Spy’s June 30 Quarter. Brand Sales Up, But Gross Margin Falls. What to do About the Balance Sheet?

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In the conference call discussion of their results Michael Marckx, Spy’s President and CEO, emphasized two things. The first was the total focus on the Spy brand. The second was that they had a solid and complete management team that was in agreement on the company’s strategy and direction.

Those are good things. In spite of the sales increase, however, the company continues to lose money, and can only pursue its strategy with the help of continuing loans from its largest shareholder. Here are the details.     
 
Sales for the quarter rose from about $9 million to $9.5 million, or by 5.3% compared to the same quarter last year. Sales of Spy products were up $1.1 million, or 13%, to $9.3 million. That number includes $300,000 of Spy brand closeouts. There was also $200,000 in closeout sales of the licensed brands (O’Neill, Melodies by MJB, and Margaritaville) that they no longer sell. I’d note that the licensed brands closeout sales were down from $800,000 in the same quarter last year, so hopefully we’re coming to the end of that. Sunglasses represented 94% of revenue during the quarter.
 
 
Total gross profit fell from $4.88 million to $4.75 million even with the sales increase. Gross profit margin was down from 54.3% to 50.3%. They give four reasons for the decline.
 
The first is reduced gross margin on international business due to poor European economic conditions (International sales in the quarter were $790,000). Second, some of the product they sold that they bought from LEM (the Italian factory they used to own) has gotten more expensive, but they’ve got a deal that requires them to continue to buy some product there. Third, there was an increased level of discounting which they say is “…primarily due to increased levels of sales to major accounts.” Finally, there were some higher freight costs because of more air freight shipments. Having to pay for air freight sucks I can say from personal experience.
 
These higher costs were offset, they say, by some increased purchases of lower cost product from China and the higher margins they got from sale of the old licensed product after they wrote it down last year.
 
Let’s focus on that last one for a minute. If you carry product in inventory at $50 and sell it for $100, you have a 50% gross margin. Assume you figure out you have way too much of that product and it’s not worth anything, so you write it off, charging the $50 to expense. Next year, to your surprise, you figure out how to sell it for $25. You carry it in inventory for nothing, so that $25, from an accounting point of view, is all gross profit. That will boost your gross profit margin nicely. We don’t know how much of that Spy had.
 
Sales and marketing expense rose 43.3% from $2.6 million to $3.8 million. The increase was “…driven primarily by increased marketing efforts to promote our SPY brand and our new SPY products…” The biggest piece of the increase was $500,000 for marketing costs. There was also $300,000 spent on product displays and $200,000 on compensation. For all of 2012, Spy has minimum annual payments to sponsored athletes of $919,000. They are betting on the Spy brand, so where else would the money go.
 
General and administrative expenses were down $900,000, or 33.8%, to $1.73 million. That reduction is largely related to the one time management restructuring costs from April 2011. 
 
As reported, total operating expenses fell 22.4% from $7.5 million to $5.8 million and the operating loss for the quarter fell from $2.64 million last year to $1.07 million in this year’s quarter. The net loss for the quarter was $1.63 million, down 45% from a loss of $2.95 million in the same quarter last year.
 
But in the quarter last year, there were the one-time charges of $1.95 million associated with getting out from under the deals for the licensed brands and the $900,000 for the management restructuring.
 
Ignoring those two charges, operating income in last year’s June 30 quarter on a proforma basis was a positive $214,000 and the reported operating income can be viewed as a decline compared to last year’s quarter caused by the fall in gross margin and the marketing spend to build the brand.
 
As you already know, Spy has financed its continuing losses mostly through loans from Costa Brava, an entity controlled by Spy’s largest shareholder. As of June 30, 2012, those loans totaled $15.1 million. A year ago, they were about $9.5 million. In a year then, Costa Brava put an additional $5.6 million into Spy. In August 2012, the amount of the line of credit from Costa Brava was increased from $7 to $10 million. Spy borrowed an additional $1 million on August 3.
 
Spy says in its 10Q, “The Company anticipates that it will continue to have requirements for significant additional cash to finance its ongoing working capital requirements and net losses, which have included increased spending and marketing and sales activities deemed necessary to achieve its desired business growth.” This seems to indicate that they expect continued losses. There’s no information on how much those losses might be or how long they might continue.
 
You may recall that Spy announced on July 2 that it was planning to raise some additional capital by the end of August. I am writing this on August 24th, but nothing has happened as far as I know.
 
With the accumulated losses and shareholder debt, the balance sheet shows a stockholders’ deficit of $11.2 million.
 
Accounts receivables have grown 16.4% over the year, from $5.5 to $6.4 million. That number is net of an allowance for doubtful accounts of $277,000 and a $1.665 million allowance for returns.   Total sales, as you recall, were up 5.3%. Inventories fell 9.5% from $8.5 million to $7.7 million. That’s good to see, though I have no idea how much of that is better inventory management as opposed to write downs of overvalued product. The inventory number is “…net of an allowance for excess and obsolete inventories of approximately $0.9 million…”
 
I think Spy is doing the right things. Certainly focusing on the brand, and spending money to build it, is what they have to do. And the management team seems stabilized, strong, and focused. As long as Costa Brava is willing to fund them, they can continue to pursue their strategy. To justify the investment that’s been made in the company, however, Spy requires a faster rate of growth and, obviously, to make a profit. Next quarter, I hope to see real improvement in their operating performance.
 

 

 

VF’s Quarterly Results and Strategy: They Do Love Outdoor and Action Sports

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VF’s reported revenues rising 16.4% in the quarter ended June 30 compared to the same quarter last year. Net income was up 20% from $129.4 million to $155.3 million. As you look at those headline numbers, there are a couple of things to keep in mind.

 
First, the Timberland acquisition closed on September 13, 2011 so this is the first June quarter where it’s been included, and it was the largest acquisition VF has made. They paid $2.3 billion for Timberland. It’s part of VF’s outdoor and action sports group. During the quarter ended June 30, it contributed revenue of $239.4 million and reported a loss (as expected- apparently that’s just how the second quarter is for Timberland) of $37.2 million.
 
Second, on April 30th VF sold the John Varvatos brand and generated a pretax gain on the sale of $41.7 million. The sale of that brand reduced revenues in the quarter by $14.4 million.
 
Organic revenue growth (growth from brands they already owned) was $125.1 million, or 3%. International business grew 33%, representing about a third of total revenues. 26% of that growth came from Timberland. Direct to consumer revenues were up 37% in the quarter (29% from Timberland) and are 21% of total revenue. VF has opened 58 new stores so far this year, and expects to have opened 130 by year end. Comparable store sales in the stores VF operates were up mid-single digits in the second quarter.
 
Without the Timberland related acquisition expenses of $3.4 million and the gain on the sale of John Varvatos, net income would have been $122.9 million instead of the $155 million reported. Operating income, without the Timberland loss and related acquisition costs, would have been $193.7 million instead of the reported $164 million. By the way, my thanks to whoever it is at VF that presents this information in a fairly easy to figure out format. Oh- and here’s the link to the 10Q.
 
Before we delve deeper into those numbers, I want to remind everybody that back in the middle of June, VF did an investors’ day presentation just on Vans.   You can listen to the whole presentation here, and I suggest you do if you haven’t already.
 
When I wrote about Nike’s annual report a couple of weeks ago, I related it to a book called The New Rules of Retail. VF is discussed in that book as an example of a company that is creating neurological connectivity with its customers, using preemptive distribution, and controlling its value chain to compete as called for and explained in the book. You can see that all over the Vans presentation.
 
So why does VF love its outdoor and action sports segment? It has something to do with the fact that it generated 49% of its total revenues, including Timberland, during the quarter. Its next largest segment is jeanswear, which generated $594 million, down from $613 million in the quarter last year. Those two segments, then, were 76.3% of the quarter’s revenues and they generated 76.4% of operating profit.
 
VF’s overall operating margin was 7.9%, down from 10.3% in last year’s second quarter. 2.3% of that decline was the result of Timberland’s loss in the quarter.   
 
Of the $125 million in organic growth in the quarter referred to above, $113.4 million came from outdoor and action sports. That’s a 12% increase; 16% in constant dollars. Organic growth in operating profit for the whole company during the quarter was $18.4 million. In the outdoor and action sports segment alone it was $25.5 million, so that segment made up for the poorer performance of some others.
 
The North Face is part of outdoor and action sports. Its revenues in the quarter were up 14% (16% in constant currency) and it’s direct to consumer (DC) grew 9%. For the whole year, they expect The North Face to approach $2 billion in revenue.
 
VF is targeting Vans revenue of $2.2 billion by 2016. Revenues in the quarter were up 25% (29% in constant currency). Its DC business rose 18%.
 
Timberland revenues were up “…slightly on a constant dollar basis…” However, VF management sounds positively giddy as they talk about the opportunities in product, operations, and marketing they have with Timberland. It will be rolling out an apparel line in the near future.
 
One analyst asked about the impact of cleaning up Timberland’s distribution. Group President of Outdoor and Action Sports Steve Rendle answered it this way:
 
“As we look to right size that business, we are closing some of the distribution. Simultaneously, we’re rightsizing the product segmentation strategy, getting the right products in the right channels.”
 
Read that again and go listen to their plans for Vans. Read about what they are doing with The North Face in the conference call. You can detect in the conference call (see it here) a certain consistency across Vans, The North Face, and Timberland in terms of product development and the approach to the consumer. I would think there might be some real opportunities there as the brands come at overlapping customer groups from different perspectives.
 
Okay, let’s get back to VF’s overall financial results. Gross margin increased to 46.1% from 45.9% in last year’s quarter. This was “…due to a greater percentage of revenues from higher gross margin businesses, including the Outdoor & Action Sports, international and retail businesses, as well as an improvement of gross margin in our Jeanswear Americas business which reflects increased pricing compared to the prior period.”
 
Marketing, administrative and general expenses as a percent of sales rose from 35.7% in last year’s quarter to 38.4% this year. 2.4% of that increase was the result of the Timberland acquisition as it had higher expense ratios than the rest of VF. I won’t be surprised to see those Timberland ratios come down.
 
0.4% of the increase came from higher domestic pension expense. VF has a defined benefit plan. Those have to be funded based on an actuarial assessment of the number of people who will retire, when they will retire, how long they will live and what the assets in the plan are projected to earn. These days, it’s a bit hard to assume your pension assets will earn 7% and this is requiring some corporations (not just VF) to contribute more to their plans. That reduces net income.
 
Interest expense rose $7.6 million in the quarter because they borrowed money to pay for part of the Timberland acquisition.
 
The balance sheet was inevitably a bit weaker compared to a year ago after they borrowed money to buy Timberland. Long term debt is up $900 million. The current ratio fell from 3 to 1 to 1.9 to one and debt to total capital rose from 18.7% to 35.7%. Inventories rose 22.2% from $1.286 billion to $1.57 billion year over year. However, $246 million of that increase is the result of the Timberland acquisition. Excluding that, the increase was just 3%.
 
Receivables rose from $889 million to $1.03 billion over the year, but $121.7 million of that increase was Timberland. I should note that VF has an agreement with a financial institution to sell certain of its receivables on a nonrecourse basis. VF still manages and collects the sold receivables, but if they are ultimately uncollectable, it’s not VF’s problem. This sale of receivables reduced the accounts receivable on VF’s balance sheet by $135.5 million at June 30, 2012.
 
VF is the third company I’ve written about recently (Skullcandy and Nike being the other two) who seem to be responding to the changing retail/wholesale dynamic in ways that have some similarities. Those responses are consistent with the conditions described in The New Rules of Retail and that book’s prescription for success.
 
I expect VF to do some good things with Timberland. And I’ll be interested to see how VF manages the other brands in its portfolio if outdoor and action sports continues to grow and perform at such a high level. 

 

 

Skullcandy’s June 30 Quarter; Focus on the Strategy

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Skull had a strong quarter, and we’ll review the numbers. But what intrigues me more are the investments Skull is making and the steps they are taking to implement their strategy. That’s where I want to spend most of our time. In what was, and continues to be, an oversimplification I’ve written that the bet Skull was placing was that they could be cool in retailers like Fred Meyer. We’re going to dig a little deeper now and talk about some things they are doing that are consistent with the requirements for success in what we all know is a dramatically changing retail environment.

 
Sales for the quarter ended June 30 were up 38.2% to $72.4 million from $52.4 million in the same quarter last year. Domestic sales rose 34.1% to $50.6 million from $37.7 million in last year’s quarter. International sales rose $6.2 million or 59.9% to $16.5 million and represented 22.8% of total sales for the quarter. Skull acquired their European distributor in August of last year, and that increased its international sales.
 
As a reminder, each of Target and Best by accounted for more than 10% of Skull’s net sales during the first six months of 2012.   
 
Online sales increased $1.0 million to $5.3 million. That 22.8% increase is almost entirely the result of their acquisition of Astro Gaming in April, 2011. As a percentage of total sales, online sales declined from 8.3% to 7.4%. Skull says this was because they stopped using their web site to sell clearance product “…in order to better preserve the integrity of the brand.” Good decision.
 
Gross margin percentage fell from 51.1% to 49.2% in this quarter. As reported in the 10Q, “The decrease in gross margin is mostly due to a shift in sales mix to higher price point products with lower gross margin structures.”
 
It would appeal to my sense of organization to just review the financials then move on to the strategic issues but, unsurprisingly, it’s hard to separate them. It was many years ago that I first suggested that it might be a good idea to focus not just on your gross margin percentage but on the total gross margin dollars you earn, as that was what you paid your bills with. A few years after that, Cary Allington at Action Watch pointed me at the idea of Gross Margin Return on Inventory Investment. It was a more formal approach to what I’d already been saying and I urged the adoption of the idea in some presentations and in a Market Watch column. It’s a particularly valuable concept in a weak economy.
 
Skull’s management is apparently all over this. They noted that their average selling price increased by double digits in the quarter. One of the analysts asked how they should think the “…margin dynamics between these on-ear and over-the-ear versus buds?”
 
Skull VP of Finance Ronald Ross had already noted that Skull was continuing “…to see a mix shift toward over-ear styles and higher-priced product.” Responding to the analyst, CEO Jeremy Andrus indicated they viewed these trends very favorably. He acknowledged buds had less technology and materials in them, so were cheaper to produce. But he thought the trends would “…increase our revenue and the dollar share of gross margin.” Another executive noted that they saw the trend as positive not just financially, but for the brand as well.
 
So Skullcandy, though of course they would love a higher gross margin, is arguing that they end up with more gross margin dollars with a higher priced product even if the gross margin is a bit lower, and that’s okay with them. I agree.
 
Selling, General and Administrative Expenses (SG&A) rose from $17.2 million to $24 million. As a percentage of sales, it went from 32.9% to 33.1%. They note that “Approximately half of the increase was related to strategic investments in our direct international and gaming platforms, including expansion of personnel.” The areas they are investing in include, “…an in-house product design model, fixtures and point of purchase displays developed to improve our in-store presentation, property and equipment to support operational growth and the purchase of certain intangible assets related to our acquisition of the distribution rights in Europe.”
 
Another argument I’ve made from time to time is that a weak economy and tough competitive conditions offer opportunities to well positioned companies with strong balance sheets. I’m not going to spend a lot of time on Skull’s balance sheet, but since their public offering it’s been strong enough to allow them to pursue their strategy with few, if any, financial constraints. I mostly like where they are spending their money.
 
One of the facts of our new retail environment, whether you’re a brand or a retailer (and assuming we can still tell the difference), is that doing all the operational and back office stuff right is no longer a source of competitive advantage. It’s a minimum bar to have a chance to compete. Doing all that stuff right costs money and requires, I’ll say again, a strong balance sheet.
 
Also due to its public offering, Skull’s interest expense fell from $2.3 million in last year’s quarter to $147,000 in this year’s. Net income rose from $4.3 to $6.8 million, and you can see that without that decline in interest expense, the growth of net income would have been a lot lower.
 
With the financials reviewed, let’s move on to other strategic considerations. Skullcandy rather eloquently expresses the connection between action sports and its target market as follows:
 
“Our brand also benefits from the increasing popularity of action sports, particularly within the youth culture. Our consumer influencers are teens and young adults that associate themselves with skateboarding, snowboarding, surfing and other action sports. These consumers influence a broader consumer base that identifies with authentic action sports lifestyle brands. In addition, music is an integral part of the youth action sports lifestyle, and headphones have become an accessory worn to express individuality.”
 
That action sports brands try and use their involvement with the core to reach a much broader customer base is hardly a new idea.   But Skullcandy draws the smaller core towards the much broader consumer market using the commonality of music and the actual product- the headphones. I’m sitting here trying to think of another company that has a product that can do this quite so well but I’m coming up blank. Maybe Nixon is another example. Perhaps this is the bedrock of Skullcandy’s success.
 
You’ll also note in the quote the term “consumer influencers.” We’re all aware of the declining role of traditional advertising and the importance of engaging with your customers. You do that, I think, by controlling as much of your value chain as you can. It’s especially important that you control it at the point of contact with the consumer, and Skull is trying to do that in various ways.
 
They are “…rolling out new point-of-sale fixtures and powered listening stations globally. By the end of the year, we plan to have over 5,000 in place.” About half of these are powered listening stations where you can listen to your own music on Skullcandy headphones as you make purchase decisions.  Some of them have video as well.
 
Their thinking is that higher price point products especially require a listening experience for the consumer at the point of sale. Where they’ve installed them, they’ve seen it “…impact sell-through from sort of low-double digits up to significantly higher than that, depending on the retailer or the fixture type.”
 
They have a retail education group within Skullcandy which is going into retailers and educating sales people on the Astro brand. I can’t see any reason you wouldn’t do that for the high end Skullcandy product as well.
 
They’ve been auditing all their retail customers in Europe since acquiring their distributor and it’s apparently leading to some changes in what they sell to whom; even at the initial cost of some sales.
 
They’ve launched the 2XL brand as a price point product they can sell to places like Walgreens and Rite Aid without damaging the Skullcandy brand. I guess I’m not quite certain why you can sell Skullcandy to Fred Meyers but not to Walgreens, but what do I know.
 
During the conference call, they were asked about selling to Walmart and the answer was along the lines of there’s no current active conversation or commitment, but we’re watching them and it’s kind of hard to ignore the biggest retailer in the world.
 
This goes back to the ability to control your value chain at the point at which it contacts the customer. If you can manage the experience the consumer has with your product so that it’s a positive one and represents the brand in the way you want, does it matter if you’re showing the product in a core shop or in Walmart? That’s an important point, and not just for Skullcandy. The breakdown of the traditional retail/wholesale distribution system requires that brands think about it.
 
Skullcandy’s financial results are good, and their balance sheet is solid. But what I really like is first, the way they are reaching their market using the commonality of music and headphones to draw together the action sports core and the broader market and, second, their strategic initiatives that seem to address the rapidly changing and emerging retail environment.

 

 

Speculation on Billabong

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Walking around a really good Agenda show last week, the question I kept getting asked was, “What’s going to happen to Billabong?”  As I told everyone who asked, I only had access to the same public information they had. Given that information, my best guess is that Billabong will be sold.  Here’s my reasoning. 

As you know, TPG offered, on July 23rd, to buy Billabong for AUD $1.45 a share subject to due diligence and other conditions. They already have an agreement from two Billabong shareholders who together control over 24% of the outstanding shares to sell if there is a deal. Billabong announced on July 27 that “TPG will be granted the opportunity to conduct non-exclusive due diligence in order to reduce the conditionality of its proposal and to improve its understanding and valuation of Billabong.”  
 
Notice it’s nonexclusive, so it’s not impossible for another buyer to pop up. But TPG has 24% of the shares already tied up with deals that give them some upside if higher price is negotiated. TPG also has agreed to allow “…Billabong’s founding shareholder, Gordon Merchant, and Collette Paull to roll over all or part of their respective shareholdings in the company into the TPG proposal.” There seems to be at this point a certain momentum, though a lot can happen between the start of due diligence and the closing of a deal; including an adjustment in the price.
 
The other reason I think a deal will happen is because of the process by which we got to where we are. Back on February 17th Billabong announced the deal to sell half of Nixon to TCP (not to be confused with TPG) for net proceeds of US $285 million. The deal closed on April 12th. That US $285 million, along with other action take to reduce expenses and close some retail stores, was supposed to address Billabong’s capital structure issues. That is, it strengthened their balance sheet.
 
 In the conference call at the time the Nixon transaction was announced, Silvia Spadea, a Merrill Lynch analyst, said, “I guess there’s no question that that will provide you with a short term reprieve with respect to your balance sheet issues. But, in my mind, it doesn’t really do much to address the fact that – you know to improve your current structural issues or stem the current deterioration in your earnings. I guess I’m just wondering how confident you are that the initiatives that you’ve outlined today are going to be enough to permanently fix that balance sheet issue, so that we don’t have this problem a year down the track.”
 
 An excellent question, I thought. In their answers, Billabong CEO Derek O’Neill and CFO Craig White never said anything like “You bet- problem solved,” and you actually wouldn’t expect them to be that definitive. But what they did do was indicate they had confidence in their projections. And my common sense told me that if they had even an inkling that the short term problem wasn’t  well and truly solved, they’d have taken more drastic steps and the Board of Directors would not been quite so cavalier about turning down an offer of AUD $3.30 a share for the company.
 
So imagine my surprise (Yours too, I expect) when Billabong management  announced on June 21st  (Former CEO Derek O’Neill departed the company on May 9th) that they were raising AUD $225 million at $1.02 a share, 44% below the previous closing price.
 
What the hell is going on in there? Had business conditions just fallen off a cliff and Billabong management hadn’t seen it coming?   Almost seems like it couldn’t happen that fast. Had they known it was worse, but had another solution in mind? In the U.S. such a failure to disclose would probably lead to shareholder lawsuits and a flogging from the Security and Exchange Commission. I don’t know what happens in Australia.
  
I suspect it’s not quite as black and white as either of those choices. In doing turnaround work, I’ve noticed a lot of denial and perseverance during periods of change even among highly competent managers/owners and I suspect there might have been some of that in this case.
 
When management has credibility issues, things appear to be going south much faster than anybody (including said management?) knew, and the shareholders take it on the chin and have a stock valued at AUD $1.39 a share they think they could have sold for AUS $3.30 just a couple of months ago, companies find themselves in play.
 
When will we know the outcome? Billabong is scheduled to report their full year earnings on August 27th. That is also the date new CEO Launa Inman is scheduled to present her plan to turn around the company. Due diligence takes some weeks typically, and I wouldn’t be surprised if an announcement coincided with the earnings report.   
 
I wonder what TPG would have found had they commenced due diligence under their previous offer of AUD $3.30? I think maybe there’s an untold story here. Anybody want to tell it to me?