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K-Swiss Inc. (NASDAQ:KSWS)

Q3 2009 Earnings Call

November 5, 2009 11:00 am ET

Executives

Steven Nichols – Chairman and President

George Powlick – Chief Financial Officer

Analysts

Jeff Van Sinderen – B. Riley & Company

Sam Poser – Sterne, Agee & Leach

Christopher Svezia – Susquehanna Financial Group

Brad Hathaway – Jay Goldman & Company

Operator

Welcome to K-Swiss's Third Quarter conference call. For opening remarks and introductions I would like to turn the call over to Chairman of the Board and President, Mr. Steven Nichols.

Steven Nichols

With me today is George Powlick our Chief Financial Officer. We appreciate you being on the call this morning. Before I begin I would like to have George cover the Safe Harbor language.

George Powlick

Certain matters discussed in this press release are subject to certain risks and uncertainties that could cause actual results to differ materially, including but not limited to non-achievement of the assumptions discussed therein, general and regional economic conditions, availability of credit, industry trends, merchandise trends, including market acceptance of the company's product offerings, customer demand, competition, the impact of terrorism, and/or a potential global conflict on the worldwide economy, and order cancellations and reduced sales resulting from a slower worldwide economy.

A complete description of these factors as well as others which could affect the company's business is said forth in the company's periodic filings, including its Form 10-Q for the quarter ended September 30, 2009, which is currently on file with SEC.

Backlog as of any date represents orders scheduled to be shipped within the next six months. Backlog does not include orders scheduled to be shipped on or prior to the date of the determination of backlog. The mix of futures and at-once orders can vary significantly from quarter-to-quarter and year-to-year, and therefore futures are not necessarily indicative of revenues for subsequent periods.

Steven Nichols

We know that last quarter that the second half of the year would be tougher as we methodically work through our inventories and closeouts. The third quarter results were consistent with the strategy and are evident in the decision to leave our full year estimates relatively unchanged. We are on target with running some encouraging sell-throughs continue at select [inaudible] sold by shoes. Our triathletes are doing well in recent events which in turn is broadening our brand recognition.

The same can be said for [Klagen], we have tightly controlled distribution of this brand, and the customers that are trying out these shoes are reporting good sell-throughs as well. We've a long way to go and we'll of course take it slow and steady, but we like what we see so far. The breakdown of sales by product category for the third quarter of 2009 was as follows, performance 18%, lifestyle 62%, other 20%.

Our performance revenues were up 20% when compared with the prior year end period. This category includes all genders, tennis, running, and training. Lifestyle revenues were down 38% when compared with the prior year period. This category includes all genders of non-performance footwear.

The biggest sellers for the quarter in lifestyle were the Classic, which sold 268,000 pair, which is a decrease of 24% for the prior year period, the Lozan II with 122,000 pair, the Molten with 77,000 pair, the Albury II with 68,000 pair, and the Mohr with 65,000 pair. The top performance seller was the ST329 with 75,000 pair. Other revenues which include apparel and Palladium were up 21%.

After strategic analysis and planning, we've established a new direction for marketing our product. The [inaudible] will focus on positioning the K-Swiss brand as the California Sports Company. Our brand was born in California in 1966. The original Classic shoe was designed here in Van Nuys, California, and our current tennis running and classic business fits nicely into the California Sports Company.

This brand positioning is the catalyst for us to create emotional connection with our consumers everywhere. Note that California has a spirit that is both different from other places as well as aspirational around the world. For us this is not about California stereotypes, instead our new brand voice will communicate a playful, creative, and progressive California attitude towards sports and lifestyle. We think this is what consumers want, K-Swiss authenticity or the unique attitude versus competitors cache and sports performance.

Tennis is our California heritage and we'll build it into this foundation; world class pro tennis players, product innovation, events sponsorship, and grass root tennis programs are keys to expanding our affinity with the tennis consumer. We're looking to add top athletes to our brand team. We've signed a term sheet with Sam Querrey, the number 2 ranked U.S.A. player. Sam grew up in California just a kick serve distance from our office.

We'll continue to bring new unique product technology to tennis community, and to maintain our commitment to the sport. The California Sports Company is real for the Classic II. Our white Classic tennis shoe is an icon of California Sports aspired lifestyle off the court.

Running is another important pillar in K-Swiss being the California Sports Company. To support this, we recently signed a multi-year partnership with the L.A. Marathon to be its official footwear and apparel brand. Serving as the hub of the L.A. Marathon will be our new K-Swiss running retail store that will soon open in Santa Monica. The store will showcase our full line running shoes including the K Series, as well as our proprietary miSOUL, and tubes cushioning technologies.

We will also continue to expand our leadership in triathlons, a sport created in San Diego, California. This includes the execution of our Iron Man global footwear and apparel licensing agreement, and sponsorship of Iron Man events around the world. Our achievements in triathlons are significant as proven by the K-Swiss triathletes finishing second, third, 11, and 15 at the Kona Iron Man World Championship last month.

Overall our team of 30 pro triathletes has won 34 major titles and 71 positions on the award podiums this year. Going forward, California Sports Company feels right for K-Swiss because it is who we are. We are developing a marketing of product initiative to make California Sports Company connect with consumers because we know it is the right direction for the brand.

I'll turn the call over to George for a few minutes to go into our financial details.

George Powlick

Revenues are $70.6 million which is 23.7% below the prior year quarter, and down 23% in the volume of footwear sold. At once business for the quarter was 37.6% compared with 24.6% a year ago, which excluded Palladium primarily due to higher number of closeouts. The company reported a net loss of $2.9 million or $0.08 per diluted share compared with net earnings of $1.1 million or $0.03 per diluted share a year ago.

For the K-Swiss brand the average wholesale price per pair decreased to $24.56 for the third quarter compared with $26.44 in the prior year period. The volume of footwear sold was 2.2 million pairs in the third quarter compared to 3.0 million pairs in the third quarter of 2008. Overall gross profit margin as a percentage of revenues was 37.2% in the third quarter compared with 39.8% in the prior year period.

A lower margin was due to a higher percentage of sales of closeout products. Our SG&A measured as a percentage of revenues was 42.9% compared with 39.3% a year ago, and in terms of dollars $6.1 million below the prior year. We had an operating loss of $4.0 million for the third quarter compared with operating margin of $500,000 in the prior year period. Our income tax benefit was 37.9% due to continued losses in the United States.

Turning to the balance sheet of September 30, 2009, working capital was $268.1 million compared with $368.1 million a year ago. Accounts receivable were $42 million or 53 days outstanding compared with 45 days the previous year. Our inventories were down 24.7% to $51.4 million compared with the year ago. And we ended the quarter with approximately $191.6 million or $5.46 per share in cash and investments, and $7.7 million in short-term debt.

I'll now turn the call back to Steven to wrap up the operational information.

Steven Nichols

Our international business was down 18% in the third quarter and backlog was down 29% at September 30, 2009. European sales were down 18% in the quarter with a 29% decrease in backlog. Europe accounted for 46% of our worldwide revenues compared with 42% a year ago. Asia region sales were down 3% in the quarter, but we posted a 1% increase in backlog. Asia is our third largest region accounting for 14% of worldwide revenues in the quarter compared with 11% a year ago. Our top goal for the fourth quarter continues to minimize net loss, reduce inventory levels, and make the right investments in the brand for the long term.

I'll now turn the call back to George to wrap up the financials.

George Powlick

As noted in our press release, the total worldwide futures order backlog decreased 32.1% to $68 million at September 30, 2009. The domestic backlog decreased 36.8% while the international backlog was down 29.3%. The total backlog is comprised of a 36.4% decrease, and fourth quarter 2009 futures orders to $25.6 million, and a 29.1% decrease in first quarter 2010 futures orders to 42.4 million.

Domestic backlog is down 34.4% for Q4 '09 and down 38.5% for Q1 2010. International backlog is down 37.6% for Q4 '09 and down 24.1% for Q1 2010. Our guidance for 2009 remains relatively unchanged. We expect revenues for 2009 to be in the range of 230 million to 240 million, and a loss for diluted share to be in the range of $0.70 to $0.80 per share. Our estimates for full year 2009 continue to reflect the significant decline in domestic and international revenues and substantial investments in product development and marketing for K-Swiss and Palladium brands.

The estimates are also based on SG&A of approximately 119 million for the year, which could fluctuate based on strategic investment decisions made during the fourth quarter and general retail trends which could vary based on the global distribution of results. I would also add that these estimates do not include the impact from any disruption to the worldwide economy from a global conflict or terrorist act here in the United States.

That covers our prepared remarks. We will now be happy to answer any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Jeff Van Sinderen –with B. Riley.

Jeff Van Sinderen – B. Riley & Company

Just a housekeeping question first, when you're reading through European backlog did you say European backlog was down 29%?

George Powlick

Yes.

Jeff Van Sinderen – B. Riley & Company

I wonder if you can talk a little bit more about the Remastered Classic, can you just give us more detail on your thoughts about that?

George Powlick

Jeff, just to make sure that was international backlog, not just European.

Jeff Van Sinderen – B. Riley & Company

That was international? What was European backlog?

George Powlick

I'm going to have to dig that out for you, why don't you ask your second question.

Jeff Van Sinderen – B. Riley & Company

Just wanted to get your thoughts on the Remastered Classic and what your expectations are there?

Steven Nichols

The Remastered Classic was brought out at a higher price and then the Classic LX that we have sold for the last six or seven years, it was really sold to somewhat up-scale stores. The result has been okay, not great, not terrible. We are since putting it back in a regular K-Swiss box and beginning to sell it to everyone. It will go into people like FootLocker, etc. in late first quarter 2010, and it's being priced at the same price as the Classic LX. So it has not gone nuts and changed the world as yet.

Jeff Van Sinderen – B. Riley & Company

Are the orders relatively small that you're getting from FootLocker and those folks?

Steven Nichols

The orders are relatively small that we're getting pretty much everywhere. One of the bright things on our horizon is something called Tubes, which we delivered just before Q3 this year, and it retailed very nicely and it will get I think some significant orders for late Q2 next year, and will be a big part of back-to-school and a big part of our efforts.

Jeff Van Sinderen – B. Riley & Company

And then can you talk a little more about what's happening with performance product in the core channel and how we should think about distribution and the evolution of that business?

Steven Nichols

The performance product we were really talking tennis and now running, and in tennis we've been a player where for 40 years. We have recently began getting more innovative and upgrading our products, having a miSOUL tennis shoe and having tennis shoes that specific function, shoes that keep your feet cooler, shoes that are lighter, shoes that are more stable. And we're also, for the first time, really going after higher profile tennis players than we ever had.

In fact in this month's tennis magazine there's about eight or nine pages of people wearing K-Swiss, which is something we haven't had before. These are editorial pages. So we're making good progress there. We have a separate sales force in addition to the K-Swiss sales force that just calls on tennis and pro-shops. And one of the things that's happening very nicely as a result of having more visibility and people getting into the quarter finals at Wimbledon and staying around longer at U.S. Open and our logo being seen, our tennis apparel is selling significantly better than it did in years past.

So tennis, we're on target, the Sam Querrey who's relatively young, I think he's ranked in the mid-20s in the world, he's number 2 in the United States and significantly younger than the number 1 guy. So he could be the number 1 American. He grew up in California right near Westlake office, he's part of this California sports positioning and he just comes in very nicely. In any event, I think our tennis is going in the right direction. Tennis is about 5% of the marketplace so it's not going to land us in the industrial 100.

So running, the other part of it now we're an interloper trying to crash the party. And the way we've done that first is with Ironman, and we have made some spectacular Ironman shoes. We've licensed Ironman for footwear and apparel and we're using that as an entry into running. And the bigger part of running beyond Ironman is real runners and everyday runners and casual runners and people that run marathons.

The leap from Ironman to marathon, which is the much bigger segment of running, and running silhouette is about 30% of the business, significantly larger than tennis. We first used Ironman at the World Championship in Kona, we actually took second and third 17,000 people start out and 8.5 hours later we ended up with second and third, also 11th and 15th.

So we've developed a following in Ironman, we had three or four booths there, sold a lot of goods, and now travel, literally, all over the world with a K-Swiss booth selling Ironman footwear and apparel, and were becoming a major player in the Ironman event.

The prize though is the true running market, and we just completed a multi-year deal with the L.A. Marathon. And again, it's part of California-based, it puts us in running everything ties together very nicely. What we'll have to do in addition to the K-Swiss sales force, as we have in tennis, we'll need a running sales force to call on running specialty shops. We'll need an event sales force to work all these events and these happen, literally, every week in the United States.

There's ten opportunities for us to have a [TEP rack] showing shoes to people at an event. So running is the bigger prize. We're way behind the people that have been established there for years and years, but we think there will be a payoff in a couple of years and we also think that it fits very, very nicely into our California Sports Company marketing positioning. So long-winded answer, but I hope that covered it.

Jeff Van Sinderen – B. Riley & Company

I mean it sounds like basically to sum it up you're gaining traction and making progress in running in the core channel. Is that a fair assessment?

Steven Nichols

Yes, but I will tell you it's teaspoons worth of progress. There are people that have been in this business for years and years and years. Retail business is very, very tough, but running shops are doing very nicely. To real runners, it's not a discretionary purchase. The darn shoe wore out and they put 300 miles on it. It doesn't have the cushioning it has and they know it and they have to come in and buy a new pair. So real running shops are doing well and we just have to bear knuckles, fight our way in there.

Our success in triathlon, which has blown me away, to end up with a second and a third and the ability to pull off the license. And now we can offer Ironman footwear and apparel to a running store, which no one else can. We have some technologies, namely miSOUL and now Tubes which are very, very interesting. And we've created points of difference. These are the things that work. They work classically. It will just take time.

Jeff Van Sinderen – B. Riley & Company

Steven, let me ask you this. When you sort of think about your business from 30,000 feet and the trends you're seeing now obviously still in a transitional mode, I guess I would call it. When do you think it might be feasible to have your revenues be sort of flattish year-over-year? Have you thought about that? Do you see that being out a few quarters? Or how should we think about that?

Steven Nichols

I would tell you what I would hope, and if someone is recording this be sure to put down the word hope because this is not a guarantee. I think by 2011 we should start to see some of the fruits of all of the long-term things we did on the downturn. We've been investing in design and development and technologies. In addition to that, even the technologies we have we're cloistering them and locking them up and many times only letting a teeny segment of the marketplace get it to build the cache. So we're not in quick fix mode.

We're very fortunate that we have the assets to say hey we'll spend two years or longer to get ourselves repositioned. Obviously we have to get it done. Business as usual will not work. We need some new dynamic things and we're fortunate based on how we operated and planned our business for the last decade we have the assets that we could say what's the right way to do it, what does it cost, okay let's do it, and that's our attitude.

George Powlick

Jeff, coincidentally both international and Europe are down 29%.

Operator

Our next question comes from Sam Poser – Sterne, Agee & Leach.

Sam Poser – Sterne, Agee & Leach

I would just like to know, you did about $10 million in Europe in Palladium according to the Q. Is that all the new product or is that still clearing out some of the older Palladium products.

Steven Nichols

So there's two Palladiums. One Palladium is the entire world and the other Palladium is France. And France is a 63-year-old company. And one of the reasons, we think, we were able to buy Palladium at the price we bought it at is there is this one shoe and it is called the Pampa. And that's the shoe that has the very rugged outsole, was developed for the French foreign legion. And that is the shoe that in the United States, in Asia, and in Europe X without France will be 100% of the sales.

Now this shoe at the moment comes in an Oxford, a mid, and a high. And then we have other derivatives in a pull-on boot with elastic gores, with a very high boot. But it's essentially it's one bottom and three or four tops. A very, very simple business.

In France, they have a business that has been developed for 60 years. About 40% of their business is infants and children's shoes that are not on this base. And then another 30% of this business is various shoes that we call me too, and these are copies of other shoes.

In the long run we will not continue with those shoes. They are marginally profitable in France and have been for years but it kind of dilutes the brand and dilutes the message. We're thinking that Palladium like the Converse All-Star essentially is one shoe and the narrowness of it is what makes it unique. And around the world, as Converse found out, there's enough business.

If you do one thing and you really do it well and Converse does a high and a low version and a slip on version of the same shoe with the same bottom. And they do various, very unique uppers and that gets them $1.5 billion worth of business around the world. And we think this one shoe concept similar Converse will be our ticket. So the business you see in France which is profitable at some point, we're going to disassociate with that in France.

Sam Poser – Sterne, Agee & Leach

So what percentage of the $10.5 million that was slated as Palladium overall business was France and what was the older styles versus the new styles.

Steven Nichols

In the 90's, 90% is the old stuff. Let me re-correct where you say old, no, the thing that we're selling around the world is the old stuff. They have newer stuff that they've developed and that's the part, they're selling. They can make a little money on it.

Sam Poser – Sterne, Agee & Leach

How much of it is the Pampa?

Steven Nichols

10%

Sam Poser – Sterne, Agee & Leach

And how should we look at that within the fourth quarter guidance, and where do you see the sales coming? Is it another quarter like that? Or will the business in Palladium sort of dip as you clear out of that 90% and then come back up as you develop the Pampa.

Steven Nichols

That's a possibility. Another possibility is that we introduced what I'm going to call the Pampa and it's derivatives in the United States in February at the WSA show of this year. And what we found was almost every buyer heard of Palladium, knew about it. Had a little run in the United States about ten years ago and all the buyers knew about it. We didn't think that consumers had any knowledge of the brand. And we priced these shoes very aggressively.

The canvas shoes the low is priced at $50, the mid at $55, and the shoe we call the baggy that's the one that turns down, is at $70. Then we do suede for about $10 more and then leather for another $10 more. So the leather oxford is $70. These are very, very price competitive shoes and the reason being is they're very efficient. We don't have any designers on this company. The shoe was designed 62 years ago. It's just variations of materials, which is a theme that Converse has done spectacularly.

So because we don't have designers, because we don't mold charges, the whole company is one mold, because there are so many efficiencies, we believe that we could work on significantly lower margins than K-Swiss ever worked on. But have significant lower expenses than K-Swiss ever had and net-net be even more profitable than K-Swiss was, and that's the plan. And we introduced these shoes and the first thing we did was we only took it to the most upscale retailers.

And if you go on our website you'll see a list of the retailers we have sold and it is the who's who of retail in the United States. We have gotten into about 80% of the retailers we called on and said please buy our shoes, about 80% did. And the result has been they've done very, very well with it. And they bought little teeny amounts.

We delivered the shoes in the United States essentially in July/August. The canvas versions of our shoes sold very, very well. And as the season is changing right now. Number one, we've just sold out of about almost every pair of canvas we had, [we're broken] on canvas. And the weather and climate is turning over to leather and now these people are going from canvas to leather and it's just working very, very nicely.

We're putting in a futures program, which we didn't have initially. And the reason we didn't have it was we just went out and bought all the shoes, pre-bought them. There was no advantage to us offering futures. It was give us an order and we'll deliver them in three weeks and we successfully did that. So now we have a futures program and we'll be looking in the next three, four weeks or the rest of this year to start book serious futures for spring of next year and back-to-school.

And based on the sell-throughs, I think that this brand is absolutely moving in the right direction, probably faster than I anticipated. In addition to that, the next step will be to go down one level at retail and go into some mall stores. We have really been with independents and in delivering to mall stores, we also developed a very interesting strategy there. And the strategy is that the shoes were priced very aggressively and they were sold into some of the absolute best retailers.

And one of the reasons the shoes went in and this was shoes that were purchased last March/April and were delivered in July/August was the retail climate last March and April and February, the world was coming to end. Retail business was terrible, these spectacular retailers, they didn't know what to do and they bought these shoes. These shoes were significantly less expensive than anything in their store.

And our fear is once business comes back, a store whose average price is $150 is not going to be happy selling a $50 or $60 shoe. So, what we have done is we developed a second collection of these shoes and this second collection is essentially the same shoes again, but built out of materials and processes that are vastly superior.

For example, if the canvas shoe was $50 and $55, we now have a leather-lined canvas shoe. If our leather boot was $80, we now have leather lined with soft, gorgeous leathers and we're calling this our Orifices line and we are offering these shoes at significantly higher prices, but the second you see these shoes it's not a rip-off. It's something that the value is built into it.

Now we're offering them, number one, to a bunch of people who passed the first time and some of the best upscale retailers. Names like Niemen Marcus, Bloomingdales, and Barneys said we can't carry shoes at these prices. Well, we've remade these shoes a second time at price points that they can carry shoes at.

And we'll be going out in the next month or two with the Orifices line against a whole group of retailers and at some point at a show if you stop in you'll see the difference in these shoes. The canvas-lined leather could be $100 and the leather-lined leather with super premium leathers could be $150. And if you put the shoes next to each other, you will understand the price.

There's no tricks and games here. So, we think that some of the retailers that bought us the first time out of fear, we'll convert them over to what we call the Orifices line and some retailers will say hey, we can't carry shoes at that price, they'll go into the Orifices line. And that will open up the original line, which we now call Infantry to mall stores and higher volume. And this should unfold over the next year or so. Another long winded one, but I hope it answered it.

Sam Poser – Sterne, Agee & Leach

It did. So, I mean, are you concerned? I already saw one of your competitors come out with a version that was very close to the Pampa boot at retail. I mean are you concerned? I know it has the heritage and everything, but are you concerned that you might just out of necessity step on the gas a little faster than you would have liked?

Steven Nichols

No, I think we might step on the gas a little faster because the demand could be there. I could copy the Converse All Star to the tee, tomorrow. They'll still do $1.5 billion and I won't sell any. So, copies are copies. People know the difference and we've done a very, very nice job of branding this.

One of the questions and one that I haven't answered really is how much will we invest in this brand next year in marketing? The marketing we've done has worked spectacularly. I mean from a standing start, we have retailers that put us in three or four stores and they have 20 stores and all the sudden they're going to all 20 stores. And we have a website that, I think, is getting thousands and thousands of visitors a day. So, the marketing has worked.

Our marketing spend has, I think exceeded sales for the launch and the question is will we do it again next year? If we do I'll pick a number if we do $10 million in sales, will we spend $10 million in marketing next year? And then in year three, will we have $100 million company? I mean that's the bet that we might make.

So, if everything goes right, this Palladium brand around the world should operate at quite a deficit because we'll just pour it on. And by the way, I did say that in the United States the retailers knew us but the consumers didn't, and we'd go into a 15 store chain and they'd put it in four stores and they'd put in a nice little selection in and we had minimums and we launched this in January.

Europe launched something called a Bread and Butter show in July about four months after us and Europe has already passed us. And the reason being, they went into a retailer in Holland with 17 stores and he put it in all 17 stores. Oh you guys are back. So the brand is significantly better known in Europe.

And probably in 2010, and a big probably, Europe might surpass the United States and because the consumers and the retailers know the shoe in Europe. So the brand is better known there and with all that said, everything will be concentrated on the very original shoes, derivatives of the original shoes and its really emulating what we saw Converse did except this is in canvas and leather boots.

Operator

(Operator instructions) Our next question comes from Christopher Svezia – Susquehanna Financial Group.

Christopher Svezia – Susquehanna Financial Group

I guess a question regarding – I'm just looking at the gross margin rate and your inventory. I mean your inventory's in a position where it seems like you took most of your lumps here in the third quarter and I'm just kind of backing into fourth quarter thought process seems like we could get back to this call it mid-40s or so gross margin rate or thereabouts.

I'm just trying to think about as we sort of move forward from this point, is it possible – I know it's a lot of puts and takes with regard to product cost, new product initiatives. How should we think about that gross margin rate? Is it possible to sustain a plus 40% gross margin rate at this point?

George Powlick

I don't think so in the fourth quarter, Christopher. We've still got some inventories. We did a great job in Q3 removing some excess inventories but with our decline in sales, our belief is that our inventory's are still too high. Not as high as they were before, but still too high. So I would suspect, no.

Christopher Svezia – Susquehanna Financial Group

George, looking at that futures window, is it possible to extrapolate that there's support possibly to a 40% or so a gross margin rate on that? I'm just trying to think more forward- looking, not so much for say fourth quarter, but I guess what I'm saying is, if you get through the fourth quarter and your inventory's in better shape, can you hopefully be stabilized somewhere in that 40% range or do you kind of need to see what sell through rates are like.

George Powlick

We're going to need to see some more information and were not making and guess or predictions on 2010 yet. If it were to get to the 40s, it would be 40 not 44 or 45 where it used to be.

Christopher Svezia – Susquehanna Financial Group

Steve, I just want to touch on the investments and your thoughts about investments behind a lot of these new branding initiatives. And I know you have the cash to take sort of a long-term approach and I'm just curious as you think about that, balancing it against – I mean you had a nice meaningful reduction in SG&A this year.

I'm just trying to think about how you're balancing the puts and takes as you think about 2010. Just sort of think forward and look forward about the business, how much more there is that you can potentially take out without sacrificing what you want to potentially put into these other sub-businesses.

Steven Nichols

So going back to the question you asked George about the margins, our problem never has been margins it's not margins. Our problem is out and out demands for the brand. When the demand is there we'll figure out how to make money, and right now the demand for the brand is very, very soft. And this California sports initiative, upgraded tennis initiative running these are things that will create demand.

And without the demand it doesn't make a difference what your margins are. Once the demand is in place we know how to create margins because we historically don't sell everybody and don't sell the discounters. So once the consumer says hey where's K-Swiss then our retailers will make money and we'll make money. And our problem is right now that's not what's happening. So when we fix that everything will fall into line.

As far as investing our real fixed costs in this company around the world are nothing. It's over an 18-month period, there's people that we employ and our headcount keeps shrinking, overhead for, we don't own any factories. We don't own distribution centers. Everything is rented. So we could shrink ourselves smaller and smaller and smaller and we have been and are doing that.

The two variables is product design and development which we have not really shrunk and we're doing very aggressive things there. And the other thing is marketing and we'll probably be very, very aggressive there. So the issue is not at this point what our margins will be in 2010 or the money we're going to make in 2010, the issue is will we have a vibrant growing company in 2011 and what will it cost for us to get there.

And that's how we're looking at the business and actually although the results right now are negative there are many positive things that we've been working on for a while. This Palladium was a very, very interesting purchase in that when we bought the company this original shoe was made on machinery that was 62 years old and the machinery was obsolete, the production was obsolete.

We spent almost a full year just redesigning the out sole from a manufacturing comfort and cost basis and we nailed it. We got it perfect and we wasted, I'm going to say wasted a whole year doing that, but that's the base that we're going to build the company on. So we could have been to market with this shoe the day after we bought it and we waited a year and got everything perfect. That's our mentality. Take your time. Spend the money. Do it right and then go in the milking business. And Palladium I think could be a very large positive surprise.

This other thing called Tubes could be a very large positive surprise. We've got things that we've been doing investing on. These things just cost us money. They made us look worse but hopefully in the long run they'll pay off.

Christopher Svezia - Susquehanna Financial Group

Steve just a question on Tubes for a second, when you talk about the distribution and taking a look at that and starting to open up you need to say a little more color in terms of is that, I think some of the Family Footwear retailers had it spattered out there a little bit here and there for testing.

Just kind of talk about what's the opportunities, you sort of ramp it up, you talked about sort of the second half of next year being more meaningful. Does that mean you're opening more mall based channel, more the sporting goods channel? Just give a little color in terms directionally what you're thinking about that.

Steven Nichols

So we showed Tubes to everybody and Tubes was presented in the marketplace by a wounded duck. That was us. And the brand isn't strong and people looked at it. They didn't know what it was. We had three or four what we call family group retailers put it in and a bunch of independents. And we said well what are we going to do about it. So we started giving shoes, they call it seeding to the retailers, the guys on the selling floor.

And wherever we could if it was a little independent our guys came in there and said you three guys who work here we're giving you a pair. And as soon as they put their foot into this shoe it just felt great. And the shoe was very, very unique and it looks high-tech but the retail price is $75. So $75 is a nice price for the K-Swiss brand in this market it's at the higher end of what's selling in volume, very high end of what's selling in volume, and the shoe sold.

We had some very nice sell-throughs at a group called Dick's. We had nice sell-throughs at a group called Academy. Real nice pushes and Dick's and Academy and now Sports Authority and these type of retailers I think are ramping up for back-to-school next year. The Footlocker group is going to be putting the shoes in. So this is not a guaranteed lock. It's not the New York Yankees ahead by six runs and Mario Rivera comes in. We still have to prove ourselves.

And this back-to-school if the money we spend in April advertising these shoes and then the money we spend in July and August if Tubes work then all of a sudden we have this demand factor back. And that's one very strong possibility.

Behind Tubes we have another technology that's coming in and it's called Blades super light technology. And these Blade shoes will only be offered to high performance running shops where we're establishing our next technology. Behind Tubes we have something called Super Tubes and believe it or not behind we have something called Super Duper Tubes. So if we get Tubes to work there's probably a five-year supply of Tube technology in the market that we'll bring into the marketplace.

So all the things we've invested in, all the things that have not produced but are teed up in the on deck circle if these work the company will be very happy and you'll be happy to listen to the great news we give you quarter-after quarter. But we're still in investing mode and we still have to get the consumer to say boy I want this K-Swiss product and that has not happened for a while.

Operator

Our next question comes from Brad Hathaway – Jay Goldman & Company.

Brad Hathaway - Jay Goldman & Company

I was wondering if you'd talk a little bit about the cash balance. During the Q2 call you mentioned you thought you'd keep kind of cash flat through the end of the year and at this point now it looks like you've actually generated a little bit of cash in Q3.

Is the thought that you can keep kind of cash flat from this level going forward both in Q4 and also can you maybe give us an idea on how to think about cash in 2010? I mean do you see a lot of investment in the brand burning cash 2010, try to see cash breakeven, I mean how should we think about that?

Steven Nichols

Part of it was liquidating inventory which turns into cash. We still have more inventory that we will liquidate.

George Powlick

But we'll also be putting some inventory on for Q1 deliveries.

Steven Nichols

So, if we do everything as aggressive as possible we will consume cash. And I'm we hoping we do. I'm hoping that we see the opportunities in this Palladium and Tubes in running that we just step to the plate and we spend the money in 2010 to get us the results in 2011 and 2012. So if we don't burn cash the business is weaker than if we, if we start really burning cash then we believe in things and we're going to just make it happen.

Brad Hathaway - Jay Goldman & Company

So I guess Q4 seems like is not really the issue, it's how much do you invest in 2010. I mean can you give us anymore ways just to think about that so we can think about the amount of cash you might be burning?

Steven Nichols

I think the only equation, the only unknown is what will it demand. The second, if these Tubes, if we sense these Tubes work we could invest every penny we're going to make and more in Tubes in 2010 because there's something called Super Tubes and then there's third generation called Super Duper Tubes we would make the bet that we would have a five or seven year franchise in Tubes. And we would just very aggressively invest in Tubes in 2010.

So the good news is we have the option to do these things. Worse case scenario, if Palladium tubes and blades doesn't work, we will have the option to try again. So our industry has always paid off for innovation that's presented aggressively and intelligently and that's innovation that people want. And once we have it, we'll know what to do with it.

Brad Hathaway - Jay Goldman & Company

I was wondering also if you could comment a little bit on the new skate division. We haven't really heard much about it since the launch. I was wondering how that's progressing.

Steven Nichols

Yes, one of the things that we don't want to do is to be everywhere and bit off more than we could chew. We did sign one skater, his name is Greg Lutzka. He was the – he one two out of the three national championships in Tampa. He's well regarded all over the world.

We have begun to make what we would call skate shoes. We're selling them. Actually had some very nice orders coming up in Europe, but not selling them as skate shoes. It's just the look of skate, which is very, very simplistic shoes.

We have to decide how aggressive we want to be in skate, what we want to do with it. One of the reasons skate is important to us is this California Sports Company. Somehow you need either skate or surf, if you're in California. And we thought skates which the basic silhouette is very close to our classic as something that we could enter.

We're putting shoes together; we're showing them to people. We're not prepared to start running ads in skate magazines and things like that. We're thinking more of a grassroots effort where the shoes go out. This Greg Lutzka doesn't wear a t-shirt with the classic K-Swiss shield on it.

He wears a t-shirt that just says KS. And we want them to figure this out. We don't want to come in with a bulldozer, we'd like to kind of come in with a little canoe or something. Sneak in quietly and let them find us, so that's our skate effort.

Operator

Our next question comes from Sam Poser – Sterne, Agee & Leech.

Sam Poser – Sterne, Agee & Leech

I just want to follow up on the SG&A. You brought the SG&A number down again for the full year. When we're looking ahead into 2010, at what point – how much of that is fixed now versus non-fixed expenses on the SG&A I mean can you really go below $119 million or would that, as you said before, would that be more of a sign of weakness rather than sign of strength?

George Powlick

Sam, we'll issue our guidance for 2010 in February, when we have our year-end press release but preliminary thinking is it's going to be difficult to squeeze a whole lot more out of the present number.

Operator

Mr. Nichols, I show no further questions at this time. Please continue with any closing remarks.

Steven Nichols

Thank you for your participation today and your continued interest in K-Swiss.

Operator

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Source: K-Swiss Inc. Q3 2009 Earnings Call Transcript
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