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Quiksilver, Inc. (NYSE:ZQK)

Q2 2009 Earnings Call

June 8, 2009 4:30 pm ET

Executives

Bruce Thomas – Vice President IR

Bob McKnight –President & CEO

Joe Scirocco – CFO

Analysts

Brandon Ferro – KeyBanc Capital Markets

Todd Slater – Lazard Capital

David Glick – Buckingham Research Group

Jeff Klinefelter – Piper Jaffray

Mitch Kummetz - Robert W. Baird

Jim Duffy – Thomas Weisel Partners

Jeff Van Sinderen – B. Riley & Company

Anna Andreeva – JPMorgan

Jennifer Black – Jennifer Black & Associates

Operator

Good afternoon, ladies and gentlemen. (Operator Instructions) I’d now like to introduce Bruce Thomas, Quiksilver’s Vice President of Investor Relations, who will chair this afternoon's call.

Bruce Thomas

Good afternoon everyone, and welcome to the Quiksilver second quarter fiscal 2009 earnings conference call. Our speakers today are Bob McKnight, our Chairman, President and Chief Executive Officer, and Joe Scirocco, our Chief Financial Officer.

Before we begin I'd like to briefly review the company's Safe Harbor language. Throughout our call today items may be discussed that are not based on historical facts and are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

In particular, statements regarding Quiksilver's business outlook and future performance constitute forward-looking statements and results could differ materially from those stated or implied by these forward-looking statements as a result of risks, uncertainties and other factors, including those identified in our filings with the Securities and Exchange Commission, specifically under the section entitled Risk Factors in our most recent Annual Report on Form 10-K.

All forward-looking statements made on this call speak only as of today's date and the company undertakes no duty to update any forward-looking statements. In addition, this presentation may contain references to non-GAAP financial information. A reconciliation of non-GAAP financial information to the most directly comparable GAAP financial information is included in our press release, which can be found in electronic form on our website at www.quiksilverinc.com.

With that out of the way, I'd like to turn the call over to Bob McKnight.

Bob McKnight

Thanks Bruce, and good afternoon everyone and thank you for joining us for our second quarter conference call. Quiksilver has certainly been through its ups and downs over the years but today is truly an exciting day that we believe represents a pivotal point in the company’s history and more importantly, our future.

As hopefully everyone has seen by now, today we announced our financial restructuring plans for the business. A cornerstone of the plan is a new $150 million term loan by the international private equity firm, Rhone, and a new $200 million line of credit in the America’s region from Banc of America and GE Capital.

The third major component is the restructuring of our European debt which we expect to finalize in the upcoming weeks. This financial restructuring accomplishes many things. First it stabilizes our capital structure and all but eliminates any near-term liquidity issues.

Second it allows us to maintain full ownership and control over each of our three core brands and provides us with the capital to further strengthen the business. Third it gives us a seasoned international strategic partner who has invested in the business and experienced in globally diversified businesses.

Rhone is an international private equity firm that has offices in New York, London, and Paris. A focus on middle market private equity investments and businesses with [Pan] European or transatlantic presence or growth prospects. They have experience in investing in globally diversified businesses across a number of sectors including consumer and retail.

They understand the complexities of international operations and the nuances of European financing. They possess and impressive track record of generating strong returns on their investments and I’m personally thrilled to have two of their partners, Steve [Langman] and Andrew Sweet joining our Board of Directors.

We expect them to be active participants bringing strategic focus and direction to our business. We are very pleased that we were able to find such a strong strategic partner. We mentioned last quarter that among the alternatives we were considering to improve our liquidity was the potential sale of assets, that could have included the sale of one of our brands.

As we evaluated our options it became increasingly clear to us that we have three of the most dynamic and popular brands in the world in Quiksilver, Roxy and DC. This view was further supported in the due diligence conducted by the many potential investors and lenders we met with in recent months.

We are absolutely ecstatic that our new financing plans enable us to keep in tact our line up of great brands and that the infusion of cash affords us the opportunity to improve profitability. While it certainly wasn’t easy bidding here and we still have some work to do to complete it, we are very pleased with the capital restructuring plan, the stability and flexibility it affords us and our new strategic partner.

So that’s why we are so enthusiastic about this call and a fresh start. Upon the completion of the capital restructuring senior management can turn its entire focus on driving change throughout the organization and operating efficiencies throughout the business model.

I want to make sure I’m clear on this because it represents an important change in our perspective on how we are doing business and running the company. In the past and 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 returns on capital suffered.

Today we are focusing on profitability, cash flow, and rationalizing our cost structure to compete in a weaker economy. We are targeting substantial cost reductions and profitability improvements that we expect to be in place by year end and have a full year impact in 2010.

We are redesigning our sourcing and design structure, consolidating certain profit, design and development teams on a global level, and taking other initiatives to reduce both cost of goods and SG&A expenses.

There is a new attitude around profitability and cash management at the company and people are energized by it. In this regard the recent changes to the senior leadership team allowed us to drive these changes through the organization in a way that is keeping with the best of Quiksilver’s product and marketing leadership.

Our global organization depends upon the mutual cooperation of our regional leadership for global initiative. Never have our people pulled together as they have recently under the leadership of this newly reorganized senior management team. And when the dust settles on our financial restructuring and some of our operational restructuring initiatives, we will reintroduce you to our executives so you can see personally what I’m talking about.

So while we know we have a lot of hard work ahead of us, we now have a clear strategy and direction and we know what we need to do. I want to personally thank and congratulate all of our dedicated employees for their work and focus throughout what has clearly been the most challenging time in the company’s history.

And now I just want to make a few comments about our brands and business, in Quiksilver tradition we are continuing with product innovation. Within our Quiksilver brand we have introduced new fabrics and technologies in men’s board shorts and wetsuits. We recently launched a new line of denim that is specifically engineered for skateboarding called Threadline, and we continue to be very pleased with our newer women’s line.

With regard to Roxy, we launched Roxy Athletics during the second quarter. Our market research has shown significant interest in a Roxy line of athletic gear for workout and sport. This new line targets the young women in her late teens to early 20’s and opens up new distribution in sporting good, gym, and team sport retailers.

With regard to DC, our expanded sportswear apparel line has been universally well received and this line continues to evolve into a full scale lifestyle brand. Although the economic downturn has impacted DC’s business its clear that DC continues to take share amongst its skate competitors in the action footwear market.

Before I turn the call over to our CFO, Joe Scirocco, let me just provide some high level commentary on the second quarter. Clearly the overall environment remains very challenging and the negative traffic trends along with the incremental expenses related to the restructuring impacted our earnings.

For the current period we have not seen any improvement to the overall tone of business and our customers are being very cautious with fall and holiday orders. As a result we have been conservative in planning our business for the second half of the year.

Finally let me conclude my prepared remarks by saying how thrilled we are to have resigned Kelly Slater, the greatest surfer and one of the greatest athletes of all time to a new five year contract. This new deal essentially insures that Quiksilver will sponsor Kelly throughout his entire competitive career which began in 1990 which has redefined the sport and art of surfing in so many ways.

Kelly has been a fantastic spokesman for Quiksilver, a terrific Ambassador and promoter for the sport of surfing and a true friend of the company. He is like family and its only fitting that he continues his incredible journey with Quiksilver by his side. But this is much more then nostalgia.

Kelly is working on a number of highly visible initiatives to promote the sport of surfing into new and innovative ways. He will be an important part of our marketing direction and certain product development initiatives in the years ahead.

With that I’d like to turn the call over to Joe Scirocco for additional details on the quarter, our capital restructuring plan, and our operating initiatives going forward.

Joe Scirocco

Thanks Bob, good afternoon everybody. I’m assuming everyone has seen the separate press releases we issued today after the close on the second fiscal quarter results and the financial restructuring plans. With regard to second quarter results, I’ll be addressing our continuing operations, that is our results without Rossignol which we sold during the first quarter.

As reported consolidated net revenues declined to $494 million in the second quarter from $596 million in the second quarter last year. In constant currency consolidated net revenues declined 8%. Revenues in the Americas were down 7% compared to last year largely due to negative retail store comps and the closure of a net four stores since the end of the second quarter 2008.

Volume in our Americas wholesale business contracted less then in our retail business but we saw a mix shift towards discounted product. European revenues in constant currency were down 13%. Retail performed slightly better then wholesale with a low double-digit comp decline helped by sales from new store openings.

We opened a net of nine new shops and concessions in the second quarter and a total of 28 net new shops and concessions over the last year. Our European business continues to deliver very good performance despite the tough economic backdrop. Operating income again grew faster then revenues in the quarter and the business generated a very healthy operating margin of approximately 19%.

Although the economies of Europe have weakened we have effectively managed our costs there and continue to earn great returns. Revenues in our Asia Pacific region were up 14% in constant currency which for us is the Australian dollar, although this is largely due to the inclusion of our Japanese business in that region.

This quarter the Yen’s 31% improvement against the Australian dollar and the timing of shipments in relation to Q1 drove the increase. Nonetheless our business throughout the region was pretty consistent year over year.

Our overall gross margin decreased by 320 basis points to 47.2% for the quarter largely as a result of price discounting in the US. This reflects prevailing market conditions and we continue to prioritize inventory reduction and cash generation at the expense of gross margin.

Given the sudden downturn in the environment we were not able to reduce our spring and summer buys early enough. We have however reduced the buys for fall and holiday. In Europe gross margins were essentially unchanged at 56.7%, a very healthy rate.

Spring, summer margins for Quiksilver and Roxy benefited from sourcing improvements but were largely offset by customer discounts while retail margins reflected higher levels of markdowns in the shops. In our Asia Pacific business overall gross margin was higher on the strength of a much healthier wholesale business especially in Japan.

Second quarter SG&A expenses decreased to $203 million from $231 million a year ago. Excluding severance related special charges of about $2 million before taxes, this amounted to a decrease of approximately $30 million or 13%. In constant currency SG&A decreased $5 million or roughly 2%.

During the quarter some of our expense savings were offset by higher then normal bad debts and advisory fees. Even though expenses were below those of last year, lower revenues caused expense deleveraging in the second quarter as pro forma SG&A grew by 180 basis points to 40.5% of sales, up from 38.7% in the same quarter a year ago.

Pro forma operating income excluding the severance charge was $32.8 million in the second quarter down from $69.2 million in the same quarter a year ago, primarily as a result of lower margins in the Americas and expense deleveraging.

After interest and taxes our pro forma consolidated income from continuing operations excluding the severance charge was $6.6 million or $0.05 per share compared to income of $38.7 million or $0.30 per share in the same quarter a year ago.

This result was essentially in line with our expectations. I’d now like to turn your attention to the balance sheet for a few moments, receivables at $411 million are 13% lower then for the same period last year and down 4% in constant currency. On an overall basis DSOs increased by three days to 70 this year compared to 67 in the second quarter a year ago reflecting an increase in the number of slower paying accounts in this difficult environment.

Inventory at quarter end was $308 million, up 1% as reported and up 12% in constant currency compared to the same period last year. Weaker then expected demand in the quarter has led to a build up of inventory however approximately one-third of the increase in constant currency terms is attributable to the inclusion in the current year of our Brazilian joint venture which we now consolidate.

We are taking aggressive action to liquidate the excess and we have made adjustments to our second half buys in order to bring supply and demand into balance. On the financial restructuring plan, there are three primary components.

The first is a $150 million senior secured term loan provided by Rhone. This is a five year loan that bears interest at the rate of 15% with half of this being paid currently and the other half that will accrue and become payable at the end of the term.

The deal includes about $25.6 million warrants that can be converted into shares of common equity at or above the 60 days weighted average stock price on the day of the agreement which is $1.86. These warrants would equate to just less then 20% of Quiksilver’s total outstanding shares.

The second component of our recapitalization plan is a new $200 million asset based lending facility from Banc of America and GE Capital for our Americas business. The new facility has a three year term and bears initial interest at LIBOR plus 425 basis points.

It will replace our existing Americas ABL facility which would otherwise mature in April, 2010. We have already signed a commitment letter and have agreed upon a term sheet and expect to have this facility in place before the end of Q3.

The third component is the refinancing of our European debt into a fully committed multi year facility that carries set interest rates and terms. As Bob mentioned, we are working diligently on this last component and we expect to have something in place in the coming weeks. We recognize that a lot of our investors have been very concerned about the uncommitted nature of our existing European financing.

To be fair however, the European banks have been great partners over the years and they have accommodated us in the past as we layered the Rossignol debt onto our apparel operations. Before they refinance they have wanted clarity on our liquidity and capital structure.

With the new $150 million term loan from Rhone and the new $200 million ABL coming online, the way is clear to put a new multi year committed facility in place. One of the main elements that Rhone has brought to the table is their ability to grasp the nuances of this unique credit situation and their willingness to work with us and our European lenders to resolve it.

The accounting for the new debt and warrants probably requires a little explanation. In brief we will apportion the $150 million from Rhone into two components. Approximately $82 million will be accounted for as debt and classified as such in the balance sheet. The remainder, approximately $68 million, will be attributed to the warrants and classified as equity on our balance sheet.

Interest expense therefore will contain three elements, cash interest on the $150 million in notes, will amount to about $11 million per year, payment in kind or PIK interest, will accrue at another $11 million per year but will not require cash, and another $17 million will be charged to the P&L as the noncash amortization of the amount attributed to the warrants together with amortization of transaction costs.

On a pro forma basis therefore for a full year, our interest expense going forward including the effects of all of the expected refinancing and new higher base rates, is expected to be around $110 million of which $33 million will be noncash.

We intend to use the proceeds of the new term loan to pay down existing debt. Before turning to our outlook let me pick up on some of Bob’s earlier comments about planned improvements in operating margins as a result of initiatives we are undertaking to improve gross margin and reduce SG&A.

We are taking new steps to reduce product costs going into our spring 2010 buys. Thus far our sourcing improvements have mostly taken place on a regional level. But for spring 2010 we are beginning to better leverage our global buys and concentrate production with selected vendors to a greater degree then ever before.

We are also looking to reduce other elements of cost of goods by streamlining the product development process into centers of excellence across regions and categories. One example of the center of excellence would be our snow outerwear division in Europe. We have consolidated the merchandise and design functions while continuing to use one designer in the US to maintain regional design elements.

The net result is the reduction of 10 positions in the US, better pricing on fabric and labor due to consolidated purchasing. That’s just one example. We also anticipate some improvement in gross margins solely on the basis of an improved mix of business meaning that we expect our sales to be comprised of a higher ratio of full priced sales as we move through the excess inventories we’ve been dealing with for spring and summer.

And although its early to say we believe there will also be substantially fewer markdowns in our retail stores as we get into 2010. On the SG&A side, we eliminated nearly 200 positions in January and have since taken further actions to consolidate functions where it makes sense in major areas of spending like merchandising and design, sales, and distribution.

Shipping costs in the Americas were down over 25% in the second quarter due to better labor management and automation in the Mira Loma distribution center. And an additional 160 positions will be eliminated at the end of July as part of the final phase of the T-shirt production facility closure and distribution center consolidation, and we continue to look for opportunities to close underperforming retail stores where possible.

We expect that some of these efforts to be an improvement in operating profitability of between $40 million and $60 million in 2010. So its really a 2010 story. Now let’s turn our attention to the outlook for Q3, based on current trends we are modeling revenues down in the mid teen’s on a percentage basis for Q3.

As with the second quarter we expect the contraction of gross margin by around 400 basis points compared to last year driven by price discounting. We continue to cut costs therefore our SG&A is expected to be lower then it was last year however we expect it to be 75 to 100 basis points higher as a percentage of the reduced sales level.

Interest expense is expect to be around $16 million. Given these assumptions we expect to generate earnings per share in the low single-digit range in third quarter and I want to emphasize that this is before any special charges and the effect of our new financing.

And with that I’ll turn the call back over to Bob for closing remarks.

Bob McKnight

Thanks Joe, to summarize as you have heard we are really pleased to have addressed our near-term liquidity needs and to begin working with Rhone in a new era at Quiksilver. We are evaluating every aspect of our business to streamline operations, improve productivity, and increase profitability.

We know we have a lot of work ahead of us but we also know that we have three of the best, most authentic brands in the action sport sector and this sector continues to gain share around the world. So while Quiksilver has always been a leader in the action sports space, we now have an opportunity to elevate the profitability of the business and better drive shareholder value.

That concludes our prepared comments, we are now ready for the question-and-answer session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Brandon Ferro – KeyBanc Capital Markets

Brandon Ferro – KeyBanc Capital Markets

I guess I’ll just limit my questions to the debt issues and then some of the organizational stuff you’re doing, can you kind of walk me through some of the maturities or debt items that you plan to pay down with the $150 million term loan.

Joe Scirocco

Yes, that’s pretty straight forward. The initial proceeds will be used to take out the ABL and based on the amortizations I mentioned earlier, there’s obviously a lot of financing costs associated with the various pieces of debt that we’re putting in place so that’s both term loan, senior term loan from Rhone, plus the US ABL and ultimately the French banking lines.

So that will be the use of capital. And that will leave us then with liquidity under the US ABL and plenty of room to maneuver.

Brandon Ferro – KeyBanc Capital Markets

How should we think about some of the other maturities you have due, the 50 million euro due at the end of June and then the deferred Rossi payment next year and the other European term loan you have.

Joe Scirocco

Well it really depends upon how we finalize things with our European lenders so I don’t want to attempt to be too precise about this but essentially we’re thinking that in 2009 and 2010 we will have somewhere in the range of maybe $100 million or so being amortized over that period of time and then the idea is that the entire, all these components of debt will term out over a multi year period, perhaps four years to be amortized over that period of time.

So the good news about this is that we have, we will have when this is all lined up, ample capacity for the near-term and if there is any concentration of maturities, it sort of comes in the 2012, 2013 time period so we’ve substantially pushed back any of these concerns with this financing. That’s why we’re so excited about it.

Brandon Ferro – KeyBanc Capital Markets

Can you give us a sense of how big the new multi year committed facility in Europe might be.

Joe Scirocco

I would just say it this way, we’re negotiating something that should enable us to wrap together all of the various components that are there now.

Brandon Ferro – KeyBanc Capital Markets

On the cost reduction piece, I think you said everything that you are doing throughout the organization, cost reductions, efficiencies, etc. net you between $40 to $60 million I think on a run rate basis beginning in 2010, just wondering if I heard that correctly and then secondly how much of that is on the headcount side versus stuff you might have to execute on from an organizational standpoint.

Joe Scirocco

First of all the principal focus of this is in the Americas. There are cost reduction initiatives going on all over the world but this is kind of the center piece of it because its been our largest region with the lowest margins and so we’ve been working on this with a new team.

The profitability improvements we see them being split roughly 50/50 between margin and SG&A and we may take some charges over the course of the next two quarters to get there but we expect that that will be money well spent. So I won’t comment on whether its headcount or other expense reductions but we are looking for in a dramatic improvement in the gross margins as a result of these sourcing and product development initiatives and that kind of thing.

Brandon Ferro – KeyBanc Capital Markets

I’m just wondering how you came about pricing the warrants and the strike pressure on that and then secondly I was wondering if you could comment on what you think Rhone brings to the table strategically and maybe its importance for the company longer-term.

Joe Scirocco

The strike price is basically a market 60 day look back and average over that period of time. So that’s pretty straight forward.

Bob McKnight

So with Rhone, the main thing about Rhone is that they’re transnational, being based in the US and Europe and they have tremendous experience and sophistication in dealing with complex capital structures and diversified businesses like we have and we are. And its very unusual for American private equity funds or investors to be involved in companies like this.

They are very entrepreneurial. We knew that from the very beginning from the first time we met them. They’re very creative in their thinking. Their firm is organized and owned and managed by its partners. They have like I said before offices in New York, London and Paris. Coincidentally two of the Rhone founders are partners, Steve Langman and Andrew Sweet, are New York and London based financial guys but they also happen to be surfers so they understand the space.

They understand the marketplace. They’ve been close to the company now for a few months and just doing all the research and all that but they just seem to be terrific people that are a great fit for Quiksilver. And I think they also in the due diligence they appreciate the strengths of all of our brands, each one of the three brands, and some of the other pieces of our company like the [Mervin] part and things like that.

And they really appreciate the management’s plans were sort of already in place and will continue to be in place to focus on strengthening the brands but also focus on profitability. So we think they’ll be terrific partners from that standpoint.

Operator

Your next question comes from the line of Todd Slater – Lazard Capital

Todd Slater – Lazard Capital

I was wondering since this is a fiscal year 2010 story, what type of operating margin that you’re now targeting given the expense reductions you talked about and the hope for gross margin improvement that you’re looking at. At what level do you ultimately think you can get back to with this structure beyond 2010 or fiscal year 2010.

Joe Scirocco

We think about this in terms of industry norms the same way we have for a period of time before this whole economic debacle came upon us and everybody else. So that’s kind of push the operating returns down substantially but we think about industry norms which you know as well as I probably somewhere in the low to mid teens.

But that’s somewhere down the road. We have a lot of wood to chop and we’re working very hard at it but we have a plan and executing against it and we have the capital now to move forward.

Todd Slater – Lazard Capital

And with respect to inventory, you said that would be a top priority and even if getting that down, even at the expense of margins if you talk about what your targeted levels are there.

Joe Scirocco

Well the indication was just to say that our gross margins have been hurt by the inventory liquidation and we expect that that will continue again into the third quarter perhaps somewhat less in the fourth but clearly we bought the spring, summer goods six months before the season in the US at least, and so we’ve got some excess goods to move through.

All of our brands felt that pressure in the second quarter so we expect to liquidate that just as hard and as fast as we can do responsibly. We’ll put it through our normal off price channels but that should happen by the end of the fiscal year.

Operator

Your next question comes from the line of David Glick – Buckingham Research Group

David Glick – Buckingham Research Group

I thought I’d just switch over to the three core brands which obviously now you have the opportunity to focus all of your energy on, and just wondering if you can give us a sense of the changes you’re seeing in the trends. DC has been your fastest growing brand obviously the economy is taking a beating on everything including very strong brands like DC. But can you give us a sense of what’s happening with Quik, Roxy, and DC and how the trends have evolved as we are moving through the fiscal year and any differences in the US versus Europe and Asia Pacific.

Bob McKnight

I’ll let Joe go through some of the percentage numbers in a second here, but just sort of looking at it from 5,000 feet, it’s a very tough market out there as we’ve said in previous conference call. Its toughest in Hawaii, California, Arizona, Nevada, Florida, over here which are our best markets. Tough in Spain, the UK, and France over there which are our three biggest markets in Europe.

So there’s no question about it that the overall economic climate has effected our sales and all three of our brands but I do believe that we’re in no worse shape then anybody else, our competitors. In fact I think we’re in better shape them most. We have three great brands. The product looks good.

We are usually the first brands to get orders and reorders if there are any out there, bookings and all that kind of stuff. We’re the first to get paid. So I think just having the strength of the brand is a really important thing in this period. We already have talked about the sort of the non growth rates in connection with Roxy in 2009. DC we put a pretty big growth expectation when the year started and we brought that down a little bit because its just tough out there even for DC.

And especially in the European market. There are pockets of places where business is good like Latin America, some parts of Asia Pac, North Asia and even Australia is okay now. But I think its just an overall economic climate that has just impacted the consumer and the customer buying more conservatively and watching inventories and watching their payables. Just like everyone else is doing and so we’re not immune to that.

David Glick – Buckingham Research Group

And any improvement you’re seeing on, you mentioned California is still tough, but some retailers are talking about seeing some improvement in California and then maybe just because a big competitor went out of business but are you seeing any bottoming out in California yet.

Bob McKnight

I sense talking to a lot of retailers which I do, that they don’t see it getting any worse and there are a weekend where all of a sudden its been a great weekend, and the following weekend, its back to normal and then another great weekend. So its kind of like spotty here and there depending on which area of California you’re in or which city they are near or whatever.

But I think that the consumer, at least in California has gotten used to the initial shock of where its at and they’re shopping, they’re just buying less and so all the businesses are down in proportionately to their consumer confidence and their buying habits.

Operator

Your next question comes from the line of Jeff Klinefelter – Piper Jaffray

Jeff Klinefelter – Piper Jaffray

Maybe just starting with another bigger picture question and thinking about the scale of your three main global regions given the margin differences that you experienced in particular between the US and Europe, do you have a sense when you think about the maturity of each of those regions or the current scale, what is the appropriate revenue base to target in order to optimize the profitability or said another way, maybe there’s a different view of channels of distribution between Europe, US and Asia.

Joe Scirocco

So I think we all know the US story, our investors and analysts know the US story quite well. I think one of the big stories in terms of future growth opportunities and continuing to take share and increased penetration in new markets is really in Europe and in that business even in this tough economy we’re seeing good sell throughs on our product. Some of our customers are challenged because they can’t get financing or its just tough for them to operate their business these days.

But we look at a brand like DC which is relatively underpenetrated throughout Europe and just as one example we have very little penetration in France in terms of the sport market. In the UK by contrast we sell into the majors but there is plenty of opportunity there and we see that being a double-digit grower for some time.

DC even in this tough environment we would expect to be a low double-digit grower this year. As Bob said earlier we came into the year thinking over 25% growth there. But still double-digit is pretty good in this environment. So I think in terms of future growth, the question will be how much can we invest, where do we choose to invest in terms of retail expansion and initiatives like that.

But ultimately we see that DC at least should be catching up to Quik and Roxy on a global scale pretty quickly.

Jeff Klinefelter – Piper Jaffray

Just one other clarification, on the US business in terms of the wholesale channel are you experiencing just pricing compression or this mix shift that you discussed down to more lower priced or clearance priced items, are there also some door closures that either your customers are experiencing our you’re initiating. I’m just curious where you’re seeing movement because for example the sporting goods channel, at least one of the chains looks to have a bigger assortment of your product and is making a [press] into the action sports base. Just wondering how that focus is shifting around between the different channels.

Bob McKnight

I think its all of it. We’re certainly getting some price compression from the retailers themselves and a lot of competition lowering prices and doing deals and getting a little desperate. We’re seeing some store closures, we’re seeing some stores having a tough time paying for inventory so we’re watching our receivables and maybe not shipping a few of those.

So there’s, its all of the above. A company like us just has to watch it very carefully and make sure that we have made the right decisions that are prudent for the business today but also protect the brands for the future.

Jeff Klinefelter – Piper Jaffray

So on a go forward basis lastly, when you look at US, Europe and Asia, how would you view the overall portfolio growth rates for those three markets once we normalize toward the end of this year, beginning of next year.

Joe Scirocco

It’s a little bit hard to say, I think that what you have to consider is that the expansion in the Americas region particularly in the US over the past couple of years has occurred in the retail business and that is a portfolio of stores that we now have to recon with and we’ve talked about that in prior calls in terms of store closures.

Europe is a different story. There it’s a question of relative opportunity and how much money is available to invest for that expansion. But I think the key message that we’re focused on today and Bob commented in his opening remarks, is that this is a story that’s about profitability, managing for cash, continuing to pay down debt as and when we can and we’re looking to improve profitability even at the expense of that growth.

We grew at double-digit rates for such a long period of time and that’s something that we’re shifting focus on right now.

Operator

Your next question comes from the line of Mitch Kummetz - Robert W. Baird

Mitch Kummetz - Robert W. Baird

You mentioned your interest expense kind of all in once you have your European piece redone at around $110 million, and so off of what kind of overall debt load is that based on, are you still looking around a billion dollars of total debt.

Joe Scirocco

Yes, so if we pro forma this off the April balance sheet we’re looking at a slight reduction from the $1.50 billion or so that we reported for April 30. And some of that is swapping senior debt for current maturities as we talked about earlier. Partially we’re also attributing a component of the new debt to paid in capital so it will go in the equity section of the balance sheet and that will be attributed to the warrants.

Mitch Kummetz - Robert W. Baird

When you look at your Q3 guidance I think you said mid-teens decline in sales which is a little better then you came in in Q2 and when you think about that on a regional basis, would you expect similar performance across the regions like you achieved in the second quarter or do you see any shift in business happening on a near-term go forward basis.

Joe Scirocco

I would say pretty consistent.

Mitch Kummetz - Robert W. Baird

And what sort of currency assumption are you using for your European and Asia Pac businesses.

Joe Scirocco

I think we’re just sort of using current rates. Current rates tipped up slightly in the past few weeks in Europe. We were probably a little below the assumptions that are there but Asia Pac has moved around as well.

Mitch Kummetz - Robert W. Baird

And then looking at your Q2 performance by brand, I know you mentioned that obviously the overall economy has taken its toll on all three of your brands or actually you’ve got more then three brands, but your three main brands, was DC still up in the quarter, was it down, was it up just not growing at the same rate that it had been growing. Was it actually down and then when you look at the Quik and Roxy businesses, one of those trending better or worse then the other. I’m guessing that the women’s business is still a little tougher then the guy’s business. So how did those three brands kind of shake out their performance in the quarter.

Joe Scirocco

DC was up overall and that was led by Europe really with Asia Pacific as well, although Asia Pacific is on a very small base. So that’s the DC story.

Mitch Kummetz - Robert W. Baird

What about Quiksilver and Roxy.

Joe Scirocco

Up in Asia Pacific for each which is as we said on the prepared remarks largely a function of translation between our Japanese business into Australian dollars. But Quik, Roxy were down in the other regions.

Mitch Kummetz - Robert W. Baird

And is one performing better then the other all in across regions or—

Joe Scirocco

I think probably Quiksilver is performing a little better which is not necessarily a function of product or anything else. I think that particularly in Europe we’ve probably pushed a little bit hard in certain distribution channels with Roxy so we have a little bit of a correction that we’re dealing with right now.

Mitch Kummetz - Robert W. Baird

Tax rate has been jumping around a lot, how should we be thinking about that in Q3.

Joe Scirocco

Well we said that we’re expecting to earn a low single-digit so that almost doesn’t matter what rate you use. I think that if you use the rate in Q3 somewhere in the 35 to 50% range, that’s about as close as we can peg it on a low quarter.

Operator

Your next question comes from the line of Jim Duffy – Thomas Weisel Partners

Jim Duffy – Thomas Weisel Partners

One thing I’m hung up on a little bit, Rhone’s commitment is apparently subject to the satisfaction of certain terms including completion of the refinancing of the European facility. It seems like a little bit of a chicken and an egg situation there. Are your European lenders more likely to work with you because of some letter that Rhone has signed or something to that effect.

Joe Scirocco

Well again, we’re in discussions without commenting too specifically on the situation there. Our whole refinancing effort has been a bit of a chicken and an egg situation. We have had these uncommitted term facilities in Europe. We have had an ABL which is heading towards expiration in April of 2010 and we have had the need for an injection of capital at a higher level in the structure.

So it really has been a chicken and egg situation all along. The situation with the European banks is an unusual one. We find that its very difficult for our investors to get their heads around and in fact many lenders and people who come in at a senior level of the capital structure, at least Americans, find that quite challenging.

So we have found in Rhone somebody who understands those nuances and has a high degree of confidence that this can be done and that’s why we are where we are today.

Jim Duffy – Thomas Weisel Partners

You talked about in your pro forma where you see debt balances at year end, do you expect you can be cash flow positive this year, where would you see cash balances and kind of projecting out where you would expect the debt structure to be. What would be the availability on lines of credit at your end.

Joe Scirocco

Well I’ll answer you a couple of ways, I mean in terms of cash flow generation from the existing business and without regard to the refinancing, I think we had earlier said we hope to achieve about $50 million in cash flow after taking into account CapEx and I think that that could still be achieved all things being equal.

We may use some cash for special charges in terms of our restructuring or whatever but it probably wouldn’t significantly deviate there. In terms of availability, once we put the new structure in place we should have ample capacity in each of our regions.

Jim Duffy – Thomas Weisel Partners

But can you be more specific then ample.

Joe Scirocco

Well we’re talking about a $200 million facility in the US. That’s going to be subject to a borrowing base and all of these details will be in the filing so you’ll be able to see this. But essentially we should have plenty of undrawn capacity on the US facility. The European facility is not finally negotiated so I would prefer to not comment on it.

But essentially there we’re looking at amortization over a four year period and we’ll see how the final negotiations come out but we don’t want to be overly pressured in the short-term. I’m sorry I really can’t be more specific. But suffice it to say we’re injecting $150 million in new capital into the company so we’re going to be expending short-term maturities and in that regard we’ll free up capacity.

Jim Duffy – Thomas Weisel Partners

With the warrants, where would you expect share count towards year end looking into fiscal 2010.

Joe Scirocco

It’s a good question, I’m glad you asked. So with the warrants, the warrants do not factor into the share count until they are actually exercised. So although there will be roughly 25.6 million outstanding they don’t get factored into the share count. Once they are exercised, we’ll account for them on the treasury method so just to help you think about that, if all of the options were exercised and the share price, hang on just one second, I’m sorry.

I’m sorry, I misspoke, I was just corrected. So the shares will be dilutive but under the treasury stock method we will account for the buyback of shares at the strike price. So it kind of depends where the share price is as to how many shares you have to factor into your denominator. Just to give you an illustration, if the share price were $3.00 there would be about nine million shares that would factor into the dilution.

If the share price goes to $6.00, there’s about 18 and so you can extrapolate in between there or higher and figure that out. We can help you with this offline if you’d like.

Operator

Your next question comes from the line of Jeff Van Sinderen – B. Riley & Company

Jeff Van Sinderen – B. Riley & Company

I wonder if you could talk a little bit more about your own retail store performance in the quarter, I know you mentioned closures there and wondering how many you’re considering closing, how many leases you have coming up over the next couple of years, any help on that would be great.

Joe Scirocco

Just to kind of repeat some comments we’ve made but to be responsive, the issue really is in the US portfolio. We’ve talked about the desire depending upon available cash to close maybe on the order of 20 to 25 stores. I think that from, on a year to date basis, we’ve probably closed five in the US and we have four more to go this year.

We’re being careful with use of cash so these are coming off based on expirations of lease and [take out] clauses are that kind of thing. And should we take charges in the third and fourth quarter, now there could be some noncash charges associated with those closures.

But in terms of negotiating out of leases, its still very challenging to do that and generally requires some excess cash to do it so we will probably not pursue that very aggressively at this point in time. Then in Europe and Asia Pacific our portfolios are pretty clean. We’ve systematically closed stores over the years as we found them to be underperforming and we don’t really have much to do in that portfolio.

Jeff Van Sinderen – B. Riley & Company

In terms of the trends in comps and operating margins, gross margins, markdowns, all that sort of thing, in your own retail stores in this quarter was it kind of, how did it compare to last year. Obviously I’m sure your comps were down and you were taking some pressure on merchandise margins, anything else you can share with us on that.

Joe Scirocco

No, I think we commented in the earlier remarks but basically the US store group during the quarter was down on the order of 20%, Europe I want to say was around 10% and Asia Pacific down only slightly. Except that in Japan, beginning in spring, the retail took the turn south. The market got very, very tough. Just a small base for us but still a pretty significant impact.

So along with that goes the markdowns which led to the margin compression that we talked about. I think we were down, well 400 basis points or whatever.

Jeff Van Sinderen – B. Riley & Company

And then just along the lines of the cost cutting, I know you’ve kind of sketched some broad strokes there in terms of talking about making changes in sourcing, and you touched on design. I’m just wondering if there’s anything else you can elaborate on there that may be a little more specific in terms of what we should look for for further cost cuts.

Joe Scirocco

Well I would kind of characterize this as profitability improvement because when we cut product cost it going to be sort of invisible to the public until such time as we sell the goods and we see what kind of margins we’ve realized but one of the things that we’re finding in terms of our spring buying trip to the Orient, at least in the Quiksilver brand, early results were that it seemed that we could improve on costs by a couple of hundred basis points and depending on how the markets are in spring 2010, as to whether or not that can be sustained through pricing, you’ll see in the gross margin.

So I’d prefer to talk about it as profitability improvement instead of just cost cutting when it comes to margin. On the SG&A side, again we said that roughly half of what our $40 to $60 million improvement is targeted in the SG&A area and a lot has to do as we said with the consolidation of distribution facilities, and taking a look at the centers of excellence and ways that we can leverage the global infrastructure.

Operator

Your next question comes from the line of Anna Andreeva – JPMorgan

Anna Andreeva – JPMorgan

Circling back to the Americas region, are you seeing any difference in performance across department store channel versus your specialty stores and also independents and just listening to some other manufacturers, some are calling out I guess some degree of stabilization in their order books for the full season and you are not seeing that. Is that the function of the category being more difficult perhaps or some of your channels of distribution, just your general thoughts would be helpful.

Joe Scirocco

Well I think as Bob said the order books are certainly down for fall but they are not worse. They’re filling more slowly at this time of the season. People are being more careful and cautious in that regard and we’re being equally careful in terms of order approval.

Bob McKnight

But we’re seeing the same sort of stabilization that you just commented on. I said that earlier that it doesn’t seem to be getting any worse and it is stabilizing and some of the pockets are encouraging. But we’re being very conservative with the future outlook just in this climate because it changes week to week seemingly.

Anna Andreeva – JPMorgan

And did you see any differences department stores versus specialty guys and independents.

Bob McKnight

Not really.

Anna Andreeva – JPMorgan

And I was also wondering if you could talk about the structure of the Kelly Slater agreement.

Bob McKnight

Always with our riders and people like that, the term, the cash shares and things like that are all very confidential so we don’t really talk about that but its, suffice it to say Kelly is taking the position in the company with amount of shares so we’re very encouraged because Kelly really believes in the company and therefore was willing to take part of his compensation agreement in shares.

He will be working on a whole bunch of projects for us. Some of them I can comment on, some of them I can’t. There’s a new IMAX movie coming out this year that he’s staring in about himself and the art of surfing and the science and educational aspects of surfing. He’s working on new different competition formats to hopefully drive competitive surfing forward in a new kind of interesting way that’s more attractive to media and media outlets to drive viewers to the sport.

And we’re working on some advanced wave pool technologies, so he’s got of plenty of projects. That’s only just to name a few but we’re really excited about it. Kelly has been with us since 1990 as I said. He started his career with us and this will continue his career and all that. We’re both really excited about the future as you read the press release. But the actual cash and shares is confidential at this stage.

Anna Andreeva – JPMorgan

What was the currency impact on the bottom line in the second quarter and then in Australia you had talked about finalizing bank commitment for $22 million line of credit, I think about half of which is uncommitted, could you give us some update there.

Joe Scirocco

Currency impact, I don’t have something off the top of my, tip of my fingers but I would just tell you that last year for example in Europe we translated the euro at 153 for the same quarter last year, this year was closer to 130 and in the Asia Pac region we were at $0.92 last year, we’re at about $0.68 this year.

So when you look at our press release tables you can do a little conversion and figure out what that meant. With respect to the debt that you’re referring to, there’s a couple of things and little bit of again this chicken and egg situation is that we’ve got to just deal with some of the inter creditor agreements and the like so as this thing comes together we will look to take care of all of that at once.

Operator

Your final question comes from the line of Jennifer Black – Jennifer Black & Associates

Jennifer Black – Jennifer Black & Associates

I wondered if you would consider using like a Lee & Fung but a couple of our companies have switched over to, and I know its adding like 800 to 1,000 basis points in some cases.

Joe Scirocco

I’m familiar with that as well, I think that one of the distinctions about Quiksilver is kind of the way that our sourcing organization grew up, highly regionalized and driven really not only by production and sourcing people but by merchandisers and various relationships along the way so there’s been a lot of autonomy to it and at this point I think the majority of the improvements that we think we can drive we should do on our own.

That’s the direction that we’re going. Not to say that that’s something we wouldn’t consider down the road but I wouldn’t call it a front burner issue right now.

Jennifer Black – Jennifer Black & Associates

And then I wondered too if you could give a little bit more detail on the Quiksilver women’s line, what your plans are and on the last call you talked about collaborations with Roxy and you just talked about the Roxy active wear, is there anything else that we don’t know about.

Bob McKnight

To answer the second question first, yes there are a couple of things coming up that you don’t know about in Roxy that are real exciting but again, we have yet to announce those. Other then our deal with JBL in the Roxy area and the athletics portion of the brand which is really exciting because women are really into sport and workout and that kind of thing and the line is very fun, very whimsical, great fabrics, all that kind of thing.

On Quiksilver women’s, Quiksilver women’s is a small group as you know and a small number right now but its incubating very well. It was actually on the top selling brand in the certain department in Nordstrom’s not too long ago which they called and told me about which was really exciting. And so it sells very well in places like American [Rag] and that so its beginning to be a really popular from a real small base.

But effort number one will be to take it global and push it through Europe and into Asia Pacific where they’re just now beginning and also one of the initiatives is to add to a little bit more of a broader assortment so its more accessible to a broader marketplace and those are the two kind of areas that we’ll be focusing on in the next 12 months. But we’re really pleased with the introduction and the sell throughs and the product in this very tough environment.

Its been one of our bright spots out there in the marketplace, we’re really excited about it.

Jennifer Black – Jennifer Black & Associates

I wondered on price points, and market weakness, it seems like every company I see are talking about sharpening their price points going in, can you comment on that.

Joe Scirocco

I don’t know that I could be that specific across the whole company. I think that its probably fair to say that consumers are kind of moving towards closer towards opening price points just as a general trend so if that’s any indication about the mix of the lines, but on a like for like basis I would think prices are fairly consistent item for item.

Jennifer Black – Jennifer Black & Associates

So there’s no plans to have any items at a sharper price point.

Bob McKnight

Well in each category we have opening price point items. So we have had that and we continue to have maybe some more focus on that but that’s always been the case here so we continue to have that.

Bruce Thomas

So that concludes today’s call everybody. On behalf of everyone here at Quiksilver thanks for your participation and we look forward to providing our third quarter results in September.

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Source: Quiksilver, Inc. F2Q09 (Qtr End 04/30/09) Earnings Call Transcript
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