The End of an Era (In a Good Way!) at Quiksilver

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I don’t think anybody else noticed this (or at least I didn’t see anybody else mention it) but on October 27th, Quik got a $20 million term loan from Bank of America. Along with some cash on hand, they used it to pay off the last $24.5 million (including accrued interest) of their original term loan from the Rhone Group.

The new term loan’s interest rate is 5.3%. You may remember that the interest rate on the Rhone money was 15%. The rest of the Rhone loan (it was originally a $150 million five year term loan made in August of 2009) has either been paid off or converted into equity.

Instead of paying $22.5 million a year in interest on the $150 million (some of it was non cash), they are now either paying nothing (to the extent it was converted to equity) or paying at a much lower rate.
Financially, of course, paying off $24.5 million in debt doesn’t fundamentally change anything for Quik. But it makes me feel good to see it happen, so I can only imagine how everybody at Quik must feel. I hope they had a Rhone Credit Agreement Termination Party and burned the note. And I wish I’d been invited.
Nice work!

Billabong’s Annual General Meeting

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On October 26th, Billabong Chairman Ted Kunkel and CEO Derek O’Neill made speeches at the company’s annual meeting.  Together they only run to to seven pages of big, easy to read, type.  You should read them, and you can read them here.  There’s a lot of good, succinct information on why fiscal 2011 is a transition year, the performance of their acquisitions, the evolution of their retail business (now almost 40% of their revenue), the impact of currency fluctuations, market conditions, and their continued focus on operating efficiency.

In a lot of ways, it’s a convenient, easy to ready, summary of the annual report that came out a couple of months ago.  It lays out their results, strategies, and issues without being too detailed and dense.

I did a detailed analysis of their annual report when it first came out and if you’re curious, and haven’t seen it before, it’s here.

 

 

 

 

Action Sports Market Evolution as Reflected in VF’s Quarterly Results

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VF released its earnings and held the quarterly conference call yesterday at 8:30 Eastern time. I’m not quite dedicated enough to listen to it at 5:30 AM on the West coast, but I did listen to the replay later in the morning. You can see the press release here. Remember, we don’t have the SEC filing on the quarter yet, so though the numbers are the same as what you’ll see in the 10Q, we do get management’s spin on things- their “happy dance,” as I like to call it.

The Numbers 

There’s no doubt VF had a good quarter.  For the quarter ended September 30, revenues were up 7% to a record $2.2 billion and gross margin at 46.5% was the highest ever. Net income for the quarter was up 11.4% to $243 million. For nine months, sales have risen 5.1% to $5.576 billion and net income is up 31% to $517 million. They accomplished this while increasing marketing, administrative and general expenses in both the quarter and the nine months compared to the same periods the prior year. The balance sheet is very strong with $403 million at the end of the quarter. They’ve got no real financial limitations in carrying out their strategy.
 
You may recall that VF divides their business into six segments they call coalitions; outdoor and action sports, jeanswear, imagewear, sportswear, contemporary brands, and other. The table below, taken from the press release, shows sales and  what I think are operating profits for each segment, though they just call it profit. As you can imagine, they were almost giddy with the
 
 
results and opportunities they see in outdoor and action sports.   They said that revenues for the North Face and Vans rose in the quarter by 17% and 19% respectively. The whole coalition rose 14%. The coalition’s growth for nine months was 12%. For the quarter, the outdoor and action sports coalition generated 59.3% of total coalition profits and 46.9% of sales. For nine months, the numbers are 50.5% of profits and 41.4% of sales.
 
You can understand the focus on outdoor and action sports. The other coalitions didn’t perform as well and aren’t as large. Jeanswear is actually down for nine months and up only slightly in the quarter. That was impacted by VF exiting the jeans mass market segment in Europe. Imagewear revenues are up 10% for the quarter but just 5% for the year. Its profit, however, increased pretty dramatically as you can see.
 
Sportswear revenues were down for both periods and profits fell rather precipitously, especially in the quarter. This is explained partly by some Nautica shipments being moved from the third to fourth quarter.   Contemporary brand revenues were up 11% for nine months, but pretty much level for the quarter. But profits in that segment fell hard in both time frames.
 
You can see why they spent so much time on outdoor and action sports. It’s the biggest chunk of their business, it’s performing well, they see lots of opportunity, and the news in some of their other segments isn’t as good.
 
Implications for the Action Sports Market
 
What I really found interesting- more than the financial statements- were a handful of observations made about their business. Those included:
 
  • They have 779 retail stores (retail comps were up about 3% for the quarter) and are on track to open 85 stores for the year. Direct to consumer revenue was up 10% for the quarter (18% in outdoor and action sports).
  • Marketing spending is up 35% for the quarter. Year to date they’ve spend an additional $50 million and expect to spend an incremental $45 million in the fourth quarter. Half of this will go to the North Face and Vans.
  • They are “…adding top freeride and slopestyle skiers, and halfpipe snowboarders to our athlete team to extend the reach of The North Face(R) as a snowsports brand during the upcoming winter X Games.”
  • In the fourth quarter and going forward into next year, they expect gross margins to be “stable.” That is, not up though in another context they note it is improving in retail.
  • They expect that their average wholesale price will be up next year. There was a lot of discussion about the cost of cotton.
I slept on this to see if an eloquent way to tie all this together would explode fully formed into my brain. It didn’t, so I guess I’ll just start writing. The North Face as a snowsports brand just sort of stopped me in my tracks. Can any brand that makes anything to be in cold weather become a snowsports brand if they have enough resources to establish the marketing position? If you’re a snowsports brand, are you an action sports brand?
 
Just what is the action sports market these days anyway? I don’t think the action sports market grows just because VF (or Nike, or Billabong, or Burton, or Quiksilver, etc.) sells one more piece of stuff to one more person who’s never been near a skateboard, snowboard, or surfboard. I know that there’s still a meaningful connection between some people who don’t participate and the “core” market of those who do, but as you get further and further from that connection and deeper and deeper into the distribution can you still talk about being an action sports brand in a meaningful way?  That is, in a way that helps you run your business.
 
Growth in the action sports market is related to growth in participation, and I don’t think we’re seeing much of that right now. As a brand, it’s dangerous to believe yourself an action sports brand once you move beyond the participants and its relatively immediate environment because you just won’t have the customer connection you think you have. 
 
VF, of course, doesn’t see itself as an action sports brand, but as a portfolio of brands some of which are in action sports. Maybe they’ve got the resources and management to make The North Face into a snowsports brand (Please, no North Face snowboards).   That won’t make it an action sports brand, but it will contribute to the confusion (at least to my confusion) about what this market is and is becoming.
 
Meanwhile, they’ve got 779 retail stores and counting. And speaking of confusion, which brands will they carry in their stores? Just their own or brands they don’t own as well? Will the brands they carry but don’t own want to be in those stores? Can they afford the possible sales decline that will occur if they aren’t in those VF (or Billabong, or Nike, or Quik) owned stores? Do more brands have to open more retail stores as a strictly defensive move to preserve their sales volume? 
 
And this is all going on while cotton costs are going to lead to some inevitable price increases and no growth in gross margins while consumers are cautious about their spending. This is happening to VF (and others, we already know) even with their sophisticated systems, supply network, and negotiating power. How will it impact smaller companies?
 
Those of you who have been around a while remember when it was clear what was and was not the action sports business. You knew who your customers and potential customers were. My suggestion, if you really are and want to be in the action sports business, is that you go back to that.   I’m not saying don’t grow. But don’t delude yourself into believing that the real action sports market and your target market is $10 billion or $20 billion or whatever the apparel/fashion/lifestyle market is. That is not the action sports market no matter how many big companies with their very own retail chains say it is.

 Dance around the 800 pound gorillas. Not with them.  

 

Vail’s Annual Report; What’s the Future of Resort Real Estate?

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This 10K was filed a couple of weeks ago for the year ended July 31. There are about 760 ski areas in North America. Vail owns five major ones that accounted for 7.7% of skier visits (about six million) during the last season. We don’t get many chances to see individual data from many of them, so taking a look at this is worthwhile. It’s particularly interesting, in our current economic circumstances, to see how the real estate component of Vail’s business is faring.

 Numbers by Segment

 Let’s start with a little table that shows Vail’s revenues over the last five years broken down by its three business segments; mountain, lodging and real estate. The numbers are rounded to the nearest millions of dollars and are for the years ending July 31.
 
                                                2010       2009       2008       2007       2006
Mountain                               638         615         686         665         620
Lodging                                169         176         170          162         156        
Real Estate                            61         186         297          113            63
Total Revenue                      869        977     1,152           941          839
 
Here the operating expenses for each segment:
 
                                                2010       2009       2008       2007       2006
Mountain                                456         451         470         463         443
Lodging                                  167         169         160         144         143        
Real Estate                              71         142         251         115           57          
Total Expense                       694         763         882         722         642
 
And here is the EBITDA (earnings before interest, taxes, depreciation and amortization) for each:
 
                                                2010       2009       2008       2007       2006
Mountain                               184         164         221         202         177        
Lodging                                   2              7            10           18           13
Real Estate                             (4)          44            46             (2)           6
Total EBITDA                        182         215         277         218         196
 
Some of the above numbers don’t add precisely because of rounding and some minor accounting stuff. I’ve ignored that to minimize the eyes glazing over factor.
 
The Mountain segment “…is comprised of the operations of five ski resort properties as well as ancillary services, primarily including ski school, dining and retail/rental operations.” Lift tickets are about 45% of revenues there. Of the three segments, it contributes by far the most revenue and EBITDA. You can see that segment revenue in 2010 is only about 3% ahead of where it was after peaking in 2008.
 
Lodging revenues come from owning and managing hotels near their resorts. It also includes revenue from golf and a transportation company they own. It follows a pattern similar to the Mountain segment, peaking then falling in the recession and ending up just 8% higher than it was at the end of fiscal 2006. I should note that the Lodging revenue numbers include $19 million and $18 million in 2010 and 2009 respectively for transportation. That’s from a company Vail bought and there were no transportation revenues in earlier years. One could argue that lodging revenues are really up only about 3.5% over five years, similar to the Mountain segment.
 
Real Estate
 
Real estate is the development and sale of homes and condos of various sizes. Look at the 2008 peak in real estate revenues in the chart above. 2010 real estate revenue, at $61 million, is only 3% below the 2006 amount of $63 million. But the 2008 real estate revenue peak of $297 million is almost 5 times the 2006 or 2010 levels. You don’t see that level of rise or fall in either the Mountain or the Lodging segments.
 
Though accounted for separately, the three segments are closely related as Vail discusses. Selling real estate and increasing the lodging options increases the bed base and options for customers. Putting in a new high speed lift or opening new restaurants or retail makes the resort more attractive and may increase the value and desirability of the real estate. At the risk of oversimplifying, mountain development makes the real estate more attractive and real estate development can make the mountain more attractive. The trick is to coordinate development so as to maximize the value of both. 
 
The real estate revenue stream is highly variable due to the nature of the business. Even when you get deposits and sign sales contracts for a property, you don’t recognize any revenue until the title to the property passes to the buyer. Your revenue depends on when you start the project, how big the project is, how well it sells, and any delays you incur in completing it. When you do close a sale and recognize the revenue, it’s in amounts of at least hundreds of thousands of dollars (the recently completed One Ski Hill Place project had an average selling price per unit of $1.4 million). You don’t have thousands of closings of similar, smaller amounts like you were selling lift tickets.
 
With that as background, what’s Vail’s take on real estate and real estate development? The first thing I’d note is that “Real estate held for sale and investment” was $422 million at July 31. That’s up 35.7% to $311 million from the same date last year. The amount the previous year was $249 million. Vail specifically states that “…we currently do not plan to undertake significant development activities on new projects until the current economic environment for real estate improves. We believe that due to our low carrying cost of real estate land investments combined with the absence of third party debt associated with our real estate investments, we are well situated to time the launch of future projects with a more favorable economic environment.”
 
Talking about their One Ski Hill Place project, they note that they “… closed on 36 units, or 61% of the 59 units that were under contract…while 23 units that were under contract defaulted. Additionally, we have another real estate project substantially completed (the Ritz-Carlton Residences, Vail) which units under contract will begin closing during the first quarter of Fiscal 2011. We have increased risk associated with selling and closing units in these projects as a result of the continued instability in the credit markets and a slowdown in the overall real estate market. Certain buyers have been or may be unable to close on their units due to a reduction in funds available to buyers and/or decreases in mortgage availability and certain buyers may successfully seek rescission of their contracts…We cannot predict the ultimate number of units that we will sell, the ultimate price we will receive, or when the units will sell. Additionally, if a prolonged weakness in the real estate market or general economic conditions were to occur we may have to adjust our selling prices in an effort to sell and close on units available for sale, although we currently have no plans to do so."
 
Back in April, when I wrote about Vail’s January 31 quarter, they had reported that 13 holders of contracts to purchase Ritz-Carlton Residences had sued to get out of the contracts and get their deposits back because of a disputed delivery date. I wrote,
 
“If you really wanted your new 2nd home, you probably don’t sue because it’s a little late being finished. Maybe you negotiate for some free upgrades (heated toilet seats?), but you don’t sue to get out of the deal. Unless, of course, you can no longer afford to buy the place and/or it’s now worth a lot less than you’ve agreed to pay for it.”
 
The problem appears to be worsening and I’m quite certain Vail isn’t the only resort that develops real estate that has these kinds of issues.
 
The Financial Statements
 
I hate resort balance sheets. When you see a current ratio that’s deteriorated from what, in traditional financial analysis, would be called a dangerous current ratio of 0.91 to an even worse 0.51 over the year you get worried. But then you remember (especially if your introduction to this industry was trying to run an equally seasonal snowboard company) that it’s all about cash flow, and you don’t borrow money and pay interest just to make your current ratio look better at the end of the year.
 
The total liabilities to equity ratio improved slightly from 1.44 to 1.40. Debt maturities are only $1.87 million in 2011, but increase to $35 million in 2012.
 
The decline in current assets is almost completely the result of a fall in cash and cash equivalents from $69 million to $15 million. Total liabilities have hardly changed at all.    I would note that cash flow from operations has fallen from $217 million in fiscal 2008, to $134 million in 2009 to $36 million in 2010.
 
You’ve seen the revenue and expense numbers by segment in the table above. Vail worked hard to reduce and manage its expenses, but income was down.   Operating income was $69 million, down from $106 million the previous year and $176 million the year before that. Net income was $30 million, down from $49 million in 2009 and $103 million in 2008. Net income as a percentage of revenue fell from 8.9% in fiscal 2008 to 5.0% in 2009 and 3.5% in 2010. 
 
As explained above, Vail’s three business segments each support the other. The Mountain and Lodging segments took a hit in the recession and are still impacted, but are starting to recover. The real estate is not and I don’t see that happening in the immediate future. As Vail management notes in the lengthy quote above, real estate development is off the table until the economic improves. They are uncertain about their ability to sell or close on sold properties and are concerned that prices might have to be reduced. They’ve got a lot of cost in completed units and undeveloped property and at some point could have to recognize some reductions in carrying value.
 
As I said when I started, we don’t get to see the numbers for most of the large resorts. The value in looking at Vail is not just in knowing how Vail is doing, but in understanding some of the pressures that any resort with real estate is likely to be under.         

 

 

Nike’s First Quarter; Strong. The Integration of Brand and Retail is Particularly Interesting

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Normally, I prefer to wait for the actual quarterly filing to be available before doing this kind of analysis, but I trust you can all appreciate what a monumental waste of time it would be to really dig into Nike’s balance sheet. They’ve got $4.7 billion in cash and short term investments and $9.7 billion in shareholders’ equity. They got only $342 million in long term debt and no outstanding bank borrowings. So my analysis? It’s strong. It’s a monster. They can do anything they want. Let’s move on.

Reported revenue for the quarter ended August 31 was up 8% to $5.175 billion compared to the same quarter last year. Gross profit was up 10% to $2.434 billion with the gross profit margin rising from 46.2% to 47.0%. This increase was the result of “…growth and improved profitability from Direct to Consumer operations, fewer and more profitable close-out sales and improved in-line product margins. These factors more than offset margin pressures resulting from changes in foreign currency and higher air freight costs to meet strong demand for NIKE Brand products.”

They note in the conference call that they were surprised by the strength of their gross margins because some cost increases were hitting later than expected. They see labor, oil, and cotton becoming more expensive. They also note that there was a delay in price increases because they negotiate prices with factories several seasons out. In the long term, they believe they can continue to expand margins.
 
Some of those statements seem worthy of some more discussion. If anticipated cost increases are down the road how, exactly, will they increase gross margins? Maybe it depends what you mean by “long term.” They indicated they might have some pricing power with certain products and maybe that’s where higher margins could come from.
 
We all have marketing or advertising and promotion expenses, but Nike has “Demand creation expense,” which I think is a much more descriptive phrase. It went up 23% to $679 million. They point to a couple of major events as being responsible for much of that increase. Their “Operating overhead expense” (what you and I might call general and administrative expense) was essentially flat at $994 million. Net income was up nine percent to $559 million.
 
Hurley, which we’d all like lots of details on but don’t get, is part of Nike’s “Other Businesses” segment. In addition to Hurley, the segment includes Cole Hann, Converse, NIKE golf and Umbro. That segment generated revenues of $693 in the quarter. Hurley revenues were up double digit, but that’s the only specific we get, and it’s not all that specific.
 
North American Revenues, at $1.903 billion, were up 8% as reported. Western Europe, at $1.056 billion, was down 4%. Central and Eastern Europe, at $263 million, was up 3%. Greater China was up 11% to $460 million but Japan fell 12% to $163 million. Emerging Markets at $591 million grew 30%.
 
For the Nike brand, footwear grew 7% to $2.798 billion and represented 54% of total quarterly revenues. Apparel, up 7% as well, was $1.362 billion or 26% of total revenues for the quarter. Equipment was $276 million, down 5% and representing 5%.
Retail sales were a record for the quarter, with comparative store sales up 13%. Digital sales grew by 22%. 
 
The immediate future looks pretty good. Worldwide future orders for Nike brand apparel and footwear “…scheduled for delivery from September 2010 through January 2010, totaled $7.1 billion, 10 percent higher than orders reported for the same period last year.” They don’t offer any numbers for equipment or the other “other” segment that includes Hurley.
 
Strategically, their discussion of flexibility, balance and alignment as the three reasons for outstanding performance was really interesting. I know it kind of sounds like a platitude, but it’s not. I could write a whole bunch on what they mean, but I couldn’t say it much better than they did. The conference call transcript is here. http://seekingalpha.com/article/226811-nike-ceo-discusses-f1q2011-results-earnings-call-transcript. I strongly suggest you read through their prepared comments in the early part of the transcript to understand what they mean. As part of it, they talk about the integration of retail and brands and how they are “… learning how to integrate and leverage the brands more than ever before.” They specifically refer to how they combined the Nike, Hurley and Converse brands at the U.S. Open in Huntington Beach. Many of you no doubt saw that.
 
This isn’t just about Nike. Multiple brands with a retail and online component seems to be the strategy most larger companies are pursuing. I’d go so far to say you won’t be able to become a larger brand unless you pursue that strategy, so you need to pay attention to it. It not only offers competitive advantages, but really lets a company leverage its back end. Look at Billabong or Quiksilver. Watch as retailer Zumiez works to make itself a brand.
 
You can learn a lot from Nike’s strategy.      

 

 

Quiksilver’s July 31st Quarter: Sales Down, But Profits Up and Balance Sheet Stronger

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Quik is the poster child of a company that’s done what it needed to do following the twin blows of the Rossignol acquisition and the recession. As somebody who’s done a bit of turnaround work, I can tell you it’s no fun, for either management or employees, to be dealing with negative stuff month after month. Quik maybe has a little more work it wants to do on its balance sheet, but it’s largely out from under the reverberations of that deal though, like all of us, not of the recession.

I still have the same question for Quik (and for other brands) that I had before; how do you grow sales? You can’t improve profitability by controlling expenses and improving gross margin forever. I imagine the new Quik women’s brand and DC’s efforts in racing will be part of the answer. They note in the conference call that 95% of Roxy’s customer base doesn’t know that Roxy is related to Quik. Partly as a result of that, they believe there’s room for a Quiksilver Girls brand. It will debut in spring, 2011 and be directed at the 18 to 24 year old market.

While we wait for that to happen, I’d like to start with the balance sheet and discuss the improvement there.
 
Deleveraging
 
Quik raised some rather expensive money from Rhone Capital as you call, and refinanced its bank lines pushing out the maturities. When you look at this year’s July 31 balance sheet and compare it to last year’s at the same date you can see the impact of those actions and of their control of expenses. Trade receivables are down by 19.6%, and average days receivables are outstanding is down by 6 days, which is good for cash flow. Inventories fell by 19% from a year ago to $271 million.   
 
Current liabilities have fallen by 41%, from $658 million to $390 million.  I’d particularly point to the decline in the line of credit outstanding from $221 million to $25 million. The amount of debt that Quik had was an issue, but also important was that way too much of it was coming due in the short term at the same time.
 
 Long term debt is up by around $25 million to $759 million, but total liabilities fell from $1.43 to $1.19 million. The current ratio has improved from 1.65 to 2.26 as has total liabilities to equity from 3.21 to 2.45. I imagine they’d like to reduce that further.
 
Actually, they have. After the quarter ended, they did a debt for equity swap with Rhone Capital that reduced their debt by an additional $140 million in exchange for 31.1 million shares of stock at $4.50 a share. I’m oversimplifying a bit, but if I take the July 31 balance sheet, reduce long term debt by $140 million and increase equity by a similar amount, the total liabilities to equity ratio falls further to 1.68. As a result of this exchange, Quik will have a “non-recurring, non-cash and non-operating” charge in the quarter ending October 31 to write off some costs associated with issuing the debt. 
 
I’m not the only one who sees this as a lot of progress. On August 27th, Quik was able to amend its North American credit agreement with an interest rate reduced to Libor plus 2.5% to 3%. Before the margin over Libor was 4% to 4.5%. Libor stands for London Interbank Offer Rate. The interest savings will be substantial. Wonder if they’ll be able to do the same thing with any of their other bank lines.
Net cash provided by operations rose from $150 million to $193 million. Increasing cash generation from operations is always a good thing.
 
Income Statement
 
Quik’s bottom line for the quarter was a profit of $8.3 million compared to a profit of $1.3 million in the same quarter the prior year. For nine months, it had a profit of $12.4 million compared to a loss of $190.3 million for nine months the previous year. Of that loss, $132.8 million was from discontinued operations- Rossignol. They had a profit from continuing operations for the nine months of $13.9 million compared to a loss of $56.5 million the previous year. For the quarter, the continuing operations profit was $8.4 million compared to $3.4 million the prior year.
 
Reported revenues for the quarter were down 12% from $501 to $441 million. Gross profit fell 1.55% in dollars to $230.7 million, but the gross profit percentage rose to 52.3% from 46.7% in the same quarter the prior year. The gross margin improvement worldwide was largely the result of less discounting and some improvements in sourcing. Quik CFO Joe Scirocco clarified this by saying that “…the vast majority of it [margin improvement] is in fact, a better mix of sales because we have cleaned inventory so well.”
 
In a related comment he noted that “…a lot of the contraction that we’re seeing this year in volume is intentional. It is done as part of our plan to clean up distribution, to get better, higher quality sales and it is coming through very strongly in the gross margin.” I’m guessing that cleaning up distribution and higher quality sales refers to some extent to only selling to accounts who are likely to continue in business and be able to pay you; a good idea.
 
You know what would be really interesting? If they would break out the wholesale gross profit margin from the retail. That way, we could look at the two segment’s performance individually. And it might make for some easier (and probably interesting) comparisons with other brands and retailers.
 
Sales, general and administrative expenses fell by 8.8% to $193 million, but rose as a percentage of sales from 4.2% to 4.4%. There was a noncash asset impairment charge of $3.2 million this quarter related to the Fiscal 2009 Cost Reduction Plan.
Interest expense rose from $15.3 to $20.6 million. The foreign exchange loss was $213,000 compared to $3.5 million last year and the income tax provision rose a bunch from $396,000 $5.1 million.
 
That’s a lot of movement in various stuff. Before all the charged that followed the impairment charge, operating income was up 52% from $22.6 to $33.5 million for the quarter and from $53.5 million to $89.2 million for nine months. Sales fell 6.7% for the nine months.
That’s the summary. Let’s dig in a little.
 
As reported on the financial statements, sales in Quik’s three segments (Americas, Europe and Asia/Pacific) fell by 9%, 20%, and 1% respectively during the quarter. Sales in each of the segments were $234 million, $152 million, and $55 million respectively. In constant currency, the Americas drop stays the same, but the European decline becomes 11% and the Asia/Pacific decline increases to 11%. Overall, the constant currency decline was 10%.
 
The gross profit margin (as reported) in the Americas segment rose from 37.7% to 46.7%. It provided $109.6 million or 47% of total gross profit for the quarter. Europe’s gross profit margin rose from 57.7% to 60.6%. It provided 40% of gross profit for the quarter. The remaining 3% of gross profit dollars came from Asia/Pacific, where gross margin percent fell from 53.7% to 52.7%.
Operating income in the Americas jumped from $4.5 million to $27.7 million. Europe’s fell from $25 million to $15.6 million and Asia/Pacific went from a profit of $2.33 million to a loss of $1.63 million.
 
The revenue decrease in the Americas segment “…was primarily attributable to generally weak economic conditions affecting both our retail and wholesale channels, with particular softness in the junior’s market. The decrease in the Americas came primarily from Roxy…and, to a lesser extent, DC. The decrease in Roxy…came primarily from our apparel product line, but was partially offset by growth in our accessories product line. The decrease in DC…came primarily from our apparel and footwear product lines and, to a lesser extent, our accessories product line. Quiksilver brand revenues remained essentially flat…”
 
“The currency adjusted revenue decrease in Europe was primarily the result of a decline in our Roxy and Quiksilver brand revenues and, to a lesser extent, a decline in our DC brand revenues.”
 
On the retail side, they note that “…retail store comps in the US were again modestly positive overall in Q3.” They saw “…strong in-store gains in the Quiksilver and DC brands…” In Europe, “…retail comps were down in the mid single digits on a percentage basis for the quarter…” Quik has opened 12 new stores in Europe over the last year, but they’ve also closed 12 so the net number has not changed. Twelve underperforming retail stores have been closed in the U.S. since the end of the third quarter of 2009. Two were closed in the quarter just ended.
 
The Future
 
Quik expects fourth quarter revenues to be down 15% after taking into account a weaker translation rate for the Euro and demand softness in Asia/Pacific. Remember that Billabong said its Australian forward orders were down 20%, and they expect a similar decline in sales. Quik isn’t immune to the late arriving economic downturn in Australia.
 
They expect to be able to deliver gross profit margins in the fourth quarter that are 4% to 4.5% higher than in the fourth quarter last year. Remember, that’s not 4% higher than this quarter I’m writing about now, but 4% higher than the same quarter last year. Pro forma operating expenses are expected to be “as much as” 7% lower than in the fourth quarter last year. Wish they’d tell us what they expect to report instead of giving the pro forma number.
 
Diluted earnings per share are expected to be “…in the mid single digit range…” At this time, they aren’t providing any guidance on fiscal 2011.
 
Joe Scirocco has the following really interesting comment that shows their focus on retail and ecommerce; not unlike some other major brands. “Well, I think the key to operating leverage frankly is getting higher sales through the retail channel – through our own retail stores. And those areas of the business in which we have a fixed cost infrastructure. So, it is basically retail stores and eCommerce are going to be the two areas at which we can most drive leverage.”
 
Quik has great brands and has largely finished deleveraging their balance sheet. They’ve taken out a lot of costs and improved their operating efficiency. But sales (especially the wholesale portion) are down. Partly, this is due to their focus on cleaning up distribution as described above. But it’s also due to lower demand and caution in who they sell to. The positive result is the big improvement in gross margin.
 
But lacking an improvement in the economy and in banks’ willingness to lend, a lot of that lost distribution isn’t coming back. Certainly new, innovative products can generate some additional sales, but I’d expect most of their growth will have to come from retail (brick and mortar and ecommerce) and new initiatives like Quik Girls.
 
It’s not just Quiksilver that approach will apply to, and there are interesting implications for competitive strategy in our industry. Maybe that’s worth a Market Watch column.

 

 

Globe Makes a Profit. It’s Good to Make a Profit, But There Are Some Unanswered Questions

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Initially, I was relieved. There was no conference call to listen to and try to take notes faster than they could talk. The press release was one page. The Appendix 4E was only 60 pages and the Investor Presentation power point didn’t really add anything to it. I thought I’d get off easy on this one.

Turns out it’s a lot easier to do an analysis when you have more solid information to analyze. Globe, however, doesn’t feel any need to provide a whole lot of information beyond what’s required by law. They’ve only got about 2,200 shareholders, of which 1,400 hold what we in the U.S. call restricted stock. That is, they can’t just go out and sell it on the market. The stock doesn’t trade much, the analysts aren’t following the company closely, and the Hill brothers control about 66% of total shares outstanding. As a result, their board of directors, Globe tells me, has decided there’s no reason to supply additional, detailed information on strategy, brand performance and future outlook that might help competitors.

I’ll give you what I’ve got, then I’ve got some questions and issues to raise. All the numbers are in Australian Dollars. Before I start, I’ll remind you that the brands the company sells, besides Globe, include Gallaz and, as part of Dwindle Distribution, Tensor, Blind, Enjoi, Darkstar, Cliché, Speed Demons, Almost, and Blind. You can see the whole report here if you want; http://www.globecorporate.com/files/announcements/APP_4E-26Aug-FINAL.pdf
 
The Financial Statements
 
Revenue for the year ended June 30, 2010 fell 22% from $117.6 million to $91.7 million. Net sales (excluding revenues, such as royalties, not received from selling product) were down 23% to $90.5 million from $116.9 million. The press release notes that in constant currency and after closing 12 retail stores in Australia over the last two year, the decline in revenue was 9%. The retail closing leaves Globe with just three flagship stores. 
 
Gross profit fell from $53.3 to $42 million. The gross profit margin rose from 45.6% to 46.4%. Employee benefits expense was reduced from $18.6 million to $13 million, or by 30%. Selling and administrative expenses dropped 37% from $39.8 to $25.1 million. Income tax expense was down by about a million bucks. Net income “before significant items” improved by $4.608 million, from a loss of $2.397 million to a profit of $2.211 million. Net income (including those items) was $1.3 million compared to a loss of $8.9 million the prior year. The major significant items are a cash charge for restructuring of $3.155 million and a non-cash reduction in tax assets of $4.666 million in the year ended June 30, 2009.
 
Total of these significant items was an expense of $6.471 million for 2009 but only $897,000 for 2010. These items represent a big chunk of the total profit turnaround
 
Globe reports its revenues by three segments; Australasia, North America, and Europe.   Revenues from these three segments were down, respectively, 29.6%, 13.3%, and 32.1% for the year ended June 30, 2010 compared to the prior year. About half the decline in Australia was the result of the retail store closings. Sales in Australasia were $24.4 million. In North America, they were$50.8 million. The number for Europe was $16.5 million. Sales in Australia, of course, are not impacted by currency fluctuations (except that product cost may decline if it’s bought in another currency when the Australian dollar strengthens).
 
The current ratio on the balance sheet improved very slightly from 2.92 to 3.09, and total debt to equity fell a bit (a good thing) from 0.36 to 0.34. Inventory fell 19.6%, which you’d expect given the sales decline. I might have expected even a bit more. Trade and other payables fell hardly at all, from $12.4 to $12.3 million. Given the 37% drop in selling and administrative expenses I might have expected this to decline. One explanation for it not declining might be that they are paying more slowly. Might also just be a timing issue and mean nothing. Globe management tells me it’s just timing.
 
Receivables fell only 6.5% to $14 million. I would have expected more of a decline again because of the lower sales. With product sales down 23%, that small receivables decline seems a bit odd.    Hmmm.   Guess it’s time to dig into the details
 
Adventures in Footnote Land
 
Ah, here’s some information. Footnote 10. It seems that trade receivables were down 27.4% (after provision for doubtful accounts), but that “Other Receivables” rose 94% from $2.616 to $5.078 million. Note c to note 10 tells us that, “This amount includes $4.5 million (2009: $2.2 million) relating to amounts recoverable under trade receivables factoring arrangements– refer to Note 26 for further information.”
 
Off we go Note 26 for that sure to be enlightening “further information.” Here’s the part of that note that’s relevant to the Other Receivables. “Other receivables include sundry other receivables and amounts due from factors. All balances are current and are not considered to be impaired.”
 
Okay, this slog for information just won’t end. We have to delve deeper into Note 26 (which runs for five pages) where we learn that Globe has factoring facilities in place in both Australia and North America.   In North America, the credit risk on the “the majority” of the receivables sold pass to the factor. No idea if that’s 51% or 98%. So Globe’s risk is largely that the North American factor won’t pay. 
But then here’s the last sentence describing the North American arrangement:
 
“These arrangements have been amended during the year. Under the terms of the revised agreements, the basic level of funding does not change, but the consolidated entity retains title to trade receivables and therefore has minimal exposure to the factor.”
 
Okay, I’m begging for mercy and have pleaded with Globe to explain this to me. It turns out that CIT is Globe’s factor. As you recall, CIT ran into some difficulties last year. There was concern (not just on Globe’s part) that CIT might go belly up and leave Globe not owning its receivables and not being able to get the money from CIT when it was collected. This would have, well, sucked. So Globe (and other companies) negotiated a change in their agreement under which the credit risk passed to CIT, but Globe owned the receivables until they were paid, thereby protecting Globe from a possible CIT bankruptcy.
 
I really wish they’d just said that. I take some comfort from the fact that Globe’s CFO has apparently had to sit down with board members and go over this footnote with them as well. I’m not the only one who’s been confused. Regardless of where the risk is or who owns the receivables, they have dropped over the year, according to Globe, from $18 million to $13.9 million, a decline of almost 23% and in line with the fall in sales.
   
Now, what do we know about the quality of these receivables? Not all that much. There’s a little table (in the endless footnote 26 of course) that shows “…trade receivables considered past due but not impaired…” Not impaired means they expect to collect them and haven’t reserved for them. That number has declined over the year from $3.23 to $2.59 million. For the year just ended, they show nothing “Past due greater than 91 days.” But if the terms of the sale were 90 days, then nothing would show up past due until the 91st day. Lacking information on what the original sales terms were, this chart isn’t very helpful.
    
We do see, however, that during 2010, Globe recognized an impairment loss of only $104,000. The previous year it was $1.627 million. Trade receivables past due and impaired were $2.077 million at the end of this year compared to $3.416 million at the end of the previous year. The impairment allowance (reserve) has fallen from $2.972 million to $1.793 million. That represents 20% of trade receivables at the end of 2009 and 18% at the end of 2010. On the one hand, I look at that and say, “That must be more than enough.” On the other hand, an 18% impairment allowance seems to suggest an awfully high level of possible problem receivables.    
 
I’m sure you’re kind of over Australian accounting for and presentation of receivables. Me too.
 
What’s the Future Look Like?
 
I have no idea. There’s not a word on how any individual brand did. Under “Future Developments and Results,” all they say is:
“No further commentary on future developments and expected results is included in this report as the directors are of the opinion that such commentary would likely result in unreasonable prejudice to the consolidated entity.”
 
Initially, this had me kind of shocked. But it turns out it’s just standard legal Australian for “We don’t have to tell you anything else and we’re not going to because it would just help competitors.” Billabong has pretty much the same wording, but they include it with a short discussion of their expectations for the coming year, so it’s not shocking. I guess everybody in Australia takes it for granted, but I almost fell over the first time I read it. Just a reminder that speaking the same language isn’t any guarantee of smooth communications.
 
It’s true that Globe went from a loss to a small profit, and that’s a good result. But, by way of summary, let’s look at how they did it. First, product sales were down 23% for the year. Tough economy, store closings, and exchange rate issues acknowledged, that can’t imply anything good for market share and brand positioning. They slashed selling and administrative expenses 37% from 33.9% of sales to 26.4% of sales. Employee benefit expense was down 30%. They acknowledge that they were being a little less than rigorous in their expense control previously, and told me that the current level of expenses was appropriate for projected revenue levels.  Those are big reductions, and I wonder if they can be maintained.
 
Lots of companies have told me the same kinds of things as they’ve adjusted to the recession. I should note that the Australian economy has, until now, been spared much of the recessionary problems of the rest of the world, but that seems to be changing. We’ll see how Globe reacts.
 
Globe didn’t have $3.2 million in restructuring expenses that they had last year. The impairment charge for receivables was about $1.5 million less than last year.
 
I’m left here with a lot of “I don’t knows” and “They didn’t say.” From my description of their shareholders at the start of this article, I can see why they don’t feel a need to provide more information. But I think they do themselves a disservice. My experience is that the assumptions made in the absence of real information are always worse than the truth. I was clearly guilty of thinking like that in my first reading of their report.
 
At the end of the day, you can only improve your bottom line by so much through cutting expenses. Finally, you have to sell more at better margins. Globe has chosen not to explain how they are going to do that. 

 

 

Zumiez’s Quarter; Other Stuff is More Interesting than the Numbers

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The Numbers

In the quarter ended July 31st, Zumiez showed some improvement over the same quarter last year. Sales grew 14.7% from $85.2 million to $97.7 million. Comparable store sales were up 9.3% and 24 new stores (net of closings) have been opened since August 1, 2009.
 
“The increase in comparable stores sales was primarily driven by an increase in comparable store transactions, partially offset by a decline in dollars per transaction. Comparable store sales increases in accessories, men’s clothing and boy’s clothing were partially offset by comparable store sales decreases in hardgoods, junior’s clothing and footwear.”
 
Gross profit was $30.7 million, up 24.6% compared to the same period the prior year. Gross profit as a percentage of sales grew from 28.9% to 31.4%. I should note that Zumiez included in their cost of goods sold some expenses that other companies allocate differently. 
 
“The increase was primarily due to product margin improvement of 170 basis points, a 130 basis points decrease in store occupancy costs and a 40 basis points decrease in inbound shipping costs, offset by a 100 basis points increase due to distribution costs primarily associated with the relocation of our distribution center.” The 1% of distribution costs sounds like a one time thing.
 
Selling, general and administrative expenses increased $3.2 million, or 10.8%, to $33.1 million. As a percentage of sales they fell from 35.0% to 33.8%.   “The primary contributors to this decrease were a 150 basis points impact of a litigation settlement charge of $1.3 million incurred in the three months ended August 1, 2009, 120 basis points due to store operating expense efficiencies, the effect of the change in accounting estimate for the depreciable lives of our leasehold improvements of 110 basis points and a 40 basis points impact of the $0.3 million impairment of long−lived assets charge incurred in the three months ended August 1, 2009, partially offset by a 210 basis points impact of a litigation settlement charge of $2.1 million incurred in the three months ended July 31, 2010 and a 80 basis points increase in corporate costs, primarily due to incentive compensation.”
 
The two law suits were both around allegations that Zumiez didn’t treat their employees as the law requires. Alleged were failure to pay over time, not providing meal breaks and a bunch of other stuff. Both cases have been settled. Without the impact of the lawsuit settlement, sales, general and administrative expenses would only have declined by 1.8% instead of by 3.8%. 
 
The company had a net loss of $1.2 million in the quarter compared to a loss of $3.1 million in the same quarter the prior year. The balance sheet is in good shape. Not all that much changed from a year ago. Thanks to Zumiez for including the balance sheet from a year ago in their press release so I didn’t have to go dig it up. Let’s move on to the more interesting stuff.
 
The More Interesting Stuff
 
On May 11th, Zumiez bought a 14.3% interest in a manufacturer of apparel and hard goods for $2 million. I emailed Zumiez asking for more details but they aren’t disclosing any, which is what I expected. Zumiez has the right to sell its interest back any time between the fifth and the seventh anniversary of the investment. And the company they invested in has an option to buy their stock back on or after the seventh anniversary of the initial investment.
 
Sorry, that’s all the information I have. I am kind of intrigued. Brands going into retail, now retailers becoming manufacturers?   If $2 million bought 14.3% of the company, then they agreed the company had a value of about $14 million. So it’s not a little tiny company. 14.3% is kind of a funny number. I wonder if this isn’t an important source for Zumiez that was having some troubles. Makes hard goods as well as apparel huh?
 
Okay, I’m over speculating here. I just don’t know anything, but you can see why I’m curious.
 
Ecommerce was 2.9% of revenues for the quarter, up from 1.8% in the same quarter the prior year. Quite an increase.
 
You noted above that they ascribed some of the drop in sales, general and administrative expenses as a percent of sales to improved operating efficiencies. They discussed that in the conference call, referring specifically to “Infrastructure projects that facilitate better merchandise analysis and planning decisions” and contribute to “improved exception based analysis.” They also mentioned a new assortment planning tool which should allow Zumiez to “plan and micro merchandise our business even better.” They said this would allow them to lower cycle times and get product into stores faster. Their new distribution center, they noted, (moved from Everett Washington to Southern California) cuts two to three days off their supply cycle because 70% of their suppliers are located in Southern California.
 
As you know, I’ve been a cheerleader for systems improvements ever since the lousy economy started to rear its ugly head. Actually, since before then as I was pretty certain a lot of companies were leaving a lot of money on the table through poor operations. Now, I think your bottom line improvement is more likely to come from running better than from growing sales and it looks like Zumiez might think I’m on to something.
 
Zumiez noted in the call that two things were working really well for them. The first was the value portion of the business. The second was a lot of “full price selling coming from unique brands we carry.” They believe that they may still have some pricing power with those brands because of their controlled distribution.
 
I’ve written about how the recession can be an opportunity for small brands that aren’t widely distributed. It’s the only way for specialty retailers to differentiate themselves.
 
Here are a few other facts:
 
·         Juniors represent only about 10% of Zumiez sales. That’s a good thing because of how tough that market has been and is. Their private label juniors has performed better than the brands in the last few quarters.
·         In the last two complete years, private label has been 15 and 15.7% of sales.
·         Last quarter, they had the biggest decline in average unit retail that they’ve had in the last six quarters.
·         Concentration in their top 10 and 20 brands has been declining for a number of years.
·         They see some costs coming up and some lead times increasing, consistent with some other companies are saying. It will be interesting to see how brands reconcile that with consumer demands for value in the next year or two.
 
Obviously, you don’t want to say everything is fine when a company is losing money. But they are going in the right direction, have the balance sheet to consistently follow their strategy, are choosing and managing the brands they carry in a way appropriate for the environment, and are working hard to build efficiency and take costs out of the system.

 

 

Billabong’s Annual Report; Why Their Retail Strategy is a Match to the Economic and Industry Environment

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Billabong’s annual report and associated documents released around it contain a wealth of information. Some of the questions asked by the analysts in the conference call, and the answers provided, were particularly interesting. But equally important, there are some insights into general market conditions, the evolution of the retail environment and issues with Chinese production. It’s a lot to cover. Let’s get started.

Strictly By the Numbers

First, let’s set the foreign exchange stage since all the numbers I use are in Australian Dollars (AUD) and Billabong’s management talks a lot about the impact of currency fluctuations. On June 30, 2010 one US dollar was worth 1.167 Australian dollars. A year earlier, on June 30, 2009, one US dollar got you 1.24 Australian dollars. That’s a 5.9% strengthening of the Australian currency over 12 months. It wasn’t a regular change. The strengthening was greater during the first six months than the second.
 
Currency fluctuations (it happened with the Euro as well) mean that reported results become harder to interpret. You can sell, for example, more in a country, but because your home currency strengthens against that country’s currency, you show lower revenue in your home currency.
 
Some people, including me, have made the argument that, as an investor in Australia, who invests in AUDs and spends AUD, all you care about is the AUD result. I still believe that, but looking at constant currency (as Billabong and other companies do) can help you evaluate comparative performance between periods.
 
Okay, enough. If you’re curious about the impact of exchange rates, the first Market Watch column I ever wrote in 1995 was on the subject. You can read it here. http://jeffharbaugh.com/1995/06/13/foreign-exchange-management-whats-all-this-brouhaha/.
But you probably don’t care and wish I would get back to Billabong, so I will.
 
Revenue fell 11.2% for the year ended June 30, 2010 (they were flat in constant currency) to $1.488 billion (In Australian dollars, remember). “European sales of $344.0 million were up 5.2% in constant currency terms, but down 11.3% in reported terms. Sales of $712.6 million in the Americas were down 1.2% in constant currency terms, or down 14.8% I reported terms. Australasian sales of $425.7 million were down 1.9% in constant currency terms, or down 4.2% in reported terms.”
 
“Gross margins strengthened to 54.4% from 53.3% in the prior year, reflecting a less promotional retail environment, primarily in the USA.”
 
Cost of goods fell 13.4% to $676 million. Selling, general and administrative expenses were down 10.6% to $470 million. Other Expenses were down from $125 to $121 million. If I’m reading my footnote 7 on page 69 of their Appendix 4E right, that includes amortization and depreciation, rental expenses, and minor impairment charges. That’s enough time spent on that.
 
Finance charges were down from $38.6 to $25.2 million, mostly as a result of the reduction in borrowing that the capital raise in May 2009 permitted. Pretax profit was off slightly from $206 to $203 million and net income was $145.2 million, down from $152.8 million.
 
Profit, if they didn’t have all that pesky exchange rate movement (in constant currency that is) would have been up 8.1% over the previous year. If they excluded last year’s impairment charge expense of $7.4 million, it would have been up 3.1% in constant currency terms. And if they hadn’t had to expense $2.7 million of post-tax acquisition costs under new accounting rules that last year they could have capitalized, their net profit after tax growth in constant currency would have been 5%.
 
So how much did they make? Every year companies have “stuff” that isn’t consistent with last year. Hey, I’ve got an idea! How about we stick with the $145.2 million Australian dollars at the bottom of their income statement? That seems like a reasonable thing to do, though maybe a little old fashioned. There can come a point where explanations don’t lend clarity, because none of them are “right.” And none of them are “wrong.”   And there are new explanations every year. If I had my way, I’d like to see five years of summary financial statements under the current year’s accounting standards. Then meaningful comparisons would be easier.
 
Billabong sees 2010/11 as a “transition year.” We’ll talk about what they mean later. They expect NPAT (net profit after taxes) to grow from 2% to 8% in constant currency terms. I completely agree with them forecasting in constant currency, by the way, because nobody has any idea what exchange rates are going to do. They expect an improving outlook in the Americas, continued strength in Europe, but a challenging market in Australia. In fact, Australian forward orders are down 20%, and Billabong is expecting a 20% reduction in sales there in fiscal year 2011.
 
EBIT (earnings before interest and taxes) is expected to be flat. They don’t say if that’s in constant currency or not. I think it is. They also expect higher interest costs and a lower tax rate. So if all this is in constant currency, and EBIT is flat and interest higher, that seems to suggest that all their NPAT growth will be due to a lower tax rate.
 
Over on the balance sheet, things are pretty much fine. My hat’s off to Billabong for raising capital in 2009 under not the most favorable conditions. It gave them the balance sheet to consistently pursue their strategy even during tougher economic times. The current ratio fell over the year from 3.3 to 2.45, but that’s plenty strong. Total liabilities to equity improved a bit from 0.89 to 0.82. In August of 2010, they refinanced and increased their bank lines to give them lower margins and more availability. The line went from US$ 483 million to US$ 790 million.
 
The increase in the line isn’t necessarily targeted on further acquisitions, but they won’t rule one out. One other use of the line will be to pay certain of their acquired companies’ bonus payments that are coming due.
 
I am a little curious about their inventory and trade receivable numbers. As you remember, total revenue was down 11.2%. Inventory fell 5.2% to $240 million and trade and other receivable was down only 1.7% to $398.4 million. It’s not that I’d expect inventory and receivables to fall in lock step with revenue, but I’m curious enough to read a few foot notes.
 
The first thing I notice in Note 1, paragraph k is that “All trade receivables…are principally on 30 day terms. Boy, good for them. I know a lot of brands who’d love to have mostly 30 day terms. They had a reserve for bad debt of $23 million at the end of last year. It’s down to $21.5 million at June 30, 2010. Billabong thinks they have problem receivables of $26.1 million, but expect to collect some part of that which I’d expect too. Of those, $14.4 million are over six months old. $26.1 million represents 6.36% of total receivables. “The individually impaired receivables mainly relate to retailers encountering difficult economic conditions.” What a surprise.
 
Note 10, paragraph b then goes on to discuss trade and other receivables that are “past due but not impaired.” They’ve got $82.8 million of these which I guess is in addition to the $26.1 impaired receivables discussed in the paragraph above.
 
I’m a bit unclear on what “past due but not impaired” means. Of this $82 million, $17 million is more than 6 months past due. That sounds pretty impaired to me. All they say is that “These relate to a number of independent customers for whom there is no recent history of default.” If they’re six months past due, I’d tend to characterize them as having a very recent history of default.
 
This number is up from $68.5 million at the end of the last fiscal year. It can’t be that there are $82 million of additional problems accounts because that would be a huge number and nobody asked about it in the conference call. So could you ladies and gentlemen at Billabong please help us stupid Americans who don’t understand Australian accounting and provide some more detail?
 
The Remuneration Report
 
This report, part of the Appendix 4E, lays out who gets paid what and how. But what impressed me were the remuneration principles on page 15. Here they are:
 
“Our remuneration principles
 Provide a market competitive reward opportunity;
 Apply performance targets that take into consideration the Group’s strategic objectives, business plan performance expectations and deliver rewards commensurate for achieving these objectives and targets;
 Ensure executives are able to have an impact on the achievement of performance targets;
 Align executive remuneration with the creation of shareholder value through providing a portion of the reward package as equity and using performance hurdles linked to shareholder return;
 Encourage the retention of executives and senior management who are critical to the future success of the Group; and
 Consider market practice and shareholder views in relation to executive remuneration, whilst ensuring that executive remuneration meets the commercial requirements of the Group.”  
    
Remuneration is divided into three parts; fixed, short term, and long term. The short and long term parts are both “at risk” and, in fact, parts of them haven’t been paid this year or last because certain agreed upon performance objectives weren’t achieve. The “at risk” portion varies by executive, but it’s not less than 20% of compensation for anybody and is typically higher.
 
This is very powerful stuff and I think goes a long ways to explain Billabong’s long term success. It aligns shareholders with management and doesn’t over emphasize short term results. Somebody’s put a lot of work in to developing and implementing this system, and I hope they got a lot of remuneration for it.
 
China, Production, Supply and Prices
 
Every company is talking about issues with labor availability, costs, and supply in China.  Billabong is no exception. Approximately 50% of their world production is in China. CEO O’Neill mentions a conversation he had with one supplier who was struggling to get workers. He also noted that the minimum wage went up 20% in May and that the currency has strengthened slightly. He points to cotton prices as being at a 13 or 14 year high and that there’s almost a shortage of it. Shipping container prices being triple what they were 12 to 15 months ago and freight prices are up as well.
 
He states, “I think that every apparel company you talk to would say that at some point over the next six to nine months that some apparel prices will have to rise.” I agree.
 
They are responding by looking for other production opportunities. Currently, they produce in approximately 27 countries. He mentions more production in South America and that “Europe’s actually began producing some items, fast turnaround items, back in places like Portugal.”
 
The Retail Environment
 
Company owned retail stores (380 at year end) contributed 24% of global sales for the year. “…in growth terms, our company-owned retail outperformed wholesale. This shows the benefit of having the extra opportunity to get the right product in front of the consumer.”
Billabong’s focus on retail isn’t new. They said many of the same things in their half year report. You can see what they said in the analysis I did at that time: http://jeffharbaugh.com/2010/02/25/billabongs-semi-annual-report/.
 
In North America, revenue from the 111 company owned stores was up 9.2% in constant currency terms. In Europe, the 103 stores were up 18.2%, again in constant currency. The number was 5.9% in Australasia with 166 stores. EBITDA for all retail stores improved from 10.2% to 10.9%. As you would expect, EBITDA margins for stores open two years or longer was even stronger, growing from 11.8% to 14.6%.
 
In talking about Billabong’s motivations for retail, they note how they’ve seen an increase in house brands by retailers in recent years, and how that ends up “…eroding the amount of space that’s available for premium brands…” and usually not working for the retailer. Though they don’t come right out and name it, I think they were thinking about PacSun, where their sales last year were down 40%.
 
There is also a general concern about the overall wholesale base. In Australia, they estimate their account base has declined 5% in the last 12 to 15 months. In addition, they have “quite a few” on credit hold and “may not continue selling to those accounts.”
 
In Europe, the decline has been between two and three percent of accounts. They had around 1,400 accounts in the US a couple of years ago, and it’s now fallen to an estimated 1,200. “What is clear is that, in real terms, there is not a lot of people opening new board sports space. So it’s not like currently there is any real new business coming online into the industry.”
 
They further note the tendency of many accounts to buy not based on what they think they can sell and best merchandise, but on the quality of the deal they can get, and expect further fallout in the retail space because of reduced consumer spending and tight credit.
With few new outlets for their products, a decline in the number of accounts and concern about the financial viability of some existing ones, and a retail base that’s cautious in their purchasing and more interesting in a deal than in merchandising high end product, you can see why Billabong is focusing on their own retail. They believe, and have said before, that they can better merchandise and sell their product in their own stores.
 
They are also interested in being more market responsive and creating new product in short time lines outside of the normal product cycle. They can do this with their own stores. An independent retailer, however, is often not prepared to buy sight unseen when Billabong asks them how much of a new product they want for delivery in four weeks. Maybe they should be if they believe in the brand.
In the short term, retail acquisitions have an interesting impact, and this is partly why Billabong refers to fiscal 2011 as a “transition year.” When Billabong sold product, for example, to West 49, they booked the sale when the product shipped. But the moment they own West 49, that sale doesn’t happen until the retail customer buys the product in the store. Revenue recognition, then, is delayed during the transition period.
 
Conference Call Questions
 
You haven’t read this far without figuring out that Billabong has some challenges to deal with, and the analysts on the conference call picked up on that. Here was a question that the JP Morgan analyst asked:
 
“You’ve highlighted higher sourcing cost, and that actually looks like a more enduring problem rather than sort of like a temporary sort of blip. You have a consumer that is seeking value and you’ve got channel base that’s sort of declining, well it has declined, and you’ve got mixed shift to lower margin regions like Brazil. I mean haven’t you got a lot of factors there that are actually negatively impacting your EBITDA margins in the US?”
 
CFO Craig White’s answer was, in part, that it depended on your time frame but he agreed there were other issues as well. “I mean we’re talking about 2010/11 as a transition year and implicit in the [mid-term] guidance we’re providing … of EPS growth in excess of 10% is a whole mix of things happening including overall gradual macroeconomic recovery; growing share of Billabong brands in retail which will improve existing margins in retail, be it West 49 or other stores; you know there is a whole range of things in there.”
 
But the analyst doesn’t seem quite satisfied with the answer: “I mean how can you give medium term 10% year on year growth guidance with a lot of confidence because in my mind it seems extraordinarily difficult to do that?”
 
I’ve summarized the exchange here.  The entire transcript, and all the reports I’ve referenced are on Billabong’s corporate web site if you want to dig in a little.
 
Billabong decided, when the recession started, that they would not be as promotional as other brands because they wanted to preserve brand equity. I thought that was a good decision. The question is how you make that work in a continuing weak economy under the circumstances the analyst outlined. At least part of the answer is by expanding your retail presence where you can better merchandise your brands, drop in new product quickly outside of the traditional product cycle, and get the margin and volume you are, to some extent, losing in your traditional retail channels. That’s what I might have told the analyst in CFO White’s place. Of course, I’ve had a couple of days to think about it and who knows what I would have said at the time.
 
There were also questions about whether or not the Billabong brand was losing market share, about whether more global styles and reduced range sizes reduced entry barriers for competitors, and on the company’s ability to manage all the owned and licensed brands. For a conference call, this was a lot of fun!
 
In difficult operating environments (this one qualifies) managers of public companies are often in no win situations. They can be cautious- and raise concerns that they aren’t acting aggressively enough in an obviously rapidly changing environment. Or they can act aggressively- and have people concerned they’re moving too quickly in too many new directions.
 
I’ve argued that the biggest risk of all is to not take a risk when things are changing and I think I’ll stand by that. Billabong does seem to be relying to some extent on a continuing US economic recovery and I’m not sure they should be. All the risks the analysts pointed out are very real ones. But business is a risk.
 
You minimize those risks by having an experienced management team, building agreement on goals and objectives among the team members, and by not sitting on your ass when you become aware that things are changing- for better or worse. I’m sure that one or more of the actions Billabong is taking won’t work out. That’s life. But in light of fast fashion, a declining wholesale base, a difficult economy, and the retail opportunity they have with the brands they’ve assembled, their strategy seems largely correct to me.    

 

 

Orange 21’s (Spy Optics) June 30 Quarter; What Doesn’t Kill You Makes You Strong

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Orange 21 turned a profit of $408,000 in the quarter ended June 30 after losing $254,000 in the same quarter last year. For six months, a loss of $1.058 million was reduced to $529,000. For the quarter, they did it by increasing sales 4.5% and increasing their gross profit margin from 45.9% to 57.8%. And they did it while incurring two hundred thousand dollars of expenses for new sales initiatives that haven’t generated the first dollar of revenue.

If you’ve followed my earlier comments on Orange, you know that they had a lawsuit with a big shareholder and former CEO, some problems with inventory (at the end of the quarter they had an allowance for obsolete inventory of $966,000), expenses that needed to be brought under control, losses that resulted in cash flow issues (managed at least partly by a rights offering to existing shareholders and a $3.0 million loan from the biggest shareholder), a factory in Italy that needed to be better managed, and some pretty heavy duty management transitions.  Oh, and there was (is?) a little recession going on, but I guess we all have to deal with that.

You can see the better management of the factory this quarter in the fact that it generated operating income of $218,000 compared to a loss of $338,000 in the same quarter last year. There’s some exchange rate impact in there, but that’s a $550,000 different in a quarter compared to a year ago.
 
Anyway, the company’s circumstances are improving and if the war isn’t over, they have certainly won some key battles.
 
The new sales initiatives that cost them $200,000 during the quarter but aren’t generating revenue yet are the Margaritaville and Melody by MJB brands.   They’ve also entered into a license agreement to develop and sell O’Neill branded eyewear.
 
Without saying how much is for which brand, the company noted that it had a minimum payment of $478,000 payable under various licensing agreements through the end of the end of the year, of which $178,000 has been paid as of August 10. During the next three calendar years, the company has minimum amounts of $1.4 million, $1.1 million, and $0.8 million, respectively, payable. They better get to selling those new brands.
 
They further noted that if they achieve certain minimum sales of some products, they will have to pay a percentage of net profits under the license agreements.
 
I would speculate that it wasn’t all that easy for Orange 21 to negotiate these agreements with these brands given their recent history. Wish I knew the back story to those discussions. But I think it’s a great thing for them to do. They need more volume to be solidly profitable and can’t sit around and wait for big sales increases through their traditional channels to bring that volume in our new economic reality.
 
90% of sales during the quarter were sunglasses, and domestic sales represented 81% of the total. The company believes the sales increase was due to improvement in the economy and consumer confidence as well as “…efforts with certain key accounts and focus on close out sales.” Hmmm. Does that mean close out sales to key accounts?
 
The explanation for the big increase in gross margin percentage is worth spending a little time on. First, there was only a $13,000 decrease in overhead allocation for the quarter compared to a $346,000 decrease in the quarter last year. What I think that means is that due to their cost controls they had a lot less expenses that got put on cost of goods sold. Well, gross margin is way up, so that’s obviously a good thing even if I’m not entirely sure what it means. And an allocation can simply be from one place to another even lacking any cost reductions. That could improve one category at the expense of another but not change the overall financial result. But in this case, it obviously did change the result, so there’s more to it than an allocation.
 
Opps, I’m rambling on about cost accounting and guessing you’ve heard enough. Sorry.
 
Next they were able to increase inventory reserves by $200,000 compared to $100,000 in the same quarter last year “…as a result of the sale and disposal of previously reserved inventory.” Selling it sounds good; disposing of it not so good.
 
They got some product cost reductions due to more favorable exchange rates against the Euro for product made in their factory and product cost decreases due to the addition of a lower cost manufacturer in China.
 
Finally, they had a decrease in sales returns of about $0.2 million and “…a slightly larger decrease in our sales return reserve.”
Overall then, you have to applaud their gross profit margin improvement. But you also have to notice that some of the improvements are accounting adjustments that reflect the hangover from and resolution of old problems. Others, like exchange rates, are out of their control. Let’s hope they can maintain the high margin going forward.
 
General and administrative expenses were reduced an impressive 7% for the quarter. Sales and marketing and research and development expense were both up, but if they weren’t you’d worry about the prospects for the new brands.
 
Over on the balance sheet, the current ratio has improved only slightly from 1.3 to 1.4. The total liabilities to equity ratio rose from 2.0 to 3.2 mostly, I think, as a result of the $3 million loan from the shareholder. Of course, when the lender owns 44% of your shares, practically speaking you might call that $3 million equity whatever the accounting treatment.
 
I’ll watch the launch of the new brands with interest. For all the things they’ve done right, the company’s ability to grow significantly, become consistently profitable, and improve its balance sheet may depend on those brands.