http://www.jeffharbaugh.com/wp-content/uploads/2014/08/logo_color_640.gif 0 0 jeff http://www.jeffharbaugh.com/wp-content/uploads/2014/08/logo_color_640.gif jeff2013-09-02 09:38:292014-09-24 17:15:50Billabong's Annual Report
Billabong released its results for the year ended June 30, 2013 a few days ago, and I’ve been plowing through the 200 or so pages of material and listening to the conference call.
My recent writings about public companies have been lamenting that they are public. Not just because they have to share their travails with us (though I kind of enjoy that), but because pursuing the strategy appropriate for our current market is in conflict with the growth requirements of a public company. It’s awfully hard to be an action sports based company and then have to grow, partly because you are public, into the broader youth culture and fashion market where the competitors have significant advantages and the new target customers may not value your story and brand.
We’ve seen this with Spy, Quiksilver, Skullcandy, and now Billabong. Reduce your growth targets (though don’t admit it), control distribution to build brand value, and be operationally efficient. The result, I’ve argued, is that you can improve the bottom line without big sales increases, but Wall Street doesn’t like that. It’s enough to make a company schizophrenic.
No doubt you’ve seen Billabong’s numbers. They reported a loss for the year of $863 million compared to a loss of $277 million in the pcp (prior calendar period). All numbers are in Australian dollars unless I say otherwise. Rather than go through the financial statement line items as I usually do, I’d like to highlight some issues that fall out of the data, but I’ll get back to the usual financial stuff later.
Status of the Refinancing Deal
As you know, Billabong had a deal with the Altamont group which the Oaktree/Centerbridge group, also interested in a deal with Billabong, asked the Australian government to review for fairness. The deal was revised so that the Australian government choose not to review it and Billabong is moving forward with documenting the Altamont deal. That’s to be completed in “weeks.” In the meantime, Dakine has been sold to Altamont and the short term bridge financing is in place. The Oaktree proposal is “…being considered in its entirety in the context of director’s fiduciary duties and in the best interests of shareholders.” My guess is that the Altamont deal will be completed.
But it isn’t done yet. And just in case you didn’t already know it, watching what Billabong has gone through should have convinced you that putting this kind of deal together is subject to various uncertainty and surprises.
Management told their auditor (PriceWaterhouseCoopers) that if for any reason they can’t get the Altamont deal to happen, the Oaktree proposal would. I can just imagine that negotiation with Oaktree if Altamont fell through.
Price said, “Okay, we believe you,” and gave them a clean opinion on their audit. But they felt it appropriate to note in their letter that if for any reason neither deal closed, Billabong’s ability to continue as a going concern might be jeopardized.
I mention that so you know that I’m not the only one who thinks a deal isn’t done until it’s done no matter how much we expect it to happen. If you want to read the language of the letter yourself, go to this page, click on “Preliminary Final Report & Full Year Statutory Accounts” under “Recent News,” open the PDF, and go to page 151 (153 as Adobe counts pages in a PDF). Can’t believe I was still awake when I got there. I will refer to this document a number of times in this article.
It seems like every time Billabong hits a bump in the road, a few more apples fall out of its management tree. They’ve lost some people I’d consider important and I’d note that CEO in waiting Scott Olivet hasn’t jumped to become CEO or invest his own money yet. Like me, and like the auditors, I suspect Scott knows a deal isn’t done until it’s done. And of course if the Altamont deal should not close and a deal with Oaktree happened, who would be CEO then?
I expect the deal with Altamont will close, Scott will become CEO and, hopefully, he’s already talking with people he’d like to bring in to build the management team. But getting the deal done just gets Billabong to the place where it gets a chance to compete. After the carnage it’s been through, one hopes good people are enthusiastic about joining the team. The documents are silent on this issue, but rebuilding management and making it effective (not just at the senior executive level) will take some time.
Billabong implemented a short term retention plan for six key executives (see page 28 of the report I referenced above) but that doesn’t address the resignations at lower levels.
The Brands and Operating Strategy
How are the individual brands doing? Literally the only thing we’re told is that “RVCA, Xcel and Von Zipper continue to perform well” In the Americas and Billabong and RVCA are doing well in Australasia. They have never broken out sales by brand and I would not expect them to start now. But that seems like a small list of brands doing well, and implies the others are not outperforming and no brand is performing well worldwide. In addition to those brands, at June 30 the company owned Element, Kustom, Palmers, Honolua, Beachculture, Amazon, Tigerlily, Sector 9 and Dakine.
Billabong also had 562 retail stores worldwide at June 30. There were 168 in North America, 113 in Europe, 126 in Australia, 37 in New Zealand, 47 in Japan, and 24 in South Africa. These stores operate under at least ten different names. They closed 93 stores during the year.
I find it interesting that they are operating at retail under ten or more names. They say on page 9 of the document that they will, “Consolidate store banners and optimize fitouts.” Good. The list of retail names will, of course, go down by at least one once they sell West 49. They tell us that the selling process is “advanced.” We learn in the conference call that West 49 is not profitable on a standalone basis, but is improving.
In broad brush, the operating strategy hasn’t changed much since former CEO Launa Inman presented it. They are rationalizing their supply chain and have reduced the number of suppliers from 275 to 50. Hard to know exactly what that means without further information on how much was produced at the ones they eliminated, but I’d expect to see the results in a reduced cost of goods sold and perhaps a reduction in certain administrative costs.
They are trying to differentiate their brands “…in key areas such as product, experience, service, convenience and innovative product design.” Isn’t everybody. One of the ways they are trying to do this is by managing their distribution better. Specifically, they note that they are reducing close out channel sales, particularly in the U.S. They characterize this as ongoing and well advanced. They call it “…a strategic shift in channel distribution away from close out/distressed sales channels towards more long term and profitable channels, such as e-commerce.”
I was a bit surprised to see that because I didn’t know that those channels were a significant part of their business. We don’t know how significant, but since they characterize the shift as “strategic” it can’t be small numbers.
This is a step towards managing distribution better to boost brand perception and, hopefully, gross margin. But it also reduces the top line (depending on the impact on each brand) and so is in conflict with the public company requirement of growing revenues.
They also are simplifying the business by reducing the number of styles. They were going to start with 15% and go from there. Other companies in our industry are doing that as well, and I’m all for it.
There are other items around developing e-commerce, executing at retail better (It’s still 50% of their total business), and trying to be more rigorous about deciding which brands to invest in where. All good stuff.
Running the business better with fewer suppliers, styles, and retail names and a more cautious approach to distribution has a favorable impact on the bottom line all by itself. But they are recognizing, I think, that operating well is closely tied to better brand building and competitive positioning.
Billabong choose to identify in their annual report $867.2 million in expense as “Significant” items. Most of it, they are at pains to point out, are intangibles and not cash. What Billabong does is exclude all these charges that are on their actual income statement and present “adjusted” results that show an after tax profit of $7.7 million instead of a loss of $863 million.
Below, from the presentation they made during their conference call, are the items they identified as significant.
There was also an associated tax expense of $26.2 million, which is how they get to the $867.2 million.
Just how reasonable is this approach?
The BIG Number
Let’s start with the $636.9 million number, $428 million of which was taken in the first half of the year. I apologize for this, but I don’t know how else to do it but to reproduce a couple of charts from their report. This first one below (page 104 in the report) shows how much they wrote off in 2012 and 2013 in both brand value and goodwill for each brand. The write-offs for countries and regions are associated with their retail operations and rationalization of their distribution operations.
This next chart (page 103) shows the carrying values with these write-offs completed.
Remember these are as of June 30 when Dakine was still owned by Billabong.
Definitely non-cash, but not without impact and implications. If you were enough of a glutton for punishment to continue reading on pages 104 and 105 about how they do the analysis to determine these write-downs, you’d find that the process was technical but also involved some assumptions (dare I say guesses?) about values and future cash flows. The bottom line is that they wrote down these assets because they aren’t worth what they once were and because their future cash flow is not going to be what they thought. It may not be cash now, but it’s sure an indication of cash they won’t get later.
You can see they wrote down the Billabong brand from $252 million to zero. They’ve also written Element down to zero. I guess those are the numbers the process led to, but obviously those brands are worth something more than zero. Brand write downs, by the way, are not something where your recover some value in the normal course of business like you would with written down inventory. But you would see a bigger gain if you sold the brand. We don’t know which, if any, additional brands Billabong might sell.
They don’t break out any write down for West 49, but I do see a $113 write down of good will in North America. Wonder if any of that is for West 49.
While taking these write down, they paid out during the year $69.7 million for “…purchase of subsidiaries and businesses, net of cash acquired.” An additional $10.5 million of deferred compensation is payable in the current fiscal year. Another $48 million is due in future periods. These numbers may decline to the extent they are associated with Dakine since it was subsequently sold, but we aren’t given that information. It would suck to still be paying for brands you’ve written down or off.
The Nixon Deal
That’s the $129.6 million on the significant Items list. Billabong has written its Nixon investment down to almost nothing.
We find out (page 100) that Billabong’s share of Nixon’s revenue in fiscal 2013 was $63.7 million. At June 30 Billabong owned 48.5% Nixon, so we can conclude that Nixon’s revenues during Billabong’s fiscal year were around $131 million. We’re also told that Billabong’s share of Nixon’s income was a loss of $5 million, so we can calculate that Nixon had a loss of just north of $10 million during that year.
Okay, here the reasons Billabong gives for writing down its Nixon investment. First, “the deterioration in the trading of Nixon…” and because they don’t expect it to do as well in the future as they thought it would. Second, it’s got $175 million in debt. Third, because of the terms of the joint venture they signed when they originally sold the equity stake. And finally, because they’ve renegotiated supply agreements with Nixon and this has reduced their interest in Nixon.
The first two are kind of self-explanatory, though I’d point out that the debt has existed since the deal was done. But the second two require some discussion. Let’s start with number three.
When they sold 48.5% of Nixon to Trilantic Capital Partners and 3% to Nixon management, Billabong got “Class A Common Units.” The buyers got “Class A Preferred Units.”
The commons only get paid when and if Nixon is sold after the preferreds get an unspecified return on their capital plus a “preferred return” of 12% on their capital. Please read the following quote carefully.
“Hence in the event of poor performance and consequently lower sale proceeds, the returns to the Common Units will be less than those on the Preferred Units. In the event of significantly lower sale proceeds, the return to the Common Units could be zero. Conversely, in the event of very strong performance and consequently high sale proceeds, the returns to the Common Units can be greater than those to the Preferred Units.”
I guess right now it looks like strong performance and high sale proceeds are unlikely events.
On to the renegotiated supply agreement. When Billabong sold 48.5% of Nixon, they made an agreement with Nixon to buy a certain amount of product over four years. Don’t know exactly how much or when. On July 23, 2013, they made a deal with Trilantic to reduce these purchase commitments. Under the terms of that agreement, they now have to make payments totaling $14.2 million during the year ending June 30, 2014. They are going to get $9 million in product from Nixon during the year.
In exchange for this Trilantic got enough Billabong units in the joint venture to reduce Billabong’s share of the Nixon joint venture to 4.85%. They are going to surrender those shares in December 2014 rather than make a final payment of $3 million at that time, and then Billabong’s share of Nixon will become zero.
So Billabong is going to pay $17.2 million and get out from under a supply contract in exchange for its 48.5% share of Nixon. Is Billabong no longer going to carry any Nixon product in its stores? Obviously, they are going to carry less because they are closing stores. Does the payment include the cost of purchasing the $9 million in product? Are they effectively paying $17.2 million for $9 million worth of product?
Billabong characterized their contract with the Nixon joint venture as “onerous” and at June 30, 2012 took a charge because they expected the required product purchases to be in excess of the group’s requirements.
But it was only in spring 2012 that Billabong sold the share in Nixon. And a month or two later they are finding out that the contract is “onerous” and taking a charge for it? I wonder what the product pricing in that contract was like. Meanwhile, Billabong retained 48.5% of Nixon, but given the difference between the common and preferred units, it’s hard to conclude that Billabong retained 48.5% of the projected earnings stream.
Billabong got cash it needed at the time they did the deal with Trilanatic, but I wonder (however Australian accounting works) if it was reasonable to characterize their stake as 48.5%. And I wonder if the terms of the supply contract didn’t favor Trilantic and the joint venture. Unfortunately, all I can do is wonder.
All the Other “Significant” Charges
Sometimes in accounting, when things are really, really bad, you decide that as long as the news is going to be god awful anyway, you might as well make it a little worse and write off absolutely everything you can to completely clean up the balance sheet. I’ve heard this called “The Big Bath Theory” and seen it in action.
Not all such write-offs generate income in subsequent accounting periods, but let’s look at one that does. Let’s you’ve got some lousy inventory. You think you can sell it, but for less than the cost you are carrying it at. When you sell it you will get cash, but recognize an accounting loss. But if you’re already writing off everything that isn’t nailed down and this lousy inventory is a small part of that, you say, “Oh the hell with it- let’s write that off too.” It’s now on the books at zero. You get the same cash when you sell it you got before you wrote it off, but you now recognize an accounting profit on it in the future period in which you sell it. And it’s a big profit, but you’ve effectively got a cost of goods sold of zero.
Not saying this is what Billabong did. Just want you to be aware of the concept. I hope they did do it.
It’s not just Billabong, of course, that adjusts for so-called one time charges in various forms in an attempt to make things look better- ah, I mean to try and present a better picture of the company’s operations. But when I see “inventory clearance below cost and receivables losses” of $32 million excluded, just as an example, I question it even as I understand the rationale.
In the presentation during the conference call, management said that the significant items reflect, in part, “…charges arising from the difficult trading conditions experienced by the Group…” Just because times are tough doesn’t mean those charges aren’t part of real operating costs.
I’ve never seen a company say, “We got some breaks this year because of a strong economy, a favorable exchange rate and some lower commodity prices, so here’s a proforma that shows a worse result.”
In the conference call, Billabong noted that they were “learning to live with a lower Australian dollar.” That brought a smile to my face because it wasn’t too long ago that Billabong was blaming the strong Australian dollar for some of their problems. Apparently, weak or strong, the Australian dollar is just a problem.
There can be value in adjusted financial statements. And they don’t always favor the company. For example, Billabong’s adjusted EBITDA in its Australasia segment improved 120% as reported, but only 17.3% as adjusted. It’s up to you to figure out what the adjustments mean and whether they produce an adjusted financial statement that’s useful, and there’s no right answer.
The Usual Financial Stuff
Billabong’s total revenue for the year was$1.34 billion, down 6.8%. As reported, they fell 15.1% to $637 million in the Americas, 16.5% in Europe to $232 million, and grew 9.7% to $472 million in Australasia.
EBITDA grew 151.6% in the Americas to $19.5 million from a loss of 37.8 million in the pcp. In Europe, it declined 113% from a loss of $11.7 million to a loss of $25.1 million. In Australasia, it improved 120% from a loss of $21.5 million to a profit of $4.4 million. On a consolidated basis, EBITDA fell from $133 million to a loss of $1.9 million. Recognize that these numbers included Nixon in the pcp, but not in the year ended June 30, 2013.
Australia was 67% of Australasia revenues and the U.S. was 56% of the Americas. France represented 86% of European revenues. That’s an interesting number, as I think things are going to get worse in France. As I mentioned earlier, retail was 50% of revenues. It was 71% of Australasia, 44% of the Americas, and 28% of Europe.
Revenues in the Americas was impacted by the 73 stores closed since February, 2012 and by comparable store sales that fell by 2.9% in the full price stores and 4.9% in outlets. Store closures and warehouse rationalization helped them reduce overhead.
In Europe, the macroeconomic environment pretty much stinks, and that required some store closings. There are fewer wholesale accounts and a lot of promotion. They reduced overhead by $9.3 million, but that wasn’t fast enough to keep up with revenue decline. SurfStitch startup losses were $7.6 million.
In Australasia, wholesale sales were softer, they closed some stores, and some wholesale accounts went out of business. The Billabong brand, as well as RVCA, is performing well. Their simplification programs are responsible for the improving EBITDA.
The gross margin fell to 51% from 52.7% in the pcp. There’s no discussion of the decline, but I assume it’s partly due to inventory write-downs ($31 million this year compared to $72 million in the pcp).
Selling, general and administrative (SG&A) expenses fell 16.3% from $645 to $540 million. They don’t give us a breakdown of what’s in here, but if you go to note 8 on page 90, they show the significant items that are included in the category. The interesting thing is that last year the total significant items were $117 million. This year, they were $49 million. That represents $68 million of the total $110 decline in SG&A. Using Billabong’s logic, and removing those significant from both year’s SG&A expense, we find they’ve fallen by 7% from $528 million to $491 million; not the 16.3% reported. And of course, there are no Nixon expenses in the 2013 SG&A and I can’t tell if they are part of the significant expenses or not (I’d expect not). So what should I conclude about Billabong’s efforts to reduce its SG&A operating expenses? Hard to tell.
Interest expense for the year was $13.4 million. Total interest and finance charges were $26.7 million (note 7, page 89). During the conference call we learn that interest costs under the Altamont deal will be between $43 and $48 million annually depending on the exchange rate. I don’t quite know which number to compare that to, but it’s quite an increase.
I suppose I should spend some time on the balance sheet, but with the Altamont financing hopefully imminent, it doesn’t seem like a good use of time. It would have been great if Billabong had, or would, provide a proforma balance sheet assuming the deal happens.
Sometimes Australian accounting leaves my head spinning and my sojourn through Billabong’s fine print hasn’t done anything to change that. I guess that’s my problem and I should move to Australia and study accounting.
Let’s move on to CEO Ian Pollard’s comments at the end of the press release. “We are nearing the end of a long process that has caused distraction, impacted on staff morale and has been very costly.” No argument there. One way or the other, it’s going to come to an end.
He goes on, “The Company looks forward to refocusing, reinvigorating its brands and rebuilding the business on a solid, long term financial footing.” I’d like to see that too.
To evaluate the possibilities, I’d like to see that proforma balance sheet I already referred to and, more importantly, I’d like to know more about the market position and potential of the company’s various brands. There are, I continue to believe, a host of cost reductions from operating better that won’t hurt any of the brands. In fact, they may help them and I applaud Billabong’s plan to reduce off price sales. But our market is changing madly. Legacy brands seem to be having a hard time getting traction and growing. You can read every word Billabong provided and not really get a better sense of where the brands stand. At the end of the day, that will be the most important thing.