WeSC’s Annual Report; Numbers and Strategy

I didn’t spot WeSC’s annual report until Shop-Eat-Surf did a story on it. Now, I’ve been through it. The Swedish approach is an interesting combination of a U.S. style annual report and our 10K SEC filings. I’ll start with a review of the numbers, but more interesting (I hope) will be a discussion of WeSC’s strategy and market position.

A Few Numbers

WeSC is a Swedish company, so their functional currency is the Krona. All numbers are in Swedish Krona unless I say otherwise. By way of reference, there were six Krona to the U.S. dollar at the end of the company’s April 30 fiscal year. A year earlier, it was 7.62.
 
WeSC’s revenues for the year ended April 30 were 408 million. At the end of fiscal year exchange rate, that’s about US$68 million, up 11.2% from 367 million the previous year. In constant currency, it grew by 20%. Gross profit margin was 45.9% down from 46.9% the previous year.
 
Pretax profit fell 28% from 56 million to 41 million. Net profit was down 40% from 48.8 million to 29.4 million. I should note that the income tax rate jumped from 13.1% to 27.7% and that pushed net income down more than you would have expected. Earnings per share fell from 6.6 to 3.98 Krona. The lower tax rate last year was due to booking a tax loss carry forward.   It was a one-time event (hopefully). 28% is a normal tax rate.
 
WeSC explains that “For the full-year 2010/2011 the dollar was an average of approximately 4.2 percent lower than in 2009/2010,” and “…the euro was an average of approximately 10.5 percent lower than in 2009/2010.”
 
“The lower dollar and euro exchange rates against the Swedish krona have had a positive effect on gross profit in the form of lower production expenses. At the same time the lower dollar and euro exchange rates against the Swedish krona have reduced revenue, because of which the total effect on gross profit was negative (the majority of purchases are in US dollar and the majority of sales are in euro).”
 
WeSC also notes that higher cotton and shipping prices had a negative impact, though they passed on some part of those increased costs as higher prices. 
 
WeSC’s lament about higher costs and exchange rates sounded an awfully lot like Billabong’s. At least WeSC didn’t have droughts and floods to worry about in their home market and isn’t as dependent there on owned retail as Billabong is. 
 
Only 18% of the company’s revenues are in the U.S. In U.S. dollars, it’s about $12.1 million at the April 30 exchange rate. Its next largest markets by revenue are Sweden, Germany, France and Italy with 16%, 10%, 9% and 9% of revenues respectively. The company reported it was in 2,410 retailers in 21 countries. 626 of those are in the U.S. The next largest is Italy with 320.
 
One of the things we’ve noticed in reviewing other company’s results is that they are focusing on growth outside of the U.S. due to better margins and growth opportunities. WeSC seems well positioned to take that approach as well. They’ve just started their program to enter China. U.S. sales for the April 30 year generated an operating loss of 2 million Krona.
 
57% of revenues come from distributors. 35% is through wholesale with the remaining 8% from direct retail sales. Like many other companies, WeSC is bringing its distribution in house as it grows. In the last fiscal year, it acquired its Danish distributor. Previously it had done the same in Germany and Austria. As of April 30, WeSC had 28 retail stores it calls concept stores. It owns eight of them directly. They plan to open more (don’t say how many) and I’m wondering how many you open before you’re seriously in the retail business and not just doing concept stores any more.
 
On the balance sheet, I noticed that inventory fell over the year from 28 million to 24.5 million. That’s interesting with the increase in sales and the acquisition of one distributor, which normally causes inventory to increase. I imagine some of it has to do with the strengthening of the Krona, which would reduce the cost of product bought in other currencies when translated back into Krona. It probably also reflects the brand exclusivity the company wants and an effort to make the distributors keep the inventory.
 
Accounts receivable rose 46% from 71.4 million to 104 million. Some or that would occur naturally with sales growth, but the strengthening of the Krona would reduce the value of receivables in other currencies, so I’m unclear as to the reason for the increase. WeSC notes the company has 57 million in overdue receivables (compared to 28 million at the end of the prior year). They have those “…without impairment losses being considered necessary.” Of this 56 million, 7.8 million is more than 91 days overdue and another 7.4 million is 61 to 90 days overdue.
 
The company’s “provisions for impaired accounts receivable at year-end” has fallen from 3.3 million to 2.6 million even as total receivables and total overdue receivables have grown significantly. I’ve seen language like this before (I think in Billabong’s financials) and it just doesn’t make sense to me that you can have a lower provision with that kind of increase in receivables. You can’t conclude that there is not an increased receivables risk, even if you assume you aren’t going to have to collect your Greek receivables in Drachmas.
 
The footnote goes on to explain that the company has 14 customers who owe the company more than a million Krona and together make up 80% of receivables. Five of those owe WeSC more than five million Krona each and account for 56% of receivable. I imagine some of those are independent distributors.
 
WeSC has no long term debt. Current liabilities rose from 52.9 million to 68.5 million as a result of a 22.3 million liabilities to credit institutions. This represents money they’ve borrowed that’s secured by receivables. The current ratio has fallen from 3.1 to 2.4, but is still more than adequate. Total debt to equity is 0.57, up from .40 a year at the end of the previous fiscal year.
 
Strategy and Some Interesting Comparisons
 
WeSC talks about its strategy as being more penetration of existing markets, entering new markets, launching new product groups, and opening more retail stores. That, of course, is more or less the same strategy that a whole bunch of other brands have. Why might WeSC succeed at it?
 
In a word, “street fashion.” It now seems like an obvious thing, but it was some time before 2000 when CEO Greger Hagelin thought of it. Or at least I think he thought of it. Reminds me of Skullcandy’s Rick Alden wandering around one day some years ago and thinking, “cool, stylish, earphones for the exploding portable electronics market.” Both seem obvious now, and I’m sure I’m not the only one who’s said, “Why didn’t I think of that?”
 
If you’re a street brand or an action sports brand, it’s hard to become a fashion brand. Ask Burton. Ask Volcom who, in my opinion, sold to PPR at least partly because they so solidly owned their own market niche that they couldn’t break out of it and continue growing without help from a fashion player.
 
But if you’re starting from scratch, selling “…streetwear with style, a cross between traditional streetwear and contemporary fashion…,” maybe you can have a foot in both markets. “Because of WeSC’s unique identify, other brands carried by retailers are seen more as complements than direct competitors.”
 
That might be a bit arrogant. But if it’s true, it’s pretty damned powerful.
 
The result, CEO Hagelin says, is that “We are one of the few brands that can sell our products in everything from action sports stores to fashion boutiques, to some of the world’s best department stores…” And they are able to “…broaden our distribution with watering down the brand…,” he goes on to say.
 
Street fashion does fit in a lot of places, and allows for product extensions, because of the brand’s positioning, that an action sports or street wear brand would have a hard time accomplishing. WeSC’s foray into high end headphones and luxury sneakers are two examples of such extensions. The company tries not to compete on price.
 
But I have to note that public companies pressured to grow seem to have an almost innate ability to screw up distribution eventually. It’s uncanny.
 
CEO Hagelin’s letter to shareholders also notes that, “The basis for our success, as well as our biggest challenge, is to continue to enlist skilled employees and outstanding WeActivists, who will help us strengthen and spread our brand and corporate culture.”
WeActivists are “…informal brand ambassadors.” They “… are strong-minded, successful individuals who are dedicated to their professions and to WeSC. WeActivists range from artists skaters and snowboarders to photographers, musicians, DJ’s and others who are extremely good at what they do, whether famous or totally unknown. WeActivists share a “street mentality,” and each one serves as an individual ambassador for their subculture.”
 
That sounds a lot like what Skullcandy does with its own extensive group of informal brand ambassadors. The focus on employees who can spread the brand and strengthen the culture sounds like Zumiez’s outstanding employee development program. There is no reason to reinvent the wheel.
 
The one thing I didn’t see in the annual report was a discussion of the competition. I hope that’s just an oversight. I’m intrigued as I think about who their competitors are, and I can’t really name them. Obviously, it’s not that they don’t have any. But if my observation that there are some barriers to being either street or fashion and moving into street fashion is accurate, then maybe WeSC has a head start.
 
But first movers, if that’s what WeSC is, aren’t always the ones who ultimately succeed in a market. It might be that WeSC is just now getting big enough to be noticed by the big fashion players, and that could force the company to pay more attention to competition. I have no knowledge of this, but perhaps the company’s longer term strategy is to get purchased by one of the very large players. I can imagine that WeSC’s positioning might attract some big multiples if those potential buyers consider it valid.