Decker’s Quarter: The Issue is Not with Sanuk

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The September 30 quarter (here’s the link to the 10Q) was not one of great happiness for Decker, the owner of UGG, Teva and, of special interest to us, Sanuk. But perhaps we should be interested in their other brands as well. Most of you who sell shoes and sandals are competing directly in the broader casual footwear market after all. 

Anyway, Decker’s sales fell 9.2% from $414 million to $376 million. In last year’s quarter, the gross profit margin was 49%. This year, it came in at 42.3%. Net income was down from $62.3 million to $43.1 million. What happened?
 
Well, it’s not Sanuk’s fault. Its sales for the quarter grew $15.6 million to $18.3 million, or by 17.3%. $1.3 million of these sales were on line. Sanuk is not sold in Decker’s retail stores. The brand’s sales for the whole year are projected to be $95 million. 
 
Sanuk’s operating income was up nicely from $1.5 million to $3.2 million. However, that increase “was primarily the result of a $1,400 reduction in accretion expense related to the contingent consideration liability from the Company’s purchase of the brand, a $900 reduction in amortization expense largely related to an order book that was fully amortized in 2011, and $500 of increased gross profit, partially offset by approximately $600 of increased marketing and promotional expenses.” After reading that closely, it’s hard to conclude that the operating income increase was primarily the result of selling more product.
 
Sanuk’s wholesale sales growth was the result of an increased selling price “…partially offset by a decrease in the volume of pairs sold.” Apparently they didn’t just increase prices for Sank. There was a shift in the product mix (sorry, no details given) and the introduction of a new shoe and boot line with higher prices.   
 
Unhappily for Deckers, Sanuk’s wholesale business represented only 4.9% of total revenue during the quarter. UGG, with revenues in the quarter of $284 million (down from $334 million), represented 76% of quarterly revenues.
 
Sheepskin is a primary material in UGG products. The cost of said sheepskin was up 30% in 2011 and another 40% in 2012. Obviously this sent the costs of UGG products through the roof. Deckers responded by raising prices and found that, as Chairman, CEO and President Angel R. Martinez put it“…our price increases over the past 2 years had pushed us above the consumer’s price value expectations for the UGG brand.” The warmest winter in the U.S. since they started keeping records didn’t help either.
 
There was probably no good answer for Deckers in the short term. Either they could hold their prices and see their gross profit go to hell, or they could raise prices to hold margins and see their sales drop. Not a happy place to be. The lesson for all of us, and I think it’s especially important these days, is that no matter how sophisticated your strategy, how well thought out your competitive positioning, how differentiated by marketing and features your product, and how many people “like” you on Facebook, every product can be substituted for and sometimes the stuff just costs too much.
 
Deckers sees sheepskin prices coming down some, and they “…made the decision to adjust our domestic pricing in mid-September on select classic styles, retroactive to all orders shipped since July 1.” They reversed some, but not all of their price increases. The issue is whether they can make enough of the price increases stick so that, given a decline in raw material costs that it sounds like will be less than the initial increase, they can recover their gross margins. Price increases, even when justified, have to be gradual I think.
 
Mr. Martinez goes on to say, “The price adjustment has been mischaracterized in recent industry coverage as “discounting.” But in fact, it’s an important strategic decision that we believe is in the best interest of the brand for the long term.” The good thing is that it sounds like they didn’t close this product out or take it to other channels. They worked with their existing retailers for everybody’s benefit, which is something we in the action sports world perhaps haven’t always done as well as we could. But I wonder where that high quality strategic analysis was when they raised their prices so much in the first place. Maybe subsumed by some pressure to make the quarter?
 
Deckers has hit what we hope is a one time bump in the road due to the large and rapid increase in the price of sheepskin. Sanuk seems to be doing fine. Given the price Deckers paid for it, I imagine they will push the brand for even better results. Please don’t push too hard.

 

 

Another Possible Retail Future

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We’ve all been watching for a while now as online and brick and mortar retail have collided and converged. We know it’s here to stay and that there’s a lot of evolving left to do. None of us know what the end product will look like (though maybe it’s better to acknowledge that there is no end product- just way points along the path). 

I think I might have stumbled on one of those way points. There’s a new concept store in the Seattle area called Hointer. No idea where the name came from or what it means, but it’s a fascinating combination of internet and brick and mortar.
 
 When you walk in the store (which at this point is men’s pants only), you download an app on your smart phone. There’s one pair of each style of pant hanging in the store. You scan the tag on that pair, put in your size in the app, and the pants shows up in the changing room for you to try on in what they say is 30 seconds. If you want to purchase after trying it on, you swipe your credit card in the scanner in the fitting room. Your receipt will be emailed to you. If not, you just put the pants in a chute in the changing room and as it falls to wherever it goes and is automatically removed from the pants you’ve selected and returned to inventory.
 
Unless you want to, you never need to interact with a sales person. I’m not quite sure if that’s good or bad. Depends on the shopper I suppose. And of course, the store keeps up to date track of its inventory and that inventory is shared with its suppliers.
 
I’ve had a tendency in recent years to harp on the importance of inventory management and operational efficiency. This store seems to make that a virtuous part of the selling process which I really love.
 
I haven’t been in the store yet. I’d want to know a lot more about the cost of the required technology, the impact on operating expense, and the comparative price points of the product. I’m also curious about the complexity that will occur as the product line is expanded.
 
Here’s a link to a news story where the reporter goes through the purchase process. I hope you’ll watch it.   Sorry about the short commercial at the start of the video.

 

 

SPY’s Quarter; Strategy and the View from the Balance Sheet.

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About a hundred years ago, around 1998, I spent a year as one in a long line of people who believed in the Sims brand enough to try and get it some traction (Some of you who are reading this are smiling; some are laughing. At me or with me- who knows). 

Sims benefitted from having a group of really competent people who had been with the company for a long time and were totally loyal to the brand. In difficult circumstances, while I was there and after, they cleaned up the brand and created a company that was doing $20 plus million a year, earning an operating profit, and had the potential to grow some.
 
But no matter how well they operated, they couldn’t overcome the high level of debt on the balance sheet and the discontinuities this created between what was good for the brand and what was good for the shareholders/debt holders.
 
Which, as you were probably expecting, gets me around to SPY.
 
Strategy and Balance Sheet
 
SPY’s sales grew 7.6% in during the quarter ended September 30, rising from $9.2 million to $9.9 million. They cut their operating loss from $2.4 million to $1.2 million and their net loss from $2.98 million to $1.78 million compared to the same quarter last year. As usual, there are some details to be discussed, and we’ll get to that. But first, let’s talk about the strategy and the balance sheet.
 
If you’ve followed SPY over the last few years through what I’ve written or other sources, you know that they’ve experienced a lot of challenges; some self-inflicted, some not. There’s been the Italian factory they bought then sold, a lawsuit with a former CEO, the detour into, and then out of, licensed brands, some inventory problems, management issues and turnover (now apparently ended), a lousy economy, and the August 2012 announcement that the company was reducing “…the level of its expenses to lower its breakeven point on an operating basis.”   Through all of the tumult, the SPY brand has somehow maintained credibility in the market.
 
Now, the company is refocused exclusively on that brand and it feels like the company is making progress. But sunglasses are a very competitive category produced by an awful lot of companies. It’s a high margin product so naturally everybody wanted a piece of that. Inevitably, that margin will come down (is already coming down?) because that’s what happens.
 
SPY needs to grow its revenues so that it can afford the cost structure it has to have to compete against much larger and better capitalized companies. To accomplish that, and to clean up all the problems mentioned above, they’ve had to invest and invest and invest. That gets us over to the balance sheet.
 
In the year since September 30, 2011 notes payable to stockholder have risen from $10.5 million to $17.5 million. The majority shareholder has lent the company another $7 million over the year. Interest on the debt is not being paid in cash, but is accrued as additional debt. Under current liabilities, the line of credit outstanding has risen by $2.1 million from $2.5 million to $4.6 million. Stockholders’ equity has dropped from an already negative $4.3 million to a deficit of $12.8 million. The only thing keeping SPY afloat is the willingness of the majority shareholder to lend the company money, and the 10Q tells us they are going to need more; “The Company anticipates that it will continue to have requirements for significant additional cash to finance its ongoing working capital requirements and net losses.”
 
Well, it’s hardly unusual for a company in this industry to find itself at the point where it needs the financial, back office and/or design/manufacturing strength of a larger company so they can “Take it to the next level” whatever the hell that means.
 
If it’s a company like Sanuk, who was more or less the same size as SPY when it was acquired by Decker and was growing, profitable and no doubt had a solid balance sheet, you can get paid a lot of money. But if you’re losing money, require more investment, and your balance sheet is upside down you don’t quite get such a good deal. In those circumstances, in our industry, “Taking it to the next level” has meant some of your debt gets assumed, you get an earn out if the company performs, and people get to keep their jobs.
 
My guess is it would make sense for SPY to be bought by a larger corporation. But whatever we might conclude the brand is worth, nobody is going to come anywhere close to paying the majority shareholder the $17.5 million he’s owed for a company that’s losing money and needs further investment.
 
There are also, of course, other shareholders who’d probably rather not lose their money. I don’t know exactly why or how SPY came to be a public company in the first place, but this would probably be more easily managed if it wasn’t a public company, though way less fun for me.
 
Nuts and Bolts
 
In the August restructuring, they took a $700,000 charge for the reduction in expenses I mentioned above. This one-time cost was for changing the direct part of its European business to a distribution model and for reducing its marketing spend. The result was a staff reduction of 20 positions.
 
For the quarter, 16.4% of its revenue, or $1.63 million, was international. I would expect that going from a direct to a distribution in Europe, while reducing some costs, will also lower their gross margin on the product being sold there. The reduction in their marketing spend, while understandable given their financial condition, is the opposite of what they’d indicated they were going to do in the past. See the conflict between what the brand and the balance sheet requires?
 
While overall sales grew by 7.6% in the quarter, the sale of the SPY brand during the quarter rose $1.4 million or 17% to $9.8 million. That included $800,000 of SPY closeouts. In the same quarter last year, the closeout number was $300,000. As we’ve noted, total sales were $9.9 million. Only $100,000 of revenue came from the left over inventory of licensed brands they’ve been getting out of. They don’t expect any significant future sales from those brands. It’s great to see that done.
 
The gross profit margin was 44% compared to 35% in last year’s quarter. The increase was the result of a number of factors, including the negative impact of the write down of the licensed brand inventory last year, purchasing more lower cost product from China, and decreased freight cost (they avoided some air freight). These positive factors were somewhat offset by lower international margins, increased closeouts, inventory reserves, and discounting, and some changes in accounting for product from the Italian factory.
 
Increased inventory reserves, discounting, and closeouts don’t sound all that positive. What would be really nice is if they would tell us the gross margins on just the SPY branded product since that’s where the company’s focus is.
 
Selling and marketing expense increased by $0.4 million, or 12%, to $3.8 million. They say this was “…driven primarily by increased marketing efforts to promote our SPY brand and our new SPY products and a portion of restructure expense included in 2012.” Yet if we breakdown the increase, there was a $500,000 charge as part of the restructuring which was meant to reduce exactly those costs. They spend an extra $100,000 in marketing costs and had a $200,000 decline in consulting and other marketing expenses.
 
So the increase was to promote the brand, but some part of the increase was a charge to cut those costs. Once again, I can only point to the conflict between the interests of the brand and the reality of the balance sheet.
 
I would expect there will come a point when the major shareholder who’s been financing SPY will be tired of putting in more money and it will be interesting to see what happens then. In the meantime, SPY has whittled its non-operating issues down to not much, and perhaps a good holiday season will result in a strong December quarter. 

 

 

Paul Naude Explores Billabong Leveraged Buyout

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I suppose you have all heard that Billabong Director and President of the Americas Paul Naude has stepped aside from his duties for six weeks to try and pull together a leveraged buyout of Billabong. You can see the Billabong announcement and the conditions under which he is working here at Billabong’s investor web site. It’s the first link under Recent News called Company Update. 

To be clear, I have no information that’s not public. However, I thought it might be useful to review just what a leveraged buyout is and how it works. And, I’ve got a couple of questions.
 
In a leveraged buyout, the buyer (or buyers) purchases the target company by using some of their own money (the equity portion) and borrowing the rest. The loan amount is secured by the assets of the target company.
 
You might reasonably ask, “How much of the purchase price is equity and how much is debt?” It used to be that you could borrow most of the purchase price, but that was back in the good old days. I’m not close to the leveraged buyout market, but I’m guessing you have to put up more equity now. That’s both because lenders are a bit more cautious then they use to be and because it’s harder in this economy (in general- I can’t speak to the specifics of Billabong) to put together a plausible business model that shows fast revenue growth to be used in paying off the debt.
 
On the other hand, interest rates have come down to historically low levels even, or maybe I should say especially, for lower rated debt. People seem to be forgetting again that there is an inevitable relationship between risk and return. You may recall that’s what got us into our current economic/financial mess in the first place.
 
Anyway, the point is that lower interest rates make it easier to make a deal pencil out. Once a leveraged buyout is complete, the new owners have to pay down the debt. They typically try to do that by some combination of asset sales, expense reductions, improved efficiencies and revenue growth.
 
You remember that Billabong had to sell half of Nixon and then a few months later raise additional equity to address concerns about their balance sheet. By definition, in a leveraged buyout, their balance sheet would deteriorate again as they added the debt used to purchase the company to it. The former owners and banks won’t care, because they will get their cash and be gone. The new owners will understand that they are taking higher risk but hey, that’s the business they are in and their plan will have convinced them that the risk is justified by the potential return.
 
We also remember, of course, that a couple of potential buyers evaluated Billabong to see if they might be interested in buying it and choose not to. Why? Well, we don’t know specifically but I think it’s fair to say that they didn’t see the risk as justifying the potential return.
 
Below is a chart of Billabong’s stock price from an article in The Australian that will remind you of the series of events.
 

       
 
One would assume that Paul Naude knows why Bain and TPG pulled out, but on the other hand maybe they had no obligation to explain it to the Billabong Board of Directors.
 
That doesn’t really matter anyway. When I evaluate a company, as you know, I do my own analysis and don’t pay attention to anybody else’s conclusions. Perhaps after I did that with Billabong I’d:
 
–          See the risks and returns a bit differently than Bain and TPG.
–          Think I could get it for a lower price because of the performance of the stock since the October 12th withdrawal of TPG.
–          Believe that the transformational strategy had the potential to drop a lot of Australian dollars to the bottom line pretty quickly.
–          Be prepared to be more aggressive in selling assets to pay down debt.
–          Think that the Australian dollar was going to depreciate a bunch over the next year.
 
Paul didn’t take this step without thinking it through. His experience with the company, reputation in the industry and, I assume, willingness to be CEO and put up some of his own money, is at least going to get him listened to. His agreement with Billabong keeps him from disclosing any confidential information, so I wonder if he won’t go back to TPG and/or Bain and show them a different vision of reality. They’ve already got the confidential information.

 

 

VF’s Quarter. Thank God for 10Qs (What an odd thing to say)

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VF had a quarter in which total revenues rose 14.3% from $2.73 billion to $3.12 billion. Net income was up 26.8% to $381 million. I don’t find it as clear cut as that sounds, and the way to approach analyzing it is to go right to Note G- Business Segment Information in VF’s 10Q and reproduce part of it for our discussion. So here it is.

 

VF refers to its business segments as coalitions. In the chart above you see the revenue and operating profit each coalition produced during the quarter. Total company revenue rose by $398 million. The Outdoor & Action Sports coalition, which includes Vans, The North Face, Timberland and Reef, grew by $415 million, or 104% of total revenue growth.
 
Without the growth in Outdoor & Action Sports, VF’s total revenue declined very slightly.
 
Total coalition profit (profit before interest, taxes and corporate overhead which I call operating profit) grew by $111 million. Outdoor & Action Sports operating profit grew by $92 million to $413 million, representing 83% of operating profit growth and 67% of total operating profit. Outdoor and action sports revenue was $1.85 billion, up 29% from $1.44 billion in the same quarter last year. It represented 59% of total revenues for the quarter.
 
I guess we better dig into the Outdoor & Action Sports results as they appear to be kind of important to VF’s overall results and because they are what we’re most interested in.
 
First, let’s remember that Timberland, which is part of that segment, was acquired by VF on September 13, 2011. So its results were included in VF’s numbers for only a few weeks in last year’s quarter, but in the whole quarter this year. 
 
In last year’s quarter, “Timberland contributed $163.6 million of revenues and $11.0 million of pretax income…” In this year’s September 30 quarter, it contributed $499.1 million of revenues and $55.8 million of pretax income.
 
Let’s adjust the Outdoor and Action Sports segment for those revenue numbers. Without Timberland last year’s quarterly revenues would have been $1.27 billion. This year they would have been $1.35 million. That is growth of 6.3% in revenue for Outdoor & Action Sports.
 
I’m not going to try and do that adjustment for operating income, because the operating income number I have for Outdoor & Action Sports is before interest, taxes and corporate overhead, but the number they give for Timberland’s quarterly impact is just pretax and I’m afraid I’d be comparing apples and oranges.
 
The North Face and Vans grew 5% and 21% during the quarter respectively. Those brand’s direct to consumer businesses grew 10% and 18% respectively. Outdoor & Action Sports U.S. revenues increased 26% with 16% of that increase coming from Timberland. International revenues for the coalition rose 32%, but 30% came from Timberland. European revenues rose 24%, but fell 6% excluding Timberland.
 
We get some further interesting comments on those brands in the conference call. The North Face’s revenue growth in the Americas was in the high single digits. It experienced mid single digit declines in revenue in Europe for the quarter, though they say the brand continues to take market share there. If their revenues can decline, but they can still take market share, things must be pretty hard in Europe.
 
They also note that The North Face’s constant currency revenue were up 60% in Asia. No idea what size numbers we’re talking about.
 
Vans grew at a mid-teens rate in the U.S. Constant currency revenues were up more than 45% in Europe and more than 40% in Asia. Both Vans and North Face are increasing their marketing investments.
 
Total Timberland revenues actually “…declined slightly in the third quarter.” The growth in Timberland we talked about before was for the period when VF owned them. Timberland was obviously generating revenues before the acquisition. I gather it was down more (“moderately”) in the Americas due to the hangover in inventory from last year’s warm winter. It was flat in constant dollars in Europe. There’s further discussion about how they are still integrating Timberland into their business model with expected improvements in performance.
 
The company’s overall revenue growth of 14.3% came mostly from Timberland. Only 2% of that growth was organic. Direct to consumer revenue grew 28%, with 19% coming from Timberland. Direct to consumer was 18% of total revenue.
 
Gross margin grew nicely, from 45.3% to 46.7%. “Gross margin increased in the third quarter in nearly every coalition due to a greater percentage of revenues from higher gross margin businesses and the impact of lower product costs. The increase in the first nine months of 2012 also reflects the continued shift in the revenue mix towards higher margin businesses, including the Outdoor & Action Sports, international and direct-to-consumer businesses.”
 
Strategy
 
The first thing I’d note is CEO Eric Wiseman’s conference call comment that “We’re seeing some slowing in the U.S. economy, increasingly challenging conditions in Europe and slowing growth in China.” Those issues aren’t unique to VF.
 
Let’s go on and quote him again. “As you know, we’re constantly looking at the shape of our portfolio because we believe that the diversity of our portfolio is our strength.” What that means is that they will sell businesses that don’t meet their expectations and look to buy ones that do. And while, “We’re pretty focused on the integration of Timberland this year for all the appropriate reasons…acquisitions are our priority, and we’re beginning to look into 2013 about what we might do.”
 
Right now, Vans appears to be the best performing sizeable brand VF owns, and you know that performance has their attention. They are trying to create some of Van’s attributes at The North Face and I expect they will do the same thing with Timberland once it’s fully integrated.
 
Given the results they are getting from Vans and expect from The North Face and Timberland, I wonder if the sale of some of their brands that aren’t performing as well isn’t in the cards.
 
It used to be hard to be a big company and be “cool” in this industry. That doesn’t seem to be the case anymore. Either the formula has changed or they’ve figured it out. Or maybe it doesn’t matter like it used to. I just think the lines between action sports, youth culture, and fashion have blurred to such an extent that it’s harder to keep a specific identity that really differentiates you.            

 

 

Some Lessons From Zara; How Fast Fashion Fits Today’s Economy

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Zara has 5,900 stores in 85 countries. Only 45 are in the United States. I’ll get back to why that is. I’ve been aware of Zara for a while of course, but when my ever vigilant research department sent me this article, I decided there were some lessons we could all learn.

Because I don’t want to rehash the whole article, this will be pretty short. Zara, headquartered in Spain, has factories and a distribution center right across from its corporate offices. Their template is “…trendy and decently made but inexpensive products sold in beautiful, high-end-looking stores. “ Sales people are trained to gather information from customers. That information goes to headquarters daily, where trends are identified, clothing designed, and manufacturing orders placed.
 
The production time is two to three weeks. There’s never an over production issue. The company does not advertise. I may have said a time or two that selling through at full margin and telling your customer, “Sorry, it’s all gone!” is the best advertising.
 
Typically, stock turns over in like 11 days. The result is that “…every purchase is an impulse buy” because you know it won’t be there when you come back.
 
Think about the quality and efficiency of operations, including inventory management, required to operate like this. I’ve been writing for a while now that operating well was no longer a competitive- just a requirement of being in the market. Maybe in fast fashion it is an advantage.
 
Here’s another quote you should pay attention to. “A business model that is closely attuned to the customer does not share the cycle of a financial crisis.” You know, we all knew that. But it’s so obvious I, at least, have never thought about it quite in that way. I guess the closest I’ve gotten is to say focus on the gross margin dollars you generate rather than sales growth.
 
Zara’s business model encouraged its customers to visit their stores often, to spend less on each item, but to buy more items because they know they won’t have each of those items long. It’s not a perfect comparison, but the moment I read about spending less on items you know you won’t have long, I thought about how the popsicle skateboard market has evolved.
 
I wonder if, at some point, an unexpected reaction to fast fashion might be for consumers to get tired of constant shopping and turnover. Maybe the next retail chain will be “Timeless Concepts” offering apparel that tends to not go out of style, at least not so quickly. Or maybe I have no clue how men and, especially, women think about fashion.
 
And why does Zara have only 45 stores in the U.S.? Partly because they are aware that foreign brands have a long history of failing here. But it’s also because the Americans “…don’t fit in the clothes. So why do it?  Having to make larger sizes makes production so much more complex.”
 
Well, that’s embarrassing. Maybe having an extra-large burrito and a milk shake for lunch will make me feel better.           

 

 

Skullcandy’s September 30 Quarter; This is Going to Get Interesting

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Since Skullcandy went public, I’ve characterized the bet they are placing as “whether or not you can be cool in Fred Meyer.” I’ve also asked if coolness is enough of a market differentiator in a product which, especially at the lower end, is increasingly something of a commodity. And finally, I’ve wondered if Skull can have any lasting technological advantage given the resources of some of their competitors. 

Let’s see what their 10Q and conference call tells us about these issues.
 
The Income Statement
 
Sales for the quarter ended Sept. 30 rose 17.1% from $60.6 million in the same quarter last year to $71 million. Gross profit rose from $28.8 million to $34.1 million as the gross profit margin rose from 47.5% to 48%. Operating income was up from $8.2 million to $10.6 million, and income before taxes grew like mad from $3.39 million to $10.2 million. That seems pretty good, but there are complications.
 
The first thing you should know is that interest and other expenses were $4.84 million last year. This year during the quarter they totaled $403,000. That’s a pretax improvement of $4.4 million that has nothing to do with selling headphones and related products. Most of that expense in last year’s quarter was related to the initial public offering and was a one-time expense. Without that, the income before taxes improvement wouldn’t be nearly as great.  Skull points this out in their public information.   
 
Next, keep in mind a transaction from last year. On August 26, 2011, Skull acquired Kungsbacka 57 AB. That was the company’s European distributor. Once they acquired it, in the middle of last year’s quarter, their numbers changed. Before the deal, they sold to Kungsbacka at a lower margin, but didn’t have any of the operating expenses of running a European business. Once the deal was complete and they were going direct, their sales and gross profit rose, but so did their operating expenses.
 
I think getting control of your distribution as you grow is a good idea, and it’s common in our industry. But Skull notes in the 10Q that, “As a result, the three month ended September 30, 2012 are not comparable to the three months ended September 30, 2011…” That’s neither bad nor good. It’s just inevitable and you need to keep it in mind.
 
If we can’t just compare quarters, let’s dig into some details and try and figure out what we think.
 
North American sales as reported rose only a little from $56.3 million to $57.4 million. International sales accounted for almost all of the net sales growth, rising from $4.4 million to $13.6 million. But remember the impact of the Kungsbacka deal. Last year, until the deal date, Skull only operated in one business segment. With the acquisition, they are now in two; North America and International.
 
The 10Q says, “Included in the North America segment for the three months ended September 30, 2012 and 2011…are international net sales of $6,015,000 and $10,713,000… that represent products that were sold from North America to retailers and distributors in other countries.”
 
In last year’s quarter, before the acquisition closed on August 26, sales to Kungsbacka were just sales. After the closing date, they were part of the international segment. And, with a whole quarter under their belt in this year’s quarter, international sales in North America fell, as you’d expect because they got moved to the international category.
 
Let’s take all those international sales out of both quarters and see how things are going just in North America. Skull tells us that North American sales included $10.7 million of international sales not all of which, I guess, were to Kungsbacka. If we subtract, we find that North American sales were $45.54 million. That includes Canada and Mexico.
 
This year, North American sales were reported as $57.41 million, including $6.02 million of international. Subtracting, we come up with $51.39 million of sales in North America. So sales in North America, excluding any product sold internationally from North America, rose from $45.5 million to $51.4 million, or by 13%. Total international sales were up 29.7% from $15.1 million to $19.6 million.
 
You can expect, they tell us, that more sales will transition from the North American to the International segment.
 
On an as reported basis, the 2.1% North American sales increase was “…primarily driven by increased Astro Gaming sales of $4.7 million.” We also learned that online sales, as a percentage of net sales, fell 3.8% to $6 million compared to last year’s quarter. Skull notes that, “An increase in Astro Gaming online net sales was offset by declines in our direct audio consumer business.” Online sales fell from 9.1% to 8.3% of revenues in the nine month period ending September 30 of each year.   “Online sales,” we’re told, “continue to be negatively impacted by price competition in the ease of online price shopping.”   
 
Total gross profit in the North American segment declined by $54,000 to $27.18 million in the quarter compared to last year’s quarter. The gross margin fell to 47.3% from 48.4%. They attribute the decline to “…a shift in sales mix to higher price point products with lower gross margin structures” as well as how some of the Astro Gaming inventory had to be accounted for at acquisition. I would have expected that the Kungsbacka acquisition would have had a positive impact on North American gross margins (because North America would no longer be selling to Kungsbacka at distributor pricing, or at all for that matter) and I was surprised they didn’t mention that.
 
The mention of lower gross margins on the higher price point merchandise was a concern to some analysts. As you know, I’ve been a champion of focusing on gross margin dollars as well as gross margin percentage so I’m maybe not so concerned.
 
The Strategy
 
CEO Jeremy Andrus reminds us in his conference call comments that Skullcandy is “…focused on 4 key strategic areas to drive continued long-term growth. Raising our average selling price, expanding the gaming category, growing international and developing other brands and categories.”
 
Here are some numbers from the conference call for the quarter that tell us something about their sales breakdown worldwide.
 
Product that retails for $30 or less represented 38% of dollar volume and 67% of units. Over the ear products were 26.5% in dollars, but only 7.4% in units. Products in the $30 to $75 range were 28.1% in dollars and 15.4% in units. And products retailing for $100 and over were 5.3% in dollars and 1% in units. The numbers don’t exactly to add to 100% and I can imagine that “over the ear” includes product in more than one price category, but you get the picture. At the moment, the less expensive products are their biggest sellers by units and dollars.
 
Management notes in a couple of places that there is increased competition in the low end buds and that they have lost some market share to competitors in that segment. While I’m obviously not the target market, I paid $2.99 for a recent pair of buds I bought because I knew they were going to get broken at the gym, lost, or left in a pocket and put through the wash.
 
That low end buds would become a bit of a commodity (try to name a consumer electronics product that hasn’t eventually become one- especially at the lower end) can’t be a surprise to anybody. Skull management pretty much acknowledged this when they introduced their 2XL brand “…developed to sell into drug, convenience and grocery channels.”
 
The Skullcandy brand is already in certain retailers (like Fred Meyer) that I’d say is equivalent to where the 2XL brand is be sold. I wonder if 2XL will replace the Skullcandy brand at certain price points and retail outlets, or if they will both be sold in the same place. 2XL, they say without giving any numbers, is small but growing quickly.
 
The Astro gaming headphone brand was about $10 million in international sales at the time Skull acquired it. Skull is pursuing the gaming market with both Astro and Skull branded products. Astro will be the premium product in Skull’s gaming offerings. They’ve just launched the Skull gaming product so it’s not a lot of business yet.
 
In international, Skullcandy is “…still in the early stages of building our direct business in Europe and expanding distribution in other foreign countries.”
 
They are also working to move up their average price points. They think they have a lot of potential in the $50 to $100 price range and “…have invested heavily on product development and are reengineering the development process through an in-house team of designers, developers and acoustic engineers. Everything from the form, function and sound quality are now being controlled in-house.” During the quarter sales in this price range rose 60%, but “…this segment is still relatively small.”
 
What’s It All Mean?
 
They’ve got the 2XL brand, but it’s still small. They see a lot of potential in Europe, but that’s at early stages. They are focusing on higher price point products in both the Astro and Skullcandy brands, but are just rolling them out. Meanwhile, they’ve got some competitive pressure in the $30 dollar and under price point which was their largest by units and dollars during the quarter. Online sales, except for Astro, declined.
 
How’s the overall business environment? “We are confident in our ability to continue to drive long-term sales and earnings growth. That said, the overall retail environment is definitely a bit uneven right now in the U.S. and overseas, particularly in Europe. Over the past few months, we have seen retailers become more cautious in their outlooks for the holiday season and at this point, it is impossible to gauge the impact of Hurricane Sandy.” Those problems aren’t unique to Skullcandy.
 
What’s the short term impact of this? “As a result, the company is lowering its operating margin and profit projections in the fourth quarter and revising its fully diluted earnings per share outlook for 2012 to a range of $1 to $1.04 from the previous range of $1.10 to $1.20.” Management expects “…the fourth quarter to roughly mirror what the third quarter has been in terms of revenue.”   They would not provide a lot of guidance for 2013 because they are in the middle of their budget process, but CEO Andrus did say“…my general sense is that operating margins will be flat next year.”
 
Here we are at the crossroads that every successful, fast growing company eventually arrives at. It’s no surprise that Skull’s lower priced products (that produced 38% of revenue and 67% of unit sales during the quarter) are to some extent becoming commodities and are under competitive pressure. I’d expect that to continue. If there’s continued price and margin pressure there, one wonders what kind of volume they need to do to be competitive in this segment. Their new 2XL brand is to be part of the solution to that.
 
Skullcandy management sees growth opportunities in Europe and in moving to higher price points with both the Skullcandy and Astro brands, but those are at early stages of development. How quickly can they be expected to compensate for the lower priced, more competitive business in North America? And if, in these small but growing niches, competitive positioning is based on the cache of the Skullcandy name- it’s “coolness” if you will- how big is that market?
 
Like I said, this is going to get interesting.

 

 

Let’s Review; Lessons for Being in the Winter Sports Business

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Well, here we are in the middle of a new snow season. Among the things people are probably thinking about are:

“It can’t be any worse than it was last season.” That seems statistically likely to be correct.
 
“What am I going to do with last year’s product?” Probably something brands and retailers are both still thinking about that.
 
“I am never, never, ever going to order (or produce) more than I’m absolutely certain I can sell.” I do hope you stick to it.
 
“Wow! Am I glad I wasn’t over inventoried when last season started.”
 
And, if you’re a smaller, single season company, there’s the ever popular, “I hate having to finance this business and I’m really, really tired of personal guarantees.”
 
With those in mind, I thought it might be useful to review the things you have to do to be successful in a one season business. Most of these ideas I’ve written about before, but I don’t think I’ve ever pulled them all together in one place.
 
Be Cognizant of What Is and Is Not Controllable
 
Business is good when it snows and bad when it doesn’t- and there’s nothing we can do about that. That means you’ve got to assume and prepare for an average season at best (though you might need to think about what you mean by “average” in a lousy economy with global warming).
 
You Have to Make Money 
 
I know this sounds kind of obvious, but if you can’t make money, don’t be in the business. We’re all aware of retailers who have pulled out of snowboarding after doing that analysis. Though I don’t like to see that, I say good for them for facing the reality. I guess the good news is that it helps those who remain in the business by reducing distribution a bit.
 
Unfortunately, the analysis is not as cut and dried as I just made it sound. You mean make money every year? How do you allocate your overhead to winter sports if that isn’t all you do? Is it cash flow positive even if it isn’t bottom line profitable (I doubt it)? Will it cost me customers who buy other stuff? Can I make it profitable by carrying different brands or inventory mix? Etcetera. 
 
Don’t Be a One Season Business
                               
I suppose the only snow only retailers left are shops associated with resorts, and they close in the summer. Except that winter resorts have figured out that not being a one season business is a good thing. Water slides, zip lines, mountain biking trails, golf, and other activities are allowing them to generate at least a bit of cash flow in the summer. What significant snowboard brand hasn’t, or isn’t trying to create year around revenue or isn’t owned by a larger company that has that year around cash flow?
You’d be stunned at what getting just 10% of your total revenue in the off season does for the ability of your finance person’s ability to sleep at night by improving the cash flow.
 
Basically, there’s no good way to finance a one season business except to make it less seasonal. You can do it with equity, but you really don’t need to tie up all that money all year and your return on equity will probably suck. You can do it with debt and pay it down in the off season but lenders, especially now, want to see a strong balance sheet (implying lots of equity) before they will lend you the money. It’s a bit of a conundrum.
 
I’ve been responsible for the financial management of a couple of snowboard companies and the only solution I see is increasing off season revenue.
 
Inventory Management
 
I would always prefer to bemoan a sale I didn’t make than inventory I had to liquidate. It was years ago I suggested that a focus on the gross margin dollars you generated rather than the gross margin percentage was a good idea, and it’s only gotten more important as the economy has become and remained soft. Sales growth is harder to come by, but maybe you can improve your bottom line anyway by growing your gross profit.
 
In a more formal sense, this method of looking at your inventory is referred to as gross margin return on inventory investment. To over simplify, it makes you confront the fact that you’d rather sell an item with a 35% gross margin that sells for $175.00 than three items with a 50% gross margin that sell for $12.00. 
 
That’s worth thinking about in any business, but especially in the seasonal snow business. To put it as directly as I can, if you’re stuck with much inventory at the end of the snow season, the chances of your making an overall profit in snow that season are slim to none.
 
And there are other advantages to managing inventory a bit more tightly and in a more sophisticated manner, as if making more money shouldn’t be enough to convince you. You tie up less working capital. You create a perception of value through scarcity. I think “Sorry it’s all sold!” does more to create value in the eyes of the consumer than all the advertising in the world. What exactly is wrong with selling a bit less, but paying the bank less interest, generating more gross margin dollars, and perhaps being able to spend a few less bucks on advertising and promotion?

I thought this was going to be a way longer article.  I know, I know.  Conceptually simple sounding, but not all that easy to do.  But much of what I’m describing just represents good business practices that these days you can’t ignore.