Quiksilver’s Quarter: The Impact of Market Trends

In the quarter ended April 30, Quiksilver’s revenue fell 10.4% from $456 to $408 million. The net loss grew from $32.4 to $53.1 million. Discontinued product lines contributed $9 million to revenue in last year’s quarter, but none in this year’s. A year ago, they also owned Mervin and the Hawk brand. I’m a little surprised they didn’t mention how much revenue those brands contributed a year ago.

I’ll spare you a long quote from CEO Andy Mooney on the profit improvement plan (PIP), but basically he says, we’ve done what we said we’d do and we’ll do more. He notes they’ve cut brands and product lines, are rationalizing sponsored athletes and event participation, licensing peripheral products, closing losing stores, reducing headcount, managing expenses down, centralizing merchandising and design, cutting SKUs and factories, and reducing SG&A.
But then they announce that they are pushing back the PIP profit target for a year to the end of fiscal 2017. Why, if they are doing all this good stuff, is that necessary?

Let me quote CFO Rick Shields as he explains what’s going on.
“Over the last 12 months in the U.S. alone we have seen approximately 20% of our smaller wholesale accounts close. This trend has also been evident in Europe where smaller core retailers face the added pressures of weak economies and higher youth unemployment… In apparel, the demand for lifestyle apparel is increasingly being met by fast-fashion vertically integrated apparel retailers at price points significantly below those currently offered in Action Sports.”
He goes on to discuss that in Europe and the Americas, “…our initial pricing has been too high for the last few seasons. This resulted in poor sell through, high markdowns and returns, a significant reduction from initial gross margin to final gross margin and lower wholesale pre-bookings for subsequent seasons. We believe that by being more competitive with initial pricing that sell in and sell through will improve along with subsequent reductions and markdowns in returns. We believe this change will support improved wholesale channel performance and we anticipate being able to hold our final gross margins.”
I agree with him. It’s not that I like to see this kind of competitive pricing pressure, but I think their approach is operationally sound and will benefit their brands. Does anybody reading this think he’s wrong about the costs and inefficiencies of the process he describes?
Now let’s hear from CEO Mooney: “We are adjusting our growth strategies to increase investments in DTC channels primarily in emerging markets to be much more competitive in core specialty and more focused on fashion right, price right, SMU programs for large and non-core wholesale channels in North America and Europe. We anticipate that these strategies will take more time to implement and consequently now anticipate achieving our PIP profit target by the end of fiscal 2017.”
This is not the market that Quik and other industry brands grew up and succeeded in. It’s more price competitive and promotional than ever. Sales increases are hard to come by. Here’s an example Andy gives.
“There’s the case of apparel, the fast fashion vertical retailers, where on the lifestyle component of the segment they are introducing products like board shorts or swimwear where it used to be the norm and still is the norm to say sale a pair of board shorts in a specialty surf shop at $60. Increasingly a lifestyle variation of that product could be sold at an account like H&M for $20.”
“So that is the significant chasm between two price points. So I think if you’re going to be with the mall-based specialty retailer in the lifestyle segment, we don’t intend to be at $20, but we probably have to be much less than $60.”
In North America, Andy tells us, “…60% of the business is in shorts.” I guess I’d be surprised if that was across all three brands. Perhaps he just means the Quik brand, but I can’t tell. What would be the impact of lowering board short prices between, say, 17% and 33%? Would price reductions on other products and brands be similar? Would it give you enough volume to make up for the lost margin?
They’ve made progress optimizing their production network. Andy gives us the example of buying t-shirts for spring 15 from only five factories where they used to buy from 55 factories. I don’t know if progress with other product is equally dramatic. They are also seeing the cost benefit of producing bigger numbers at fewer factories.
They are going to take some costs out of some products we learn. I don’t know the impact on quality and features, though Andy tells us, “I know in spring ‘15 that the quality of our product will improve, particularly when you look at it from a price to value perspective because we’re basically plowing much if not all of the factory price improvements that we’re getting through reduced SKUs and a narrower factory base into product quality and sharper pricing to drive the top-line growth again and drive sell-through in our wholesale channel.”
Two comments. First, it seems the reason they have to push out the impact of the PIP is because the cost reductions they have achieved through better factory pricing and logistics are going right back into reduced pricing. Second, one definition of improved product quality is apparently product with fewer features and lower quality, but with a lower price.
A lot of what Quik (and other industry brands) are doing strikes me as defensive as nature. They are being forced to compete in a market they really would prefer didn’t exist. That bothers me. Let’s take a look at some of the numbers then come back to that idea in the conclusion
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The Numbers
I started off the article with the sales numbers. Let’s break those down a bit by geographic segment, brand, and channel as reported in the filing. You can review the 10Q yourself here is you want.
You can see that all three regions declined, but that most of the decline was in the Americas. North American revenues fell 20%, but those in Brazil and Mexico rose 30%. We don’t have any information on the relative sizes of those markets or of other country markets not specifically mentioned.
“EMEA segment net revenues decreased by a high single-digit percentage in the wholesale channel and a low single-digit percentage in the retail channel. These decreases were partially offset by strong double-digit percentage growth in the e-commerce channel. The net revenue decrease in the EMEA wholesale channel was primarily due to decreased year-over-year net revenues of Spring/Summer products and increased returns and markdowns to aid inventory sell-through versus the prior year period.”
“APAC segment net revenues increased by a high-teens percentage in the retail channel and in excess of 40% in the e-commerce channel. These increases were partially offset by a high single-digit percentage decrease in wholesale channel net revenues.”
There was the following comment in the conference call by Andy Mooney; “And as we work through litigation with our partner in China, we hope to be able to develop that market there as quickly as we possibly can.” The litigation section of the 10Q doesn’t mention this. However, China seems to be a market Quik, and everybody else for that matter, is counting on. I hope the litigation issue is not serious and that they work through it quickly.
Revenue for all three brands was down, but you can see that the decline in DC, at 20%, was by far the largest. As Andy Mooney put it, “…the decline in DC footwear is largely a result of poor execution [and] distribution expansion in the U.S.” He says that with less inventory in the wholesale channel, they are starting to see some improvement. DC was down 30% in the Americas wholesale channel and 20% at retail in that market.
As you see directly above, the biggest chunk of the problem is in wholesale. They highlight the 30% increase in ecommerce, but it’s from $23 to $30 million. You know what would be really interesting? Taking out the DC wholesale business in North America and seeing what things looked like.
Quik ended the quarter with 658 company owned retail stores. That’s 28 more than at the end of last year’s quarter. Most of the new stores are in the Asia-Pacific (APAC) region.
Moving on to gross margin, we have the following result by region.
From the 10Q: “This 280 basis point improvement in gross margins was primarily due to four factors: 1) lower net revenues from clearance sales within the wholesale channel (120 basis points); 2) a net revenue mix shift toward the higher margin retail and e-commerce channels (80 basis points); 3) the net revenue mix shift toward the higher margin EMEA and APAC segments (40 basis points); and 4) the gross margin benefits from licensing activities (20 basis points).”
I’m glad to see the biggest part of the improvement coming from reduced clearance sales. Though I know it’s GAAP, I’m not sure how I feel about including licensing revenue as part of gross profit as there is no product cost involved.
SG&A expenses were down a few million from $217 to $214 million. But with the revenue decline, they rose as a percent of sales from 47.6% to 52.3%. SG&A expense reductions were offset by an $11 million bad debt expense for “…two rather unusual distributor situations… “
There were impairment charges of $20 million from a $15 million write down of Surfdome goodwill and $4 million to restructure their ecommerce system. The operating loss was $34.7 million, up from $13.3 million in last year’s quarter.
Interest expense rose from $15.3 to $19.2 million, and that’s a good lead in to discussing the balance sheet.
The headline for me is that long term debt rose from $769 million a year ago to $847 million due, I assume, to higher borrowing and increasing interest rates.   This does not include the current portion of that long term debt.
The current ratio improved a bit, rising from 2.64 to 2.84. Inventory fell by 12% from $366 to $321 million. They don’t tell us how much of that was from selling brands and discontinuing product lines. Their inventory days on hand rose by 7 days to 138 days. That reflects declining sales. There’s some more work to be done with inventory, which they acknowledge.
Equity has fallen from $546 to $333 million. That decline, coupled with the rise in debt, has pushed the total liabilities to equity ratio from 2.08 to 3.63 over the year.  Net cash used in operations rose from $18.4 to $40.2 million.
Sorry to inflict a blinding flash of the obvious on you, but the balance sheet deterioration can’t continue.
Known or Anticipated Trends
That’s actually the title of a short section that Quik has seen fit to include on page 28 of their 10Q. Here’s what it says:
“Based on our recent operating results and current perspective on our operating environment we anticipate certain trends continuing to impact our operating results during the second half of fiscal 2014, including:”
“• Year-over-year net revenue comparisons continuing to be unfavorable. Within this trend, we expect the year-over-year net revenue comparisons to be unfavorable in our North America and Europe wholesale channels, and favorable in our emerging markets and our ecommerce channel;”
“• Year-over-year SG&A comparisons being less favorable in the second half of fiscal 2014 due to annualizing against the expense reduction initiatives we implemented last year and to the timing of planned marketing campaigns; and”
“• Fiscal 2014 Adjusted EBITDA being below fiscal 2013 results with third quarter year-over-year comparisons being more impacted.”
My interpretation of this is that things are going to get worse before they get better. We’ve seen that the worst of Quik’s problems are in the wholesale market in North America and, to a lesser extent, in Europe across all three brands. The trends may be positive for ecommerce and emerging markets, but I wonder just what percentage of revenues we’re talking about for those two markets.
The competitive environment has changed and Quik, along with other industry companies, finds itself on the defensive in a lower priced, fast fashion, broader market where their traditional strengths aren’t as important. I agree with pretty much everything they’ve done. I am certain it is having and will continue to have a major operational impact.  What I don’t know is whether it will make them into a more successful competitor in the market they now have to compete in.
Part of the problem, if I can say it again for the 12 or so time, come down to the contradiction between solidifying your brands on the one hand and being a public company requiring revenue growth on the other. I continue to see the two as being incompatible.
In a perfect world, I’d like to see Quik taken private, where I believe the value of their brands could be more easily realized.
For those of you who can’t see that happening remember that, like me, you probably didn’t see VF buying Vans coming either.