Volcom’s Quarter Ended June 30, 2009

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Volcom filed their 10Q in the last couple of days. There’s some good news here, though of course Volcom’s income statement for the quarter and six months reflects the impact of the recession. And the issue of how to manage their PacSun business is an interesting one.

Let’s start with the balance sheet. The filing includes balance sheets for June 30, 2009 and December 31, 2008. I went back and plucked out the June 30, 2008 balance sheet to make a better comparison to June 30, 2009.

I should start by saying that their balance sheet was already strong last June, and it’s strengthened further. Cash and short term investments rose from $71 to $96 million. Accounts receivable and inventories fell by 20% and 18% respectively. Accrued payables and expenses were down 18% from a year ago. Those changes are consistent with the recession and how you manage in it.
 
Volcom’s current ratio rose from 4.78 to 6.22 while total debt to equity fell from 0.20 to 0.15. Those are both good things. They had no drawings under their line of credit (though $1.6 million in letters of credit were outstanding). Availability under the line was $38.4 million. Volcom has a balance sheet that allows it to continue to pursue its strategy and take advantage of competitor weaknesses during a tough economy. I may have mentioned a time or two that having a strong balance sheet right now is a real advantage for any company.
 
Revenues, to nobody’s surprise, declined. They fell 25% for the quarter to $54 million and 20% for six months to $123 million. Gross profit margin for the quarter actually rose from 48% to 48.6%. For six months it fell from 50.3% to 49.6%. Selling, general and administrative expenses fell 7.4% for the quarter, reflecting careful management of expenses and compensation. I’d note that these declines are not as dramatic as I’ve heard about in some other companies. Again, Volcom has the balance sheet to maintain its initiatives.
 
Net income, however, fell 82% in the quarter from $4.8 million to $872 thousand. For six months, it was down 64% from $14.2 to $5.1 million. Revenues and gross profit dollars were down for the quarter in Volcom’s three operating segments- United States, Europe, and Electric.
 
 Volcom reported that sales to PacSun decreased 23.7%, or $5.4 million, during the six months ended June 30, 2009 compared to the same six months the prior year. $5.4 million is approximately 18% of their total sales drop of $30 million from the first six months of 2008 compared to the first six months of 2009. They don’t say what the drop was for the quarter ended June 30 compared to the same quarter last year.
 
They say that PacSun represented 16% of product revenues in 2008 (I assume they mean the whole year), and 14% for the six months ended June 30, 2009. That would be $17 million.
    
Let’s try playing around with the numbers a bit more. If $5.4 million is a 23.7% drop, what were total sales to PacSun for the six months of the prior year? A little less than $23 million. That’s about 15% of total sales during that period.
 
Volcom “…expects a decrease in 2009 revenue from Pacific Sunwear when compared to 2008.” They go on to say, “Pacific Sunwear remains an important customer for us and we are working both internally and with Pacific Sunwear to maximize our business with them. We believe our brand continues to be an important part of the Pacific Sunwear business. We also recognize that any customer concentration creates risks and we are, therefore, assessing strategies to lessen our concentration with Pacific Sunwear.”
 
How can Volcom maximize their business with PacSun while lessening their concentration with them? Can you maximize your business while you decrease it? They seem to think so since 2009 revenue from PacSun will be less than 2008. You can lessen concentration either by selling PacSun less or by selling everybody else more. Those are the only two choices I can see.
 
Only from public companies who are required to focus on quarterly results can you get these kinds of semi-contradictory statements. Volcom has to figure out how to replace sales from PacSun in an environment where finding sales growth isn’t easy. They are “assessing strategies” for accomplishing this but don’t have it solved. Oh well- not even the best companies are having an easy time right now. 

 

 

Boardshorts from a Vending Machine

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If you read this http://www.nbcnewyork.com/blogs/the-thread/Swimsuit-Vending-Machines-to-be-Stocked-in-Hotel-52089002.html you’ll see that Quik has partnered with Standard Hotels to sell cobranded swim suits at boutiques and poolside vending machines for $75 a pair.

I’m not writing this to express an opinion (though I’m usually not loathe to do that) but just to let you know it’s happening and to talk about the general implications.

Just when you think there are no new distribution channels, up pops another one. I don’t know where the next one will come from, but I know it will appear. Is it at the expense of some other distribution channel? Sure. To some extent. But might it also create some new customers? Sure. To some extent.
 
Sales at resorts or hotel shops and pools are often to people who need something they need right now. I’d say you fit into that category if you want to swim and don’t have a suit.
 
Every time you choose a new way to distribute your product- each time it can be found somewhere different-, you change your customer base and the market’s perception of your brand. To some extent. Can you manage that so you get more customers than you lose? How many different distribution channels, partners, products and price tiers can you have before your brand evolves from what it started as to what it needs to be to attract those new customers you need for growth? Can you keep the old customers? To some extent. Figuring this kind of stuff out is what the best executives do.
 
I lied. I do have an opinion. I might not go as far as the writer of the linked article and say its “brilliant,” but I think it’s a good idea which might grow and is consistent with how Quik has evolved their brand. Even if it grows, it doesn’t feel like it will have much downside for other parts of their distribution. I imagine there are some specialty retailers already shell shocked by the recession and distribution issues that might disagree. But Quik, like all brands and all retailers, has to do what it perceives to be in its own best interest. I think they made a good decision.                           

 

 

The New Management Environment- A Few Ideas

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In 1995 I wrote a Market Watch column called “Getting in Deep Trouble.”   For those of you who might have accidentally misplaced your copies it talked, as the snowboard industry was starting its (first) consolidation, about what led companies to face survival issues and how they could save themselves. I started with the following:

“All businesses in trouble share two characteristics: denial and perseverance in the face of inescapable change. It’s easy to believe in what worked in the past, and hard to step outside our comfort zone and do things differently.”
It does look as though we have some inescapable change going on. And as difficult as that change is and will continue to be, I’d point out that issues of distribution, hard goods margins, lack of product differentiation and others existed long before the economy went south. Growing sales and free spending consumers made it easier to manage (or maybe ignore) them, but they were there.
Last year, and especially in the fourth quarter, we reacted by cutting orders, reducing expenses, and controlling inventories. That’s what you do when customer demand declines. I guess. Maybe I mean that’s the first thing you do. Some of that attention to detail would have been, and is, appropriate to all business conditions. Perhaps some businesses wouldn’t be having such a hard time if they’d been focusing on those management nuts and bolts all along. And maybe they would have had the balance sheet to take advantage of the opportunities the existing conditions present.
Now, we’re all waiting for the recession to end. And it will end, though I probably think that’s going to take a little longer to happen than some of you do. The concern I have, speaking of denial and perseverance, is that there are still some people with unrealistic expectations as to what a recovery will mean.
So I’m going to give you my perception of what the recovery may look like, what appropriate management behaviors could be if I’m right, and tie it to some interesting emails I’ve received and conversations I’ve had.
The New Normal (and Other Overused Clichés)
I’ve written some of this before, so I’ll be brief. But I’d like us all to be on the same page as far as the expected environment goes.
Growth, when it comes, will be a lot slower than we’re use to. Overall sales increases may be harder to come by, but there will be some fewer retailers and maybe fewer brands to share them. I expect consumers to continue to save. The time it will take to complete the ongoing deleveraging will be measured in years, not months. The Federal Reserve has cut interest rates as low as is possible and done everything they can to expand the money supply. Their goal is to get banks lending and people borrowing. Trouble is, banks are busy rebuilding their capital base, and consumers, having turned cautious, aren’t in a rush to borrow any more money. They’ve got to deal with the mortgages, credit card balances, and car payments they already have.
I think it gives you some good perspective to realize that what got us into trouble in the first place (excessive consumption and debt) is what some authorities seem to be hoping will get us out of trouble. I don’t think that’s going to happen. The Bush tax cuts expire in 2010 and I don’t expect them to be renewed. That’s going to take a lot of purchasing power out of the economy at just the wrong time.
Unemployment, always a lagging indicator (and worse than the number looks when you add the number of part time employed people who can’t find full time work), may be slow to decline. I’m concerned this recovery isn’t going to produce a lot of good jobs.
Well, that was cheery. Sorry. Feel free to send me lots of emails telling him I’m too negative. Hope you’re right. If you do email me out of annoyance, please tell me why you disagree with my analysis- not just that I shouldn’t write stuff like that. Hey- we’re trying to run businesses. We need the best information we can get- good or bad.
Some Things You Can Do
I wrote with enthusiasm last month about Gross Margin Return on Inventory Investment (GMROII) as a tool to help you increase those gross margin dollars and choose your inventory more carefully. I noted in that article that taking the best advantage of it required that you had and maintained quality management information systems. Last week, I asked a pretty senior manager of a major brand if they knew about GMROII. “Sure!” they said, “But our systems are so bad we can’t pull out the information we need to really take advantage of it.” That was disappointing.
Especially in a slower sales growth environment, whether you’re a retailer or a brand, there’s a lot of money on the table if you can manage your inventory and improve your inventory turns. There is some expense involved in buying the software and hardware you need to establish or upgrade your systems. But the real costs come in converting the data, training, and making maintenance of the system and its data a priority. I can’t say this strongly enough. You’ve got to have and use good systems. Please make the investment.
My online article on SIMA’s retail study and core snowboard retailers lead to an interesting exchange from a retailer whose sales were down 20% but whose profits were actually up due to better management including ruthless expense and inventory control. Not up a lot, they hastened to point out, but up nevertheless. I believe that kind of result is possible with good management practices for both retailers and brands. However, this retailer pointed out that at least part of their success was due to a level of cooperation and enthusiasm from the staff in controlling expenses that just couldn’t be sustained over the long term.
You know what else you can do? You can remember that nobody who’s a manager in this industry (or, for that matter, in any other industry) has ever managed under these conditions. In a lot of ways, we literally don’t know what to do. You know what the good news is? There are no rules. If change in the business environment is dramatic and long lasting, as I think this is, then you’ve got to blow up your preconceptions, be willing to take new approaches, and bring your entire team along with you.
There’s a limit to analysis. When I did turnarounds, we’d refer to “just working the deal.” We weren’t quite sure what the right thing to do was, or what exactly was going to happen when we took an action, but we knew that not trying some stuff and going along the way we had been was fatal. So what did we have to lose? Question your preconceptions. When Target is hiring team riders, they may need a close look.
One of the best ways I know to do that is to go talk to people you haven’t known for 20 years and who aren’t in this industry. Tell them about your problems, issues, and opportunities and see how they react. We spent way too much time talking to each other. I think that tends to reinforce our preconceptions.
Ed Seymour, the Director of Global Sales for Westbeach, emailed me about an interesting approach they are taking with some of their core retailers. As he describes it, under their Affiliate program, they don’t sell any product to certain key retailers, but end up making more money. I suppose that require some explanation.
They work with each store they have this relationship with and agree on a display and a location in the store. They train a key staff member as their brand champion and share the margin with the store after the product is sold. The store never owns the product. He didn’t tell me exactly how they split the margin.
After closeouts and the end of the season, Westbeach takes back the unsold merchandise and puts new stuff in. Stores with their own web sites can banner link to the Westbeach site. They track sales and share the margin with the store the same as if the customer had made the purchase in the store. They also give the retailer 12% of any product sold to somebody in their area directly through Westbeach’s web site.
Ed says Westbeach gets paid faster, the store is more willing to take risks with merchandise, and Westbeach knows right away when a shop starts to get in trouble.
Consignment, of course, isn’t a new idea. But it sounds like the structure Westbeach has built around it is making it more effective.
If you are uneasy from my description of the emerging economy, maybe my description of what others are doing, and what you can do, will help lift you up. You’ve got to get out of the denial and perseverance way of thinking and find the opportunities that are always out there when things change. Get out there and try some new stuff.

Gross Margin Return on Inventory Investment A Tool for Our Times

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Since last fall, as our new economic reality has evolved, I’ve had a few things to say about what to do. They’ve included building your balance sheet, controlling your inventory and other expenses, focusing on the gross profit line, looking at gross margin dollars as well as percentages, and making good use of your management accounting system, which I consider a strategic tool in this environment.

All very sage and business like stuff I’m sure you’ll agree. Trouble is, I didn’t really have a method to help you do it all. Problem solved.
Serendipitously, Cary Allington, President of ActionWatch, the collector and supplier of sophisticated, detailed retail information on what’s selling at what prices and margins in our industry sent me an article on the Gross Margin Return on Inventory Investment concept (GMROII). He was pretty excited. So was I after I’d read it.
 
The concept isn’t new. It’s valid for brands and retailers. It comes as close as I could hope to drawing together most of the ideas I’ve been talking about lately. Hopefully, you’ll read this and say, “Oh hell, I already know and do all that.” But I don’t think so. Neither does Cary, who spends a lot of time talking with retailers and brands about the data they have or want and its quality.
 
What Is It?
GMROII is a conceptually simple method for measuring which inventory items (or categories, or brands) give you your best return on your investment in that inventory. It combines gross profit with inventory turns in a way that allows you to compare the profitability of snowboards (or a particular snowboard) with, say, surf wax at the gross profit level. It’s not perfect, and we’ll discuss the caveats below, but it looks like it can be very useful.
 
Just as a refresher, inventory turn refers to how many times you have to replenish your inventory for a given level of sales over the year. It’s important because the more turns you have, the less inventory you can carry for a given level of sales. And the less chance your inventory will have to be marked down. Carrying extra inventory costs you money in lots of ways including cost of capital, overhead, and opportunity cost when you have money tied up in something that takes a long time to sell and has to be discounted instead of in fast moving, full margin inventory. 
 
The GMROII calculation itself is simple. It’s just the number of gross margin dollars you make selling a product (or category or brand) over whatever period of time you choose to measure it divided by the average inventory at cost over the same period. Typically, it’s done over a year. The result is a number (in dollars- not a percentage) that tells you how many gross margin dollars you earned for each dollar invested in inventory over the period.
 
Having calculated these numbers, what might you do with them? For the first time, you’ll be able to compare what I’ll call the inventory financial efficiency (I just made that up! Kind of like it) of any item you sell with any other item. You can also do it for a brand or a category. You can actually say, based on the example above, I’d rather sell the same amount of Item A than Item B even though one sells for $600 and the other sells for $12.00 and they are in completely unrelated categories. You can see which ones you’re wasting your time selling (or at least recognize that there’s no financial reason to be selling them). You can eliminate too much emphasis on gross profit margin, which I think you can see in the table below can be misleading. You may significantly reduce your inventory investment.
 
Below is a table supplied by ActionWatch that calculates the GMROII for a number of categories using data they collected from their panel of retail shops.

 

 

The GMROII is the number of gross margin dollars generated for each dollar of inventory you had in that category over the period of a year. If you could plan your whole business around GMROII, obviously you’d get rid of everything but long completes and just sell them. But your customers probably wouldn’t go along with that.

That shoes are at the bottom of the list isn’t a surprise, at least to me. Given all the color, sizes, and styles you have to carry the inventory investment is pretty significant. The opportunity is to calculate the GMROII for each SKU and figure out how you can change your mix to drive that shoe GMROII up.
 
I was kind of surprised to see the GMROII for accessories as far down on the list as it was. We’re all favorably disposed to accessories and think of them as a high margin, profitable product. This particular analysis suggests they aren’t quite as spiffy as we thought.
That skate hard goods all had GMROIIs higher than soft goods was kind of a surprise. I’d especially note the high values for short decks. We bitch and moan that the gross margins need to be higher, but because of the speed at which short deck inventory turns, they look pretty good in a GMROII analysis. This analysis doesn’t break out branded from shop decks. That would be interesting to see.
Notice how increasing the annual inventory turns boosts the GMROII even when the gross margin percentages are lower. You’d rather have an extra half turn on that inventory than a couple of gross margin points any day. But how many of you calculate the inventory you buy based on the dollars you have to spend and the percentage gross margin you expect to make? You can’t ignore those factors, but pretty clearly turn needs to be part of the analysis. 
 
The basic calculation for GMROII is conceptually simple as you can see. But I’m afraid it requires some work. What an inconvenience.
 
The System Thing
You won’t be doing a lot with GMROII unless you have a quality management information system. For the calculations to be meaningful, your sales history and inventory tracking have to be solid. If you want to track it by category or brand, your chart of accounts has to have been set up to aggregate the numbers. And of course this isn’t a onetime activity. You need to keep it current as product comes and goes, as credits are processed, as write downs occur. You get the picture.
 
I’ve talked about the need for good systems before. I’ve gone so far as to say you can’t get by without one- especially now. Some systems do the GMROII calculations for you. I’ve been told that these include Cam Commerce, which offers it in their Retail STAR and Retail ICE applications. Win Retail also offers it. I’m not sure which systems for brands might offer it.
 
Other Considerations
You can’t just keep the products with the highest GMROII. Total dollars generated matter and there are other reasons besides financial to stock a product. You can have products with huge GMROII that wouldn’t generate enough gross margin dollars to cover expenses (and some bottom line profit besides would be nice).
 
You have to already have been carrying a product for a period of time before you can do the calculation. If you want to conduct a GMROII analysis at the item level, it works best for items that you replenish rather than replace. If you’re out of inventory for a period of time, that will impact the value of the calculation.   In general, the longer you’ve carried the product, the better the calculation will be because the average inventory number will be more accurate. 
 
Come to think of it, for those of you who are statistically inclined, I recommend calculating the mean inventory and the standard deviation (dispersion around the mean) rather than just average inventory. That would give you a good sense of whether or not you can calculate GMROII for shorter time periods. Though I suppose you’d need to calculate it for the same period for all products to get comparable results.
 
If only because it gives a result in dollars, GMROII is not a traditional return on investment calculation and should not be confused with one. It’s a way to manage your inventory- not your whole business. But inventory is often the biggest number on your balance sheet, so managing it well pays big dividends. How might you start?
 
To take the greatest advantage of the concept, you really do need the good system and data I describe above. Just to work up some enthusiasm, assuming your system isn’t quite set up to make the calculations, get a pencil, calculator, paper and inventory and sales records going back a year. Pick, oh, I don’t know, sunglasses. Choose a brand. Or a style or color. Whatever it’s easy to get the data for.
Figure out the total gross margin dollars (after all allowances and markdowns) you earned on that product or product group over the year. Now add up the inventory at cost of the product or product group at the end of each month over the last year and divide by 12. Divide the gross margin dollars by that average inventory number and you’ve got your GMROII.
 
Next, depending on what you decided to do the first calculation on, do it again for another brand, color, or style. Now you’ve got the GMROII for two groups of products. Is the result similar? If not, why not? Was a style you ordered the most of just a dog? One brand just cooler than the other? Did the order get screwed up?
 
What adjustments should you make in your purchasing so you’re selling more of the higher GMROII stuff?
 
Now, for even more fun, do the same calculation for surf wax. Or whatever. Which should you want to be selling more of; the sunglasses or the surf wax? Bet you didn’t have a way to figure that out before.
 
It won’t be as simple or clear cut as I’m making it sound here. It will never be exactly accurate, but the more you use it, the more useful it will become. It’s clearly harder to do with seasonal merchandise and changing styles, but I think it’s worth the extra work, though the quality of your information won’t be as good.
 
Cary has put a link to the article I referred to on the ActionWatch web site. You can access it in the section called “POS Tips Links” at www.ActionWatchReports.com.   The GMROII concept is worth some of your time. There’s a bunch of money on the table.

 

 

Here’s a Chart Worth Seeing

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After my post on SIMA’s 2008 retail study yesterday, I got curious about the percentage changes quarter over quarter it implied. The Media Highlights gave me total core sales for the year and the percentage of sales in each quarter. SIMA gave me the same information for 2006. The rest of the calculations are mine and I used them to create the table below. The numbers don’t exactly add because of rounding, but that doesn’t really matter.

 

 

 

 

 

 

 

 

Fourth quarter skate/surf core sales were 17.5% lower in 2008 than in 2006. We don’t have 2007 numbers because SIMA only does the survey every other year, but I’m guessing the 2007/2008 comparison would look worse. SIMA has now told me that this information is in their full report, but I don’t have that and I’m guessing a lot of you don’t either.

I don’t think that number will surprise anybody who’s actually running a business, and I don’t believe it’s worse than other consumer related businesses. I look forward to improvement from this point on.

 

 

Blowback From the 4th Quarter; The SIMA Study and Snowboard Retailers

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I received The 2008 SIMA Retail Distribution Study (highlights only) about the same time I got yet another phone call from another snowboard focused, core retailer that had been around a long time and was in trouble. I hate those calls because these are shops that I would like to see do well.

My little accidental, informal, snowboard shop survey can’t hold a candle to SIMA’s study. But I thought there was some value in talking about them together.

 
SIMA does its study every two years. 2004 was the first year and the current one is for 2008. It’s great information. We all need more of this kind of stuff to run our businesses better.
 
The retailers surveyed “…carry either surf product alone or a combination of both surf and skate product.” No snowboard focused shops included. It focuses on stores that have been labeled as “core.” “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.”
 
 Total core channel retail sales are reported to have fallen 3.45% to $5.32 billion in 2008 compared to 2006. We don’t have 2007 numbers because, obviously, they only do the survey every other year. Nor do we have a quarterly breakdown of sales changes in 2008, at least not in the summary I received.
 
If we did have a quarterly breakdown, I’m guessing we might see sales increases in the first three quarters of 2008 compared to 2006, and probably to 2007, and then a big decline in the 4th quarter. Which brings me to the calls I’ve been fielding from snowboard focused core retailers.
 
Last fall represented the convergence of trends that put a lot of pressure on snowboard retailers. First, they were operating in a market that wasn’t growing (There- I said that tactfully). A lot of brands, especially larger ones, in an attempt to move inventory and make money, expanded their distribution.   Awareness of the recession hit full force and consumers stopped spending. Meanwhile, discounted product was all over the internet and finding that product got easier and easier.
 
Snowboard retailers found they couldn’t hold prices almost from the day their preseason orders arrived. In a one season business, where most of the product (even a lot of the apparel) is useful mostly when actually participating in the sport, and participation is expensive at a time when consumers are cutting back, it was a perfect storm.
 
The SIMA report says that core skate and snow retailers didn’t have near as hard a time as core snow shops did, though I think maybe the press release headline, “Surf Industry Riding Out the Economic Storm” overstates the case a bit. I suppose that’s SIMA’s job. Certainly skate and surf retailers are better off than snow. Their categories are in better overall shape, they aren’t as dramatically seasonal, and lots more people need an attractive, comfortable shoe than need an attractive, comfortable snowboard boot.
 
But I wish we had some comparative fourth quarter numbers. Certainly there were over inventoried issue for skate and surf just like for snow. I wouldn’t call those issues easy to manage, but they are easier than in snow where if you don’t sell it, you have to practically give it away or keep it until next year.
 
SIMA includes a table that shows product mix contribution to retail sales for the three years the study has been done- 2004, 2006, and 2008. The two largest categories, each about $1.1 billion in core retail sales out of a total of $5.32 billion, are Surf/Skate Shoes and Surf/Skate Men’s Apparel. Third at about $1 billion was Surf/Skate Equipment, down 4.5% since 2006. There are a total of 13 categories, of which only five were up between 2006 and 2008.
 
 My point is that the 4th quarter of 2008 wasn’t just the worst quarter most of us have ever seen. It was the fulcrum of change from the old to the new economy. I’ve been writing that for a while, so I don’t suppose I need to go into detail again.
 
The one good thing that may come out of all this is that I can imagine some product shortages this fall and during the holiday season. Doing what they “perceive to be in their own best interest in the short term” retailers have cut orders and manufacturers have cut production. I know that doesn’t sound good, but read on.
 
Most everybody in this industry who sells stuff has suffered from over distribution. It turns products into commodities and reduces gross profits. It occurs because all companies, in their competitive zeal for more sales, do what they “perceive to be in their own best interest in the short term.” But at this stage in our industry’s development, it turns out not to be in anybody’s best interest.
So for a change, everybody dong what they “perceive to be in their own best interest in the short term” may turn out to work for the industry though obviously not for individual companies. Unless of course, they are managed very, very well.
 
The consumer may find that the product they want isn’t 20% off and isn’t available everywhere. They may find that if they don’t buy it now, they won’t see it. They might actually start to see more of our products as special again, and worth having even at a higher price. Retailers and brands alike will of course tear their hair out when they find they have a hot product they can’t get any more of. But as they’ve adjusted to this new economy, they’ve probably started to manage for gross margin dollars and not just for sales. They might find that the adjustments to their operating structure they’ve made leaves them with more net income even with lower sales. 

Or maybe I’m just dreaming. I guess we’ll find out.  

 

A Little Random Perspective on the Financial/Market/Credit crisis

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Once upon a time, way back in 2003, an investment bank could only have leverage of up to twelve to one. In 2004, the Security and Exchange Commission gave five investment banks, and only five, the ability to leverage up to 30 or 40 times or so. Guess which five they were? I almost don’t want to bother listing them, because the list is so obvious. But for the benefit of all the readers who have just awakened from a coma they’ve been in for most of the year, they are Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs.

There’s a lesson there somewhere.

On my last posting on Zumiez, I wrote about how they had to classify their various investments under the terms of FASB 157. Basically, companies are required to “mark to market” their various securities. The problem arises when you know your securities are worth something, but you have no idea what because they aren’t trading. Should you carry them at $0.00?
Back in the early 80s, I was an international banker living in Sao Paulo, Brazil and having a hell of a good time. All the South American countries had defaulted on their debt to the American banks. It was a lot of money and if the banks had been required to “mark to market” all those loans, they would have been broke. A bank’s ability to lend depends on its capital ratios. If they have to write off all their loans, they have no capital and can’t lend. The Fed decided that would be bad so they let the banks keep those loans on their book, writing them off bit by bit as they earned profits to cover them. Eventually, they did get some payments. The loans were certainly impaired, but they weren’t worth zero.
 
This mark to market provision needs to be changed. Just because there’s not a market right this minute doesn’t mean the loans are worthless, and we shouldn’t treat them as if they are. And we can’t afford for our banks’ capital to all go away.
 
Which reminds me- as you hear this number of a bailout costing $700 billion being bandied about, remember that these loans do have some value. We’re not quite sure what the number is, but it’s not small and the net cost will eventually be a lot less than the gross number. In fact, because of all the fear out there, some killer investment opportunities in some of these securities exist and anybody who knows how to tell the good from the bad and the ugly should call me.
 
This morning I read that a local Seattle utility had only been able to refinance $28.5 out of the $30 million in debt it wanted to refinance. And it had to do it at 5.5% instead of 1.5%. The possibility that these additional costs would be passed through to utility customers if the credit markets didn’t get unstuck was mentioned, in case anybody out there thinks this might not impact them. If you’ve tried to get a credit card, mortgage, car loan or home equity line of credit lately and your credit isn’t pristine, you’ve probably already figured it out.
 
The discussion about the bailout is not about losing money. The money, however much it turns out to be, has already been lost. The discussion is about who’s going to absorb the loss. I’m afraid it will largely be you and me.
 
My reading of history is that the Great Depression happened largely because of a bubble that was left to correct itself and the paralysis that followed. Chairman Bernanke and Secretary Paulsen, no slouches when it comes to reading history themselves I’m thinking, have followed the drop in commercial paper issued, saw the sudden spike in its cost just in the last ten days, and decided this wasn’t something to fool around with. Hence, the package that’s before Congress right now. I’m hopeful it will be passed quickly and without a lot of other stuff tacked on.

 

 

Subprimes, Teen Spending and the Economy; Yup, It’s a U.S. Recession. Can’t Europe Just Ignore It?

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Daniel is my favorite economic indicator. He and his guys install wood floors. To get him to do some work at our house last summer, we had to book him two months in advance. When I called him to do another room not long ago he said, “How about next Tuesday?” He told me people were becoming more cautious and pulling back on projects.

With the Daniel Indicator in the caution zone, I decided it was time to look at the rationale for and impact of a U. S. recession for a second time in my writing career. The first time was, I think, in 2001 in the midst of the Great Skateboard Boom. Shops I talked with about any softening of their sales pretty much laughed uncontrollably after they realized I was serious. The recession was short and shallow and the only damage done in our industry was to my reputation for asking retailers such stupid questions.

I’m going to try again. Let’s look at some current U. S. economic indicators with particular attention to the subprime mess and its worldwide ramifications. Then I’ll review the latest stock market results for the publically traded big retailers as well as the companies that are specifically in our industry and see what the stock market thinks is going on.
     
Housing and the U. S. Economy
Consumer spending represents 70% of U. S. gross domestic product. Keep that in your mind while we talk about the subprime situation.
 
I need to describe in a few hundred words something people are writing books about. Since a picture is worth a thousand words, check out the chart below.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Source: “The Mortgage Pig in the Python” by John Mauldin. August 3rd, 2007. You can see the article at John’s http://www.2000wave.com/article.asp?id=mwo080307.   I recommend signing up for John’s newsletter.
 
What this says is that without people taking lots of money out of their rapidly appreciating homes and spending it, U. S. gross domestic product growth would have been a fraction of what was reported, especially in recent years. Now, here’s another cheery table from the same source.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
This table shows the dollar amount of adjustable rate mortgages that reset, or will reset, each month in 2007 and 2008. You can see that the peak isn’t until next, well, now. These resets are partly what lead to foreclosures because people suddenly have a payment they just can’t afford to make and the expected refinancing is no longer available. The other piece of the puzzle of course is the decline in housing values. It was just announced nationally that they were down 10.7% in major U. S. cities compared to a year ago. Of course in some markets, it’s worse than that. Much worse. And it isn’t over. I’ll discuss the impact below.
 
Okay, so sitting in Europe, why the hell should you care about the U.S. housing market?
   
The house price run-up started with low interest rates and a generally strong economy. It accelerated when banks stopped being banks.  It has historically been the role of banks to evaluate credit, make loans based on that credit, and then get paid back. Then they learned how to “securitize” loans. They bundles them all together, got one of the rating agencies to rate them AAA, and sold them to all kinds of investors who relied on that AAA rating. Suddenly, they’re earning their money from making the loans and servicing them- not from collecting them. They don’t care about the credit risk. Neither do the loan brokers or the appraisers or the escrow companies. Neither do the investors who are buying the bundled loans, because the rating agency says they are AAA. And through some financial magic, you can package some AAA rated loans with a bunch that aren’t AAA rated and still end up with an AAA rating on the whole security. Go figure that out.
 
Lots of money available, lots of fees to be earned, no worries about credit and everybody wants to get on the house buying band wagon. So they did. And, as you’ve read, many of the loans that financed this spree, especially in the last couple of years, were interest only, or nothing down, or no income verification, or/and adjustable rate. No worries about those low teaser rates on the adjustable loans though. When it’s time for the rate to adjust upwards, you’ll be able to refinance because of all the easy money and the fact that your house will be worth even more.   
Opps. Didn’t quite work out that way. Foreclosures have doubled since the 3rd quarter of 2006. The National Association of Consumer Advocates reports that four million subprime borrowers will see their monthly mortgage payments increase by an average of 40% in the next eighteen months.  House prices have fallen a little or a lot depending on where you live, lending standards have tightened as a result of loses on subprimes, and refinancing your mortgage has gotten more difficult, assuming you can even do it. If you put no money down and your house is worth less than at the time you purchased it, what’s the motivation for the bank to refinance the house since they know they won’t be able to sell the loan? You probably aren’t surprised to learn that the market for bundled loans, even ones that the raters say are AAA (whatever that means now) isn’t what it was some months ago.
 
As you know, this isn’t just impacting the subprime market in the U.S., but credit markets worldwide. And that means you. There’s no lack of liquidity- central banks all over the world have pushed cash into the system. There is a lack of confidence. Even perfectly good corporate debt has taken a hit. Between the various forms of these bundled securities and the derivatives associated with them, there’s real confusion about how big the risk is and who is holding it. How do you decide how much a security is worth if it’s not trading? The cash is there, but it’s not flowing. Banks that are caught in this have to raise capital and tighten lending standards. That’s as true for Union Bank of Switzerland as it is for Bear Stearns (May it rest in pieces). Basically, securitization let the U. S. subprime problems evolve into a global credit crunch.
 
Let’s say you were a hedge fund. You have $100 million in capital. The banks (in the good old days) would lend you $2 billion on that, leveraging you twenty to one. And they’ll lend it at, say, 5%. You turn around and lend it for, say, 6%. On the difference between the 5% cost of funds and the 6% earnings of the assets, you’re earning $20 million a year. You have a $100 million in capital, so you’re earning 20% a year on that. And hey, those securities are all rated AAA, so what can go wrong? Life is good.
 
But suddenly there’s a glitch in the system. The value of those securities you have falls one percent. You’re leveraged twenty to one, so you lose 20%, of your capital, or $20 million. As some panic and a little paralysis sets in, you’re easily and suddenly down 5% (Since these AAA securities are no longer trading, it’s actually kind of hard to know how much you’re down) and all your capital is gone. You get the margin call from hell. You can’t meet it, so the bank steps in and tries to sell the underlying securities. But there’s no market for them. The hedge fund is out of business and the bank is facing serious loses. Cue the lawyers.
 
You’ve seen some write downs of these securities and you’re going to see more.   But so what? All we want to do is sell a few decks, some pairs of shoes, and various jackets, t-shirts and beanies. Should we be worried that the consumer spending is going to slow is our little part of the world?
 
Stock Market Wisdom
 The University of Michigan Consumer Sentiment Survey in the U. S. fell to 70.5 in March, down from 80 in October. That’s the lowest reading in 16 years. The survey also reported that inflation expectations rose sharply, but I don’t suppose that’s a surprise to anybody who buys food and gas.
 
Meanwhile, consumer spending is falling, and the people who watch the stock market seems to think that decline is for real. The S&P 500 retail index (symbol $RLX) is down 25.6% during the nine months ended 31 March. The stocks of Dillards, J.C. Penney, Nordstrom, Kohls, Sears and Macy’s (large US mainstream retailers focused mostly on apparel) are each down between 22% and 48% over the same period. The average decline was 37.7%
 
But we can argue, and I think accurately, that those retailers don’t necessarily represent our market. Let’s look at some US publically traded companies that do. In alphabetical order, let’s see what’s happened to the stocks of American Eagle, Dick’s Sporting Goods, Ho t Topic, Pacific Sunwear, Quiksilver, Urban Outfitters, Volcom and Zumiez over the same period.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The average decline here is 33.1%. That’s not much better than the average of 37.7% for the general retailers. If you eliminate Urban Outfitter’s positive result, we’re actually worse with a decline of 44.2%.
 
Some months ago, when I did this exercise over a six month horizon, it looked like Wall Street expected the action sports market to hold up better than the general retail industry. It’s always been an article of faith in the industry that we would. Now, it’s not so clear.
       
It’s A Small World After All
When I spoke to U.S. retailers months ago, they were cautious, but hoping they didn’t need to be cautious. During trade show, I found this caution had become greater.   Before, they hoped to avoid a recession. Now, they hope it’s not too bad a recession.
That we’re going to have, or maybe are having, some slowing in consumer spending seems obvious to me. Especially since the morning paper announced that Starbucks saw a 1% falloff in store traffic last summer. We in Seattle take stuff like that seriously and that seems as good as the Daniel indicator I started this column off with and that we’re somehow protected because we sell fun.
How vulnerable is our industry? The evidence says we can expect some impact- more than it looked like a few months ago. First, we hoped the problems would be limited to the U.S. housing market. Then, to the U.S. economy in general. Then we hoped that the rest of the world would make up for U.S. economic weakness. But unfortunately it looks like the process of deleveraging the world (which is a good and necessary thing in the long run) is a worldwide phenomenon.
 
If you run your business carefully, and you have a strong balance sheet, you’re going to find yourself with opportunities while others struggle. Recession or not, people want to have fun.

 

 

Spy Optics’ 3/31/07 Quarterly Report: Lemonade Out of Lemons

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Until recently, it’s been kind of a tough road for Spy Optics (publically traded under the corporate name of Orange 21). Though sales grew from $22.3 million in 2002 to $42.4 million in 2006, profits of $911,000, $500,000, and $807,000 in 2002 through 2004 gave way to losses of $1.7 and $7.3 million respectively in 2005 and 2006. Gross profit, at 51% in 2002, had fallen to 41% in 2006. In addition, there was the expense of being a public company, the distraction of a shareholder lawsuit, and the usual stresses associated with an acquisition- in this case their primary manufacturer located in Italy.

Apparently the Board of Directors got tired of this and over the last year a number of positive things have happened. The lawsuit was settled in early May. There have been a lot of personal changes over the last year or so. Mark Simo, the Chairman of the Board and former CEO, has stepped in as CEO, replacing former CEO Barry Buchholtz who was sent over to run the Italian operation (Hmmm. Feels a bit like, “You bought it, you go run it!”) Fran Richards, formerly of Transworld and Future USA came in as VP of Marketing in April of 2006. The old CFO resigned (I don’t quite know if that should be in quotes or not) and was replaced by Jerry Collazo in August of 2006. He’s a CPA with 20 years of diversified financial and accounting experience. They hired Jerry Kohlscheen as Chief Operating Officer giving them another 20 years of experience in manufacturing and operations.
 
So, what has all this high powered talent been doing exactly? A lot, I’d say judging from their recent quarterly releases.
 
 They must be making a lot of money now, right? Nope. Still losing it. Almost $1.8 million in the quarter ended March 31, 2007 (they were late filing the report) on sales of $9.4 million. But I am impressed with the way they are losing it. Okay, there’s no good way to lose money. But a lot of what they are doing, which is costing money, has the feel of getting their house in order. Let’s look.
 
They reported that gross profit increased to 52.2% from 48.1% in the same quarter the previous year. It was indicated that the increase was “primarily due to sales during the three months ended March 31, 2007 of some inventory items that were previously written down and efficiencies achieved at LEM S.r.l.  LEM is the acquired Italian manufacturer.
 
This particularly increase in gross margin may be partly a onetime event, but it shows that they are getting their inventory in order and improving operations at LEM.
 
Sales and marketing expense was up 9% while sales didn’t budge. But two-thirds of this increase was the result of additional depreciation on point of purchase store displays. Why is this good? First, it’s a non cash expense. More importantly, it implies a realistic approach to their numbers and balance sheet values much like the inventory write down mentioned above. That’s great to hear. Ever try and run a business without good numbers?
 
General and administrative expenses were up 17%, or $400,000. But half of that was employee related compensation in the US. Yes, these new people who are going to do wonderful things want to be paid. $100,000 was severance for employees at LEM- part of getting that operation working efficiently I assume. Another hundred grand was getting some new systems up and running. Like I said, you can’t run a business without good numbers. They also cut their legal and audit fees by $300,000 but had some additional expenses for depreciation and bank fees related to a new loan agreement.
 
See the trend here. Higher expenses- yes. But spent on the right things.
 
This continues when they talk about warehouse expense being higher because of air freight resulting from manufacturing delays. Well, nobody likes to pay air freight, but the only thing worse it not getting the product to the customer on time.
In the words of their Chairman, Mark Simo, “We continue our efforts to stabilize the business and position it for long term growth.” That’s what it looks like to me.

 

 

K2’s 2006 Annual Report

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      For the longest time, I thought about K2 as a ski and snowboard company. But that’s ancient history. They call themselves a “premier branded consumer products company” and divide their business into four segments: Marine and Outdoors ($407.6-million in 2006 sales), Action Sports ($421.4-million), Team Sports ($383.4-million), and Apparel and Footwear ($182.3-million). That’s a bit over $1.3-billion in total 2006 revenues.

      Snowboarding, obviously, is included in the action-sports segment. And now, going directly to the discussion of that segment, I’m going to tell you exactly how each of their four snowboard brands are doing, right?
      Not hardly. They don’t provide a breakdown beyond those four segments. The only piece of information I was able to find was in footnote thirteen of the financial statements on page 92 of their 10K where they note that one-third of the action-sports segment (around $140-million) was snowboarding. They also note that one-third of the apparel and footwear segment revenue ($61-million) was skateboard shoes, apparel, and accessories.
      If only fifteen percent of K2’s 2006 revenues were in what we would all call action sports, why am I writing about them? Two reasons. First, $200-million still isn’t small potatoes in the action-sports industry as it has traditionally been defined. Second, in discussing their business, they say a number of insightful things about their strategy and the industry’s evolution that are worth highlighting.
      Let’s start by remembering what K2’s product lines include. Snowboarding and skate we’ve already mentioned, and we all know about their ski business. But they are also selling snowshoes, paintball products, baseballs and gloves, softballs, fishing kits and combos, fishing rods, personal flotation devices, hunting accessories, all-terrain vehicle accessories, inline skates, Nordic skis, and snowshoes. I think that covers it.
      K2’s management thinks that “the growing influence of large format sporting goods retailers and retailer buying groups, as well as the consolidation of certain sporting-goods retailers worldwide, is leading to a consolidation of sporting-goods suppliers.” As a result, they expect retailers to buy increasingly from fewer larger suppliers. This, according to K2, will allow those retailers to operate more efficiently and cut their costs. Those few larger suppliers will be “those with greater financial and other resources, including those with the ability to produce or source high-quality, low-cost products and deliver these products on a timely basis to invest in product development projects and to access distribution channels with a broad array of products and brands.”
      In its market, including the action-sports business but obviously going far beyond it, K2 thinks size matters. Their general strategy of improving operating efficiency, maximizing how they utilize their distribution channels, leveraging existing operations and “complementing and diversifying its product offerings” reflects this. 
      The second part of this strategy is making acquisitions “of other sporting-goods companies with well-established brands and with complementary distribution channels.” So far, they have made two in 2007. There were three in 2006 and two others in 2005. They note that much of their revenue growth in 2006 came from acquisitions made in 2003–2006.
      There are two things they don’t talk about—opening retail stores and expanding into the fashion/apparel business. K2 is largely a hardgoods (I think a baseball glove is a hardgood) company that believes an increasing percent of its sales and profits will come from large retailers and that those retailers will control more and more of the market. Fifteen percent of its sales were to Wal-Mart in 2005 and 2006. Given their strategy and analysis of how the market is evolving, that makes perfect sense.
      And now, three weeks later, after this story is long gone to the editors and basically out of my memory, but about one day before it was too late to do anything about it, K2 goes and sells itself to Jarden , who had revenues of $3.8 billion in 2006 (see the related story in this issue). Jarden is a “leading provider of niche consumer products used in and around the home.” They have a huge stable of brands, many of which we all recognize.  They divide their business into three segments- branded consumables, consumer solutions and outdoor solutions. K2 will become part of their outdoor solutions and snowboarding will become an even smaller piece of the whole pie. Jarden’s growth strategy “is based on introducing new products, as well as on expanding existing product categories which is supplemented through acquiring businesses with highly recognized brands, innovative products and multi-channel distribution” Go back and review K2’s strategy and market analysis and you’ll see why the two companies thought it made sense to get together.
 
      I’m not sure our comfortable little action-sports niche is still little, or comfortable, or a niche, but sitting in it we have tended to make fun of in-line skates, team sports and, not very long ago, skis. K2 doesn’t care. They’ve just looked at where they think the industry is going and have devised a strategy to respond to that evolution—which, as far as I know, is what management at any company is suppose to do.
      Okay, you’re not K2. There is no sale of fishing poles in your future. But if you think their analysis of the broader sporting-goods market and its retailers is valid, what does it mean for your brand? Snowboards, skateboards, and surf boards are, I’m afraid, sporting goods. They are not isolated from these trends.