Get Out of the Office! It’s Amazing What You Can Learn

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Yesterday, I had occasion to meet up with Jaimeson Keegan, who’s the President/Floor Sweeper (according to his business card) of SUPERHEROES Management. It offers athlete and entertainment talent representation combined with social media strategies and some other stuff that I thought was a very sensible aggregation. Anyway, we’re both up here in the Northwest and just thought we should get together and meet each other. Not being from Southern California, we get lonely and don’t have that many people to talk to.

And since we both knew where it was and there was a great coffee place down the street, we met at The Snowboard Connection in downtown Seattle. Owners John Logic and Adam Gerken weren’t there. John, it seems was over at the storage unit at their old location finally cleaning the thing out. They are apparently putting a wrecking ball to that old building, so there was just no way to put off cleaning it out any longer. Adam was off on his first vacation in three years. I took that as a sign the business was doing well.

I saw the Skullcandy display in the store. The sales person was raving about some new, customized display Skull was going to give them that would wrap around the post, or something. I asked if they carried any other headphones and the only thing they had was one pair of Nixon headphones in the case with the other Nixon product.
 
It made for an interesting comparison. Nixon started out in watches and has diversified their product line rather dramatically. Skullcandy has quite a line of tees, sweats, and beanies, but the focus is clearly on buds and headphones. We’ll see if that changes. One reason it might not change is because of different distribution strategies. Skull’s two biggest customers are Target and Best Buy. I’ve seen their product in Fred Meyers and, well, kind of all over the place. Their challenge, as I’ve written before, is to be cool even in wide and widening distribution. I’m prepared to believe you might manage that with headphones (ignoring, for the moment, the issue of inevitable competition). Not with apparel or other products.
 
I didn’t look for Nixon in Fred Meyers and don’t expect to see them there. But I’d expect their brand strength would allow them to sell a broader range of products than Skull but in a more limited distribution. Think of it like this. Skull has broader distribution in a narrower product line. Nixon has narrower distribution with a broader product line.
 
As long as I was downtown and had time on the parking meter, I thought I’d walk across to REI and see what was going on there. The first thing I noticed was that there wasn’t all that much merchandise in the store. I don’t mean it was poorly merchandised or looked bad. I just mean the store could have held a lot more product and not have been even close to cluttered. I’d chalk that up to the economy. As a member of the industry, I say, “Great!” Carefully managed inventory means fewer markdowns, less investment, and consumers anxious to buy. As you know, I think you can sometimes earn more selling less.
 
The ski and snowboard hard goods were right next to each other, more or less forming one section of the store. I really liked the snowboard racks. Ever shopped for area rugs? You know how they hang from a rack and move them from side to side like turning the pages of the book so you get a good look at them? That’s how these racks worked. Great idea.
 
I also noticed that the racks weren’t full. Hope that’s due to good inventory management rather than late shipments.
 
The winter apparel was nowhere in sight. I had to go upstairs to find it. It was pretty much all together with no ski/snowboard differentiation. Patagonia with Marmot with Burton with Nike with Betty Rides and some others. I’ve known Betty Rides owner Janet Freeman for more years than I’m prepared to admit. I don’t think this is the brand’s first year in REI, but it was great to see. Janet, you’ll be glad to know that your brand was as well represented as much larger brands, though it was a bit in the corner. It was interesting, in fact, to notice that no brand had all that much more space than any other. I was also told that REI does no private label.
 
So anyway, that’s what I learned just because I got my ass out of my office chair. I should do it more often.

Lessons From Interbike: Focus In or Focus Out

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I had occasion to be in Vegas on business while Interbike was going on. The company I was working with was exhibiting there, so I took the day to wander around the show. I’d never been to Interbike before. There was something different about this trade show from all the others I’d ever been to. It took me a little thinking time with my favorite adult beverage after I got back to begin to figure it out.
 
What I did notice at the show, of course, was that everybody there- exhibitors, buyers, hangers on- were about riding bikes and making riding better. That’s not a completely unique observation. I’ve made a similar comment about SIA’s snow show in Denver where everybody is somehow or other associated with sliding on snow.
 
But I wouldn’t want to push that comparison too hard. Technology, and improving the technology, in the cause of better riding, was king at Interbike. I guess that’s partly because the technology is so visible and touchable and, apparently, constantly changing. I don’t claim there’s no marketing component to this, or that all the “new technologies” really represent significant changes. But it seemed to my bike uneducated eye that product evolution and improvement was very real.
 
And when I looked at the prices of bikes, it appears the consumer agrees and is willing to pay for it. When a friend told me that the price of a top end bike could be $10,000.00 or even more, I almost peed my pants. It’s been a while since I bought a bike and yes, I do know there are also cheap bikes out there.
 
The other thing that my friend told me was that he had bought his bike some years ago, and still had it. But various parts had been replaced as they wore out or he found an upgrade he wanted. It was the same frame, but not necessarily the same bike.
                   
There’s market value in this kind of focus and community of interests. It tells you who your customers are (and who they are not). It invests the customers in their relationship with the retailer and provides reasons to visit that retailer. It gives the consumer an ownership of the product you can only get when the product is upgradeable, not a commodity, and long lived.
 
It’s not that there isn’t a fashion component to all this, but I didn’t seem much “after biking” clothing or “casual” bike shoes. That’s kind of where the comparison to the SIA show falls apart. Obviously, there’s a huge fashion component there.
  
Where else have I seen the kind of commitment to technology and community of interests I saw at Interbike? The only place that comes to mind is in longboarding. Longboarders, like bikers, seem to be an inclusive, group of people who are accepting of anybody who uses any kind of longboard for any purpose. They share an interest in longboard technology and product improvement. That’s probably why they’ve become as big a chunk of the skateboard market as they have.
 
I had a chance to talk to a bike retailer about skateboarding. He didn’t do skate, but was considering picking up longboards. Not short decks- just longboards. He said he wouldn’t know how to sell short decks and they just wouldn’t fit in his shop. He meant “fit,” I think, in a couple of ways. There was no way he could do a wall of short decks, and his customers wouldn’t be interested. But long boards, as a community with improving technology, and as a mode of transportation as well as competition he could relate to.
 
Biking also has the advantage of being something you can do from oh, I don’t know, ages 5 to 75? And, like skate, you can do it anywhere.
 
But where surf, skate, and snow break down, at least compared to biking and, I suppose, longboarding, is that they have diffused their customer focus. Much of the market (most?) is apparel, shoes, and other products, sold to non-participants. Biking has a broad community of common interest defined by participation. Action sports uses participation to attract nonparticipants to its “lifestyle.” Isn’t it interesting that biking, except for BMX, isn’t considered to be part of action sports?
 
Action sports works hard to keep its core distinctive and maybe even exclusive. You, the uncool person, can’t really belong to that core but you can sort of emulate it if you want by buying this shirt. That’s seen as a marketing strength and for some companies it certainly is.  Biking is about hard goods and everybody is invited in as in longboarding. Hmmm. Is longboarding action sports? Maybe how we label it doesn’t matter and I don’t care.
 
Because of its inclusiveness and focus on participation, you compete in the bike market by making a product that helps the rider participate better. When you do that by definition you join and support the community. If you can’t do that, nobody cares. Energy in the industry is concentrated and focused inward.
 
In actions sports, on the contrary, our growth efforts have inevitably become focused outward. Our energy is diffused and bigger, stronger competitors can break in as the distinction between action sports and fashion becomes blurred.
 
I’m not saying that action sports have done it “wrong” and biking and longboarding have done it “right.” At the end of the day, more people are going to bike at some point in their life than are going to surf.  It’s just the way it is. But there’s food for thought here. Is it better to build your market, like bike and longboarding seem to do, by welcoming anybody who wants to participate or can contribute to better participation? Ultimately, you create some limit to your market.
 
Or should you, as action sports has done, go for the much larger market of nonparticipants, recognizing that as you diffuse your energy over this larger market you invite serious competition and make the exclusivity that was initially your greatest competitive advantage less important?
 
I’ll be damned if I know, but the comparison is certainly intriguing.

Quik Grows its Sales and Profits; I Thought I Heard a New Attitude

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At the start of the quarterly conference call, Quiksilver founder and CEO Bob McKnight always makes a short speech highlighting the good things that are going on. After Rossignol, and through the balance sheet restructuring, they felt a bit like pep talks. He would highlight in a pretty nonspecific ways some things that were going well, and often they seemed like small things. It felt like he was offering reassurance where he could.

Suddenly that’s changed. Call me crazy and hell, maybe I’m imagining this, but his speech for the July 31 quarter didn’t sound like, “It’s going to get better.” It was more like, “It is better.” That was great to hear.

Reported sales were up 14% to $503 million from $441 million in the same quarter last year. They were up 11% in the Americas to $260.2 million, 16% in Europe to $176.4 million, and 20% in Asia/Pacific to $65.5 million. The percentages in constant currency were, respectively, 11%, 2%, and (3%). Quik’s largest customer accounts for about 3% of revenue. Comparative sales for company owned retail was up 21% in the quarter. Ecommerce business rose 65%, and they expect it will represent $25 million in revenue by year end. Overall for the quarter, “…Roxy was down just slightly in the quarter as a brand. Quik was up low single digits, and DC was way up. It’s in the range of 15% to 20% higher.”
 
 
I’ve previously expressed some concern that Quik might put too much pressure on DC for growth. I’ll look forward to seeing some revenue growth from Roxy and Quik and their new collections.  
 
The new Quiksilver Girls line and Quiksilver Women’s business are expected to generate revenues of $15 million. The Waterman collection, and its European equivalent, is now a $35 million business.  Quik needs some serious growth here.
 
One of the things that really caught my attention in CEO McKnight’s talk was the strategy for certain Roxy product to provide better quality and value at a higher price. Aside from generally just liking the strategy as a point of differentiation, it seemed positive, proactive, and confident.    
 
The growth in the Americas came “primarily” from the DC brand. The DC growth came “primarily” from footwear. The Quiksilver’s brand Americas growth was mostly in accessories and Roxy’s growth was from footwear and accessories. Roxy apparel declined.
In Europe in constant currency, DC and Quiksilver revenues rose, but Roxy was down. The 3% constant currency decline in Asia/Pacific came from the Quiksilver and Roxy brands, offset by strong growth in DC.
 
Gross margin percent fell from 52.3% to 50.7%. In the Americas, it fell from 46.7% to 44.2% mostly because of higher cost of goods, but also due to some mark downs. European gross margin fell from 60.6% to 60.3%. In Asia/Pacific it was down from 52.7% to 52.4%. I note again the attractiveness of sales outside of the Americas.
 
Selling, general and administrative expense jumped 14.5% to $221 million. It remained relatively constant as a percent of sales.
Operating income actually fell a bit from $35.4 million to $33.9 million even though they had no asset impairment charge this quarter compared to a charge of $3.2 million last year. It was down in the Americas from $27.7 million to $27.1 million. In Europe it rose 34.7% from $15.6 million to $21.0 million. Asia/Pacific, even with that big gross margin percent, reported an operating loss of $2.0 million up from $1.6 million in the quarter last year. For the whole company, operating income was 6.7% of sales compared to 7.8% in the quarter last year.
     
Interest expense fell from $20.6 million to $15.7 million due to reduction in their total debt. Net income rose from $8.6 million to $10.4 million.
 
The balance sheet has improved from a year ago, with the current ration rising from 2.26 to 2.45 and total liabilities to equity down from 2.45 to 2.14. Receivables are up consistent with sales. Days sales outstanding remained at about 65 from a year ago. In constant currency, inventory rose 24% compared to a year ago. This was required to support higher revenue levels. There were also some early receipts of fall season inventory.
 
I expect to see continuous, gradual, balance sheet improvement as long as the economy doesn’t worsen. And I’d like to see some growth out of the Quiksilver and Roxy brands. But you know what? If we could see those two brands grow slowly but be managed to generate a lot of gross profit dollars, if DC continued to grow but at a moderating pace, and some of the new initiatives began to generate some significant revenues I think we’d have a financial model that might make a lot of sense at the bottom line given the projected economy.        

 

 

Zumiez’s Quarterly Results; Their Computer Systems are a Competitive Advantage

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From a financial statement analysis point of view, this is kind of boring. The balance sheet is solid enough that I’ll pay it the ultimate compliment of not discussing it. No bank debt, and the inventory was more or less constant on a per square foot basis.

In the conference call, one of the analysts even wanted to know if they had any plans for dividends or acquisitions as a way to use up some cash. The answer was no. Zumiez like’s having cash when the economy sucks. Me too.

Sales for the quarter ended July 30 were $112.2 million, up 14.9% compared to the same quarter last year. Comparable store sales grew 7.5%. They opened a net of 31 stores during the fiscal year so far, bringing their total to 424 in 38 states and Canada. There are six stores in Canada and will be 10 by end of the year. Ecommerce sales were 5.3% of total sales for the quarter compared to 2.9% in the same quarter last year.
 
Gross profit rose 22.3% to $37.3 million. As a percentage of sales it was up from 31.2% to 33.2%. This improvement largely represents cost reductions and the ability to spread costs over a larger sales base rather than higher sale prices or lower product cost.  Remember that in the quarter last year they had a bunch of expense associated with the relocation of their distribution center that they don’t have this year. That represented 1% of the gross margin improvement.
 
Sales, general and administrative (SG&A) expenses rose about $1 million, but fell as a percentage of sales from 33.6% to 30%. 2.2% of that decline was due to last year’s payment of $2.1 million to settle a lawsuit. They didn’t have that expense this quarter. The rest was due to spreading costs over a bigger store base and reducing some expenses. Rent expense, in case you’re curious, was $16.7 million or not quite 50% of the SG&A total.
 
Net income improved to $2.59 million from a loss of $1.2 million in the same quarter last year.
 
That was easy. Now for the more intriguing stuff.
 
Zumiez still has a 14.3% equity investment “…in a manufacturer of apparel and hard goods.” And I still don’t know who it is or why they have it. It doesn’t actually matter particularly, but I’m just really curious about the circumstances behind it.
 
Zumiez’s 10Q (you can see it here) runs to 39 pages, which isn’t particularly long. But 10 pages of that- 25%- are taken up by a risk factors section that starts on page 22. PacSun doesn’t even include any risk factors, though they refer to the list in their last annual report. Zumiez must have more conservative lawyers.
 
The risk factor I focused on, as we work our way over to Zumiez’s strategy, was the one that said, “Our failure to meet our staffing needs could adversely affect our ability to implement our growth strategy and could have a material impact on our results of operations.”
This comes after, and is in addition, to the one about how they could be screwed if they lose key management, which is a risk factor most companies include.
 
Basically, they’re talking about getting enough of the people who work in the stores. You might think that in this economic environment it would be a little easier to get people. It is, but Zumiez doesn’t just want competent people. It wants competent people who are active action sports participants and who are committed to the life style. Unless they want to take some big risks with their business model, they can only grow as fast as they can recruit and train those people. They think they have the potential to open another 175 to 275 stores in the U.S.
 
Next, here’s CEO Rick Brooks talking about why Zumiez is successful:
 
“The foundation of our success and what will continue to strengthen our position as the leading branded action sports retailer is our product and our people. Our diverse mix of branded apparel, footwear, accessories, and hard goods, combined with a unique shopping experience, clearly distinguishes us from the competition. Our merchandise teams continue to do a great job fine-tuning our product assortments by mixing new hard-to-find brands with larger core brands that reflect current trends in demand.”
 
Then, after talking about the difficult economic conditions, he says the following:
 
“In this environment, the mall has become highly promotional. However, we believe that as a specialty retailer of product that’s hard to find elsewhere and with the in-store and Web experience that we provide, our concept reflects the quality of our strategies. We’ll benefit in the long run by staying true to this concept and will sustain our position as a quality destination lifestyle-driven retailer.”
 
They don’t much care, in other words, what others are doing. They are going to keep focused on doing what they do. CEO Brooks put it this way in response to an analyst’s question about Zumiez’s competitors. “It’s not that so much we’re concerned with what they’re doing, Jeff, from my perspective. It’s we’re concerned about what we need to do and what our plans are.”
 
And they have the balance sheet, cash flow, and marketing positioning as the core shop in the mall to back that up. To be fair, they also have the happy circumstance of not getting much of their revenue from the juniors business.
 
I guess I’ll let Rick Brooks continue to write this article for me.
 
“…we have a lot of brands you can’t find elsewhere. So, we are not inclined to discount brands that can sell at full price. In fact, again, I think we’ve been successful in being able to push through the price increases where there is demand for those brands.”
 
“We have been trying to assort — do local assortments in stores from virtually the very beginning of Zumiez under a very simple sales-driven philosophy that you should put things in stores that people want to buy. Now with scale, that gets to be tougher and tougher, so over the last number of years, going back 10 or 15 years, we have been instituting technology enhancements to allow — to provide better tools for our merchandise teams to assort — to do local store assortments.”
 
Well, I don’t know, I guess I can see some logic to putting stuff in stores people want to buy. How exactly do you know which stuff should be in what store?
 
As CEO Brooks says, they’ve been working on that for 10 to 15 years. Serious competitive advantages don’t just spring fully formed out of a planning meeting. They are still working on it, and are “…instituting new business intelligence reporting tools.”
 
In the longer term, “…we’ll be able to do all sorts of things that we’ve never be able to do at a much more detailed level. Better size optimization within that structure, right color size, getting more fine-tuned about what mix of products and categories and lifestyles go together in each store.”
 
“And ultimately, we would — give us a few years out, there will be another evolution in that relative to around planning rack capacity and building rack capacity into this model.”
 
You can see, as I said in the title, why Zumiez’s systems are a competitive advantage. Like their personnel and hiring policies. Like their core store positioning in the malls. They aren’t invulnerable to a poor economy and see their customers buying closer to need. But thanks to certain operational efficiencies developed over many years (which is the only way they can be developed) and a consistency in applying their business model they are as well positioned as any retailer in our industry to deal with it.

 

 

Cyberboutiques. I Don’t Know if this is a Great Idea or a Waste of Bandwidth.

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My wife sent me this article from the New York Time’s Fashion and Style section. For some reason, I don’t read that section regularly. Not enough graphs, charts, and numbers to get me excited I guess.

I played around a bit with the application at the web site. It was a bit jerky and slow, but I could certainly see the potential. Either that or I couldn’t, and I guess that conundrum is what’s leading me to write this.

On the one hand, maybe this is the next step in integrating online with brick and mortar retail. What might happen if each store in a chain had its own virtual store with avatars of the actual sales people who worked in the store? What is the customer could chat with the actual people in the store through their mobile device and the inventory online reflected the inventory in the store? Or you could click on an icon to talk with the actual sales person on a web cam.
 
Or maybe I’m over thinking this and nobody would care. Just because you can do something doesn’t always mean it’s a good idea. Like all of you, I learned that when I was very young.
 
I can imagine some kind of temporary marketing advantage here due to the immediate “that’s cool” factor. But I also felt like it had the potential to slow down my shopping. I don’t necessarily want to wander around a web site the way I wander around a store. And there seemed to be some glitches in the navigation. Make sure you go up the stairs (though it isn’t clear that you can at first and I sort of stumbled on it). 
 
Of course, I’m looking at version 1.0 so we need to consider the general concept and not be too critical of the specifics. You know the software will improve if the concept is well received.   But what’s the purpose? I’m not sure it adds to the shopping experience and nobody expects a web site to be the same as a brick and mortar store. Do they?
 
I guess I think that if it doesn’t improve web site navigation, make shopping more efficient, or give me some new information I want then I don’t care. No doubt there are people working right now to make those very things happen. It will be interesting to see what they come up with.      

 

 

PacSun’s Quarter. Can the Strategy Work in this Economy?

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PacSun’s 10Q was filed two days ago. I’ve been through it and it offers a few tidbits of interesting information. But mostly, PacSun CEO Gary Schoenfeld said a lot of what needs to be said, at least strategically, in the conference call. Here are his most relevant comments:

“The economy is not getting better and competition remains fierce for a limited amount of discretionary spending. As a team, we remain committed to our turnaround strategy that includes a long-term focus on delivering trend-right products and creating a distinctive PacSun brand identity and experience tied to our unique California heritage.”

“But we also know our store gets shopped, but we’ve got to move up higher. There’s 8, 10, 12 good choices for her in the mall. And where you sit in that pecking order is pretty important.”
 
It’s hard to argue with the strategy, though it isn’t very distinctive and has elements of what most brands want to do. If a strategy lacks uniqueness, it can be expensive to implement. The question in my mind, which hasn’t changed much since the last time I took a look at PacSun, is whether there’s enough uniqueness so they can afford to implement it given the economy and the company’s financial circumstances.
 
Oh damn, I seem to have written the conclusion first. I guess I’ll just ignore that and move on to the numbers.
 
Sales for the quarter ended July 30 fell 1.6% to $214.9 million compared to the same quarter last year. I should point out they closed 31 stores during the first six months and expect to close 50 to 60 for the whole fiscal year.  Closing stores reduced sales by $8 million in the quarter. But stores not yet included in the comparable store calculation and a slight increase in comparable store sales increased sales $5 million, resulting in the net decline of $3 million. Women’s comparable store sales rose by 1%. Men’s were flat.
 
The gross margin fell from 23.2% to 23.0%. Merchandise margins fell by 1.3% but occupancy and buying and distribution costs fell so the decline in the gross margin was minimal.
 
Sales, general and administrative expenses fell 8% from $74 million to $68 million. As a percentage of sales it was down fro0m 33.9% to 31.6%. Most of the decline was payroll expense ($5 million) and depreciation ($4 million). You kind of wonder if their strategy doesn’t call for increasing certain of these expenses, but there’s that conflict between financial capability and the requirements of the strategy.
 
Inventory on the balance sheet fell from $174.8 million a year ago to $163.3 million at July 30, 2011. They have 59 less stores than they had a year ago. Total store count is now 821, down 59 from a year ago. Reported inventory is down 7%, but management indicated it would have been down 10% if they hadn’t taken some back to school deliveries early. There’s no discussion of the impact of any higher costs on inventory levels.
 
Cash was down from $25 million to $13.3 million. The current ratio fell from 1.61 to 1.44 over the year. Total debt to equity rose from 0.85 to 1.43. At least according to this cursory evaluation, the balance sheet has weakened a bit. They have nothing drawn on their line of credit, but indicate they might have to use it if current trends continue.
 
After the quarter ended, PacSun completed negotiations with some landlords. They are making payments of $1.3 million to buy out the leases on five stores which will be closed by the end of the year. They also made deals with 95 stores to reduce rents and extend leases at more favorable terms. They indicate this will save them $9.5 million over the lives of these leases (through most of fiscal 2012). They also issued 900,000 shares of stock (to the landlords I assume) as partial compensation for these lease changes.
One cool thing they did was to roll out Apple iPads in 300 stores. I’ve had the experience of shopping where clerks are equipped with them, and I like it a lot.
 
Along with other companies, PacSun has found the start of back to school difficult. As they describe it, “…the primary drivers included declining consumer confidence and a higher competitive promotional environment.” As a result, they are anticipating that same store sales “…will be in the mid to high negative single digits for the third quarter…”
 
I really miss the good, old fashioned reliable kind of recession where supply gets ahead of demand, companies pull back, we have a recession, then move forward as demand catches up. These debt excessive leverage recessions (of which this is my first one) are hard and very, very long because people paying down debt don’t buy stuff. It sucks to be a company- any company- trying to sell product to consumers that they can easily put off buying.
 
Okay, I’m done.  Like I said, I wrote the conclusion first so if you’re looking for closure, please read it again.

 

Billabong’s Annual Report; The Relationship between Strategy and Operating Environment

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Billabong’s annual documents (which you can see here and here) provides us with a superlative opportunity to look at the nexus of a company’s strategy and its operating environment. The conference call transcript was also worth reading, but it seems to have disappeared from their web site. I can send anybody who wants it a copy.

Of course I’ll spew forth all sorts of numbers (in Australian dollars). But I want to look at those numbers in terms of the evolution of Billabong’s strategy, the impact of external factors, and some operational initiatives which, given the operating environment, are going to have a lot to do with Billabong’s future performance.

I’m sorry I’m so late getting this done, but I’ve been back on the East coast helping my mother and her husband move. Family has to come first.
 
A Transition Year
 
The year ended June 30, 2011 was a transition year. Billabong told us it would be and has been telling us that since last year.
 
Reported revenue rose 13.6% to $1.68 billion. Net profit was down 18.4% to $119.1 million. In constant currency terms, revenues were up 23.8% and net profit fell 6.9%. The currency fluctuations cost Billabong $123 million in revenues and $18 million in net profit. 
 
I will point out that Billabong had taxable income of $126.9 million and paid only $8.86 million in taxes. That’s a tax rate of 7%. Last year, they paid $57.9 million in taxes on $203 million of taxable income and had a rate of 28.5%. If this year’s tax rate had approximated last year’s rate, their net profit would obviously been a lot lower. Billabong tells us to expect a rate of 23% to 24% in the current year.
 
Here, then, is the income statement headline. Net profit fell in spite of higher sales and a very low and not to be repeated tax rate. That’s not good.    
 
Now, why was this a transition year? Mostly because of acquisitions. They closed the acquisitions of retailers West 49 in Canada, and Surf Dive ‘n’ Ski, Jetty Surf, and Rush Surf in Australia. As a result, the number of company owned stores rose from 380 at the end of the last fiscal year to 639 at the end of this one.
 
They bought the RVCA brand in the U.S. Inevitably, they ended up with a lot more inventory and took on some debt to finance all these deals. I’ll get to that when I talk about the balance sheet.
 
The retail acquisitions took their direct to consumer share of revenue from 24% of total revenue at the end of last year to 38% at the end of this one. Now that’s a transition and we’ll talk about the impact when we look at the evolution of their strategy.
 
Operationally, acquisitions leave you with a lot to do. Here’s how Billabong puts it.
 
“A range of initiatives have been pursued within the business to reflect the change in mix between wholesale and retail. The standardization of various IT systems and sales intelligence software is underway, overhead has been adjusted, management within key retail divisions has been enhanced, design teams to build faster‐to‐market product have been established and greater investment has been made into the Group’s fast‐growing and profitable online operations. The strategy to build a more robust business model in response to the changing consumer environment is on track.”
 
They also closed 65 stores during the year due mostly to high occupancy costs. Many of these were stores acquired during the year.
 
The retail acquisitions caused some initial margin dilution and, maybe more importantly, it delayed some sales revenue because once you own the retailer, you have to wait to book a sale until the product is sold to the consumer. Before they bought them, Billabong got to book the revenue when product was shipped to the retailer. 
 
It takes time and costs money before you realize the benefits of these kinds of actions. They had $12.3 million in pre-tax one-time merger and restructuring costs. As you know if you read me regularly, I find the so called nonrecurring costs a bit problematic in evaluating a company’s results. While it’s true that these exact costs won’t recur next year, there always seem to be new non-recurring costs at some level every year.
 
There’s a lot going on. Billabong expects to see more of the benefits in the current year. I’d go so far as to say they’re counting on it.
 
External Factors
 
As you saw above from the difference between as reported and constant currency numbers, Billabong got hammered by the strength of the Australian dollar (At June 30, one Australian dollar was about $1.06 U. S.). The Australian economy going into recession and getting hit with floods in Queensland didn’t help either. And, speaking of natural disasters, remember the earthquakes and tsunami in New Zealand and Japan.  Like every other industry company, they had to deal with higher product costs as the price of cotton rose. The good news is that the price has now fallen and that should start to benefit Billabong next calendar year.
 
Meanwhile, consumers worldwide are just not cooperating. “With the exception of the USA and some Asian territories, global trading conditions have generally deteriorated significantly,” is how they put it. They noted they’d seen some deteriorating in conditions in Europe during the last two months of the year.
 
Damn those pesky consumers!
 
It is, in short a tough operating environment (not just for Billabong) with a continuing high level of uncertainty. As a result, Billabong is not going to offer any earnings per share guidance until things calm down.
 
Operational Initiatives
 
 I quoted Billabong above in describing the operational initiatives they are pursuing.   Some are the direct result of acquisition, but none are bad ideas in and of themselves regardless of any acquisitions. I’ve been writing for a few years now that it was time to stop over-focusing on the top line, where revenue increases are continuing to prove tough to come by. Look instead to generate more gross and operating margin dollars through better operations.
 
I’d like to believe Billabong took my advice, but I’m afraid they probably figured it out on their own. As reported, their gross margin fell only slightly from 54.4% to 53.8%. In a promotional, higher cost environment, that seems like a good result. Even with the turn towards retail, their long term strategy implies the kind of cost management focus I advocate.
 
The initiatives they describe are not inclusive of everything they’re doing. And I wonder, as a public company, if they would have taken on quite all of it if they’d known what the year was going to be like. Still, as they get through all this stuff, assuming it goes well, on budget and on schedule, the impact on the bottom line should be substantial. 
 
Strategy
 
Early on, Billabong recognized the limits of long term growth if you’ve only got one brand. They decided to grow by paying full price for established brands with growth potential and good management in place. I suspect there won’t be any more significant acquisitions for a while. Their balance sheet wouldn’t really support them, and they’ve got more than enough on their plate.
 
Part of their strategy has always been to protect their brand names by being cautious about inventory, distribution, and promotions. Even when the recession started, they choose to lose some sales rather than devaluing their brands by discounting. As noted above, their gross margin last of year of 53.8% fell only slightly from the previous year even in a difficult environment.
 
The strategy of growing retail (hardly unique to Billabong) had, in my opinion, a number of sources. First, it was the same desire for growth that lead them to buy other brands. Second, it was the knowledge that the number of solid brands they owned made a retail strategy more viable because they had the ability to stock their owned retail with these brands and generate extra margin dollars. Third, it was their analysis of the difficulties facing the independent specialty retailers worldwide. Things go a lot smoother when you don’t have to get orders from independent retailers and then collect from them.
 
The change in strategy, if you want to call it that, was the speed of growth in retail. I doubt they planned to have 38% of revenues coming from retail at the end of the year. And remember when these retailers have been owned for a full year, the percentage will probably be higher.
 
I suspect the accelerated growth was opportunistic. They could hardly ask West 49, or any of the other retail acquisitions, to wait and be for sale next year.
 
Finally, I want to remind you of some Billabong policies and procedures that some might not call strategic, but I see as the most strategic things they do. Look at the remuneration report starting on page 12 of Appendix 4E (the second link in the second paragraph of the article).   Then check out the eight governing principals starting on page 43.
 
The remuneration report shows how Billabong works very hard to align company and employee interests. The governing principals simplify managing by making it clear what’s most important. When you sit at the desk of the senior executive, you are constantly inundated with stuff crying for attention. These principals make it easier to not waste time on the wrong stuff. Even more powerfully, they can help do the same thing for every employee in the organization if they are communicated effectively. Wonder how much time and money that can save.
 
I also noted that all directors attended all nine scheduled board meetings and three unscheduled ones as well. I love to see that level of commitment.
 
Oh Yeah- Forgot the Financial Statements
 
The first thing I want to know if what the sales would have been without the acquisitions. We know that U.S. wholesale was flat excluding RVCA. I also see that trade receivables fell from $389 million to $341 million suggesting an overall decline in wholesale sales. But I don’t have a way to isolate any currency or timing impacts so I can’t be sure. All of last year’s acquisitions occurred between July and November of 2010, so their impact on sales in the year ended June 30, 2011 is substantial.  I think I’ll call a friend.
 
The friend got back to me and tells me I didn’t read footnote 35 closely enough.  My friend is right.  Acquisitions contributed $313.3 million to revenue during the year ended June 30, 2011.  Without the acquisitions, Billabong’s revenue would have been $1.374 billion, down 7.6% from the previous year.   
 
As you may recall, Billabong operates and reports its business in four segments; Australasia, Americas, Europe, and Rest of the World. I’ll ignore the rest of the world as it only represents $2.2 million in revenue.
 
Revenues in all three regions were up significantly in constant currency but, again, I can’t isolate the impact of the acquisitions. The Americas had revenue of $844 million, up 32.5% (18.4% as reported). Europe grew by 11.5% to $338 million (it was down 1.9% as reported). Australasia grew 19.5% to $502 million.
 
As reported, EBITDA (earnings before interest, taxes, depreciation and amortization) fell in all three regions. It fell from $89 million to $55 million in the Australasia. It was down from $92 million to $80 million in the Americas and from $70 million to $54 million in Europe. Consolidated EBITDA was $192 million, down 24.3% in reported terms and 16.2% in constant currency. The reported EBITDA margin was 11.4%, down from 17.1% the previous year.
 
Without the inventory impact of the acquisitions (projected to be temporary) it would only have fallen to 13.1%. Other factors include the merger and restructuring costs of $12.3 million already mentioned and foreign exchange losses. There was also $4.5 million associated with restructuring and rolling over the company’s syndicated debt facility and some accounts payable timing issues that dragged payments into the year.
 
We’ve already talked about the external factors that influenced this.
 
Overall, selling, general and administrative expenses rose 27.5% to $599 million. That includes employee expense that rose from $226 million to $283 million. Obviously, a chunk of this increase is the result of the acquisitions. There are people working in all those places and they inconveniently want to be paid.
 
The balance sheet took a hit. Remember a couple of years ago when Billabong raised some capital even though they didn’t really need to? It’s a good thing they did because I don’t think some of the acquisitions they did would have happened without it.
 
The current ratio fell from 2.48 top 2.33. Total liabilities to equity rose from 0.82 to 1.02. Net borrowings were up from $217 million to $468 million. Their interest coverage ratio fell from 12.6 times to 6.1 times. Some of the analysts were concerned about that.
 
Inventories rose 45% from $240 million to $349 million. This includes the inventory of all the acquired companies so naturally inventory rose. But there’s more to it than that. All the inventory in the acquired stores is at full wholesale cost. Even the Billabong and Billabong owned brand inventory. Once Billabong is stocking those stores directly, the owned brand product will go into the store inventory at Billabong’s cost- not full wholesale. Branded inventory from other companies will still come in at full wholesale cost, but I’m sure Billabong hopes to make some better deals based on its larger retail purchasing power and we know they expect to increase the percentage of owned brand inventory in those stores.
 
In other words, some of that inventory increase should go away over the next year as the owned brand inventory turns over, and its share of total inventory in these stores expands. The inventory increase is partly, but not completely, a one time event.
 
There is also some excess inventory they bought in anticipation of sales that didn’t occur and some they bought and received early because of concern about possible supply constraints that didn’t emerge. In total, they see $60 to $65 million of existing current assets turning into cash during the year.
 
Net cash flow from operating activities fell from $187.2 million to $24.3 million. That’s a big drop. There are also about $86 million in acquisition payments scheduled for this year.
 
There was some wailing and gnashing of teeth from some of the analysts about the weakening of the balance sheet and the decline in operating cash flow. They should be concerned. It’s rather critical to Billabong that these operational and margin improvements kick in this year because we continue to be in an environment where sales increases may be harder to come by. Europe is weakening and, at least in my mind, it’s not certain that the U.S. will strengthen much.
 
But I also think some of the analysts were caught by surprise by the size of the increase in retail business. Rather than focusing on the strategic impact, they were concerned with the short term financial impact. I guess that’s their job. That’s why there are quarterly conference calls.
 
At the end of the day, a stock goes up in the long run because of increases in earnings. Nothing else matters. I imagine there were discussions around Billabong as to whether they should do quite so many acquisitions last year. They knew the economic environment was iffy, and they could more or less calculate the balance sheet impact. Still, if you look at their strategy you can conclude the concepts of the deal made sense even if the timing wasn’t quite what they might have preferred. It was the best path they could see to improved, long term profitability given the environment they have to operate in.
 
But they’ve taken on some additional risk to do it. The balance sheet shows it. And, like the rest of us, they can no longer count on automatically higher revenues generated by strong consumer demand.         
 
I think we can assume that the world economy is not going to miraculously rise up during the next 12 months. So what we’ll be doing is watching to see how well Billabong executes its operational strategies internally to improve its earnings and strengthen the balance sheet.