MARKET WATCH: Quik’s Quarterly Results and Financial Restructuring

Yesterday, Quiksilver issued press releases outlining their results for the quarter ended April 30, 2009 and announcing some details of their financial restructuring. They also held a conference call to discuss these both.  An 8-K I saw this morning summarized the new loan facilities and included copies of the commitment letters for two new facilities. You can view that 8-K here.

There's a lot of information, so we'd better get started.

First, I want to quote at some length something CEO Bob McKnight said during the conference call.  He referred to an "…important change in our perspective on how we are doing business and running the company. In the past, particularly during the Rossignol era, we were very focused on growth. In hindsight, we probably pushed the businesses too hard to compensate for the losses in hard goods and as a result, our profit margins and return on capital suffered. Today, we are focusing on profitability, cash flow and rationalizing our cost structure to compete in a weaker economy."

There were other comments about distribution and discussion about how they are managing costs. If I can summarize and paraphrase it a bit, Quik thinks maybe they pushed their distribution a bit hard to get sales.

But this new economic environment makes sales increases harder to come by. So the way you make money is by focusing on expense control and working to increase your gross margin dollars.

I've been making similar comments in some of what I've written, but there's no reason you should pay attention to me. But when Bob McKnight and the Quik management team are saying it, you kind of have to take notice. IASC (International Association of Skateboard Companies,) by the way, will be rolling out some material on a concept called GMROII (Gross margin return on inventory investment) and I expect they will present a seminar on it at ASR. It's not a new concept, but it particularly relevant right now and focuses on how, exactly, to maximize those gross margin dollars.

The Financial Restructuring Deals

Quik announced that they had signed letters of commitment for two new credit lines. The first is a $150 million five year term loan from the private equity firm Rhone. It's actually two loans; $125 million in the US and Euro 20 million in Europe. The interest rate on both will be 15%.  However, 6% of that amount can be paid "in kind" in the U.S. All the interest on the European portion can be paid that way.  "In kind" means they don't have to pay that portion in cash. They just add it to the existing debt. The loan does not amortize.  Quik can pay all or part of it back early if they want, but they are not required to. If there's any prepayment before the third anniversary of the closing and the dollar has depreciated, Quik will have to pay enough dollars so that Rhone gets the same numbers of Euros they would have gotten if the U. S. Dollar to Euro exchange rate was 1.42.

The Quik Board of Directors will be expanded by two slots and Rhone will appoint two representatives to it.  Rhone will also get warrants to purchase "…approximately 20% of the then-outstanding shares of Quiksilver's common stock at a strike price of $1.86…"  Quik will pay a fee equal to 3% of the loan amount ($4.5 million) at closing and will also pay all of Rhone's legal, out of pocket, and advisory fees.

The proceeds of the loan "…would be used to refinance certain existing indebtedness of the Borrower and its subsidiaries, to pay related transaction fees and expenses and for general corporate purposes."  In the conference call, they indicated the main purpose would be paying down existing debt; specifically the existing asset based line of credit.

The second commitment letter was for a $200 million revolving asset based line of credit from Bank of America and General Electric Capital Corporation secured by inventory and receivables with a term of three years. The interest rate would be Libor (London Interbank Offer Rate) plus four to four and a half percent, or a base rate (prime or fed funds based) plus three to three and a half percent.

One of the conditions of closing is that Quik has received a $125 million term loan which I assume is the Rhone money. There is also, interestingly, a requirement that Quik "…shall not have not have executed a sale agreement with respect to the DC Shoes business." The Rhone documentation has a section called "Alternate Transactions" where they discuss what happens if DC is sold, so I guess that was or is a backup option for Quik.

These two deals take care of two of the three legs of Quik's financial restructuring stool. The third leg is the European short term lines of credit. We learned in the conference call that Quik "…expects to have something in place in the coming weeks."

Quik's CFO Joe Scirocco said, "Before they refinance they [the European banks] wanted priority on our liquidity and capital structure.' With these loans [the new ones described above] the way is clear to put a new multiyear committed facility in place."

I expect that what you'll see is a more or less simultaneous closing on all three pieces of this. I can't imagine any of them want to close without knowing the other two pieces are in place.

When the deals are done, there will be only a "slight reduction" in Quik's existing debt of around $1.05 billion.  They won't have reduced their debt significantly, but they will have made the maturities more manageable.  "When all this is lined up we will have ample capacity for the near term," Mr. Scirocco said.
Total interest expense for the year is expected to be around $110 million, according to the conference call.  For the last completed fiscal year ended October 31, 2008 it was $45.3 million. The expectation is that the deals will close by the end of July.

Quarterly Results

Revenues for the quarter ended April 30, 2009 fell 17% compared to the same quarter the previous year.  Gross profit fell 22% to $203 million. As a percent of sales it fell from 50.4% to 47.2%. This was largely due to price discounting in the U.S. according to the conference call. The gross margin in Europe was unchanged at 56.7%, where improvements in sourcing offset customer discounts. Income from continuing operations (which ignores Rossignol) fell from $38.7 million to $4.9 million. Net income (including Rossignol) improved from a loss of $206 million to a profit of $2.8 million.

Over on the balance sheet inventory actually increased a bit to $308 million from $304 million the previous April 30th. They acknowledged that they had not reduced their spring and summer buys quickly enough because of the speed of the downturn, but they had reduced them for fall and the holidays. As was apparent from the decline in gross margin, they are working hard to get inventory levels in line. The current ratio fell a bit from 1.62 to 1.42. Both current assets and current liabilities were down dramatically, but most of that was the result of getting Rossignol off the balance sheet.

Total liabilities to equity rose from 2.21 to 3.51 times.

They indicated that the economic environment seemed to be stabilizing rather than continuing to worsen.

They are expecting fewer retail markdowns in fiscal 2010, and a $40 to $60 million improvement in operating profits due the actions they are taking to reduce costs. These include the already announced layoffs, concentrating buys with selected vendors, reducing inventory, and facilities consolidation.

When these new financing deals close, Quik will have managed their immediate short term liquidity issues.  But they won't have reduced their debt significantly, and the money they are getting is expensive. However, their strong brand portfolio is intact. Improving profitability requires that they find enough margin improvements and expense reductions to compensate for the higher financing expense.

Jeff Harbaugh is a consultant for the action sports industry and works with companies to identify and focus on critical business issues and opportunities fundamental to the bottom line. For more information, visit www.jeffharbaugh.com.