Billabong’s Annual Report; The Relationship between Strategy and Operating Environment

Billabong’s annual documents (which you can see here and here) provides us with a superlative opportunity to look at the nexus of a company’s strategy and its operating environment. The conference call transcript was also worth reading, but it seems to have disappeared from their web site. I can send anybody who wants it a copy.

Of course I’ll spew forth all sorts of numbers (in Australian dollars). But I want to look at those numbers in terms of the evolution of Billabong’s strategy, the impact of external factors, and some operational initiatives which, given the operating environment, are going to have a lot to do with Billabong’s future performance.

I’m sorry I’m so late getting this done, but I’ve been back on the East coast helping my mother and her husband move. Family has to come first.
A Transition Year
The year ended June 30, 2011 was a transition year. Billabong told us it would be and has been telling us that since last year.
Reported revenue rose 13.6% to $1.68 billion. Net profit was down 18.4% to $119.1 million. In constant currency terms, revenues were up 23.8% and net profit fell 6.9%. The currency fluctuations cost Billabong $123 million in revenues and $18 million in net profit. 
I will point out that Billabong had taxable income of $126.9 million and paid only $8.86 million in taxes. That’s a tax rate of 7%. Last year, they paid $57.9 million in taxes on $203 million of taxable income and had a rate of 28.5%. If this year’s tax rate had approximated last year’s rate, their net profit would obviously been a lot lower. Billabong tells us to expect a rate of 23% to 24% in the current year.
Here, then, is the income statement headline. Net profit fell in spite of higher sales and a very low and not to be repeated tax rate. That’s not good.    
Now, why was this a transition year? Mostly because of acquisitions. They closed the acquisitions of retailers West 49 in Canada, and Surf Dive ‘n’ Ski, Jetty Surf, and Rush Surf in Australia. As a result, the number of company owned stores rose from 380 at the end of the last fiscal year to 639 at the end of this one.
They bought the RVCA brand in the U.S. Inevitably, they ended up with a lot more inventory and took on some debt to finance all these deals. I’ll get to that when I talk about the balance sheet.
The retail acquisitions took their direct to consumer share of revenue from 24% of total revenue at the end of last year to 38% at the end of this one. Now that’s a transition and we’ll talk about the impact when we look at the evolution of their strategy.
Operationally, acquisitions leave you with a lot to do. Here’s how Billabong puts it.
“A range of initiatives have been pursued within the business to reflect the change in mix between wholesale and retail. The standardization of various IT systems and sales intelligence software is underway, overhead has been adjusted, management within key retail divisions has been enhanced, design teams to build faster‐to‐market product have been established and greater investment has been made into the Group’s fast‐growing and profitable online operations. The strategy to build a more robust business model in response to the changing consumer environment is on track.”
They also closed 65 stores during the year due mostly to high occupancy costs. Many of these were stores acquired during the year.
The retail acquisitions caused some initial margin dilution and, maybe more importantly, it delayed some sales revenue because once you own the retailer, you have to wait to book a sale until the product is sold to the consumer. Before they bought them, Billabong got to book the revenue when product was shipped to the retailer. 
It takes time and costs money before you realize the benefits of these kinds of actions. They had $12.3 million in pre-tax one-time merger and restructuring costs. As you know if you read me regularly, I find the so called nonrecurring costs a bit problematic in evaluating a company’s results. While it’s true that these exact costs won’t recur next year, there always seem to be new non-recurring costs at some level every year.
There’s a lot going on. Billabong expects to see more of the benefits in the current year. I’d go so far as to say they’re counting on it.
External Factors
As you saw above from the difference between as reported and constant currency numbers, Billabong got hammered by the strength of the Australian dollar (At June 30, one Australian dollar was about $1.06 U. S.). The Australian economy going into recession and getting hit with floods in Queensland didn’t help either. And, speaking of natural disasters, remember the earthquakes and tsunami in New Zealand and Japan.  Like every other industry company, they had to deal with higher product costs as the price of cotton rose. The good news is that the price has now fallen and that should start to benefit Billabong next calendar year.
Meanwhile, consumers worldwide are just not cooperating. “With the exception of the USA and some Asian territories, global trading conditions have generally deteriorated significantly,” is how they put it. They noted they’d seen some deteriorating in conditions in Europe during the last two months of the year.
Damn those pesky consumers!
It is, in short a tough operating environment (not just for Billabong) with a continuing high level of uncertainty. As a result, Billabong is not going to offer any earnings per share guidance until things calm down.
Operational Initiatives
 I quoted Billabong above in describing the operational initiatives they are pursuing.   Some are the direct result of acquisition, but none are bad ideas in and of themselves regardless of any acquisitions. I’ve been writing for a few years now that it was time to stop over-focusing on the top line, where revenue increases are continuing to prove tough to come by. Look instead to generate more gross and operating margin dollars through better operations.
I’d like to believe Billabong took my advice, but I’m afraid they probably figured it out on their own. As reported, their gross margin fell only slightly from 54.4% to 53.8%. In a promotional, higher cost environment, that seems like a good result. Even with the turn towards retail, their long term strategy implies the kind of cost management focus I advocate.
The initiatives they describe are not inclusive of everything they’re doing. And I wonder, as a public company, if they would have taken on quite all of it if they’d known what the year was going to be like. Still, as they get through all this stuff, assuming it goes well, on budget and on schedule, the impact on the bottom line should be substantial. 
Early on, Billabong recognized the limits of long term growth if you’ve only got one brand. They decided to grow by paying full price for established brands with growth potential and good management in place. I suspect there won’t be any more significant acquisitions for a while. Their balance sheet wouldn’t really support them, and they’ve got more than enough on their plate.
Part of their strategy has always been to protect their brand names by being cautious about inventory, distribution, and promotions. Even when the recession started, they choose to lose some sales rather than devaluing their brands by discounting. As noted above, their gross margin last of year of 53.8% fell only slightly from the previous year even in a difficult environment.
The strategy of growing retail (hardly unique to Billabong) had, in my opinion, a number of sources. First, it was the same desire for growth that lead them to buy other brands. Second, it was the knowledge that the number of solid brands they owned made a retail strategy more viable because they had the ability to stock their owned retail with these brands and generate extra margin dollars. Third, it was their analysis of the difficulties facing the independent specialty retailers worldwide. Things go a lot smoother when you don’t have to get orders from independent retailers and then collect from them.
The change in strategy, if you want to call it that, was the speed of growth in retail. I doubt they planned to have 38% of revenues coming from retail at the end of the year. And remember when these retailers have been owned for a full year, the percentage will probably be higher.
I suspect the accelerated growth was opportunistic. They could hardly ask West 49, or any of the other retail acquisitions, to wait and be for sale next year.
Finally, I want to remind you of some Billabong policies and procedures that some might not call strategic, but I see as the most strategic things they do. Look at the remuneration report starting on page 12 of Appendix 4E (the second link in the second paragraph of the article).   Then check out the eight governing principals starting on page 43.
The remuneration report shows how Billabong works very hard to align company and employee interests. The governing principals simplify managing by making it clear what’s most important. When you sit at the desk of the senior executive, you are constantly inundated with stuff crying for attention. These principals make it easier to not waste time on the wrong stuff. Even more powerfully, they can help do the same thing for every employee in the organization if they are communicated effectively. Wonder how much time and money that can save.
I also noted that all directors attended all nine scheduled board meetings and three unscheduled ones as well. I love to see that level of commitment.
Oh Yeah- Forgot the Financial Statements
The first thing I want to know if what the sales would have been without the acquisitions. We know that U.S. wholesale was flat excluding RVCA. I also see that trade receivables fell from $389 million to $341 million suggesting an overall decline in wholesale sales. But I don’t have a way to isolate any currency or timing impacts so I can’t be sure. All of last year’s acquisitions occurred between July and November of 2010, so their impact on sales in the year ended June 30, 2011 is substantial.  I think I’ll call a friend.
The friend got back to me and tells me I didn’t read footnote 35 closely enough.  My friend is right.  Acquisitions contributed $313.3 million to revenue during the year ended June 30, 2011.  Without the acquisitions, Billabong’s revenue would have been $1.374 billion, down 7.6% from the previous year.   
As you may recall, Billabong operates and reports its business in four segments; Australasia, Americas, Europe, and Rest of the World. I’ll ignore the rest of the world as it only represents $2.2 million in revenue.
Revenues in all three regions were up significantly in constant currency but, again, I can’t isolate the impact of the acquisitions. The Americas had revenue of $844 million, up 32.5% (18.4% as reported). Europe grew by 11.5% to $338 million (it was down 1.9% as reported). Australasia grew 19.5% to $502 million.
As reported, EBITDA (earnings before interest, taxes, depreciation and amortization) fell in all three regions. It fell from $89 million to $55 million in the Australasia. It was down from $92 million to $80 million in the Americas and from $70 million to $54 million in Europe. Consolidated EBITDA was $192 million, down 24.3% in reported terms and 16.2% in constant currency. The reported EBITDA margin was 11.4%, down from 17.1% the previous year.
Without the inventory impact of the acquisitions (projected to be temporary) it would only have fallen to 13.1%. Other factors include the merger and restructuring costs of $12.3 million already mentioned and foreign exchange losses. There was also $4.5 million associated with restructuring and rolling over the company’s syndicated debt facility and some accounts payable timing issues that dragged payments into the year.
We’ve already talked about the external factors that influenced this.
Overall, selling, general and administrative expenses rose 27.5% to $599 million. That includes employee expense that rose from $226 million to $283 million. Obviously, a chunk of this increase is the result of the acquisitions. There are people working in all those places and they inconveniently want to be paid.
The balance sheet took a hit. Remember a couple of years ago when Billabong raised some capital even though they didn’t really need to? It’s a good thing they did because I don’t think some of the acquisitions they did would have happened without it.
The current ratio fell from 2.48 top 2.33. Total liabilities to equity rose from 0.82 to 1.02. Net borrowings were up from $217 million to $468 million. Their interest coverage ratio fell from 12.6 times to 6.1 times. Some of the analysts were concerned about that.
Inventories rose 45% from $240 million to $349 million. This includes the inventory of all the acquired companies so naturally inventory rose. But there’s more to it than that. All the inventory in the acquired stores is at full wholesale cost. Even the Billabong and Billabong owned brand inventory. Once Billabong is stocking those stores directly, the owned brand product will go into the store inventory at Billabong’s cost- not full wholesale. Branded inventory from other companies will still come in at full wholesale cost, but I’m sure Billabong hopes to make some better deals based on its larger retail purchasing power and we know they expect to increase the percentage of owned brand inventory in those stores.
In other words, some of that inventory increase should go away over the next year as the owned brand inventory turns over, and its share of total inventory in these stores expands. The inventory increase is partly, but not completely, a one time event.
There is also some excess inventory they bought in anticipation of sales that didn’t occur and some they bought and received early because of concern about possible supply constraints that didn’t emerge. In total, they see $60 to $65 million of existing current assets turning into cash during the year.
Net cash flow from operating activities fell from $187.2 million to $24.3 million. That’s a big drop. There are also about $86 million in acquisition payments scheduled for this year.
There was some wailing and gnashing of teeth from some of the analysts about the weakening of the balance sheet and the decline in operating cash flow. They should be concerned. It’s rather critical to Billabong that these operational and margin improvements kick in this year because we continue to be in an environment where sales increases may be harder to come by. Europe is weakening and, at least in my mind, it’s not certain that the U.S. will strengthen much.
But I also think some of the analysts were caught by surprise by the size of the increase in retail business. Rather than focusing on the strategic impact, they were concerned with the short term financial impact. I guess that’s their job. That’s why there are quarterly conference calls.
At the end of the day, a stock goes up in the long run because of increases in earnings. Nothing else matters. I imagine there were discussions around Billabong as to whether they should do quite so many acquisitions last year. They knew the economic environment was iffy, and they could more or less calculate the balance sheet impact. Still, if you look at their strategy you can conclude the concepts of the deal made sense even if the timing wasn’t quite what they might have preferred. It was the best path they could see to improved, long term profitability given the environment they have to operate in.
But they’ve taken on some additional risk to do it. The balance sheet shows it. And, like the rest of us, they can no longer count on automatically higher revenues generated by strong consumer demand.         
I think we can assume that the world economy is not going to miraculously rise up during the next 12 months. So what we’ll be doing is watching to see how well Billabong executes its operational strategies internally to improve its earnings and strengthen the balance sheet.