Joining the Party; Quiksilver’s July 31 Quarter

It’s almost unanimous. Companies in our industry, (whatever industry we’re in) or for that matter most other industries, are cutting expenses, rationalizing supply chains, targeting marketing efforts, cutting SKUs, creating omni channels, growing ecommerce business, being more discriminating in distribution and generally doing all the things they have to do if they assume that sales growth will continue to be hard to come by. 

In their 10Q for the July 31 quarter, they list the action items for their Profit Improvement Plan:
 
“Important elements of the PIP include:
• clarifying the positioning of our three flagship brands (Quiksilver, Roxy and DC);
• consider divesting certain non-core brands;
• globalizing product design and merchandising;
• consider licensing of secondary or peripheral product categories;
• reprioritization of marketing investments to emphasize in-store and print marketing along with digital and social media;
• continued investment in emerging markets and E-commerce;
• improving sales execution;
• supply chain optimization;
• reduction of SKUs; [Note from Jeff: CEO Andy Mooney says they want to reduce SKUs by 40%]
• centralizing global responsibility for key functions, including product design, supply chain, marketing, retail stores, licensing and
administrative functions; and
• closing underperforming retail stores, reorganizing wholesale sales operations and implementing greater pricing discipline.”
 
They plan to be finished with plan implementation by the end of fiscal 2016 and expect it could “…improve adjusted EBITDA by approximately $150 million.” And they are only expecting “…modest new revenue growth compared with fiscal 2012 results.”
 
According to CEO Mooney in the conference call, Quik continues to focus on its “…3 key strategies of strengthening our brands, growing revenues and driving operating efficiencies.” However, “…revenue growth in the short-term will be difficult to achieve.” They don’t expect to see improved revenue results until the fall of 2014, “And we’re really looking at spring 2015 for the teams to hit full stride.” 
 
This all feels like good stuff. But to the extent it’s kind of ubiquitous, where does the competitive advantage come from? Let’s keep that in mind as we go through the numbers.
 
Income Statement
 
Sales were down 3.3% from $512 to $496 million. Last year’s quarter included $2.5 million of Quiksilver Women’s sales, a line the company has now exited. CFO Richard Shields tell us that, “…The decline was primarily in the Americas wholesale channel, where revenues decreased $16 million…”   As reported, the Americas fell 6.3% to $268 million, EMEA (Europe, Middle East and Africa) grew 6.3% to $164 million, and APAC (Asia Pacific) was down 11.5% to $63 million. In constant currency the Americas was down 6%, EMEA grow 3% and APAC was down 1%. More than 60% of Quik’s revenue came from outside the U.S.
 
 
The Quiksilver brand’s revenue was down 10% as reported to from $191 to $172 million. Most of the decline was “…due to a high-teens percentage decline in wholesale channel net revenues…” worldwide. It’s noted in the conference call that sales of Quiksilver product to clearance channels was down $5 million. I hope that’s an intentional trend.
 
Roxy revenues fell 1% to $130 million “…due to a high-twenties percentage decrease in the APAC wholesale channel and a high-teens percentage decrease in the retail channel within both the Americas and APAC segments…These decreases were largely offset by a low double-digit percentage increase in the Americas wholesale channel and growth across all channels within the EMEA segment.”
 
DC was also down 1% to $166 million “…with a low-double digit percentage decline in the Americas wholesale channel largely offset by growth across all other channels and regional segments. This growth was largely driven by increased discounting and clearance sales as we continue to reduce slow-selling DC inventories. Based on current channel inventories, we anticipate that DC brand net revenues in the fourth quarter of fiscal 2013 will decrease by approximately 15% from the $166 million recognized in the third quarter of fiscal 2013.”
 
You know, I seem to remember somebody writing that they hoped Quik wouldn’t push the DC brand too hard in their search for revenues because they might hurt it. Oh wait, that was me! I know- I shouldn’t do that, but once in a while I just can’t resist.
 
Revenues in Quik’s wholesale channel fell 7% from $369 to $345 million. Retail was constant at $120 million, and ecommerce grew 33% to $31 million. From the 10Q:
 
“Wholesale net revenues declined across all three regional segments, particularly in the Americas and APAC segments. Wholesale net revenue declines were focused within the Quiksilver brand across all three regional segments and the DC brand in the Americas segment.”
 
“Retail net revenues increased in the EMEA segment but were offset by decreases in the Americas and APAC segments….Retail net revenues in the DC brand increased significantly across all three regional segments but were offset by single-digit percentage decreases in the Quiksilver and Roxy brands. Retail same-store sales increased 2% during the third quarter of fiscal 2013.”
 
They are continuing to close underperforming stores and had 15 fewer than at the end of last year’s quarter. This accounts for most of the decline in retail sales. Quik ended the quarter with 562 stores. I didn’t get a sense for how many additional stores they are planning to close.
 
Gross margin was essentially unchanged, going from 49.5% to 49.4%, but total gross profit fell from $253 to $245 million with the sales decline. Quiksilver and Roxy gross margins improved, but DC’s was down. We are told they “…expect continued discounting on DC footwear product in the back-to-school and holiday seasons.”
 
Selling, general and administrative expenses fell 4.1% from $226 to $216 million. As a percentage of sales, it was down from 44.1% to 43.7%. Quik accomplished that decline in spite of $9 million of SG&A expense for employee severance and restructuring costs.
 
Those pesky, but noncash, asset impairment charges were $2.2 million compared to $141,000 in last year’s quarter, resulting in an operating income that fell 5.5% from $27.6 to $26 million.
 
Interest expense rose from $14.8 to $20.2 million, but was offset by a foreign currency result that went from a loss of $2.2 million to a gain of $4 million. Net income fell from $12.5 million to $1.8 million. The result for the quarter includes a total of $14.8 million in restructuring charges. For the nine months ended July 31, Quik had a net loss of $61 million compared to a loss of $15 million in the nine months the previous year.
 
Balance Sheet and Cash Flow
 
Quiksilver continued to use (rather than produce) cash in its operating activities. They used $12.5 million, down from $16.9 million in last year’s quarter. Trade receivables rose a bit from $399 to $418 million. The number of days it takes them to collect their receivables increased by 6%, “…driven by the timing of customer payments, longer credit terms granted to certain wholesale customers and the net revenue decrease…”     Inventory was also up from $391 million to $399 million, or 2%. Mostly, that’s because of the sales decline. However, inventory from prior years represented 9% of the total compared to 16% a year ago. Wonder how much of the old inventory is DC?
 
The current ratio dropped from 2.3 times to 1.7 times a year ago. Leverage increased with total liabilities to equity rising from 2.06 to 2.97. However, their debt includes $409 million that they paid off now from the $409 million in restricted cash that is part of their current assets, so be careful what conclusions you draw.  Basically, they’re refinancing their senior notes to push out the maturity and improve liquidity.
 
The Secret Sauce
 
I don’t have much doubt as to Quik’s ability to generate the cost savings it expects. It feels like there’s just too much low hanging fruit and we’re already seeing the results. And things will also improve on the cost side once they are mostly done with closing stores and with incurring restructuring expenses.
 
The question is around sales growth. I’ve been saying that those might be hard to find and I still feel that way. Quik is taking the approach of building their plan around low increases but expecting, as they note in their conference call, that they can do better.  But even if larger increases don’t happen, I think their approach will give them the ability to improve profitability. Let me quote from CEO Mooney in the conference call to explain this.
 
“We’re not really using discounting to drive the top line growth in our retail or e-comm channels.”
 
“But I think the other aspect that really caused the kind of slowdown of sell-through in North America is that the men’s product line wasn’t particularly well-segmented across the various distribution channels. And that’s one of the things that we’re very much focused on right now.”
 
“…we have just made significant progress on over the last few months is a reallocation of the marketing mix to a downshift in athlete endorsements, a downshift in events, a downshift in headcounts. So we freed up within the current percentages significantly more demand creation dollars that we believe will have some potential to drive demand at a higher rate. But even within the model that we’ve developed, the $150 million profit improvement model, we have factored in taking up demand creation from 5% as a percentage of revenue to 8%, basically stair-stepping up a percent point per year.”
 
“…the issue on the gross margin side for our company has never been one of the delta between pricing and cost. The issue has been one of — entirely of inventory management, so buying too much and then having to flush it through the clearance channel.”
 
Do you see the relationships here? Better inventory control and fewer SKU’s means lower closeout sales and makes it a lot easier not to use discounting to drive revenue growth. More thought as to distribution and better focusing marketing dollars to support that distribution strengthens the brands. Does this mean unexpectedly good sales growth? Not necessarily. In fact I’ll not be upset if it means lower sales for a couple of quarters, and it looks like that what we can expect. But the profitability of the business should improve, and I’d hope they can reduce their working capital investment and maybe, over time, debt and interest expense, further enhancing profitability.
 
We’re still left with the conundrum of being a public company that comes out of the action sports world. How and where do you grow while maintaining your brand’s strength and positioning? At some level, the two can be contradictory.