Cyberboutiques. I Don’t Know if this is a Great Idea or a Waste of Bandwidth.

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My wife sent me this article from the New York Time’s Fashion and Style section. For some reason, I don’t read that section regularly. Not enough graphs, charts, and numbers to get me excited I guess.

I played around a bit with the application at the web site. It was a bit jerky and slow, but I could certainly see the potential. Either that or I couldn’t, and I guess that conundrum is what’s leading me to write this.

On the one hand, maybe this is the next step in integrating online with brick and mortar retail. What might happen if each store in a chain had its own virtual store with avatars of the actual sales people who worked in the store? What is the customer could chat with the actual people in the store through their mobile device and the inventory online reflected the inventory in the store? Or you could click on an icon to talk with the actual sales person on a web cam.
 
Or maybe I’m over thinking this and nobody would care. Just because you can do something doesn’t always mean it’s a good idea. Like all of you, I learned that when I was very young.
 
I can imagine some kind of temporary marketing advantage here due to the immediate “that’s cool” factor. But I also felt like it had the potential to slow down my shopping. I don’t necessarily want to wander around a web site the way I wander around a store. And there seemed to be some glitches in the navigation. Make sure you go up the stairs (though it isn’t clear that you can at first and I sort of stumbled on it). 
 
Of course, I’m looking at version 1.0 so we need to consider the general concept and not be too critical of the specifics. You know the software will improve if the concept is well received.   But what’s the purpose? I’m not sure it adds to the shopping experience and nobody expects a web site to be the same as a brick and mortar store. Do they?
 
I guess I think that if it doesn’t improve web site navigation, make shopping more efficient, or give me some new information I want then I don’t care. No doubt there are people working right now to make those very things happen. It will be interesting to see what they come up with.      

 

 

PacSun’s Quarter. Can the Strategy Work in this Economy?

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PacSun’s 10Q was filed two days ago. I’ve been through it and it offers a few tidbits of interesting information. But mostly, PacSun CEO Gary Schoenfeld said a lot of what needs to be said, at least strategically, in the conference call. Here are his most relevant comments:

“The economy is not getting better and competition remains fierce for a limited amount of discretionary spending. As a team, we remain committed to our turnaround strategy that includes a long-term focus on delivering trend-right products and creating a distinctive PacSun brand identity and experience tied to our unique California heritage.”

“But we also know our store gets shopped, but we’ve got to move up higher. There’s 8, 10, 12 good choices for her in the mall. And where you sit in that pecking order is pretty important.”
 
It’s hard to argue with the strategy, though it isn’t very distinctive and has elements of what most brands want to do. If a strategy lacks uniqueness, it can be expensive to implement. The question in my mind, which hasn’t changed much since the last time I took a look at PacSun, is whether there’s enough uniqueness so they can afford to implement it given the economy and the company’s financial circumstances.
 
Oh damn, I seem to have written the conclusion first. I guess I’ll just ignore that and move on to the numbers.
 
Sales for the quarter ended July 30 fell 1.6% to $214.9 million compared to the same quarter last year. I should point out they closed 31 stores during the first six months and expect to close 50 to 60 for the whole fiscal year.  Closing stores reduced sales by $8 million in the quarter. But stores not yet included in the comparable store calculation and a slight increase in comparable store sales increased sales $5 million, resulting in the net decline of $3 million. Women’s comparable store sales rose by 1%. Men’s were flat.
 
The gross margin fell from 23.2% to 23.0%. Merchandise margins fell by 1.3% but occupancy and buying and distribution costs fell so the decline in the gross margin was minimal.
 
Sales, general and administrative expenses fell 8% from $74 million to $68 million. As a percentage of sales it was down fro0m 33.9% to 31.6%. Most of the decline was payroll expense ($5 million) and depreciation ($4 million). You kind of wonder if their strategy doesn’t call for increasing certain of these expenses, but there’s that conflict between financial capability and the requirements of the strategy.
 
Inventory on the balance sheet fell from $174.8 million a year ago to $163.3 million at July 30, 2011. They have 59 less stores than they had a year ago. Total store count is now 821, down 59 from a year ago. Reported inventory is down 7%, but management indicated it would have been down 10% if they hadn’t taken some back to school deliveries early. There’s no discussion of the impact of any higher costs on inventory levels.
 
Cash was down from $25 million to $13.3 million. The current ratio fell from 1.61 to 1.44 over the year. Total debt to equity rose from 0.85 to 1.43. At least according to this cursory evaluation, the balance sheet has weakened a bit. They have nothing drawn on their line of credit, but indicate they might have to use it if current trends continue.
 
After the quarter ended, PacSun completed negotiations with some landlords. They are making payments of $1.3 million to buy out the leases on five stores which will be closed by the end of the year. They also made deals with 95 stores to reduce rents and extend leases at more favorable terms. They indicate this will save them $9.5 million over the lives of these leases (through most of fiscal 2012). They also issued 900,000 shares of stock (to the landlords I assume) as partial compensation for these lease changes.
One cool thing they did was to roll out Apple iPads in 300 stores. I’ve had the experience of shopping where clerks are equipped with them, and I like it a lot.
 
Along with other companies, PacSun has found the start of back to school difficult. As they describe it, “…the primary drivers included declining consumer confidence and a higher competitive promotional environment.” As a result, they are anticipating that same store sales “…will be in the mid to high negative single digits for the third quarter…”
 
I really miss the good, old fashioned reliable kind of recession where supply gets ahead of demand, companies pull back, we have a recession, then move forward as demand catches up. These debt excessive leverage recessions (of which this is my first one) are hard and very, very long because people paying down debt don’t buy stuff. It sucks to be a company- any company- trying to sell product to consumers that they can easily put off buying.
 
Okay, I’m done.  Like I said, I wrote the conclusion first so if you’re looking for closure, please read it again.

 

Billabong’s Annual Report; The Relationship between Strategy and Operating Environment

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Billabong’s annual documents (which you can see here and here) provides us with a superlative opportunity to look at the nexus of a company’s strategy and its operating environment. The conference call transcript was also worth reading, but it seems to have disappeared from their web site. I can send anybody who wants it a copy.

Of course I’ll spew forth all sorts of numbers (in Australian dollars). But I want to look at those numbers in terms of the evolution of Billabong’s strategy, the impact of external factors, and some operational initiatives which, given the operating environment, are going to have a lot to do with Billabong’s future performance.

I’m sorry I’m so late getting this done, but I’ve been back on the East coast helping my mother and her husband move. Family has to come first.
 
A Transition Year
 
The year ended June 30, 2011 was a transition year. Billabong told us it would be and has been telling us that since last year.
 
Reported revenue rose 13.6% to $1.68 billion. Net profit was down 18.4% to $119.1 million. In constant currency terms, revenues were up 23.8% and net profit fell 6.9%. The currency fluctuations cost Billabong $123 million in revenues and $18 million in net profit. 
 
I will point out that Billabong had taxable income of $126.9 million and paid only $8.86 million in taxes. That’s a tax rate of 7%. Last year, they paid $57.9 million in taxes on $203 million of taxable income and had a rate of 28.5%. If this year’s tax rate had approximated last year’s rate, their net profit would obviously been a lot lower. Billabong tells us to expect a rate of 23% to 24% in the current year.
 
Here, then, is the income statement headline. Net profit fell in spite of higher sales and a very low and not to be repeated tax rate. That’s not good.    
 
Now, why was this a transition year? Mostly because of acquisitions. They closed the acquisitions of retailers West 49 in Canada, and Surf Dive ‘n’ Ski, Jetty Surf, and Rush Surf in Australia. As a result, the number of company owned stores rose from 380 at the end of the last fiscal year to 639 at the end of this one.
 
They bought the RVCA brand in the U.S. Inevitably, they ended up with a lot more inventory and took on some debt to finance all these deals. I’ll get to that when I talk about the balance sheet.
 
The retail acquisitions took their direct to consumer share of revenue from 24% of total revenue at the end of last year to 38% at the end of this one. Now that’s a transition and we’ll talk about the impact when we look at the evolution of their strategy.
 
Operationally, acquisitions leave you with a lot to do. Here’s how Billabong puts it.
 
“A range of initiatives have been pursued within the business to reflect the change in mix between wholesale and retail. The standardization of various IT systems and sales intelligence software is underway, overhead has been adjusted, management within key retail divisions has been enhanced, design teams to build faster‐to‐market product have been established and greater investment has been made into the Group’s fast‐growing and profitable online operations. The strategy to build a more robust business model in response to the changing consumer environment is on track.”
 
They also closed 65 stores during the year due mostly to high occupancy costs. Many of these were stores acquired during the year.
 
The retail acquisitions caused some initial margin dilution and, maybe more importantly, it delayed some sales revenue because once you own the retailer, you have to wait to book a sale until the product is sold to the consumer. Before they bought them, Billabong got to book the revenue when product was shipped to the retailer. 
 
It takes time and costs money before you realize the benefits of these kinds of actions. They had $12.3 million in pre-tax one-time merger and restructuring costs. As you know if you read me regularly, I find the so called nonrecurring costs a bit problematic in evaluating a company’s results. While it’s true that these exact costs won’t recur next year, there always seem to be new non-recurring costs at some level every year.
 
There’s a lot going on. Billabong expects to see more of the benefits in the current year. I’d go so far as to say they’re counting on it.
 
External Factors
 
As you saw above from the difference between as reported and constant currency numbers, Billabong got hammered by the strength of the Australian dollar (At June 30, one Australian dollar was about $1.06 U. S.). The Australian economy going into recession and getting hit with floods in Queensland didn’t help either. And, speaking of natural disasters, remember the earthquakes and tsunami in New Zealand and Japan.  Like every other industry company, they had to deal with higher product costs as the price of cotton rose. The good news is that the price has now fallen and that should start to benefit Billabong next calendar year.
 
Meanwhile, consumers worldwide are just not cooperating. “With the exception of the USA and some Asian territories, global trading conditions have generally deteriorated significantly,” is how they put it. They noted they’d seen some deteriorating in conditions in Europe during the last two months of the year.
 
Damn those pesky consumers!
 
It is, in short a tough operating environment (not just for Billabong) with a continuing high level of uncertainty. As a result, Billabong is not going to offer any earnings per share guidance until things calm down.
 
Operational Initiatives
 
 I quoted Billabong above in describing the operational initiatives they are pursuing.   Some are the direct result of acquisition, but none are bad ideas in and of themselves regardless of any acquisitions. I’ve been writing for a few years now that it was time to stop over-focusing on the top line, where revenue increases are continuing to prove tough to come by. Look instead to generate more gross and operating margin dollars through better operations.
 
I’d like to believe Billabong took my advice, but I’m afraid they probably figured it out on their own. As reported, their gross margin fell only slightly from 54.4% to 53.8%. In a promotional, higher cost environment, that seems like a good result. Even with the turn towards retail, their long term strategy implies the kind of cost management focus I advocate.
 
The initiatives they describe are not inclusive of everything they’re doing. And I wonder, as a public company, if they would have taken on quite all of it if they’d known what the year was going to be like. Still, as they get through all this stuff, assuming it goes well, on budget and on schedule, the impact on the bottom line should be substantial. 
 
Strategy
 
Early on, Billabong recognized the limits of long term growth if you’ve only got one brand. They decided to grow by paying full price for established brands with growth potential and good management in place. I suspect there won’t be any more significant acquisitions for a while. Their balance sheet wouldn’t really support them, and they’ve got more than enough on their plate.
 
Part of their strategy has always been to protect their brand names by being cautious about inventory, distribution, and promotions. Even when the recession started, they choose to lose some sales rather than devaluing their brands by discounting. As noted above, their gross margin last of year of 53.8% fell only slightly from the previous year even in a difficult environment.
 
The strategy of growing retail (hardly unique to Billabong) had, in my opinion, a number of sources. First, it was the same desire for growth that lead them to buy other brands. Second, it was the knowledge that the number of solid brands they owned made a retail strategy more viable because they had the ability to stock their owned retail with these brands and generate extra margin dollars. Third, it was their analysis of the difficulties facing the independent specialty retailers worldwide. Things go a lot smoother when you don’t have to get orders from independent retailers and then collect from them.
 
The change in strategy, if you want to call it that, was the speed of growth in retail. I doubt they planned to have 38% of revenues coming from retail at the end of the year. And remember when these retailers have been owned for a full year, the percentage will probably be higher.
 
I suspect the accelerated growth was opportunistic. They could hardly ask West 49, or any of the other retail acquisitions, to wait and be for sale next year.
 
Finally, I want to remind you of some Billabong policies and procedures that some might not call strategic, but I see as the most strategic things they do. Look at the remuneration report starting on page 12 of Appendix 4E (the second link in the second paragraph of the article).   Then check out the eight governing principals starting on page 43.
 
The remuneration report shows how Billabong works very hard to align company and employee interests. The governing principals simplify managing by making it clear what’s most important. When you sit at the desk of the senior executive, you are constantly inundated with stuff crying for attention. These principals make it easier to not waste time on the wrong stuff. Even more powerfully, they can help do the same thing for every employee in the organization if they are communicated effectively. Wonder how much time and money that can save.
 
I also noted that all directors attended all nine scheduled board meetings and three unscheduled ones as well. I love to see that level of commitment.
 
Oh Yeah- Forgot the Financial Statements
 
The first thing I want to know if what the sales would have been without the acquisitions. We know that U.S. wholesale was flat excluding RVCA. I also see that trade receivables fell from $389 million to $341 million suggesting an overall decline in wholesale sales. But I don’t have a way to isolate any currency or timing impacts so I can’t be sure. All of last year’s acquisitions occurred between July and November of 2010, so their impact on sales in the year ended June 30, 2011 is substantial.  I think I’ll call a friend.
 
The friend got back to me and tells me I didn’t read footnote 35 closely enough.  My friend is right.  Acquisitions contributed $313.3 million to revenue during the year ended June 30, 2011.  Without the acquisitions, Billabong’s revenue would have been $1.374 billion, down 7.6% from the previous year.   
 
As you may recall, Billabong operates and reports its business in four segments; Australasia, Americas, Europe, and Rest of the World. I’ll ignore the rest of the world as it only represents $2.2 million in revenue.
 
Revenues in all three regions were up significantly in constant currency but, again, I can’t isolate the impact of the acquisitions. The Americas had revenue of $844 million, up 32.5% (18.4% as reported). Europe grew by 11.5% to $338 million (it was down 1.9% as reported). Australasia grew 19.5% to $502 million.
 
As reported, EBITDA (earnings before interest, taxes, depreciation and amortization) fell in all three regions. It fell from $89 million to $55 million in the Australasia. It was down from $92 million to $80 million in the Americas and from $70 million to $54 million in Europe. Consolidated EBITDA was $192 million, down 24.3% in reported terms and 16.2% in constant currency. The reported EBITDA margin was 11.4%, down from 17.1% the previous year.
 
Without the inventory impact of the acquisitions (projected to be temporary) it would only have fallen to 13.1%. Other factors include the merger and restructuring costs of $12.3 million already mentioned and foreign exchange losses. There was also $4.5 million associated with restructuring and rolling over the company’s syndicated debt facility and some accounts payable timing issues that dragged payments into the year.
 
We’ve already talked about the external factors that influenced this.
 
Overall, selling, general and administrative expenses rose 27.5% to $599 million. That includes employee expense that rose from $226 million to $283 million. Obviously, a chunk of this increase is the result of the acquisitions. There are people working in all those places and they inconveniently want to be paid.
 
The balance sheet took a hit. Remember a couple of years ago when Billabong raised some capital even though they didn’t really need to? It’s a good thing they did because I don’t think some of the acquisitions they did would have happened without it.
 
The current ratio fell from 2.48 top 2.33. Total liabilities to equity rose from 0.82 to 1.02. Net borrowings were up from $217 million to $468 million. Their interest coverage ratio fell from 12.6 times to 6.1 times. Some of the analysts were concerned about that.
 
Inventories rose 45% from $240 million to $349 million. This includes the inventory of all the acquired companies so naturally inventory rose. But there’s more to it than that. All the inventory in the acquired stores is at full wholesale cost. Even the Billabong and Billabong owned brand inventory. Once Billabong is stocking those stores directly, the owned brand product will go into the store inventory at Billabong’s cost- not full wholesale. Branded inventory from other companies will still come in at full wholesale cost, but I’m sure Billabong hopes to make some better deals based on its larger retail purchasing power and we know they expect to increase the percentage of owned brand inventory in those stores.
 
In other words, some of that inventory increase should go away over the next year as the owned brand inventory turns over, and its share of total inventory in these stores expands. The inventory increase is partly, but not completely, a one time event.
 
There is also some excess inventory they bought in anticipation of sales that didn’t occur and some they bought and received early because of concern about possible supply constraints that didn’t emerge. In total, they see $60 to $65 million of existing current assets turning into cash during the year.
 
Net cash flow from operating activities fell from $187.2 million to $24.3 million. That’s a big drop. There are also about $86 million in acquisition payments scheduled for this year.
 
There was some wailing and gnashing of teeth from some of the analysts about the weakening of the balance sheet and the decline in operating cash flow. They should be concerned. It’s rather critical to Billabong that these operational and margin improvements kick in this year because we continue to be in an environment where sales increases may be harder to come by. Europe is weakening and, at least in my mind, it’s not certain that the U.S. will strengthen much.
 
But I also think some of the analysts were caught by surprise by the size of the increase in retail business. Rather than focusing on the strategic impact, they were concerned with the short term financial impact. I guess that’s their job. That’s why there are quarterly conference calls.
 
At the end of the day, a stock goes up in the long run because of increases in earnings. Nothing else matters. I imagine there were discussions around Billabong as to whether they should do quite so many acquisitions last year. They knew the economic environment was iffy, and they could more or less calculate the balance sheet impact. Still, if you look at their strategy you can conclude the concepts of the deal made sense even if the timing wasn’t quite what they might have preferred. It was the best path they could see to improved, long term profitability given the environment they have to operate in.
 
But they’ve taken on some additional risk to do it. The balance sheet shows it. And, like the rest of us, they can no longer count on automatically higher revenues generated by strong consumer demand.         
 
I think we can assume that the world economy is not going to miraculously rise up during the next 12 months. So what we’ll be doing is watching to see how well Billabong executes its operational strategies internally to improve its earnings and strengthen the balance sheet. 

 

 

Globe’s Annual Report; Making a Profit Under Tough Conditions

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Globe’s annual report for the year ended June 30 showed up on their web site a couple of days ago. It doesn’t contain much in the way of a detailed analysis of results, but I’ll give you what’s there.   All the numbers are in Australian dollars.  You can read it yourself if you want to.

As reported, sales were down 3.5% from $91.7 million to $88.5 million. Net profit declined from $1.31 million to $1.09 million. Globe’s tax rate fell from 59.4% to 38.7%, keeping the profit decline from being higher.

At June 30, one Australian dollar was about $1.06 U. S.
 
In constant currency, ignoring changes in the exchange rate that is, sales rose 5%. In local currencies, North America and Europe were up 6% and 12% respectively. Australian sales fell 2% “…due to weak trading conditions in the retail sector throughout the year.”
Globe’s gross profit margin declined from 47.5% to 45.9%. Earnings before interest, taxes, depreciation and amortization (EBITDA) fell 47% from $5.5 to $2.9 million.  $735,000 of that decline resulted from an increase in corporate expenses not allocated to the geographic segments.   
 
As reported, sales in all three reporting segments fell during the year. In the Australian segment, they were down from $24.4 million to $24 million. North America went from $50.8 million to $49.3 million. Europe’s numbers dropped from $16.5 million to $15.0 million. The United States, by itself, fell from $34 million to $31.6 million.
 
Over on the balance sheet, current assets are down consistent with the fall in sales. Receivables fell by 13% to $12.2 million. Past due receivables rose a bit from $2.59 to $2.72 million. None of that is more than 91 days past due in either year. More than half is past due only zero to thirty days. In other words, past due doesn’t mean it won’t be collected though no doubt there will be a few problems accounts. There always are. 
 
Inventory rose by 12.7%. While you’d like not to see that with sales falling, we’ve got to remember that higher product costs translates to more dollars in inventory even if the number of units should be the same. Current liabilities were also down. The company has no long term debt and I guess no bank debt of any kind. The current ratio remains more or less unchanged from last year at 3.0. Total debt to equity is also more or less the same at about 35%.
 
Total equity fell from $51.1 million to $46.9 million. Total contributed equity is $144.2 million, but accrued losses of $86.8 million over the life of the company reduce the total equity number.      
 
The strong Australian dollar meant that sales in the U.S. and Europe translated into fewer Australian dollars. Globe had the same problem with higher product costs from China that everybody has. That explained a chunk of the gross margin percentage decline. And the Australian economy took it’s time about going into recession but once it started did a fine job of it.
 
Lower sales and profits, of course, are lower sales and profits no matter what the reasons are, and it doesn’t look like Globe is expecting much improvement next year. “All things being equal, the performance of the business [for fiscal 2012] is expected to be approximately in line with the 2011 financial year.”

 

 

Skullcandy has a Strong Quarter

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Skull’s sales for the quarter ended June 30 rose 46.4% to $52.4 million over the same quarter last year. Net income more than doubled from $2.1 to $4.3 million. This was helped by an income tax rate that fell from 56.6% to 41.6%. Gross margin essentially stayed the same, falling just one tenth of a percent to 51.1%. You can see the 10Q here.

Selling, general and administrative expenses rose $7.9 million or 84% to $17.2 million. There was a $3.7 million increase in payroll and $2.9 in marketing expenses. There were, obviously, also higher commission expenses on higher sales. As a percentage of sales, these expenses increased 6.8% to 32.9%.

Income from operations rose, but as a percentage of revenue it fell from 25% to 18.3%.
 
Skull is dependent on two Chinese manufacturers for their product. Like everybody else, they are experiencing higher costs from China and note that their gross margin might decline if they can’t pass these costs on to consumers.     
 
Remember that this quarter closed before they went public. As a result, we have $1.9 million in related party interest expense that wouldn’t be there if the offering had closed during the quarter. Also, I’m not going to spend any time on the balance sheet as it improved dramatically after the IPO. A bunch of cash has that impact on a balance sheet.
 
Just one balance sheet comment. Inventories grew 86% from $22.6 to $41.9 million. They discuss this in the conference call. Part of the growth was due to inventory levels being too low last year, and part is because of the acquisition of Astro Gaming. They also decided to increase their stock levels in 2011 to better service their retailers.
 
In discussing their outstanding orders, Skull says, “We typically receive the bulk of our orders from retailers about three weeks prior to the date the products are to be shipped and from distributors approximately six weeks prior to the date the products are to be shipped….As of June 30, 2011, our order backlog was $10.1 million, compared to $10.0 million as June 30, 2010. Retailers regularly request reduced order lead-time, which puts pressure on our supply chain.”
 
Obviously, they can’t wait for orders from retailers before placing orders with their factories. They say in the conference call inventory growth was roughly in line with sales if you ignore those three factors. But it looks to me like some of the inventory increase results, as Skull puts it, from “…pressure on our supply chain” that’s requiring some inventory growth in excess of sales growth.
 
Okay, one more balance sheet comment. There was a statement on the call about how, because they carried their inventory under FIFO, product margins had benefitted so far this year. In the second half of the year, as they start to sell the higher cost product, that benefit will go away. This inventory accounting stuff is going to start to matter with costs rising. I wrote about it in a bit more detail when I took my last look at VF Corporation.
 
The company’s net proceeds from the public offering in July were $77.5 million. Of that amount, $43.5 million, or 56.1% of the net proceeds, went right back out the door to pay accrued interest on convertible notes, unsecured subordinated promissory notes to existing shareholders, notes in connection with already accrued management incentive bonuses, and a bunch of other moneys due to existing stockholders. They used an additional $8.6 million to pay down their asset based line of credit in early August, and they may use a portion of the proceeds to buy back their European distribution rights. If that happened, that would leave them with $10.4 million of the offering proceeds, but they continue to have availability under their line of credit. 
 
If I had all the time in the world I’d like to go review and understand in detail how Skull financed its growth. It’s always hard to finance fast growth and it got harder when the economy went south. It must have been an interesting experience. Ah well, what doesn’t kill you makes you stronger.
 
In the conference call Skull management laid out its five major strategies. The first was to further penetrate the domestic retail channel. Skull is currently in Best Buy, Target, Dick’s and AT&T wireless. Domestic sales were about 80% of the total. During the quarter net sales to three customers totaled 27.4% of total sales and represented 44.4% of receivables at the end of the quarter.   That’s down from 33.2% of total sales and 46.9% of receivables at the end of the same quarter the previous year.
 
The second was to accelerate its international business, which is largely in Canada and Europe. It grew by 47.1% in the quarter and represented about 20% of total sales. A dispute with their European distributor had reduced 2010 sales, so part of the growth is catching up.
 
They sell in 70 countries and have 26 independent distributors. They want to distribute directly in key markets. This is a strategy most other companies in our industry have utilized.
 
57 North, their European distributor, represented more than 10% of their sales during the first half of 2011. In June, Skull entered into a non-binding letter of intent to buy those distribution rights back from 57 North for $15 million. As noted above, Skull has had a previous dispute with 57 North, and from the way they describe it in the 10Q, it sounds like there’s some uncertainty the deal will close. Maybe that’s just what they have to say because it’s a non-binding letter and negotiations are still ongoing. 
 
The third strategy is to expand their premium priced product category. The “vast majority” of their products are priced in the $20 to $70 range. They said they had premium products in the pipeline that could be released in the next 24 months. I’m pretty sure they said “could,” so unless they just used the wrong word, there seems to be some doubt as to the timing.
 
One of their existing premium products is the Aviator. They launched it in Apple stores and it was exclusively available there for six month. I like that distribution strategy but of course it may cost you some sales early on.
 
A fourth strategy is to expand complimentary product categories. This includes Astro Gaming’s head phones. They bought the company in April for $10.8 million. Astro sales are obviously included in the June 30 quarter. I don’t know exactly how much those sales were.
The fifth strategy is to increase online sales. Those sales were $4.3 million in the quarter, or 8.4% of net sales. In the quarter last year, online sales were 3.9% of total sales. $2.5 million was organic growth, which tells us that $1.8 million in online sales came from the Astro Gaming product. Organic online growth was 117% over the same quarter last year.
 
These are all fine strategies. In fact, they are so good that most companies are trying to implement them. What Skull says they have done is, “…revolutionized the headphone market by stylizing a previously-commoditized product and capitalizing on the increasing pervasiveness, portability and personalization of music.” I think they are right, but we’ll have to keep watching to see if they can continue to do it better than anybody else.   

 

 

Orange 21’s Quarter. Sales Improvement, But More Ongoing Cash Needs

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As you know, I tend to hate proforma financial statements, but once in a while they make sense. Orange’s quarter ended June 30 is one of those times. They sold their factory in Italy (LEM) on December 31, 2010. The June 30, 2010 quarter contains sales and expenses associated with LEM. The June 30, 2011 quarter does not. 

Happily, Orange has helped us out and provided a pro forma income statement for the June 30, 2010 quarter as if LEM was gone. We’re going to use that one to evaluate what’s going on.

The “as filed” income statement for the June 30, 2010 quarter showed revenue of $9.53 million and a profit of $408,000. The proforma statement for that quarter, taking out the LEM sales and expenses, showed revenue of $8.4 million and a loss of $925,000. Now, most people would think a profit of $408,000 would be better than a loss of $925,000 and they’d be right. But our interest is in figuring out how Orange might do going forward and it’s much easier to see that without the late, not so lamented, LEM in the way.
 
They do a really good job explaining this in their conference call. It might be worth a listen, but I suspect most of you prefer that I listen to it and tell you what they said.
 
Sales for the quarter ended June 30, 2011 were $8.99 million, up 6.8% from the pro forma sales number for last year’s quarter. For the six months ended June 30, sales were essentially flat compared to the previous year excluding the LEM sales.
 
Aside from the Spy brand, we know Orange also has had deals to sell licensed product from Margaritaville, O’Neil, and Mary J. Blige. So far sales from those products haven’t been significant, and I’ve already written about the deal to get out from under the contract with Mary. It’s costing them $1.5 million, but they would have had to pay royalties of $2.5 million if they hadn’t renegotiated. They also indicated that, as a result of the revised deal, that they have more flexibility to get rid of the existing inventory.
 
So most of that sales increase is the Spy brand. Good for the Spy brand. Not so good for the licensed brands effort. They note in the conference call that the management reorganization that started in mid-April put the Margaritaville product sales on hold and that sales of that brand have been “lackluster.” They said they were working together to determine the true value of the Margaritaville eyewear brand.   No, I don’t know what that means exactly.
 
The net loss was $2.95 million, much worse than the same quarter last year whether as filed or proforma. This is progress?
Yes, if you look at some of the charges during the quarter that resulted in the loss. There was non-cash stock and warrant compensation, severance payments, and the settlement with Mary J. Bilge charged to the company during the quarter. Together, these three come close to the total loss.
 
I do see their point that if you ignore all the “stuff” things can be construed to be looking up. But the stuff happened and continues to impact the company. This is like “The Turnaround That Wouldn’t End.” Yet the fact that it hasn’t ended (badly) suggests two things. First, that there is some significant brand strength there.
 
Second, moving over to the balance sheet and cash flow, it suggests that 45% shareholder Seth Hamot has a lot of money. As of June 30, 2011 his company, Costa Brava, had lent Orange $9.5 million and is prepared, under a line of credit established in June, to lend them $3.5 million more if they need it.
 
They say they are going to need it and will borrow it either from the Costa Brava line of credit or from their asset based lender BFI, assuming that line continues to be available. They think these lines will be enough over the next 12 months “If the Company is able to achieve some or a combination of…” sales growth, improved working capital management, reduce inventory, and/or better operating expense management.
 
They do have a lot of money tied up in inventory ($8.5 million down from $9 million a year ago). But a year ago, a bunch of that inventory had to involve LEM. I don’t know how much. Inventory is higher due to purchases “…in anticipation of sales that did not occur,” including for the licensed brands, and product purchased from LEM under a take or pay contract. Orange is required to purchase almost $5 million in product from LEM during 2011.
 
Net receivables have fallen from $6.5 million last June 30 to $5.5 million this June 30. But their gross receivables are $7.4 million. Against that they have an allowance for doubtful accounts of $625,000 and an allowance for returns of $1.25 million. If you happen to look at the whole 10Q, you can see on page 33 a discussion and table of how they calculate the return allowance. You’ll see that the average return percentage at June 30 for the Melodies by MJB brand was 18.8%. Gives you some indication of why they decided to renegotiate that deal. The Spy brand, by way of comparison was 5.4%.
 
The conference call included a rather lengthy discussion of all the operational and marketing changes they are making. These include new sales and marketing initiatives, advertising campaign, online ecommerce and branding platforms, revamping of the marketing mix, a more focused approach to sales, and a newly invigorated sales team.
 
That all sounds good of course, but the devil’s in the details we didn’t get. And when they said, “The rollout of the focused and fun Spy brand identity, with a creative execution in the market that will have a measureable effectiveness which will include a new level of sales and operational performance to meet the new demand for the brand,”  I decided we’d just have to wait and see what happened.
Strategically, I think it’s their plan to take the Spy brand into all the niches they think it fits in. That’s going to include optical retailers, just as an example, and they are looking at some surf space as well.
 
I can imagine a time in the not too distant future where this brand might be for sale. Well, I’m sure it is right now for some price (all brands are), so let me rephrase that. I won’t be surprised to see a sale after the promised turnaround is a little more evident. When that is, I guess, depends on Mr. Hamot’s appetite for continuing to finance Orange 21.

 

 

Skullcandy Licensing Agreement with Sonomax

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Don’t know how many of you saw this (I missed it for a while), but back in June, Skullcandy signed a licensing agreement with Sonomax to use its technology in Skullcandy’s headphones. Here’s the press release on the agreement and some information on Sonomax. The direct to consumer web site for Sonomax product is here. As far as I can tell, Skullcandy didn’t announce the deal. As they weren’t public yet, they didn’t have to.

Basically, Sonomax head phones allow you to go through a four minute process that sculpts your ear buds to your ear, giving you a custom fit. It works with a “…disposable fitting system that delivers a customized earpiece.”

I gather they aren’t cheap, but as somebody who’s had his share of trouble getting and keeping comfortable ear buds, I’m interested.
“Sonomax intends to modify its current earphone product line to incorporate Skullcandy’s industrial design and branding. The companies will work towards creating a line of Skullcandy products featuring SonoFit,” the press release says.
 
It’s a non-exclusive deal, but I’m glad to see Skullcandy bringing some more technology to its product, even though others will eventually have it too. At least Skullcandy is first. It’s not clear how long it will be until the product is actually available for purchase.
 
Sonomax is a small, almost development stage, company. Its calendar 2010 revenues were $643,000 Canadian and it lost $4.15 million. Its balance sheet is none too wonderful and I’d say it’s going to need to raise some more cash expeditiously if it hasn’t already since the end of 2010.
 
Skullcandy releases its first quarterly earnings tomorrow. I’ll take you through them once I have the 10Q.       

 

 

Popup Playgrounds; An Intriguing Marketing Idea

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It’s not like I look to the New York Times for all my good industry advertising and promotion ideas. Still, once in a while, they come up with something that gets me thinking. Their “Presto Instant Playground” article is one such idea. You may have to register to read it, but it won’t cost you anything.

“During a two-month period last year, seven civic coalitions in New York neighborhoods like East Harlem and the South Bronx got permits from the city to close certain local streets to traffic for designated periods of time — say, between 10 a.m. and 3 p.m. on a summer weekday. Working with the police and other city agencies, they re-designated the areas as temporary “play streets,” encouraging neighborhood children to use them for exercise and offering a range of free games, athletic activities and coaching.”

My immediate reactions was that this was an especially good idea for skate brands because a skater’s playground is the street and brands already have connections with skate parks and park and recreation commissions. But I really liked it because it connects with parents and kids, doesn’t appear to cost much if you don’t want it to, involves the local community, and gets kids outside and active. We have a business as well as a social reason to want to see that happen.
 
I know retailers and brands (sometimes in cooperation) have done some similar things. And I recognize it might be a little harder for a snowboard or surf company to make the connection. But the approach I was thinking about was not for a brand to do it themselves, but to contact their local civic organizations and see if they could do something similar in cooperation with those groups.
 
I’d start by contacting some of the groups that did it in New York and find out just how they pulled it off and if they had contacts in other locations that might also be interested. My hope would be that the civic organization would do most of the organizational work using already existing contacts with the local government and other stakeholders. The brand, or retailer, would be left to provide maybe a bit of cash, some product, the presence of team riders perhaps, pop up tents, and maybe some food and drink. I don’t know- it would depend on the specifics.
 
I also recognize that a snowboard company, for example, might have to be a bit cautious in their approach if they were doing it with lower income, inner city kids whose chances of going snowboarding were poor. But maybe, for example, you give some of those kids a chance to go and maybe you’re just there to get the kids outside and active at a low cost and you hope for some brand benefit somewhere down the line.
 
Anyway, it just seemed like a low cost, positive, valuable thing to do, so think about it.

 

 

VF’s June 30 Quarter Results; Pretty Impressive

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VF released its earnings and had its conference call back on July 21, but the 10Q was only released August 10th.  The results, as you probably already heard, were good. Revenue for the quarter was up 15.4% to $1.8 billion and net income rose 16.2% to $130 million. They accomplished this with a gross margin that fell from 47.1% to 45.9% partly by reducing their marketing, administrative and general expenses as a percentage of revenues to 35.7% from 36.5% in the same quarter last year.

The decline in the gross margin percentage was the result of product cost increases that weren’t fully passed on to their customers. The product margin was actually a bit lower as the reported gross margin benefited by 65 basis points from the closing of a European jeanswear facility. It also benefitted from the higher margins in the direct to consumer business.

They expect some further margin reductions in the rest of the year because of higher cotton prices and their decision not to pass through all the cost increases. They also note that cotton prices have fallen from $3.00 a pound to $1.00 a pound, and hope to see that positively impact product cost starting in 2012. 
 
VF has seen little impact from price increases on unit volume. But they are waiting to see how the consumer reacts to even higher prices in the second half of the year. All brands and retailers are waiting. VF is hoping that if cotton prices come down next year they might be able to recapture some margin they lost when they didn’t raise prices as much as costs rose.
 
Price increases accounted for 3% to 3.5% of the quarter’s total revenue gain of 15.4%. Two-thirds of that came from the U.S. jeans business. 
 
International revenues rose 30% in the quarter. They represented 29% of total revenue. Asia was up 30%. Europe was up 30%, Latin America 40%, and Mexico 26%.  They think international may hit 33% of total revenue this year, and they plan for it to reach 40% in five. If you’re interested in learning more about VF’s growth plans, you might go here.
 
Direct to consumer revenues were up 17% as a result of new store openings, a 46% increase in ecommerce revenue, and growth in comparable store sales. They’ve opened 44 new owned stores this year so far and are on track to open a total of 100. Operating margins for the direct to consumer business is up 3% this quarter, so you can see why they find it attractive.
 
There was no growth from new acquisitions this quarter compared to the same quarter last year. All $246 million came from existing businesses, though $43.5 million was the result of foreign currency translation. It’s great that VF breaks these numbers out in a separate table. 
 
VF, as you’re probably aware, divides its business into six segments they call coalitions. The quarter’s results for those segments are shown below.
 
       

Quarterly Sales

Change Since Same

Coalition Profit
       

In Millions of $

Quarter Last year

In Millions of $

Outdoor & Action Sports
  

$718
  

23.0%
  

$81.5
  

Jeanswear
    

$613
  

10.3%
  

$94.7
  

Imagewear
    

$244
  

15.6%
  

$26.0
  

Sportswear
    

$120
  

10.1%
  

$9.7
  

Contemporary Brands
  

$118
  

11.3%
  

$8.2
  

Other
      

$26
  

-3.2%
  

$0.0
  
                   
 
Most of our interest, for some reason, is in the Outdoor & Action Sports segment that includes Vans, The North Face, and Reef as well as other as six other brands. The North Face and Vans grew 21% and 22% respectively during the quarter. No mention, as usual, of what Reef did. The entire segment grew 14% domestically, and 42% internationally during the quarter (34% in constant dollars).  Revenues in Asia were also up 42% during the quarter compared to the same quarter the previous year.
 
These results don’t include the Timberland acquisition, which is expected to be completed in the third quarter.
 
The balance sheet remains very strong, but there are a couple of interesting things I want to point out. Just to give you a couple of numbers, the current ratio improved from 2.3 to 3.0 and the debt to total capital ratio fell from 24.5% to 18.7%. High current ratios are good, low debt to capital ratios are good for those of you who don’t have a financial background.
 
On January 2, VF changed its inventory accounting method from LIFO (last in, first out) to FIFO (first in, first out) for that inventory it wasn’t already accounting for using FIFO (about 25% of the total). The impact for the first six months of the year would have been to reduce their cost of goods sold by $8 million.
 
Okay, small number so why am I tormenting you with this technical accounting crap? If everything you put into inventory always cost the same, it wouldn’t matter. In an inflationary environment, the product you enter into inventory is going to be at a higher cost than the product you bought earlier. So if you decide you’re going to sell the older inventory first, you decrease your cost of goods sold and increase your profit. 
 
No big deal. This isn’t about VF but it’s about your need to be aware that this accounting change can matter if we’re dealing with product cost inflation, as we have been in the case of products made with cotton. 
 
On a related issue, inventory at the end of the quarter rose almost 17% from a year ago. But they note in the conference call that 9% of that was due to higher product costs. So units in inventory grew at a slower pace consistent with sales growth.
 
Three things stand out for me from reviewing VF’s quarter besides the good financial results. The first is the push into international. They’ve decided, along with a lot of other larger companies, that the growth opportunities are much greater outside of the U.S. The second is the growth of their direct to consumer business. Hardly a new industry trend, but I think we’ll continue to see more of it. Having this many brands with this kind of growth and margins makes it irresistible.
 
Finally, VF chose last year to make an incremental marketing spend of $100 million to promote their brands. They are continuing, and in fact have increased that spend slightly, this year. It shows a lot of confidence in their plan, as well as the strength of their balance sheet.     

 

 

The 2010 SIMA Retail Distribution Study

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The first thing to say is thanks to SIMA for making this study happen and to Leisure Trends Group for doing the research. We don’t get access to near enough industry and market data.

As I’m not a member of SIMA, I don’t have access to the complete study. I’m working with the “Media Highlights” package that came out after the press release on the study.     

Two years ago, when the previous study came out, I did the same kind of analysis I’m going to do now. You can see that analysis here.
 
As usual, I’m doing this to try and identify trends and information that will help you run your business better and make you think about important issues. But the Media Highlights weren’t constructed with my needs in mind. SIMA’s goal in producing the highlights is to promote the industry to the broader market and to make it look good. I do not, by the way, fault them for a moment for doing that. It’s part of their job.
 
Anyway, keep that in mind here as we proceed.
 
The Headline Numbers
 
I’m sure most of you all saw these numbers in the press release. The “core channel” sales at retail (all these numbers are at retail) fell 13.5% between 2008 and 2010 from $5.32 billion to $4.6 billion. Sales at skate focused stores were down 11.6% from $2.85 billion to $2.52 billion. At surf focused stores, they fell 15.8% from $2.47 billion to $2.08 billion.
 
Footwear in core channels rose 8.2% to $1.5 billion and represents one third of total sales. Hard goods sales over two years were up 35.3% to $1.46 billion and represent another third. Well, if footwear and hard goods were up, but total core sales fell 13.5%, then apparel must be, well, not specifically too good. Down 41.1% actually to $1.0 billion. Interestingly, men’s/boy’s apparel accounted for 57% of overall apparel sales. Even with the weakness in juniors, that surprised me.
 
So if you’re like me you looked at these numbers and went, “Huh?!” On the face of it the hard goods increase and apparel decline seem just impossible even though it’s over two years. Then there’s the “other” category of sales which fell from $498.8 million to $18.4 million in two years. I hypothesize that there are some changes in classification and what’s included or not included going on here.
 
Core stores do not include military exchanges, company stores, and national department stores. I know what a military exchange and a national department store are. But when it excludes company stores does that mean, for example, that the Billabong store in my local mall is excluded?
 
That’s just what it means and, having discussed it with SIMA, I can see their point of view. If you called a company owned store, SIMA said, and asked them what their best-selling board short was, what might you guess the answer would be? The weighting towards company owned brands in company owned stores, SIMA argues, would skew the data.
 
You can see the difficulty SIMA and Leisure Trends have in decided who to survey or not to survey. The other side of the argument, of course, is that those board shorts sold in a company owned stores are real board shorts sold to real customers. Surveying them might skew the results, but all the brands who have company owned stores are working every day just as hard as they can to do just that.
 
Then there’s the issue of company owned stores that carry brands in addition to those brands owned by the company. What would SIMA do with Billabong owned West 49 and its 125 or so stores if it was a U.S., rather than Canadian, retailer? On the one hand, it carries other brands. On the other hand, Billabong is working to increase the owned brands component of those stores to as high as 60%. Would that skew the sample in such a way that West 49 stores shouldn’t be included in the survey?
 
I don’t know.  I’ve got an opinion, but I don’t know in a definitive way. You don’t know either. Neither do SIMA or Leisure Trends. They make the best decisions they can make given the information they have.
 
Internet and catalog sales contributed 16% of the total, compared to 14% in 2004. 55% of retailers are now selling on the internet. That’s double the 2008 percentage of 24%. I’m surprised it’s only 55%.
 
SIMA also estimates that surf and skate sales in all channels (including company stores, military exchanges and national department stores) fell 13.6% from $7.22 billion to $6.24 billion.
 
There’s a chart on page 5 called “Putting Things into Perspective-Retail Size of Other Sports/Recreational Industries that I didn’t agree with.” It lists that all channel estimate for surf/skate and shows 2010 retail sales for Outdoor (core), including paddle sales at $5.70 billion. Bicycle comes in at $3.2 billion, snow sports at $2.92 billion, scuba at $658 million, snowboard at $481 million and paddle by itself at $360 million. Next to the chart it says the following:
 
“Based on other work completed by Leisure Trends Group, surf/skate is impressively positioned among other retail industries.”
I don’t know what “impressively positioned” means. And I would dispute the idea that an industry’s size is determinate of its competitive positioning against other industries. I wish that could have been stated a little differently.
 
Definitions and Methodology
 
Just what is “core,” we’ve all wondered. In doing the research for this study SIMA says, “The CORE channel includes retail operations that classify themselves as specialty, lifestyle or sporting goods stores. Core stores do not include military exchanges, company stores, and national department stores.”
 
I asked SIMA if surveyed stores really did classify themselves and if that meant that Sports Authority could be “core.” They clarified that sporting goods stores are, in fact, included in the core numbers but couldn’t tell me about specific retailers because of confidentiality reasons. I can understand that. You aren’t likely to get much cooperation if the retailers submitting data don’t think it will be confidential.
During January and February of 2011, Leisure Trends did 446 telephone interviews with surf and skate retailers in the U.S. This sample was taken from a list of retailers reviewed and provided to Leisure Trends by SIMA. “The list of core shops that are surveyed is a list that has been compiled by brands’ accounts.” The brands provided the list.
 
“By being on the list, and qualifying for the study by having at least 10% or higher of their operation’s overall sales coming from surf and/or skate products they are considered within the Core Surf/Skate Channel,” SIMA told me.
 
That 10% bar seems kind of low for me. Especially as that’s for surf and skate combined. I wonder to what extent setting the bar that low expands the size of the total market?
 
I also wonder how they measure which retailer makes it to the 10% bar and what products are included in the calculation. It sounds like the retailers decide if they are 10% skate/surf. If a sporting goods store thinks they sell 10% skate/surf by including boogie boards, beach umbrellas, various brands of apparel, cheap complete skate decks, every swimsuit in the place and sun tan lotion, can they end up classified as being in what SIMA calls the core channel? Okay, kind of an extreme example but you can see my point.
 
SIMA clarified for me that they weren’t trying to define what a “core shop” means by the study and use the word only to define the shops that were surveyed. They suggested that something like “surveyed stores” might be a better term. I think it might be and hope they consider using it in two years.
 
Just to say it again, every study like this one has methodological and statistical challenges to deal with. There are tradeoffs and choices you make as you do your best to collect good data. But my readers know I think the core market is a lot smaller than this study suggests and I suspect many of you agree with me. If so, do me a favor and put a comment to that effect on my web site please.
 
Some Interesting Trends
 
The most interesting thing I found was that chain stores represented 35% of the total list of stores compared to only 9% in 2008.  The report notes that “Independent stores closed many doors in the past two years. Most of these were replaced by specialty chain stores causing a less than expected drop (-1.7%) in total surf and skate doors to 4,826 in 2010.”  That speaks more eloquently than I can to the way the industry is changing; or maybe it’s better to say the way larger brands are evolving out of the core action sports space.
Consistent with this, 81% of all surveyed retailers use a point of sale system, up from 60% in 2008. I conjecture that’s because a lot of the smaller, unsophisticated stores are gone, replaced by chains with good systems. SIMA points to two other trends that are probably driven by the growth of chain stores in their sample.
 
The first is the increase in the average number of store employees from 6.5 to 7.7. I’m guessing this could also reflect some recovery from the depth of the recession.
 
They also note more stores carrying snowboarding, wakeboarding, motocross, BMX and other sporting goods and suggest this is because more chains are in the sample. Probably true.
 
I’ve spent more timing writing and rewriting this than you would believe. It’s kind of old news, I’m working with incomplete data, and while SIMA was as cooperative as they could be, there was just some data they aren’t allowed to give me and questions confidentiality prevented them from answering. Why am I doing it?
 
As usual, because I think there’s a business lesson to learn. You just can’t look at the headline numbers and say, “Oh, this represents how the industry has changed.” 
 
The dramatic changes in certain categories (hard goods up so much, apparel down so much, the “other” category) gives me pause. They are indicative of huge changes in our competitive environment. They reflect vertical integration, the rise of chains, specialty shops going out of business, a broader definition of what our industry is, the use of systems by the survivors (and probably some different classification of product as a result), a lousy economy, and some others as well.   
 
You shouldn’t be depressed because the industry is smaller than it was two years ago. There’s good news for some segments, and for some companies, in there.    At the same time, you shouldn’t be giddy with joy as a hard goods company just because hard goods were reported to be up 35%.
 
What we can learn, as a reader of the press release and even the media highlights or the whole study if you have it available to you, is that you have to be cautious in drawing conclusions from summary data lacking a thorough understanding of how the study (or any study for that matter) was conducted.