Cash Flow Revisited; Why Hardly Any Successful Business is Just Snowboarding Anymore

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I know it’s because of crossover, and the mainstreaming of action sports, and because we’re selling to parents as much as to kids. I know all that. Largely, I believe it. I just did my occasional and not nearly frequent enough sojourn into a bunch of local snowboard retail stores, big and small, and looked at what they’re selling. Snowboards and snowboarding equipment, apparel and accessories- sure. But they are also selling skateboarding, surfing, skiing, wakeboarding, bikes, roller blades, tennis and/or some others depending on the time of year.

 
Have they become as diversified as they are because of “the market?” Yes, “the market” demands it. But lurking in the lichens is the financial requirement of businesses that are highly competitive and selling products that are awfully similar to each other in a given product category, differentiated largely by the brand marketing strategy. Bottom line is that the less seasonal your business is, the more money you can expect to make.
 
Let’s take a journey into fantasy land and take a look at a couple of hypothetical business that are in snowboarding (retailers or manufacturers- makes no difference) and see how their financial equations differ with the seasonality of their sales. I know you already know that it’s bad to be seasonal, and good to sell all year around. But the extent of the difference on the two company’s financial results-especially the return on investment- may surprise you.
 
Meet the Contestants
 
Seasonal Enterprises (SE) and Year Around Ventures (YAV) both sell snowboard hard and soft goods. But while SE sells almost exclusively snowboarding and snowboard related products, YAV has diversified into other action sports.
 
Both SE and YAV sell $12 million a year. SE does all its business in five months. YAV boringly sells $2 million a month, month in and month out. 
 
At the end of the year their income statements, down to the Income before Interest and Taxes Line, look identical.
 
Net Sales                                                                   $12,000,000
Cost of Goods Sold                                                 $ 7,800,000
Gross Profit                                                               $ 4,200,000 
 
Operating Expenses                                               $ 3,600,000
 
Income Before Interest and Taxes                        $     600,000 
 
Now, $12 million is kind of an awkward revenue number. It’s much more than your typical specialty shop sells, and it’s probably less than a snowboarding brand needs to do in revenue to break even (I think that number is maybe a little north of $20 million unless you have a very well established brand and market niche).
 
Just for your information, in their most recent complete years, Vans, K2, and Pacific Sunwear had gross profit margins of, respectively, 43.5%, 31.1%, and 33.5% of sales. Operating expenses, respectively, were 35.7%, 25.3%, and 22.7%. Unfortunately, no specialty shops publish their financial results.
 
This hypothetical income statement is kind of a cross between a retailer and a brand. The goal, however, is to make a point so allow me a little creative license as I set the stage to make it.
 
Balance Sheets and Working Capital
 
Working capital is the money you have invested in a business so that it can operate.   Rent, salaries, product costs all of which are incurred before you sell anything represent working capital invested in the business. To the extent that you can get terms from the supplier of the product or service you are using, your working capital requirements can be reduced.
 
The balance sheet shows, as a point in time, the financial viability of a company and its ability to finance itself. Let’s compare the working capital and balance sheet situation of SE and YAV.
 
Seasonal Enterprises
 
SE, you will recall, does all its business in five months. But it has to operate for twelve months, and buy the product it sells in a way that it has product to ship during its selling window. Assume its total expenses of $3.6 million are spent evenly over the year- $300,000 a month. In practice, selling and marketing expenses would be weighted towards its selling season.
 
It’s got to buy its product for a total of $7.8 million. Remember SE is getting some terms from its suppliers, but it may also be giving some terms to its customers. Where does that all net out in the real world?    Obviously it’s different depending on whether you’re a retailer or a manufacturer.
 
SE’s going to spend $300,000 a month for seven months before it sells a thing. It will probably collect some money from the previous season during this period, but it will also have some expenses that go out during its selling season before much comes in the door. If, then, it has to borrow $300,000 a month for seven months it will have $2.1 million in loans just for operating expenses by the time it starts selling. And of course you won’t pay it all off the day you start selling.
 
Then there’s the $7.8 million in cost of goods sold SE has had to finance. For how long? Shall we say four months?
 
The last prime lending rate cut was to 6.5 percent on August 22nd. Just to make my calculations easier, let’s say you are borrowing at 10 per cent. I know that may be high for some borrowers, but if we think about credit card fees (which I consider basically financing costs) letter of credit fees, commitment fees, etc. maybe it’s not too far off when you look at your real cost of borrowed capital- especially for smaller businesses.
 
If you assume you pay off the loan for operating costs completely literally the day you start selling, your interest charge would be $70,000. It’s more realistic to say you pay it off over a couple of months at best, so let’s say it’s really $90,000.
 
At 10% for four months, financing the cost of goods sold comes to $240,000. Total interest expense, then, is $350,000.
 
After interest, pretax income is $250,000. Assuming a 30% tax rate, the business earned $175,000 for the year, or 1.46 percent of sales.
 
Year Around Ventures
 
This is a little easier to explain. They just do $2 million in business each month. No big inventory buildup. No operating expenses to finance without any income.  They get some terms from their suppliers, and, with luck and depending on the type of business it is, may even collect before they have to pay. They don’t need millions of dollars in temporary working capital just to get through the business cycle. All they have to finance, more or less, is a month’s worth of expenses or maybe a little more. Their interest expense? Hardly anything. Maybe if they’ve got any sort of balance sheet at all, nothing. If that’s the case, and with the same 30 percent tax rate their net income for the year is $420,000, or 3.5% of sales.
 
Balance Sheets and Rates of Return
 
Income statements don’t happen in isolation from balance sheets. On your balance sheet, you (hopefully) show some equity- the total of the investment in the business plus the profit you’ve made, less any losses you’ve incurred, and less any dividends you’ve paid out. The larger the number is, the stronger the business is, and the less money you should have to borrow. So, you can truthfully exclaim, “If I’ve got a whole bunch of equity in my business I don’t have to borrow squat and I’ll have no interest expense! My return on sales will be the same whether I’m SE or YAV.”
 
True, but that’s a misleading and incomplete analysis. The financial issue is always what are you earning on the money you have invested (the equity in the company, more or less) and how much risk are you taking? Most simply stated, return on investment is net income divided by total equity. YAV, due to its year around sales, doesn’t need much equity to have basically no interest expense. It’s probably got a great return on equity, and because of the diversification that allows it to sell the same amount each month, it’s risk is lower.
 
SE, on the other hand, has to have a pile of equity if it’s going to eliminate its need to borrow money. If it does that, it will have the same net income at YAV, but it’s return on equity will be much, much lower. And its seasonality makes its risk higher.
 
As you consider your return on equity, be aware that if you’d invested your equity in an intermediate term bond fund for five years, you would have earned around eight percent a year before taxes. Over the last twelve months, with the Fed cutting rates, you would have earned something like thirteen percent. We can probably agree that the risk in an intermediate term bond fund is less than the risk of an action sports business.
 
In the market we’re in right now, is there any competitive advantage to being a “snowboarding only” business? I can think of a couple of possible exceptions but generally, I’d say probably not. If there was, it would be financially rewarding from a return on investment point of view. Isn’t it interesting how the industry’s requirements for success from a marketing and a financial perspective have come together?

 

 

Product Selection and Merchandising: The Blackjack Analogy

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I guess this is a little incestuous, but the idea for this column came from reading Sharon Harrison’s “Ten Shops, One Question” in the June issue of this prestigious rag. The question was “What type of bearings are skaters in your shop buying?”

 
What struck me was how each retailer had similar, but different answers. It made me think about how they selected and presented skate products in their shops. If you read between the lines of that article, there were, I thought, some lessons and ideas that could be generalized for decks, shoes, wheels, trucks and clothing as well as bearings.
 
What They Said
 
“It’s the brand.” It’s the price” (low or high). “It’s the packaging.” “It’s the ABEC rating.” “It’s our service and reputation.”
 
Obviously, there are some customers who want the lowest price. Period. Some just want the cool package. For quite a few, it’s the brand that dominates the purchase decision. 
 
But there’s a lot of ambiguity, and purchasers often fall within those extremes. They’d like a certain brand, as long as it’s not too expensive. They want to keep the package, so they’ll pay a bit more. They got to have what their friends’ have- unless you’re out of that in which case you can probably transition them to another product.
 
About a hundred years ago, in the first marketing book I ever read, a guy named Kotler introduced me to the concept of the four Ps in marketing; product, price, place, promotion. In traditional marketing at least, they are the cornerstone of how you sell any product. And you’ll notice they correspond pretty well to what retailers said motivates buyers of skateboard bearings.
 
I never miss an opportunity to remind us all, including me, that we may all love skateboarding, but from a business perspective it’s, well, just business. At its core, the process of choosing, pricing, merchandising and selling the product is the same as in every other business. Enthusiasm and commitment is part of business success, but so is realism and objectivity. We can’t just believe what we would like to be true.
 
But I digress. I know (hope?) there was a point I was trying to make. Maybe if I keep writing it will come back to me.
 
Ambiguity- How To Utilize and Minimize It
 
There’s good news and there’s bad news. There always is. On the one hand, you know your customers’ basic motivations. You understand in a general sense why they buy what they buy. On the other hand, for the individual customer, those motivations are often pliable depending on the choices presented to them at a given moment. If you understand your customer you can help them make good choices. I almost used the word “manipulate,” but that has a nasty connotation to it. I’m suggesting you can support the customer in making decisions that are good for him and for you. That’s not a bad definition of successful retailing.
 
Casinos love people who play blackjack but know nothing about the odds. They make a whole lot of money from that kind of person. That’s why they give you free drinks. They also like, though not as well, the person who is sophisticated enough to more or less play the so-called “neutral strategy.” The casino will consistently win around one and a half percent from that person.
 
They hate the card counter. She will minimize her risk and make big bets at the right time and, over the long run, take money from the casino. She won’t win all the time. She may not even win half of the time. But when she does win, it will tend to be big, and that can make up for a lot of small losses. She doesn’t have perfect information. But she has the best information she can get and uses it to control how she plays. That’s not a bad strategy in the stock market either.
 
I want to suggest you can use a similar strategy in skate retailing.
 
The ambiguity of customer motivations isn’t a hell of a lot different from the ambiguity of how the cards will come out in blackjack- even when you’re counting. A single blackjack hand is a statistical, probabilistic result. A single customer’s decision is not. But a lot of customer decisions, taken as a group, are.
 
Goals
 
What’s the goal of blackjack? Easy- to make money. Right? I can’t argue with that, but I’d point out that setting a goal of making money doesn’t tell you what to do or how to go about it. If you set a goal of making your bets according to the count of the cards, you will make money in blackjack.
 
In retailing, the goal of making money suffers from the same shortcoming- it doesn’t tell you what to do. Every time I look at a retail situation, I end up suggesting a focus on the same two goals:
 
1.    Get the customer to come back.
 
2.    Maximize your gross profit dollars.
 
By doing these two things, you maximize your chance of making money.   
 
Gross Profit Dollars
 
Where do your earn the most gross profit dollars by percentage and total dollars by product category and by brand? Do you communicate that to everybody who works in your shop? Do you make your purchasing decisions with that information in your hand?
 
Yeah, yeah, I know- “Well, we make most of our money on shoes and clothing.” That is not an acceptable answer. Neither is:
 
  • “Hey, I’ve been in this business a long time and have a good gut for it.”
  • “We just buy what the customer wants.”
  • “We don’t have the system to track that.”
  • Etc., etc., etc.
 
That’s all a bunch of fatuous blather and if you’re taking anything other than a quantitatively rigorous approach to figuring out where you make your gross margin dollars, you’re no different from the guy who sits down at the blackjack table in Vegas with no knowledge of the odds, has five drinks and bets in the dark. You may have fun, but it’s not likely to last for long.
 
Getting Customers Back
 
I don’t get into enough shops, but I have never gone into one and gotten a good answer to, “What factors are most important to your customers in making their buying decisions?” Everybody names all the same factors, but nobody can rank or quantify them in a valid way. What I’m always hoping for is “Well, we don’t talk to every customer, of course, but the data base of responses we’ve kept tells us that 32% come in here because they know us and we’re conveniently located. 27% know us as a shop that has the brands they want and the rest are guys trying to pick up the cute girl we’ve got on the floor.”
 
Why haven’t I ever gotten an answer like that? Because nobody asks their customers in a systematic way and tracks the answers. The more customers you ask the more valid the responses become. To go back to the blackjack analogy one more time, it’s a lot like a card counter that doesn’t keep track of how many ten value cards are left in the deck. He has no idea how big a bet to place or when to place it.
 
Now we’re getting somewhere. It’s always nice when I’m writing one of these and that finally starts to happen. There you are sitting with concise information about where you get your gross margin dollars, and some solid insights into your customer’s motivations. What might you do with that information?
 
First, recognize that there’s some inevitable conflict between giving your customers what they want and maximizing your gross profit dollars, especially where there’s a lot of price sensitivity. Welcome to specialty retail, where your success as a shop will depend on your ability to position yourself and the brands you carry so that customers don’t just focus on price. 
 
Perhaps you’ll move some product around to highlight high margin, fast moving products. Are there brands being asked for you aren’t carrying? When you’ve been out of, say, a specific deck, has the customer bought something another one and does that tell you anything about how many brands you really need to carry? If you do a lose some sales because you don’t carry as many brands, but sell some higher margin stuff instead, are you better or worse off? Maybe you should forget all this and just hire more cute sales girls.
 
Let me share a little secret with you. What I’ve been trying to do with recent article is to help shop owners prepare themselves for a recession if it happens. Last issue, I think, I suggested a few steps you might take to prepare yourself for a slowdown that made good business sense even if one doesn’t happen. This article has a couple of more. As I write this, the Federal Reserve has come out with its “beige book-“ a regional anecdotal survey of economic conditions. Manufacturing is still suffering, but the gloom is spreading to other sectors. Consumer spending is looking like it might falter and the stock market shows no signs of reviving.
 
Nothing I’m suggesting is a bad idea even if skateboarding continues to boom. Try it- you’ll like it.

 

 

A Good Snow Year Does Not Make Us Heroes of Management; A Minor Reality Check

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1980- Michael Porter, the Harvard strategy Guru published Competitive Strategy.   In it, he discusses how industries change, and how companies have to change, as they transition from growth to maturity.

 I want to look briefly at what Porter says stereotypically happens during this transition and see how it applies to the winter resort business. Like all industries, this one has become insular- we talk to each other too much. Yet basically, we are experiencing the same trends that every other maturing industry faces. Maybe if we realize we aren’t different or immune, it will make it easier to respond to these inevitable and ongoing changes. Twenty years working with companies in transition has convinced me that the sooner you respond, the easier and more successful your transition will be. There must be something to what Porter writes, because I’ve found him relevant to every industry I’ve worked with.
 
He recognizes, of course, that maturity doesn’t happen at a fixed point in an industry’s development, and that it can be delayed. He also notes that rapid growth can return due to strategic breakthroughs, and that mature industries can therefore go through more than one transition to maturity.
 
Here are eight things he says happen during this transition.
 
  1. Slowing growth means more competition for market share.
  2. Firms in the industry increasingly are selling to experienced repeat buyers.
  3. Competition often shifts toward greater emphasis on cost and service.
  4. There is a topping-out problem in adding industry capacity and personnel. Thus companies’ orientations toward adding capacity and personnel must fundamentally shift and be disassociated from the euphoria of the past.
  5. Manufacturing, marketing, distribution, selling, and research methods are often undergoing change. The firm is faced with the need for either a fundamental reorientation of its functional policies or some strategic action that will make reorientation unnecessary.
  6. New products and applications are harder to come by.
  7. International competition increases.
  8. Industry profits often fall during the transition period, sometimes temporarily and sometimes permanently.
 
Does any of this look familiar? Can we just for a moment see through the industry’s historical momentum and inbred myopia to recognize that this is us? I lived through it in the snowboard industry. I’ve watched it in computers, automobiles, and funeral homes. It’s happening right now in retail, telecommunications and, by the way, winter resorts.
 
The winter resort business is no different from any other industry in how it responds to maturity and consolidation. One good snow winter doesn’t change that.
 
At best, we’re growing slowly. Maybe demographics will change that. We’re sure as hell selling to more repeat buyers, and they mostly want to get more and spend less.
 
Cheap season passes are competition based on price no matter how you rationalize it. That’s not to say there aren’t valid business and competitive reasons for some resorts to utilize them. But hopefully, those reasons are consistent with a carefully thought out business plan- not just a response to needing to improve cash flow.
 
If you’re adding capacity and personnel and our industry growth rate doesn’t pickup, then the only way you succeed is by taking market share from other players. I’d say we’ve turned the corner as far as euphorically adding capacity and personnel goes. But competitive conditions, in the overall leisure as well as in the winter sports market, seems to require resorts to invest in new facilities and capabilities just to stay even with other resorts.
 
If you’re big enough and well enough capitalized to diversify into real estate, golf courses, conference centers, retail, theme parks or whatever then perhaps at some level it can be business as usual for you. If you’re strictly a winter resort and you make most of your money from lift tickets, then you are going to have to do business better than you’ve done it before. Tubing, snow skates, snow bikes and mini skis can all add some incremental revenue. But there’s not another snowboarding on the horizon. Like the man said, new products and applications are harder to come by unless you can change what you are.
 
What can you say about profitability when the before tax profit was only eight tenths of one percent (0.8%) in the 1999-00 season? That’s down from 5.8% the previous season (that season was six days longer). Leading short term government bond mutual funds have one year returns of eight to twelve percent with just a bit less risk.
 
If margins are lousy and competition extreme, it’s hard to justify investing in the winter sports business because of its seasonality and the financial implications of that.  On the one hand, you’d really like to operate the business with somebody else’s money, because you don’t want to tie up all year equity you really only need in the business for four or five months. On the other hand, lacking a good balance sheet and reserves for bad snow years, which I expect we all agree will continue to happen, nobody will lend you the money you need to get through the season, because they see it as an equity risk. And if they do lend it to you, and your margins and/or total revenue are too low, the interest expense will kill you.
 
You know from the number of resorts that have reported financial problems that this is a very real problem. On the other hand, there are a significant number of resorts that make money year after year. They are big and they are small and they are all over the continent. They are mostly privately held so you don’t hear much about them. Besides, a financial and management crisis is much more interesting than a low key, boring, resort that just goes along knowing who their customers are and meeting their needs in consistent and predictable, but changing, ways.
 
How do they do it?
 
In any industry I’ve ever seen, there are always a few who are in the right place at the right time. I’ve got nothing against luck, but it usually doesn’t last. What I expect you’ll find if you talk to the people running these resorts (or any manager of a company succeeding in a maturing industry) is that they mostly never heard of Michael Porter. They do know who their customers are and why they come to their resort. They know whom they compete against. They have good management information systems, and their finger is on the pulse of their cash flow. They have had to deal with most of the issues listed above, and continue to deal with them.
 
But not in a crisis mode. Not with the bank threatening to pull the line of credit and uncertainty about how they will make payroll next week. They were more or less open-minded and aware of the changes that were happening. They have responded, and continue to respond, over a period of years with changes in how they do business. For the most part, no single change represented, by itself, a life or death issue. But the cumulative impact was dramatic.
 
Paraphrasing Les Otten, “They didn’t have a problem- they had an opportunity.” It was an opportunity because they saw the need for change and dealt with it before it was paralyzingly threatening. They never had to step outside their box. They just extended it a little at a time.
 
Don’t feel comfortable because it snowed.