Billabong’s Annual Report; Why Their Retail Strategy is a Match to the Economic and Industry Environment

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Billabong’s annual report and associated documents released around it contain a wealth of information. Some of the questions asked by the analysts in the conference call, and the answers provided, were particularly interesting. But equally important, there are some insights into general market conditions, the evolution of the retail environment and issues with Chinese production. It’s a lot to cover. Let’s get started.

Strictly By the Numbers

First, let’s set the foreign exchange stage since all the numbers I use are in Australian Dollars (AUD) and Billabong’s management talks a lot about the impact of currency fluctuations. On June 30, 2010 one US dollar was worth 1.167 Australian dollars. A year earlier, on June 30, 2009, one US dollar got you 1.24 Australian dollars. That’s a 5.9% strengthening of the Australian currency over 12 months. It wasn’t a regular change. The strengthening was greater during the first six months than the second.
 
Currency fluctuations (it happened with the Euro as well) mean that reported results become harder to interpret. You can sell, for example, more in a country, but because your home currency strengthens against that country’s currency, you show lower revenue in your home currency.
 
Some people, including me, have made the argument that, as an investor in Australia, who invests in AUDs and spends AUD, all you care about is the AUD result. I still believe that, but looking at constant currency (as Billabong and other companies do) can help you evaluate comparative performance between periods.
 
Okay, enough. If you’re curious about the impact of exchange rates, the first Market Watch column I ever wrote in 1995 was on the subject. You can read it here. http://jeffharbaugh.com/1995/06/13/foreign-exchange-management-whats-all-this-brouhaha/.
But you probably don’t care and wish I would get back to Billabong, so I will.
 
Revenue fell 11.2% for the year ended June 30, 2010 (they were flat in constant currency) to $1.488 billion (In Australian dollars, remember). “European sales of $344.0 million were up 5.2% in constant currency terms, but down 11.3% in reported terms. Sales of $712.6 million in the Americas were down 1.2% in constant currency terms, or down 14.8% I reported terms. Australasian sales of $425.7 million were down 1.9% in constant currency terms, or down 4.2% in reported terms.”
 
“Gross margins strengthened to 54.4% from 53.3% in the prior year, reflecting a less promotional retail environment, primarily in the USA.”
 
Cost of goods fell 13.4% to $676 million. Selling, general and administrative expenses were down 10.6% to $470 million. Other Expenses were down from $125 to $121 million. If I’m reading my footnote 7 on page 69 of their Appendix 4E right, that includes amortization and depreciation, rental expenses, and minor impairment charges. That’s enough time spent on that.
 
Finance charges were down from $38.6 to $25.2 million, mostly as a result of the reduction in borrowing that the capital raise in May 2009 permitted. Pretax profit was off slightly from $206 to $203 million and net income was $145.2 million, down from $152.8 million.
 
Profit, if they didn’t have all that pesky exchange rate movement (in constant currency that is) would have been up 8.1% over the previous year. If they excluded last year’s impairment charge expense of $7.4 million, it would have been up 3.1% in constant currency terms. And if they hadn’t had to expense $2.7 million of post-tax acquisition costs under new accounting rules that last year they could have capitalized, their net profit after tax growth in constant currency would have been 5%.
 
So how much did they make? Every year companies have “stuff” that isn’t consistent with last year. Hey, I’ve got an idea! How about we stick with the $145.2 million Australian dollars at the bottom of their income statement? That seems like a reasonable thing to do, though maybe a little old fashioned. There can come a point where explanations don’t lend clarity, because none of them are “right.” And none of them are “wrong.”   And there are new explanations every year. If I had my way, I’d like to see five years of summary financial statements under the current year’s accounting standards. Then meaningful comparisons would be easier.
 
Billabong sees 2010/11 as a “transition year.” We’ll talk about what they mean later. They expect NPAT (net profit after taxes) to grow from 2% to 8% in constant currency terms. I completely agree with them forecasting in constant currency, by the way, because nobody has any idea what exchange rates are going to do. They expect an improving outlook in the Americas, continued strength in Europe, but a challenging market in Australia. In fact, Australian forward orders are down 20%, and Billabong is expecting a 20% reduction in sales there in fiscal year 2011.
 
EBIT (earnings before interest and taxes) is expected to be flat. They don’t say if that’s in constant currency or not. I think it is. They also expect higher interest costs and a lower tax rate. So if all this is in constant currency, and EBIT is flat and interest higher, that seems to suggest that all their NPAT growth will be due to a lower tax rate.
 
Over on the balance sheet, things are pretty much fine. My hat’s off to Billabong for raising capital in 2009 under not the most favorable conditions. It gave them the balance sheet to consistently pursue their strategy even during tougher economic times. The current ratio fell over the year from 3.3 to 2.45, but that’s plenty strong. Total liabilities to equity improved a bit from 0.89 to 0.82. In August of 2010, they refinanced and increased their bank lines to give them lower margins and more availability. The line went from US$ 483 million to US$ 790 million.
 
The increase in the line isn’t necessarily targeted on further acquisitions, but they won’t rule one out. One other use of the line will be to pay certain of their acquired companies’ bonus payments that are coming due.
 
I am a little curious about their inventory and trade receivable numbers. As you remember, total revenue was down 11.2%. Inventory fell 5.2% to $240 million and trade and other receivable was down only 1.7% to $398.4 million. It’s not that I’d expect inventory and receivables to fall in lock step with revenue, but I’m curious enough to read a few foot notes.
 
The first thing I notice in Note 1, paragraph k is that “All trade receivables…are principally on 30 day terms. Boy, good for them. I know a lot of brands who’d love to have mostly 30 day terms. They had a reserve for bad debt of $23 million at the end of last year. It’s down to $21.5 million at June 30, 2010. Billabong thinks they have problem receivables of $26.1 million, but expect to collect some part of that which I’d expect too. Of those, $14.4 million are over six months old. $26.1 million represents 6.36% of total receivables. “The individually impaired receivables mainly relate to retailers encountering difficult economic conditions.” What a surprise.
 
Note 10, paragraph b then goes on to discuss trade and other receivables that are “past due but not impaired.” They’ve got $82.8 million of these which I guess is in addition to the $26.1 impaired receivables discussed in the paragraph above.
 
I’m a bit unclear on what “past due but not impaired” means. Of this $82 million, $17 million is more than 6 months past due. That sounds pretty impaired to me. All they say is that “These relate to a number of independent customers for whom there is no recent history of default.” If they’re six months past due, I’d tend to characterize them as having a very recent history of default.
 
This number is up from $68.5 million at the end of the last fiscal year. It can’t be that there are $82 million of additional problems accounts because that would be a huge number and nobody asked about it in the conference call. So could you ladies and gentlemen at Billabong please help us stupid Americans who don’t understand Australian accounting and provide some more detail?
 
The Remuneration Report
 
This report, part of the Appendix 4E, lays out who gets paid what and how. But what impressed me were the remuneration principles on page 15. Here they are:
 
“Our remuneration principles
 Provide a market competitive reward opportunity;
 Apply performance targets that take into consideration the Group’s strategic objectives, business plan performance expectations and deliver rewards commensurate for achieving these objectives and targets;
 Ensure executives are able to have an impact on the achievement of performance targets;
 Align executive remuneration with the creation of shareholder value through providing a portion of the reward package as equity and using performance hurdles linked to shareholder return;
 Encourage the retention of executives and senior management who are critical to the future success of the Group; and
 Consider market practice and shareholder views in relation to executive remuneration, whilst ensuring that executive remuneration meets the commercial requirements of the Group.”  
    
Remuneration is divided into three parts; fixed, short term, and long term. The short and long term parts are both “at risk” and, in fact, parts of them haven’t been paid this year or last because certain agreed upon performance objectives weren’t achieve. The “at risk” portion varies by executive, but it’s not less than 20% of compensation for anybody and is typically higher.
 
This is very powerful stuff and I think goes a long ways to explain Billabong’s long term success. It aligns shareholders with management and doesn’t over emphasize short term results. Somebody’s put a lot of work in to developing and implementing this system, and I hope they got a lot of remuneration for it.
 
China, Production, Supply and Prices
 
Every company is talking about issues with labor availability, costs, and supply in China.  Billabong is no exception. Approximately 50% of their world production is in China. CEO O’Neill mentions a conversation he had with one supplier who was struggling to get workers. He also noted that the minimum wage went up 20% in May and that the currency has strengthened slightly. He points to cotton prices as being at a 13 or 14 year high and that there’s almost a shortage of it. Shipping container prices being triple what they were 12 to 15 months ago and freight prices are up as well.
 
He states, “I think that every apparel company you talk to would say that at some point over the next six to nine months that some apparel prices will have to rise.” I agree.
 
They are responding by looking for other production opportunities. Currently, they produce in approximately 27 countries. He mentions more production in South America and that “Europe’s actually began producing some items, fast turnaround items, back in places like Portugal.”
 
The Retail Environment
 
Company owned retail stores (380 at year end) contributed 24% of global sales for the year. “…in growth terms, our company-owned retail outperformed wholesale. This shows the benefit of having the extra opportunity to get the right product in front of the consumer.”
Billabong’s focus on retail isn’t new. They said many of the same things in their half year report. You can see what they said in the analysis I did at that time: http://jeffharbaugh.com/2010/02/25/billabongs-semi-annual-report/.
 
In North America, revenue from the 111 company owned stores was up 9.2% in constant currency terms. In Europe, the 103 stores were up 18.2%, again in constant currency. The number was 5.9% in Australasia with 166 stores. EBITDA for all retail stores improved from 10.2% to 10.9%. As you would expect, EBITDA margins for stores open two years or longer was even stronger, growing from 11.8% to 14.6%.
 
In talking about Billabong’s motivations for retail, they note how they’ve seen an increase in house brands by retailers in recent years, and how that ends up “…eroding the amount of space that’s available for premium brands…” and usually not working for the retailer. Though they don’t come right out and name it, I think they were thinking about PacSun, where their sales last year were down 40%.
 
There is also a general concern about the overall wholesale base. In Australia, they estimate their account base has declined 5% in the last 12 to 15 months. In addition, they have “quite a few” on credit hold and “may not continue selling to those accounts.”
 
In Europe, the decline has been between two and three percent of accounts. They had around 1,400 accounts in the US a couple of years ago, and it’s now fallen to an estimated 1,200. “What is clear is that, in real terms, there is not a lot of people opening new board sports space. So it’s not like currently there is any real new business coming online into the industry.”
 
They further note the tendency of many accounts to buy not based on what they think they can sell and best merchandise, but on the quality of the deal they can get, and expect further fallout in the retail space because of reduced consumer spending and tight credit.
With few new outlets for their products, a decline in the number of accounts and concern about the financial viability of some existing ones, and a retail base that’s cautious in their purchasing and more interesting in a deal than in merchandising high end product, you can see why Billabong is focusing on their own retail. They believe, and have said before, that they can better merchandise and sell their product in their own stores.
 
They are also interested in being more market responsive and creating new product in short time lines outside of the normal product cycle. They can do this with their own stores. An independent retailer, however, is often not prepared to buy sight unseen when Billabong asks them how much of a new product they want for delivery in four weeks. Maybe they should be if they believe in the brand.
In the short term, retail acquisitions have an interesting impact, and this is partly why Billabong refers to fiscal 2011 as a “transition year.” When Billabong sold product, for example, to West 49, they booked the sale when the product shipped. But the moment they own West 49, that sale doesn’t happen until the retail customer buys the product in the store. Revenue recognition, then, is delayed during the transition period.
 
Conference Call Questions
 
You haven’t read this far without figuring out that Billabong has some challenges to deal with, and the analysts on the conference call picked up on that. Here was a question that the JP Morgan analyst asked:
 
“You’ve highlighted higher sourcing cost, and that actually looks like a more enduring problem rather than sort of like a temporary sort of blip. You have a consumer that is seeking value and you’ve got channel base that’s sort of declining, well it has declined, and you’ve got mixed shift to lower margin regions like Brazil. I mean haven’t you got a lot of factors there that are actually negatively impacting your EBITDA margins in the US?”
 
CFO Craig White’s answer was, in part, that it depended on your time frame but he agreed there were other issues as well. “I mean we’re talking about 2010/11 as a transition year and implicit in the [mid-term] guidance we’re providing … of EPS growth in excess of 10% is a whole mix of things happening including overall gradual macroeconomic recovery; growing share of Billabong brands in retail which will improve existing margins in retail, be it West 49 or other stores; you know there is a whole range of things in there.”
 
But the analyst doesn’t seem quite satisfied with the answer: “I mean how can you give medium term 10% year on year growth guidance with a lot of confidence because in my mind it seems extraordinarily difficult to do that?”
 
I’ve summarized the exchange here.  The entire transcript, and all the reports I’ve referenced are on Billabong’s corporate web site if you want to dig in a little.
 
Billabong decided, when the recession started, that they would not be as promotional as other brands because they wanted to preserve brand equity. I thought that was a good decision. The question is how you make that work in a continuing weak economy under the circumstances the analyst outlined. At least part of the answer is by expanding your retail presence where you can better merchandise your brands, drop in new product quickly outside of the traditional product cycle, and get the margin and volume you are, to some extent, losing in your traditional retail channels. That’s what I might have told the analyst in CFO White’s place. Of course, I’ve had a couple of days to think about it and who knows what I would have said at the time.
 
There were also questions about whether or not the Billabong brand was losing market share, about whether more global styles and reduced range sizes reduced entry barriers for competitors, and on the company’s ability to manage all the owned and licensed brands. For a conference call, this was a lot of fun!
 
In difficult operating environments (this one qualifies) managers of public companies are often in no win situations. They can be cautious- and raise concerns that they aren’t acting aggressively enough in an obviously rapidly changing environment. Or they can act aggressively- and have people concerned they’re moving too quickly in too many new directions.
 
I’ve argued that the biggest risk of all is to not take a risk when things are changing and I think I’ll stand by that. Billabong does seem to be relying to some extent on a continuing US economic recovery and I’m not sure they should be. All the risks the analysts pointed out are very real ones. But business is a risk.
 
You minimize those risks by having an experienced management team, building agreement on goals and objectives among the team members, and by not sitting on your ass when you become aware that things are changing- for better or worse. I’m sure that one or more of the actions Billabong is taking won’t work out. That’s life. But in light of fast fashion, a declining wholesale base, a difficult economy, and the retail opportunity they have with the brands they’ve assembled, their strategy seems largely correct to me.    

 

 

Orange 21’s (Spy Optics) June 30 Quarter; What Doesn’t Kill You Makes You Strong

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Orange 21 turned a profit of $408,000 in the quarter ended June 30 after losing $254,000 in the same quarter last year. For six months, a loss of $1.058 million was reduced to $529,000. For the quarter, they did it by increasing sales 4.5% and increasing their gross profit margin from 45.9% to 57.8%. And they did it while incurring two hundred thousand dollars of expenses for new sales initiatives that haven’t generated the first dollar of revenue.

If you’ve followed my earlier comments on Orange, you know that they had a lawsuit with a big shareholder and former CEO, some problems with inventory (at the end of the quarter they had an allowance for obsolete inventory of $966,000), expenses that needed to be brought under control, losses that resulted in cash flow issues (managed at least partly by a rights offering to existing shareholders and a $3.0 million loan from the biggest shareholder), a factory in Italy that needed to be better managed, and some pretty heavy duty management transitions.  Oh, and there was (is?) a little recession going on, but I guess we all have to deal with that.

You can see the better management of the factory this quarter in the fact that it generated operating income of $218,000 compared to a loss of $338,000 in the same quarter last year. There’s some exchange rate impact in there, but that’s a $550,000 different in a quarter compared to a year ago.
 
Anyway, the company’s circumstances are improving and if the war isn’t over, they have certainly won some key battles.
 
The new sales initiatives that cost them $200,000 during the quarter but aren’t generating revenue yet are the Margaritaville and Melody by MJB brands.   They’ve also entered into a license agreement to develop and sell O’Neill branded eyewear.
 
Without saying how much is for which brand, the company noted that it had a minimum payment of $478,000 payable under various licensing agreements through the end of the end of the year, of which $178,000 has been paid as of August 10. During the next three calendar years, the company has minimum amounts of $1.4 million, $1.1 million, and $0.8 million, respectively, payable. They better get to selling those new brands.
 
They further noted that if they achieve certain minimum sales of some products, they will have to pay a percentage of net profits under the license agreements.
 
I would speculate that it wasn’t all that easy for Orange 21 to negotiate these agreements with these brands given their recent history. Wish I knew the back story to those discussions. But I think it’s a great thing for them to do. They need more volume to be solidly profitable and can’t sit around and wait for big sales increases through their traditional channels to bring that volume in our new economic reality.
 
90% of sales during the quarter were sunglasses, and domestic sales represented 81% of the total. The company believes the sales increase was due to improvement in the economy and consumer confidence as well as “…efforts with certain key accounts and focus on close out sales.” Hmmm. Does that mean close out sales to key accounts?
 
The explanation for the big increase in gross margin percentage is worth spending a little time on. First, there was only a $13,000 decrease in overhead allocation for the quarter compared to a $346,000 decrease in the quarter last year. What I think that means is that due to their cost controls they had a lot less expenses that got put on cost of goods sold. Well, gross margin is way up, so that’s obviously a good thing even if I’m not entirely sure what it means. And an allocation can simply be from one place to another even lacking any cost reductions. That could improve one category at the expense of another but not change the overall financial result. But in this case, it obviously did change the result, so there’s more to it than an allocation.
 
Opps, I’m rambling on about cost accounting and guessing you’ve heard enough. Sorry.
 
Next they were able to increase inventory reserves by $200,000 compared to $100,000 in the same quarter last year “…as a result of the sale and disposal of previously reserved inventory.” Selling it sounds good; disposing of it not so good.
 
They got some product cost reductions due to more favorable exchange rates against the Euro for product made in their factory and product cost decreases due to the addition of a lower cost manufacturer in China.
 
Finally, they had a decrease in sales returns of about $0.2 million and “…a slightly larger decrease in our sales return reserve.”
Overall then, you have to applaud their gross profit margin improvement. But you also have to notice that some of the improvements are accounting adjustments that reflect the hangover from and resolution of old problems. Others, like exchange rates, are out of their control. Let’s hope they can maintain the high margin going forward.
 
General and administrative expenses were reduced an impressive 7% for the quarter. Sales and marketing and research and development expense were both up, but if they weren’t you’d worry about the prospects for the new brands.
 
Over on the balance sheet, the current ratio has improved only slightly from 1.3 to 1.4. The total liabilities to equity ratio rose from 2.0 to 3.2 mostly, I think, as a result of the $3 million loan from the shareholder. Of course, when the lender owns 44% of your shares, practically speaking you might call that $3 million equity whatever the accounting treatment.
 
I’ll watch the launch of the new brands with interest. For all the things they’ve done right, the company’s ability to grow significantly, become consistently profitable, and improve its balance sheet may depend on those brands.

 

 

I Wonder if PacSun Might Carry Hard Goods; And What Would Zumiez Think?

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Just for a moment, hypothetically, let’s think about PacSun’s turnaround strategy, whether it might make sense for them to start carrying hard goods, and how other companies might react.

PacSun’s Strategy

That PacSun is in the middle of a turnaround is hardly disputable, if only because their management has characterized it that way. And in my judgment, they are pretty much doing the right things. First and foremost, they acknowledged that their stores had stopped being a destination for their target customers, and they are working to fix that. They want to “Reestablish PacSun as a destination for great brands.” What does that mean exactly?
 
First, it means completely revamping their management team- to the point where at their last conference call they said they had cut back their juniors inventory because they did not have the right leadership or strategy in place. The management changes are well under way and, when we listen to their next conference call (okay, when I listen to it), probably within a couple of weeks, we may find it’s complete.
 
That impresses me. While there’s absolutely nothing as disruptive to a company as a total makeover of top management, there’s also no way for a company to succeed if the team isn’t aligned and in agreement as to the company’s strategy. Those of you who were at the Group Y Action Sports Conference a couple of weeks ago heard exactly the same thing from Van’s Vice President of Marketing Doug Palladini as he explained Van’s success.
 
Second, they’ve recognized they can’t have the same merchandise selection in all stores, regardless of location, and are working to localize their inventory. Third they are starting, like a lot of other brands, to emphasize speed and freshness in product. “The days of shopping in Europe for trends and then delivering a whole new collection are pretty much behind us,” was how they put it. We may all bemoan fast fashion, but there’s no choice but to react to it if it’s what the customer wants.
 
Fourth, they are going to be more cautious with private label and have eliminated private label board shorts. Fifth, they’ve rolled out a new advertising and promotion campaign that has a more appropriate focus. Last, they’ve recognized that more stores isn’t the answer and are focusing on making the ones they have better places to shop.
 
The Hard Goods Issue
All good stuff. If I were a hard goods brand and PacSun asked me to sell them some hard goods I’d get excited by the fact that Pac Sun could buy a whole lot of product from me (though I doubt any hard goods brand can expect to be in all their stores). On the other hand, I’d need to feel good about their chances for making their stores an attractive destination for my customers again. If they were lame, I wouldn’t want to be there because the lameness might rub off on my brand.   I would, in other words, need to feel good about PacSun’s ability to implement the strategy I’ve described above.
 
I’d get to feel good by spending some time with the people in charge of implementing the hard goods strategy for PacSun.    Assuming there was such a strategy, that is.
 
I’d want to roll out the product in, say, 10 or 20 stores initially. And I’d want those to be stores that already reflected PacSun’s revised strategy- ones that were remodeled to reflect the new focus, had a reduced reliance on house brand product, and had inventory specifically selected for the location. I’d want to have some involvement in how my product was merchandised and I’d like to know where PacSun was going to get sales people who could represent and sell hard goods. And while all these discussions were going on, I’d be chatting with my friendly competitors who also make hard goods to try and find out if they were selling to PacSun.
 
Some level of hard goods can make sense for PacSun as part of a strategy of regaining credibility with their target customer.   It’s certainly part of what has differentiated Zumiez among mall stores and made them successful, and that brings us to an interesting part of the discussion.
 
Though both are mall based chains with an overlapping focus, Zumiez is not PacSun and PacSun is not Zumiez. They have different ambiances, and different, though obviously overlapping, target customers. Zumiez has always carried hard goods and has prided itself on having employees at all levels that are in touch with the action sports culture. Though PacSun may have originally been closer to the “core” than it is now, it was never as close as Zumiez and it drifted even further away with growth and some of the decisions it made.   Zumiez has always been closer.   That has been important in how it has kept its credibility with customers even as it has grown.
 
PacSun wants some of that credibility back. I have to assume Zumiez would rather not share that market space with a nine hundred store gorilla. Even though Zumiez is only more or less one third the size of PacSun by number of stores and their geography doesn’t completely overlap( PacSun is in all 50 states, Zumiez in 35) I have to believe that PacSun’s problems made life easier for Zumiez in some ways and in some locations.
 
How might things go if PacSun starts carrying hard goods? A couple of years ago, I might have said that if they represent the brands well it would be good for everybody. But economic times are different and I think that’s less likely. It will also depend on what hard goods, exactly, they carry. I don’t imagine it will be snowboards (though of course I don’t know that). I can certainly imagine skate and while surf fits PacSun (and not really Zumiez) it’s generally difficult to imagine selling surf boards in mall stores.
 
I’m sure Pac Sun expects to make money on any hard goods it sells, but that wouldn’t be the primary motivation. They want to rebuilt credibility with their target market and get that customer back in the store. It’s a component of their overall strategy.   Superficially at least, a PacSun with hard goods will have moved a bit towards Zumiez’s in its positioning. Will the customers see that? Will Zumiez’s customers be more likely to shop at PacSun? Or will customers who chose PacSun over Zumiez be disappointed? Depends on just how much actual customer overlap there is I guess. But unless they subscribe to the “a rising tide raises all boats” theory, I can’t see Zumiez as thrilled.
 
Other brands, not hard goods, are currently sold at both Zumiez and PacSun. Wonder how they would see this if it happened. Would PacSun pick up some apparel or other products from the hard goods brands they decided to carry? 
 
 A PacSun who carries hard goods and uses that to revive their credibility with the action sport oriented consumer is a stronger competitor to Zumiez.   A PacSun who carries hard goods and does it badly damages the idea of such stores in malls, and that could reflect on Zumiez. It’s not that PacSun will be the same as Zumiez, or even that they will necessarily target exactly the same customer group. But some of those customers may only see the superficial similarities. Think how consumer looked at Hollister.
 
As Zumiez, PacSun, and any hard goods brands that might consider selling to PacSun know, having hard goods doesn’t instantly give you credibility and attract customers. You have to do it just right and the devil is in the details.

 

 

Nike’s Annual Report- A Few Interesting Facts

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Nike came out with their 10K annual report maybe 10 days ago. Because we’re in the habit of focusing on the press release and the conference call which happens much sooner, nobody seems to have paid any attention to this 145 page document. But never fear, I’m a glutton for punishment and there were a few interesting facts I thought I might provide.

You’ll excuse me if I don’t do my usual financial analysis. With hardly any long term debt (given their balance sheet though some of us probably think $400 million is a lot), a few billions in cash, and just over $19 billion in revenue, I just don’t think I’d discover anything useful if I stared squint eyed at their cash flow statement for very long.

Revenue was down from $19.176 billion in 2010 from $19,014 the previous year. But their gross profit margin, at 46.3%, was the highest since 2006. “The increase in gross margin percentage was primarily the result of favorable product mix, cost reduction initiatives, lower input costs and sales growth in our NIKE-owned retail business. (Emphasis added)” The retail increase was from both new store openings and growing comparable store sales.
 
“While our wholesale business remains the largest component of our NIKE Brand revenues, our NIKE-owned retail business continues to grow, representing approximately 15% of our total NIKE Brand   revenues in fiscal 2010 as compared to 13% in fiscal 2009.”
 
In the U.S., they’ve got 18 Hurley stores, 145 factory stores for closeouts, 12 Nike stores, 11 Niketowns, 51 converse factory stores, and 106 Cole Haan stores. In the rest of the world, there are 205 Nike factory stores, one Hurley, 55 Nike, 2 Niketown, 12 employee only stores, and 68 Cole Haan. They’ve got more stores to handle their closeouts then most chains have stores.
 
 Net income rose from $1.487 to $1.907 billion. They reduced their inventories 13.4% to $2.041 billion.
They’ve got 34,400 employees worldwide and 42% of their sales are in the U.S. The three largest customers represent 24% of U.S. sales, but none are more than 10%.   Hurley’s sales grew from $203 million to $221 million, but that’s the only specific action sports number or comment we get in the whole document.
 
They note that 89% of their U.S. wholesale footwear shipments (excluding “Other Businesses” of which Hurley is part) were made under their futures program. I think that’s the same as prebooks, which is pretty impressive. The number for U.S. apparel shipments is 62%. Where do they get all this stuff made?
 
“Virtually all of our footwear is produced by factories we contract with outside of the United States. In fiscal 2010, contract factories in Vietnam, China, Indonesia, Thailand, and India manufactured approximately 37%, 34%, 23%, 2% and 1% of total NIKE Brand footwear, respectively. We also have manufacturing agreements with independent factories in Argentina, Brazil, India, and Mexico to manufacture footwear for sale primarily within those countries. The largest single footwear factory that we have contracted with accounted for approximately 5% of total fiscal 2010 footwear production.”
 
But not even Nike is immune from macroeconomics and some of the labor issues in China.
 
“We anticipate our gross margins in fiscal 2011 may be negatively impacted by macroeconomic factors including changes in currency exchange rates and rising costs for product input costs. We also anticipate higher air freight costs as we work with our suppliers to meet increasing demand for certain running footwear products in the first half of the year.”
 
I strolled through the U.S. Open of Surfing last week and kind of noticed that Nike and Hurley dominated the place. It looks like Nike has plans for our industry.

 

 

How’s Volcom Doing? Their Quarterly Results

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I swear I wrote as fast as I possibly could during the conference call and hope I got all the good stuff. The press release was pretty much lacking in detailed management discussion and there were no footnotes to the financial statements. I know probably nobody will care by the time the actual quarterly report is filed with the SEC, but I promise to go through it and let you know what interesting info (if any) there is in the details.

Revenues for the quarter were up 15.4% to $62.4 million compared to $54.2 million in the same quarter the previous year. Gross profit in was up 13.2% to $29.8 million compared to $26.4 million. Gross profit margin was 47.7%, down from 48.6% in the same quarter last year. In its US segment, which includes the US, Canada, Asia/Pacific, Central and South America, it fell from 48.8% to 46.1%. It rose in Europe from 44.8% to 46.1% because of more direct retail selling and less to distributors.

In the first quarter of the year, the gross profit margin was 54.7%. In the complete years of 2007, 08, and 09 it was, respectively, 48.4%, 48.8%, and 50.2%.
 
Okay, let’s pause here and focus a bit. Volcom management tells us in the conference call that the lower gross margin percentage in the U.S. segment was primarily due to incentive pricing that was part of a strategy to gain market share. They also note that they carried more inventory to capture in season orders and that low margin liquidation sales were higher than in the second quarter last year in the U.S. segment. And CEO Richard Wolcott said they were “Getting great sell through.” They say that sell through reports show that Volcom product is “resonating” well with customers.
 
This is pretty much the part of the conference call where I go crazy with frustration because I don’t get to ask any questions. The ones I might have asked include:
  • If sell through is so great, why is the gross margin down?
  • If you are gaining market share, is it strictly because of the discounts you’re offering that lead to the lower gross margin or do you think you’ll hold that share when you raise prices? Anybody can get more share if they charge less.
  • Does carrying more inventory to capture in season orders mean your prebooks were off? Do you get as good a margin on those in season sales as on the prebooks?
  • Is carrying more inventory for in season orders a temporary tactic or do you expect to continue it?
  • You noted that low margin liquidation sales were higher in the second quarter last year. There decline should contribute to a higher gross margin. Can you give us any insight as to the size of those sales and their impact on gross margin?
These questions might be particularly appropriate given that during the question section of the conference, they said to expect some gross margin pressure during the third quarter and that higher liquidation and incentive sales were expected. Some of these pressures come from problem with supply and costs in China right now. Volcom specifically notes delays in snow product delivery due to labor shortages in China. Almost every company, of course, has to deal with these same pressures. 
 
Sales, general and administrative expenses stayed about the same as a percentage of sales at 47.6% but went up about $3.9 million. That’s part of their plan to increase market share and it’s probably the right time to do that. They have a balance sheet that allows them to.
 
Operating income tell from $504,000 last year to $67,000 for the quarter this year. For six months, operating income rose from $6.9 million to $11.1 million. Net income was $872,000 in 2009 for the quarter compared to $68,000 in the quarter ended June 30, 2010. You’re better off looking at operating income though. In last year there was a foreign exchange gain of $651,000 during the quarter. In the same quarter this year, it was loss of $66,000. The income tax provision fell from $352,000 to $31,000. Basically, in the quarter ended June 30, 2009, Volcom was a million bucks better off due to items below the operating income line.
 
In discussing the general economic environment, they say the macro demand environment has weakened a bit and retailers have become more cautious. In the U.S., they describe the retail attitude as “somewhat choppy.” They indicated that the core was continuing to grow (I wonder what that means exactly) but that some retailers were still having difficulties. In a related comment, they see the Billabong acquisition of West 49 as a positive because it will strengthen West 49. If you saw my analysis of that deal, you know that West 49’s most recent financials were weak and that I thought that weakness might have been a major motivator for the deal.
 
In Europe, Volcom sees a challenging environment. The business there has held steady for the last several quarters. Volcom in Japan is still “having problems” because of the macroeconomic situation.
 
But even with the current economic weakness, CEO Woolcott believes “…that investing now will serve us well when the recovery really begins to turn on.” I think he’s right.   The issue for all of us is when is that going to happen. And of course it wouldn’t hurt if the sun would come out in Southern California. I was just down there for the Group Y Action Sports Conference, the Agenda show, and to see the U. S. Open and felt like I’d never left Seattle. I also got to see Jack’s, a retailer I’d never been in before. I was impressed and will have more to say about that in another article.
 
In the U.S., all of their categories were up except juniors which fell 22%. That seems to be the category from hell for everybody right now. I have a hunch that’s going to continue and some brands getting on the “fast fashion” band wagon isn’t going to improve the situation. Revenue from Volcom’s five largest U.S. accounts was down 2% to 15.3 million and represented 30% of U.S. product sales. PacSun was down 2% to $8.7 million (17% of U.S. segment). Volcom has new displays in 25 top PacSun doors, and noted that they were enjoying working with the new PacSun management. It will be interesting to watch the direction of Volcom’s sales there.
 
CEO Woolcott said, “The Macy’s business is doing particularly well, especially in men’s and boys’.” Volcom has become among the top surf skate brands in men’s, boys and kids there, he indicated, and they believe this is due to an increased focus on Volcom’s merchandising and marketing efforts there.
 
I sure hope they are working on the merchandising in Macy’s. I stopped off to see the Volcom presentation in Macy’s a while ago and you can see what I found about half way down this article. http://jeffharbaugh.com/2010/05/19/volcoms-1st-quarter-ended-march-31-numbers-macy-inventory-management/. It wasn’t pretty but of course it was only one store and, I hope, not typical.
 
I’d love to be able to explore the gross margin issue in more detail, and I’ll let you know if there’s any more info in the 10Q when it’s filed. In the meantime, Volcom is pursuing a strategy which makes great sense as long as some economic improvement isn’t too long in coming. I guess every brand is to some extent hostage to a recovery.