Do Retailers Really Need to Carry All That Inventory?

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I suppose that seems like a stupid question. But having just been through another Christmas shopping (and return) season, I’m not so sure it is. I’ve shopped on line. I’ve been to too many malls too often (I confess it- I hate shopping). In those malls I saw way too much product on sale at way larger discounts than I like to see before Christmas.

As an aside, I’m wondering if the increased holiday sales being trumpeted by the media were at prices which will generate bottom line profit which, I take as a matter of faith, is still the idea.

I’ve made an effort this week, as I usually do this time of year, to catch up on my reading. Some of that reading included retail trends, pop up stores, inventory management, Sears closing 100 plus stores, and various other mostly business and action sports related topics. It all got me thinking about the retail environment.
 
Inventory is where retailers tie up most of their working capital. Retailers (and brands) have made heroic efforts to control inventory in recent years, but I think there might be still an opportunity for improvement by following the ongoing process of integration between brick and mortar and online retailing. I want to talk about that and ask what you think.
 
The Online Experience
 
I’m not going to tell you anything here you don’t know, but I want to build a (hopefully) logical argument. Consumers like online shopping because it’s efficient, it allows ease of comparison, it may be cheaper, and you don’t have to leave the comfort of your desk chair.
 
They dislike it because they can’t physically interact with the product (which is more or less important depending on the product), and they don’t get it the moment they buy it. They may also miss the personal interaction with a sales person. Or not.
 
The improved functionality of web sites and the development of logistics to get products to the customer (and back from them if necessary) faster and easier has accentuated the reasons for the consumer to shop on line, and reduced the reasons not to. You need look no further than the growth in online sales in a soft economy to know that’s true.
 
Brands and retailers (remember it’s getting harder and harder to differentiate between the two) see a role for web sites and social media in brand building. The competitive environment requires them to be on line and sell there either independently or in coordination with retailers.
 
Building, maintaining and keeping fresh a quality web site with ecommerce capabilities cost a bunch of money. The expense is not just in designing and creating it, but in keeping it up. Servicing online customers generates additional expense.
 
See- I told you I wasn’t going to tell you anything you didn’t already know. Let’s continue.
 
Is the brand building from being online worth it? That is, does it generate enough new customers, or increased sales to existing customers, to pay for all the incremental expense? Being the way I am, I guess I’d ask if it generated enough gross profit dollars.
Maybe you sell to new customers who are too far away to get to your store. Maybe your online communications program increases traffic and/or the average sale. Maybe, as a brand, you sell products in your line that retailers didn’t typically have room to carry and consumers didn’t previously know much about. Maybe a lot of things. Or maybe not.
 
So, competitive pressures require you to be online. Being online in a competitive way is expensive. You have to earn enough incremental gross profit to at least pay for the cost of being online. Cannibalizing brick and mortar sales for online won’t do it. If you accept those points, then you have to agree that total sales, including online, have to rise enough to pay for the online expense or overall industry profit will fall.
 
Let’s say that again in a slightly different way. With the existence of online retail, in the absence of any change in the brick and mortal expense structure, sales have to rise just to break even because of the additional expense of being online. And not, I’d estimate, by a trivial amount.
 
But consumers don’t automatically and graciously just spend more just because we’ve boosted our expense structure. What might we do about that structure?  
  
A Lesson from the Airport
 
Last time I was at the airport (not over the holidays happily), I was struck by how the airlines have learned to use online to manage their business “in their store” so to speak. Pretty much everything happens at the monitor unless you’re changing your flight, checking baggage, or have some other variety of crises. You can do most of it at home, or you can wait and do it at the airport. At the airport or at home is pretty much the same for the airline and its passengers. They’ve gone a long way towards integrating brick and mortar, if I can call it that, and online. And they’ve done it in a way that the passengers seem to like. Although now, instead of standing in line at the airline counter, we stand in line to get through security. Oh well.
 
How does this translate to our retail business?
 
Taking Trends the Next Step
 
Retailers are already giving consumers the online or in store choice. They are dealing with the brands they carry (when the brand and the retailer are not one and the same) through not only the traditional model of purchasing inventory but of taking it on consignment or even having the brand run its own store in their existing store. My point (and once again, you already know this) is that the traditional model of see it, order it, receive it, sell it, pay for it is evolving. 
 
In general terms, what I’m seeing is independent retailers take less and less inventory risk. The brands may not like this but have been dragged towards supporting it. Bluntly, they can’t afford to sell product to retailers who can be hard pressed to pay them, may dispose of the merchandise at prices and through channels the brand would prefer they didn’t use, and can’t really merchandise the complete line the way the brand wants. 
 
We’ve got retailers becoming brands and brands becoming retailers. Zumiez, to use one example, thinks of itself as a brand. And go look at a Buckles someday. I’ve got to write about that.
 
We’ve got the merging of online with brick and mortar and the rapid growth of online sales. Through pop up stores, renting space in existing retailers, consignment and other gyrations we’ve got inventory risk migrating to brands. The relationship between brands and retailers is more codependent than it used to be. Brands want to capture the higher retail margins, and have the ability to better control and accelerate the process of creating and getting product into stores. Retailers are selling their own brands.
 
We tend to look at these developments as independent events. I don’t think they are. How might they be addressed in a positive, structured way?
 
Here’s a Wild Idea   
 
What if a brick and mortar retailer cut the inventory it kept in half? Maybe by two thirds. Like the airlines, they let their customer decide whether they want to “check in” at home or at the airport (the store) and handle various purchases or changes at either place. The customer can come into the store, see the product and decide what they want to buy, but it gets shipped that day to their home (or they can come back to the store and pick it up).
 
Yeah, yeah, I know, I’m crazy. And the world is flat and real estate prices only go up. Maybe I am crazy. That’s why I’m asking you.  
Maybe for the first time a retailer, due to the much lower inventory I’m proposing, is able (and can afford) to display most of a brand’s line rather than just the pieces they bought because they thought that was what would sell and it was all they had room for. The quality of the presentation, and the customer experience, might increase significantly. Part of the reason brands want to get into the retail business is so their brands can be controlled and presented the way they want.
 
The customer would come to the store either because they want help and like the in store experience (which I’m suggesting would improve), or because it’s a product they don’t want to buy without seeing and touching it. But they wouldn’t necessarily walk out with it. The very broad but not deep inventory would mean that the product would not necessarily be available for the customer to take home. The customer, after having had the opportunity to look at the biggest selection of a particular product they’ve ever seen, would make a selection and have the clerk swipe their card and tell them, “It will ship to your home tonight.”
 
The biggest objection, I suppose, is that customers who come into stores want to take the product with them. But we know that more and more customers are making the decision to wait a few days for their product. We also know that they are coming into stores to evaluate products then going home and ordering on line. And there is some benefit to not having to carry the product around with you.
Another interesting problem would be for the retailer to determine (in consultation with the brands it carries) exactly what to carry in inventory and how to price it. Do you charge some percentage more for product people walk out with? Which products will people be most determined to take with them? How do inventories get replenished under this situation of in store scarcity? Will you need to replace the product on the floor because people are playing with it so much? The gross margin return on inventory investment approach I’ve discussed before might be a tool that could add some value in figuring some of this out.
 
What I’m proposing is an approach to brick and mortar retailing where the role of online and the melding of brands with retailers is recognized. The retailer would tie up a bunch less working capital in inventory. The quality of their merchandising could improve and I think the customer would have a better experience. Thinking globally for a minute, this might also play to the U.S.’s competitive strengths in logistics and distribution.
 
Brands would take less collection risk and would be better presented at retail. They’d have more inventory risk but, as I said, that seems to be where we’re heading anyway.
 
I don’t want to trivialize what I’m suggesting. There would have to be some interesting negotiations between brands and retailers to sort out a lot of details. Retailers would have to invest in some new fixtures and other merchandising expense. In addition, I imagine there’d be some in store technology costs. Hopefully this is more than made up for by a massively lower inventory investment.
 
I’m suggesting this brick and mortar low inventory internet fulfillment approach because that’s where I see the trends taking us anyway. I figure you might as well ride the wave rather than have it break on your head and drive you into the sand. If the trends I’ve highlighted are valid, I’m not sure there’s much of a choice.

 

 

Billabong Reports Deteriorating Sales Growth Trend; The Strategy or the Economy?

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Billabong’s announcement about sales trends since the end of October and the actions it’s taking may portend issues for other companies as well as for Billabong. Let’s take a look at what they announced, what actions they are taking, how they found themselves in this position, and how it relates to the global economic environment.

Here’s what they said (you can go here to read the announcement and the transcript of the conference call):

“Following receipt and finalization of management accounts reflecting actual trading results for the month of November and receipt of preliminary retail sales data for company owned stores for the period ended 11 December, the sales growth trend has deteriorated significantly in this critical retail period.”
 
They report that constant currency sales revenue growth for the three months ended September 30 was 24.7%. For the four months through October 31 it was 17.2% and for the five months ended November 30, 11.7%. If you exclude acquisitions, the numbers were 6.2%, 2.8% and 0.4%. Remember these are constant currency numbers. I don’t know what the “as reported” numbers will look like.
 
For a single month, and then two months, to pull the numbers down this hard means that things went south pretty quickly, and apparently so far they aren’t looking good in December. Remember that a lot of business is done during the holiday season, so these percentage declines translate into a whole lot more dollars than they would at other times of the year.
 
“Based on preliminary sales data to 11 December and assuming a continuation of current trends, it is now anticipated that sales revenue for the six months to 31 December will be approximately 5% higher than the pcp [prior calendar period] in constant currency terms (down approximately 3% adjusting for the impact of acquisitions).”
 
 They say this “…reflects the European sovereign debt issues and the ensuing fears of global recession which are impacting consumer confidence and spending patterns significantly.” You can read their description of conditions in each region in the announcement. Weather has made a difference in both Europe and Australia. Billabong reports seeing “very low” sell through at retail, and poor reorders. CEO Derek O’Neill notes that reorders “…must be at reduced prices due to large amounts of unsold inventory washing through the marketplace therefore impacting gross margins.”
 
Basically, Europe is the toughest market followed by Australia and then the U.S. But whatever strength there was in the U.S. apparently dissipated in the first two weeks of December “…on growing global concerns about Europe. Challenging trading conditions remain in Canada, in both wholesale and retail.” 
 
In discussing the U.S., CEO O’Neill refers to some weakness from PacSun orders related to their accelerated store closing. He estimated Billabong had lost a “couple of million’ in business over the last four weeks as a result. I had highlighted this issue when I reviewed PacSun’s results.  I’m sure other brands will experience similar impacts consistent with their exposure to PacSun.
 
The good news is that Asia continues to perform well and Japan has rebounded. They also note that they have a “low double digit forward order book for late Spring and Summer in the USA in the wholesale business.” They had noted, however, that some orders (not just in the U.S.) had slipped from first half to the second half, and I wonder how that might impact those comparisons.
 
The result of all this is that Billabong expects their EBITDA for the six months ending December 31 to be between $70 and $75 million Australian dollars compared to $94.6 million in the same period the prior year.
 
Remember, so far the other public companies have reported just their end of quarter results- typically for October 31. None have felt an obligation to stand up and announce that conditions have gotten tough since then. But they report earnings every quarter where Billabong reports only every six months. I suppose these conditions could be unique to Billabong, but that seems improbable. It’s my belief that the on again, off again meetings about European sovereign debt and the growing realization that nothing has actually been done to solve the issue is creating a global caution among consumers.
 
What’s Billabong Doing?
 
I have the sense from the conference call that Billabong was a bit caught by surprise by the extent of the decline, but they seem to be acting decisively. The first thing they are doing is working to move inventory. This is in contrast to the position they took when the financial crisis hit in 2008. At that time, they indicated they were more concerned with holding margins and brand position than with losing some sales. They choose to be less promotional than others as a matter of brand positioning. Not so much this time I guess.
 
They are also undertaking a complete operational review to see where they can take costs out of the company. I expect that will reverberate through all their brands and locations.
 
Next, and most intriguing, a “strategic capital structure review” is under way with Goldman Sachs, the company’s advisor. What they indicated was that nothing was off the table, but raising more equity was pretty much the last choice. That makes sense when you note that their stock closed today (Tuesday) at AUD $1.77.
 
So that means that besides reducing expenses there’s at least the possibility of selling a brand, accelerating the closing of underperforming stores, maybe raising some kind of convertible debt, or, I guess, even selling the company.
 
They are doing this because their balance sheet position may require it, especially if business conditions deteriorate further. They noted that they were not in violation of any of their banking covenants as of December 19, but would not speculate on where their debt coverage ratio would be at the end of December. CEO O’Neill said the poor business conditions were “…expected to result in a deteriorating leverage position [at December 31].” Here’s how CFO Craig White puts it:
 
“The fact is that we’ve gone from a position where I could say that we were comfortably within covenants to a position that’s less comfortable, but I’m not going to speculate on where we’ll end up at the end of December. There’s a lot of things that can move around in that time.” 
 
It’s reasonable of them to say that they don’t know yet where they will be at the end of December. December, as they point out, is a big month. But they are concerned enough that they’ve got Goldman Sachs looking at their choices. How did they get to this position?
 
Good Strategy, Bad Timing?
 
During the conference call, CEO O’Neill continued to support the company’s overall strategy of retail growth. He discussed the systems they have in place to manage it, and the progress they are making of getting better product to market faster in a more coordinated, efficient way.  The more or less unspoken question during the call was “Hey, if this strategy is so hot, how come you got Goldman Sachs helping you figure out how to strengthen your balance sheet?!”
 
It’s not a bad question. As you recall, the West 49 acquisition was a big one. And it came along not necessarily at the time Billabong wanted it to. But there it was looking too good to pass up and fitting the company’s strategic criteria. You may remember they borrowed a bunch of money to pay for it, and I noted at the time it was a good thing they’d raised some capital earlier when they could even though they didn’t need it or the deal probably couldn’t have happened.
 
The other thing I emphasized was that buying a turnaround, which West 49 clearly was, was a whole different story from buying a solid brand or retail chain with a history of profitable growth and strong management in place. If they’d asked me at the time (they didn’t) I would have told them that whenever I’ve walked into a turnaround, it’s always been worse than I expected before I got there.
 
In a stronger economy, that might be an inconvenience. In a lousy one, it’s a problem. I’m not suggesting that the West 49 deal is the basis of all Billabong’s issues. The economy would still suck even without it. But if they didn’t have the debt they used to pay for the company, and hadn’t had to invest management time and some money into integrating and cleaning it up and stocking it with more of their owned brands, maybe they wouldn’t need Goldman Sachs to help them work through their potential balance sheet issues.
 
This is a tough situation that’s come on Billabong pretty suddenly. There were some concerns over the inventory and balance sheet at the last review but clearly they’ve accelerated due to deteriorating business conditions. There appears to be a not trivial chance that Billabong will violate some of its bank covenants at the end of the year.
 
The thing is, if it’s a small violation and you can see how it’s going to work its way out over a quarter or two, you don’t necessarily need Goldman Sachs to help fix the problem. What I might do (what I have done) is go to the bank and have a conversation about a soft quarter, and cash flow, and how it’s just a temporary thing, and about how I’m going to fix it, and couldn’t they see their way clear to waive the covenant for may six months, and yes, of course I’d be thrilled to pay them a fee to do that. Grovel, grovel, grovel.
 
Banks are a little more gun shy than they use to be (10 years too late may I point out), so maybe it’s not that simple. I still think the Billabong strategy makes sense as long as they exercise some caution as to how much of their owned brands end up in their owned stores. I also continue to think that tough times create opportunities, but only for those with strong balance sheets. Billabong apparently needs to shore their balance sheet up. We’ll find out in February if not before by how much and what they do.            

 

 

Quik’s October 31st Quarter and Full Year

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I’m going to work without my usual net of an SEC filing this time. That’s because year-end 10Ks always take a long time to come out, and I don’t want to wait that long to look at Quik’s results. I’ll review the 10K when it does show up. Right now, we’ll go with the press release and conference call transcript.

Not to be old fashioned here, but I think I’ll avoid proforma adjusted EBITDA numbers and start with the good old fashioned generally accepted accounting principles numbers. I’ll discuss some of the adjustments Quik takes into account in coming up with their presentation.

The Quarter’s Income Statement
 
Quik’s revenues for the quarter rose 10.1% to $545 million from $495 million the same quarter the previous year. Ecommerce revenues grew 69% globally, but they don’t tell us what that means in dollars.
 
The gross profit margin fell from 53.5% to 51.9% largely, as reported in the conference call, due to the cost and price increases all industry companies experienced. Selling, general and administrative expenses rose from $222 million to $248 million. As a percentage of sales, they were up from 44.9% to 45.4%. A chunk of the increase was the cost of the Quik Pro NYC, which we’ve learned today won’t be held next year.
 
The asset impairment charge for the quarter was $11.8 million, up from $8.4 million last year. These, as you probably know and which companies always like to point out to us, are noncash charges associated with changes in long term asset values. 
 
Operating income fell by 31% from $34.3 million to $23.7 million. That is earnings before, interest, taxes, foreign currency loss and discontinued operations. Let’s look at some of those items.
 
Interest expense in the quarter fell $50.6 million to $14.1 million. I think that decline is the result of Rhone converting its debt into equity and some of the restructuring and debt repayment Quik has done over the last year. This is why I really like to have the SEC filing in my hand. It would allow me to be more specific.
 
That’s a hell of a decline in interest expense. But as a shareholder you need to remember that the Rhone conversion that’s largely responsible for the decline resulted in a lot more shares being outstanding, so the value of each share declined, all other things being equal.
 
Foreign currency loss was about $5.8 million compared to $463 million in the same quarter last year. That leaves us with pretax income of $3.9 million compared to a pretax loss of $16.7 million in last year’s quarter.
 
Due to a settlement mostly with the French tax authorities that I guess goes back to the Rossignol deal and Quik’s losses on that deal, there is a one-time $64 million non-cash income tax benefit in this quarter compared to a charge of $5.2 million last year. This leaves Quik with a reported net income for the quarter of $68 million compared to a loss of $22 million in the quarter last year.
 
How do we think about this?
 
Well, every year companies have “one-time events.” So I tend to have a hard time ignoring them on the grounds that they won’t recur, because something always happens to generate a new “one-time event.” But in the case of this French tax credit, it’s so enormous and out of the ordinary we’ve got to ignore it as we consider how Quik is operating. That’s what Quik does in presenting its proforma results.
 
The Complete Year
 
For the year, sales rose 6.3% to $1.95 billion. The gross profit margin was down only very slightly from 52.6% to 52.4%. Operating income fell by 66% from $123 million to $41.5 million. Most of that decline is the result of the asset impairment charges (Non-cash!) that rose from $11.6 million last year to $86.4 million. Interest expense fell from $114 million to $74 million. The net loss for the year rose from $6.3 million to $17.9 million.
 
I should point out (I have before) that these non-cash charges reflect an expected decline in the future cash flow of the assets being written down. That may be non-cash, but it’s hardly irrelevant.
 
The Americas generated $61 million in operating income for the whole year, up 7% from $57 million the previous year. Europe’s operating income grew from $94 million to $112 million. Asia/Pacific went from an operating profit of $11.8 to a loss of $84 for the year.
 
The Quik brand, we’re told, grew 5% during the year to $806 million. Roxy was down 2% to $519 million, but it improved each quarter, growing 10% in the final quarter compared to the same quarter the previous year. One of the analysts noted that Roxy’s revenues were down around $250 million from its peak in 2008. DC was up 15% to $545 million.
 
You know what I just realized? There’s no complete balance sheet provided in the press release. Gimme my SEC filing! What they tell us in the conference call is that receivables at $397 million are 6% higher than a year ago in constant currency. Inventory of $347 million was up 26% in constant currency, with much of the increase due to the early receipt of goods. Ten to fifteen percent of the increase is the result of higher cost of goods. Prior season’s goods represent only 5% of inventory. Cash on hand was $110 million. 
 
Lacking the complete presentation we won’t see until the 10K, I’ve got no opinion on their balance sheet position.   
      
Details by Region
 
With the broad income statements discussed, let’s look at some of the quarterly detail in the documents.
 
Americas revenue was up 12.7% to $250 million for the quarter. Same store sales were up 16%.   Europe was up 11.5% to $213 million (6% in constant currency). Same store retail sales turned positive for the first time in 6 quarters in Europe. Asia/Pacific rose only 1.9% (down 7% in constant currency) to $82 million. The recession in Australia and strong Aussie dollar are making that a tough market. Japanese revenues at $25 million for the quarter are nearly back to the pre-tsunami levels.
 
The gross profit margin in the Americas fell from 48.1% to 47.1%. Europe was down from 60.2% to 57.2% and Asia/Pacific fell from 54.7% to 52.6%. As I’ve noted before, margins are a lot more attractive outside of the Americas. I wonder if the U.S. margin is much different from what’s reported for the Americas as a whole.
 
Operating income in the Americas fell 27% from $12.7 million to $9.3 million. Europe’s operating income jumped 50% from $20.9 million to $30.3 million. Asia/Pacific had an operating loss of $3 million after a profit of $8.6 million in the same quarter the previous year. 
 
Opportunities
 
The company’s goal is to get to $3 billion in revenues in five years. They think the Quiksilver Girls and Women’s business have a $100 million opportunity in the next five years. They also expect growth in ecommerce of a similar amount. In DC, especially outside of the United States, they think there’s a half billion dollar opportunity. And they see a couple of hundred million dollar of revenue from emerging markets.
 
I would have been happier if we’d gotten some more specifics about some of their initiatives in the conference call. I probably expect too much from that forum.
 
It looks to me like growth will be limited in the United States (and margins are lower). Europe generated 71% of Quik’s operating earnings excluding corporate expenses in the fourth quarter. For the year, as you can see in the numbers above, Quik wouldn’t have had any operating earnings without Europe. But Europe is poised for a recession.     
  
When we ask how Quik is doing in general, I have to go back to the operating income that declined 31% for the quarter and 66% for the year. I guess I should point out that the stock market, in its collective wisdom, doesn’t, at least with immediacy, think much of my point of view. Quik’s stock closed up 12.7% today (the day after the announcement) at $3.46 on volume that was almost three times its 90 day average. They must like that proforma, adjusted, EBITDA stuff.

 

 

Heinz’s New Ketchup; New Product Introductions and Social Media

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I came across this a few weeks ago (actually, my wife sent it to me and if I don’t give her credit, I’ll hear about it), but have been busy reading quarterly filings. Heinz, it seems, has introduced what it considers to be upmarket ketchup blended with balsamic vinegar. Read the article here. No, no, no, there’s no surfer on the label or anything really stupid yet amusing like that.

What’s interesting is that they have introduced it and made it available initially only on Facebook, where they have 825,000 followers. At $2.49 for a 10 ounce bottle, it’s $0.60 cents more expensive than their standard product.

And the question I find myself asking is whether this product would even be introduced if it wasn’t for the internet and social media.
 
Heinz, the article says, has 59% of the ketchup market and has been making the stuff since 1876 so I guess they can do anything they want. It will show up in stores in late December and be available through March as a “limited edition.” If it’s selling well, they’ll make it a regular offering. I guess it will become an “unlimited edition,” so to speak.
 
The development and packing costs are the same no matter how they introduce it.   But if there’s no social media, they have to distribute it, they have to advertise and promote it, they have to follow up with the supermarkets they tested in to see how it went, and they get no direct consumer feedback and unless they work really, really hard to get it. There’s a lot of cost there.
 
By introducing it on Facebook, they get immediate consumer feedback on the concept (though it will take some work to find out if they liked the taste), and they don’t have to distribute it immediately to markets. There’s not necessarily an advertising program. For all I know, they don’t even have to bottle the stuff until they get orders. Hopefully, when they do put it in the markets, it’s already sold well enough that there’s some demand from “committed” Heinz fans, whatever that means. If only because they charge $2.00 to ship each $2.49 bottle if you buy it online.
 
I don’t expect that Heinz’s bottom line is going to move much even if limited edition balsamic ketchup succeeds beyond their wildest dreams. (If I wanted balsamic ketchup, I’d probably just mix a bit of balsamic vinegar with my ketchup and see how it tasted, even though I’d be missing out on a limited edition). But this makes me think about the process and rationale for introducing a new product and the evolving and increasing impact of electronic interconnectedness.
 
I wonder if companies might start introducing new products because they can. With the cost of test marketing, if you want to call it that, so low and the feedback so immediate, what do they have to lose? Well, I suppose they might get laughed at if it’s a lame product. Negative opinions are transmitted just as fast or faster than positive ones on the internet. But there’s always that risk with any new product.
 
I’ve written over the years that there’s some value in products that everybody talks about even if they don’t sell that well. Maybe the internet lets new products have an advertising and promotional component that could justify the lower expense even if the product doesn’t turn out to be hit.
 
But then again, there’s a danger of introducing too many new products if it’s that easy (probably is for ketchup, toothpaste, deodorant, laundry detergent, etc.) and creating some consumer confusion.
 
You also have to wonder if your Facebook followers represent more than a small segment of your customers. I imagine they do in our Action Sports/Youth Culture market, but maybe not in ketchup, where 97% of people have it in their homes.
 
Most of you know a hell of a lot more than I do about using the internet and social media. I’m sure what Heinz is doing isn’t unusual. But I can’t help but think that there’s a danger in introducing a product just because you can and technology has made it cheaper and easier to do. No matter how cool the technology gets, it still matters that you offer value to your identified customer base. Make sure your version of limited edition balsamic ketchup does that before you fling it on the market via social media.

 

 

PacSun Makes Progress; Third Quarter Results, Store Closings, and Financing

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When I looked at PacSun’s previous quarter I wrote, “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 [their strategy] given the economy and the company’s financial circumstances.”

Whether or not their strategy is a good one, they were becoming too cash constrained to implement it. If you were paying attention to this post at Boardistan in late November and the associated New York Post article, you knew something was going to happen.

Now it’s happened. As part of their conference call yesterday and release of their 10Q for the quarter ended October 29th, PacSun announced a $100 million line of credit from Wells Fargo that basically replaces their old line, a five year term loan of $60 million from private equity firm Golden Gate Capital (GGC), and plans to close 190 stores by the end of January 2013. Most of the closings will come near the end of the fiscal years. That makes sense as you’d like the holiday season to help you move inventory.
 
At the end of this quarter, PacSun had 820 stores and inventory of $152 million (at cost). 190 stores are 23% of their total stores. Assuming inventory is equally distributed among all the stores, they would have to reduce their inventory by 23% or $35 million. If you’re a brand that sells to PacSun, how do you think about that? Will PacSun move it to other stores? Will they close it out? Will they try and get you to take it back? Will they sell it somewhere you’d really rather it wasn’t sold? What’s the impact on your brand going to be when a chunk of your sales to PacSun just disappear?
 
One of the analysts kind of asked about this in the conference call saying, “Could you talk about conversations you’re having at the same level with the brands and your suppliers to make sure that you’re still in the best products and getting goods timely at the best prices and getting the best products from the key vendors?”
 
CEO Schoenfeld answered, “Yes, I really feel good about relationships, both with our key brand partners and our suppliers on our proprietary products. And they’ve been critical to the progress we’ve made and recognize that we still got work to do to get ourselves back to profitability, and they continue to be very supportive of our efforts.”
 
It’s the expected conference call kind of answer, and as always the devil will be in the details of the relationship with each brand.   
I’ll bet lots of brands are thinking about this issue. Makes those who tried to reduce their dependence on PacSun over the last year or two look pretty clever.
 
Tactics
 
You know what it takes to close stores and revamp the ones you’ve got left (about 620 by the end of January 2013)? It takes money, and PacSun didn’t have enough. After the deal with GGC, they say they do. As CEO Gary Schoenfeld put it, “Securing this additional capital will enable us to fund the lease terminations previously mentioned, make selective store refresh and technology investments and supplement any further near-term operational cash flow needs.”
 
The deal gave GGC two seats on PacSun’s Board of Directors. The interest rate is 13%. 5.5% has to be paid in cash quarterly. The other 7.5% is accrues annually in arrears. That is, they increase the amount they owe and pay interest on that increase as well. PacSun also issued to GGC convertible preferred stock that can be converted into about 20% of the company’s stock at $1.75 a share. Expensive money, but they needed to do it.
 
Note that the date at which the deals with Wells Fargo and with GGC were signed was December 7th– the same date as the conference call and release of quarterly results. What clever person said, “The task expands to fill the time available?”
 
We also find out that before the quarter ended Pacsun was madly negotiating with its landlords and had negotiated buyouts of 75 leases at a cost of $13 million, short term lease extensions for 50 stores, and termination on lease expiration for 115 stores. They think they will close 80 stores during the rest of this fiscal year and 110 in the next one. They expect savings in the year that starts February 1, 2012 of $9 million before the buyout payments. Those annual savings should rise as more stores are closed and, of course, those savings are annual while the buyout payments are one time. So the return on invested capital looks pretty good.
 
The stores they are closing had average sales of $600,000 over the last 12 months and their sales were down 9% compared to the previous year. The 600 stores they expect to have left when the closing process is completed average $1.1 million in revenue and their comparative store sales were only down 1%.
 
The store closures are expected to reduce revenue by $100 million to $125 million, but improve EBITDA by $10 million to $15 million. The reduction in inventory should offer a similar improvement to the balance sheet. 
 
I assume that the landlord negotiations, GGC loan, and Wells Fargo credit negotiation didn’t each take place in a vacuum. Much like when Quiksilver got the Rhone investment, I’m guessing there were multiple party dependencies that had to come together. Must have been interesting, though that might not be the word you’d use if you were in the middle of it.
 
The Numbers
 
Over the year that ended October 29, 2011, PacSun’s balance sheet weakened some due to the ongoing losses. Over the year, the current ratio fell from 2.02 to 1.44. And total liabilities to equity rose from 0.89 to 1.5. Inventory fell 8%.
 
Even with sales down 6.2% this quarter compared to the same quarter last year, current liabilities rose 15% from $112 million to $129 million. It’s possible that’s nothing more than timing differences, but I think we can say that PacSun needed to find some additional resources so they could pursue their strategy faster. The GGC term loan won’t improve the balance sheet since it’s debt, but it will give PacSun the cash it needs to move forward. In a turnaround, cash flow is way, way more important than your balance sheet I can tell you from experience.
 
$13 million of the sales decline resulted from store closures. Another $7 million was from a 3% decrease in comparable store sales. They gained $4 million from stores not yet included in the comparable store calculation and from a 12% increase in ecommerce sales. Men’s sales were flat and women’s down about 5%.
 
The gross profit margin fell slightly from 25.0% to 24.2%. You would think there’d be a big opportunity to improve that if PacSun could get its coolness back. Selling, general and administrative expenses actually rose 6% from $71.1 million to $75.4 million. As a percentage of sales that’s up from 27.6% to 31.1%. This included $6.2 million in charges related to closing stores ($4.4 million of which was noncash).
 
The net loss rose 153% to $17.6 million from $7 million in the same quarter last year.
 
Strategy
 
I characterize the store closings, new line of credit, and term loan as tactics that allow PacSun to pursue its strategy. I don’t think that strategy has really changed since Gary Schoenfeld became CEO two years ago. As he puts it, “We still have more to do to reestablish our brand identity and emotional connection with our customers, but I believe we are on the right path to make this happen.” He continues in another part of the conference call, “So we do continue to recognize that part of our turnaround is getting people excited again about PacSun and what our brand means and strengthening that emotional connection."
 
I agree with that. I’ll bet everybody in the industry agree with it because that’s what we all try to do with our brands. We don’t have, and I wouldn’t expect, details on exactly how they are going about that. To some extent, as I’ve written, they’ve been ham strung by a lack of financial resources. Now that’s resolved, and I guess we’ll get to see if PacSun can become cool again. Remember, even the stores they are keeping have 1% negative comps and the economy is still tough and the competitive environment highly promotional, so this isn’t a slam dunk even with some cash in the bank.

 

 

Zumiez’s October 29 Quarter; Consistently Pursuing a Solid Strategy

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I know I’ve written about it before, but let’s review the pillars of Zumiez’s strategy as I see them before we get to the numbers. Here’s the link to the 10Q if you’re interested.

  • Find and retain employees who are actively committed to the action sports lifestyle and make sure they are customer service focused. I suspect this might restrain their growth sometimes, but that’s okay.
  • Have a wide selection of established and new brands, including ones that are hard to find in other places. Manage these brands, and the associated inventory, so you can be generally less promotional than competitors. Their largest vendor represented less than 7% of total sales during the quarter.
  • Grow only as fast as you can find the right mall locations and staff.
  • Be the only mall retailer that offers hard and soft goods in a specialty shop-like environment.
  • Continuously work to have systems and procedures in place that let each store carry what its customers want to buy.
 In broad brush, this hasn’t really changed since the company was founded.
 
Zumiez’s 442 stores in 38 states now include 10 in Canada. Sales for the quarter ended October 29th were up 10.3% to $154 million compared to $135.9 million in the same quarter last year. Comparable store sales were up 6% and a net of 42 new stores have been opened since the end of the quarter last year. Ecommerce sales were 6.4% of the total, or $9.9 million. In the same quarter last year they were 4.4% of the total, or $6 million.
 
It’s interesting to hear how they talked about the comparable store sales increase during the conference call. CFO Marc Stolzman said, “The comparable store sales gain was primarily driven by an increase in dollars per transaction, partially offset by a decline in comp store transactions. The increase in dollars per transaction in the quarter was primarily a result of an increase in average unit retail, partially offset by a decrease in units per transaction.”
 
To me, that speaks at least partly to the success of their brand strategy. They were able to increase comparative store sales because they got more dollars per sale even though the number of transactions fell. 
 
Gross profit margin rose from 38.7% to 39.1%. The improvement was largely the result of distribution center efficiencies (remember they opened their new distribution center in California).
 
Selling, general and administrative expenses rose 11% to $37.3 million. As a percentage of sales, they were down from 24.7% to 24.3%.
 
Net income was up 14.8% from $12.3 million to 14.1 million.
 
The balance sheet is strong, and they have no debt except for the normal kinds of current liabilities every business incurs in the normal course of business. The increase in inventory was in line with the sales growth.
 
Though they didn’t talk about it in any detail, they noted that 15% to 20% of their business was private label. Private label business is particularly compelling when you’re already a retailer because of the higher margin with no additional costs. But we’ve learned in our industry that too much private label can be a bad thing. If only it was easy to know how much was too much before you got to too much. It is, I suppose, possible that Zumiez’s strategy of having a lot of brands and turning them frequently lends itself to more private label business. I’ll watch with interest to see how much they grow it.
 
Well, that’s pretty much it. When things are going well and the strategy hasn’t changed much there’s not a whole lot to write about. Here’s hoping I get to do lots of short articles like this one because of good results from a host of industry companies.     

 

 

Orange 21’s September 30 Quarter: Sales are Up, But So Is the Loss

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This is one of the few times where it makes sense to start on the balance sheet to really understand what’s going on. It shows stockholders’ equity of a negative $4.3 million. How, you might ask, are they paying their bills? If you look under liabilities, you’ll see a “Note payable to stockholder” of $10.5 million.

That $10.5 million is owed to Costa Brava. Costa Brava “beneficially owns” approximately 50% (depends on how you calculate) of Orange 21’s common stock. The sole general partner of Costa Brava is Mr. Seth Hamot, who is the Chairman of the Board of Orange 21. To put it succinctly, if Mr. Hamot didn’t have a whole lot of money and wasn’t willing to lend a bunch of it to Orange 21, the company would have been closed or sold long ago.

It would be great fun to speculate on why this company went public in the first place, what the original plans for the public platform was, and why Mr. Hamot has been willing to commit this level of resources to the company (more to come according to the 10Q). But it would be only speculation and I guess I’ll stick to what we know. In any event, the fact that it is public has allowed us to watch it move through various management and strategic direction changes, and it’s been interesting. It continues to be interesting actually.
 
Since the end of the September 30 quarter, former CEO Carol Montgomery has resigned and been added to the board of directors. Michael Marcks is the new CEO, consultant Michael Angel has become the permanent CFO, and Greg Hagerman is the Executive VP for Sales and Operations. Meanwhile, as reported in the 10Q, the company has given up on its licensing agreements with O’Neill, Melodies by MJB, and Margaritaville and is still feeling the impact of the sale of its Italian factory (LEM). I should point out that I thought the licensing agreements were a good idea because, if successful, they’d give the company volume it needed to cover expenses it was going to incur in growing the Spy brand. I don’t know if licensing turned out to just be a bad idea or if there was some slippage in implementing the strategy.
 
Anyway, all this stuff has and is costing them a lot of money. They are refocused now on growing the Spy brand. Here’s how the company put it:
 
“We have recently decided to focus our development, marketing and sales activity on our SPY products. As part of that focus, we decided to cease any new purchase orders of additional inventory for the O’Neill , Melodies by MJB or Margaritaville eyewear brands.”
 
Reported sales for the quarter were up 11.7% to $9.2 million. If we ignore the LEM sales in the September 30 quarter last year, we see that proforma sales actually increased by $2.3 million, from $6.9 million to $9.2 million. Sales of Spy products were up $1.6 million. Closeout sales during the quarter were $900,000 and were primarily O’Neill and Melodies by MJB product. Sunglasses and goggles represented 57% and 43% of sales, respectively, during the quarter.
 
Reported gross profit fell from $3.9 million to $3.2 million. As a percentage of sales reported gross profit fell from 47.1% to 35.3%. This was largely the result of selling O’Neill and Melodies by MJB product at cost and of taking inventory reserves for Margaritaville product.
Sales and marketing expense rose almost 51% from $2.3 million to $3.4 million. $400,000 of the increase was for commission on higher sales (can’t argue with that). Another $400,000 was for staff additions and the remaining $300,000 represented additional marketing costs.
 
Total operating expenses were up 21.3%. $1.5 million of this was to terminate the Melodies by MJB deal. A million was paid in cash in July and $500,000 will be paid next March 31, but was accrued during the quarter. 
 
The loss from operations rose from $819,000 to $2.4 million. Not unexpectedly given the borrowing from Costa Brava, interest expense was up from $160,000 to $413,000. The net loss was $3 million, up from $932,000 in the same quarter the previous year.
 
Cash flow remains an issue for Orange 21 and “The Company anticipates that it will need additional capital during the next 12 months to support its planned operations, and intends both to borrow more on its existing lines of credit from Costa Brava and BFI, provided they remain available and on terms acceptable to the Company, and to, if necessary, raise additional capital through a combination of debt and/or equity financings.”
 
It’s too long to quote, but they then go on to describe the circumstances under which the existing lines of credit from Costa Brava and BFI will be adequate. Recognizing that a 10Q is a legal document that’s by definition focused on what could go wrong, I still walked away with a sense there’s a not insignificant chance that capital from another source might be required. I know you let me read SEC filings so you don’t have to, but you might use the link above to look at the first three paragraphs of page 12 of the 10Q to see what I mean.
 
Where we’d like to focus now is on the potential and growth of the Spy brand. But there are still some significant required minimum purchases from LEM in 2012 and I don’t know if we’ll see any more write downs of licensed brand inventory or not. The saga continues.