more, from $31.5 million to $15.6 million. But last year in the quarter there was a $2.8 million loss on discontinued operations (none this year- see below). And this year they had a $6.3 million gain on derivative liability associated with the Golden Gate Capital loan and $3.3 million in other expenses below the operating line that didn’t show up in the quarter last year. That’s why I started with the operating numbers.   
 
Sales grew only slightly from $171.9 million to $173.8 million. Remember they are working with 729 stores at the end of the quarter compared to 827 a year ago.
 
They had a 1% increase in comparable store sales in both men’s and women’s. It’s the first time they’ve done that in a quarter since fiscal 2005, they reported.
 
Mostly, they improved their results by increasing their gross margin from 19.3% to 23.6%. 1.6% of the increase was from higher initial markups and a decrease in promotions. 2.2% was from leveraging occupancy costs over higher comparable store sales.
 
When you close 98 stores, you get rid of a lot of costs. But of course you also lose the sales associated with those stores. CEO Schoenfeld talked a bit about these stores during PacSun’s presentation at the Piper Jaffray Consumer Conference on June 6. He noted that many of these closed stores were low volume stores and that there was simply no way to fix them. You can click through from PacSun’s web site to listen to that presentation.
 
You can see the impact of these stores from a 10Q footnote on discontinued operations (number 12 if anybody cares). As defined, they didn’t have discontinued operations for the quarter ended this April (they only closed 5 stores and the cash flow implications weren’t “significant”).
 
But in the quarter ended April 30, 2011 they closed 25 stores. Those stores had revenue of $13.9 million and generated a net loss of $2.8 million on a gross profit margin of only 16.6%. Boy, you can really hear those dogs barking. PacSun will close another 100 stores this year- mostly after the holiday season, which makes sense, and you can imagine the positive impact that will have if their numbers are similar.
 
PacSun reduced its selling, general and administrative expenses from $61 million to $59.3 million. As a percent of sales it fell from 35.5% to 34.1%.
 
The balance sheet weakened, as you would expect with continuing losses and the loan from Golden Gate. But inventories were down a bit over 10%, which you’d expect with the store closings. They pointed out in the conference call that inventories fell 3% on a comparable store basis.
 
Implicit in some of the discussion in the conference call and the presentation was the way PacSun was thinking about brands and its mix of purchased and proprietary brands. What I heard was that they were being a little more thoughtful- maybe more purposeful is a good way to put it- about how the two work with each other. Proprietary brands are no longer just what you use to make some extra gross margin to the extent your store merchandising can stand it. They are being used in coordination with purchased brands to offer customers the best assortment of pricing, design, features, and merchandising they can. PacSun isn’t the only retailer thinking that way of course, but it’s an important change nevertheless.
 
Sitting in my ivory tower, I can make various pronouncements that PacSun needs to make its stores “cool” and a destination again. At the Piper Jaffray conference, Gary Schoenfeld reminded the audience (and me) that accomplishing that involves “…doing lots of blocking and tackling…” every day. “Cool” is the results is thousands of individual actions over an extended period of time. It’s a lot of work and takes a solid management team. In the case of PacSun, the management team underwent an almost complete change after Schoenfeld came in.
 
Making that change and then getting new ideas, processes, and attitudes to filter down to the rest of the organization takes a while. You can hear it’s getting some traction now.
 
It will also be interesting to see how PacSun performs a year or so from now when those last 100 stores are closed. You don’t celebrate having to do that, but the cost, management focus, perception of the company, and just having that hanging over you isn’t good. No positive energy there.
 
Hopefully, getting that done along with the impact of the new management team will do a lot for PacSun’s performance.      
 

 

 

Retail Evolution and Industry Conferences: What’s the Connection?

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Maybe ten days ago, I wrote this article that talked about JC Penney’s new pricing policy and strategy and referred you to an article on that strategy and why it might not work. I thought that article had some implications for our industry and I discussed them. 

Now, my ultra-sophisticated research department (thank you dear) has identified another article called “Retailers Rethink Stores to Fight Online Competition.”   It talks about all the things retailers are trying and concludes with a quote that from Wendy Liebmann, CEO of WSL Strategic Retail saying, “If retailers aren’t experimenting, then they are doomed to fail.”
 
The way you’ve heard me put it is, “The biggest risk is not taking a risk at all.” I’m thinking Ms. Liebmann and I would agree.
 
Meanwhile, speaking of retail chaos, my ever vigilant research department also forwarded this article on foreign fashion brands aggressively moving to open retail locations in the U.S. Well, I guess somebody has to fill up all that empty retail space.
 
You know, it’s funny- the suggestions in the above referenced articles seem equally applicable to retailers from Costco down to a 750 square foot specialty shop.
 
Being reactive in a changing environment has often been a bad idea, but now it seems like it’s damned near impossible given the pace of change in retail. You’re on to change number two before you can react to number one. Do what’s right for your own business.
 
That probably includes spending some money on technology, having the best numbers you can have about what sells (and what doesn’t) and the gross margin dollars you earn, taking chances on brands, taking a new hard look on who your competitors are (finding out where else your customers shop would be great), making decisions with an eye to your balance sheet, and not stressing too much about distribution (as the cat is largely out of the bag).
 
Don’t worry so much about what the other guy is doing. I think I might have first suggested that approach back in 2002, when I wrote after the Surf Industry Conference that maybe they should focus on running their own businesses rather than worrying about skateboarding. Ten years later, it holds up pretty well. You can read it here.
 
Speaking of industry conferences, the snow, skate, and surf conferences for the year are history.   I only made it to the skate conference. I’ll do better next year. Assuming the people that run the companies are attending, that is.
 
But here’s the dilemma for me. Let’s call it a suggestion for conference organizers.
 
I am not expecting many calls or emails telling me that I’m wrong about the changes in retail and the speed at which it’s changing. I don’t even expect to get told my “what to do” list is out of line (though if somebody told me that listing them is a hell of a lot easier than doing them, I’d have to agree).
 
But if the retail and competitive environment (with its implications for brands as well as retailers) is changing as much and as quickly as I think we all agree it is, why is it our conferences still have a tendency to feel like membership meetings at a private club?
 
Look, I love seeing friends I’ve known a long time and don’t see that often. It’s low key, low stress, and fun. We have a great time validating each other’s point of view in a non-threatening environment. I want more people there, as both speakers and attendees who will rattle our comfortable cages.
 
Where’s the skateboard buyer from Amazon? How exactly does the offer of ten blanks for $100 end up right next to the branded deck for $48.95?
 
Can we get somebody from PPR who’s not Volcom to talk about their perception of and plans for our industry? Just how many branded stores for their luxury brands are they going to open in the U.S. and who’s their target customer?
 
Is the Chinese manufacturer of soft surfboards there?
 
How about a retail panel made up of representatives from Sports Authority, Target, Costco, and Dick’s? Or maybe Zumiez, Journeys, and Tilly’s.
 
Have companies in our industry moved their production out of China due to higher prices? Let’s put them on a panel and find out where they moved and how it went.
 
How about a sociologist talking about how long, leveraged caused recessions impact consumer attitudes and spending over decades and maybe generations? There are marketing implications that could be valuable right now. Get Neil Howe, one of the authors of The Fourth Turning, which you should all read, as a speaker.
 
It’s possible nobody could afford Mr. Howe. Well, unless of course we had one conference instead of three. And looking at the strategic issues I’m suggesting we should be addressing, maybe that’s not so silly. Consider the overlap across customers in the industry.
 
I want to invite people to conferences who, whether we wish it or not or like it or not, are powerful players in our space but don’t usually attend. I want us to address issues we’re uncomfortable with, or hope will just go away- because they won’t. I don’t want what I already think to be validated because I’m talking only to like-minded people I’ve known a long time.
 
I’d like all these industry players that make us uncomfortable to be there not just as speakers or panelists, but just as participants. I don’t know if they’d want to come or if they’d be interested in telling us the kinds of things we want to know, but we’ll never know until we ask. They’d be a like more likely to come if there was one large conference instead of three.
 
I didn’t have the idea of consolidating conferences in mind until, honestly, the last paragraphs. I know that by raising the idea, I’m blithely stumbling into issues of industry politics, relationships and revenue sources. Yet it seems to make some sense if my premise about the issues we should be addressing at conferences is reasonable.
 
Don’t you agree?  Or not?
 


 

Zumiez’s Quarter; Ho Hum, Another Good One. How Do They Keep Doing It?

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If it wasn’t so intriguing, it would be getting boring. Zumiez’s sales for the quarter ended April 28, 2012 grew 22.7% to $129.9 million from $105.9 million in the same quarter the previous year. Comparable store sales were up 12.9%. Ecommerce sales rose 7.7% and were 6.2% of the quarter’s total sales. They think ecommerce may eventually be 10% of their sales. They had 47 more stores than they had at quarter’s end a year ago (445 in total).

You can see their complete 10Q here.

Their gross profit margin rose to 32.4% up from 31.3 in last year’s quarter. Mostly, the increase is due to leveraging their costs across more stores. That is, they have 47 more stores but didn’t have to buy another accounting system to support them, so the accounting system cost per store, to use one example, declined.

Selling, General and Administrative expenses as a percentage of sales fell by 210 basis points (2.1%). Three-quarters of that was due to operating efficiencies from having more stores, and one-quarter from a decrease in corporate costs.
 
Net income rose from $1.9 million to $4.5 million. The balance sheet is solid with no bank or other borrowing. Inventory was up of course, but it was essentially flat on a per square foot basis they tell us.
 
How does Zumiez’s do so well when others are struggling? We can get some insights from the conference call discussion. I also want to remind you of some advantages that aren’t mentioned there.
 
First, Zumiez is at a “sweet spot” in their growth curve. Their goal, you may remember, is 600 stores and right now, at 445 stores and growing, they are still able to find good places to open stores. It’s not like that’s an easy thing to do. Management reminds us of their disciplined application of a strategy they’ve followed since the company was founded, their employee development program, their commitment to infrastructure and systems, and their marketing approach of “…offering highly differentiated assortments of merchandise and delivering best-in-class service.” In other words, they run the business well.
 
Secondly, as I’ve written before, they were the first in the malls and are still the only ones, as far as I know, to offer hard goods. Actually, Billabong stores sell Sector 9 Longboards so I guess it’s not strictly true that they are the only ones anymore.
 
With so many independent specialty retailers closing due to the recession, and with all the brands opening stores in malls, Zumiez’s strategy has been validated by everybody else, but they are still the leaders in executing that strategy.
 
Now, on to some things they said in the conference call. One analyst asks the question I’m asking; “I guess I think probably the question we could ask the most is what is Zumiez doing, I mean that your sales trend is so good?” Here’s management’s answer in part.
 
CFO Marc Stolzman says, “…one of the real strengths…is our merchant’s ability to micro merchandise the product assortment. As a multi-branded retailer, that really is trying to capture each of the micro trends as they are occurring, it really takes a dedicated, very hard focus on the data, and really trying to keep everyone of those hot products in stock. Unlike a lot of our competition, we have purchase orders going back and forth with our vendors on a constant basis, and product coming into our warehouse constantly, instead of having more of an upfront purchase and then working through that inventory or replenishing it.”
 
CEO Richard Brooks adds, “…the benefit of our whole system is what you see is taking place here. With great job by our product team, great job by our sales teams on the web and in stores. And what you’re seeing is, us being able to rack quickly, move to what customers want, still being incredibly well diversified in our brands. I think last year our largest brand was about 6% of sales.”
 
Let’s consider the implications of that. If they have the systems and people to identify the micro trends, as they call them, in each store and the systems to react so they can stock according to those trends, my hat’s off to them. But how might this be impacting the brands Zumiez carries?
 
Note that no brand they carry was more than 6% of sales last June (their private label brands account for about 18% of total revenue for the year). If that’s generally true over the whole year, it limits the leverage any single brand has in negotiating with Zumiez. This is compounded by the fact that Zumiez is becoming a brand by itself and, in my judgment at least, is the most credible of the action sports retailers of any size. It’s good to have your brand in Zumiez. I’ve been saying for years that the best retailers give credibility to the brands they carry.
 
I wonder how Zumiez’s search for micro trends translates into individual store manager’s authority to select inventory and merchandise their stores. CFO Stolzman has told us, ‘…we have purchase orders going back and forth with our vendors on a constant basis…”
 
I can see how this translates into a good thing for Zumiez, and I’d love to talk with them about the algorithms they use in their system to manage their open to buy. But there’s some potential extra work, and therefore costs, for brands selling to Zumiez with, it sounds like, more, smaller purchase orders and potential frequent changes in those orders.
 
Apparently there are few brands that Zumiez absolutely has to carry, and part of their formula for success likely puts some extra demands on brands. That must make for interesting negotiations. If I had that kind of leverage I’d certainly use it.
 
Zumiez management refers to working closely with brands, and I hope part of that relationship is teaching some brands techniques that Zumiez uses to project demand and manage inventory. I can imagine that might be of benefit to everybody.