Preparing for Long Term Market Ambiguity; Zumiez’s April 30th Quarter

I’ve generally been a supporter of Zumiez’s strategy and believe they’ve done most things right.  So when I see them suffering right along with everybody else in a difficult (not nearly a strong enough word) retail environment, it really brings home to me just what we’re dealing with.

The numbers first, then the strategic issues.

Financial Results

During the quarter, Zumiez’s revenues fell 2.6% to $173 million from $178 million in last year’s quarter ended May 2, 2015.  “The decrease primarily reflected a decrease in comparable sales of $13.2 million and a decrease of $0.2 million due to the impact of changes in foreign exchange rates, partially offset by the net addition of 47 stores…”  Comparable store sales were down 7.5%.

The gross profit margin fell from 31.8% to 28.9%.  “The decrease was primarily driven by a 160 basis point decrease due to the deleveraging of our store occupancy costs, 50 basis points due to a decrease in our product margin, and 30 basis points due to higher outbound shipping expenses for customer orders as a percent of total sales.”

Deleveraging means costs had to be spread across a lower sales level.

SG&A expense was up a bit from $52.4 to $53.9 million.  Operating income declined from a profit of $4.13 million to a loss of $3.94 million.  Net income fell from a profit of $2.77 million in the previous year’s quarter to a loss of $2.14 million in this year’s.

The balance sheet weakened a bit compared to a year ago by most measures.  Cash and marketable securities fell from $151 to $62 million.  The current ratio was down from 3.34 to 2.38 (still plenty strong).  Total liabilities to equity is a still very low 0.46, but it’s up from 0.39.  Equity dropped from $364 to $289 million.  Inventory was up 8.5% from $104 to $113 million.  Not a big increase especially considering new store openings over the year, but it increased as sales declined.

More interesting to me was the announcement that, “On February 5, 2016, the Company entered into an asset-based revolving credit agreement with Wells Fargo Bank…”  It’s interesting because in their last filing (The 10-K filed on March 14th) the line was not an asset based one.  Typically, when a lender takes a borrower from a secured to an asset based facility, it implies a little less confidence in the financial condition of the borrower.  But in this case, it may just be because the size of the line went from $25 million to $100 million.  The 10-Q doesn’t discuss why Zumiez needs the larger line.  There were no drawings under the line as of April 30.  Zumiez has never been much of a user of the lines of credit it has.  Increasing it just comes under the heading of “Why not?” I imagine.

I also want to talk about the commitments and contingencies section, where brick and mortar retailers disclose how much they have to pay under the signed leases for their stores.  Those amounts are not required to be carried on the balance sheet.  In fiscal years 2016, for example Zumiez expects those costs to be $50.5 million.  That “…does not include real estate taxes, insurance, common area maintenance charges and other executory costs.”  Those costs were $10.2 million for the quarter.

The reason I’m bringing this up now is that we’re in a time when flexibility in managing your brick and mortar may be a big advantage, as how many stores you need, where you need them, what configuration they should have and how much you can afford to pay are all in flux .  At least some of the bankruptcy filings we’ve seen were done in part because the filer didn’t have another way to get out from under store leases that just weren’t working for them.

Zumiez, however, seems to have some flexibility built into some of their leases.

“A majority of our leases provide for ongoing co-tenancy requirements or early cancellation clauses that would further lower rental rates, or permit lease terminations, or both, in the event that co-tenants cease to operate for specific periods or if certain sales levels are not met in specific periods.”

Note that it says “a majority,” not most.

Strategies for a New Kind of Market

Let’s start with the rollout of their new software- the “Customer Engagement Suite.”  They are the first retailer to have this and were intimately involved in its creation as I’ve written before.  I haven’t seen it in operation and it won’t be completely rolled out until sometime in 2017.  It’s to be a continuation and improvement on Zumiez’s omni-channel strategy.  It’s to build on and improve what they’ve already been doing in supply management, micro-sorting of inventory, customer connection and speed to the customer.  I’m guessing that the more they use it, the better data they will have.

This isn’t conceptually different from what other retailers are trying to do, but I see Zumiez as having a head start.  They won’t be the only ones with the software.

Zumiez ended the quarter with 663 stores, including 43 in Canada and 24 in Europe.  They’ve reduced their estimate of the numbers of stores they are going to open this year from 27 down to 22.

CEO Rick Brooks describes how they think about stores this way:

“As the rate of new store growth slows in 2016, our focus shifts towards optimizing existing physical store footprint and leveraging our integrated structural and technological platform to maximize the impact of each store within this geographic region…We do not want to open one more store than is necessary to serve the customer within each market that we operate in and deliver optimal shareholder return.”

There are several forces at work here.  First, where and when to open stores isn’t quite as obvious in the days of the internet.  Second, finding good locations in a weak economy where mall traffic is hurting is tough.  Finally, Zumiez is starting to get near to the maximum number of stores they believe their brand can support in North America.  I expect that number may have dropped some given business conditions and the internet.

You can see why the flexibility in the majority of their leases I highlighted earlier may be a good thing to have.

Rick made a comment about optimizing “…our store portfolio within a trade area.”  I think that’s a fascinating comment, and next time I can corner Rick, I’m going to nag him until he explains to me how they define trade areas.

The next issue is responding to a spoiled rotten customer who expects what they want when and where they want it with great service and an attractive price.  You always have to have something to show them when they ask, “What’s new?”  Those expectations will continue to be impossible for some retailers to meet and the number of retailers will continue to contract.

Rick Brooks describes how Zumiez is trying to meet this challenge:

“…customers have very high expectations today at all such points in the omni-channel world and that includes as it relates to the digital experience and I think that’s been driven a lot by the major player in the marketplace. So we have to work very hard to meet those expectations at every consumer touch point. So for us, localized fulfillment is most importantly about delivering a great brand experience and speed is definitely an important component to that for our customer who wants to buy unique cool stuff, which is what we’re trying to do for them, allow them their chance to individualize who they are through what they were and their connection and attachment to Zumiez in that regard. So speed is important and our ability to serve them.”

If everybody knows what they need to do (well, some don’t know that, but they won’t be around), nobody is completely sure how to do it.  Zumiez isn’t completely sure either, but they seem to be creating a structure that can function with an unusually high level of ambiguity.  Part of this is their focus on finding and nurturing new brands, letting each brand succeed as little or as much as it can with Zumiez, but also being ready to move on quickly to other brands as the market demands it.

Rick Brooks doesn’t think the fundamentals of retail have changed, though he recognizes that “…part of the hangover of the great recession is a level of frugality among our customers.”  I think Rick sees this as a temporary situation that will be relieved when the retail consolidation is over.  I think it may be generational.  But even if I’m closer to right than Rick, Zumiez is positioning itself to manage it.