PacSun’s Annual Report: Missions, Strategies, Prospects

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PacSun rode the economic expansion to 950 plus mostly mall based stores (they were down to 852 at the end of the year). They got over extended, had systems that didn’t give them the ability to merchandise as they needed to, didn’t keep their stores updated, became too dependent on their own brands, and basically lost the cool factor that made their target customers come to their stores. Then came the recession and cratering of the juniors market (38% of their revenues in 2010).

Since becoming CEO, Gary Schoenfeld has started to make the changes required to address these issues. But as I said when I wrote about them last December, change takes time. And money. In a word, what PacSun has to do is make itself relevant again to the “teens and young adults” it’s focused on. While they’ve got the time and money to do it.

Before the analysis, here’s the link to their 10K if you want to see it.

Missions and Strategies
 
PacSun’s objective “…is to provide our customers with a compelling merchandise assortment and great shopping experience that together highlight a great mix of heritage brands, proprietary brands and emerging brands that speak to the action sports, fashion and music influences of the California lifestyle.”
 
Their first strategy is to have a strong emphasis on brands. They divide those brands into three components; the industry brands they’ve worked with for a long time (heritage brands they call them), their proprietary brands, and new, emerging brands. But their proprietary brands were 46% of revenue in 2010. That’s down from 48% the prior year, but way up from 38% the year before that.
 
Retailers should have their own brands. But at some level of revenue, those brands are no longer complimentary, but competitive with the industry brands the retailer carries. At 46%, PacSun is focused on the performance of their own brands. Yet those owned brands obviously can’t compete with Quiksilver or Volcom from a market position point of view, so it becomes at least partly a price game. And at 46% of revenue, well, what kind of store are you? Are you a store where customers come to get good deals on less well known brands? PacSun warns in its risk factors that “Our customers may not prefer our proprietary brand merchandise which may negatively impact our profitability.” Probably wouldn’t need that risk factor if their brands were 15% of revenue instead of 46%.
 
I recognize that PacSun can’t change this dependency quickly if only because of cash flow implications, but I hope they work to reduce it. I think it might be difficult for them to become important again to their target consumers if they don’t unless they have a whole lot of money to spend on promoting their own brands. Then, of course, they would become direct competitors with their heritage brands.
 
Their next strategy is to undertake “New Strategic Marketing Initiatives.” We’ve seen some positive activities from them in this area. They also note that they are working with key heritage brands to “…create new programs and approaches to generate excitement around PacSun and the California lifestyle we embody…” But they plan to do it “without meaningfully increasing our total marketing expenses.” Advertising expense was $17 million in 2010, $14 million in 2009, and $16 million in 2008.
 
Related to marketing, they have a risk factor that focuses on the danger of not reinvesting in existing stores. They say, in part, “We believe that store design is an important element in the customer shopping experience. Many of our stores have been in operation for many years and have not been updated or renovated since opening. Some of our competitors are in the process of updating, or have updated, their store designs, which may make our stores appear less attractive in comparison. Due to the current economic environment and store performance, we have significantly scaled back our store refresh program.”
 
What I’m hearing is that they know what they need to do, but have some constraints in terms of what they can afford. More on that when we get into the financials.
 
Their third strategy is localized assortment planning. They are moving away from the “one size fits all” method of allocating inventory and starting to do it according to what sells best where. Good idea. I’m not sure it rises to the level of a strategy, however. It’s just something retailers have to do to be competitive. Let’s call it an operating imperative.
 
While they don’t call it a strategy, they’ve closed 44, 40 and 38 stores respectively in each of the last three years. They expect to close 30 to 50 during 2011. They have close to 400 leases that end or can be modified through 2013, so I expect we’ll continue to see either store closing or better results from stores where negotiations with landlords are successful. They note that they will be closing more stores than they open.
 
The Financials
 
In the fourth quarter, PacSun lost $35.2 million on sales of $263 million. For the year ended January 29, 2011, sales fell 9.5% from $1.027 billion to $930 million. The loss increased from $70.3 million to $96.6 million.
 
Sales per square foot for the year fell from $275 to $258. In 2007, it was $350. Well, we’ve all taken some hits since 2007. Internet sales represented 5% of sales in both 2010 and 2009. That mean internet sales fell for PacSun. Average dollar sales per store were $1 million, down from $1.1 million the previous year and $1.3 million the year before that. Comparable store sales fell 8%. Men’s increased 2% but women’s was down 19%.
   
Management says that a big factor in the sales per square foot decline was the performance of denim. It was 22% of revenues in 2009 “…driven by our proprietary Bullhead denim and our foundational ‘skinny’ fit.” In 2010, PacSun’s denim sales fell by 20% because “….denim became a very price-competitive business with very little newness or uniqueness in the marketplace in terms of fit or trend.”
Everybody had a hard time with denim in 2010. But what I think I’m hearing is that their Bullhead proprietary brand didn’t have the brand positioning it needed to withstand the difficult competitive conditions. Uh, you might go back up and read what I wrote about proprietary brands above. Maybe I’m onto something?
 
The other factor in the sales per square foot decline PacSun mentions is accessories and footwear. It represented 30% of sales in 2007, but only 12% in 2009. Remember they got out of the shoe business? They have reentered it and now have shoes in 450 stores.
Gross margin fell from 25.2% to 22.1%. Please note that gross margin as PacSun defines it is after buying, distribution and occupancy cost. They indicate that 1.6% of that decline came from having to spread costs over a smaller sales base. 1.4% came from the merchandise margins (what many of you think of as gross margin) falling from 48.1% to 46.7% “…due to a decrease in initial markups and an increase in markdowns…”
 
Selling, general and administrative expenses were down $40 million to $301 million. They also fell as a percentage of sales.
Okay, now let’s take a look at the balance sheet and its change over the year. The current ratio fell from 2.42 to 2.11. Cash declined from $93 million to $64 million. Interestingly, inventory rose from $89.7 million to $95.7 million at a time when sales are down and stores are being closed. I would not have expected to see that. Total debt to equity rose from 0.56 to 0.87. Equity is down by about one-third from $307 million to $214 million.
 
In August, PacSun did a couple of mortgage transactions, borrowing a total of $29.8 million. They note in the Management Discussion (as well as in the risk factors), “If we were to experience a same-store sales decline similar to what occurred in fiscal 2010, combined with further gross margin erosion, we may have to access most, if not all, of our credit facility and potentially require other sources of financing to fund our operations, which might not be available.”
 
Since Gary Schoenfeld became CEO, PacSun has done most things right. In my mind, there are two major issues. First is whether the financial constraints they appear to be operating under will allow them to finish the turnaround without additional capital. Second, and actually more important, is whether they can get the customer they want back. The company’s decline and then some time spent treading water has given PacSun’s target customers an awfully long time and good reasons to shop elsewhere. It might take as long to get them to come back.               

 

 

The Lesson to be Learned from SIA’s Sales Report

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SIA recently reported that the snow sports market in February exceeded $3 billion. You probably get the same emails I get, but if not, you can see the announcement and analysis here. SIA expects the industry to set a record by the time the season ends. Through February, sales are up 13% in dollars and 8% in units. In February unit sales were down 2% and dollars sales 1.5% compared to February last year. But gross margins rose 8%.

With the usual cautionary note that we always do well when the snow gods favor us, let’s look briefly at the opportunities these results present us with.

I’m thrilled to see February sales down and margins up 8%. That happened because inventories were tight. For the whole season, sales are up more than units, also reflecting rising margins.
 
If dollar sales fell 1.5% in February but margins were up 8%, how did you do? I’d say you had more gross margin dollars than if sales had been a bit higher but margins lower. Those gross margin dollars, I may have argued a time or two, are what you use to pay your bills. But wait! There’s more!
 
You have less working capital tied up in inventory. You could have spent less money on advertising and promotion. Your customer is learning not to wait for a deal. Tons of closeout product isn’t showing up in places we really don’t want it (unless you’re one of those close out people, in which case you may not be too happy). There’s not a pile of left over product in your warehouse waiting to be cleared out before the start of the season next year.
 
Won’t it be fun when customers start coming in looking for cheap stuff and you can tell them that not only isn’t there any, but if they don’t get what they want now, they may not get it? You’ve already improved your gross margin by next year just by not having a bunch of inventory left and we’ve collectively improved our brands’ images.
 
As an industry, we go to conferences, hold trade shows, create learn to ski/ride programs, run all sorts of programs, do studies advertise and promote, and spend overall millions of dollars trying to get people to try riding/skiing and stick with it.
But I’d hypothesize that we could forgo a bunch of that if we just didn’t get so damned greedy and continued to control our inventories. Oh, and we- you, that is- could make more money with less risk.
 
Now, I’m the guy who’s always said every business is going to (and should) make the decisions that they perceive to be in their own best interest. That’s true. But it looks to me right now that what’s good for your business is probably good for the industry in at least this one instance. Everybody left standing in the ski/board industry has figured out, finally, that there’s no way to make money in winter sports if you’ve got a pile of left over inventory. And also you won’t be able to pay your bills.
 
I know we’re left with the not so simple issue of trying to match production and purchases with how much it’s going to snow and where. And I know that somebody, somewhere (probably more than one) is going to see the inventory shortage as an opportunity and crank up their factory and/or purchasing. But if most of us perceive that it’s in our interest to buy and sell a little less at higher margins, we can sleep better over the summer, have stronger balance sheets, make more money with less investment and help get more people on the mountain.
 
At least think about that before you say, “Shit, I could have sold more last year” and up your orders.                           

 

 

A Perspective on Zumiez Accounting Treatments as Reported by Forbes

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An article in Forbes called “Great Speculations” had the subtitle “Accounting Smells a Little Fishy Down at the Zumiez Surf Shop.” It calls into question Zumiez’s reported earnings and balance sheet strength due to a couple of their accounting practices. Boardistan called our attention to it and concluded, “Apparently, Zumiez is shifting over to the “whatever it takes” program.” I had a couple of people email it to me, though nobody expressed an opinion. Maybe they thought I’d jump on Zumiez or something or were just pointing out to me that I hadn’t covered either of the issues mentioned by Forbes in my recent analysis. We didn’t hear anything about this in either Transworld Business or Shop- Eat-Surf.

Forbes analysis and explanation was fine as far as it went, though I’d have trouble reaching the same conclusion they reached. I thought it might be useful if I looked in a bit more detail at the two issues they raise. My goal is not just to give you some perspective on the accounting issues, but to show you that the issues are not quite as clear cut as Forbes explained them and to make you leery of short, pithy, articles you read in the popular media. Hopefully, nobody thinks my stuff is pithy. Well, maybe from time to time I’m a little pithy.

I’m going to assume you clicked on the link above and read the article. Let’s start with a little perspective on accounting.
 
Over many, many years, many people have struggled to figure out what the “right” accounting procedure for certain transactions is. It’s typically obvious what’s just not acceptable. It’s sometimes not so easy to choose from a number of reasonable approaches. Eventually a consensus is reached by the accounting powers that be and they choose a way to do it. The goals are consistency, comparability, and accuracy. Reasonable people can reasonable believe that different approaches are correct.  If you think of accounting as being exact, get over it.
 
The first thing the Forbes article points out is that Zumiez increased the useful life of its leasehold improvements. That’s the cost of the stuff you do to stores after you lease the space to make them ready to open or to improve how they look. When you increase useful life, you decrease the annual depreciation and so have less reported expense. So your income goes up. Zumiez changed its useful life from the lesser of 7 years or the term of the least to the lesser of 10 years or the term of the lease.
 
“For the fiscal year ended January 29, 2011, the effect of this change in estimate was to reduce depreciation expense by $4.2 million, increase net income by $2.7 million and increase basic and diluted earnings per share by $0.09,” Zumiez states.
 
Forbes notes that “…ZUMZ is the only retail com­pany, and 1 of only 9 in the 3000+ com­pa­nies we cover, to increase the esti­mated use­ful life of any of its assets accord­ing to all 10-Ks filed since Jan­u­ary 2010.” There’s a kind of “Aha! We caught you!” sense to the article. But what we don’t know, either from the article or from Zumiez’s 10K is why this is, or is not, a reasonable thing to do.
 
The other thing that the Forbes article points to is that Zumiez “…car­ries over $310 million (nearly 50% of its mar­ket cap and over 120% of reported net assets) in off-balance sheet debt.” It’s all in footnote 9 in Zumiez 10K; Commitments and Contingencies. The number I see is actually $347 million which is more than Forbes reported. The number for Pacsun, by comparison, is $506 million (they have a lot more stores) and is disclosed in a similar footnote. And you’d find the same thing for other larger, multi-store retailers. In this case, then, we have good comparability.
 
Should that amount be on the balance sheet? Maybe. The Financial Accounting Standards Board came out with FAS 13 in 1976 to tell companies how to account for leases. It’s been amended quite a few times since then. A link in the Forbes article describes how they are considering requiring that these leases be included on the balance sheet as a liability starting in 2012. 
 
I should make it clear that the idea of a public company managing (some would say manipulating) their earnings to put their best foot forward is hardly new. There are lots and lots of ways to do that. You change your reserve for bad debts. You can decide to ship and invoice on the last day of the quarter or early in the new quarter to determine what quarter the sales go in. The list goes on. Did Zumiez do something wrong? All we can say, taking the Forbes article at face value, is that increasing the useful life of leasehold improvements is unusual. Is it justified? We don’t know. Does it meet generally accepted accounted principles? Yes.
 
Not including the lease liabilities on the balance sheet is normal practice. Is it the “best” way to do it?   Damned if I know. Let’s leave that to the Financial Accounting Standards Board.
 
And if they do change (again) the way leases are accounted for, it will be hard to compare the first year they do that with the previous year’s results. We’ll probably need a footnote to take care of that.  It will be hidden in the back of the report, and you’ll have to go find it and read it. And then there will be some other change, and some other accounting issue will rear its early head. But we still won’t know the “right” way to do the accounting.”
 
The moral of the story is that there’s a certain inevitable amount of complexity and ambiguity when it comes to evaluating the “quality” of a company’s earnings. We can and will move towards doing it better, but we’ll never get to end of that road. Evaluating a company’s financial statements and their reasonableness probably means you have to get a little dirty back in the footnotes to get a clear perspective. You shouldn’t rely on what Forbes says. Or on what I say for that matter.
 
But don’t get too dirty. Knowing that Zumiez increased their earnings per share by $0.09 for the year by increasing the useful life of its leasehold improvements doesn’t, by itself, change my evaluation of their market position and strategy. But I’m glad that Forbes highlighted the issues for us to think about.

 

 

Zumiez’s Quarter and Full Year Results: It’s All About the Strategy and the Economy

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Can a quality strategy consistently pursued over many years and offering a meaningful competitive advantage overcome the impact of cost increases, a weak economy and still cautious consumers? That pretty much sums up Zumiez’s 10K and conference call. The cost increases and weak economy are, of course, issues for all companies.

If you’ve never done it, it’s worth clicking through on the link above and reading the first four or five pages of the 10K that describes Zumiez strategy and market position. Here’s my summary of how they say they operate. On the off chance you don’t know, they’ve got 400 stores in 37 states that average 2,900 square feet; mostly in malls.

1.       They try to make their stores look and feel like specialty shops, with an “organized chaos” that they think reflects their customer’s lifestyle.
2.       They do everything they can to make sure their employees are committed to action sports and the action sports lifestyle.
3.       They know who their customers are; ages 12 to 24 and interested in brands associated with action sports. 
4.       They promote from within. Their regional and divisional managers all started out in working in stores.
5.       They treat Zumiez as an action sports brand- not just a retailer- to build credibility with its customers
6.       There are very clear measurements of employee success, but store managers have a lot of discretion. I doubt there’s anybody who works there who doesn’t know where they stand.
7.       They have quality information systems that let them know what’s selling, what isn’t, and where. They use the systems to localize inventory (some brands may be in as few as ten stores) and measure product sell through and profitability.
8.       They rely on their employees to keep them up to date on trends and fashions, and don’t hesitate to turn over brands in response to what they learn. In fact, they see that turnover as part of the reason for their success. Over the last two years “…we have had over 50% turnover in our top 10 brands and our top 20 brands. Again, we view that as a very good thing…”   No single brand (including private label) accounted for more than 6.5% of sales in 2010. Merchandise is generally shipped to each store five times a week.
9.       They have serious employee training and reward programs.
10.   They offer career paths that reduce turnover and the associated expense.
11.   They recognize that there are some limits on their growth imposed by the requirement for trained and quality store employees. I think that’s why they weren’t really serious about buying West 49.
12.   They do private label (18% of revenues in 2010, up from 17.5% the previous year), but are cautious that it doesn’t damage customer perceptions of Zumiez.
13.   They are pretty much the only store in the mall that does skate and snow hard goods in a serious way.
14.   They are rigorous and disciplined in pursuing their business model.
 
Remember, the points above are what Zumiez says they do and what works for them. It’s (mostly) not my opinion. But they’ve been at it for 32 years, and it seems to be working so far. Those of you who have read some of my earlier articles know I believe in many of the things they do- for any retailer. I’ll bet Zumiez’s management could tell us all about gross margin return on inventory investment.
 
I’ve been asking recently just what is action sports and the action sports market. Zumiez doesn’t have a direct answer, but the list of whom they consider to be competitors is instructive. 
 
“…we currently compete with other teenage-focused retailers such as Abercrombie & Fitch, Aeropostale, American Apparel, American Eagle Outfitters, Boathouse, CCS, Forever 21, Hollister, Hot Topic, Old Navy, Pacific Sunwear of California, The Buckle, The Wet Seal, Tillys, Urban Outfitters and West 49. In addition, in the softgoods markets we compete with independent specialty shops, department stores and direct marketers that sell similar lines of merchandise and target customers through catalogs and ecommerce. In the hardgoods markets, which includes skateboards, snowboards, bindings, components and other equipment, we compete directly or indirectly with the following categories of companies: other specialty retailers that compete with us across a significant portion of our merchandising categories, such as local snowboard and skate shops; large-format sporting goods stores and chains, such as Big 5 Sporting Goods Corporation, Dick’s Sporting Goods, Sport Chalet and The Sports Authority and ecommerce retailers.”
 
So Zumiez pretty much sees themselves as competing with everybody who sells any of their products to their target customers. Their definition of who’s in the action sports market is pretty broad. But they don’t focus on what those competitors are doing- they’d be overwhelmed just trying to keep track. They focus on executing their plan and nurturing their advantages. Good for them. It is interesting that they don’t mention that certain of the brands they carry are increasingly direct retail competitors. Wonder when that will show up in the Risk Factors section.   
 
By the Numbers
 
Discussing strategy is always fun, but eventually there’s just no way to avoid reviewing the numbers. The balance sheet is strong, with plenty of cash, strong ratios, and no long term or bank debt. Let’s see, what about their balance sheet might be interesting? Well, they’ve got $3.3 million in unredeemed gift cards on their balance sheet as of January 29. No big deal. I’m just intrigued by the gift card phenomena.
 
Boy, I really miss companies with screwed up balance sheets. They are so much more fun to analyze. I guess they mostly didn’t make it through the recession.
 
Zumiez’s fiscal year and quarter ended January 29th. Fourth quarter sales rose 18.2% to $156 million compared to $132 million in the same quarter the previous year. Comparable store sales were up 13%. The gross profit margin rose from 36.3% to 39.0%. I should remind you that Zumiez includes some expenses in its cost of goods sold calculations that some others don’t include, so it’s hard to make a direct comparison.
 
Net income for the quarter was $15 million or 9.6% of sales compared with $8.8 million, or 6.6% of sales in the same quarter last year.
 
For the year ended January 31, 2011, sales grew 17.5% from $408 million to $479 million “…primarily driven by an increase in transactions.” That’s as opposed to an increase in transaction size I assume. Men’s Apparel accounted for 32.5% of sales. Juniors was 10.1% and Accessories and Other, 57.4%. That last category includes hardgoods and footwear. They estimate in the conference call that 85% is sold to male. Sales for the January 31, 2009 year were also $408 million. Shows the impact of the recession.
 
Gross profit margin rose from 33.1% to 35.6%. The increase was due to an increase in product margin and a reduction in occupancy costs offset by some costs associated with moving to their new distribution facility.
 
Selling, general and administrative expenses were up 9% for the year to $133 million. As a percent of sales, they fell from 30% to 27.8%. Advertising expenses (which are net of sponsorships and vendor reimbursements) were $1.3 million for the year. I’m surprised it isn’t higher than that given their focus on Zumiez as a brand. Operating income tripled to $37 million, as did their income tax provision. Net income rose from $9.1 million to $24.2 million.
 
They opened a net of 23 stores during the year, and comparable store sales rose 11.9% after falling 10% the prior year. Rising 11.9% after falling 10% does not mean they got back to where they were plus 1.9% due to how percentages work. Here’s a simple example:
 
If you start at 100 and fall 10%, you’re at 90. If you rise 11.9% from 90, you get to 100.71- not 101.9. It’s all about the base you start the calculation from. You should think about that whenever you work with percentage changes.
 
Net sales per square foot rose from $367 to $396. But their high was for the year ended Feb. 3, 2007 when they were $499. In the next two years, they fell to $488 and $424.  Net sales per store were $1.2 million. The “gross cost” of new stores has fallen from $440,000 to $350,000 largely, I think, because of better leasing deals. They don’t discuss the reasons.
   
For fiscal year 2011, Zumiez is ‘cautiously optimistic.” They expect to open 44 new stores (including up to 10 in Canada) but are concerned about “…increases in production costs that may have an impact on our ability to maintain product margins.” Aren’t we all. Number 1 in Zumiez’s list of risk factors is “Significant fluctuations and volatility in the price of cotton, foreign labor costs and other raw materials used in the production of our merchandise may have a material adverse effect on our business, results of operations and financial conditions.”
 
They believe that these costs pressure are here to stay for a while (so do I) but that they “…are in a good position to deal with the increase in input costs, given a lot of what we sell is unique and hard to find elsewhere in the mall.” They also note that approximately half of the products they sell contain no cotton. I don’t think that means there will be no cost pressures on those products, but certainly they should be less.
 
Screw this “cost pressure” phrase everybody is using. Can’t we just say “inflation?”
 
Conference calls always frustrate me. The analysts never ask the questions I want to ask. I’d love to know more about how Zumiez evaluate employees and the kind of feedback those employees get. I wonder how brands that Zumiez buys from becoming retailers impacts Zumiez’s purchasing decisions. I’d like to have a long talk with Zumiez management about what it means for them to be a brand, as opposed to just stores full of brands, and where they might take that.
 
Anyway, even without answers to those questions, it’s always nice when the conclusion you end up write matches the title you started out with. Zumiez is well positioned in their chosen market; as well as any retailer. My sense is that the operate better than most companies in their space (though of course you never read SEC filings or conference calls expecting them to tell you how they really, really, screwed up and what’s not working). Their challenge (every company’s challenge) will be the economy and inflation and if they are, as they claim, better positioned than others to manage it, they aren’t invulnerable.      

 

 

Skechers- Some Insights from Their 10K Annual Report

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Look, I know Skechers isn’t particularly cool and we don’t pay that much attention it.   But it’s another $2 billion company with a strong balance sheet that’s in most segments of the shoe business and, whether we like it or not, competes with more action sport aligned brands.

This isn’t a full analysis. I just reviewed the 10K and saw a few things I thought you might be interested in. I’ve been bitching and moaning that I don’t know what the term “action sports” means any more. As the boundaries continue to blur, consolidation happens, and retail goes vertical every brand has to begin to define its competitive position and customer base in light of those trends. Part of how you do is to acknowledge that companies like Skechers have an impact, and think about what that impact is. It was with that mindset that I took a brief look at Jarden Corporation a week or two ago.

Skechers does shoes and pretty much nothing but shoes. They do them in lots of categories. Skechers USA, Skechers Sport, Skechers Active, Skechers Kids, Shape-Ups by Skechers, and Fashion and Street Brands. There are various categories under each of these categories. You might click on the 10K link above and look at pages three through six that describe their products and markets they are in. It’s quite a list. Some, of course, have absolutely nothing to do with our market even broadly defined. But a lot do.
 
They divide their business into four segments. In 2010, the domestic wholesale business was $1.31 billion. They sell to “…department stores, specialty stores, athletic specialty shoe stores and independent retailers, as well as catalog and internet retailers.” That’s, uh, kind of pretty much everybody.
 
 International wholesale was $437 million. Their product is sold in more than 100 countries. They sell internationally directly to stores, to foreign distributors and to some licensees. 19 international distributors run 143 distributor owner retail stores which apparently aren’t part of the retail segment because they don’t own them.
 
Retail was $411 million and e-commerce $27.6 million. They own and operate 105 concept stores, 99 factory outlet stores, and 40 warehouse outlet stores in the U.S. They own 28 concept stores and 16 factory outlet stores internationally.
 
The concept stores are basically for brand building, as they “…estimate that our average wholesale customer carries no more than 5% of the complete Skechers line in any one location.” See why I suggested you go look at the pages that describe the breadth of their product line?
 
The factory outlet stores are in direct outlet centers. The warehouse outlet stores are the ones used to “liquidate excess merchandise, discontinued lines and odd-size inventory in a cost-efficient manner.
 
So outlet stores aren’t part of their strategy to get rid of lousy inventory. As I’m sure you’re aware “outlet malls” have become their own retail concept by suggesting to the consumer a better deal that may or may not exist at such malls.
 
In total, Skechers had 244 domestic and 44 international retail stores at the end of the year. They plan to open 30 to 35 more during the year.   
 
Skechers’ U.S. sales were $1.52 billion in 2010. Canada was $54 million and the rest $430 million.
 
The company is projecting lower revenue and margins during the first half of 2011 due to a whole lot of excess inventory (their year over year inventory had increased $172.4 million as of December 31, 2010) that resulted from customer order cancellations during the first half of 2010. They will be busily liquidating that.
 
Those of you who don’t think all that much of Skechers (not me obviously, because I’m always objective) might be thinking, “Great! I hope they choke on that crap!” Sounds like they will choke a little, but that also means all that inventory will be floating around and somewhere, somehow some of our customers will find a deal and that impacts us.
 
You may recall how excited I was when the snow industry managed to tightly control its inventory for the season that’s just ending and what the very positive results were. The shoe business is no different.
 
Skechers spent $154 million on advertising during the last year. You may not look at them as a direct competitor, but they do have an impact you can’t ignore even if all they do is bring prices down.
 
Okay, so  now the article is over, but there was one little financial tidbit that doesn’t quite fit in anywhere else.  Skechers finances its production "…in part through the use of interest bearing open purchase arrangements with certain of our Asian manufacturers.  These facilities currently bear interest at a rate between 0% and 1.5% for 30 to 60 day financing, depending on the factory."  Zero percent is a lot like open terms.  But when it’s higher than that, Skechers has its factories acting as its bank.  I’m not sure if that’s a good deal or not.  1% for 30 days would translate into 12% a year.    

 

 

Volcom’s Numbers and Opportunities for Growth

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What I’ve admired about Volcom is its consistent approach to the market over most of the life of the company. You get rewarded for that consistent approach with a strong market position and brand awareness among your target customer group. Reef did the same thing with a similar result over many years.

But there comes a time, especially as a public company, when that strong brand positioning with a targeted consumer can make growing more of a challenge as the new customers you need don’t feel a strong connection with the brand and the customer you have may feel alienated if and as you do what you have to do to build a connection with the new one.

It’s not like this is a surprise to anybody who’s been around our industry for a while. Large or small, public or not, every company deals with this when they grow. I wrote last week about how Quiksilver is pushing its DC brand and my concern that they might push it too hard. Burton, when it changed its name from Burton Snowboards to just Burton, was dealing with this issue.
 
I’ll get to Volcom’s numbers. But the numbers tend to work out if the strategy and positioning is correct. Let’s take a close look at some of the comments in Volcom’s annual 10K and recent conference call to see how they’re managing it.
 
Brand Positioning and Growth
Volcom characterizes itself as, “…an innovative designer, marketer and distributor of premium quality young mens and young womens clothing, footwear, accessories and related products under the Volcom brand name.” They say they have, “…one of the world’s leading brands in the action sports industry, built upon our history in the boardsports of skateboarding, snowboarding and surfing. Our position as a premier brand in these three boardsports differentiates us from many of our competitors within the broader action sports industry…”
 
As an apparel/soft goods brand, it’s easier to build your franchise across sports in the action sports market than it is if you’re a hard goods brand based on an individual sport. It’s also easier to grow beyond action sports into the broader market. Everybody needs pants, shirts, and shoes, but not everybody needs snowboards, skateboards and surf boards. I think that’s non-controversial, so I’m not going to spend time on it.
 
Volcom characterizes its brand as “…athlete-driven, innovative and creative. We have consistently followed our motto of “youth against establishment,” and our brand is inspired by the energy of youth culture.” They go on to say that, “We seek to enhance our brand image by controlling the distribution of our products. We sell to retailers that we believe merchandise our products in an environment that supports and reinforces our brand and that provide a superior in-store experience.”
 
From what I can tell, that works just fine in “core” shops and in certain chains, like Zumiez. But once you get to Macy’s and Nordstrom, and your motto is “youth against establishment,” are you controlling your distribution and can these retailers “support and reinforce” the brand?
 
Well, this is hardly an issue that’s unique to Volcom. Every successful brand in our industry thinks about issues of distribution (where to sell and how fast) every day. And of course you have to be successful enough for Macy’s and Nordstrom to want you in the first place before it becomes an issue so it’s kind of under the heading of “good problem.”
 
Volcom indicated in the conference call that they are presently in 150 Macy stores. But I want to return to what they said, and what I wrote, after their last conference call on their Sept. 30, 2010 quarter.
 
“In the conference call, Nordstrom’s is mentioned as having stopped carrying action sports last year. In their previous conference call [for the June 30, 2010 quarter], Volcom was describing the opportunity they had at Macy’s. In this call, we’re told, “Macy’s has been more difficult for us right now in terms of our door count has been reduced over the course of, I think, this year, kind of quarter to quarter.” Quite a change for one quarter. Now Volcom is saying that “…Bloomingdales is our bright spot for our department store business.” But they’re only in eleven stores.”
 
“Those of you who read my last article on Volcom know that I visited a handful of Macy’s stores to look for Volcom and other action sports brands. What I found was that Volcom and other brands were either miserably merchandised or not present at all. It seems kind of clear that there’s some work to be done before Volcom moves much of its inventory in those channels.”
 
Over three quarters, then, Volcom’s description of its success in department stores has been pretty volatile. Last quarter, Nordstrom was noted as having stopped carrying action sports, but this quarter’s 10K lists them as a customer of Volcom.
 
I’m confused. At least in the U.S. Volcom’s growth prospects are closely tied to their performance in some broader distribution channels including department stores, but from public data, I have no clear idea how they are doing there.
 
If Volcom’s management asked me (I won’t hold my breathe) I’d probably suggest that rather than department stores, which are apparently having some difficulties understanding and merchandising action sports brands, they might look for growth in the U.S. through  fashion boutique kind of stores. Volcom says they make premium product that typically sells at premium prices and they’ve got a very distinctive image they’ve worked hard and successfully to build over 20 years. That sounds boutique like to me- not department store. Just saying.
 
But then there’s the public company thing. The department stores offer the possibility of larger purchases which is obviously attractive to any public company that wants quarterly growth.
 
When I wrote about Quiksilver last week, I noted that margins and growth opportunities seemed higher outside of the U.S. The same may be true for Volcom, as we see when we review their numbers. Boy, life was sure easier for a strong action sports brand in this country before the economy went to hell.
 
The Numbers
 
Sales for the quarter ended December 31 rose 22% to $78.6 million. The U.S. segment (which includes Canada and Japan and most other international territories outside of Europe and Australia, but not Electric) increased 18% to $54.3 million. Their five largest full price accounts grew 19% to $15.4 million and represented 29% of the segment’s revenues. It was the same percentage in Q4, 2009. PacSun was $7.9 million for the quarter, up 31% and represented 15% of the U. S. segment revenues.
 
Gross margin for the quarter fell from 49.2% to 45% overall. In the U.S. segment (remember that’s not just the U.S.) It was 42% down from 48.1% in the same quarter in 2009. The reason is that they were too optimistic in their sales projections and inventory had to be liquidated in the fourth quarter. Probably has something to do with the rise in PacSun revenues.
 
Net income for the quarter was $1.6 million, down from $3.4 million in the 4th quarter of 2009.
 
For the year, revenues rose 15.2% to $321 million. That’s still below 2008’s $334.3 million.
Gross profit margin fell from 50.2% to 49.2%, but that’s an improvement over the 48.8% of 2008.
 
U.S. segment sales rose 15.3% to $218 million and represented 67% of revenues. Europe, at $70.3 million, was essentially constant and was 22% of the total. Electric grew 30.3% to $27.5 million and was 9% of the total. Australian segment revenue was only $7.7 million, but remember Volcom just acquired it’s licensee in that country last August 1, so the numbers will be much higher this year.
 
Sales in the U.S. (the country- not the segment) totaled $161.4 million. Canada was $37.4 million and Asia/Pacific $32.1 million. 18% of 2010 revenue came from Volcom’s five largest customers. That’s down from 20% the previous year, and 28% the year before that. PacSun was 10% of total product revenue in 2010. 10% of total product revenue is $32.1 million. PacSun operates only in the U.S. and Puerto Rico. Knowing Volcom’s U.S. sales, we can calculate that 20% of those sales were to PacSun. 
 
Volcom sells product that it categorizes as men’s, girls, snow, boys, footwear, girls swim, Electric, or other. Of these nine categories, men’s was $168 million, or 52.4% of product revenue. Girls, at $55 million or 17% is the next largest.   
 
The gross profit margin in the U.S. segment was 46.1% for the year. It was 55.6% in Europe, 58.9% for Electric, and 43.8% in Australia. Management tells us that the Australian gross margin will be around 50% once it’s fully integrated.
 
We don’t have a gross margin number broken out for just the U.S. If I were a betting man, I bet that the gross profit margin in just the U.S. is lower than that 46.1% for the U.S. segment. As with Quiksilver, you can see that Volcom’s bias would be to increase sales outside of the U.S., where margins are significantly better.
 
Volcom notes that one of its strategies is to take control of its international operations in countries where they have licensees when the license agreement expires. The one in South Africa expires at the end of this year. Brazil is at the end of 2013. So is Argentina, but it can be extended for five years. Indonesia’s expires at the end of 2014.   
 
 Selling, general and administrative expenses rose 16% from $111 million to $129 million. As a percentage of sales, they rose a bit from 39.5% to 39.8%. Of that total advertising and promotion accounted for $26.8 million in 2010 and $21.9 million in 2009. In 2011, estimated minimum payments for professional athlete sponsorships are projected to be $8.7 million.
 
Net income rose slightly from $21.7 million to $22.3 million. In 2008 it was $21.7 million. As percent of sales, it fell from 7.7% to 6.9%.
 
The balance sheet continues to be solid with no long term debt even after they paid out $24 million as a special dividend to shareholders.
 
Other Information
 
Retail’s always interesting to talk about.  Volcom owns 13 full-price retail stores and licenses 11 more around the world. They own the two multi-brand Laguna Surf and Sport stores and have 10 outlet stores. As you’ve probably heard, they are purchasing those 10 stores from the operator. Volcom seems focused on retail locations that “present our brand message directly to our target market.” I think that’s a good reason for a brand to have a limited number of retail outlets.
 
Volcom has basically the same cost pressures that other companies are feeling, and expects input costs to be up between 15% and 20% in the second half of the year. What was a bit different was their apparent confidence that, “As far as the cost increases go, generally, those are going to be passed through as price increases.”
 
Maybe that says something about the strength of the brand. Other companies are not quite so certain they will be able to pass through all the costs increases, recognizing that the consumer will have something to say about that. CEO Woolcott acknowledges later in the conference that consumer acceptance of price increases is an open issue.
 
Volcom has as strong a brand as any significant player in our industry. Maybe, within its target segment, stronger. But, as was discussed above, the price of that kind of strength can be difficulty growing outside of that segment. Like a lot of brands, I think we’ll see a strong international focus from Volcom. That’s where the margins and growth opportunities seem to be. In the U.S., it will be interesting to watch where growth happens. I imagine Volcom would like to sell less to PacSun, core stores can be hard to get enough consistent growth out of and, as I indicated, some of the department stores just don’t seem to get it.

 

 

What a Specialty Retailer Might Learn From Genesco

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I’m not really that interested in doing a full analysis of Genesco. Mostly because I doubt you’re that interested in reading it. But Journeys, owned by Genesco is 813 stores and the Journeys group of stores is over 1,000 in the U.S. and Canada so we can hardly not pay attention to what they’re up to.

 For the year ended January 29th, Genesco’s revenues were almost $1.8 billion. Of that, Journeys represented $804 million, or 45%.  Their hat retail business, Lids, is the second largest piece of their business. It has 985 stores. It and Journeys represent 80% of Genesco’s total revenue.

I did a more thorough analysis of Genesco a while ago. The approach to retail and the strategy I highlighted in that article is still very interesting to read about, and one of the reasons I don’t feel the need to go in depth here. If you want you can also view the press release on their fourth quarter and year end results. 
 
Genesco wants a brand leadership position for all their businesses. They want to be number one and have a reason to believe that their position is hard to duplicate. They believe they are number one in teen fashion footwear in Journeys, and number one in headwear through Lids.
 
In Lids, they believe that what makes their position hard to duplicate is that they will always been the competitor with the largest localized assortment. In a college town, to use their example, they will have every permutation and combination of logoed product that the college offers. 
 
They talked about teenagers migrating away from athletic footwear into “brown shoes” that still have an athletic base and construction. Their sense is that these kinds of cycles last years and that they are still very early in this one.
 
We’ve all heard about that trend before, but let’s consider the implications. First, Journeys, or other large retailers, don’t care whether the kids want skate shoes, or brown shoes, or ballet slippers as long as they can get the ones the kids want. Second, if you are in the skate shoe, or athletic shoe business you’d better be able to transition to the so called brown shoe market. That will depend on your existing market position (that is, how your customers perceive your brand) and whether you have the resources and manufacturing relationships to pull it off. I can imagine it is hard for some action sports brands to follow this brown shoe trend for either or both of those reasons.
 
Genesco goes right on to discuss that as Journeys is the biggest retailer in the space they have very strong relationships with vendors. One part of “very strong relationships,” of course, is that they can get better prices. Wonder if the vendors like that part of “very strong relationships.” Anything for volume I guess.
 
Genesco notes that these strong relationships give them access to exclusive product “on a preferred basis” and to special make up product as well. It seemed like they were talking about two different things there, but I’m not sure I understand the distinction between exclusive product and special make up.
 
Saying it as bluntly as anybody I’ve studied has, they note that “The economics improve with national scale.” Part of the reason that’s true is because you have to be big to afford the management and inventory systems that make local assortment management possible with a couple of thousand stores.
 
Genesco is refreshingly honest about rolling up the little guys in fragmented industries and using their size to compete. It was probably eight years at the Surf Summit in Cabo when I stood up and asked a panel of specialty retailers what they would do when there were 5,000 branded stores competing with them. Boy was I wrong. There are way more than 5,000. But the specialty retailers who are still standing can’t compete on price or national scale.
 
They can take a cue from Genesco and compete on localization by digging deep into their customers’ preferences. Resist the temptation to select product according to terms, margin, discount or because the rep’s an old friend (this is where having a strong balance sheet comes in). Buy what you know you can sell to your customer based on solid information. That’s what Genesco strives to do.       

 

 

Billabong Reduces Guidance Due to Japanese Disaster.

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Billabong announced yesterday that its Net Profit after Taxes in constant currency would be lower this fiscal year than last year by 2% to 6% due to the problems in Japan. Previously, as announced on February 18, they had expected it to be flat. The announcement describes their position in Japan and the disaster’s impact on it. Happily, none of their employees were seriously hurt.

I expect we’ll see similar announcements from other companies, and I think Billabong gets credit for stepping up and announcing it quickly even though the precise impact is somewhere between difficult and impossible to estimate right now. There is no company or person with any experience in dealing with 8.9 level earthquakes, tsunamis, and possible radiation releases all at the same time.

Obviously, earning less money rather than more money isn’t generally a good thing.  But this has no impact on Billabong’s longer term market positioning or the validity of its strategy except to the extent that events in Japan impact the global economy. That’s a potential problem for all of us.

 

 

Some Comments on Quiksilver’s Quarterly Report

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Quik came out with its quarterly results last week and filed the 10Q with SEC all at the same time so I’ve got that and the conference call to work with. I know Volcom and Zumiez have also released their results for the quarter and year, but so far they haven’t filed their 10Ks for me to peruse. When they do that, I’ll give you a report. I don’t like delaying, but I just don’t know how to do a good job without those documents. Hope you understand.

This is really the first report from Quik in a long while where we don’t have to adjust for discontinued operations as Rossignol has worked its way off the financial statements. That’s great to see.

For the three months ended January 31, 2011, Quik reported a loss of $16.3 million compared to a loss of $5.4 million during the same quarter the prior year. Sales fell 1.45% from $432.7 million to $426.5 million. Sales in Asia/Pacific were essentially the same from one quarter to the other and rose $6.8 million in the Americas. But European sales fell 7.1% from $177.8 million to $165.2 million.
 
In the Americas, the 4% growth was driven by mid-teen growth in Quik’s retail business. Wholesale revenues were “essentially unchanged.” That means all the Americas growth came from retail which they say grew in the “mid-teens.” Let’s call that 15%. It follows that the Americas quarter over quarter sales growth of $6.83 million represents something like 15% growth in retail. To use a little simple algebra, if 0.15x = $6.829 million and we solve for x, we find that retail sales during the quarter were around $45 million, or about 23% of the total.
        
We don’t get any specific sales numbers by brand. Quiksilver was flat in constant currency. They expect it will grow in the second half of the year. They note that there was “very strong demand” for their winter sports and technical snowboard apparel. But we don’t know how many dollars that involves.
 
Roxy does about $525 million in annual revenues. CEO McKnight characterizes that business as “stabilizing.” Its revenues were down 10% to 15%. They think they see girls getting tired of the “cheap quality” that fast fashion has provided.
 
Management is positively giddy about the DC brand and its prospects. It grew 15% to 20% in the quarter. Bob McKnight says DC is “…dedicated to being the most sought after skate-driven action sports brand in the world.” He then goes on to discuss DC and Ken Block’s Gymkhana franchise and being the exclusive shoe sponsor of the Monster Energy AMA Supercross series.
 
Maybe I’m too old to be cool enough to understand the relationship between skate and motocross. Quik bought a great brand in DC and has managed its growth impressively. I just hope, with the Roxy and Quiksilver brands not growing as well right now, that they don’t expect more from DC than it can deliver. Their goal is to double DC’s revenues in five years. 
 
Gross profit as a percentage of sales rose from 51.3% to 52.4%. CEO Bob McKnight indicated the increase was the result of “…improvements in our U.S. retail stores and lower levels of discounting in the wholesale channel.” It’s not clear if he means to say those are things the company can take credit for.
 
In the Americas, gross margin was up from 43.3% to 46.2%. In Europe, it rose from 56.6% to 58.9%. It fell in Asia/Pacific from 55.3% to 54.7%.
 
All things being equal, I’m guessing that the Americas are Quik’s third choice for where they’d like to sell stuff. Look at the gross margin differences. Enthusiasm for international business and its growth opportunities come across in the reports and conference calls of Quik and a lot of other companies as well. And not just in our industry. I suppose that’s the inevitable result of real incomes dropping in this country.
 
Quik, like Billabong, is referring to 2011 as a transition year, where they are investing in certain initiatives that aren’t expected to produce significant results until 2012. You see this in selling, general and administrative expenses that rose 3.58% to $210.4 million. As a percent of sales, they rose from 46.9% to 49.3%.
 
Interest expense rose from $21.9 million to $29 million. But that included a $13.7 million non-cash charge for writing off “…deferred debt issuance costs associated with our European term loans that were paid off during the quarter…” Basically, those costs have to be put on the books as an asset like a building and written off over the life of the loan just as a building is depreciated. But when the loan goes away, the remaining value has to be written off. They note that their total interest expense was $6.6 million lower than it would otherwise have been due the reduction in their total debt over the last year.
 
Their 10Q presents balance sheets for January 31, 2011 and October 31, 2010. As usual, I chased down the one from January 31 of the previous year so we’d have a more valid comparison and I’m referring to the year over year changes below. Interestingly, they refer to the year over year change in the conference call as they discuss the balance sheet, so it would be logical for them to include it in the filing.
 
Over the year, the current ratio has improved from 2.24 to 2.56. Total liabilities to equity has also improved, falling from 2.91 to 1.82. Long term debt was down 18.8% to $697 million and stockholders’ equity rose from $456 million to $602 million. The rise in equity is largely the result of Rhone debt being converted to equity. Quik has had losses over the last year which obviously reduced equity.   Inventories are up about 2.8%. Days sales outstanding (how long it takes to collect receivables) declined by six days compared to last year from 64 to 58 days. That’s good work. Being tougher on extending credit and collecting is not unique to Quiksilver in this environment. 
 
In discussing their hedging activities and foreign exchange management, Quik makes a comment I want you to read. Not because it says anything about Quik, but because it teaches us something about how we got into our current economic problems in the first place. Here’s the comment from the 10Q.
 
“The Company enters into forward exchange and other derivative contracts with major banks and is exposed to exchange rate losses in the event of nonperformance by these banks. The Company anticipates, however, that these banks will be able to fully satisfy their obligations under the contracts. Accordingly, the Company does not obtain collateral or other security to support the contracts.”
 
Okay, but what if these banks (the counterparties, to use a phrase you may remember) can’t “fully satisfy their obligations?” I remember when that’s exactly what happened. Don’t you? The institutions that couldn’t “fully satisfy their obligations” included AIG, Lehman Brothers, Merrill Lynch, and a host of others.
 
Quik’s derivative numbers are small and it’s in no way an issue for them. But isn’t it amazing how quickly we forget? People are trusting Moody’s and S&P bond ratings again. They were the ones who rated subprime stuff triple A. It’s inability to remember even the recent past, I suppose, and the fact that greed is eternal that guarantees it will happen again.
 
Okay, off the soapbox.
 
Quik expects its gross margin to be the same this year as last year. They have raised some prices selectively. They see cost increases averaging 5% to 10% with some as high as 15%. The question, as CFO Joe Scirocco points out, is how the consumer will react to the higher prices. I’d say that’s on everybody’s mind.
 
Right now, DC is providing a lot of Quik’s growth momentum, and I hope they don’t push the brand too hard. As they indicated, 2011 is a transition year for Quiksilver. We’ll find out in 2012 how some of their marketing initiatives and the launching of the Quiksilver women’s line went. If DC can keep growing, Roxy can stop shrinking and start growing, the Quiksilver can get just a bit more momentum, and some of these marketing bets pay off, the company will be doing fine.  

 

 

Jarden Corporation; Remember Them?

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Whenever VF comes out with its earnings, we all gather around to see if we can find anything about how Vans and Reef are doing. But when Jarden, who owns a winter lineup of brands that includes Atlas, Full Tilt, K2, Ride, Line, Little Bear, Madshus, Marker, Morrow, Tubbs, Volkl and 5150, we don’t even notice. Wonder why.

Jarden is another large company with $6 billion in revenue. Its Outdoor Solutions Group, of which the winter sports brands listed above are a part, represented $2.5 billion, or 42% of total revenues in the year ended December 31, 2010.

The catch of course, like with VF, is that they don’t tell us anything specific about brand performance. But if you listen carefully to the conference call, you can pick up a few things.
 
The Outdoor Solutions Group grew 17% during the year. Of that, 13% was organic (not the result of acquisitions). They tell us that growth was led by the winter sports brands. They view winter sports sales as a barometer for consumer confidence. Performance for winter sports was “exceptionally strong” and produced record sales and EBITDA. They say that their winter performance was a lot stronger than many of their competitors due to certain technical improvements they made in the product.
 
Well, it ain’t much information, but it’s better than nothing. We probably can’t afford to ignore $6 billion companies that play in our back yard.
 
Jarden’s winter business is run by Robert Marcovitch and judging from the smile on his face in Denver, things are going just as well as management indicated in the conference call. I wonder if those guys saw Ride’s booth. I was really disappointed when “Our customers come first” came off the sign on the booth entrance after the first day of the show. Sorry I missed seeing the booth in Europe.