Quik’s October 31st Quarter and Full Year

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I’m going to work without my usual net of an SEC filing this time. That’s because year-end 10Ks always take a long time to come out, and I don’t want to wait that long to look at Quik’s results. I’ll review the 10K when it does show up. Right now, we’ll go with the press release and conference call transcript.

Not to be old fashioned here, but I think I’ll avoid proforma adjusted EBITDA numbers and start with the good old fashioned generally accepted accounting principles numbers. I’ll discuss some of the adjustments Quik takes into account in coming up with their presentation.

The Quarter’s Income Statement
 
Quik’s revenues for the quarter rose 10.1% to $545 million from $495 million the same quarter the previous year. Ecommerce revenues grew 69% globally, but they don’t tell us what that means in dollars.
 
The gross profit margin fell from 53.5% to 51.9% largely, as reported in the conference call, due to the cost and price increases all industry companies experienced. Selling, general and administrative expenses rose from $222 million to $248 million. As a percentage of sales, they were up from 44.9% to 45.4%. A chunk of the increase was the cost of the Quik Pro NYC, which we’ve learned today won’t be held next year.
 
The asset impairment charge for the quarter was $11.8 million, up from $8.4 million last year. These, as you probably know and which companies always like to point out to us, are noncash charges associated with changes in long term asset values. 
 
Operating income fell by 31% from $34.3 million to $23.7 million. That is earnings before, interest, taxes, foreign currency loss and discontinued operations. Let’s look at some of those items.
 
Interest expense in the quarter fell $50.6 million to $14.1 million. I think that decline is the result of Rhone converting its debt into equity and some of the restructuring and debt repayment Quik has done over the last year. This is why I really like to have the SEC filing in my hand. It would allow me to be more specific.
 
That’s a hell of a decline in interest expense. But as a shareholder you need to remember that the Rhone conversion that’s largely responsible for the decline resulted in a lot more shares being outstanding, so the value of each share declined, all other things being equal.
 
Foreign currency loss was about $5.8 million compared to $463 million in the same quarter last year. That leaves us with pretax income of $3.9 million compared to a pretax loss of $16.7 million in last year’s quarter.
 
Due to a settlement mostly with the French tax authorities that I guess goes back to the Rossignol deal and Quik’s losses on that deal, there is a one-time $64 million non-cash income tax benefit in this quarter compared to a charge of $5.2 million last year. This leaves Quik with a reported net income for the quarter of $68 million compared to a loss of $22 million in the quarter last year.
 
How do we think about this?
 
Well, every year companies have “one-time events.” So I tend to have a hard time ignoring them on the grounds that they won’t recur, because something always happens to generate a new “one-time event.” But in the case of this French tax credit, it’s so enormous and out of the ordinary we’ve got to ignore it as we consider how Quik is operating. That’s what Quik does in presenting its proforma results.
 
The Complete Year
 
For the year, sales rose 6.3% to $1.95 billion. The gross profit margin was down only very slightly from 52.6% to 52.4%. Operating income fell by 66% from $123 million to $41.5 million. Most of that decline is the result of the asset impairment charges (Non-cash!) that rose from $11.6 million last year to $86.4 million. Interest expense fell from $114 million to $74 million. The net loss for the year rose from $6.3 million to $17.9 million.
 
I should point out (I have before) that these non-cash charges reflect an expected decline in the future cash flow of the assets being written down. That may be non-cash, but it’s hardly irrelevant.
 
The Americas generated $61 million in operating income for the whole year, up 7% from $57 million the previous year. Europe’s operating income grew from $94 million to $112 million. Asia/Pacific went from an operating profit of $11.8 to a loss of $84 for the year.
 
The Quik brand, we’re told, grew 5% during the year to $806 million. Roxy was down 2% to $519 million, but it improved each quarter, growing 10% in the final quarter compared to the same quarter the previous year. One of the analysts noted that Roxy’s revenues were down around $250 million from its peak in 2008. DC was up 15% to $545 million.
 
You know what I just realized? There’s no complete balance sheet provided in the press release. Gimme my SEC filing! What they tell us in the conference call is that receivables at $397 million are 6% higher than a year ago in constant currency. Inventory of $347 million was up 26% in constant currency, with much of the increase due to the early receipt of goods. Ten to fifteen percent of the increase is the result of higher cost of goods. Prior season’s goods represent only 5% of inventory. Cash on hand was $110 million. 
 
Lacking the complete presentation we won’t see until the 10K, I’ve got no opinion on their balance sheet position.   
      
Details by Region
 
With the broad income statements discussed, let’s look at some of the quarterly detail in the documents.
 
Americas revenue was up 12.7% to $250 million for the quarter. Same store sales were up 16%.   Europe was up 11.5% to $213 million (6% in constant currency). Same store retail sales turned positive for the first time in 6 quarters in Europe. Asia/Pacific rose only 1.9% (down 7% in constant currency) to $82 million. The recession in Australia and strong Aussie dollar are making that a tough market. Japanese revenues at $25 million for the quarter are nearly back to the pre-tsunami levels.
 
The gross profit margin in the Americas fell from 48.1% to 47.1%. Europe was down from 60.2% to 57.2% and Asia/Pacific fell from 54.7% to 52.6%. As I’ve noted before, margins are a lot more attractive outside of the Americas. I wonder if the U.S. margin is much different from what’s reported for the Americas as a whole.
 
Operating income in the Americas fell 27% from $12.7 million to $9.3 million. Europe’s operating income jumped 50% from $20.9 million to $30.3 million. Asia/Pacific had an operating loss of $3 million after a profit of $8.6 million in the same quarter the previous year. 
 
Opportunities
 
The company’s goal is to get to $3 billion in revenues in five years. They think the Quiksilver Girls and Women’s business have a $100 million opportunity in the next five years. They also expect growth in ecommerce of a similar amount. In DC, especially outside of the United States, they think there’s a half billion dollar opportunity. And they see a couple of hundred million dollar of revenue from emerging markets.
 
I would have been happier if we’d gotten some more specifics about some of their initiatives in the conference call. I probably expect too much from that forum.
 
It looks to me like growth will be limited in the United States (and margins are lower). Europe generated 71% of Quik’s operating earnings excluding corporate expenses in the fourth quarter. For the year, as you can see in the numbers above, Quik wouldn’t have had any operating earnings without Europe. But Europe is poised for a recession.     
  
When we ask how Quik is doing in general, I have to go back to the operating income that declined 31% for the quarter and 66% for the year. I guess I should point out that the stock market, in its collective wisdom, doesn’t, at least with immediacy, think much of my point of view. Quik’s stock closed up 12.7% today (the day after the announcement) at $3.46 on volume that was almost three times its 90 day average. They must like that proforma, adjusted, EBITDA stuff.

 

 

Heinz’s New Ketchup; New Product Introductions and Social Media

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I came across this a few weeks ago (actually, my wife sent it to me and if I don’t give her credit, I’ll hear about it), but have been busy reading quarterly filings. Heinz, it seems, has introduced what it considers to be upmarket ketchup blended with balsamic vinegar. Read the article here. No, no, no, there’s no surfer on the label or anything really stupid yet amusing like that.

What’s interesting is that they have introduced it and made it available initially only on Facebook, where they have 825,000 followers. At $2.49 for a 10 ounce bottle, it’s $0.60 cents more expensive than their standard product.

And the question I find myself asking is whether this product would even be introduced if it wasn’t for the internet and social media.
 
Heinz, the article says, has 59% of the ketchup market and has been making the stuff since 1876 so I guess they can do anything they want. It will show up in stores in late December and be available through March as a “limited edition.” If it’s selling well, they’ll make it a regular offering. I guess it will become an “unlimited edition,” so to speak.
 
The development and packing costs are the same no matter how they introduce it.   But if there’s no social media, they have to distribute it, they have to advertise and promote it, they have to follow up with the supermarkets they tested in to see how it went, and they get no direct consumer feedback and unless they work really, really hard to get it. There’s a lot of cost there.
 
By introducing it on Facebook, they get immediate consumer feedback on the concept (though it will take some work to find out if they liked the taste), and they don’t have to distribute it immediately to markets. There’s not necessarily an advertising program. For all I know, they don’t even have to bottle the stuff until they get orders. Hopefully, when they do put it in the markets, it’s already sold well enough that there’s some demand from “committed” Heinz fans, whatever that means. If only because they charge $2.00 to ship each $2.49 bottle if you buy it online.
 
I don’t expect that Heinz’s bottom line is going to move much even if limited edition balsamic ketchup succeeds beyond their wildest dreams. (If I wanted balsamic ketchup, I’d probably just mix a bit of balsamic vinegar with my ketchup and see how it tasted, even though I’d be missing out on a limited edition). But this makes me think about the process and rationale for introducing a new product and the evolving and increasing impact of electronic interconnectedness.
 
I wonder if companies might start introducing new products because they can. With the cost of test marketing, if you want to call it that, so low and the feedback so immediate, what do they have to lose? Well, I suppose they might get laughed at if it’s a lame product. Negative opinions are transmitted just as fast or faster than positive ones on the internet. But there’s always that risk with any new product.
 
I’ve written over the years that there’s some value in products that everybody talks about even if they don’t sell that well. Maybe the internet lets new products have an advertising and promotional component that could justify the lower expense even if the product doesn’t turn out to be hit.
 
But then again, there’s a danger of introducing too many new products if it’s that easy (probably is for ketchup, toothpaste, deodorant, laundry detergent, etc.) and creating some consumer confusion.
 
You also have to wonder if your Facebook followers represent more than a small segment of your customers. I imagine they do in our Action Sports/Youth Culture market, but maybe not in ketchup, where 97% of people have it in their homes.
 
Most of you know a hell of a lot more than I do about using the internet and social media. I’m sure what Heinz is doing isn’t unusual. But I can’t help but think that there’s a danger in introducing a product just because you can and technology has made it cheaper and easier to do. No matter how cool the technology gets, it still matters that you offer value to your identified customer base. Make sure your version of limited edition balsamic ketchup does that before you fling it on the market via social media.

 

 

PacSun Makes Progress; Third Quarter Results, Store Closings, and Financing

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When I looked at PacSun’s previous quarter I wrote, “The question in my mind, which hasn’t changed much since the last time I took a look at PacSun, is whether there’s enough uniqueness so they can afford to implement it [their strategy] given the economy and the company’s financial circumstances.”

Whether or not their strategy is a good one, they were becoming too cash constrained to implement it. If you were paying attention to this post at Boardistan in late November and the associated New York Post article, you knew something was going to happen.

Now it’s happened. As part of their conference call yesterday and release of their 10Q for the quarter ended October 29th, PacSun announced a $100 million line of credit from Wells Fargo that basically replaces their old line, a five year term loan of $60 million from private equity firm Golden Gate Capital (GGC), and plans to close 190 stores by the end of January 2013. Most of the closings will come near the end of the fiscal years. That makes sense as you’d like the holiday season to help you move inventory.
 
At the end of this quarter, PacSun had 820 stores and inventory of $152 million (at cost). 190 stores are 23% of their total stores. Assuming inventory is equally distributed among all the stores, they would have to reduce their inventory by 23% or $35 million. If you’re a brand that sells to PacSun, how do you think about that? Will PacSun move it to other stores? Will they close it out? Will they try and get you to take it back? Will they sell it somewhere you’d really rather it wasn’t sold? What’s the impact on your brand going to be when a chunk of your sales to PacSun just disappear?
 
One of the analysts kind of asked about this in the conference call saying, “Could you talk about conversations you’re having at the same level with the brands and your suppliers to make sure that you’re still in the best products and getting goods timely at the best prices and getting the best products from the key vendors?”
 
CEO Schoenfeld answered, “Yes, I really feel good about relationships, both with our key brand partners and our suppliers on our proprietary products. And they’ve been critical to the progress we’ve made and recognize that we still got work to do to get ourselves back to profitability, and they continue to be very supportive of our efforts.”
 
It’s the expected conference call kind of answer, and as always the devil will be in the details of the relationship with each brand.   
I’ll bet lots of brands are thinking about this issue. Makes those who tried to reduce their dependence on PacSun over the last year or two look pretty clever.
 
Tactics
 
You know what it takes to close stores and revamp the ones you’ve got left (about 620 by the end of January 2013)? It takes money, and PacSun didn’t have enough. After the deal with GGC, they say they do. As CEO Gary Schoenfeld put it, “Securing this additional capital will enable us to fund the lease terminations previously mentioned, make selective store refresh and technology investments and supplement any further near-term operational cash flow needs.”
 
The deal gave GGC two seats on PacSun’s Board of Directors. The interest rate is 13%. 5.5% has to be paid in cash quarterly. The other 7.5% is accrues annually in arrears. That is, they increase the amount they owe and pay interest on that increase as well. PacSun also issued to GGC convertible preferred stock that can be converted into about 20% of the company’s stock at $1.75 a share. Expensive money, but they needed to do it.
 
Note that the date at which the deals with Wells Fargo and with GGC were signed was December 7th– the same date as the conference call and release of quarterly results. What clever person said, “The task expands to fill the time available?”
 
We also find out that before the quarter ended Pacsun was madly negotiating with its landlords and had negotiated buyouts of 75 leases at a cost of $13 million, short term lease extensions for 50 stores, and termination on lease expiration for 115 stores. They think they will close 80 stores during the rest of this fiscal year and 110 in the next one. They expect savings in the year that starts February 1, 2012 of $9 million before the buyout payments. Those annual savings should rise as more stores are closed and, of course, those savings are annual while the buyout payments are one time. So the return on invested capital looks pretty good.
 
The stores they are closing had average sales of $600,000 over the last 12 months and their sales were down 9% compared to the previous year. The 600 stores they expect to have left when the closing process is completed average $1.1 million in revenue and their comparative store sales were only down 1%.
 
The store closures are expected to reduce revenue by $100 million to $125 million, but improve EBITDA by $10 million to $15 million. The reduction in inventory should offer a similar improvement to the balance sheet. 
 
I assume that the landlord negotiations, GGC loan, and Wells Fargo credit negotiation didn’t each take place in a vacuum. Much like when Quiksilver got the Rhone investment, I’m guessing there were multiple party dependencies that had to come together. Must have been interesting, though that might not be the word you’d use if you were in the middle of it.
 
The Numbers
 
Over the year that ended October 29, 2011, PacSun’s balance sheet weakened some due to the ongoing losses. Over the year, the current ratio fell from 2.02 to 1.44. And total liabilities to equity rose from 0.89 to 1.5. Inventory fell 8%.
 
Even with sales down 6.2% this quarter compared to the same quarter last year, current liabilities rose 15% from $112 million to $129 million. It’s possible that’s nothing more than timing differences, but I think we can say that PacSun needed to find some additional resources so they could pursue their strategy faster. The GGC term loan won’t improve the balance sheet since it’s debt, but it will give PacSun the cash it needs to move forward. In a turnaround, cash flow is way, way more important than your balance sheet I can tell you from experience.
 
$13 million of the sales decline resulted from store closures. Another $7 million was from a 3% decrease in comparable store sales. They gained $4 million from stores not yet included in the comparable store calculation and from a 12% increase in ecommerce sales. Men’s sales were flat and women’s down about 5%.
 
The gross profit margin fell slightly from 25.0% to 24.2%. You would think there’d be a big opportunity to improve that if PacSun could get its coolness back. Selling, general and administrative expenses actually rose 6% from $71.1 million to $75.4 million. As a percentage of sales that’s up from 27.6% to 31.1%. This included $6.2 million in charges related to closing stores ($4.4 million of which was noncash).
 
The net loss rose 153% to $17.6 million from $7 million in the same quarter last year.
 
Strategy
 
I characterize the store closings, new line of credit, and term loan as tactics that allow PacSun to pursue its strategy. I don’t think that strategy has really changed since Gary Schoenfeld became CEO two years ago. As he puts it, “We still have more to do to reestablish our brand identity and emotional connection with our customers, but I believe we are on the right path to make this happen.” He continues in another part of the conference call, “So we do continue to recognize that part of our turnaround is getting people excited again about PacSun and what our brand means and strengthening that emotional connection."
 
I agree with that. I’ll bet everybody in the industry agree with it because that’s what we all try to do with our brands. We don’t have, and I wouldn’t expect, details on exactly how they are going about that. To some extent, as I’ve written, they’ve been ham strung by a lack of financial resources. Now that’s resolved, and I guess we’ll get to see if PacSun can become cool again. Remember, even the stores they are keeping have 1% negative comps and the economy is still tough and the competitive environment highly promotional, so this isn’t a slam dunk even with some cash in the bank.

 

 

Zumiez’s October 29 Quarter; Consistently Pursuing a Solid Strategy

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I know I’ve written about it before, but let’s review the pillars of Zumiez’s strategy as I see them before we get to the numbers. Here’s the link to the 10Q if you’re interested.

  • Find and retain employees who are actively committed to the action sports lifestyle and make sure they are customer service focused. I suspect this might restrain their growth sometimes, but that’s okay.
  • Have a wide selection of established and new brands, including ones that are hard to find in other places. Manage these brands, and the associated inventory, so you can be generally less promotional than competitors. Their largest vendor represented less than 7% of total sales during the quarter.
  • Grow only as fast as you can find the right mall locations and staff.
  • Be the only mall retailer that offers hard and soft goods in a specialty shop-like environment.
  • Continuously work to have systems and procedures in place that let each store carry what its customers want to buy.
 In broad brush, this hasn’t really changed since the company was founded.
 
Zumiez’s 442 stores in 38 states now include 10 in Canada. Sales for the quarter ended October 29th were up 10.3% to $154 million compared to $135.9 million in the same quarter last year. Comparable store sales were up 6% and a net of 42 new stores have been opened since the end of the quarter last year. Ecommerce sales were 6.4% of the total, or $9.9 million. In the same quarter last year they were 4.4% of the total, or $6 million.
 
It’s interesting to hear how they talked about the comparable store sales increase during the conference call. CFO Marc Stolzman said, “The comparable store sales gain was primarily driven by an increase in dollars per transaction, partially offset by a decline in comp store transactions. The increase in dollars per transaction in the quarter was primarily a result of an increase in average unit retail, partially offset by a decrease in units per transaction.”
 
To me, that speaks at least partly to the success of their brand strategy. They were able to increase comparative store sales because they got more dollars per sale even though the number of transactions fell. 
 
Gross profit margin rose from 38.7% to 39.1%. The improvement was largely the result of distribution center efficiencies (remember they opened their new distribution center in California).
 
Selling, general and administrative expenses rose 11% to $37.3 million. As a percentage of sales, they were down from 24.7% to 24.3%.
 
Net income was up 14.8% from $12.3 million to 14.1 million.
 
The balance sheet is strong, and they have no debt except for the normal kinds of current liabilities every business incurs in the normal course of business. The increase in inventory was in line with the sales growth.
 
Though they didn’t talk about it in any detail, they noted that 15% to 20% of their business was private label. Private label business is particularly compelling when you’re already a retailer because of the higher margin with no additional costs. But we’ve learned in our industry that too much private label can be a bad thing. If only it was easy to know how much was too much before you got to too much. It is, I suppose, possible that Zumiez’s strategy of having a lot of brands and turning them frequently lends itself to more private label business. I’ll watch with interest to see how much they grow it.
 
Well, that’s pretty much it. When things are going well and the strategy hasn’t changed much there’s not a whole lot to write about. Here’s hoping I get to do lots of short articles like this one because of good results from a host of industry companies.     

 

 

Orange 21’s September 30 Quarter: Sales are Up, But So Is the Loss

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This is one of the few times where it makes sense to start on the balance sheet to really understand what’s going on. It shows stockholders’ equity of a negative $4.3 million. How, you might ask, are they paying their bills? If you look under liabilities, you’ll see a “Note payable to stockholder” of $10.5 million.

That $10.5 million is owed to Costa Brava. Costa Brava “beneficially owns” approximately 50% (depends on how you calculate) of Orange 21’s common stock. The sole general partner of Costa Brava is Mr. Seth Hamot, who is the Chairman of the Board of Orange 21. To put it succinctly, if Mr. Hamot didn’t have a whole lot of money and wasn’t willing to lend a bunch of it to Orange 21, the company would have been closed or sold long ago.

It would be great fun to speculate on why this company went public in the first place, what the original plans for the public platform was, and why Mr. Hamot has been willing to commit this level of resources to the company (more to come according to the 10Q). But it would be only speculation and I guess I’ll stick to what we know. In any event, the fact that it is public has allowed us to watch it move through various management and strategic direction changes, and it’s been interesting. It continues to be interesting actually.
 
Since the end of the September 30 quarter, former CEO Carol Montgomery has resigned and been added to the board of directors. Michael Marcks is the new CEO, consultant Michael Angel has become the permanent CFO, and Greg Hagerman is the Executive VP for Sales and Operations. Meanwhile, as reported in the 10Q, the company has given up on its licensing agreements with O’Neill, Melodies by MJB, and Margaritaville and is still feeling the impact of the sale of its Italian factory (LEM). I should point out that I thought the licensing agreements were a good idea because, if successful, they’d give the company volume it needed to cover expenses it was going to incur in growing the Spy brand. I don’t know if licensing turned out to just be a bad idea or if there was some slippage in implementing the strategy.
 
Anyway, all this stuff has and is costing them a lot of money. They are refocused now on growing the Spy brand. Here’s how the company put it:
 
“We have recently decided to focus our development, marketing and sales activity on our SPY products. As part of that focus, we decided to cease any new purchase orders of additional inventory for the O’Neill , Melodies by MJB or Margaritaville eyewear brands.”
 
Reported sales for the quarter were up 11.7% to $9.2 million. If we ignore the LEM sales in the September 30 quarter last year, we see that proforma sales actually increased by $2.3 million, from $6.9 million to $9.2 million. Sales of Spy products were up $1.6 million. Closeout sales during the quarter were $900,000 and were primarily O’Neill and Melodies by MJB product. Sunglasses and goggles represented 57% and 43% of sales, respectively, during the quarter.
 
Reported gross profit fell from $3.9 million to $3.2 million. As a percentage of sales reported gross profit fell from 47.1% to 35.3%. This was largely the result of selling O’Neill and Melodies by MJB product at cost and of taking inventory reserves for Margaritaville product.
Sales and marketing expense rose almost 51% from $2.3 million to $3.4 million. $400,000 of the increase was for commission on higher sales (can’t argue with that). Another $400,000 was for staff additions and the remaining $300,000 represented additional marketing costs.
 
Total operating expenses were up 21.3%. $1.5 million of this was to terminate the Melodies by MJB deal. A million was paid in cash in July and $500,000 will be paid next March 31, but was accrued during the quarter. 
 
The loss from operations rose from $819,000 to $2.4 million. Not unexpectedly given the borrowing from Costa Brava, interest expense was up from $160,000 to $413,000. The net loss was $3 million, up from $932,000 in the same quarter the previous year.
 
Cash flow remains an issue for Orange 21 and “The Company anticipates that it will need additional capital during the next 12 months to support its planned operations, and intends both to borrow more on its existing lines of credit from Costa Brava and BFI, provided they remain available and on terms acceptable to the Company, and to, if necessary, raise additional capital through a combination of debt and/or equity financings.”
 
It’s too long to quote, but they then go on to describe the circumstances under which the existing lines of credit from Costa Brava and BFI will be adequate. Recognizing that a 10Q is a legal document that’s by definition focused on what could go wrong, I still walked away with a sense there’s a not insignificant chance that capital from another source might be required. I know you let me read SEC filings so you don’t have to, but you might use the link above to look at the first three paragraphs of page 12 of the 10Q to see what I mean.
 
Where we’d like to focus now is on the potential and growth of the Spy brand. But there are still some significant required minimum purchases from LEM in 2012 and I don’t know if we’ll see any more write downs of licensed brand inventory or not. The saga continues.

 

 

VF’s Quarterly Result; Why is it We Bother?

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We review VF’s results because they own brands we are interested in. Same reason we review Jarden’s, PPR’s and other companies. But we rarely get much information on those brands because they are part of a larger segment by which the corporations represents its business. And, in the case of VF, we get literally nothing on Reef because it’s so small that its contribution to the action sports and outdoor segment isn’t significant I guess.

This is, in part, the inevitable result of consolidation. But if we’re paying attention to these conglomerates, in spite of the lack of information on brands we’re interested in, there must be a reason.

It’s because for most brands in our industry, the focus is on youth culture or fashion or some other word as much or more than the core action sports market. That much larger target is where most of the customers are. We use terms like “consolidation” and “vertical integration” benignly, and it’s a little too easy to forget just how hard these trends make it for specialty shops, smaller companies, and brands that are strictly wholesale. I don’t say that critically of companies that are consolidating and integrating, but as a reminder to those of you who aren’t of what your competitive environment looks like.
 
Let’s get to the specifics of VF and then I’ll point you to something you might want to read.
 
Revenues for the quarter ended September 30 were $2.75 billion, up 23% from the same quarter last year. However, the acquisition of Timberland was completed during the quarter and it contributed $163.6 million, or 7%, of the increase to revenues. Direct to consumer and international grew 15% and 29% organically (excluding acquisitions) during the quarter. Including acquisitions, the numbers were 21% and 44%. A weaker U.S. dollar increased the quarter’s revenues by $56 million.
 
I guess what we’re most interested in is VF’s outdoor and action sports group that contributed, including Timberland, $1.437 million in revenue, up 37% from $1.045 billion in the prior year’s quarter. This is the segment that includes Vans and Reef, as well as The North Face and others. It’s 52% of VF’s revenues for the quarter. The next closest segment, of their six, is about half that. Profit from the action sports and outdoor segment before interest, taxes and common corporate expenses was $321 million, up from $248 million in the previous year’s quarter. That’s 65% of the quarter’s profit before the expenses I mentioned. No wonder VF likes action sports and outdoors.
 
Action sports and outdoor business in the Americas rose 21% in the quarter (13% excluding Timberland). Worldwide, The North Face and Vans grew 22% and 25% respectively. In Asia, the segment’s revenues were up 81% (50% excluding Timberland). “Direct-to-consumer revenues in this coalition [segment] rose 31% in the 2011 quarter (20% excluding Timberland), with increases of 29% and 18% in The North Face® and Vans® direct-to-consumer businesses, respectively. Direct-to-consumer revenue growth was driven by new store openings, comp store revenue growth and an expanding e-commerce business.”
 
The gross margin percentage fell from 46.5% to 45.3%. There was a “…1.8% net impact from higher product costs that were not fully offset by pricing increases. This decline was partially offset by a greater percentage of revenues coming from higher gross margin businesses, including the Outdoor & Action Sports, international, and direct-to-consumer businesses.” Not so different than a lot of other companies.
 
Having read that quote, anybody want to speculate on where VF if going to focus its attention?
 
Net income was $301 million, up from $243 million in the same quarter the previous year. Timberland contributed $8 million of the increase.
 
The balance sheet took a bit of a hit because VF borrowed money to pay for Timberland. The current ratio fell from 2.5 a year ago to 1.5. Debt to total capital was up from 20.1% to 40.1%. Short term borrowings rose from $49 million a year ago to $1.145 billion at the end of this quarter. They expect the short term borrowings to be repaid by year end. They also borrowed $900 million in longer term debt for the acquisition. $400 million matures in August of 2013. $500 million isn’t due until 2021.
 
Receivables grew 40% from $1.1 billion to $1.548 billion. But $315 million of that was the result of the Timberland acquisition. As you think about inventory levels for VF and other companies, remember that higher prices mean higher inventory even when the units don’t change. VF says 9% of its inventory growth was the result of higher prices.
 
One of the analysts in the conference call pointed out that Timberland did some of its own manufacturing, and asked if VF might see this as an opportunity to make some more of its other products as well. It’s something it sounds like they will look into, but it’s too soon after the deal closing for them to be specific was the response. 

As you have probably concluded for yourself, VF is doing just fine.  Rather than think up some clever closing paragraph, I thought I’d offer you a link to an article that Rob Valerio of business consultants CPO sent me on the expansion strategies of retail CEOs.  It doesn’t refer just to our industry, and VF is much more than a retailer.  Still, you’ll see certain continuity between the strategies retailers in general are using and what VF and others in our industry are doing.  As I said at the start of this article, independent retailers, small brands, and brands that are strictly wholesalers are being pressured by bigger, sophisticated companies.  You may not be able to do what VF does, but you can look at some of these strategies and pick a few places where you can perhaps do something new, different or better.   

 

What Will You Do When Your Greek Receivables are in Devalued Drachmas?

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There are lots of public company quarterly reports I should be writing about, but I am going to step off that track and think, for a bit, the unthinkable.

Or at least it was the unthinkable. But at this point the Eurozone seems to be moving towards two choices, either of which has huge implications for managing any international business.

Let’s review for a minute. What are the three things you can do to get rid of debt? You can pay it off. You can default (a “restructuring” is basically an agreed on default). And finally, at least if you’re a government, you can inflate it away by printing money.
 
The third approach has always been the favorite among governments, because it’s kind of sneaky and doesn’t require politicians to directly take anything away from anybody. It’s happened many times. But don’t take my word for it. Go and read This Time is Different; Eight Centuries of Financial Follies. The point, of the book, of course, is that it’s never different. It won’t be this time. I reviewed the book on my site and you can buy it here.
 
Next, let’s talk about Iceland. Iceland thought it had turned itself into a financial capital, and its banks borrowed lots and lots of money from various British and other European banks. They were, of course, heavily leveraged. So when the cash stopped flowing and they couldn’t renew any of those loans, everything went to hell in the proverbial hand basket. The British and other Europeans howled that Iceland’s government had to make good on their banks debt. Unlike the Irish government, Iceland said, “Uh, actually we don’t.” And they didn’t.
 
Their economy went south and their currency devalued dramatically. It was ugly. But with the competitive boost of a devalued currency, they’ve started growing again.
 
That’s how it’s supposed to work. But Greece, and Ireland, Italy, and Spain, can’t devalue their currencies because they are part of the Euro.
 
Next, let’s talk about the bond market. The bond market is the biggest, meanest, son of a bitch on the continent. It has decided that there’s more risk in these country’s debt, and has pushed their interest rates way up. Italy is up over 7% even with the European Central Bank buying Italian debt (increasing demand and theoretically driving the cost down). Inevitably, higher interest rates make the debt burden even higher and paying off the debt harder. Spain is around 7% as well.
 
So what is Greece, or Ireland or Italy, to do? Austerity! Fiscal Responsibility! Which might work if they could devalue their currency as it is working in Iceland. It’s painful, but it can work. But with this much debt, and no devaluation possible, austerity in the form of spending cuts and tax increases just reduces the economy’s growth, which reduces tax collections, requiring more austerity. It’s a pretty vicious cycle.
 
Here’s the bottom line. There’s too much debt to be paid off. Somebody is going to lose money. They’re just fighting over how much and who.
 
If you’re a debtor nation like the Southern Europeans, you like the inflation solution, because it effectively reduces your debt. If you’re a creditor national like Northern Europe and Germany, you aren’t so enthusiastic because you know inflation also reduces the value of assets. And the Germans, of course have an institutionalized fear of inflation from the hyperinflation of the Weimar Republic. There’s the story of the cup of coffee that cost more when you had to pay the bill then it cost when you ordered it.
 
Remember when Fed Chairman Ben Bernanke told us the subprime crisis would be contained? Then Lehman Brothers collapsed and it wasn’t. I don’t know what will happen in Europe, but it can happen just as dramatically and just as suddenly. Most people seem to think the European banks are a bigger mess than ours ever were. There are simply not two to six trillion Euros (estimates vary) available to bail everybody out (unless they just start printing those Euros) and if there were, it wouldn’t solve any of the competitive issues that lead to this mess.
 
Long term Greek government debt is priced to yield about 30% right now. I’m sure it’s obvious that they can’t pay that, or anywhere near it, and actually service their debt. Something is going to happen. I think it’s either going to be inflation, or one or more countries leaving the Eurozone and defaulting on their debt on the way.
 
In not one quarterly report or conference call I’ve read so far have I seen any discussion of the management of this possible risk. It feels like it’s too uncomfortable to consider. Maybe it’s just concern that talking about it might make it happen. Perception does matter.
 
I doubt any of our major industry players’ sales to Greece are make or break for it. Still, if you’re selling and holding receivables in Euros and have assets denominated in Euros there and Greece suddenly goes back to the Drachma, what exactly happens? Nobody knows. Well, we know the lawyers would make a lot of money.
 
I assume companies are trying to hedge their exposures (not just in Greece) but I’ll bet that’s getting really expensive. I might consider offering discounts for prepayments. I guess you could try and denominate your contracts in dollars, but that might not help. There’s no mechanism for a country to exit the Euro, so they’d be making it up as they go along.
 
I’m not projecting a breakup of the Eurozone, but the possibility of some countries leaving it is certainly higher than it used to be. Frankly, I think they’ll resort to the good old printing press. That’s what’s happened historically, and the powers that be are all issuing coordinated statements about how they will “manage” it; that is, not let inflation get out of control.
 
What am I asking you to do? As always, just to consider the possibility, it’s impact on your company, and your strategy to manage it.

 

 

Skullcandy’s Strong Quarter; It’s Amazing What an IPO Can Do for Your Balance Sheet

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My favorite footnote in Skullcandy’s 10Q for the quarter ended September 30 is footnote nine and specifically the table on long term debt (Yes, I know it’s kind of sad that I have favorite footnotes). It shows no long term debt at the quarter’s end compared to $73.4 million on December 31, 2010. They raised $77.5 million through the IPO, and you can see what they used it for. Equity is now $92 million compared to a deficit of $16 million a year ago. The current ratio improved slightly from 1.89 to 2.19. They’ve got $15 million in cash at the end of the quarter compared to $2.3 million a year ago. Their bank debt is up a bit from $11.2 million to $14.2 million. 

Sales rose 58% from $38.5 million to $60.6 million. But they said in the conference call that sales in the 3rd quarter last year were impacted by late deliveries, difficulties getting product made, and inventory shortages. They note as a result that “…our increased sales guidance implies second-half sales growth of 38%, this year, versus 29% last year.” International sales were up 75.9% to $14.6 million. They closed the acquisition of their European distributor on August 26th. Online sales were up 413% to $6.2 million. That growth includes $2.9 million of sales of Astro Gaming products which Skull acquired in May.

Skull notes that they “…rely on Target and Best Buy for a significant portion of our net sales.” Each accounted for more than 10% of sales in 2010. Best buy continues to account for more than 10% in the first three quarters of 2011. As I noted when I reviewed their initial public offering documents, the bet Skull is making is that they can be very widely distributed but still be cool and desirable to their target market.
 
The gross profit margin fell from 52% to 47.5% though gross profit rose from $20 million to $28.8 million. Like most companies, they are experiencing higher product prices in China and they rely on two manufacturers there for “substantially all” of their product line.
 
Selling, general and administrative expenses were up from $13.3 million to $20.6 million. As a percentage of sales, they declined slightly from 34.5% to 33.9%. There was an additional $1.3 million of marketing expenses during the quarter.   Interest expense to related parties was $2.77 million during the quarter. That’s gone with the IPO complete and will mean improved profitability in future quarters. Profit was $952,000 compared to a loss of $1.22 million in the same quarter last year.
 
I’ve laid out the numbers first so we could talk about Skull’s strategy and positioning a bit. Skull is the first mover in a market they identified. The brand reflects “…the collision of the music, fashion and action sports lifestyles.” They have stylized “…a previously commoditized product… The Skullcandy name and distinctive logo have rapidly become icons and contributed to our leading market position.”      
 
As you’ve probably noticed, many companies are jumping into the market Skull created. There are limited barriers to entry and, right now at least, not a lot of technological product differentiation. In those circumstances maintaining and improving its market position requires Skull to grow quickly and continue to spend freely on advertising and promotion because that’s what the product differentiation is based on. And they are.
 
But growing costs money. You need more people and more inventory and continued marketing. In the 10Q Skull notes that they “…typically receive the bulk of our orders from retailers about three weeks prior to the date the products are to be shipped and from distributors approximately six weeks prior to the date the products are to be shipped…Retailers regularly request reduced order lead-time, which puts pressure on our supply chain.”
 
It would really be interesting to know more about the order cycle so we had a better understanding of how much Skull has to build inventory with growth.
 
Skull’s management talked in the conference call about how they are addressing some of these competitive issues. They indicate they are transitioning to “…an in-house ODM model, where we originate and control more of the design and manufacturing process.” The goal is to help them create new, proprietary products. They’ve also hired a “very senior acoustics engineer” to work with the product development team. “Dual sourcing remains a key priority…” Approximately 10% of products were dual sourced at the end of the third quarter, and this is to increase over the next year.
 
Importantly, they refer to an increasing average selling price (ASP), though they don’t give any specifics. They say that was “…driven by growth in our own premium category along with mid-shift towards higher priced products across our entire line of headphones.” Domestically, their ASP was up double digits.   That’s great. When you spend a bunch of money on creating the brand, you’ve got to get higher product prices for the business model to make senses. That’s why you build a brand.
 
High end headphones feel a bit like a little luxury people can afford (and need) in a tough economy. Maybe that’s why there’s room to move up in price point. I really wish all the money from the public offering hadn’t gone right out the door to pay the investors. I’ll bet Skull could do even better things with some more working capital.                 

 

 

WeSC’s Annual Report; Numbers and Strategy

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I didn’t spot WeSC’s annual report until Shop-Eat-Surf did a story on it. Now, I’ve been through it. The Swedish approach is an interesting combination of a U.S. style annual report and our 10K SEC filings. I’ll start with a review of the numbers, but more interesting (I hope) will be a discussion of WeSC’s strategy and market position.

A Few Numbers

WeSC is a Swedish company, so their functional currency is the Krona. All numbers are in Swedish Krona unless I say otherwise. By way of reference, there were six Krona to the U.S. dollar at the end of the company’s April 30 fiscal year. A year earlier, it was 7.62.
 
WeSC’s revenues for the year ended April 30 were 408 million. At the end of fiscal year exchange rate, that’s about US$68 million, up 11.2% from 367 million the previous year. In constant currency, it grew by 20%. Gross profit margin was 45.9% down from 46.9% the previous year.
 
Pretax profit fell 28% from 56 million to 41 million. Net profit was down 40% from 48.8 million to 29.4 million. I should note that the income tax rate jumped from 13.1% to 27.7% and that pushed net income down more than you would have expected. Earnings per share fell from 6.6 to 3.98 Krona. The lower tax rate last year was due to booking a tax loss carry forward.   It was a one-time event (hopefully). 28% is a normal tax rate.
 
WeSC explains that “For the full-year 2010/2011 the dollar was an average of approximately 4.2 percent lower than in 2009/2010,” and “…the euro was an average of approximately 10.5 percent lower than in 2009/2010.”
 
“The lower dollar and euro exchange rates against the Swedish krona have had a positive effect on gross profit in the form of lower production expenses. At the same time the lower dollar and euro exchange rates against the Swedish krona have reduced revenue, because of which the total effect on gross profit was negative (the majority of purchases are in US dollar and the majority of sales are in euro).”
 
WeSC also notes that higher cotton and shipping prices had a negative impact, though they passed on some part of those increased costs as higher prices. 
 
WeSC’s lament about higher costs and exchange rates sounded an awfully lot like Billabong’s. At least WeSC didn’t have droughts and floods to worry about in their home market and isn’t as dependent there on owned retail as Billabong is. 
 
Only 18% of the company’s revenues are in the U.S. In U.S. dollars, it’s about $12.1 million at the April 30 exchange rate. Its next largest markets by revenue are Sweden, Germany, France and Italy with 16%, 10%, 9% and 9% of revenues respectively. The company reported it was in 2,410 retailers in 21 countries. 626 of those are in the U.S. The next largest is Italy with 320.
 
One of the things we’ve noticed in reviewing other company’s results is that they are focusing on growth outside of the U.S. due to better margins and growth opportunities. WeSC seems well positioned to take that approach as well. They’ve just started their program to enter China. U.S. sales for the April 30 year generated an operating loss of 2 million Krona.
 
57% of revenues come from distributors. 35% is through wholesale with the remaining 8% from direct retail sales. Like many other companies, WeSC is bringing its distribution in house as it grows. In the last fiscal year, it acquired its Danish distributor. Previously it had done the same in Germany and Austria. As of April 30, WeSC had 28 retail stores it calls concept stores. It owns eight of them directly. They plan to open more (don’t say how many) and I’m wondering how many you open before you’re seriously in the retail business and not just doing concept stores any more.
 
On the balance sheet, I noticed that inventory fell over the year from 28 million to 24.5 million. That’s interesting with the increase in sales and the acquisition of one distributor, which normally causes inventory to increase. I imagine some of it has to do with the strengthening of the Krona, which would reduce the cost of product bought in other currencies when translated back into Krona. It probably also reflects the brand exclusivity the company wants and an effort to make the distributors keep the inventory.
 
Accounts receivable rose 46% from 71.4 million to 104 million. Some or that would occur naturally with sales growth, but the strengthening of the Krona would reduce the value of receivables in other currencies, so I’m unclear as to the reason for the increase. WeSC notes the company has 57 million in overdue receivables (compared to 28 million at the end of the prior year). They have those “…without impairment losses being considered necessary.” Of this 56 million, 7.8 million is more than 91 days overdue and another 7.4 million is 61 to 90 days overdue.
 
The company’s “provisions for impaired accounts receivable at year-end” has fallen from 3.3 million to 2.6 million even as total receivables and total overdue receivables have grown significantly. I’ve seen language like this before (I think in Billabong’s financials) and it just doesn’t make sense to me that you can have a lower provision with that kind of increase in receivables. You can’t conclude that there is not an increased receivables risk, even if you assume you aren’t going to have to collect your Greek receivables in Drachmas.
 
The footnote goes on to explain that the company has 14 customers who owe the company more than a million Krona and together make up 80% of receivables. Five of those owe WeSC more than five million Krona each and account for 56% of receivable. I imagine some of those are independent distributors.
 
WeSC has no long term debt. Current liabilities rose from 52.9 million to 68.5 million as a result of a 22.3 million liabilities to credit institutions. This represents money they’ve borrowed that’s secured by receivables. The current ratio has fallen from 3.1 to 2.4, but is still more than adequate. Total debt to equity is 0.57, up from .40 a year at the end of the previous fiscal year.
 
Strategy and Some Interesting Comparisons
 
WeSC talks about its strategy as being more penetration of existing markets, entering new markets, launching new product groups, and opening more retail stores. That, of course, is more or less the same strategy that a whole bunch of other brands have. Why might WeSC succeed at it?
 
In a word, “street fashion.” It now seems like an obvious thing, but it was some time before 2000 when CEO Greger Hagelin thought of it. Or at least I think he thought of it. Reminds me of Skullcandy’s Rick Alden wandering around one day some years ago and thinking, “cool, stylish, earphones for the exploding portable electronics market.” Both seem obvious now, and I’m sure I’m not the only one who’s said, “Why didn’t I think of that?”
 
If you’re a street brand or an action sports brand, it’s hard to become a fashion brand. Ask Burton. Ask Volcom who, in my opinion, sold to PPR at least partly because they so solidly owned their own market niche that they couldn’t break out of it and continue growing without help from a fashion player.
 
But if you’re starting from scratch, selling “…streetwear with style, a cross between traditional streetwear and contemporary fashion…,” maybe you can have a foot in both markets. “Because of WeSC’s unique identify, other brands carried by retailers are seen more as complements than direct competitors.”
 
That might be a bit arrogant. But if it’s true, it’s pretty damned powerful.
 
The result, CEO Hagelin says, is that “We are one of the few brands that can sell our products in everything from action sports stores to fashion boutiques, to some of the world’s best department stores…” And they are able to “…broaden our distribution with watering down the brand…,” he goes on to say.
 
Street fashion does fit in a lot of places, and allows for product extensions, because of the brand’s positioning, that an action sports or street wear brand would have a hard time accomplishing. WeSC’s foray into high end headphones and luxury sneakers are two examples of such extensions. The company tries not to compete on price.
 
But I have to note that public companies pressured to grow seem to have an almost innate ability to screw up distribution eventually. It’s uncanny.
 
CEO Hagelin’s letter to shareholders also notes that, “The basis for our success, as well as our biggest challenge, is to continue to enlist skilled employees and outstanding WeActivists, who will help us strengthen and spread our brand and corporate culture.”
WeActivists are “…informal brand ambassadors.” They “… are strong-minded, successful individuals who are dedicated to their professions and to WeSC. WeActivists range from artists skaters and snowboarders to photographers, musicians, DJ’s and others who are extremely good at what they do, whether famous or totally unknown. WeActivists share a “street mentality,” and each one serves as an individual ambassador for their subculture.”
 
That sounds a lot like what Skullcandy does with its own extensive group of informal brand ambassadors. The focus on employees who can spread the brand and strengthen the culture sounds like Zumiez’s outstanding employee development program. There is no reason to reinvent the wheel.
 
The one thing I didn’t see in the annual report was a discussion of the competition. I hope that’s just an oversight. I’m intrigued as I think about who their competitors are, and I can’t really name them. Obviously, it’s not that they don’t have any. But if my observation that there are some barriers to being either street or fashion and moving into street fashion is accurate, then maybe WeSC has a head start.
 
But first movers, if that’s what WeSC is, aren’t always the ones who ultimately succeed in a market. It might be that WeSC is just now getting big enough to be noticed by the big fashion players, and that could force the company to pay more attention to competition. I have no knowledge of this, but perhaps the company’s longer term strategy is to get purchased by one of the very large players. I can imagine that WeSC’s positioning might attract some big multiples if those potential buyers consider it valid.   

 

 

Jarden’s September 30 Quarter And the K2 Rolling Stones’ Limited Edition Ski Collection

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As you know, Jarden is a big, multi brand company that did $6 billion in its last complete year. They’ve got over 100 brands including Crock Pot, First Alert, Coleman, and Mr. Coffee. They also own K2, Ride, 5150, Planet Earth, and Volkl and that’s pretty much why we are interested in the company, though I think I’ve got a toaster oven one of their brands made.

The brands we care about are part of their Outdoor Solutions segment that did $707 million during the quarter (the whole company did $1.8 billion) and aren’t broken out from the rest of the brands in that segment. So we’re reduced to scouring footnotes and the conference call to see if we can find anything interesting.

Here’s the link to the 10Q. I’m not going to do my standard analysis of the income statement and balance sheet because the company’s pretty solid and I can’t really pull out any specifics that are relevant to action sports and youth culture.
 
Hiding in plain sight is the fact that Jarden is another big corporation that’s in our space and has been for some years now. Guess we should be used to it. That size and the extent of their operations gives them a perspective on the on the economy and business conditions that can highlights some things we are also thinking about.
 
One of those is China. Jarden management noted in the conference call that they expect Chinese wages and benefits will “…continue to rise by 15% to 20% annually as the Chinese economy becomes more consumer oriented and that the long-term trend in shipping and transportation costs will continue upwards.” As a result, they are bringing certain products back to the U.S. for manufacture. Time Magazine wrote about it as an example of an expanding trend. No snowboards or skis yet, according to the article.
 
A second is their focus on “achieving greater efficiencies from working capital.” That’s the stuff we’ve all been working on since the economy got tough; controlling inventories, being careful with credit, watching expenses. You know- all the operating stuff you do to try and bring a few more bucks to the bottom line when sales growth is a bit harder to come by.
 
With regards to the winter sports business, we did get a few pieces of information. They note that K2, Volkl and Marker have had strong early orders, especially in Europe. They think retailers are trying to replenish record low inventory positions.
 
There’s also a note about there being a Seattle K2 concept store that’s open on a seasonal basis. I haven’t seen it, but will have to track it down. Jarden has Rawlings and Coleman outlet stores. They say they are interested in doing more retail, but don’t offer any specifics.
 
I also found out that Jarden has an investment in Rossignol (size not specified) though they aren’t involved in running it.
 
Finally there are, in fact, going to be Rolling Stone limited edition skis from K2. I really don’t know whether or not I like this idea. I’d love to talk to the marketing guys about their rationale. I was relieved to see that it’s apparently not on any snowboards. Maybe it was the threat of putting Rolling Stones graphics on Ride that made Robert Marcovitch leave town.
 
As you know, Robert was the CEO of Ride and stayed with the company when it was acquired by K2 and when K2 was acquired by Jarden. He was running (very successfully I heard) the entire Jarden winter sports business until a bit more than two months ago, when he was promoted to CEO of Coleman and sent to their headquarter in Wichita, Kansas from Seattle.
 
Now the plot thickens. We learn in the conference call that, “…Robert and his senior team have been looking at Coleman on a global basis, looking at where our customers are, and how we need to be able to respond to a growing global presence…”
 
Out of this review came a decision for Coleman to put a facility in Denver“…that puts us closer to an international airport, puts us closer to people to work in the outdoor industries in our core consumer group and we think it’s a move that is going to kind of reinvigorate Coleman and put us on its next leg of growth over the next 10 years.”
 
Nice work Robert!! I don’t actually know any of this, but it just feels like he took the job, got to Wichita, and decided he needed to be back near the mountains. I’d love to see the Power Point he used to convince senior management.
 
On a serious note, I suspect that part of his new job is to get Coleman out of Wichita figuratively as well as, I guess, literally. This is a well-known brand that I think of as reliable, workmanlike, and venerable. In some ways it feels like a utility; it always works and it’s always there when you need it, but it’s definitely not cool. Robert has the background to make it cool and expand its market reach and I’ll bet that’s part of the plan. I think there’s a lot of potential there.
 
Should be fun to watch.