Why Crocs Might Go Private

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I’ve been holding on to this article on Crocs for a while mostly because I just didn’t have time to do anything with it.  What it says is that Crocs is looking to go private because it’s just not as cool as it was.  Currently, it’s traded under the symbol CROX on the NASDAQ and is at $12.88 as I write this.  Here’s a five year stock chart on the stock’s movement.


You’ll note that the stock is trending down at a time when the market has been trending up. 

In the 9 months ended last September 30th, Crocs earned $77.4 million on revenue of $964 million.  That doesn’t sound so bad.  Okay, but in the same 9 months in 2012, it earned $135 million on revenue of $898 million. Selling more and making less.  If that isn’t a sign of being less cool, I don’t know what is. 

So what have we got here?  The gross margin for the nine months fell from 55.8% to 53.9% and selling, general and administrative expenses rose 18.3% from $350 to $414 million.  Operating income fell from $151 to $106 million.  I’m going to resist the urge to do a complete financial analysis (I hear those sighs of relief).   

My point is simple.  It seems a lot of people still want to buy Crocs, and the company can make money.  What they can’t do is satisfy Wall Street’s endless demands for the growth that makes stock prices rise.  And I’ll bet anything that if they try to do that, their gross margin will continue down and the brand will lose credibility as it tries to push its distribution harder, faster, further.  Remember it would be trying to do that in a poor economy with a lot of competition. 

Is this starting to sound at all like any other companies we follow? 

Some smart person probably said, “Hey, if we weren’t public, we could pull back our distribution, improve our brand positioning and gross margin, cut some expenses (from not being a public company and because our improved distribution would let us reduce some marketing expenses) and maybe make more money with less working capital invested!”  Perhaps they’d consider closing some of their 600 or so stores as well. 

Maybe that would work or maybe, for this brand, it wouldn’t.  But continuing to try and satisfy the requirements of the public market looks like a bad plan.  I haven’t heard that there’s a deal done yet.  I’ll let you know if I hear and you do the same for me.

Does it Matter What Industry We Think We’re In? Zumiez’s Quarter

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For many of us, “action sports” doesn’t really describe our target market anymore. We struggle (or at least I struggle) with words like “youth culture” or “fashion” or “outdoor” to describe it. None of them work very well. They are all correct, but not adequate or complete. 

Maybe Zumiez has helped me figure out why. During the conference call, CEO Rick Brooks said, “…it’s really not about e-commerce, it’s really not about stores, it’s about meeting whatever our customers want and whatever channel they want it, anyway they want to get the product. That’s where we’re trying to play and we’re trying to dominate the market in that arena of integrated multichannel selling.”
 
He’s also talked about the fact that they had reduced their North American store projection over the years from 800 to between 600 and 700, but with no decline in revenue from what they would have expected with 800. That is due to the growth of ecommerce and integrated multichannel selling (also known as the now ubiquitous omni channel).
 
The thought that popped into my head was that Rick probably didn’t care quite as much as he used to whether the customer was best classified as action sports, youth culture, fashion, outdoor, or something else. What he cares about was that Zumiez carried the apparel, accessory, footwear, and limited hard goods brands (because that’s a point of differentiation- for now- for Zumiez) that his teen to young adult customers want.
 
At some level Zumiez, or any other retailer for that matter, isn’t going to define itself quite as rigorously as it used to. Its customer is going to define it. That will happen at least partly through Zumiez’s rigorous and ongoing process of identifying and assisting new brands and integrating them into Zumiez’s selling channels at whatever level they can succeed. They discuss the process of identifying and supporting new brands in the conference call. Here’s part of what CEO Brooks say on the subject:
 
“…we are just laser-focused on trying to be supportive and a really good partner for our small retail brands. And again, we have hundreds of brands today that we’re doing business with, just like we always have. And some of them are just in a few doors, and we want to be the right way for that young brand, and we want to do everything we can to help see them be successful. Maybe it’s just those 10 doors, but we’re hoping that over time — and they have to do their job well, too, of making sure that they have great products. They have to have a great marketing, and product and marketing have to be completely aligned with the unique brand positioning. And then they have to have great retail partners that believe in full price selling.”
 
It occurs to me we’re already seeing the customer define the brand happen in the decline of traditional print and media advertising. Why bother spending money (whose impact was already unclear) to define yourself to a certain customer group when the omnipotent, endlessly connected customer with near perfect information is going to decide for themselves what you stand for? 
 
It certainly changes the roll of the marketing department. It doesn’t have to explain what the company is about. It has to listen to the customer to evolve with them but not, it occurs to me, let that customer pull the company too fast or in a direction which will ultimately be wrong.
 
And yet, in response to analyst’s question, Rick talks about their Ultimate Gift Guide that they are mailing to selected control groups to see what kind of response they get. Maybe the role of print is changing in ways we don’t quite understand yet. I’d love more details on how they see the guide tying into their ecommerce channel.  
 
Zumiez may also have an advantage in this environment in the way they identify store managers and give them a high level of management discretion.
 
So I think I’m going to stop stressing out about what to call our industry. I’ve concluded not only that it’s less important, but that it might be a mistake to worry about it as it could lead to resistance to inevitable change.
 
Meanwhile, back in the financial statements, Zumiez’s revenues rose 6.2% to $191.1 million in the quarter ended November compared to the quarter ended October 27 last year. Ecommerce sales were 11% of the total (10.7% in last year’s quarter). They had a net of 55 more stores open in this year’s quarter (541 in North America at the end of the quarter). Comparable store sales increased 1.5%, “…partially offset by the negative impact of the calendar shift, which moved a week of the back-to-school season into the second fiscal quarter of fiscal 2013 and out of the three months ended November 2, 2013 compared to the prior year quarter.” The impact was $7 million.
 
Comparable store sales include ecommerce sales. They rose 7.9% while brick and mortar sales were up only 0.7%. 
 
The gross margin declined slightly from 37.3% to 37%. “The decrease was primarily driven by the deleveraging of our store occupancy costs and an increase in ecommerce related costs due to ecommerce sales increasing as a percent of total sales. This decrease was partially offset by an 80 basis points benefit due to prior year costs related to a step-up in inventory to estimated fair value in conjunction with our acquisition of Blue Tomato.”
 
Without the Blue Tomato inventory step-up, then, the gross margin would have been 36.2%.
 
SG&A expense as a percentage of sales rose from 25.4% to 26.2% or from $45.7 to $50.1 million. Part of the increase was from “…deleveraging of our store operating expenses.” I might have expected the opposite result with 55 more stores open. No detailed explanation is offered.
 
There was a charge of $1.3 million for settling litigation included, and some additional investments in their ecommerce business. There was a benefit of 0.6% because they reduced the expected earnout payments for the Blue Tomato acquisition. That happens because Blue Tomato isn’t performing as well as they had previously expected. That does not necessarily mean it’s performing badly. Total charge for the Blue Tomato acquisition this quarter was $1.7 million.
 
Operating profit fell from $21.4 to $20.7 million and net income was down from $12.7 to $11.9 million. The balance sheet is fine, and there’s no big change from last year. Inventory is up, but it’s consistent with having 55 more stores. In North America, inventory per square foot was basically flat.
 
I guess I’ll have Rick Brooks help me end this. 
 
“I just view retail in America as over-stored. I think, in particular, teen retail is way over-stored. And that is one of the reasons that there’s such tremendous promotional pressure in the teen retail world. One of the reasons, not all of them. But it is a significant reason, I think, that we see the level of promotional cadence in the teen world that we’re seeing today.”
 
That’s a problem for everybody in this space- not just Zumiez. And it’s a reason why you have to operate well. Sales and margin increases are hard to come by. The winners, I think, will be letting their customers help them determine their market position. I think Zumiez’s management would agree with that.

 

 

Billabong: Light at the End of the Tunnel

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At the annual meeting on December 10, Billabong’s Chairman, Ian Pollard, and new CEO Neil Fiske talked to shareholders. Ian talked about what the last year plus had been like and Neil outlined his ideas and strategies for Billabong going forward. You can see their presentations here if you want to. At the moment, it’s the first item under “Recent News.” 

Though I’ll get to it, it wasn’t Neil’s strategic presentation and plan going forward that I found most interesting. Honestly, there wasn’t much in it that hadn’t been mentioned before or that was, at least to me, unexpected.
 
But in both presentations there was an honesty, a focus, a clarity of purpose that has been missing from Billabong presentations over the last year or two as they’ve struggled to stabilize the company and deal with competing proposals.
 
There was a palpable sense of relief in Ian’s remarks. As he put it, “It is also the first time in at least 12 months where the company’s future success will be firmly in the hands of management and their ability to achieve their business goals – rather than the Company’s need to respond to change of control or refinancing proposals.”
 
He went on to say:
 
“These proposals inhibited reform in two ways:
·         First by dominating the attention of both the Board and management.
·         Secondly, potential bidders would only remain engaged if major strategic changes were put on hold.”
 
“The consequent delays in strategic change impacted the Company’s overall financial
performance.”
 
I have previously expressed some surprise that more of former CEO Inman’s plan hadn’t been implemented while she was there and since she left. Chairman Pollard is telling us why that is. The bidders didn’t want it happening until they were on board because, I guess, they didn’t want what they were investing in to change without their involvement. Fair enough, but it seems like some of her proposals (a number of which are also in Neil’s plan) were going to make sense no matter who was in charge, and I’m sorry they couldn’t make some progress sooner.
 
So are Billabong’s board and management I’m sure. Must have been frustrating as hell to know what you needed to do, have a plan to do it, be ready to do it, and not be able to do it. As Ian put it, “Throughout this period a brand that has been built on some of the simplest joys of life has been mired in high profile corporate transactions of extreme complexity.”
 
“Mired.”  Yup, pretty much sums it up.
 
CEO Neil Fiske practically had me sold as soon as he stopped going through his background and said:
 
“A good turnaround has three components:
·         A clear strategy
·         A management team that can execute on that strategy
·         A capital structure that provides stability and room to reshape the business.”
 
He’s right. Or at least that’s been my experience as well. It’s important for you to realize that having two out of three isn’t enough; it doesn’t let you get two thirds of the work done. There’s damned little you can do without all three.
 
This attitude- that the worst is behind them, they can focus on building the business, work on positive things, maybe even have some fun- is as important as Neil’s three components. Don’t worry, I haven’t gone completely touchy feely on you. We’ll get into the strategy next. There’s a lot of work to do and no guarantee of success. It’s a turnaround. Still, I can’t over emphasize the importance of this apparent attitude adjustment (which needs to permeate the whole organization) if they are going to succeed.
 
They are going to focus and simplify. As Neil puts it:
 
“We have been trying to do too many things – and none of them particularly well. Building global brands takes one skill set. Running regional multi-brand retail is something totally different. And being a pure play multi-brand e-commerce business is another thing altogether. Then multiply that complexity by a regionalized organization structure with independent decision making and different operating infrastructures. As complexity grew, we lost focus. We confused the organization.”
 
You’ll notice similarities to what Quiksilver is doing. And to K2’s reorganization a couple of years ago. And for that matter to Microsoft’s “One Microsoft” strategy they announced this past July.
 
When sales increases are harder to come by, operating in independent silos is just too expensive. If you want sales increases, you better put your best foot forward. “Fewer, bigger, better” is how Neil puts it.
 
Neil and his team have determined that Billabong is about “building powerful global brands.” They are going to divide all their brands into the big three (Billabong, Element and RVCA) and the other “emerging” brands. There will be specific strategies for each brand based on its potential and market position. It sound like there may be some brands among the emerging brands sold if they don’t see a strong competitive position and bright future for them.
 
They will differentiate brands partly by using “the creativity and uniqueness of the brand Founders” and will “focus on the authentic core youth consumer.”
 
To me, that implies a certain period of retrenchment where they will “…push the uniqueness of each brand by fostering creative and cultural environments with distinctive brand DNA and vivid personalities.” I wonder (and I’ve said this before, oh, dozens of times at this point) if that focus is consistent with the requirements of being a public company. Where and how do they grow each brand, but retain its uniqueness- its competitive strength if you will. I guess they’re figuring that out.
 
As he moves on to talk about a product, Neil says we can expect at least a 25% reduction in the number of styles. He notes that Billabong “…lacks clear merchandising strategies. We have great design and terrific products. But we don’t have great merchandise planning, buying, allocating and inventory management.” Obviously, there are some systems issues there that need to be addressed. It will be made easier both by simplifying the organization and cutting the number of styles.
 
What was most interesting in the discussion of marketing was that Billabong had tended to fund each brand at the same level (by which I think they mean a similar percentage of sales). They are changing that and will put more resources towards brands where they think they can get a better return. Imagine that.
 
It makes it seem even more likely to me that some additional brands might be sold. Weaker brands are not going to perform better when their marketing spend is reduced.
 
I also like the idea that they are going to “…have an integrated marketing calendar that lays out the major story and key items each month – and then aligning all our marketing and our depth of buy against those big stories. Windows. Print ads. Digital media. Front Tables. Everything converges on and amplifies the big story.”
 
That seems kind of obvious when you read it, but it’s damned hard to do when you have “…a regionalized organization structure with independent decision making and different operating infrastructures.” That’s part of why the structure is changing.
 
The marketing “war chest” is going to be funded by cuts in other G&A expenses.
 
These days, no discussion of marketing strategy is complete if you don’t work in the term “Omni-Channel” and low and behold, here it is as point IV in Neil’s presentation. He notes that “The best customers shop in all our channels – digital, our own retail stores, and wholesale. And they are worth 3-4 times the value of a traditional single channel customer.” I haven’t heard that stat before, but it’s pretty compelling.
 
He goes on, “One of our priority initiatives, therefore, is to build our mono-brand direct to consumer platform – which integrates digital, retail, and CRM. That Direct to Consumer segment should grow to a substantial part of our sales over the next five years. Again, we believe this can be done in a way that grows consumption and market share – and is complementary to our wholesale strategy.”
 
Every company wants to do this. And if you can’t, all you end up with is a really expensive digital presence that potentially cannibalizes your brick and mortar stores. Why is Billabong going to be better at this than its competitors? I think Neil would say because of the quality of their brands, the unique focus each brand is going to have, and the simplification of the organization. Billabong’s multiple ecommerce platforms around the world are going to be unified.
 
You’re going to see a supply chain with fewer, bigger, suppliers. Neil hopes to increase inventory turns from 2.4 to 4.0 times. That will take a couple of years, but will free up a bunch of cash and reduce other costs. That includes distribution and logistics costs, which Neil sees as being 50 to 100 basis points higher than they should be.
 
We are going to see a companywide reorganization rolled out at the end of January or early February. Hardly a surprise given what’s been described above. There will also be some improvements in financial discipline- also not much of a surprise. I can guarantee you won’t increase your inventory turns from 2.4 to 4 without some.
 
What we have here is a series of solid initiatives that are similar to what a lot of other companies in a lot of other industries are doing given the economy we’re all operating in. Wish Billabong could have gotten started sooner, but they’ve told us why they couldn’t.
 
I think we’ll see sales of some additional brands because of the focus on prioritizing the brands with the most potential (and some limits on financial resources). Reading between the lines, we’re also going to see continuing deemphasize on retail, because Billabong’s focus is on “building powerful global brands.” West 49 is about to be gone. My guess is that every store decision will now be based on how it supports brand building. If it doesn’t make money and it doesn’t make the brands look good, it will be closed. How does the omni-channel strategy change how many stores they need and where they need them? Probably a good question for any brand.
 
As Neil says, this is going to take some time. One of the first signs of success I’ll be looking for is an improvement in the gross margin and operating income even if sales don’t rise much, or even decline. I’ll also be curious to see how he recruits for the management team. Remember when Gary Schoenfeld came in as PacSun’s CEO he essentially rebuilt the whole senior management? It was months to accomplish and longer to get them working well with the organization.
 
Feels like a good start. Now all they have to do is implement.

 

 

PacSun’s Quarter: The Transition Continues

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I have been writing for a while now, without having a really good answer, about just what market we are in as action sports doesn’t, for most of our companies, adequately describe the customer base or competitive environment. Outdoor, youth culture, fashion are all words bandied about to describe it. It’s probably some of all of those. 

Pacific Sunwear has figured this out. It’s recognized that action sports isn’t a big enough market to support its plans. As a public company it has to seek some growth and it needs the broader market to find that. It’s choice of brands and positioning as a southern California lifestyle company is indicative of this. I think they’ve made the right choice (in fact the only choice they could make) even though it puts them in a position to have to compete against other fashion focused retailers like Forever 21 that Zumiez, for example, with its action sports positioning and focus doesn’t compete against quite so directly.
 
Reported sales for the quarter ended November 2nd fell 4% from $215.5 million to $206.6 million. However, due to the retail calendar shift, fiscal 2012 had an extra week in it. 
 
“Due to the inclusion of a 53rd week in fiscal 2012, there is a one-week calendar shift in the comparison of the third quarter of fiscal 2013 ended November 2, 2013, to the third quarter of fiscal 2012 ended October 27, 2012. The third quarter of fiscal 2012 included a higher volume back-to-school week as a result of the 53rd week retail calendar shift compared to the third quarter of fiscal 2013. This resulted in a decrease in net sales of approximately $11 million, a 1.9% decrease in gross margin…”
 
So there would have been higher margins and sales if not for the shift in the calendar. Gross margin fell from 28.1% during the quarter to 25% in the same quarter last year. It was basically all due to the calendar shift. 1.9% of the decline was due to lower merchandise margins. The rest of the gross margin decline was also due to the calendar shift because it caused an “Increase in occupancy, distribution costs and all other non-merchandise margin costs…”
In the conference call they tell us, “The decline in gross margin in the third quarter was the result of a challenging and competitive back-to-school landscape, leading to a higher promotional activity.” I wish somebody had asked them to compare what the 10Q says about gross margin with that statement from the conference call.
Selling, general and administrative expenses as a percentage of sales fell from 27.5% to 26.1%. Half the decline was due to a reduction in depreciation that resulted from store closings. The rest was from lower expenses. PacSun reported an operating loss of $2.24 million compared to an operating profit of $1.15 million in last year’s quarter. For the nine months ended November 2nd, the operating loss fell to $8.1 million compared to $22.8 million in the comparable nine months the previous year.
 
 Net income for the quarter rose from $948,000 to $17.2 million. Obviously, when you have an operating loss but a positive net income, there has to be something interesting going on between the middle of the income statement and the bottom- and there is.
 
There’s a gain on derivative liability of $23.4 million. In last year’s quarter the gain was $5.6 million. That is a non cash item associated with some of their financing activities that I’ve described before. You may read the footnotes in the 10Q if you have a compelling urge to know the details.
 
If we remove that non cash item from both quarters, we find that the loss in last year’s quarter before taxes and discontinued operations would have been $2.01 million. In this year’s quarter, it would have been $5.8 million.
 
In the cash flow, we see PacSun continues to use, rather than generate cash in operations. They used a bit over $21 million in both this fiscal year’s 9 months and last year’s. On the balance sheet, the current ratio has fallen from 1.38 to 1.21 and total liabilities to equity rose from 3.18 to 6.99 times compared to a year ago. Current liabilities in this quarter include a separate line item for derivative liability of $27.1 million. It was not broken out in last year’s quarter. I assume it was included in other current liabilities.
 
Merchandise inventories were almost constant at $137 million. They ended the quarter with 635 stores compared to 722 stores a year ago. They are, by the way, going to close another 15 to 20 stores during this quarter.
 
I might have expected a 12% decline in store count to result in some inventory reduction. They note in the conference call that “Adjusting for the timing of the 53rd week calendar shift, total inventory was down approximately 3% on a comparable store basis,” but I don’t think that takes closed stores into effect.
 
If I were running PacSun I think I’d have done basically what they’ve done. Because I don’t see a second viable choice. The balance sheet is still weakening. What PacSun (not to mention a host of other retailers) needs is some improvement in consumer spending.

 

 

Lululemon Appoints Laurent Potdevin as New CEO; Founder Chip Wilson Steps Down.

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Okay, so really short article. I don’t have much to say. One could say I’m speechless. Anyway, here’s the link to the press release announcing the appointment. If you want more info, here’s another link where you can find additional information and listen to this morning’s conference call. Laurent, as you know, spent a lot of years at Burton Snowboards (as the press release calls it) and was President and CEO from 2005 to 2010. More recently, Laurent was President of Toms Shoes. 

Lululemon founder Chip Wilson is stepping down as CEO but will remain as a member of the board of directors. I imagine most of you are aware of Chip’s roots in action sports with Westbeach, which he found around 1980. You are probably also aware that some of his recent comments about some women’s bodies just not working for Lululemon clothing have pissed off a bunch of people. Strangely enough, that issue didn’t get mentioned in the conference call or press release. 
 
Michael Casey, Lead Director of the Lululemon Board of Directors, will be their next Chairman of the Board. In introducing the new CEO, he described Laurent’s experience at Burton this way:   
 
“During his time at the company, he helped the company grow far beyond its roots in snowboarding to become a truly global brand synonymous with the sport and lifestyle.”
 
There was time for just three or four questions from analysts. They generally focused on Laurent’s background and experience as it related to Lululemon.
 
That’s it. I look forward to the comments and discussion on my web site.

 

 

Intrawest Files for Initial Public Offering. Will it Happen?

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On November 12, Intrawest Resort Holdings, Inc. filed the first draft of a form S1 with the SEC for an initial public offering. Like all first drafts, there’s some significant information missing, including the proposed price of the stock and how much they want to raise. But at 400 pages as a PDF, there’s also a lot of interesting information that I thought you’d want to hear about. Here’s the link if you want to skim it yourself. 

Intrawest, to refresh your memories, owns and operates Steamboat, Winter Park, Mont Tremblant, Stratton Mountain, and Snowshoe. It also owns 50% of Blue Mountain. In the year ended June 30, 2013, Intrawest had total revenue of $517 million. 65.5%, or $339 million, came from the mountain and lodging operations at those resorts. 22%, or $114 million, came from their adventure segment. Mostly that’s Canadian Mountain Holidays that provides heli-skiing trips. The remainder of the revenue, 12.5% or $64 million, came from real estate. That includes real estate development as well as real estate management, except there isn’t any real estate development going on right now.
 
Now, some of you will recall that back in the good old days of “The Best Economy Ever” Intrawest and other resorts made a whole bunch of money developing and selling real estate in coordination with the improvement of the mountain experience. The real estate market has changed a bit since 2007.
 
Intrawest tell us they have 1,150 acres of “core development parcels” surrounding or adjacent to their resorts. They also say, “While we do not have any specific plans for the development of our core entitled land, we are focused on designing strategies for future development of this land in concert with planning for on-mountain and base village improvement.”
 
Sounds like there’s a lot of planning going on, but not much else. When might it move past planning?
 
“As the economy continues to improve, we expect consumers will have more disposable income and a greater inclination to engage in and spend on leisure activities. We also expect recreational adventure and experiential travel to continue to gain in popularity as individuals, including the important “baby boomer” generation, live longer, healthier lives. We believe that our business is well positioned to capitalize on these favorable trends…”
 
I don’t know when consumer spending is going to improve, or how much improvement Intrawest requires before they might put some of these plans into action. But if they’re waiting for consumers to start partying like it’s 1999 again, I suspect they’re in for a long wait. The focus on the baby boomers isn’t new for resorts, and I’ve previously questioned whether that’s an adequate strategy. The focus has to be on people with high disposable incomes, boomers or not, though obviously there’s a big overlap there.
 
But I digress. I do that sometimes. Let’s get back to the impact that resort real estate development had on Intrawest. It will lead us to why they are going public.
 
Here’s what they say the real estate collapse that started in 2007 did to them:
 
“Prior to the collapse in the housing markets in late 2007 and the global financial crisis that followed, we were actively engaged in large scale development and sales of resort real estate, primarily in North America. In light of the then prevailing market conditions, we ceased new development activities in late 2009. As a result, we were left with a portfolio of real estate assets, high leverage levels and litigation initiated by purchasers of resort real estate seeking to rescind their purchase obligations or otherwise mitigate their losses. This confluence of factors had a material impact on our consolidated financial results for the fiscal years presented below.”
 
Material impact indeed. Here’s some summary numbers from their income statement for the last three years ended June 30 (In $000s).
 
       
2011
2012
2013
Total Revenues
    
$559,523
$513,447
$524,407
(Loss) Income From Operations
  
(196,516)
(19,332)
3,478
Interest Expense on 3rd Party Debt
(143,463)
(135,929)
(98,437)
Interest Expense on Notes Payable to Partners
(160,943)
(195,842)
(236,598)
Net Loss
      
(498,506)
(336,063)
(296,714)
             
2011 had almost $150 million in impairment charges for goodwill, real estate, and long lived assets. There was also a $26 million loss on the sale of some assets. These all impacted operating income. The total of such charges fell to about $21 million in 2012 and to almost nothing in 2013, permitting Intrawest to show an operating profit.
 
But now look at the interest expense numbers. This is interest on loans that was going to be paid, and the loans paid off, through the development and sale of real estate. And said real estate is no longer being developed or sold. If we visit the June 30, 2013 balance sheet, we see long term debt of $581 million and notes due to partners of $1.359 billion. With a “B.” What they call partners’ deficit (basically equity) is a negative $1.02 billion, having worsened from a negative $724 billion a year ago. 
 
The people to whom all this money is owed seem to have recognized that there is no imaginable combination of economic improvement, perfect snow conditions, and growing visitor days that will let them get out from under this debt. I’d say they’re right. Shades of American Skiing Company- though they didn’t have the issue of an imploding real estate market.
 
Their solution is to take Intrawest public. But what fool would buy shares in a company with this kind of balance sheet losing this much money? The answer is none, or at least not enough.
 
The partners’ solution is to convert their $1.359 billion in notes to equity, moving it out of liabilities. That includes the accrued, but unpaid, interest of $761.7 million as of June 30, 2013.   The restructuring reduces total liabilities from $2.14 billion to $756 million, producing a much cleaner balance sheet. How clean exactly we don’t know yet because the proforma balance sheet in the S1 is incomplete- no surprise since we don’t know how much money they will be raising.
 
But we do have a proforma income statement for the year ended June 30, 2013 prepared as if the deal had been done a year earlier. It shows net income of $8.5 million instead of a loss of $297 million.
 
Why, you might ask, don’t the partners just restructure the balance sheet without going public? Well, if you’re a shareholder (especially if you didn’t really want to be a shareholder) you might want to be able to sell your stock someday. That’s a lot easier if the stock is publically traded. It may also be the case that Intrawest needs the cash that will be raised in the public offering.
 
Intrawest, you may recall, was acquired by Fortress Investment Group in a leveraged buyout. Wikipedia tells us that “Three weeks before the opening of the 2010 Olympics, Fortress failed to make payment on its loan used to buy out Intrawest. This caused its creditors to force Intrawest to divest itself of several of its resort holdings in 2009 and 2010 which includes Whistler Blackcomb, in order to reduce its debt load.”
 
As part of the restructuring for the IPO, which is a bit more complicated than I’ve bothered to describe in this article, a subsidiary of Fortress is “contributing” $50 million to Intrawest. Why would they do that?
 
“As of June 30, 2013, Cayman L.P. [the legal entity that owns Intrawest’s resorts until this deal happens] had loans due to affiliates of Fortress, consisting of notes payable to partners with a principal balance of approximately $597.0 million and accrued interest of approximately $761.7 million. Pursuant to the applicable loan agreements, Cayman L.P. currently accrues interest at rates ranging between 15.6% and 20.0% per annum on the notes payable to partners.” 
 
There are two more things I want you to know. The first is that after the offering is completed, if it is completed, an affiliate of Fortress will own enough of the equity to be able to appoint a majority of the board of directors. Hardly a surprise as it’s their debt that’s being converted.
 
The second is that somehow Intrawest can be classified as an Emerging Growth Company under the Jumpstart Our Business Startups Act of 2012. No, I don’t really understand that either and find it kind of amusing. But what it means is that they don’t, among other things I guess, have to provide five years of financial statements (which they don’t), have the auditor give an opinion over their financial controls, or disclose as much about compensation as usual.
 
We know that Intrawest management knows how to run resorts. And it’s correct to say that they got hammered by the collapse of the real estate market and, if this deal gets done, the impact of that will have been financially flushed out. But they are planning to succeed doing the same things they did before under very different economic circumstances. The question a potential buyer of this common stock has to ask is if they think that’s a reasonable expectation.

 

 

Quiksilver’s Decision to License Children’s Apparel

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On November 26, when Quik announced that LF USA  (a subsidiary of Hong Kong headquartered Li & Fung, a multinational consumer goods sourcing, logistics and distribution group) would “…design, manufacture and market children’s apparel bearing the Quiksilver and DC brand trademarks in the Americas…” I tried to ignore it. It was a short press release and, on the surface, consistent with Quik’s announced strategy of focusing “…our energies and resources on our core apparel business and significantly reduce product styles and SKUs in our supply chain,” as CEO Andy Mooney put it in the press release. 

Then one of my readers inconveniently messed with my comfortable mind set and asked, more or less, “Hey Jeff, if kids aren’t part of Quik’s core business, what is?” I thought that was a good enough question to require some discussion.
 
I’ve talked before about brands aging out. That is, the customers who grew up with them (and with whom the brand grew up) get older and decidedly less cool. The brand may retain those customers. They may even sell them new products.
 
I’d like to pause for a moment and tell you just how hard it is to move on here without stopping to have some fun imagining what those products might be. Send me your ideas. I’ll put them on my web site (anonymously of course).
 
But the future of a business can’t be only with those existing customers because they are going to start buying less and eventually buy nothing at all. New demographic groups have to discover the brand as they grow up and, with luck, make it their own.
 
Quik’s management team knows that kids matter. My reader is implying that Quik is somehow making a mistake by licensing the kid products because of its critical importance to the company’s future. Maybe, but maybe not.
 
Let’s recall that Quiksilver has been losing money. They’re working hard to turn that around by reducing expenses, improving operational efficiency, and focusing their limited resources where they think they can get the most bang for the buck. Remember in recent years they’ve tried selling bathing suits in vending machines at resorts, board shorts with NFL logos, etc. I sense perhaps they’ve learned a lesson.
 
A royalty revenue stream, no operating expenses and, as CEO Mooney points out, fewer SKUs, may be the right way to go operationally and financially given their resource constraints. I’m guessing this is as much a financial as a marketing decision.
 
More important is what’s in the license agreement and how LF USA will handle this. We know nothing about that. What products, exactly, will they sell? Through what distribution in what quantities? At what prices? How will product quality be? Does Quik have any input into design or any of these other issues?
 
The devil is always in the details in any licensing agreement I’ve seen. Obviously, poorly made products only tangentially related to Quiksilver’s market showing up in schlocky distribution would bad no matter how much royalty income it generated. Quik knows this and I am sure it’s managed in the agreement.
 
Do I wish Quik was doing and completely controlling its own kid’s products? Sure. They probably wish that too. Do they recognize the importance of the kid’s market to their future? Of course. Is it a mistake to license the product? Not if they know they need to be in the kid’s market and don’t’ have the resources to do it the right way themselves.
 
The product will hit retail in 2014, and I guess we’ll start to find out then what kind of deal they made with LF USA.

 

 

Some Additional Financial Information on Mervin

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For some reason, following the November 7th sale of Mervin, Quiksilver had to file an 8K that showed Quik’s proforma financial statements as if the sale of Mervin had already occurred. To do that, Quik shows us the adjustments they have to make to represent their balance sheet as if Mervin had been sold at the beginning of the 9 months ended July 31, 2013 and to the income statement to show what the Quik income statement would have looked like for the year ended October 31, 2012 if Mervin had been sold at the beginning of that year. 

They do that by inserting a column between Quik’s historical and proforma financial statements that shows the Mervin numbers that have to be subtracted to get to how Quik would have looked without Mervin. Below is the part of the income statement that shows Mervin’s numbers (center column).
 
 
Quik points out in the 8K that this is subject to certain assumptions and doesn’t necessarily reflect what the results would have been if the split had actually happened October 31, 2011. Don’t be confused by the brackets around the Mervin numbers in the middle column. That just shows they are being subtracted to get to Quik’s proforma numbers without Mervin, as shown in the third column.
 
You can see, then, that Mervin’s revenue for that full year was $33.5 million, and they had a gross margin of 52.7%. Seems impressive to me given they make lots of hard goods and much of it, as far as I know, is made in the U.S. Down at the bottom, you can see Mervin had net income of $6.79 million while Quik, including Mervin, lost $10.76 million. Mervin, then, made a big contribution to Quik’s bottom line in that year.
 
I want to emphasize again that these Mervin numbers aren’t necessarily what Mervin would look like on a stand-alone basis. I’d think the revenue would be the same, but issues of taxes, interest expense, allocation of corporate expenses, etc. would probably mean a different result. Still, you can see why Altamont was prepared to pay $51.5 million for Mervin. Actually, if they could rely on Mervin, as a stand-alone company, to earn $6.8 million after taxes on revenue of $33.5 million (20.3%!), they would probably have been prepared to pay more.
 
I had been prepared to see the Mervin revenue number be higher on the assumption that Quik had really pushed them for sales while they were working through their issues. As regular readers know, my point of view is that the bottom line looks so good, and the gross margin is so high, exactly because they didn’t push revenues too hard.
 
The July 31, 2013 balance sheet shows Mervin with accounts receivable of $7.2 million. That’s higher than you’d want to see a snowboard company of this size have at July 31 of any year. I suppose that’s just a reflection of snow conditions the prior season. Mervin inventory was $13.8 million, which doesn’t seem out of line going into the shipping season.
 
Anyway, that’s all there is. Just thought you might be curious.

 

 

How’s Sanuk Doing? Decker’s Quarterly Results

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So I guess I’ll start by telling you what Deckers says about Sanuk. In the 10Q for the quarter ended March 31, 2013 they provide this Sanuk Brand Overview (page 17). I’ve highlighted the phrase I want you to pay attention to. 

“The Sanuk brand was founded 15 years ago, and from its origins in the Southern California surf culture, has grown into a global presence. The Sanuk brand’s use of unexpected materials and unconventional constructions has contributed to the brand’s identity and growth since its inception, and led to successful products such as the Yoga Mat sandal collection and the patented SIDEWALK SURFERS®. We believe that the Sanuk brand provides substantial growth opportunities within the action sports market, as well as other domestic and global markets and channels in which Deckers is already established.”
 
In the June 30, 2013 10Q the Sanuk Brand Overview (page 17 again) says exactly the same thing, but they’ve added the following sentence at the end (which I’ve highlighted): 
 
“However, we cannot assure investors that our efforts to grow the brand will be successful.”
 
They say exactly the same thing in the current 10Q (September 30 quarter). I’m kind of embarrassed I was a quarter late noticing it. But I’m also kind of concerned I noticed it at all. I have so got to get a life. 
 
Why did they think they had to add it?
 
Decker’s management paid $120 million in cash for Sanuk (subject to adjustments at closing) plus earn outs. The deal closed in July of 2011. In its last complete year as an independent company, Sanuk did $43 million in sales. I don’t recall what Deckers has paid out so far for the earnout, but as of September 30, 2013, they estimate the discounted value of the remaining required payout at $47 million (page 7 of the 10Q which you can see here). That payout assumes a “compound annual growth rate” of 16.9%.  They used 17.3% last quarter.
 
Below, from the 10Q, is a table showing Sanuk’s sales by channel and the change from last year’s quarter. Column one is this year’s quarter, and column two last year’s. The last two columns are the dollar and percentage changes (dollars in 000’s). You can see that total sales were up by just $85,000, and they fell in the wholesale channel. 
 
 
And here are the numbers for the 9 months ended September 30 compared to last year. 
 
 
With 9 month revenue of $79.4 million, Deckers has certainly gotten some good growth out of Sanuk in a bit over two years, though growth has now slowed. 
 
Sanuk’s income from operations from its wholesale business rose from $2.86 million to $3.66 million during the quarter and from $16.2 million to $19.5 million for the nine months. Here’s what they say about why the operating income increased in the quarter:
 
“The increase in income from operations of Sanuk brand wholesale was primarily the result of decreased expense related to the fair value of the Sanuk contingent consideration liability and decreased marketing and promotional expenses. The decrease in expenses was partially offset by the decrease in net sales and resulting gross profit.”
 
Let me translate- We cut expenses and, because the brand isn’t performing as well, didn’t have to book at much for the earn out. That helped, but with sales and gross margin down, not as much as we would have liked.
 
We aren’t provided with operating income for the direct to consumer sales. Here’s what they have to say about Sanuk’s wholesale results for the quarter.
 
“Wholesale net sales… decreased primarily due to a decrease in the average selling price, partially offset by an increase in the volume of pairs sold. The decrease in average selling price was primarily due to increased closeout sales in the US, partially offset by increased average selling prices outside the US primarily due to the addition of international wholesale sales, which generally carry higher price points than distributor sales. The increase in volume of pairs sold was primarily due to our wholesale customers in the US and UK, as well as our distributors throughout Europe and wholesale customers in France, Japan and Benelux. These increases in volume were partially offset by a decrease in volume to our distributors throughout Asia. For Sanuk wholesale net sales, the decrease in average selling price had an impact of approximately $2,500 and the overall increase in volume had an impact of approximately $2,000.”
 
Go back and read that carefully. Note that when they talk about the decrease in average selling price in the US, they say it’s “partially offset” by increased prices outside the US. But that’s because they apparently changed some distribution from distributor to wholesale. I mean, it’s true that you get higher margins selling at wholesale than through a distributor, but you also incur more expenses in getting the sale.
 
Net, is this a good thing? Well, we don’t really know, though obviously they think it made sense to change the distribution or they wouldn’t have done it. But they try and spin it as a counterbalance to lower prices due to closeouts in the US, though I don’t think it is. Everything they say is no doubt true, accurate, and complete as interpreted by a squad of lawyers.
 
Here endeth the daily lesson on the care you have to take when reading SEC filings (and press releases and conference calls even more) for any company. Especially when they have to share some bad news.
 
One symptom of the problems Deckers seem to be having with Sanuk is that “…Sanuk brand inventory increased $3.9 million to $12.5 million.” That’s a 45% increase from $8.6 million a year ago. 
 
Deckers, as you know, also own UGGs and Teva, as well as some smaller brands. Total company sales rose 2.75% during the quarter compared to last year’s quarter from $376.4 million to $386.7 million. The gross profit rose from 42.3% to 43.2%. This increase was “…primarily attributable to a shift in the mix of channel revenue with a greater contribution coming from our Direct to Consumer division…”
 
Once again, I feel obligated to point out that you get higher margins from direct to consumer business but also incur higher expenses. The question for any company is whether there’s any of that extra gross margin left after you cover those higher costs.
 
Deckers reported an increase in selling, general and administrative expenses of 20.8% from $99.7 to $120.4 million. About $12 million of the increase was for 37 new retail stores that weren’t open a year ago. Operating income from retail stores for the quarter fell from $321,000 to a loss of $2.26 million. Same store sales revenues rose 1.9% for the quarter. For nine months, operating income from retail fell from $8.5 million in 2012 to a loss of $1.6 million in 2013.  
 
Largely as a result of that SG&A increase, Decker’s income from operations for the quarter declined from $59.6 to $46.5 million. Net income was down from $43 million $33 million.
 
Overall, Deckers is suffering from the same worldwide economic problems that are afflicting everybody else. They also got hammered when their UGG brand, which accounted for 87% of total revenues during the quarter, was hit by spiking sheepskin prices over the last couple of years. My perception is that they’ve managed that pretty well after initially trying to push through more of the cost increase than the consumer would accept.
 
But they are having trouble with Sanuk, and I’m starting to believe that some of that trouble is of their own making. Growth has slowed, they’re having to close out some excess inventory and, probably inevitably, gross margin is down. They’ve cut spending in response.   
 
I’d remind Deckers management of Nike’s various attempts to enter the action sports business some years ago. They were pretty certain of their success, thought they could buy their way in and that they understood the business. As I’ve noted, we went to their parties, ate their food, drank their beer, but for a long time didn’t buy their product.
 
Then Nike figured out that they didn’t understand this business after all. They got humble (or maybe just more determined), developed some patience, hired a few people who knew what was up, and left them alone. They backed them up with their balance sheet and logistic resources even when they weren’t quite sure what the hell those guys were doing and it worked.
 
The situation isn’t the same, and the market has changed. Still, there’s a lesson there somewhere for Deckers and how they might consider managing Sanuk.

 

 

SPY’s Quarter: More of the Same. That’s Good and Bad

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To sum it all up, the good news is that sales for the quarter ended September 30.2013 rose 2.7% compared to the same quarter last year from $9.89 to $10.15 million and the net loss declined from $1.78 million to $302,000. The bad news continues to be the balance sheet, where the long term debt to stockholders is $20.86 million, up from $17.53 million a year ago. Here’s the link to the 10Q for those who might be interested, though I’m pretty sure most of you read my stuff specifically to avoid having to look at the 10Q. 

I suppose I could stop here and have the shortest article ever. But there are a few financial points that need highlighting and a big strategic issue.
 
The sales amounts are pretty much all SPY branded product except for $100,000 in last year’s quarter. However they note that there was $600,000 in SPY sales this quarter “…which were considered to be closeouts, defined as (a) older styles not in the current product offering or (b) the sales of certain excess inventory of current products sold at reduced pricing levels.” The amount in last year’s quarter was $800,000 and it’s good to see it declining. It’s about 6% of sales. Apparently, they are still clearing up some inventory issues.
 
Sunglasses and optical were 56% of sales. Goggles were 43%. The numbers in last year’s quarter were 64% and 35% respectively. North American sales were 80% of the total compared to 84% last year.
 
The reduction in the net loss was driven by two things. First was a monster improvement in the gross profit margin from 43.5% to 48.5%. 
 
“The increase in our gross profit as a percent of net sales during the three months ended September 30, 2013 compared to the same period in 2012 was primarily due to: (i) improved overall sales mix of our higher margin products; (ii) a higher percentage of lower cost inventory purchases from China; (iii) lower overhead as a percentage of sales partially due to the consolidation of our European distribution center to North America; and (iv) lower sales of closeout products at reduced price levels.”
 
I would be very interested to know what their margin was on the $600,000 in closeout sales.
 
The second was a 19% decline in operating expenses from $5.53 to $4.47 million resulting in an operating profit of $454,000 compared to an operating loss of $1.22 million a year ago. Most of this was the result of a $900,000 decline in sales and marketing expense to $3 million due to “…(i) a $0.3 million decrease in advertising, public relations, marketing events, and related marketing costs; (ii) a $0.6 million decrease in sales and marketing salary and travel related expenses primarily for reductions in headcount.”
 
I’d also note that cash provided by operations over the nine months of the year so far was a positive $2.49 million compared to a negative $4.13 million in last year’s first nine months. Keep in mind that the interest on the shareholder debt is not being paid in cash but being added to principal and that has something to do with the improvement.
 
Enough on the numbers. Let’s talk about the brand’s positioning. Here’s how they describe it in the 10Q:
 
“…the Company believes it has captured the imagination of the action sports market with authentic, distinctive, performance-driven products under the SPY ® brand. Today, the Company believes the SPY ® brand, symbolized by the distinct “cross” logo, is a well-recognized eyewear brand in its segment of the action sports industry, with a reputation for its high quality products, style and innovation.”
 
Fair enough. Now, here’s some branding discussion from the press release:
 
“We have a HAPPY disrespect for the usual way of looking (at life). This mindset helps drive us to design, market and distribute premium products for people who "live" to be outdoors, doing intense action sports, motorsports, snow sports, cycling and multi-sports-the things that make them HAPPY. We actively support the lifestyle subcultures that surround these pursuits, and as a result our products serve the broader fashion, music and entertainment markets of the youth culture.”
 
I think the happy disrespect approach is great as long as they can keep it up. It really can supply some differentiation. Irreverence works in this industry. But note that the second quote talks about the broader youth culture market, and the first does not.
 
Maybe I’m reading too much into this. It seems symptomatic of a problem I’ve been highlighting for a while. How does a company maintain its positioning in the historical action sports industry while expanding into the broader youth culture business? It’s proven to be difficult (Burton? Volcom? Skullcandy? Sanuk?).
 
Long term, SPY’s challenge is exactly to do that. I think it has to if it’s going to find enough growth and profitability to get out from under its debt to shareholders. Strategically, that’s what I’ll be watching for.