Quiksilver’s Annual Report

In the middle of December, when Quik came out with its quarterly and fiscal year results and held aconference call, I pretty much ignored it.  I glanced at the release and read the conference call transcript, but I had no idea how to evaluate the results of a company that was highly leveraged without a complete balance sheet and the associated notes even though they included some summary balance sheet information in the release.

Last week, the annual report came out.  Now we can have a more meaningful discussion.  Let’s start
with the strategic issues, which I consider the most important.  Here is the link to the 10K if you want to
check it out yourself.

http://www.sec.gov/Archives/edgar/data/805305/000095012310002048/a54776e10vk.htm

Strategic and Competitive Considerations

First, let’s look at Quik’s description of how they compete.

“We compete primarily on the basis of successful brand management, product design and quality born
out of our ability to:
 

  • maintain our reputation for authenticity in the core boardriding and outdoor sports lifestyle demographics;
  • continue to develop and respond to global fashion and lifestyle trends in our core markets;
  • create innovative, high quality and stylish products at appropriate price points; and
  • convey our outdoor sports lifestyle messages to consumers worldwide.”
     

Who could argue with that?  Nobody.  In fact, that’s why most every company in this industry tries to do
those exact same things.  But, as I tend to ask clients and people who call me about starting brands,
“What’s going to distinguish your brand and product?”  Quik can honestly and correctly look me in the
eye and say, “Our reputation, our longevity, our commitment to surfing, the sheer amount of
advertising and promotion we do, and our size.”  They are right, but things are changing in a number of
ways.

First, of course, is the economy.  We’re in a period of reduced consumer spending and deleveraging that
may last years.  That impacts all companies.  It’s harder to get the next sale than it was.  Second,
consumer receptivity to promotional messages and the way we receive and evaluate information is
changing thanks to the internet, social marketing, and the growing ability to segment customers more
and more accurately.  And we are increasingly the gatekeepers of the information we get.  Our
attention, we are coming to realize, is a valuable commodity that we no longer give up freely.  My guess
is that traditional brand management activities aren’t going to work as well as they use to.

Finally, and this is especially important for larger companies like Quik, there are issues of distribution.  In
fiscal 2009, 39% of Quik’s consolidated revenues were from core market shops.  You know what those
are.  That includes Quik’s 518 company owned stores worldwide (They also have 213 licensed stores). 
37% was to “specialty stores” that include “…Pacific Sunwear, Nordstrom, Zumiez, Dick’s Sporting
Goods, Famous Footwear and Journeys, as well as many independent active lifestyle stores and sports
shops in the United States and around the world.”  10% went to department stores and the remaining to
U.S. exports (9%) and distributors in Europe (5%).  Approximately 19% of consolidated revenues were to
their ten largest customers, but none of these represented more than 4% of the total.  

There are, of course, fewer retailers than there used to be.  And they are buying less and being more
cautious.  But even before that happened, the ability of the core market shops and specialty stores (to
use Quik’s terms) to increase their purchases of Quik product was going to decline.  You can’t increase
your purchase of any brand every year forever without becoming that brand’s store.  And, as I’ve argued
before, independent retailers just can’t compete any more by only carrying widely distributed brands.  It
doesn’t differentiate them as a shop, and the competitively required pricing and resulting margin may
not be something they can survive with.

So I expect that Quik’s ability to grow in their core and specialty segments was limited even before the
economy slowed.  Excluding opening more stores or acquisitions (which I don’t think they are in a
financial position to make), that leaves them more dependent on the department store segment and
other nontraditional sales outlets for growth.

But you have to be cautious how you do that because, for the reasons described above, you can damage
your sales in the core channel.  And according to Quik, “…The foundation of our business is the
distribution of our products through surf shops, skateboard shops, snowboard shops and our
proprietary concept stores, where the environment communicates our brand messages. This core
distribution channel serves as a base of legitimacy and long-term loyalty to us and our brands.”

As you build sales in department stores and in any other broader distribution, you move further away
from your roots.  You’re suddenly in the fashion business.  You potentially have a new set of competitors
who are larger and better resourced than you are even if you’re Quiksilver.  You have customers who
are a bit farther removed from surf and, though they may know the Quiksilver name, are not quite as
committed as core market customers.  To them, it’s a matter of picking between checked shirts from
competing brands that seem very similar to them.  They want the one they like best- not necessarily the
one from the brand they associate with.  And their buying influences probably extend beyond Quik’s
normal advertising and promotion channels.

Quik’s strategic conundrum isn’t all that different from Burton’s, except that I understood why Quik, as a
public company, had to look aggressively for growth.

I’ve written before that the issue of where growth would come from was a big one for Quik.  Neither the
annual report nor the conference call specifically addresses that.  That’s not completely surprising as
you can’t expect any company to lay out its whole strategy for the benefit of its competitors.  But I did
think Bob McKnight’s comment on Roxy in the conference call was interesting.  He said, “…the juniors
market continues to be very challenging.  Driven by the poor economy, recent trends in the market
toward fast fashion and purely price point driven goods has resulted in share shifts towards companies
whose business models were designed for these dynamics.  We are not going to chase the fast fashion
mode.”

I agree you never want to be caught chasing a market, but if the tastes and purchasing habits of your
customers are changing, and you want to keep those customers, it may be that you have to change right
along with them and can’t afford to stand on principle.  Dramatically different long term economic and
business conditions, in other words, may require new business models.  They always have in the past.

Random Numbers

Before I go through the financial statements, there are some numbers I’d like to present in bullet point
form just to give you a sense of Quik and where it stands.

  • Apparel is 66% of revenues, footwear 20% and accessories 14%.  This is not much changed from
  • the previous year.
  • At the end of November 2009, their backlog was $535 million, down 15% from $629 million the
  • year before.
  • They sell in over 90 countries.  The Quiksilver brands are in around 11,800 store locations in the
  • Americas.  Roxy is in 11,700.  Most locations carry both brands.  DC is in about 13,800 stores in
  • the Americas.  For all their brands combined, they’ve got 7,800 locations in Europe 3,350 in
  • Asia/Pacific.
  • 38% of sales are in the U.S.  Other Americas are 9%.  France is 11% and the United Kingdom and
  • Spain are another 11%.  The rest of Europe is 18% and Asia/Pacific is 13%.
  • No quarter is more than 27% of annual sales and no quarter less than 23%.  That lack of
  • seasonality on a global basis is nice to see.  As somebody who started in this industry trying to
  • manage cash flow in a one season snowboard company, I can really appreciate that.
  • Advertising and promotional expense was $101.8 million in fiscal 2009, down from $122.1
  • million the previous year.
  • Allowance for doubtful accounts was $47.2 million at the end of the fiscal year, up from $31.3
  • million at the end of the prior year.  I expect most brands are increasing those reserves.

Results for the Year

Net revenues fell 12.7% from $2.264 billion to $1.977 billion.  Gross profit percentage declined from
49.5% to 47.1% and total gross profit was down 16.9% from $1.120 billion to $931 million.  “The gross
profit margin in the Americas segment decreased to 37.6% from 42.0% in the prior year, our European
segment gross profit margin decreased to 56.4% from 57.0%, and our Asia/Pacific segment gross profit
margin increased to 53.9% from 52.9%. The decrease in the Americas segment gross profit margin was
due primarily to market related price compression in both our company-owned retail stores and our
wholesale business.”

They reduced selling, general and administrative expenses by 7% to $852 million, but as a percentage of
sales it actually rose 40.4% to 43.1%.  You would have seen more of a reduction here except for $28.8
million in charges related to restructuring activities.  These included severance costs.
Interest expense rose from $45 to $64 million.  Some of this was “…due to our recognition of additional
interest expense that was previously allocated to the discontinued operations of Rossignol in the prior
year…”  There’s also higher interest expense as a result of their completed refinancing in the last quarter
of fiscal 2009.

Operating income was down 50.4% from $139 million to $69 million.  They had a loss before taxes of
$6.5 million compared to a profit before taxes of $98.6 million the prior year.

Interestingly, their provision for income taxes doubled from $33 to $66 million.  They explain why that
is, but this article is getting long enough and I’m going to guess that most of you aren’t all that excited
about the ins and outs of calculating corporate income tax provisions.  But for those of you who just
have to know, email me and I’ll point you to the explanation.  I won’t wait for my inbox to be
overwhelmed with requests.

Now, the net loss last year was $226 million.  This year it fell to a loss of $192 million.  However, we
need to break that down between continuing and discontinued operations (Rossignol) to see what’s
going on.

Last year, Quik had income from continuing operations of $65.5 million.  This year, that turned into a
loss of $73.2 million.  That’s the result from selling all their branded products.  The loss from
discontinued operations was $292 million last year and fell to $119 million in fiscal 2009.
The headline from the balance sheet is that the total of lines of credit and long term debt is essentially
unchanged.  It was $1.060 billion at the end of the last fiscal year and it’s $1.039 billion at the end of this
one.  The big refinancing they closed in the last quarter didn’t reduce debt- it just pushed out maturities. 
You can see this when you note that the current ratio has improved from 1.86 to 2.3, but the total debt
to equity ratio grew from 2.62 to 3.06.

Inventories and accounts receivable are down as you would expect.  So are lines of credit (because of
the refinancing) and accounts payable.  Overall, current assets fell from $1.365 billion to $992 million
and current liabilities from $735 million to $431 million.

It’s a lousy time to have a balance sheet that isn’t strong.  It might be worth your while to go to page 10
of the 10K filing (the link is at the start of this article) and read their discussion as part of risk factors on
their debt obligations and cash flow requirements for servicing.  Later on, they put it like this;

“Our financial performance has been, and may continue to be, negatively affected by unfavorable global
economic conditions. Continued or further deteriorating economic conditions are likely to have an
adverse impact on our sales volumes, pricing levels and profitability. As domestic and international
economic conditions change, trends in discretionary consumer spending become unpredictable and
subject to reductions due to uncertainties about the future. When consumers reduce discretionary
spending, purchases of apparel and footwear tend to decline. A general reduction in consumer
discretionary spending due to the recession in the domestic and international economies or
uncertainties regarding future economic prospects could have a material adverse effect on our results of
operations. “

As you evaluate Quiksilver’s prospects, it’s incumbent on you to decide how much of a recovery we’re
going to have and when.

During the conference call, Bob McKnight enumerated the fiscal 2009 accomplishments they were
proud of.  These were the completion of the Rossignol sale, the refinancing of the capital structure and
the operational restructuring of the business.  “Having accomplished these objectives,” he said, “we
believe that we’re not much better positioned to operate within today’s environment.”

You can’t argue with that, and I’m really glad they’re done with that stuff.  I can tell you from personal
experience that it’s no fun to be in a highly uncertain environment dealing with what are fundamentally
negative issues day in and day out.  It gets to you, and it gets to all the employees.  It costs money, it
takes all your time and attention, and it doesn’t sell a single pair of board shorts.

This will be the year when Quiksilver can finally focus on running their businesses.  What the economy
does, how they change (or don’t change) their business model to respond to that, and how they manage
their cash flow so as to meet their debt service requirements while keeping their product development
and advertising and promotional programs moving forward are where you will want to focus your
attention.