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

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

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

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

 

 

Biting to the Core: The Future of Mom-and-Pops, the Majors, and Brand Labels in the Evolving Retail Landscape

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In a rapid and rather remarkable convergence of four key trends, a lot is changing for core retailers and for retail in general. The accelerating push of large brands into retail, their reduced dependence on core shops, the decline in the number of true core shops, and the financial/management model required in our new economic environment pose many challenges but also many opportunities for those still standing. I’ve written about some of these issues before, but it’s time to pull them all together. There’s a lot to cover, so let’s get started.

Evolution of the Core Shop
Once upon a time, 20, 30 years ago (pick the timing for the sport that interests you most), a true core shop was the place you dropped in on to get your fix of whatever subculture sport you were in to. You were an active participant part of a tight community, the products were niche and exclusive, and the few other places to turn to for the goods you were looking for took some effort. The folks in the shop had thorough knowledge and the best product service not to mention they were participants themselves who really lived the lifestyle and were driving forces in the progression of the time. They were the first to see new trends and introduce innovative products.
            There was a certain interdependency between brands and shops. A bigger percentage of a brand’s sales went through the core shops, there were fewer other distribution channels, and there was more of a risk to consumer brand perception if they went outside the core shops. Further, the cost structure of the time made it easier for the small retailer to succeed. There was one land phone line. No computer and internet expenses. Insurance was a lot less. Stores weren’t open as many hours. Consumers had fewer options in terms of getting their hands on product and product information. Bottom line: It was considerably easier to be a destination shop.
            Then some time after 1980 began the great economic melt-up. At some point even further down the road, “shops” started to pop up like mushrooms on damp, warm, manure. If they carried a collection of hardgoods and stood alone as single brick-and-mortar storefronts or even small independent chains, we labelled them as “core.” Eventually, large numbers of doors emerged. But the cost of operating a shop grew. Competition exploded and put pressure on margins, distribution expanded, consumers had more choices and easier access to products and information, internet sales took off creating a space of zero travel distance between product and consumers, brands moved into the retail space, and lifestyle customers became increasingly more important than participants. Brands, as they grew, inevitably became less dependent on core shops.
            None of these emerging trends mattered so much as long as sales and cash flow grew and the economy was throwing a wild party. But like always happens, the bash ended and there were some terminal hangovers involved. All of the issues that growth and cash flow had let us work around came home to roost. Many core shops have had to scramble for cover or, worse, literally close up shop.
            Thing is, though some may have been independent of any significant financial source, many of them were never really the core shops outlined above in the first place. We called them that because we didn’t have a better term and it didn’t really seem to matter. What were they then? I don’t know. Aberrations of a hot economy? Symptoms of unsustainable consumer spending?
            Now, the overall number of shops has declined. The real core shops—the kind that were around a couple of decades back—will get a little breathing room if only because there are no longer five shops in a 10 block area. But not, in all cases, enough breathing room because the trending issues touched on above that economic prosperity allowed us to push to the side are still very much alive. And, as we’ll see below, big brands are getting very serious about retail.
 
The New Economic Model
Sales growth, though improving over last year, doesn’t seem likely to return to 2006 or 2007 levels. Credit is tougher to obtain and that issue is likely to stick around for a whiile. Being aware of risk and actually managing it is back in vogue.
            Inventory is being vigilantly managed and expenses carefully controlled. The focus should now be on generating more gross margin dollars. You can’t get anywhere without a strong balance sheet. Systems, which are pretty bad in a lot of smaller retailers and brands, are a strategic advantage and a place you need to spend money. Issues of the cost of doing business, distribution, and the internet are not going away even when the recession completely ends. And consumers, though they seem to be spending more than they were a year or so ago, haven’t reopened their wallets with the same giddy abandon we enjoyed for so long.
            What’s been really interesting are the conversations with shops and brands that have had to cut spending pretty dramatically and manage their businesses more closely. Almost universally, they tend to say, Damn! If only I’d done this 10 years ago, I’d be in great shape and have a whole lot more money in the bank. Turns out that, in many cases, these necessary actions the economic downturn required of retail to stay afloat were just smart business moves. Just because there was a long period where it wasn’t absolutely crucial to run your business well doesn’t mean there wasn’t a lot to gain by doing it. Oh, by the way, now you have to or you won’t be around.
The Eight Hundred Pound Gorillas
The conventional wisdom on why core stores are important to our industry says that they’re an early warning system for trends coming and going, they are builders of community, they provide better margins for both the shop and the brands sold in them because of who the customers are, they are incubators of brands, and they help keep the sport and culture a bit edgy and, well, special.
            Obviously, some of that isn’t as true as it used to be, but I still think core shops are important. I’m not certain some larger companies feel as strongly about that as they once did. Or, at least, they have other priorities that make them less sensitive to the role of the core shop than they once were. Among these priorities is growth. It’s a public company thing and the growth, mathematically, just can’t come from small shops.
            I’ve been pretty surprised over the last couple of months to hear what some of these major companies are saying in their Security and Exchange Commission filings and in the company conference calls where they discuss their results publically, meaning anyone can listen. All the quotes compiled below are from one of those two sources. Overall, they seem unclear about growth opportunities in core stores and, moreover, about the survival of some of those stores.
            Billabong CEO Derek O’Neill says, “I can’t sit here at all and say that all the accounts that we’re currently dealing with will still be there in three months time.” He also says his company may have to tighten credit by the end of the next six months.
            Genesco CEO Robert Dennis (Genesco owns U.S. shoe chain Journeys) notes that when, for example, a five-store chain has a lease coming up for renewal, it will find Genesco on their landlord’s doorstep taking over that space. The other thing that’s happening, as Dennis describes in discussing Genesco’s hat, uniform and sport apparel business, is that they “…are consolidating the industry,” he says. “The mom and pops are going out of business or they are credit constrained and can’t stay fresh.” I’m not so sure that’s any different than in action sports.
            It’s interesting to note how U.S. retail giant Zumiez characterizes its stores in a recent 10-Q report. Except for being in malls, it’s typical of the description a traditional core store might use: “Our stores bring the look and feel of an independent specialty shop to the mall by emphasizing the action sports lifestyle through a distinctive store environment and high-energy sales personnel. We seek to staff our stores with associates who are knowledgeable users of our products, which we believe provides our customers with enhanced customer service and supplements our ability to identify and react quickly to emerging trends and fashions. We design our stores to appeal to teenagers and young adults and to serve as a destination for our customers. Most of our stores, which average approximately 2,900 square feet, feature couches and action sports oriented video game stations that are intended to encourage our customers to shop for longer periods of time and to interact with each other and our store associates.”
            The big companies are also coming around to the idea that they can potentially merchandise their own brands in their own stores better than through core stores.
            Nike: “We will continue to invest in bringing world-class solutions to consumers who are hungry for new retail experiences. Nowhere is this more important than online. The digital lifestyle is driving dramatic change in our industry and significant potential to our company. We are attacking that in every dimension; online shopping, customization, immersing our brands in consumer cultures and telling inspiring and entertaining stories.”
            Billabong: “If you look at the wholesale level, most of the business going on, the buyers are focused on your price point category and up to your mid price print category. …In our own retail, which has definitely outperformed our wholesale side in this period, in our own retail we can showcase and merchandise a product across all the price points and we’re doing really well right across the board.”
            Billabong continues: “…we are beginning to drop product into our own retail even faster than wholesale channel. We are beginning to, on certain key styles… build product that may go into our own retail before even the wholesale consumer sees it in an indent process.”
            They see systems and operations as key. Operating well is a key advantage that can put a lot of money to their bottom lines.
            Zumiez: “We have developed a disciplined approach to buying and a dynamic inventory planning and allocation process to support our merchandise strategy. We utilize a broad vendor base that allows us to shift our merchandise purchases as required to react quickly to changing market conditions. We manage the purchasing and allocation process by reviewing branded merchandise lines from new and existing vendors, identifying emerging fashion trends and selecting branded merchandise styles in quantities, colors and sizes to meet inventory levels established by management… Our management information systems provide us with current inventory levels at each store and for our company as a whole, as well as current selling history within each store by merchandise classification and by style.”
            Nike: “To do that we committed to building our retail capabilities, smoother product flow, surgical assortment planning that focuses on key items, more compelling merchandising, stronger brand stories and more efficient back-of-house systems.”
            Billabong: “If you look at the big retail brands out there, they don’t have a buyer to get past, they just decide what they’re going to make and they put it in their own stores and therefore they could have a very short cycle.…we are looking more and more at some of our own retail stores where we can looking at touching on a more vertical model. And not having that delay with going out and having an eight week ordering pattern and then go away and ordering product, we’ll just go straight to retail.”
            PacSun talked about doing the same thing in their conference call last week. Genesco’s CEO characterized small retailers systems as being “from the dark ages.” The current overall consensus from these big brands and major retailers is that they’re looking at the vertical integration and fast fashion models of retailers like H&M and American Apparel. Essentially offering on-trend, in-season apparel at lower prices. What’s more, these retailers stock stores more frequently, but with limited quantities of merchandise, giving shoppers a reason to visit stores more often. As you can see, there’s a lot going on in the retailing world. So what’s a smaller retailer to do?
The Road Ahead
The first thing to recognize is that only you as a shop operator can change your own behavior. These big companies are going to do what they’re going to do. As the saying goes, it’s just business, and developing outward is the natural progression of economic growth. The good news is that there’s a role for specialty shops based on the original model, that is to say, a store that properly services the core participants of the sport and lifestyle. But you’re going to have to run your shop like a business. Location and community will be your key attributes, and a credible online presence is now a requirement. Running it like a business is just the price of admission.
            Another piece of good news is that there are some natural limits on just how big big chains can get while still being credible. In his first conference call as Pac Sun CEO, Gary Schoenfeld said, “Nobody needs 900 Pac Sun stores.” The company is trimming back and reducing its number. Journeys store numbers will be almost static over this year. Genesco expects to open only 50 stores over five years across the whole company. Meanwhile, Footlocker, The Gap and Starbucks are other big retailers who we’ve seen that have learned this lesson and had to close storefronts.
            Next, some of your suppliers—skate comes to mind—are able to supply you with new product regularly and quickly. Take advantage of that to the fullest extent possible. Another important element, and something that has been lost in recent years, but goes back to the historical specialty shop model, is finding and featureing new brands—even when it looks risky. It’s a point of differentiation you can’t afford to give up, and what’s even riskier is not taking chances on smaller, emerging brands. It’s always been the case that new brands grow up in the core shops and then move on into broader distribution. It’s true that it may be happening faster than in the past but that comes under the heading of something you can’t fix. That doesn’t mean you’re helpless. Favour brands that offer product exclusively for specialty shops. Do some private label (but not too much, you don’t want to completely bite off the hand that feeds you) that gives you a better margin.
            Recognize the bigger brands’ concerns with the price points you’re buying and your ability to merchandise across their line well in the space you have available (see the quotes above). You’re never going to be in a position to carry everything by Quiksilver or Burton, but sit down and work with your brands to achieve a mix you’re both happy with. I mean, what’s wrong with saying to Brand XYZ, “Look, I’ve only got x-number of square feet in the whole store and can’t do what you’d like without turning myself into a Brand XYZ store. But I’d love to sell more expensive, faster-turn product that puts more gross margin dollars towards the bottom line. How can you help me do that?” Recognize their legitimate concern and interests in this area. If they don’t have a good answer, you’ve learned something and at least your conscience is clear. And if they do have a good answer, you might make a few more bucks. Finally, remember that the best shops give credibility to the brands they carry—not the other way around. I can’t believe how much mileage I’ve gotten out of saying that.
            Okay, let’s talk systems. A lot of retailers, perhaps more than half in action sports, have point of sale systems that they don’t use as anything but glorified cash registers. That’s got to end. If you agree that your focus has to be on capturing gross margin dollars and that you can no longer rely on big sales increases, then what choice do you have? You probably already own most of the hardware and software you need. If not, it’s cheap enough to get. Yes, the training will be a pain in the ass and this management accounting stuff kind of sucks, but if you don’t know which inventory is moving (and which isn’t), how quickly, and at what margins, then you are simply screwed. At best, you’re leaving a pile of money on the table. Good for you if you can afford that. At worst, poor systems will guarantee you go out of business.
            Conceptually, the whole analysis above isn’t that hard to get your head around. Do you agree with the evolution and role of core shops I’ve described? Does the financial model make sense given the current economic conditions? You can’t argue with what big brands are doing in retail. They are doing it and they are transparently telling you they’re doing it. But don’t despair. You’ve got tools and you can compete, even prosper, if you just remember the values of what the core shop really consists of and apply these to your own retail environment.

 

 

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

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

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

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

 

 

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

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The Numbers

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

 

 

A Medium to Long Term Perspective on the Job Market

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The chart below is something you need to see to have some medium to long term perspective on the economy and the job market.  It comes under the heading of something you won’t see in the mainstream media.  I have finally been doing this long enough to know that people don’t always like it when I present something that’s troubling and I actually thought about not posting it.  But I reminded myself that my job is to give you the best information I can that will help you run your business, even if it’s not cheery, or maybe especially then since nobody else seems anxious to do it.

The purpose of posting this is to give you some perspective on the possible duration of our current economic conditions.   Remember we need something like 100,000 to 125,000 new jobs a month just to keep up with population growth.   Eventually, new jobs and new industries will be created and the country will prosper if only because of its massive natural advantages.  But financially caused recessions are historically always the worse, and the deleveraging process we are going through has to be measured in years.

 

 

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

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

Strictly By the Numbers

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

 

 

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

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

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

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

 

 

I Wonder if PacSun Might Carry Hard Goods; And What Would Zumiez Think?

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Just for a moment, hypothetically, let’s think about PacSun’s turnaround strategy, whether it might make sense for them to start carrying hard goods, and how other companies might react.

PacSun’s Strategy

That PacSun is in the middle of a turnaround is hardly disputable, if only because their management has characterized it that way. And in my judgment, they are pretty much doing the right things. First and foremost, they acknowledged that their stores had stopped being a destination for their target customers, and they are working to fix that. They want to “Reestablish PacSun as a destination for great brands.” What does that mean exactly?
 
First, it means completely revamping their management team- to the point where at their last conference call they said they had cut back their juniors inventory because they did not have the right leadership or strategy in place. The management changes are well under way and, when we listen to their next conference call (okay, when I listen to it), probably within a couple of weeks, we may find it’s complete.
 
That impresses me. While there’s absolutely nothing as disruptive to a company as a total makeover of top management, there’s also no way for a company to succeed if the team isn’t aligned and in agreement as to the company’s strategy. Those of you who were at the Group Y Action Sports Conference a couple of weeks ago heard exactly the same thing from Van’s Vice President of Marketing Doug Palladini as he explained Van’s success.
 
Second, they’ve recognized they can’t have the same merchandise selection in all stores, regardless of location, and are working to localize their inventory. Third they are starting, like a lot of other brands, to emphasize speed and freshness in product. “The days of shopping in Europe for trends and then delivering a whole new collection are pretty much behind us,” was how they put it. We may all bemoan fast fashion, but there’s no choice but to react to it if it’s what the customer wants.
 
Fourth, they are going to be more cautious with private label and have eliminated private label board shorts. Fifth, they’ve rolled out a new advertising and promotion campaign that has a more appropriate focus. Last, they’ve recognized that more stores isn’t the answer and are focusing on making the ones they have better places to shop.
 
The Hard Goods Issue
All good stuff. If I were a hard goods brand and PacSun asked me to sell them some hard goods I’d get excited by the fact that Pac Sun could buy a whole lot of product from me (though I doubt any hard goods brand can expect to be in all their stores). On the other hand, I’d need to feel good about their chances for making their stores an attractive destination for my customers again. If they were lame, I wouldn’t want to be there because the lameness might rub off on my brand.   I would, in other words, need to feel good about PacSun’s ability to implement the strategy I’ve described above.
 
I’d get to feel good by spending some time with the people in charge of implementing the hard goods strategy for PacSun.    Assuming there was such a strategy, that is.
 
I’d want to roll out the product in, say, 10 or 20 stores initially. And I’d want those to be stores that already reflected PacSun’s revised strategy- ones that were remodeled to reflect the new focus, had a reduced reliance on house brand product, and had inventory specifically selected for the location. I’d want to have some involvement in how my product was merchandised and I’d like to know where PacSun was going to get sales people who could represent and sell hard goods. And while all these discussions were going on, I’d be chatting with my friendly competitors who also make hard goods to try and find out if they were selling to PacSun.
 
Some level of hard goods can make sense for PacSun as part of a strategy of regaining credibility with their target customer.   It’s certainly part of what has differentiated Zumiez among mall stores and made them successful, and that brings us to an interesting part of the discussion.
 
Though both are mall based chains with an overlapping focus, Zumiez is not PacSun and PacSun is not Zumiez. They have different ambiances, and different, though obviously overlapping, target customers. Zumiez has always carried hard goods and has prided itself on having employees at all levels that are in touch with the action sports culture. Though PacSun may have originally been closer to the “core” than it is now, it was never as close as Zumiez and it drifted even further away with growth and some of the decisions it made.   Zumiez has always been closer.   That has been important in how it has kept its credibility with customers even as it has grown.
 
PacSun wants some of that credibility back. I have to assume Zumiez would rather not share that market space with a nine hundred store gorilla. Even though Zumiez is only more or less one third the size of PacSun by number of stores and their geography doesn’t completely overlap( PacSun is in all 50 states, Zumiez in 35) I have to believe that PacSun’s problems made life easier for Zumiez in some ways and in some locations.
 
How might things go if PacSun starts carrying hard goods? A couple of years ago, I might have said that if they represent the brands well it would be good for everybody. But economic times are different and I think that’s less likely. It will also depend on what hard goods, exactly, they carry. I don’t imagine it will be snowboards (though of course I don’t know that). I can certainly imagine skate and while surf fits PacSun (and not really Zumiez) it’s generally difficult to imagine selling surf boards in mall stores.
 
I’m sure Pac Sun expects to make money on any hard goods it sells, but that wouldn’t be the primary motivation. They want to rebuilt credibility with their target market and get that customer back in the store. It’s a component of their overall strategy.   Superficially at least, a PacSun with hard goods will have moved a bit towards Zumiez’s in its positioning. Will the customers see that? Will Zumiez’s customers be more likely to shop at PacSun? Or will customers who chose PacSun over Zumiez be disappointed? Depends on just how much actual customer overlap there is I guess. But unless they subscribe to the “a rising tide raises all boats” theory, I can’t see Zumiez as thrilled.
 
Other brands, not hard goods, are currently sold at both Zumiez and PacSun. Wonder how they would see this if it happened. Would PacSun pick up some apparel or other products from the hard goods brands they decided to carry? 
 
 A PacSun who carries hard goods and uses that to revive their credibility with the action sport oriented consumer is a stronger competitor to Zumiez.   A PacSun who carries hard goods and does it badly damages the idea of such stores in malls, and that could reflect on Zumiez. It’s not that PacSun will be the same as Zumiez, or even that they will necessarily target exactly the same customer group. But some of those customers may only see the superficial similarities. Think how consumer looked at Hollister.
 
As Zumiez, PacSun, and any hard goods brands that might consider selling to PacSun know, having hard goods doesn’t instantly give you credibility and attract customers. You have to do it just right and the devil is in the details.

 

 

Nike’s Annual Report- A Few Interesting Facts

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Nike came out with their 10K annual report maybe 10 days ago. Because we’re in the habit of focusing on the press release and the conference call which happens much sooner, nobody seems to have paid any attention to this 145 page document. But never fear, I’m a glutton for punishment and there were a few interesting facts I thought I might provide.

You’ll excuse me if I don’t do my usual financial analysis. With hardly any long term debt (given their balance sheet though some of us probably think $400 million is a lot), a few billions in cash, and just over $19 billion in revenue, I just don’t think I’d discover anything useful if I stared squint eyed at their cash flow statement for very long.

Revenue was down from $19.176 billion in 2010 from $19,014 the previous year. But their gross profit margin, at 46.3%, was the highest since 2006. “The increase in gross margin percentage was primarily the result of favorable product mix, cost reduction initiatives, lower input costs and sales growth in our NIKE-owned retail business. (Emphasis added)” The retail increase was from both new store openings and growing comparable store sales.
 
“While our wholesale business remains the largest component of our NIKE Brand revenues, our NIKE-owned retail business continues to grow, representing approximately 15% of our total NIKE Brand   revenues in fiscal 2010 as compared to 13% in fiscal 2009.”
 
In the U.S., they’ve got 18 Hurley stores, 145 factory stores for closeouts, 12 Nike stores, 11 Niketowns, 51 converse factory stores, and 106 Cole Haan stores. In the rest of the world, there are 205 Nike factory stores, one Hurley, 55 Nike, 2 Niketown, 12 employee only stores, and 68 Cole Haan. They’ve got more stores to handle their closeouts then most chains have stores.
 
 Net income rose from $1.487 to $1.907 billion. They reduced their inventories 13.4% to $2.041 billion.
They’ve got 34,400 employees worldwide and 42% of their sales are in the U.S. The three largest customers represent 24% of U.S. sales, but none are more than 10%.   Hurley’s sales grew from $203 million to $221 million, but that’s the only specific action sports number or comment we get in the whole document.
 
They note that 89% of their U.S. wholesale footwear shipments (excluding “Other Businesses” of which Hurley is part) were made under their futures program. I think that’s the same as prebooks, which is pretty impressive. The number for U.S. apparel shipments is 62%. Where do they get all this stuff made?
 
“Virtually all of our footwear is produced by factories we contract with outside of the United States. In fiscal 2010, contract factories in Vietnam, China, Indonesia, Thailand, and India manufactured approximately 37%, 34%, 23%, 2% and 1% of total NIKE Brand footwear, respectively. We also have manufacturing agreements with independent factories in Argentina, Brazil, India, and Mexico to manufacture footwear for sale primarily within those countries. The largest single footwear factory that we have contracted with accounted for approximately 5% of total fiscal 2010 footwear production.”
 
But not even Nike is immune from macroeconomics and some of the labor issues in China.
 
“We anticipate our gross margins in fiscal 2011 may be negatively impacted by macroeconomic factors including changes in currency exchange rates and rising costs for product input costs. We also anticipate higher air freight costs as we work with our suppliers to meet increasing demand for certain running footwear products in the first half of the year.”
 
I strolled through the U.S. Open of Surfing last week and kind of noticed that Nike and Hurley dominated the place. It looks like Nike has plans for our industry.

 

 

How’s Volcom Doing? Their Quarterly Results

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I swear I wrote as fast as I possibly could during the conference call and hope I got all the good stuff. The press release was pretty much lacking in detailed management discussion and there were no footnotes to the financial statements. I know probably nobody will care by the time the actual quarterly report is filed with the SEC, but I promise to go through it and let you know what interesting info (if any) there is in the details.

Revenues for the quarter were up 15.4% to $62.4 million compared to $54.2 million in the same quarter the previous year. Gross profit in was up 13.2% to $29.8 million compared to $26.4 million. Gross profit margin was 47.7%, down from 48.6% in the same quarter last year. In its US segment, which includes the US, Canada, Asia/Pacific, Central and South America, it fell from 48.8% to 46.1%. It rose in Europe from 44.8% to 46.1% because of more direct retail selling and less to distributors.

In the first quarter of the year, the gross profit margin was 54.7%. In the complete years of 2007, 08, and 09 it was, respectively, 48.4%, 48.8%, and 50.2%.
 
Okay, let’s pause here and focus a bit. Volcom management tells us in the conference call that the lower gross margin percentage in the U.S. segment was primarily due to incentive pricing that was part of a strategy to gain market share. They also note that they carried more inventory to capture in season orders and that low margin liquidation sales were higher than in the second quarter last year in the U.S. segment. And CEO Richard Wolcott said they were “Getting great sell through.” They say that sell through reports show that Volcom product is “resonating” well with customers.
 
This is pretty much the part of the conference call where I go crazy with frustration because I don’t get to ask any questions. The ones I might have asked include:
  • If sell through is so great, why is the gross margin down?
  • If you are gaining market share, is it strictly because of the discounts you’re offering that lead to the lower gross margin or do you think you’ll hold that share when you raise prices? Anybody can get more share if they charge less.
  • Does carrying more inventory to capture in season orders mean your prebooks were off? Do you get as good a margin on those in season sales as on the prebooks?
  • Is carrying more inventory for in season orders a temporary tactic or do you expect to continue it?
  • You noted that low margin liquidation sales were higher in the second quarter last year. There decline should contribute to a higher gross margin. Can you give us any insight as to the size of those sales and their impact on gross margin?
These questions might be particularly appropriate given that during the question section of the conference, they said to expect some gross margin pressure during the third quarter and that higher liquidation and incentive sales were expected. Some of these pressures come from problem with supply and costs in China right now. Volcom specifically notes delays in snow product delivery due to labor shortages in China. Almost every company, of course, has to deal with these same pressures. 
 
Sales, general and administrative expenses stayed about the same as a percentage of sales at 47.6% but went up about $3.9 million. That’s part of their plan to increase market share and it’s probably the right time to do that. They have a balance sheet that allows them to.
 
Operating income tell from $504,000 last year to $67,000 for the quarter this year. For six months, operating income rose from $6.9 million to $11.1 million. Net income was $872,000 in 2009 for the quarter compared to $68,000 in the quarter ended June 30, 2010. You’re better off looking at operating income though. In last year there was a foreign exchange gain of $651,000 during the quarter. In the same quarter this year, it was loss of $66,000. The income tax provision fell from $352,000 to $31,000. Basically, in the quarter ended June 30, 2009, Volcom was a million bucks better off due to items below the operating income line.
 
In discussing the general economic environment, they say the macro demand environment has weakened a bit and retailers have become more cautious. In the U.S., they describe the retail attitude as “somewhat choppy.” They indicated that the core was continuing to grow (I wonder what that means exactly) but that some retailers were still having difficulties. In a related comment, they see the Billabong acquisition of West 49 as a positive because it will strengthen West 49. If you saw my analysis of that deal, you know that West 49’s most recent financials were weak and that I thought that weakness might have been a major motivator for the deal.
 
In Europe, Volcom sees a challenging environment. The business there has held steady for the last several quarters. Volcom in Japan is still “having problems” because of the macroeconomic situation.
 
But even with the current economic weakness, CEO Woolcott believes “…that investing now will serve us well when the recovery really begins to turn on.” I think he’s right.   The issue for all of us is when is that going to happen. And of course it wouldn’t hurt if the sun would come out in Southern California. I was just down there for the Group Y Action Sports Conference, the Agenda show, and to see the U. S. Open and felt like I’d never left Seattle. I also got to see Jack’s, a retailer I’d never been in before. I was impressed and will have more to say about that in another article.
 
In the U.S., all of their categories were up except juniors which fell 22%. That seems to be the category from hell for everybody right now. I have a hunch that’s going to continue and some brands getting on the “fast fashion” band wagon isn’t going to improve the situation. Revenue from Volcom’s five largest U.S. accounts was down 2% to 15.3 million and represented 30% of U.S. product sales. PacSun was down 2% to $8.7 million (17% of U.S. segment). Volcom has new displays in 25 top PacSun doors, and noted that they were enjoying working with the new PacSun management. It will be interesting to watch the direction of Volcom’s sales there.
 
CEO Woolcott said, “The Macy’s business is doing particularly well, especially in men’s and boys’.” Volcom has become among the top surf skate brands in men’s, boys and kids there, he indicated, and they believe this is due to an increased focus on Volcom’s merchandising and marketing efforts there.
 
I sure hope they are working on the merchandising in Macy’s. I stopped off to see the Volcom presentation in Macy’s a while ago and you can see what I found about half way down this article. http://jeffharbaugh.com/2010/05/19/volcoms-1st-quarter-ended-march-31-numbers-macy-inventory-management/. It wasn’t pretty but of course it was only one store and, I hope, not typical.
 
I’d love to be able to explore the gross margin issue in more detail, and I’ll let you know if there’s any more info in the 10Q when it’s filed. In the meantime, Volcom is pursuing a strategy which makes great sense as long as some economic improvement isn’t too long in coming. I guess every brand is to some extent hostage to a recovery.