Billabong Acquiring West 49

Or Maybe Zumiez is Going to Buy Them
 
Oh, and Billabong Bought RVCA
 
Okay, Zumiez is Out of the Picture
 
Anyway, This is All Really Interesting- and Related
 
As you know, Billabong made an offer on June 30 to acquire the Canadian action sports retailer West 49. Only July 9th, Zumiez said that, subject to a satisfactory due diligence review, it would be prepared to make a higher offer. On the 14th, they said, “Never mind.” What we’ve got work with here are some of Billabong’s comments about retail in its last half yearly review conference call, it’s conference call and presentation on the proposed West 49 acquisition, West 49’s financial results for the quarter ended May 1 and the associated conference call, Zumiez’s announcement that they were prepared to beat Billabong’s offer (and then that they weren’t) and their announcement that they were opening some stores in Canada. Meanwhile as I was writing this, Billabong announced it had bought RVCA, which fits nicely in the discussion below on Billabong’s strategy and retail positioning.
 
Damn, I feel like a kid in a candy store. Although I have to admit that having Zumiez come and go and RVCA bought since I started researching this article has made for an interesting editorial challenge.
 
This analysis will be strategic in nature. Though obviously we’ll discuss the numbers and specifics of the offer what’s more interesting to me is what this says about the retail environment, the evolution of the industry and the shape that larger, successful industry companies are going to take as they continue to expand into the broader market. Let’s start by looking at the players.
 
West 49
The chain is a Canadian action sport retailer founded in 1995 by current CEO Sam Baio. They’ve got 138 mostly mall based stores (not unlike Zumiez- the plot thickens). There are 81 West 49 stores. They also have five Billabong stores.
 
The remaining 52 stores include 19 under the D-Tox label, 16 Off the Wall Stores, and 17 Amnesia store. Billabong’s presentation on this deal has some info on page describing how these other brands are positioned. You can see the complete presentation here and I suggest you take a minute to do that. It’s just 12 Power Point slides long and won’t take long.
 
Many of these other brands (Most? I’m not sure.) were acquired by acquisition. More brands, of course, means more marketing expense and some complexities in operating around, for example, inventory purchasing and management. Keep that in mind as we review briefly West 49’s recent financial results, which include all 138 stores. I wonder if Billabong would keep all those other store brands. Would Zumiez have renamed all 138 stores as Zumiez?
 
In the quarter ended May 1, 2010 West 49 lost $2.6 million Canadian on sales of $40.9 million. This was very close to the same sales and loss they experienced in the same quarter one year ago. Comparable store sales were down $2.6% (3% for West 49 branded stores). CEO Baio cited pressures on margins as a result of the competitive landscape and said they were still waiting for consumer confidence to return. As you’ve probably noted, other retailers and brands have shown some almost inevitable rebound in their quarterly results as the very difficult conditions of a year ago have eased. West 49 did not and that was some cause for concern.
 
The balance showed $0.00 in cash and cash equivalents compared to $7.9 million on January 30, 2010. Obviously, no business operates without some cash to pay its ongoing bills. For all I know, the day after this balance sheet they drew down an available line of credit in the ordinary course of business and the balance showed some cash again. But I’d note that the current ratio at 1.05 was barely over one.
 
We didn’t get any more information on their financial condition because at the end of the conference call, there were no questions. That’s because the stock is pretty closely held (note that Billabong already has 56% of the voting shares agreeing to the transaction) and I guess the analysts don’t follow it. I certainly don’t have the information to conclude that West 49 has serious financial or liquidity issues.  But the information I do have makes me think that concerns in those areas could be a factor in their being prepared to sell the business now.
 
Billabong’s Retail Strategy
This isn’t a new topic for me. I wrote about their half yearly review and spend a lot of time on their retail strategy. See that here. http://www.jeffharbaugh.com/2010/02/25/billabongs-semi-annual-report/. At least scan through it and read the quotes about their retail strategy. Here’s what I said early in that article.
 
“Billabong CEO Derek O’Neill is clear in the conference call that we shouldn’t ‘…expect for retail to suddenly become a huge component of our business but it’s clear we will continue to identify opportunities to get our product to market where required.’ I read a little bit of ambiguity as to Billabong’s retail strategy into that statement, or maybe a little understandable reluctance to state what they really think of the retail situation.”
 
Billabong has described its acquisition approach as “opportunistic.” At the same time, they’ve discussed the tendency of independent retailers to purchase lower and mid price point product and to often not be able to merchandise the complete Billabong line well. They have noted that their own retail had outperformed their wholesale business and expressed some concern about tight credit conditions and the health of independent retailers. The company is also looking for ways to short cut its product cycle so it can have product sooner that it will just drop in its own stores before it gets to the independents.
 
You really need to go read the complete quotes in that article. Billabong’s strategy may be opportunistic with regards to timing (anybody’s acquisition strategy is) but I don’t think there’s any doubt that they have been planning to make retail a bigger part of their business. The presentation on West 49 says, in part, “Billabong has a long track record of successfully acquiring and integrating ‘bolt-on’ acquisitions consistent with its key strategic objectives of growing its brand portfolio and expanding its retail distribution network.”  (Emphasis added) And their store count has grown from 49 in 2004 to 510 this year assuming they complete the West 49 deal.
 
An acquisition strategy, of course, supports a general business strategy and can be the tool a company uses to transform itself. You might go look at what VF Industries, Collective Brands, and Genesco have done by selectively buying (and selling) brands to grow their companies and reposition themselves in markets they found attractive. It wouldn’t completely surprise me to find that those company’s strategies are a subject for discussion around Billabong’s executive offices from time to time.
 
Nuts and Bolts
 Billabong has offered to buy West 49 for $99 million Canadian. That’s about $96 million US. The deal is supposed to close in September, and will be funded using Billabong’s existing credit lines. Remember a year or two ago when Billabong raised some capital to improve its balance sheet? It wasn’t really a necessary thing to do, and the timing could have been more favorable. But without it, Billabong wouldn’t be able to do this deal without a financing contingency. This is one of the things I really like about Billabong. They always have consensus on what their strategy is and they have their eye on the long term ball as they pursue it.
 
Presently, “…across West 49’s portfolio Billabong has a brand share of approximately 15%.” They will be looking to increase that over time, but will leave the stores multi branded. CEO Derek O’Neill indicated in the conference call on the deal that the share of Billabong product in the West 49 stores might reach 45% over a couple of years.
 
If the West 49 stores go from 15% to 45% Billabong and Billabong owned brand products, obviously some other brands are likely to be unhappy with their share. There is, as we all know and no longer try to dispute, an inevitable tension between retailers and brands when the brand becomes a retailer.
 
In the past, when Billabong bought Nixon, Sector 9 and Dakine they paid high (fair might be a better term) prices for profitable companies with clear growth potential that Billabong could support, but that could more or less run on their own. I applauded that strategy because my experience is that buying a company is easy. Integrating a company and fixing it if it’s broken is much harder.
 
This deal isn’t quite the same judging from the data on West 49’s performance we reviewed at the start of this article.    In addition, just from going from 15% to 45% of Billabong brand product in its stores implies a transition that Billabong didn’t have to manage with those other three acquisitions. Of course, they have managed it with other retailers they’ve acquired, but none of those had 138 stores.
 
The analysts expressed some concern in the conference call. Though they didn’t come right out and say it (analysts never do) they seem to have some concerns that Billabong might be overpaying for this one.
 
As an example, Craig Woolford, and analyst with Citigroup, asked, “…even if I look back to ’08, it looks like it’s [West 49] been a very low margin business at an EBITDA level. Can you comment as to some reasons why it’s had such low profit margins?
 
CEO O’Neill’s basic response was that they had a plan to increase those margins over time, and that they’d talked to West 49 CEO Sam Baio who had a credible plan to get those margins up to “mid to high single digit EBITDA.”   I should note that Billabong’s last quarter results had its EBITDA retail margins at 14%.
 
Analyst Woolford continued, “Forgive me if I sound cynical but why would the shareholders of West 49 sell — I mean on a sales multiple, it’s 0.5 times sales, surely they would feel that they can then improve margins themselves before selling out to Billabong?”  Other analysts had questions that focused on the multiple being paid and how the deal would improve Billabong’s earnings per share during fiscal 2011.
 
Billabong’s answer to why margins would improve and why it would turn out to be a good deal was three fold; synergies, elimination of the costs of being a public company, and the higher margins they get when they put their own product in the stores in place of another brand’s products. They also think there’s potential to open some more stores in Canada.
 
Those are all good answers, but only eliminating the costs of being a public company is a slam dunk. Synergies can be surprisingly elusive and take time and cost money to realize. Billabong, to be fair, has just announced an agreement in principal- not a closed deal. So they can’t necessarily talk about exactly what they’d do and how they’d do it. But with other acquisitions of similar size, the issues just didn’t come up in quite the same way.
 
Partly, they didn’t come up because Nixon, Sector 9 and Dakine weren’t public companies. There was no public stock price. But this is also a different kind of deal that will require Billabong not just to support its new brand behind the scenes, but to take a very active role in helping it evolve. As a result I thought, when they first announced their interest, there was a reasonable chance that Zumiez would end up owning West 49. 
 
The Zumiez Offer
On July 9th, Zumiez came out and announced that they’d like to buy West 49 too. They had previously announced an interest in opening stores in Canada. Like Billabong’s, Zumiez offer would not have been contingent on financing. It “…would be prepared to make an offer, that would not be subject to a financing condition, to acquire all of the outstanding common shares and preferred shares of West 49 for a cash price in excess of $1.30 Canadian per share [what Billabong offered]” The offer would be contingent on Zumiez’s satisfactory completion of a due diligence review.
 
If an offer had been made, Billabong would have had five days to decide whether or not to match it.
 
West 49 already had a deal with Billabong but, as a public company, they have a fiduciary responsibility to act in the best interest of their shareholders. If two deals are equally likely to close, shareholders tend to like the one with the higher price per share.
 
West 49, of course, would love a higher offer, but isn’t all that thrilled at the idea of telling a retail competitor who’s just announced it’s entering West 49’s market everything about itself as would happen during a typical due diligence review. I’ll be interested to see how the two parties finesse that.
 
I’m happy to tell you that I wrote the sentences above before Zumiez’s July 13 announcement that they couldn’t reach an agreement with West 49 on how to conduct a due diligence review. I’m not completely surprised by that result, but I am a little disappointed. I think it would have been great fun to have a good old fashioned bidding contest for a company in our industry.
 
As has been discussed above, Billabong has some work to do to realize the value of a West 49 acquisition. This is a bit different from some of its other larger deals, and has some stakeholders nervous about the price being paid and the sources of the improved performance.
 
Zumiez is exclusively a retailer with a proven model. Like West 49, its stores are largely mall based. Like Billabong, it could have eliminated the West 49 public company expenses and no doubt realize some synergies itself in a combination. It wouldn’t have gotten the benefit of higher margins that Billabong gets when it places more of its owned brand product into its retail, but maybe it would have gotten some better terms from suppliers due to higher volume, though it probably gets pretty good deals already.
 
The argument that Zumiez could have made was that it just has to transplant its existing systems and management programs onto the West 49 stores to achieve results comparable to what it gets in the US. That sounds conceptually simple, but would not have been in practice. For one thing, Zumiez has always prided itself (rightfully so I think) on its management training and the fact that everybody works their way up from being a sales associate. I have to believe that finding and/or training enough people to turn West 49 stores into Zumiez stores (which I assume would be the long term goal) would have been a challenge. And I’m assuming a lot of similarity between the US and Canadian markets, which may not be the case.
 
I don’t know if the $1.30 Canadian that Billabong is prepared to pay is a fair price or not, but my immediate take is that Zumiez could have justified paying a little more than Billabong. Guess we won’t find out now. 
 
RVCA Deal 
And as if there wasn’t enough going on, Billabong has announced the long anticipated acquisition of RVCA. It’s a comparatively small deal, so not many details were announced, but we know that RVCA will add about $30 million to Billabong’s annual revenues at its current size.
 
And it’s an easy deal to explain. Like they typically have in the past Billabong is buying a solid brand that they will support, but leave management to run from a marketing and product development point of view. They will benefit not only from the growth of the brand’s sales to non-owned retail, but from putting RVCA into Billabong’s retail distribution. Pretty much the same concept they had for Nixon, Dakine, Sector 9 and most of their other acquisitions.
 
It’s pretty simple to explain, and it’s worked before. As we’ve spent parts of this way too long article discussing, it’s an interesting comparison to a West 49 deal that I see as more complex for Billabong and not quite fitting their historical approach. At the end of the day, that’s why I think Zumiez might have ended up as the successful bidder if they had been able to get past the due diligence issue with West 49.
 
In the economic environment we have now and, I think, will have for a few more years, brands are uncertain of the viability of core shops and unsure how much growth they can expect from them. As they and their lines get larger, they are also finding they can merchandise better and make more money through their own retail. Vertical integration, fast fashion, the imperative for cost control, market expansion into the mainstream, and the need for growth if you’re a public company all will push companies in the direction Billabong is taking as they get larger.