Volcom’s Quarter Ended Sept. 30 and Some Strategic Industry Issues

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Those of you who read my stuff know I never try to be the first published. When Volcom did their press release I reviewed it. I listened to the conference call and read its transcript and thought about it. Then I reviewed their 10Q when it was finally released. Then I thought about it some more.

Now, I’ve thought enough. What I was thinking about as I reviewed Volcom’s material was the distinctions (and similarities) between the action sports, youth culture, and fashion markets. You see, I’m not sure just what market we are any more. Action sports, to me, is that fairly small market composed of consumers who are participants in the sports and maybe the first level of nonparticipants who are closely interested in the sports and the lifestyle. Fashion is by far the largest market. If the people in that market want a surf brand, they may be as content with Hollister as with Quiksilver. Or they may just like a plaid shirt style they saw somewhere and are happy to buy it at JC Penney. They may not even know that isn’t cool.

I see Volcom as being in the youth culture market, but holding on to its action sports roots and trying to reach up into fashion as a condition of growing. That could leave Volcom (or any other brand) stretched a bit thin in terms of market positioning.
So let’s look at Volcom’s results and discussion around those results in term of the changes that are going on in our industry and market and see if we can draw broader conclusions that go beyond Volcom.
 
The Balance Sheet and Issues of Strategy
 
Volcom’s balance sheet at September 30 remains very strong, if not quite as strong as a year ago. But it’s strong enough for them to pay a $1.00 a share cash dividend to shareholders of record at November 8th at a cost of $24.4 million. Even though it’s strong, I want to spend time on the receivable and inventory numbers, as this might get us to some of the broader industry trends I want to focus on.
 
Consolidated accounts receivable were up 17% to $81.8 million at September 30, 2010 compared to one year ago. Days sales outstanding were up to 91 days from 88 days a year ago. So on average it’s taking them three days longer to collect.
 
Inventories over the year are up 65% from $22.4 million to $37 million. By comparison, sales grew 11%. Inventory turns over the year fell from 5.8 times to 4.6 times. The number of days it took them to turn their inventory, therefore, rose from 63 to 80 days. Higher is generally better than lower when you talk about inventory turns, though too high a turn rate can indicate you’re not keeping enough inventory on hand.
 
With those numbers as background, let’s look at their discussion of inventory. Here’s what Volcom said about their inventory situation in their 10Q. “We believe that as of September 30, 2010, we have excess inventory levels on hand and in order to align these inventory levels with current in-season demand, we anticipate that we will experience higher inventory liquidation sales during the fourth quarter of 2010.”
 
They talk about this at some length in the conference call and give more detail on how it happened and what they are doing about it. First, they note that their 2010 strategy “…has been to gain floor space and market share throughout our account base. Along with increased focus on marketing and promotions, these initiatives have included incentive programs to improve retailer margins in order to insure continued strong orders for Volcom products.”
 
They certainly aren’t the only company with a strong balance sheet that thought a recession was a good time to take some market share, and they are probably right about that. But they chose to do it partly with programs (including some pre-book discounts and a little more markdown allowance) that reduced their gross margin in their United States segment (that includes Japan and Canada but not the Electric results in any of those countries) from 49.9% in the same quarter last year to 45.4% in the same quarter this year. Overall, their gross profit margin fell from 51.6% to 49.6% in the quarter.
 
Moving into next year, they expect to curtail some of these incentive programs. “We believe this will help us recover some of the lost gross margin, while maintaining our market share gain.”
 
Will whatever market share gain they’ve achieved be maintained when they remove the incentives? Yup, that’s the big question. Billabong was concerned enough about this issue that they chose to limit their discounts and incentives during the recession even at the cost of some sales. I’ve argued pretty strongly that your focus in a period of slower sales growth needs to be on expense control and generating gross margin dollars even at the expense of sales growth. It’s an issue for every solid brand in the industry and we’ll find out over time what the right answer is. It is, of course, possible that there are different answers for different brands.
 
Meanwhile, speaking of issues everybody in the industry has to deal with, Volcom indicated they are seeing upward pressure on manufacturing, freight, and raw material costs in the area of 15% to 20% FOB.  That’s more than some other companies have suggested. But Volcom, and everybody else, has to ask how consumers will react in this economic environment as brands try and make up for some or all of these costs increase with higher prices. And Volcom will be dealing with that as they withdraw certain
of these incentives from their customers.
 
Just this morning, somebody sent me a short, article on these costs increases coming out of China. You can read it here.
 
We are, by the way, still talking about inventory. What I like about how this article is working out is that we’re tying balance sheet to income statement to global strategy. It’s important to understand those relationships.
 
Why did inventory get so high? Volcom chose to carry more inventory “…to capitalize on potential in-season business.” They did this because of “…the retailers’ general reluctance to pre-book at historic levels.” They also “…made earlier and bigger buys on select styles due to longer lead times in China, and to take advantage of volume pricing.” When they did that, they had higher expectations for the second half of the year which did not materialize.
 
I wonder if retailer’s reluctance to pre-book should be looked at as an opportunity to sell in season or as an indication that consumers are expected to remain cautious in their spending.
 
Some of this inventory is going to carry over to next year and was bought with that in mind. I think that carrying over some styles in certain basic product is a good idea as long as the market will accept it. But Volcom said they “…plan to get rid of…” about $3 million in inventory in the fourth quarter and that will impact their margins.
 
How exactly are they going to get rid of the excess inventory? They don’t exactly say, but they do note that they expect that sales to PacSun will increase 17% in the fourth quarter. In the third quarter, PacSun bought $6.9 million. 17% would be an increase of about $1.17 million, and I wouldn’t be surprised if a chunk of $3 million in inventory they want to get rid of is going there.
That certainly creates an opportunity to discuss PacSun’s strategy and place in the market and Volcom’s relationship with them, but this article is going to be long enough and I’d better move on.
 
Before I get off inventory, there’s one more industry strategy issue that relates to it I want to discuss. It’s the role of the department stores. In the conference call, Nordstrom’s is mentioned as having stopped carrying action sports last year. In their previous conference call, 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.
 
Volcom’s inventory numbers, then, span a bunch of industry strategic issues that are important to all the players in our industry. These include the strength of the economic recovery, increasing product cost, delivery issues, the impact of fast fashion, changes in the retail base and its willingness to place preseason orders, and the inevitable difficulties of growing into the fashion/department store market. Nobody’s business model works the same way forever.
 
And that is the end of the inventory discussion. Finally.
 
Income Statement
 
For the quarter, revenue rose 11.4% to $104.7 million. For nine months, the increase was 13% to $244.6 million. Electric was the best performing segment, with an increase of 29% to $8.9 million. That’s 8.5% of the quarter’s total revenues.
 
Gross profit rose from $48.5 million to $52.8 million in the quarter, but gross profit margin fell from 51.6% to 49.6%. Selling, general and administrative expense rose by 17.6% to $33.9 million.  As a percentage of revenues, they rose from 30.7% to 32.4%. Volcom states:
 
“The increase in absolute dollars was due primarily to increased payroll and payroll related costs of $1.5 million, incremental expenses of $1.1 million associated with our recently acquired Australian licensee, increased marketing and advertising costs of $1.0 million, and increased commissions expense of $0.6 million associated with an increase in revenues between periods. The net increase in various other expense categories was $0.9 million.”
 
Operating income was down 8.6% to $18 million. Net income fell slightly from $13.3 to $13 million. It would have fallen by another million if Volcom hadn’t had “other income” that was about $1 million higher than in the same quarter last year due to a foreign currency gain.
 
Conclusion
 
I hate calling a section “conclusion,” but I couldn’t come up with anything pithy and witty and wanted you to know the income statement part was over. What I hope you’ve gotten out of this is the importance of the inventory change and number and how it relates directly to a series of strategic issues that Volcom, and the rest of the industry, is managing. I wish I had more detail on their inventory. How they manage the issues around inventory will have a lot to do with how Volcom progresses as a company. That’s always true, but my point is that it’s particularly true in our current operating environment.
 
As I said at the start, Volcom is a youth culture company with its roots in action sports and reaching for fashion as a condition of continued growth. They seem to have arrived at that time in their growth and development (due partly to economic conditions) when their business model may have to evolve a bit. That’s not a criticism. Every company that starts small in this industry hopes that someday they have to deal with the issue.             

 

 

Requiem for the ASR Show. Now What?

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At the moment you hear about it, it’s kind of a surprise. But when the initial shock passes, it’s not. I thought The Editors over at Boardistan put it best. Back in 2009, referring to ASR, they said;

“We have to wonder what happens to the entire trade show business model when they have to pay retailers to attend. Lord knows retailers need to be treated well these days, but it still seems to bring us back to the question that’s been plaguing the boardsports business for several years: are trade shows even relevant anymore?”

I couldn’t have put it any better. Or at least not so succinctly. In fact, I didn’t put it succinctly. In the summer of 2009, I wrote a long article about trade shows in general for Transworld Business. Much of what I said then is still relevant. On the assumption that you don’t want to hear me re-pontificate it all, I’ll just include the link here. If you don’t read the serious part of the article and haven’t seen it, you might just to go to the section “In the Beginning,” where I wax biblical. There’s always room for a little humor. It’s one of my favorite things I’ve ever written.
 
What Went Wrong for ASR?
 
As I’ve heard it, the straw that broke the camel’s back was the decision of a number of large brands not to participate in the show. But the poor camel had been under stress for quite a while and the recession, exacerbating a number of existing trends, accelerated the process.  What are these trends?
 
  • Fewer retailers. And the ones that were showing up brought fewer people.
  • Brands showing product and getting orders outside of the trade show environment.
  • The internet and everything you can do on it
  • The union/convention center cost structure.
  • Industry consolidation. Big companies don’t have as much need of trade shows. See the second point above.
  • Recognition that competing against your competitors at trade shows with your show presentation is silly.
  • Slower industry growth.
  • More trade shows while demand was falling. Crossroads. Agenda.
  • Declining clarity as to just what the action sports market is. Did starting Class help ASR, or did it cause confusion as to just what the show was about and who should attend?
 
And then there’s that old bugaboo called momentum. As I’ve said, companies, trade show or otherwise, get in trouble due to denial and perseverance in a period of change.
 
In hindsight it’s easy to see what ASR should have done; Blown up the existing format and started over with another ASR show that recognized changing conditions. Specifically, that the show was essentially a regional show for smaller and new brands. And if that sounds a bit like Agenda well, okay. Maybe they should have just bought Agenda.
 
I hasten to admit that’s all easier to say than to do. It’s that momentum thing. I’m pretty certain ASR boss Andy Tompkins was quite aware of all the factors I listed above. I know he was. He lived with them every day. Yet it’s hard to imagine him (or anybody in his position) going to his boss, and his boss’s boss a couple of years ago and saying, “This isn’t working. We need to blow it up and start with a new focus and a smaller show.” Or maybe he did and got overruled by some people further up in the organization who aren’t quite in touch with our market. Big organizations often don’t make difficult, unpleasant changes until forced to.
 
With that short forensic analysis of what happened behind us what happens now?
 
Everybody’s talking
 
Just from the flurry of public discussion after the announcement, we can assume that IASC is talking to Agenda is talking to SIMA is talking to BRA is talking to Crossroads is talking to Surf Expo is talking to IASC. And if there was some talking going on at Outdoor Retailer and SIA I wouldn’t be surprised.
 
It’s public knowledge that certain of these organizations have (had?) deals with ASR that provided them with a certain amount of funding. Nobody much likes it when revenue goes away. I know I don’t. Those who lost income will want to replace it. Where? How? From whom? That will be a lot of the focus right now.
 
Concrete Wave is sponsoring a show by an organization called  Homegrown called the Midwest Skateboard Industry Summit next May.  As they are selling booth space for $200, I guess it also has elements of a trade show.  I suspect there will be more announcements from various players. 
 
There was an immediate reaction from various sources that Agenda had “won” and ASR “lost.” I didn’t see it that way. I don’t expect Agenda to take over the ASR space. I just don’t think the ASR format and structure for a trade show is valid any longer for the reasons I list above. I’ve also written (see the above link to my earlier trade show article) that anybody who tried might find themselves with the same issues that lead ASR to close.
 
Aaron and Seth at Agenda have themselves a small, solid, regional show. Can they grow it? I expect them can. They have. How much? And in which market? Is Agenda fashion or action sports? I’d be really careful saying “both.” ASR, with Class, tried to be both. When they opened Class, it was a symptom of the problems- not part of a solution.
 
The action sports industry is going back to what it used to be; a fairly small industry and its customers consisting of participants in the sports and the immediate circle of people who may not be participants but are committed to the lifestyle and truly interested in the sports. The rest is fashion; a style sold to customers who’ve seen surfing only on TV and have never been near a skate park. Bigger public companies looking to grow are after that market. They have to be to find growth. They may have their roots in action sports, but it’s getting harder, if you just look at their customer base, to call them action sports companies.
 
That has a huge impact on what our trade shows should or shouldn’t be. It’s incumbent on anybody running a trade show to figure out who their market is. Trouble is, I’m not sure either “fashion” or “action sports” really describes it. Youth culture might be closer.
As all this talking among the various industry organizations goes on, I hope it’s not just about replacing ASR. Let’s assume there were no trade shows. What would we want ours to look like?
 
First, it should look however the retailers want it to look. And as I indicated above, it would initially be regional and would be for new and small brands. Maybe it gets combined with the industry boot camp or other conferences. Perhaps it’s not only brands with booths, but venture capitalists, attorneys, bankers, accountants and other organizations that can help new brands and are interested in them as customers.
 
There should be a web site associated with the show that doesn’t just promote the show, but encourages interactions among the participants. Would it be closed to retailers for a day just so the focus could be on how these companies could run their businesses better? I’d like to see us try and charge non-endemic companies a big price to show up and be educated about the industry. I hope whoever runs this new show has authority to decide which companies can exhibit regardless of who belongs to what group.
 
If we’re going to break some new ground, let’s do it quickly. I find myself sitting here wondering if I should go to Agenda, Surf Expo, or Outdoor Retailer instead. Obviously, some companies are going to be looking for a replacement venue.
 
Fundamentally, however, we have to start by asking if we need another trade show. Maybe there will be surfboards at Outdoor Retailer, skateboards at Agenda and brands that tend towards fashion at Magic and some fashion shows I don’t even know about. Remember that skate had more or less pulled out of ASR, so it’s hard to argue that skate and surf have to be together, though one trade show makes it a whole lot easier for retailers.
 
Whatever happens, I hope the discussion among all the people who are talking is more around what the industry needs or doesn’t need rather than the requirements of the organizations they represent.
 
This is great opportunity to do the trade show we want if we’re really sure we want it.

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

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

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

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

Billabong’s Annual General Meeting

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

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

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

 

 

 

 

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

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

The Numbers 

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

 Dance around the 800 pound gorillas. Not with them.  

 

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

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

 Numbers by Segment

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

 

 

An Insider’s History of the Surf Industry; Good Reading!

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Part of my weekend was spent reading Phil Jarratt’s excellent book, Salts and Suits; How a bunch of surf bums created a multi-billion dollar industry…and almost lost it. Phil has worked in surf publishing and the surf industry for more than 35 years, including five years as the head of marketing in Europe for Quiksilver. He seems to know and have talked to everybody in the industry over a period of years, but just got around to putting it all together in this book, published in Australia around April of this year.

It’s very Australia centric, though anybody in the industry will know of or have met many of the individuals who figure prominently in it. It has not been released in the U.S. and you can’t, to my amazement, buy it at Amazon. However, it looks like you can order it from Australia and here’s one link where you can get it.

The sense of history and the perspective it gives you on the origins and evolution of the surf industry is very valuable. And the stories of how our most respected industry players got into the business, along with descriptions of some of their antics and foibles is a lot of fun to read.
 
It also reminds you that for all the changes, some things just haven’t changed. Here’s a quote from the author’s 2005 interview with Duke Boyd who, in 1960, was trying to sell some early board shorts.

Most of the surf shops sold boards and wax, and that was about it. I knocked on Dewey Weber’s door twenty times before he’d talk to me, and then he goes, ‘Okay, I’ll take them, but only white and only in my size, in case they don’t sell.’ Then one day I had a coffee with the guy at Hobie’s and I told him my trunks would make him forty percent of the sale price. I asked him how much he made off of a surfboard sale. It was half that, and the boards were taking up all the space! He got that, and soon all the guys started to realize that trunks would pay the rent.

So it seems that the issue of margin on hard goods goes back at least fifty years.
 
The hardest thing for me was not skipping to the end of the book where the Quiksilver’s hiring of Bernard Mariette, the Rossignol deal, and its aftermath are described in, if not as much detail as I would have liked, more than I’ve seen anywhere else.
 
Anyway the book is fun, evocative, entertaining, and educational and I hope Phil Jarratt brings it out in the U.S. soon.
 
Maybe I should offer to be his distributor. 

 

 

Never Summer’s and Mervin Manufacturing’s Little Patent Brouhaha

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I guess I should start by admitting that I’m not an expert on snowboard technology, and I don’t have a strong opinion (any opinion, actually) on which kind of camber is best and I don’t know who made which claim first. I also haven’t read, and don’t intend to read, the patents.   I figure I suffer enough just having to read the public company’s SEC filings.

Having followed some of the discussion on various web sites, it’s clear that you don’t have to know all that much to have an opinion. But I’m going to cleverly stick to history, marketing and industry strategy. Those are subjects which I do know something about in this industry, or at least it’s hard to prove that I don’t.

Let’s start with a little history. Months and months ago, before my new web site was up and running, I posted an article on Facebook that talked about alternative camber and my personal experience with it. It also included some information from an interview with Mervin’s Mike Olson. It might give you some perspective on what’s going on and you can view it here.
 
Meanwhile, I’d like to remind you that I’ve said from time to time, “What’s the Goal? Begin With the End in Mind.” What’s the goal for Mervin and Never Summer in this dispute? It’s not to see who can spend the most in legal fees. It’s not to beat the other one in court and have their patent proclaimed the winner. The goals are to build their respective businesses, earn a return for their shareholders and grow snowboarding by making it easier and more attractive to learn and participate in.
 
How does a business do that? At least in snowboarding, we can say that having the best patented technology first is no guarantee of success (see the above referenced article). I’d argue that’s also true in skateboarding and surfing. Not to mention in software, semiconductors and most any industry you can name. First off, it’s the consumer who decides what’s “best” and they can sometimes have a different perception of our innovations, technologies, and patents than we in the industry do. Second, companies in this industry have spent a lot of time and a truly unbelievable amount of money creating their brands’ market position and image in the hope that the consumer will purchase their branded product based on that image. Even with a patented innovation, a consumer may go with a brand image. Because, let’s face it; there’s no bad snowboard product out there anymore.
 
We all talk to each other too much. This, like all industries, is a bit incestuous. Too much of the discussion, perhaps because a confrontation is so intriguing, seems to be around whose patent is better, who’s got the best lawyers, and who might “win.” I really hope it doesn’t come to that.
 
As two niche brands with long histories and both making product in the U.S., Never Summer and Mervin have a lot in common. Mervin, owned by Quiksilver has done very well the last couple of years. I imagine, given Quik’s situation, that Mervin is under some pressure to grow and I hope that doesn’t impact the resolution of this dispute. Never Summer, because of its reputation for quality and long standing control of distribution is also in good shape. I’m hoping Mervin and Never Summer don’t get caught up in the partially industry generated controversy and forget to ask how this technology can best serve the snowboarders to the benefit of both companies and the industry. There must be a royalty or cross licensing agreement or something somewhere in our future.
 
I know it’s business, and I don’t want to sound naïve. I don’t know who’s “right” and who’s “wrong” but I am pretty sure the interests of both companies and the industry are served by a deal.
 
I read Transworld Business’s excellent interviews with Mervin’s Mike Olson and Never Summer’s Tracey Canaday (you can read them here) and was stunned to hear they’d never met each other. I lived in Ireland for two years and learned that there’s nothing that can’t be settled at the pub. I’d be happy to introduce you two and help you make a deal. I work for beer and I’m hopeful this isn’t more than a four or five pint problem.

 

 

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

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

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

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

 

 

SIA Article on the Rising Costs of Chinese Production

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About a week ago, SIA published a really good article on why production costs in China are rising.  If you haven’t read it you can, and should, here: http://www.snowsports.org/SuppliersServiceProviders/SIANewsletter/NewsletterDetail/Contentid/1272/#top.
The article is pretty tactical in nature, and I thought a little bit of the longer term social and political perspective might be interesting to you.  It should at least convince you that this is probably not a temporary trend.
Chinese governments have always derived their legitimacy from their ability to provide stability and jobs. “Harmony,” if you will.  And when I say “always” I don’t mean a measly couple of hundred years.  The first history of China was written about 1,500 BC.  China’s current export oriented economic system is unsustainable.  The Chinese know this.  But the changes they need to make to improve domestic consumption move up the valued added chain in what they manufacture and resolve some of their significant structural issues are not conducive to that stability.
That’s a very short and very oversimplified explanation of the situation.  But the next time you hear that “everybody” knows that China is going to become the next superpower you might not rush to agree.  Could it happen?  Sure.  But remember in the 1980s when “everybody” knew Japan was going to take over the world?  Didn’t quite work out that way.  The chart below illustrates one of the issues China has.  Note the coming decrease in the working age population.