Zumiez Has a Good Quarter Too

Zumiez’s 10-Q for its quarter ended October 31 reported an increase in sales and profits.  I used the word “Too” in the article title because it sounds a bit like the Tilly’s results I reported a few days ago. Zumiez, like Tilly’s, would like to point to all the good things it’s doing as being responsible for the result.  And no doubt it’s fair to do that, but Zumiez, like Tilly’s was surprised by the strength it’s seeing and is cautious as to whether it will continue.

Net sales rose 8.4% from $204.3 to $221.4 million.  “The increase primarily reflected an increase in comparable sales of $8.2 million and the net addition of 35 stores (made up of 27 new stores in North America, 5 new stores in Europe, and 5 new stores in Australia partially offset by 1 store closure in North America and 1 store closure in Europe) subsequent to October 31, 2015. By region, North America sales increased $14.7 million or 7.8% and other international (which consists of Europe and Australia) sales increased $2.4 million or 14.6% for the three months ended October 29, 2016…”

Zumiez ended the quarter with 608 stores in the U.S., 47 in Canada, 28 in Europe, and 5 in Australia.

The gross profit margin was up 0.1% to 34.4% due to a small improvement in product margin.  SG&A expenses rose 8.1% from $54.8 to $59.3 million, but was constant as a percent of revenue at 26.8%.  Operating profit was up 11.1% from $15.2 to $16.9 million and net income was up 10.8% from $9.65 to $10.70 million.

CEO Rick Brooks starts the conference call by saying, “Third quarter diluted earnings per share increased 19% to $0.43 from $0.36 a year ago. This is well ahead of our initial guidance range of $0.21 to $0.26, due primarily to stronger than expected sales.”

I’m going to quibble with him a bit.  Certainly, increasing sales drove growth in earnings per share, but so did a reduction in the number of shares outstanding.  At the end of last year’s quarter there were 26.602 million shares outstanding.  This quarter, the number was 24.662 million, a 7.3% decline.  They’ve bought back 1.2 million shares so far this fiscal year.

Had the number of shares outstanding stayed the same as at the end of last year’s quarter, diluted earnings per share would have been $0.40 rather than $0.43.  The share reduction, then, was responsible for about 43% of the increase.  Maybe as an investor you don’t care where the earnings per share increase comes from as long as it comes.  But as you evaluate any company’s performance, remember that an increase in EPS from reducing the share count isn’t an indication the company is competing more effectively.

The balance sheet showed an inventory increase consistent with the store increase and going into the holiday season.  Current ratio fell from 2.48 at the end of last year’s quarter to 1.97.  No long-term debt.  I do note $11.8 million in short term borrowings where there was none a year ago.  Equity is down about $10 million to $289.4 million.  Nothing to see here.  Let’s move on people.

I reviewed their risk factors and stopped at the one that said, “Our growth strategy depends on our ability to open and operate new stores each year, which could strain our resources and cause the performance of our existing stores to suffer.”

Risk factors are partly boiler plate and this isn’t a new one.  But I read it thinking about their omni-channel strategy and acknowledged limit of 600 to 700 North American stores.  Rick acknowledged that the rate of store openings in North America would “further slow” in 2017.  He said what he’s said before- that they want to have the right number of stores in each trade area to serve the customers.  So they’ve got a risk factor saying their growth depends on opening new stores, but in their dominant market they are reducing the rate of openings and telling us the focus is on having the right stores in the right places with the right configuration to serve the customers.  The importance of new brick and mortar in generating revenue and profit in North America is going to decline.  That risk factor might have to be modified.

Which makes perfect sense.  First, because the business environment requires it.  Second, and more importantly, Zumiez has spent years now telling us about localizing inventory, fulfilling online orders in stores, empowering their store managers, their customer enhancement suite, the concept of “trade areas,” and, generally, their omni-channel strategy.  It’s not that Zumiez won’t open more stores- especially internationally, but I expect that their motivations to open (and close) stores is already evolving.  “Opening stores” may no longer be the most important way in which a retailer grows revenue or profit.  Here’s what Rick says about this in the conference call.

“…we’re not exactly sure what the right size of the fleet is in a mature market at this point. And so, that’s part why we say we’re going to slow down a bit, because we really want to spend some time thinking about optimizing in a trade area, the right mix between the digital and physical activities that we have in place along the customer journey to capture market share.”

Rick also notes that he expects there’s a lot of consolidation yet to come.  I agree.  As the saying goes, half the battle is showing up.  If some competitors don’t, you’re likely to do better.

He continues, “…there’s going to be fewer retailers in the marketplace, the share consolidation continues over the next five years. I think, many retailers own a larger share clearly of the marketplace. And you’re going to have to be able to serve customers in all new ways than we are today. And those are the things that we’re working on that. We know we can control that we like we talk about our hyper local – hyper localized assortments and in-store fulfillment, where we’re just flat out faster to the consumer, that’s important when you’re selling things at that.”

One of the things we’ve always talked about and that Zumiez emphasizes is the quality of their process for hiring, training and retaining people.  In this faster paced, localized, diversified world that’s going to be more important than ever.  In response to an analyst’s question on the issue, Rick says, “I think that we expect that we’re going to be able to provide growth opportunities for our people through basically increasing the challenge that as we believe is going to exist in a new kind of – a new level of retail that moves forward.”

Now, recall that Zumiez has talked a lot about identifying and working with new brands and has acknowledged the importance of assisting those brands.  An analyst asked about having a “multi-year track” with some of those brands and maybe even maintaining “…some exclusivity around those trends of the brands…”

And Rick said:

“I think that the brands that we’re talking about are unique to Zumiez, particularly in the mall setting. I know, we are by far the biggest partner for these brands by a large margin. I think that we again are trying to position ourselves, so that we can provide the brands growth opportunities within the network, because brands today can quickly – very quickly look to be over distributed because of the power of everyone’s multi – multiple retailers and distribution channels and media and social media outlets.”

“So I think brands are very smart today about how they think about distribution, about how they want to play it out, and of course, they think about their own longevity as a brand. I can tell you some of our brands of – that we’ve had been very successful have cutback distribution over the last year or two, because they thought it was the right thing to do.”

“I think we’re at a new point in understanding this cycle from a brand perspective with our brands. I think, probably more clearly than ever understanding that control distribution and allows them to control pricing and margins more effectively as a brand, which of course, controls how their brand is perceived. So I think, we’re in a new – kind of a new state there.”

Please read that carefully.  What I hear Rick saying is that the new opportunities for employees as store growth slows is, at least in part, in how Zumiez manages its relationship with brands it works hard to identify and nurture.  Okay, I’m reading between the lines a little bit.  And now I’m going to outright speculate.  In the new retail environment that’s emerging (whatever that looks like), and as brands as well as retailers recognize that improving profitability may require more thoughtfulness about distribution, what will Zumiez’s relationship with some of these brands be?

Will any of them be sold exclusively through Zumiez?  Will Zumiez maybe help them get product made and offer them some back office kind of support?  Might Zumiez take small equity positions in any of these brands as part of a relationship?  That might generate a lot of opportunities for employees.

In the environment I see emerging, those things, and others we haven’t imagined, are all possible.  Some of them will happen- and not just at Zumiez. And it’s going to favor the big players because they have the capability to pull it off.

The big news isn’t Zumiez’s quarterly results.  It’s how they, and other retailers are approaching the market and how fundamentally different the market is becoming.