Making Changes in a Difficult Market; Orange 21’s Sept. 30 Quarter and Nine Months

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Orange 21 (Spy Optic) is one of my favorite brands for a couple of reasons. First, over the last couple of years they’ve worked themselves through some really tough issues, making difficult decisions when required. And they’ve had to do it during the recession. Second, for better or worse they’re public. We get to see the numbers, actions, and management strategies of a smaller company in this industry. 

 Finally, they are representative of the issues that most smaller companies are facing right now, and we can learn a lot from how they are responding. Let’s get learning. I should make it clear that the following analysis is mine based strictly on their public documents. Nobody at Orange 21 has talked to me about it.   
 
Key Strategic Decision
 
Orange 21’s sales fell 6.3% for the quarter to $8.2 million compared to the same quarter the prior year. For nine months, they increased 2.8% to $26 million. Like almost every other company, they know that sales increases are harder to come by than they use to be and that there are some pressures on margins. I’d say the latter is especially true in the sun glass business and would be (though to a lesser extent) even if there was no recession. Sun glasses are (were?) a high margin product that inevitably attracted competition from many sources and put pressure on those margins.
 
Orange 21 is at that awkward stage of its life- too big to be small and too small to be big. There are margin pressures and fewer core retailers to sell product to. They’ve been disciplined in controlling expenses, but a brand needs advertising and promotional support, and you can only reduce expenses by so much for so long. Essentially, they need to grow but I don’t think they thought they could grow as much as they need to with their core product lines.
 
The last article I wrote was about Volcom. In that, I talked about how brands, and maybe our whole industry, was transitioning from action sports, to youth culture, to the fashion market. The markets are of course not as distinct as I make it sound, and moving from one to the other is in no sense linear or inevitable for all companies. But Orange 21 has decided they need to move towards the fashion market in order to find the growth they need.   
 
Enter their licensing agreements. In September of 2009, they signed a licensing agreement to develop and sell O’Neill branded eyewear. Along with Spy and Spy Optic, the O’Neill brand is targeted at the action sports market. In February 2010, they signed a licensing agreement with Jimmy Buffett and his Margaritaville brand for eyewear. They did the same with Mary J. Blige in May. Blige is pretty clearly the fashion business.  I don’t quite know if you’d characterize Buffett as fashion, but it’s sure not action sports or youth culture. Is “parrot head” a market segment?  
 
A few years ago, Orange 21 bought the factory that was making some of its product in Italy. At the time I thought maybe that was mistake. But since the purchase, they’ve worked hard to restructure, revamp and generally rejigger that factory so that it’s an asset. I’m guessing it will never compete on price with Chinese made glasses. But for the market Orange 21 is aiming at with the newly licensed brands, the factory may be just what they need. In fact, I’d bet that a desire to increase its throughput was a factor in the licensing decisions.
 
So Orange 21’s key strategic decision was to recognize their need for growth and that the amount they needed couldn’t come from their traditional sales channels. Hence the licensing agreements.
 
The downside is that the licensing agreements come with certain design, development and marketing expenses before they generate the first dollar of revenue. They spent about $400,000 in license related operating expenses during the quarter. There are also various minimum payments under the licensing agreements that total $479,000 for the year ending December 31, 2010. For the next three years, those minimums are $1.4 million, $1.1 million, and $0.8 million.    The Blige product started to sell in September. The Buffett product was to have hit markets in November. It better sell well.
 
The company’s decision to seek its growth outside of its traditional channels had a financial impact that we’ll now examine.
 
The Balance Sheet- Inventory is What I’ll Be Watching
 
Back in March, Orange 21 borrowed $3 million from Costa Brava Partnership. Costa Brava and its general partner own 46% of the company’s stock. $2.6 million of the $3 million was used to pay down its asset based line of credit from BFI. We can tell from the current balance sheet that they later drew down part of that line of credit again. At September 30, their line of credit outstanding was at $2.6 million. Subsequent to the September 30 balance sheet date, the company borrowed an additional $2 million from Costa Brava in two loans for $1 million each dated October 5 and November 1. What are they doing with this $5 million?
 
The first thing we notice is that in the nine months ending Sept. 30 2010, inventory has increased 41% from $7.76 million to $10.9 million, so there’s over $3 million in additional cash  tied up there. As noted above, sales over the same period were up only 2.8%. I expect part of this increase is for the holiday season. But some, I assume, is also to meet expected sales from the newly licensed brands that have launched or are launching now. They’ve are also funding, as noted, significant royalty payments and expenses for the new brands that are not yet generating income.
 
Income Statement- Improved Gross Margin and Expenses in a Good Cause
 
The gross margin for nine months rose from 42% to 50%. For the quarter, it was up from 33% to 47%. I’m glad to see those increases. Orange 21 had some problem inventory and if the problem isn’t solved, the increasing gross margin at least suggests they are getting it under control. They’ve got gross accounts receivable of $6.885 million. Their allowance for doubtful accounts is $720,000 (10.5%) and a further allowance for returns of $1.114 million. Subtracting those two gets us down to the balance sheet reported receivables number of $5.051 million. So some of the slow moving inventory may still be around, but it’s been written down or off and when they do sell it, the margin in big.
 
In spite of the small sales decline for the quarter, total operating expenses were up 17.8%. From what they said in their 10Q, I expect most of this is for the newly licensed brands. They’ve been too good at controlling their expenses to let them increase like that without a very strong justification.
 
I would note that in spite of these increased expenses and a decline in sales, their loss for the quarter fell from $1.136 to $932,000. Witness the power of an improved gross profit margin! What Orange 21 is really doing right now is investing in their new product lines. If we weren’t seeing those investments, they’d have no chance these new brands could succeed.
 
We can see that Orange 21 is getting hit by most of the problems that afflict other brands in this industry. A tough economy, a decline in the number of specialty retailers, smaller orders from the ones that are still standing, and some difficulty getting paid. The sunglass and goggle market is also very competitive and, as I’ve written before, brands with their own retail have a bias towards replacing other brands with their owned brands. Lousy West Coast summer weather also hit reorders during the sunglass season, and they had some vendor delays on snow goggle product.
 
All about par for the course. What seems to me to be different at Orange 21 is that they didn’t limit their response to struggling with those issues on a day to day basis, though they have certainly had to do some struggling. They said, “Hey! Doing more of the same isn’t going to cut it. What can we do differently?” They came up with the licensing.
 

These licensing deals are a risk.   But business is a risk and my personal opinion is that if they hadn’t tried something new, their longer term future might be problematic. I wrote years ago that when things change, the biggest risk is to do nothing. I wish I could take credit for Orange 21’s decisions, but I think they figured it out all by themselves.

 

Volcom’s Quarter Ended Sept. 30 and Some Strategic Industry Issues

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Those of you who read my stuff know I never try to be the first published. When Volcom did their press release I reviewed it. I listened to the conference call and read its transcript and thought about it. Then I reviewed their 10Q when it was finally released. Then I thought about it some more.

Now, I’ve thought enough. What I was thinking about as I reviewed Volcom’s material was the distinctions (and similarities) between the action sports, youth culture, and fashion markets. You see, I’m not sure just what market we are any more. Action sports, to me, is that fairly small market composed of consumers who are participants in the sports and maybe the first level of nonparticipants who are closely interested in the sports and the lifestyle. Fashion is by far the largest market. If the people in that market want a surf brand, they may be as content with Hollister as with Quiksilver. Or they may just like a plaid shirt style they saw somewhere and are happy to buy it at JC Penney. They may not even know that isn’t cool.

I see Volcom as being in the youth culture market, but holding on to its action sports roots and trying to reach up into fashion as a condition of growing. That could leave Volcom (or any other brand) stretched a bit thin in terms of market positioning.
So let’s look at Volcom’s results and discussion around those results in term of the changes that are going on in our industry and market and see if we can draw broader conclusions that go beyond Volcom.
 
The Balance Sheet and Issues of Strategy
 
Volcom’s balance sheet at September 30 remains very strong, if not quite as strong as a year ago. But it’s strong enough for them to pay a $1.00 a share cash dividend to shareholders of record at November 8th at a cost of $24.4 million. Even though it’s strong, I want to spend time on the receivable and inventory numbers, as this might get us to some of the broader industry trends I want to focus on.
 
Consolidated accounts receivable were up 17% to $81.8 million at September 30, 2010 compared to one year ago. Days sales outstanding were up to 91 days from 88 days a year ago. So on average it’s taking them three days longer to collect.
 
Inventories over the year are up 65% from $22.4 million to $37 million. By comparison, sales grew 11%. Inventory turns over the year fell from 5.8 times to 4.6 times. The number of days it took them to turn their inventory, therefore, rose from 63 to 80 days. Higher is generally better than lower when you talk about inventory turns, though too high a turn rate can indicate you’re not keeping enough inventory on hand.
 
With those numbers as background, let’s look at their discussion of inventory. Here’s what Volcom said about their inventory situation in their 10Q. “We believe that as of September 30, 2010, we have excess inventory levels on hand and in order to align these inventory levels with current in-season demand, we anticipate that we will experience higher inventory liquidation sales during the fourth quarter of 2010.”
 
They talk about this at some length in the conference call and give more detail on how it happened and what they are doing about it. First, they note that their 2010 strategy “…has been to gain floor space and market share throughout our account base. Along with increased focus on marketing and promotions, these initiatives have included incentive programs to improve retailer margins in order to insure continued strong orders for Volcom products.”
 
They certainly aren’t the only company with a strong balance sheet that thought a recession was a good time to take some market share, and they are probably right about that. But they chose to do it partly with programs (including some pre-book discounts and a little more markdown allowance) that reduced their gross margin in their United States segment (that includes Japan and Canada but not the Electric results in any of those countries) from 49.9% in the same quarter last year to 45.4% in the same quarter this year. Overall, their gross profit margin fell from 51.6% to 49.6% in the quarter.
 
Moving into next year, they expect to curtail some of these incentive programs. “We believe this will help us recover some of the lost gross margin, while maintaining our market share gain.”
 
Will whatever market share gain they’ve achieved be maintained when they remove the incentives? Yup, that’s the big question. Billabong was concerned enough about this issue that they chose to limit their discounts and incentives during the recession even at the cost of some sales. I’ve argued pretty strongly that your focus in a period of slower sales growth needs to be on expense control and generating gross margin dollars even at the expense of sales growth. It’s an issue for every solid brand in the industry and we’ll find out over time what the right answer is. It is, of course, possible that there are different answers for different brands.
 
Meanwhile, speaking of issues everybody in the industry has to deal with, Volcom indicated they are seeing upward pressure on manufacturing, freight, and raw material costs in the area of 15% to 20% FOB.  That’s more than some other companies have suggested. But Volcom, and everybody else, has to ask how consumers will react in this economic environment as brands try and make up for some or all of these costs increase with higher prices. And Volcom will be dealing with that as they withdraw certain
of these incentives from their customers.
 
Just this morning, somebody sent me a short, article on these costs increases coming out of China. You can read it here.
 
We are, by the way, still talking about inventory. What I like about how this article is working out is that we’re tying balance sheet to income statement to global strategy. It’s important to understand those relationships.
 
Why did inventory get so high? Volcom chose to carry more inventory “…to capitalize on potential in-season business.” They did this because of “…the retailers’ general reluctance to pre-book at historic levels.” They also “…made earlier and bigger buys on select styles due to longer lead times in China, and to take advantage of volume pricing.” When they did that, they had higher expectations for the second half of the year which did not materialize.
 
I wonder if retailer’s reluctance to pre-book should be looked at as an opportunity to sell in season or as an indication that consumers are expected to remain cautious in their spending.
 
Some of this inventory is going to carry over to next year and was bought with that in mind. I think that carrying over some styles in certain basic product is a good idea as long as the market will accept it. But Volcom said they “…plan to get rid of…” about $3 million in inventory in the fourth quarter and that will impact their margins.
 
How exactly are they going to get rid of the excess inventory? They don’t exactly say, but they do note that they expect that sales to PacSun will increase 17% in the fourth quarter. In the third quarter, PacSun bought $6.9 million. 17% would be an increase of about $1.17 million, and I wouldn’t be surprised if a chunk of $3 million in inventory they want to get rid of is going there.
That certainly creates an opportunity to discuss PacSun’s strategy and place in the market and Volcom’s relationship with them, but this article is going to be long enough and I’d better move on.
 
Before I get off inventory, there’s one more industry strategy issue that relates to it I want to discuss. It’s the role of the department stores. In the conference call, Nordstrom’s is mentioned as having stopped carrying action sports last year. In their previous conference call, Volcom was describing the opportunity they had at Macy’s. In this call, we’re told, “Macy’s has been more difficult for us right now in terms of our door count has been reduced over the course of, I think, this year, kind of quarter to quarter.” Quite a change for one quarter. Now Volcom is saying that “…Bloomingdales is our bright spot for our department store business.” But they’re only in eleven stores.
 
Those of you who read my last article on Volcom know that I visited a handful of Macy’s stores to look for Volcom and other action sports brands. What I found was that Volcom and other brands were either miserably merchandised or not present at all. It seems kind of clear that there’s some work to be done before Volcom moves much of its inventory in those channels.
 
Volcom’s inventory numbers, then, span a bunch of industry strategic issues that are important to all the players in our industry. These include the strength of the economic recovery, increasing product cost, delivery issues, the impact of fast fashion, changes in the retail base and its willingness to place preseason orders, and the inevitable difficulties of growing into the fashion/department store market. Nobody’s business model works the same way forever.
 
And that is the end of the inventory discussion. Finally.
 
Income Statement
 
For the quarter, revenue rose 11.4% to $104.7 million. For nine months, the increase was 13% to $244.6 million. Electric was the best performing segment, with an increase of 29% to $8.9 million. That’s 8.5% of the quarter’s total revenues.
 
Gross profit rose from $48.5 million to $52.8 million in the quarter, but gross profit margin fell from 51.6% to 49.6%. Selling, general and administrative expense rose by 17.6% to $33.9 million.  As a percentage of revenues, they rose from 30.7% to 32.4%. Volcom states:
 
“The increase in absolute dollars was due primarily to increased payroll and payroll related costs of $1.5 million, incremental expenses of $1.1 million associated with our recently acquired Australian licensee, increased marketing and advertising costs of $1.0 million, and increased commissions expense of $0.6 million associated with an increase in revenues between periods. The net increase in various other expense categories was $0.9 million.”
 
Operating income was down 8.6% to $18 million. Net income fell slightly from $13.3 to $13 million. It would have fallen by another million if Volcom hadn’t had “other income” that was about $1 million higher than in the same quarter last year due to a foreign currency gain.
 
Conclusion
 
I hate calling a section “conclusion,” but I couldn’t come up with anything pithy and witty and wanted you to know the income statement part was over. What I hope you’ve gotten out of this is the importance of the inventory change and number and how it relates directly to a series of strategic issues that Volcom, and the rest of the industry, is managing. I wish I had more detail on their inventory. How they manage the issues around inventory will have a lot to do with how Volcom progresses as a company. That’s always true, but my point is that it’s particularly true in our current operating environment.
 
As I said at the start, Volcom is a youth culture company with its roots in action sports and reaching for fashion as a condition of continued growth. They seem to have arrived at that time in their growth and development (due partly to economic conditions) when their business model may have to evolve a bit. That’s not a criticism. Every company that starts small in this industry hopes that someday they have to deal with the issue.             

 

 

Requiem for the ASR Show. Now What?

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At the moment you hear about it, it’s kind of a surprise. But when the initial shock passes, it’s not. I thought The Editors over at Boardistan put it best. Back in 2009, referring to ASR, they said;

“We have to wonder what happens to the entire trade show business model when they have to pay retailers to attend. Lord knows retailers need to be treated well these days, but it still seems to bring us back to the question that’s been plaguing the boardsports business for several years: are trade shows even relevant anymore?”

I couldn’t have put it any better. Or at least not so succinctly. In fact, I didn’t put it succinctly. In the summer of 2009, I wrote a long article about trade shows in general for Transworld Business. Much of what I said then is still relevant. On the assumption that you don’t want to hear me re-pontificate it all, I’ll just include the link here. If you don’t read the serious part of the article and haven’t seen it, you might just to go to the section “In the Beginning,” where I wax biblical. There’s always room for a little humor. It’s one of my favorite things I’ve ever written.
 
What Went Wrong for ASR?
 
As I’ve heard it, the straw that broke the camel’s back was the decision of a number of large brands not to participate in the show. But the poor camel had been under stress for quite a while and the recession, exacerbating a number of existing trends, accelerated the process.  What are these trends?
 
  • Fewer retailers. And the ones that were showing up brought fewer people.
  • Brands showing product and getting orders outside of the trade show environment.
  • The internet and everything you can do on it
  • The union/convention center cost structure.
  • Industry consolidation. Big companies don’t have as much need of trade shows. See the second point above.
  • Recognition that competing against your competitors at trade shows with your show presentation is silly.
  • Slower industry growth.
  • More trade shows while demand was falling. Crossroads. Agenda.
  • Declining clarity as to just what the action sports market is. Did starting Class help ASR, or did it cause confusion as to just what the show was about and who should attend?
 
And then there’s that old bugaboo called momentum. As I’ve said, companies, trade show or otherwise, get in trouble due to denial and perseverance in a period of change.
 
In hindsight it’s easy to see what ASR should have done; Blown up the existing format and started over with another ASR show that recognized changing conditions. Specifically, that the show was essentially a regional show for smaller and new brands. And if that sounds a bit like Agenda well, okay. Maybe they should have just bought Agenda.
 
I hasten to admit that’s all easier to say than to do. It’s that momentum thing. I’m pretty certain ASR boss Andy Tompkins was quite aware of all the factors I listed above. I know he was. He lived with them every day. Yet it’s hard to imagine him (or anybody in his position) going to his boss, and his boss’s boss a couple of years ago and saying, “This isn’t working. We need to blow it up and start with a new focus and a smaller show.” Or maybe he did and got overruled by some people further up in the organization who aren’t quite in touch with our market. Big organizations often don’t make difficult, unpleasant changes until forced to.
 
With that short forensic analysis of what happened behind us what happens now?
 
Everybody’s talking
 
Just from the flurry of public discussion after the announcement, we can assume that IASC is talking to Agenda is talking to SIMA is talking to BRA is talking to Crossroads is talking to Surf Expo is talking to IASC. And if there was some talking going on at Outdoor Retailer and SIA I wouldn’t be surprised.
 
It’s public knowledge that certain of these organizations have (had?) deals with ASR that provided them with a certain amount of funding. Nobody much likes it when revenue goes away. I know I don’t. Those who lost income will want to replace it. Where? How? From whom? That will be a lot of the focus right now.
 
Concrete Wave is sponsoring a show by an organization called  Homegrown called the Midwest Skateboard Industry Summit next May.  As they are selling booth space for $200, I guess it also has elements of a trade show.  I suspect there will be more announcements from various players. 
 
There was an immediate reaction from various sources that Agenda had “won” and ASR “lost.” I didn’t see it that way. I don’t expect Agenda to take over the ASR space. I just don’t think the ASR format and structure for a trade show is valid any longer for the reasons I list above. I’ve also written (see the above link to my earlier trade show article) that anybody who tried might find themselves with the same issues that lead ASR to close.
 
Aaron and Seth at Agenda have themselves a small, solid, regional show. Can they grow it? I expect them can. They have. How much? And in which market? Is Agenda fashion or action sports? I’d be really careful saying “both.” ASR, with Class, tried to be both. When they opened Class, it was a symptom of the problems- not part of a solution.
 
The action sports industry is going back to what it used to be; a fairly small industry and its customers consisting of participants in the sports and the immediate circle of people who may not be participants but are committed to the lifestyle and truly interested in the sports. The rest is fashion; a style sold to customers who’ve seen surfing only on TV and have never been near a skate park. Bigger public companies looking to grow are after that market. They have to be to find growth. They may have their roots in action sports, but it’s getting harder, if you just look at their customer base, to call them action sports companies.
 
That has a huge impact on what our trade shows should or shouldn’t be. It’s incumbent on anybody running a trade show to figure out who their market is. Trouble is, I’m not sure either “fashion” or “action sports” really describes it. Youth culture might be closer.
As all this talking among the various industry organizations goes on, I hope it’s not just about replacing ASR. Let’s assume there were no trade shows. What would we want ours to look like?
 
First, it should look however the retailers want it to look. And as I indicated above, it would initially be regional and would be for new and small brands. Maybe it gets combined with the industry boot camp or other conferences. Perhaps it’s not only brands with booths, but venture capitalists, attorneys, bankers, accountants and other organizations that can help new brands and are interested in them as customers.
 
There should be a web site associated with the show that doesn’t just promote the show, but encourages interactions among the participants. Would it be closed to retailers for a day just so the focus could be on how these companies could run their businesses better? I’d like to see us try and charge non-endemic companies a big price to show up and be educated about the industry. I hope whoever runs this new show has authority to decide which companies can exhibit regardless of who belongs to what group.
 
If we’re going to break some new ground, let’s do it quickly. I find myself sitting here wondering if I should go to Agenda, Surf Expo, or Outdoor Retailer instead. Obviously, some companies are going to be looking for a replacement venue.
 
Fundamentally, however, we have to start by asking if we need another trade show. Maybe there will be surfboards at Outdoor Retailer, skateboards at Agenda and brands that tend towards fashion at Magic and some fashion shows I don’t even know about. Remember that skate had more or less pulled out of ASR, so it’s hard to argue that skate and surf have to be together, though one trade show makes it a whole lot easier for retailers.
 
Whatever happens, I hope the discussion among all the people who are talking is more around what the industry needs or doesn’t need rather than the requirements of the organizations they represent.
 
This is great opportunity to do the trade show we want if we’re really sure we want it.

The End of an Era (In a Good Way!) at Quiksilver

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I don’t think anybody else noticed this (or at least I didn’t see anybody else mention it) but on October 27th, Quik got a $20 million term loan from Bank of America. Along with some cash on hand, they used it to pay off the last $24.5 million (including accrued interest) of their original term loan from the Rhone Group.

The new term loan’s interest rate is 5.3%. You may remember that the interest rate on the Rhone money was 15%. The rest of the Rhone loan (it was originally a $150 million five year term loan made in August of 2009) has either been paid off or converted into equity.

Instead of paying $22.5 million a year in interest on the $150 million (some of it was non cash), they are now either paying nothing (to the extent it was converted to equity) or paying at a much lower rate.
Financially, of course, paying off $24.5 million in debt doesn’t fundamentally change anything for Quik. But it makes me feel good to see it happen, so I can only imagine how everybody at Quik must feel. I hope they had a Rhone Credit Agreement Termination Party and burned the note. And I wish I’d been invited.
Nice work!