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Stay Away From Quiksilver Inc. until the SG&A Driver Kicks In

The Quiksilver Inc.(NYSE:ZQK) Idea

I recommend waiting for a pullback to buy Quiksilver Inc.(ZQK) and I think there is a reasonable chance we will get one. Quiksilver's dramatic recent stock price appreciation (+347% since its July '12 lows) was driven by the announcement of a new CEO and CFO along with the recognition that the company has been significantly undermanaged. Although Quiksilver is currently way overpriced based on its fundamentals, the turnaround potential is compelling. If the new management team can make the SG&A changes they're planning, the stock has the potential to rise 2x to 2.5x by the end of fiscal 2015. But the initial burst of anticipation should "take a breather" once management has to deliver results and experiences some inevitable bumps along the road. I think Quiksilver will emerge as a leaner, more efficient company without compromising its brands, but I doubt this is an overnight, hiccup-free, transition.

Price:

7.24

Earning/Share 2012

$(0.07)

Shares outstanding (in M):

167

P/E 2013

29

Market Cap (in M):

1210

P/FCF

-

Net Debt (in M):

788

EBIT(in M)

57

Enterprise Value(in M):

1,800

TEV/ 2013 EBIT

26.46

I recommend adding to ZQK below the 5.40 level, around a P/E of 6x or 7X (TEV/EBIT around 7-7.5x) for 2014. The stock currently trades at a forward P/E of around 29x without delivering a profit yet. By comparison, Nike Inc. (NYSE:NKE) who just beat expectations and has virtually no debt, is trading at a P/E of 25x. What this means is that there should be several opportunities to add ZQK as it comes back to earth but before it galvanizes its potential.

The Catalysts:

The founder and CEO for the last thirty years has resigned to become Chairman of the Board and has hired Andy Mooney as CEO and Richard Shields as CFO, both from outside the company.

  • Cost and SKU rationalization and a new SAP inventory/ops efficiency system coming online in May.

Other Positives

  • Management team holds restricted stock units that only vest if the company is sold above $9.28 a share or the company's stock goes above $12.50 a share and stays there for more than a month before the end of October 2016.

The New Management Team

Richard Shields was hired from Oakley where he worked as CFO starting in 2005. He was the CFO before and after Oakley was acquired by Luxotica.

Andrew Mooney was the CEO of Disney's (NYSE:DIS) consumer products line from 2003 until 2011. Before that he worked for twenty years at Nike, leaving his career there as, according to Wikipedia "chief marketing officer and head of Nike's $3 billion Global Apparel organization with additional responsibilities for worldwide marketing strategies for the Nike and Jordan brands. He led the reorganization of Nike's brand marketing activities and introduced new advertising strategies." At Disney, Mooney is credited with coming up with the Princess line of merchandise and turning that into a $4B franchise. His Nike experience is going to be key to ZQK's success because Quiksilver has long been a powerful brand with extremely sloppy merchandising and cost controls.

Comparables

Why These Comps

It is very difficult to find an action sportswear company with a similar market cap to ZQK, let alone one in the United States in the board sports market. I did not include NKE in the averages -too big- below but kept them in the chart because NKE is in Mr. Mooney's blood and are his targets. The one company that is closest in size and business to ZQK is Columbia (NASDAQ:COLM), but they have nothing to do with either surf or skate per se. V. F. Corporation (NYSE:VFC) is the behemoth in the group but is most heavily into surf, skate, and snow. Although I want to drop Abercombie & Fitch Co.(NYSE:ANF) from the list because their margins are atypical, they are making a run at surf with their Hollister brand. Another company with a different margin structure on the list is Hanesbrands Inc. (NYSE:HBI). Wolverine (NYSE:WWW) is primarily a niche shoemaker, like ZQK's DC, but they also make niche clothes and distribute for outdoor brands Patagonia and Merrill.

Key Comp Take Always

  • The 5yr CAGR for these companies is not great. The model, as Mr. Mooney has mentioned, is VFC and NKE.
  • ZQK has the second best Gross Margin on the list.
  • ZQK's SG&A/Sales ratio is 11% higher than the comparables' average. Quite simply, Quiksilver is a mess: too many SKUs, poor inventory information systems and far too many employees relative to its level of sales
  • Only NKE and VFC have operating margins above ten percent. During a recent visit, management mentioned that their target was a 13% operating margin - an enviable target, but sales growth is required to get there.

ZQK

NKE

ANF

HBI

COLM

VFC

WWW

Avg.

PE

-

25.43

17.84

16.47

19.19

17.72

31.79

20.60

Market Cap

1.05

57.18

4.06

4.96

2.02

19.95

2.52

CAGR

-0.3%

8%

2%

0.2%

4%

9%

6%

4%

GMGN

49%

43%

62%

31%

39%

46%

39%

44%

SG&A Margin

45.5%

31%

53%

22%

36%

33%

29%

35%

OMGN

-2%

13%

8%

10%

8%

13%

7%

9%

NMGN

0%

9%

5%

5%

6%

10%

5%

6%

ROIC

-1%

20%

10%

8%

9%

4%

6%

9%

ROE

-2%

22%

13%

30%

9%

23%

13%

17%

Inventory Turn

2.66

4.08

7.29

2.48

5.99

4.30

2.16

4.44

DOI

137

90

50

147

79

85

169

106

D/C

57%

3%

3%

37%

0%

26%

66%

27%

Quiksilver's key opportunities are to:

  • Slash the expense ratio
  • Improve working capital efficiency
  • Do so without compromising sales (and hopefully achieve moderate growth driven by a more focused offering)
  • De-lever

SG&A - The Key Driver

SG&A is the one mess that CEO Andy Mooney has the most control over. Quiksilver was originally licensed to independent entities throughout the world and even after all the licensees were bought out in 2000, the U.S., Europe, and Australia continued to operate as independent businesses. Each unit designs everything on their own, from separate catalogues to products. The product philosophy and merchandising mix has varied by country. Information systems are terrible and very little discipline has been applied to capital expenditure decisions. Quiksilver owns too many brands and there is inter-company sales cannibalization.

Only boardshorts (US) and snow jackets (Europe) are consolidated under one roof. There are approximately 30,000 SKU's and only 4,000 are performing. Quiksilver's goal is to eliminate 30-40% of the SKU's in the next two years. While tastes vary between countries, the patterns and style variation can be reduced. To enable this, they're creating a global style / pattern library. To consolidate jobs they're implementing their new ERP computer system. As Richard Shields said in the Q4 conference call, "you see us continuing to make CapEx investments around SAP, which we think is going to be a significant opportunity for us to, again, automate work that's currently being done in multiple locations inefficiently."

ZQK's new management announced that they're shutting down the Quiksilver Girls and Women's, closing two other pet brands (VSTR and Summer Teeth), eliminating the crossover between the brands; specifically Quiksilver and Roxy are exiting from skate and DC from surf. They're also cutting marginal athlete sponsorships. Mr. Mooney hopes that by focusing on their best athletes, i.e. eleven time surfing champion Kelly Slater, they can make those athletes and the brands household names. There should be no detrimental impact on revenue from these cuts because these lines/sponsorships generally ate up more revenue than they generated.

The SG&A/Sales ratio is currently 45.5% while ZQK's operating margin is 3%. EBIT was $57M but a $60M interest expense wiped out Net Income. The table below shows decreases in SG&A by 5% increments at the same time revenue increases 7%. Management has said privately that their goal is a 13% Ops margin by 2015. The table below shows that a 15% drop in SG&A from 2012 levels and a 7% increase in revenue gets them there, provided their current gross margin stays the same. This would give ZQK a better operating margin than the average of the comps, but their SG&A/Sales ratio would still be higher than the comps and have room for improvement. The bottom line is that, given the low hanging fruit, a 15% reduction in SG&A and 7% cumulative revenue growth through 2015 are not heroic assumptions and show, with a little SG&A discipline, how quickly ZQK becomes profitable:

SG&A

Cumulative Revenue Growth by 2015

7%

7%

7%

7%

Revenues

2,154,166

$2,154,166

$2,154,166

$2,154,166

COGS

$1,098,625

$1,098,625

$1,098,625

$1,098,625

Gross Margin

49%

49%

49%

49%

SG&A

$870,337

$824,530

$778,722

$732,915

% decrease from 2012 level

-5.00%

-10.00%

-15.00%

-20.00%

SGA/Sales

40.40%

38.28%

36.15%

34.02%

EBIT

$185,205

$231,012

$276,819

$322,626

Operating Margin

9%

11%

13%

15%

Revenue

Focusing the merchandising could drive sales growth. Mr. Mooney's message to his company is to return to focusing on their brand's core product, not cannibalize it. If Quiksilver can extend their reputation for making the best boardshorts into making the best year round technical and casual wear, and do the equivalent for Roxy and DC, they will capture market share and gain traction in middle America. Billabong, Hurley and other competitors have struggled these last years to make distinct products while growing into year round brands. Like ZQK, they've taken an undisciplined approach to merchandising.

What investors should like about ZQK's prospects for revenue growth are that they represent the kicker rather than the crux of the investment case. ZQK is a case in which investors don't need a bad business to become good, we just need a badly run business to become less bad!

Before Mr. Mooney took over, ZQK guided 4-7% revenue growth for 2013. In our meeting, management also mentioned $400M EBITDA as the goal by fiscal 2015. Table 3 models SG&A moving to a target of 35.5% by fiscal 2014 along with incremental revenue growth while gross margin drops to 46%, the level of the comps. Table 4 shows the exact same scenario as Table 3, but with ZQK maintaining their current gross margin. We know SG&A should be easy to fix and revenue growth of 3-10% for a newly focused company isn't that staggering. However, the effects are. If my bear case, Table 3, is correct, Op income will go from $57M to around $260M. Therefore, a solid 358% increase. If my bull case, Table 4, is correct, the Ops Margin would reach 14% and make investors want to drop an "O" from Mr. Mooney's name:

2012

2013

2014

2015

Revenues, net

$2,013,239

$2,073,636

$2,218,791

$2,440,670

% Change

3.00%

7.00%

10.00%

COGS

$1,032,893

$1,119,764

$1,198,147

$1,317,962

COGS YOY % Change

8%

7%

10%

GMARGIN

46%

46%

46%

SG&A

$916,144

$839,823

$787,671

$866,438

SG&A YOY % Change

-8.33%

-6.21%

10.00%

SG&A / Sales

45.50%

40.50%

35.50%

35.50%

Operating income

$56,968

114,050

232,973

256,270

% Change

-

200%

104%

10%

Operating Margin

3%

5%

11%

11%

Interest Expense

$60,000

$60,000

$60,000

$60,000

Income After Interest Expense

($3,032)

$54,050

$172,973

$196,270

Tax Expense (25%)

_

$13,512

$43,243

$49,068

Net Income

($3,032)

$40,537

$129,730

$147,203

Shares Outstanding

165,000

165,000

165,000

165,000

EPS

$(0.02)

$0.25

$0.79

$0.89

P/E

29

9

8

Note: Both tables assume, relatively conservatively, that the $60M interest expense will hold steady through 2015 even though management will be paying down and restructuring debt. The tables also apply a 25% the tax rate, not accounting for any previous write downs.

2012

2013

2014

2015

Revenues, net

$2,013,239

$2,073,636

$2,218,791

$2,440,670

% Change

$-

3.00%

7.00%

10.00%

COGS

$1,032,893

$1,057,554

$1,131,583

$1,244,742

% Change

2%

7%

10%

GMARGIN

49%

49%

49%

SG&A

$916,144

$839,823

$787,671

$866,438

SG&A YOY % Change

-8.33%

-6.21%

10.00%

SG&A Margin

45.50%

40.50%

35.50%

35.50%

Operating income

$56,968

176,259

305,136

335,649

% Change

-

209%

73%

10%

Operating Margin

3%

9%

14%

14%

Interest Expense

$60,000

$60,000

$60,000

$60,000

Income After Interest Expense

($3,032)

$116,259

$245,136

$275,649

Tax Expense (25%)

$29,065

$61,284

$68,912

Net Income

$87,194

$183,852

$206,737

Shares Outstanding

165,000

165,000

165,000

EPS

$0.53

$1.11

$1.25

P/E

14

7

6

In summary, ZQK trades at only 5.4x EV/EBIT 2015 (bullcase) and 7.0x (basecase.)

EBITDA/AGITA - Worries, Pitfalls, and Downsides

Culture Clash

Mooney comes from Disney, a place that is not so affectionately nicknamed Mauschwitz by its employees. Some authoritarian discipline is exactly what ZQK needs but too much regulatory fairy dust and the surfers will want to lock Mr. Mooney in Thunder Mountain. Counter cultures are always suspicious and boardriders always think nonriders can't ever understand their worlds. Mr. Mooney has said, "I don't surf and I'm not going to learn." That's funny but that attitude will not give his core customers faith that he knows what surfers need. After his first cuts, the social networks lit up with complaints that new management was cutting all sponsorships and gutting the brands. He was caught off guard by the reaction, saying, "I was hoping people would cut me some slack and look at my 20 years at Nike..." He needs to know that he's not going to get any slack, that he needs to sing a song of solidarity with his "progressive" athletes while he finds new ways to interest the dairy farms of Wisconsin in action sports. If Mr. Mooney doesn't understand that he is dealing with a counter culture that long ago stopped being counter culture (it's a $7 billion industry!) yet still likes to think of itself as one, he'll lose core customers and market share. While no action sports company has been able to sustain growth among the mainstream, every action sports brand has lost core customers trying.

Competition:

Billabong, the second largest surf brand, recently announced they're expecting losses larger than their entire market cap and is entertaining a takeover offer. If ZQK can shore up its appeal to their core customers, they can take market share from the other stumbling large brands. If not…

An Investment Impaired by Impairment Charges:

The charges from restructuring, severance pay, and moving some popular lines (Quiksilver Women's) to other brands (Roxy) will suppress this stock. The upcoming onetime charges are going to be heavy and it's going to take a skilled eye and an iron stomach to get through some of the coming ups and downs.

Debt:

The reason investors ran from ZQK was that they levered up a clean balance sheet by buying Rossignol in 2005 for $560M and then sold it in 2008 for $37.5M at the same time revenue was going south. Now they have $788M in total debt. If they can't cut SG&A, they get buried in debt. This was my original fear of this stock but Mr. Mooney is already addressing the SG&A.

Gross Margin:

Gross Margin got pummeled in Q4 and dropped to 5 percentage points while COGs grew 13% YOY mainly do to an inventory backlog, discounting, and wholesaling. The problem was and has been that ZQK hasn't had a globalized system to monitor sales and thus overbought and got caught. The new global computer system and library should eliminate the problem. With the new systems going live spring/summer and new management's oversight, gross margin should hold steady… once they clean up the inventory mess left behind, of course.

Summary:

If Table 3 is correct, than the stock is currently trading around a P/E of 8x for 2015. If ZQK were to trade at a P/E of 15x in 2015, it would be priced around $13.35, close to a 80% return or more depending on where you buy. However, in the current crazy market, it looks like a 10% cut in SG&A has already been priced in even though no one will know if any of the changes are working probably until Q3 2014. The stock should rise close to 2x by the end of 2015, but there should be a lot of uncertainty in the interim and the stock should drop once the euphoria over new management subsides.

In conclusion, buy Quiksilver, but do so opportunistically over the next year or so around the inevitable pullbacks surrounding disappointing earnings.

Disclosure: I have a small long position in ZQK and will look to add to it when the stock pulls back. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Quiksilver's Potential - The SG&A Driver