Notes from the Skateboard Industry Conference and Hotel Lobby Bowling Event

IASC and BRA did a great job putting on the annual skateboard industry conference this week at the Doubletree in Orange, CA. The attendance was good, the subjects all worthy of attention, and the beer sponsor much better than last year. Credit also has to go to Steve Van Doren and Vans for providing some food, some goodies, and use of their skate park which, happily, was within walking distance of the hotel.

There was also a floor show Tuesday night at the hotel (technically, it was Wednesday morning).   I’m told it involved some conference participants, four cop cars, and a red bowling ball that was prominently displayed the next day in the conference room. My only real complaint about the conference is that if there’s going to be entertainment, could you try and schedule it before I go to sleep?

Oh- and it would have been nice to have more than five or six retailers at the conference.
 
I wrote last week about distribution in anticipation of running the distribution panel at the show. But we spend north of an hour on distribution in the round tables and the conference was running an hour late, so the actual panel was cancelled by acclimation. As that panel was all that was standing between the participants and food, drink, and skating and it was the last panel of the last day, I won’t be surprised if it was the favorite panel of the whole conference. Thanks to Frank Messman from Blackbox, Timothy Nickloff from Sole Technology and Darin O’Brien from Nike Skate for being ready to participate. Maybe next year.
 
Now, I want to get the slightest bit serious. And probably way, way too direct for some of you. Please don’t shoot the messenger. Or shoot him- but do it in a cogent and thoughtful way from which we all learn something.
 
These are the assumptions on which my argument is based:
 
1.       There is way too much skate hard goods product out there and with the availability of blank skateboards and deck printing machinery, there are essentially no barriers to entry.
 
2.       The “core’ brands continue to pursue much the same business model they have always pursued where pro riders (of which there are also too many) form the basis for differentiating the brand.
 
3.       There’s less margin and margin dollars to go around and not enough to split between distributors and brands if the brands are going to continue to follow the same team based business model. The brands can’t afford to carry out their traditional marketing models at the level they used to.
 
4.       Long boards are taking a certain percentage of the traditional skate market to the extent that skaters who just want to cruise are choosing longs over short. They may be less influenced by the pros.
 
5.       Distributors allow some brands that would otherwise not be in business survive- at least for a while. This creates a cash flow dependence on the distributor.
 
6.       Companies who had confidence that their brand was competitively distinctive in the market and who had the balance sheet to survive the transition might tend not to sell through distributors.
 
7.       If the hard goods market isn’t healthy, the skate shoe and apparel market will suffer.
 
No brand has shared with me their financial statements, and no doubt there are exceptions to what I’ve described above. Each brand is different. But in general this model of doing essentially what’s been done before and hoping things get better can’t continue. How might it change in a positive way?
 
Demographics might start favoring skateboarding again. Angel Ponzi from Board-Trac told us that the drought of new kids of skating age is ending and that we’d see a surge in skate age kids. That’s good news, but it’s obviously a very gradual, multi-year process.
 
Technology may be increasingly accepted. As it was explained to me, pros who want nothing to do with new technology are finally retiring and are being replaced by riders who have grown up with it. This is also not a short term process, but I’d say we’re a couple of years anyway into it and it might start getting some traction. It’s not a panacea. It won’t work for every brand and it’s going to require some retailer rethinking and retraining by the brands. Let’s call it clinicing, like they do in the snowboard industry. That came up at one of the round tables.
 
Most sports (don’t mean to offend anybody by calling skate a sport) have something new every year that, even if it isn’t a major breakthrough, is at least a talking point that allows some differentiation and, hopefully, improves performance. In a lot of industries, it means higher prices and margins due to increased consumer interest and limited availability. It also increases barriers to entry. I heard one suggestion that skate boards were already so refined over many years that it was hard to improve on them. I hope that proves to be wrong.
 
There could also, theoretically, be some mergers among brands. That’s financially efficient because it allows you to spread your overhead, but it doesn’t solve the problems of no barriers to entry and lack of product differentiation. Along those lines, there was awareness at the conference of what Mike West, owner of the 686 brand of snow outerwear was doing. He’s recently announced that he’s going in to the fulfillment business in partnership with a Canadian company he has a long term working relationship with to help small industry brands operate more efficiently. He expects to spread his overhead and make a few bucks.
 
I suspect mergers are unlikely due to the long term personal relationships among brand executives. Oh hell, let’s just say egos. I am not quite certain that the owner of one brand would step aside to let his long term competitor run it, and I suspect that there is inadequate liquidity for buy outs.
 
My personal belief, and I’ve been saying this for some years, is that product differentiation via technology is the answer. Or at least, I don’t know another viable choice.
 
I do know that a small business with no barriers to entry and limited product differentiation and a business model that needs big advertising and promotion expenditures and shares its revenue with distributors over whom it has no control is unlikely to prosper in the current and foreseeable business environment- no matter how healthy skating is as an activity.  I’ve been known to say that not taking a risk is the biggest risk of all.  I think that might be relevant here.

The Skateboard Distribution Model- It Never Was Broken

I just found out I’d volunteered to facilitate the panel on distribution at next week’s IASC and BRA sponsored Skateboard Industry Summit. I had to spend some time getting my thoughts about distribution in order, and I know of no better way than to write them down.

Distribution has always been a bit of a contentious issue in the skateboard industry. I’d regularly go to the IASC sponsored breakfasts at ASR and listen to the participants agree that the industry should “do something” about distribution. Then came the implied blame and pointing of fingers as the brands, retailers and distributors all looked at each other. Needless to say, nothing much was accomplished.

“The industry,” of course, is never going to “fix” distribution. Every company, if I can recite for the umpteenth time what seems to be becoming my mantra, is going to do what it perceives to be in its own best interest- as it should.  And, by the way, distribution isn’t and was never “broken” and doesn’t need fixing. As it does in every industry, it just evolved based on consumer requirements and competitive actions by companies. Distribution may be inconvenient and not the way we’d like it to be, but it’s not broken.
 
When concern about distribution is expressed, I usually translate it into “Where and how the other guy is selling his product is pushing my gross margins down and I need higher gross margins so they should change what they’re doing.” Another translation might be, “I need to run my business a little differently in the existing competitive environment, but I’d rather not.”
 
But of course eventually you will or you won’t be here. Let’s take a short look at how distribution evolved and what the drivers have been and are.
 
A Little History
 
Maybe ten years ago, skate hard goods distribution was pretty closely controlled. When it was still a smaller, underground activity the smaller number of skaters were content, or committed enough, to pay a high price for branded decks. Also, they had few options.  This gave the companies enough margin dollars to support their team and marketing programs.
 
Then a handful of things happened. The Chinese learned to make quality decks. The internet market place blossomed. Skateboarding went mainstream. The industry was slow to innovate. Big companies with way, way more money than a skate company could even imagine got interested in skating. Skaters figured out that what the skate companies had been telling them for years was true- a skate board was seven or eight plies of laminated Canadian maple and anything not made like that wasn’t a skateboard. But they took it a step further then we in the industry might have wanted them to. Many of them decided that since all the decks were the same (as they perceived it), it would be nice to have an extra $25 in their pocket for a product that was going to wear out anyway.
 
My belief is that the number of skaters grew dramatically for a while. But of course somebody who identifies themself as a skater isn’t necessarily skating every day, or even every week in our new broader market, so how much product they buy is unclear. As with any activity, you can identify closely with it, but not do it regularly yourself. Maybe you buy shoes and clothes instead of hard goods.
 
 In spite of the increase in the number of skaters, the market for branded, full price decks fell. There will always be a market for branded decks, but the overall number of skaters that feel it’s necessary to pay that price has fallen even as the number of skaters has increased. Please remember here I’m talking about the industry here- not specific brands.
 
We can’t talk about distribution without mentioning blanks and shop decks. Blanks are still out there, and those who want them can get them. But the shops, correctly I think, have decided that carrying blanks isn’t in their interest, and they’ve turned to shop decks. The margins are good, and those shop branded decks go a long way towards helping them connect with their customers and build the local skate community. And quite a few skaters, I gather, like belonging to the more tangible community revolving around their local shop than to the one represented by a pro skater they’ve only seen in videos. 
 
Cary Allington at Action Watch reports that in 2010 “shop deck” was the leading brand at the stores in his panel, accounting for something like 25% of short deck revenues. The second brand was about 6%. He further reports that the average price paid for a branded short deck (under 34 inches) was $47.34 in 2007 and $47.31 in 2010- essentially unchanged. Wonder what the cost of a deck did over that period. The average gross margin over the same period rose from 34.1% to 36. 2%.
 
The Distributors
 
Brands have two choices. They can sell in smaller quantities directly to retailers. They have to carry and manage the inventory to cover those orders, cover the associated overhead and, to the extent they extend terms, collect from the retailers. This ties up working capital. Or they can sell in larger quantities to distributors. If they take that approach they don’t have to collect, they get paid quickly, they don’t have to stock as much inventory and they save some operating expenses. It is, to put it succinctly, less balance sheet intensive.
 
In practice brands do both, selling to distributors and directly to retailers as well. I guess it’s pretty much up to the retailer to decide who they buy from. We could have a long and interesting conversation about the role of distributors in marketing brands. But let’s keep to the numbers part of things right now.
 
Distributors require discounts off the brand’s usual wholesale price- typically around 25% I’m told. At a time when margins for brands are already squeezed one wonders why brands haven’t stopped selling to distributors and gone direct. Nobody has shared their rationale for continuing to use distributors with me, but I suspect it’s at least partly a cash flow issue. Here’s why.
 
Let’s say a brand pulls out of a distributor. Immediately, the brand’s sales will fall to the extent of its sales to the distributor and assuming that all the distributor’s customers for that brand don’t turn right away to that brand to buy their product direct. And the distributor would continue to sell its existing stock of the brand’s product unless, maybe, the brand bought that stock back.
 
Over some amount of time, depending on the brands market strength, some of those sales would migrate from the distributor back to the brand giving the brand a higher overall margin. The question is how much and how fast? Once again, it depends on the brand. Would retailers that had been buying from a distributor just shrug their shoulders and say, “Oh well, I’ll buy a different brand” or would they say, “We’ve got to have that brand in our store.”
 
There would, then, be some initial decline in cash flow (hopefully temporary) and some permanent increase in expenses as a brand made the transition from the distributor to selling direct. My hypothesis is that business conditions have evolved for some brands to the point where they just don’t have the balance sheet to consider making that kind of change even if their analysis shows it would make business sense.
   
A Different Point of View
 
Snowsports Industries of America recently reported that February industry sales were down 1.5% for the month compared to the previous year. A bad thing? Nope, a great thing because gross margins had risen 8%. I wrote about it on my web site and basically said, “You made more money by selling less.” Now, a great snow year didn’t hurt, but basically most of the snow brands were scared shitless by the recession into ordering and producing less product and the consumer, finding shortages, was willing to pay more and valued the brands more. And if the snow guys are lucky and not too many brands and retailers get too greedy, and if it snows some, the industry can expect customers who won’t have any closeouts available to them this fall and who will be anxious to buy at full margin to get what they want.
 
I also wrote recently about Orange 21’s (Spy Optic) financial results for the year and recent management changes. I looked at their strategies, market position and competitive environment and suggested that maybe a $34 million company just didn’t have the resources to do all the things it needed to do to compete successfully in the sunglass and goggle market given the competitors and their resources.
 
I think both these ideas are worthy of consideration by the skate industry. Selling more doesn’t necessarily make you more money if everybody else is trying to do the same thing. And, like Orange 21, some of the industry companies may simply not have the resources to effectively pursue the skate team pro rider strategy that’s been the anointed foundation of this industry forever.
 
That’s not to say that isn’t a great strategy for certain brands, but I suspect that with the growth of skateboarding it’s become less important to more skaters. And that’s before we even talk about long boarding.
 
Shops are becoming brands. Quality decks are available from a variety of sources and can be found in a broader retail environment. Price matters more than it used to. Some brands have become dependent, to a greater or lesser extent, on distributors who could easily become their competitors if they choose to. Large companies with massive resources want a piece of the pie.
 
As much as we might want to, we’re not going back to the skate brand and retailer friendly distribution and pricing scenario of some years ago. Let’s stop talking about “fixing” distribution and focus on competing in the environment we’ve been handed.
 
I’m hoping, by the way, that some of what I’ve written is just the slightest bit controversial and that some of you will take the opportunity at the conference next week to explain to me how it is that my head found its way into such a warm, dark place. The goal isn’t to be right or wrong but to exchange information and maybe get a new perspective that will help us run our businesses better and build the industry. I always learn a lot when people tell me why I’m wrong.   

 

 

Orange 21 Year End Results and Management Restructuring

I unexpectedly had to spend about 10 days back east on family issues. Everything turned out fine, but I got way, way behind on my analysis. But sometimes things work out, and Orange 21’s management changes of last week gave me the perfect opportunity to tie those changes to their financial results and write a way more interesting piece.

I’ve been writing about the saga of Orange 21 (Spy Optic) for a while now. You remember the basic story. Solid, small brand has some self-inflicted management and operational problems (Bought a factory in Italy- now sold, too much inventory, the Mark Simo/No Fear episode, etc.). Went public for no reason I could ever figure out. Things are tough enough then the recession hits. Stone Douglass, a turnaround guy with no experience in our industry (that is not a criticism) is brought in to clean up the mess and get things back on the right track. He does, as far as I can tell, all the stuff he should do. But, so far at least, we haven’t seen sales growth and the company continues to lose money.

The income statement for the year ended December 31 showed a loss of $4.6 million on revenue of $35 million. When you read through the overview of the business, the target markets, the growth strategy and the products sections of the 10K report you can’t help but think that maybe a $34 million revenue business just doesn’t have the resources it needs to compete in the sunglass and goggle business given the competitors and their resources. Sunglasses and goggles represented 99% of Orange 21’s revenues in 2010.
 
Given those factors and the economic environment, I’d guess that Orange 21 management reached the same conclusion. They responded, in September of 2009, by licensing the O’Neill brand for eyewear. In February and May of 2010 respectively, they made deals with Jimmy Buffett and Mary J. Blige to design, produce and distribute a line of eyewear for each of them. 
 
Seems like a good idea. But it required expenditures for royalties, design, production and building inventory before the first pair could be sold. In 2010, the company spent $1.2 million associated with those brands but generated “minimal” sales. Inventory increased between the end of 2009 and the end of 2010 by $1.14 million to $8.9 million. Much of that increase was in preparation for the launch of the new products. The discussion of cash flow activities (page 34 of the 10K if you care) states, “Working capital and other activities includes a $2.9 million increase in net inventories for the addition of the O’Neill™, Margaritaville™ and Melodies by MJB™ eyewear lines, and a buildup of mainly top selling Spy™ sunglasses in anticipation of both an increase in sales of such Spy™ sunglasses and the sale of 90% of LEM.”  LEM is the factory in Italy they sold.
 
Anyway, they’ve got a lot of money tied up in these initiatives. Where’d it all come from since the company is losing money?
 
It came from the Chairman of Orange 21’s board and largest shareholder Seth Hamot. Actually, it came from Costa Brava Partnership III, L.P. Mr. Hamot “…is the President and sole member of Roark, Rearden & Hamot, LLC, which is the sole general partner of Costa Brava.” Costa Brava has invested $7 million in Orange 21 in 2010. Through Costa Brava, he put in $3 million, $1 million and another $ 1million in March 2010, October 2010 and November 2010, respectively. On December 20, he put in another $2 million and rolled all that debt into one promissory note for the entire $7 million. 
 
The whole $7 million is subordinated to any borrowings under the asset based line of credit from BFI Business Finance. $2.235 million in borrowings were outstanding under that line at the end of 2010.
 
Basically, that $7 million funded the loss for the year and the inventory build for the newly licensed brands. But those brands still aren’t producing significant sales- at least as of the end of the year.
 
You know, it always seems to be the case that new deals have bumps in the road you don’t expect, cost more than you expect, and don’t produce revenue as quickly as you’d hoped. I’m guessing that might be the case here. Add that to the fact that the Spy brand isn’t growing as they had hoped, and you get to last week’s management restructuring.
 
Stone Douglas resigned, but he’s going to get paid his $300,000 salary for a year. Carol Montgomery, who has quite a background in the sunglass/optical industry, was hired as the CEO at a base salary of $360,000. I read that change mostly as the board of directors deciding that the clean up the mess and restructuring part of the job was largely done and that the strategic positioning build the brands part required somebody who knew the industry better. I agree with that thinking, though I imagine that if Spy was growing and sales of the Buffett and Blige brands were ahead of schedule, we might not have seen the change at this time.
 
Michael Marx, who joined the company in February as VP of Marketing, was promoted to President with a salary of $250,000. I’m not quite clear why a company this size needs a CEO and a President. There must be a plan. 
 
And I think that partly because on April 11, Orange 21 entered into a retainer agreement with Regent Pacific Management Corporation to provide the services of Michael D. Angel as interim chief financial officer. Orange is paying $50,000 every four weeks for his services. Regent Pacific will also be paid some fees for achieving certain goals and get a warrant to purchase 1.5% of the company’s fully diluted common stock at an exercise price of $1.85.
 
I’m not sure that a company of this size expecting some modest growth and, I assumed, with Stone Douglass having done most of the blocking and tackling a turnaround usually requires, would really require this kind of management and financial fire power. Stone Douglass was acting chief financial officer after Jerry Collazo left in February, 2010 until his resignation last week.
 
The company’s costs, as a result of all these arrangements, have increased by north of $100,000 a month. With this new expense level, the required royalties for the Buffett and Blige brands, and even with some reasonable growth by the Spy Brand, it feels like Orange 21 could need some more cash or a different kind of deal in 2011 unless the Buffett, Blige and O’Neill brands really take off. Let’s hope they do.           

 

 

PacSun’s Annual Report: Missions, Strategies, Prospects

PacSun rode the economic expansion to 950 plus mostly mall based stores (they were down to 852 at the end of the year). They got over extended, had systems that didn’t give them the ability to merchandise as they needed to, didn’t keep their stores updated, became too dependent on their own brands, and basically lost the cool factor that made their target customers come to their stores. Then came the recession and cratering of the juniors market (38% of their revenues in 2010).

Since becoming CEO, Gary Schoenfeld has started to make the changes required to address these issues. But as I said when I wrote about them last December, change takes time. And money. In a word, what PacSun has to do is make itself relevant again to the “teens and young adults” it’s focused on. While they’ve got the time and money to do it.

Before the analysis, here’s the link to their 10K if you want to see it.

Missions and Strategies
 
PacSun’s objective “…is to provide our customers with a compelling merchandise assortment and great shopping experience that together highlight a great mix of heritage brands, proprietary brands and emerging brands that speak to the action sports, fashion and music influences of the California lifestyle.”
 
Their first strategy is to have a strong emphasis on brands. They divide those brands into three components; the industry brands they’ve worked with for a long time (heritage brands they call them), their proprietary brands, and new, emerging brands. But their proprietary brands were 46% of revenue in 2010. That’s down from 48% the prior year, but way up from 38% the year before that.
 
Retailers should have their own brands. But at some level of revenue, those brands are no longer complimentary, but competitive with the industry brands the retailer carries. At 46%, PacSun is focused on the performance of their own brands. Yet those owned brands obviously can’t compete with Quiksilver or Volcom from a market position point of view, so it becomes at least partly a price game. And at 46% of revenue, well, what kind of store are you? Are you a store where customers come to get good deals on less well known brands? PacSun warns in its risk factors that “Our customers may not prefer our proprietary brand merchandise which may negatively impact our profitability.” Probably wouldn’t need that risk factor if their brands were 15% of revenue instead of 46%.
 
I recognize that PacSun can’t change this dependency quickly if only because of cash flow implications, but I hope they work to reduce it. I think it might be difficult for them to become important again to their target consumers if they don’t unless they have a whole lot of money to spend on promoting their own brands. Then, of course, they would become direct competitors with their heritage brands.
 
Their next strategy is to undertake “New Strategic Marketing Initiatives.” We’ve seen some positive activities from them in this area. They also note that they are working with key heritage brands to “…create new programs and approaches to generate excitement around PacSun and the California lifestyle we embody…” But they plan to do it “without meaningfully increasing our total marketing expenses.” Advertising expense was $17 million in 2010, $14 million in 2009, and $16 million in 2008.
 
Related to marketing, they have a risk factor that focuses on the danger of not reinvesting in existing stores. They say, in part, “We believe that store design is an important element in the customer shopping experience. Many of our stores have been in operation for many years and have not been updated or renovated since opening. Some of our competitors are in the process of updating, or have updated, their store designs, which may make our stores appear less attractive in comparison. Due to the current economic environment and store performance, we have significantly scaled back our store refresh program.”
 
What I’m hearing is that they know what they need to do, but have some constraints in terms of what they can afford. More on that when we get into the financials.
 
Their third strategy is localized assortment planning. They are moving away from the “one size fits all” method of allocating inventory and starting to do it according to what sells best where. Good idea. I’m not sure it rises to the level of a strategy, however. It’s just something retailers have to do to be competitive. Let’s call it an operating imperative.
 
While they don’t call it a strategy, they’ve closed 44, 40 and 38 stores respectively in each of the last three years. They expect to close 30 to 50 during 2011. They have close to 400 leases that end or can be modified through 2013, so I expect we’ll continue to see either store closing or better results from stores where negotiations with landlords are successful. They note that they will be closing more stores than they open.
 
The Financials
 
In the fourth quarter, PacSun lost $35.2 million on sales of $263 million. For the year ended January 29, 2011, sales fell 9.5% from $1.027 billion to $930 million. The loss increased from $70.3 million to $96.6 million.
 
Sales per square foot for the year fell from $275 to $258. In 2007, it was $350. Well, we’ve all taken some hits since 2007. Internet sales represented 5% of sales in both 2010 and 2009. That mean internet sales fell for PacSun. Average dollar sales per store were $1 million, down from $1.1 million the previous year and $1.3 million the year before that. Comparable store sales fell 8%. Men’s increased 2% but women’s was down 19%.
   
Management says that a big factor in the sales per square foot decline was the performance of denim. It was 22% of revenues in 2009 “…driven by our proprietary Bullhead denim and our foundational ‘skinny’ fit.” In 2010, PacSun’s denim sales fell by 20% because “….denim became a very price-competitive business with very little newness or uniqueness in the marketplace in terms of fit or trend.”
Everybody had a hard time with denim in 2010. But what I think I’m hearing is that their Bullhead proprietary brand didn’t have the brand positioning it needed to withstand the difficult competitive conditions. Uh, you might go back up and read what I wrote about proprietary brands above. Maybe I’m onto something?
 
The other factor in the sales per square foot decline PacSun mentions is accessories and footwear. It represented 30% of sales in 2007, but only 12% in 2009. Remember they got out of the shoe business? They have reentered it and now have shoes in 450 stores.
Gross margin fell from 25.2% to 22.1%. Please note that gross margin as PacSun defines it is after buying, distribution and occupancy cost. They indicate that 1.6% of that decline came from having to spread costs over a smaller sales base. 1.4% came from the merchandise margins (what many of you think of as gross margin) falling from 48.1% to 46.7% “…due to a decrease in initial markups and an increase in markdowns…”
 
Selling, general and administrative expenses were down $40 million to $301 million. They also fell as a percentage of sales.
Okay, now let’s take a look at the balance sheet and its change over the year. The current ratio fell from 2.42 to 2.11. Cash declined from $93 million to $64 million. Interestingly, inventory rose from $89.7 million to $95.7 million at a time when sales are down and stores are being closed. I would not have expected to see that. Total debt to equity rose from 0.56 to 0.87. Equity is down by about one-third from $307 million to $214 million.
 
In August, PacSun did a couple of mortgage transactions, borrowing a total of $29.8 million. They note in the Management Discussion (as well as in the risk factors), “If we were to experience a same-store sales decline similar to what occurred in fiscal 2010, combined with further gross margin erosion, we may have to access most, if not all, of our credit facility and potentially require other sources of financing to fund our operations, which might not be available.”
 
Since Gary Schoenfeld became CEO, PacSun has done most things right. In my mind, there are two major issues. First is whether the financial constraints they appear to be operating under will allow them to finish the turnaround without additional capital. Second, and actually more important, is whether they can get the customer they want back. The company’s decline and then some time spent treading water has given PacSun’s target customers an awfully long time and good reasons to shop elsewhere. It might take as long to get them to come back.               

 

 

The Lesson to be Learned from SIA’s Sales Report

SIA recently reported that the snow sports market in February exceeded $3 billion. You probably get the same emails I get, but if not, you can see the announcement and analysis here. SIA expects the industry to set a record by the time the season ends. Through February, sales are up 13% in dollars and 8% in units. In February unit sales were down 2% and dollars sales 1.5% compared to February last year. But gross margins rose 8%.

With the usual cautionary note that we always do well when the snow gods favor us, let’s look briefly at the opportunities these results present us with.

I’m thrilled to see February sales down and margins up 8%. That happened because inventories were tight. For the whole season, sales are up more than units, also reflecting rising margins.
 
If dollar sales fell 1.5% in February but margins were up 8%, how did you do? I’d say you had more gross margin dollars than if sales had been a bit higher but margins lower. Those gross margin dollars, I may have argued a time or two, are what you use to pay your bills. But wait! There’s more!
 
You have less working capital tied up in inventory. You could have spent less money on advertising and promotion. Your customer is learning not to wait for a deal. Tons of closeout product isn’t showing up in places we really don’t want it (unless you’re one of those close out people, in which case you may not be too happy). There’s not a pile of left over product in your warehouse waiting to be cleared out before the start of the season next year.
 
Won’t it be fun when customers start coming in looking for cheap stuff and you can tell them that not only isn’t there any, but if they don’t get what they want now, they may not get it? You’ve already improved your gross margin by next year just by not having a bunch of inventory left and we’ve collectively improved our brands’ images.
 
As an industry, we go to conferences, hold trade shows, create learn to ski/ride programs, run all sorts of programs, do studies advertise and promote, and spend overall millions of dollars trying to get people to try riding/skiing and stick with it.
But I’d hypothesize that we could forgo a bunch of that if we just didn’t get so damned greedy and continued to control our inventories. Oh, and we- you, that is- could make more money with less risk.
 
Now, I’m the guy who’s always said every business is going to (and should) make the decisions that they perceive to be in their own best interest. That’s true. But it looks to me right now that what’s good for your business is probably good for the industry in at least this one instance. Everybody left standing in the ski/board industry has figured out, finally, that there’s no way to make money in winter sports if you’ve got a pile of left over inventory. And also you won’t be able to pay your bills.
 
I know we’re left with the not so simple issue of trying to match production and purchases with how much it’s going to snow and where. And I know that somebody, somewhere (probably more than one) is going to see the inventory shortage as an opportunity and crank up their factory and/or purchasing. But if most of us perceive that it’s in our interest to buy and sell a little less at higher margins, we can sleep better over the summer, have stronger balance sheets, make more money with less investment and help get more people on the mountain.
 
At least think about that before you say, “Shit, I could have sold more last year” and up your orders.                           

 

 

A Perspective on Zumiez Accounting Treatments as Reported by Forbes

An article in Forbes called “Great Speculations” had the subtitle “Accounting Smells a Little Fishy Down at the Zumiez Surf Shop.” It calls into question Zumiez’s reported earnings and balance sheet strength due to a couple of their accounting practices. Boardistan called our attention to it and concluded, “Apparently, Zumiez is shifting over to the “whatever it takes” program.” I had a couple of people email it to me, though nobody expressed an opinion. Maybe they thought I’d jump on Zumiez or something or were just pointing out to me that I hadn’t covered either of the issues mentioned by Forbes in my recent analysis. We didn’t hear anything about this in either Transworld Business or Shop- Eat-Surf.

Forbes analysis and explanation was fine as far as it went, though I’d have trouble reaching the same conclusion they reached. I thought it might be useful if I looked in a bit more detail at the two issues they raise. My goal is not just to give you some perspective on the accounting issues, but to show you that the issues are not quite as clear cut as Forbes explained them and to make you leery of short, pithy, articles you read in the popular media. Hopefully, nobody thinks my stuff is pithy. Well, maybe from time to time I’m a little pithy.

I’m going to assume you clicked on the link above and read the article. Let’s start with a little perspective on accounting.
 
Over many, many years, many people have struggled to figure out what the “right” accounting procedure for certain transactions is. It’s typically obvious what’s just not acceptable. It’s sometimes not so easy to choose from a number of reasonable approaches. Eventually a consensus is reached by the accounting powers that be and they choose a way to do it. The goals are consistency, comparability, and accuracy. Reasonable people can reasonable believe that different approaches are correct.  If you think of accounting as being exact, get over it.
 
The first thing the Forbes article points out is that Zumiez increased the useful life of its leasehold improvements. That’s the cost of the stuff you do to stores after you lease the space to make them ready to open or to improve how they look. When you increase useful life, you decrease the annual depreciation and so have less reported expense. So your income goes up. Zumiez changed its useful life from the lesser of 7 years or the term of the least to the lesser of 10 years or the term of the lease.
 
“For the fiscal year ended January 29, 2011, the effect of this change in estimate was to reduce depreciation expense by $4.2 million, increase net income by $2.7 million and increase basic and diluted earnings per share by $0.09,” Zumiez states.
 
Forbes notes that “…ZUMZ is the only retail com­pany, and 1 of only 9 in the 3000+ com­pa­nies we cover, to increase the esti­mated use­ful life of any of its assets accord­ing to all 10-Ks filed since Jan­u­ary 2010.” There’s a kind of “Aha! We caught you!” sense to the article. But what we don’t know, either from the article or from Zumiez’s 10K is why this is, or is not, a reasonable thing to do.
 
The other thing that the Forbes article points to is that Zumiez “…car­ries over $310 million (nearly 50% of its mar­ket cap and over 120% of reported net assets) in off-balance sheet debt.” It’s all in footnote 9 in Zumiez 10K; Commitments and Contingencies. The number I see is actually $347 million which is more than Forbes reported. The number for Pacsun, by comparison, is $506 million (they have a lot more stores) and is disclosed in a similar footnote. And you’d find the same thing for other larger, multi-store retailers. In this case, then, we have good comparability.
 
Should that amount be on the balance sheet? Maybe. The Financial Accounting Standards Board came out with FAS 13 in 1976 to tell companies how to account for leases. It’s been amended quite a few times since then. A link in the Forbes article describes how they are considering requiring that these leases be included on the balance sheet as a liability starting in 2012. 
 
I should make it clear that the idea of a public company managing (some would say manipulating) their earnings to put their best foot forward is hardly new. There are lots and lots of ways to do that. You change your reserve for bad debts. You can decide to ship and invoice on the last day of the quarter or early in the new quarter to determine what quarter the sales go in. The list goes on. Did Zumiez do something wrong? All we can say, taking the Forbes article at face value, is that increasing the useful life of leasehold improvements is unusual. Is it justified? We don’t know. Does it meet generally accepted accounted principles? Yes.
 
Not including the lease liabilities on the balance sheet is normal practice. Is it the “best” way to do it?   Damned if I know. Let’s leave that to the Financial Accounting Standards Board.
 
And if they do change (again) the way leases are accounted for, it will be hard to compare the first year they do that with the previous year’s results. We’ll probably need a footnote to take care of that.  It will be hidden in the back of the report, and you’ll have to go find it and read it. And then there will be some other change, and some other accounting issue will rear its early head. But we still won’t know the “right” way to do the accounting.”
 
The moral of the story is that there’s a certain inevitable amount of complexity and ambiguity when it comes to evaluating the “quality” of a company’s earnings. We can and will move towards doing it better, but we’ll never get to end of that road. Evaluating a company’s financial statements and their reasonableness probably means you have to get a little dirty back in the footnotes to get a clear perspective. You shouldn’t rely on what Forbes says. Or on what I say for that matter.
 
But don’t get too dirty. Knowing that Zumiez increased their earnings per share by $0.09 for the year by increasing the useful life of its leasehold improvements doesn’t, by itself, change my evaluation of their market position and strategy. But I’m glad that Forbes highlighted the issues for us to think about.