Billabong management told us at least six months ago that 2011 would be a “transition year” and it is. But the strategy they started to tell us about a few years ago remains intact and they continue to pursue it. As I’ve written before, I generally agree with that strategy and my experience is that companies that pursue a solid strategy over the long term succeed- unless the market environment changes and the strategy doesn’t.
Let’s set the stage a little. All the documents on which this analysis is based can be found here.
First, Billabong has always been protective of its brands. You’ll remember that when the recession hit, they resisted the urge to discount more than most other brands with the goal of maintaining their brand equity. Probably cost them some sales, but gave them better gross margins. My readers know that, in the current economic environment (which I expect we’ll be in for years) I believe in generating gross margin dollars even at the cost of some sales.
Second, they are probably done with acquisitions for now. They won’t say never or none, but they aren’t looking and think they have enough opportunities integrating what they’ve bought. Indeed, much of the reason Billabong describes 2011 as a transition year is because of the need to complete that integration and the positive impact they expect it to have.
Third, the nature and structure of Billabong has changed as their retail component and owned brands have increased. At December 31, 2010 they had 635 company owned stores. These stores represented about 40% of group revenue for the half year and all that new retail wasn’t owned for the whole six months. The core Billabong brand represents, for the first time, just under 50% of revenues. So Billabong is heavily focused on retail and is a portfolio of brands that needs to be managed. But due to the retail component, they can’t be managed completely in isolation of each other.
The final point I want to raise before getting to the analysis is not specific to Billabong and concerns the issues that are mostly of our control, though of course we try our best to manage them. I guess this relates to consistently pursuing your strategy unless the market changes.
Everybody who makes anything from cotton knows that cotton prices are at record highs. Billabong CEO Derek O’Neill points out in the conference call that cotton typically represents something like 40% of the FOB price of a garment and that some price increases are inevitable for all companies. It’s in the supply chain where he sees the biggest downside risk to their business. But inflation isn’t just in cotton, and it’s not just in China. With a soft economy, you wonder just how much of those increases you will be able to pass along. I’m pretty clear on what people with stagnant incomes, no jobs, or too much debt who have to choose from more expensive food, gas, or board shorts will tend to pick.
Which gets us to the subject of economic recovery, because a little inflation can be irrelevant if the world is growing, jobs are being created and customers are happy. Billabong, like most other companies I think, is assuming some improvement. Or at least they need that improvement to achieve their projected results. Here’s how they put it:
“…the Group expects NPAT to be flat in constant currency terms for the full financial year ending 30 June 2011 and, thereafter, assuming global trading conditions gradually improve, in particular in the Australian consumer environment, the Group expects to return to more historic EPS growth rates in excess of 10% per annum in constant currency terms.”
Finally, there’s the uncontrollable issue of exchange rates. This is a good time to remind you that the numbers in here are in Australian dollars (AUD) unless I say otherwise. Between July 1 and December 31, 2010 the AUD strengthened from $US 0.85 to $US 1.02. That’s 20%. So revenues earned in US dollars were worth a lot fewer AUD at the end of the period than at the beginning. The Euro strengthened by about 11.6% over the same period against the AUD. I always felt that if you’re an investor, what you care about is your return in the currency you invested in and expect to get paid in. But looking at constant currency provides a valuable perspective, and I’ll refer to it in this discussion.
Quick Look at the Balance Sheet
Let’s do the easy part first. Billabong has always been ahead of the curve in managing their balance sheet in anticipation of their cash flow, acquisition and expected growth requirements. In August, it increased its bank line from US$483.5 million to US$790 million and extended the two segments of the facility by one year to July 1, 2013 and July 1, 2014 respectively. This provided some flexibility, ability to fund acquisitions, lower costs, and general breathing room so opportunities and surprises could be managed.
Between December 31, 2009 and December 31, 2010, long term borrowings rose from $397 million to $571 million (remember those are Australian dollars). The number at June 30, 2010 was $405 million so most of the increase came in the six month period.
The largest was West 49, acquired on September 1, 2010. There were four other acquisitions between July 2 and November 8. Note six to the financial statements reports that the “Outflow of cash to acquire subsidiary, net of cash acquired” was $203.6 million. $94 million was for West 49.
Inevitably, borrowing money has an impact on the balance sheet. Comparing last December 31 with the prior year, we find the current ratio has fallen from 3.81 to 2.27. Higher is usually better. Total liabilities to equity over the same period rose from 0.67 to 1.03. In this case, lower is generally better.
I feel obligated to report the change, but the balance sheet is still strong and it’s not like there’s an issue here. We know why it happened, that it was deliberate, and that they adjusted their lines of credit to give them the flexibility to manage it. Balance sheets can never be looked at in isolation from cash flow management. Well managed balance sheets give me a warm, fuzzy feeling.
Digging Into the Income Statement
Here are the summary numbers as reported. Half year revenues rose 15.7% to $837.1 million compared to the same period the prior year. The gross profit margin fell from 55.7% to 54.4%. Selling, general and administrative expenses rose 20% from $239 million to $287 million. Other expenses were up $33 million to $87 million. Interest expense rose from $12.2 million to $19.9 million.
Profit before tax dropped from $98.4 million to $62.3 million, or 36.7%. After tax income fell 17.9% from $69.7 million to $57.2 million. The income tax provision was down from $28.7 million to $5.1 million. The lower tax rate was largely the result of several one-time events. Without those, the tax rate would have been 24%.
EBITDA (earnings before interest, taxes, depreciation and amortization) fell by 23.4% as reported. Billabong says five factors were responsible for the decline:
1) The very weak retail environment in Australia.
2) The strength of the AUD against the US$ and the Euro.
3) The impact of the recent acquisition of retailers (see discussion below).
4) M & A and restructuring costs of $10.3 million.
5) An increase in global overhead costs.
In constant currency, revenue was up 24.4%, EBITDA fell by 17.3% and after tax profit fell 9.8%. Revenues would have been $49 million higher. Net income would have been up $6 million. Big currency impact.
Billabong reports its business in three segments; Americas, European, and Australasian. Sales in the Americas were up 28.6% as reported and 38.2% in constant currency. In Europe, they fell 4.1% as reported and rose 14.3 in constant currency. In Australasia, it was 12.4% and 13%.
As reported, EBITDA in the Americas fell from 13.7% during the period from $33.7 million to $29.1 million. The EBITDA margin was down from 10.6% to 7.1%. In constant currency it fell 5.8% from $30.9 million to $29.1 million and, as a percent, from 10.4% to 7.1%. It was noted that conditions in the wholesale accounts were showing some improvement, but that retailers were still cautious about holding inventory. Good for them. During the conference call it was noted there were “significant declines” in sales to Pac Sun during the six months, with orders for the Billabong and Element brands down 50%.
Reported European EBITDA fell 17.4% from $29.1 million to $24.1 million. The margin dropped from 17.8% to 15.3%. In constant currency, it rose 3.9% from $23.2 million to $24.1 million but the EBITDA margin declined from 16.8% to 15.3%. Growth in this segment was led by the Element, Nixon and DaKine brands.
For the Australasian segment, it was reported to decline 32.5% from $59.7 million to $40.3 million. The EBITDA margin fell from 24.9% to 15%. In constant currency, the numbers in this segment were almost the same as reported.
The Impact and Management Challenge of Acquisitions
The other expenses line in the income statement includes $7.4 million in acquisition related expenses. West 49 contributed $82 million in revenue and $1.7 in after tax profit to the group for the six months ended December 31, 2010. The other acquisitions (which aren’t broken out separately because, I assume, of their smaller size) contributed revenue of $66.5 million and after tax profit of $6.2 million during the same period. If you take that $148.5 in acquisition related revenue out of the total for the period, total revenue from existing brands was $688.6 million, down 4.5% from the same period the prior year. CEO O’Neill says in the conference call that “…once we strip out the acquisitions, there was revenue growth in the underlying business…” Strangely enough, I’m guessing both statements may be correct. The difference, which is discussed in some detail during the conference call and below, may come from how you categorize between wholesale and retail during the transition period following acquisitions.
Now, let’s talk about the impact on sales and margins when a brand acquires a retailer that was a customer before it was acquired. First, revenues no longer get recognized when the brand ships its product to the retailer. The retailer has to sell that new inventory before it’s recognized as revenue by the consolidated entity. On the other hand, Billabong immediately starts recognizing sales of inventory held by the retailer as of the closing date. But if Billabong has previously sold some Billabong branded product to, say, West 49 and the product’s still in the West 49 store after the closing date, what happens? Billabong has already recognized the sale of that merchandise and taken it out of their inventory. It comes back into their inventory at the acquisition date, but at what cost? You can’t go back and adjust your financial statements based on an acquisition that occurs the next period. I guess you bring it in at the acquired company’s cost. Okay, I’ll stop. I don’t want to go all debit and credit on you. But you can see that there’s some delay in recognizing sales and the increasing gross margin.
And these retail acquisitions start out with lower margins than Billabong is use to earning. Before they can really influence that, according to CEO O’Neill, “…we have to sell the inventory on the floor, the inventory in the warehouse and also the inventory on order by the previous owners before we get the opportunity to affect the mix of product on the floor and generate additional wholesale margin through the sale of company owned product to the stores. So that means we have to get through one or two inventory turns of existing product from third party suppliers before we can start to realize the benefits of owning retail.”
Changing the product mix on the floor and getting better margins sounds so simple, but it’s pretty complex as I’ve pointed out previously. Billabong has to decide how much of which of its owned brands it can carry in the stores. Obviously, they make more money on those brands. Are they going to reduce the footprint of the brands their retail carries that they don’t own? By how much? How will those other brands react to that? CEO O’Neill says, “As far as the third-party brands go, I think we are still having a lot of discussions in terms of who’s coming with us over the medium term.” I’ll bet they are.
You can see why these acquisitions have a lot to do with why management calls 2011 a transition year.
As you think about the things that will influence Billabong’s success, where should you focus? First, on the economy. Billabong appears to be counting on some improvement there to meet its goals. Well, why should they be different from the rest of us? I hope we get that improvement, but I’m not certain it will come quickly.
Second, as I discussed above, they’ve got some non-trivial work to do to realize the benefits of their retail acquisitions. It’s easy to buy a company. It’s hard work to achieve the benefits you projected when you bought it. We’ll get a better sense of how it’s going in six months or so. I was glad to see the discussion in the conference call about the progress they are making in consolidating four computer systems, warehouses, and back office functions into one. I don’t know the details, but there’s typically some money to be saved and efficiencies to be gained there.
Some of those efficiencies come in getting product to market a little faster and having to hold less in inventory, and I suspect that requires those integrated systems. That was also a subject of the call, but this isn’t the first time Billabong management has focused on it.
Accomplishing that requires that things go smoothly in the supply chain. Billabong has some concerns not just about the price of cotton, but about labor shortages and shipment delays. Once again, this is a concern we all share.
Finally, with no acquisitions expected in the near future and the economy improving slowly at best, you have to ask where growth will come from. Every company that protects its brands through control of distribution eventually runs up against this. Where can you sell without diluting your brand equity?
My sense is that Billabong, while they wouldn’t trumpet it from the roof tops, knows sales increases are harder to come by than they’d like. But they believe that can accept slower top line growth in exchange for vertical margin, system efficiency, and certain savings you can sometimes achieve when your brands are well positioned and cautiously distributed. If they do think that, well, I agree with them