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K-Swiss Inc. (NASDAQ:KSWS)

Q1 2010 Earnings Call

May 6, 2010 11:00 AM EST

Executives

Steven Nichols – Chairman, President, and CEO

George Powlick – CFO

David Nichols – EVP

Analysts

Jeff Van Sinderen – B. Riley

Sam Poser – Sterne, Agee

Brad Hathaway – Jay Goldman

Chris Svezia – Susquehanna

Operator

Welcome to K-Swiss’s First Quarter 2010 Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session.

(Operator Instructions)

As a reminder, this conference is being recorded, Thursday, May 6th, 2010.

I would now like to turn the conference over to Mr. Steven Nichols, Chairman, President, and Chief Executive Officer. Please go ahead, sir.

Steven Nichols

Thank you and good morning, everyone. With me today is George Powlick, our Chief Financial Officer, and David Nichols, our Executive Vice President. We appreciate you being on the call this morning.

Before I begin, I would like to have George cover the Safe Harbor language. George?

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 herein, 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 the 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 March 31, 2010 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 the subsequent periods.

Steven Nichols

We started to year off as we expected with some momentum carried over from our marketing launches in the fourth quarter and earlier this year. We made quite a few announcements during the quarter that highlights where we are investing in growing the Palladium brand and extending the K-Swiss brand. We will continue to ramp up our investments during the year. This is a pivotal year to setup for success in 2011. We will speak more of these efforts in a moment.

Let me first touch on our sales performance during the quarter. The breakdown of sales by product category for the first quarter of 2010 was as follows: performance 28%, lifestyle 52%, other 20%.

Our performance revenues were up 2% when compared to the prior-year period. This category includes all genders of tennis, running, and training. Lifestyle revenues were down 28% when compared to the prior-year period. This category includes all genders of non-performance footwear.

The biggest sellers for the quarter in lifestyle were the Classic, we sold 258,000 pair and increased 8% from the prior-year period; the Trifuno with 80,000 pair; the Albury II with 72,000 pair; and the Grande Court with 44,000.

Top performance sellers were the ST329 with 75,000 pair and the Contesta II (ph) with 44,000 pair. Other revenues which included apparel and Palladium were up 34%, but on a small base. Overall, our domestic business was down 21% in the quarter and backlog was up 3%.

Our international business was down 4% in the first quarter and backlog was down 4%, as well at March 31st, 2010. European sales were down 12% for the quarter with a 16% decrease in backlog. Europe accounted for 41% of our worldwide revenues compared with 42% a year-ago. Sales in Asia were up 22% in the quarter, but a 33% increase in backlog. Asia is our third largest reason, which accounted for 15% of worldwide revenues in the quarter compared with 11% a year-ago.

You will note in our press release, we were notified in April that our contract manufacturer in Thailand has ceased operations. This is the only one of three we use in this capacity worldwide. And this particularly manufacturer was fulfilling orders for 700,000 pair, primarily vulcanized rubber soles and some cold cement. This production was primarily concentrated for Latin America and to a lesser extent Europe. We are working hard to replace this loss capacity, but it will likely take us some time to line it up.

We have already experienced some cancellations due to our inability to deliver the primary canvas products and there is no guarantee that there won’t be more cancellations over the next two months. However, we hope these cancellations will be contained only to these orders which would represent the loss of approximately $5 million in revenues right across the second and third quarters.

I would now like to turn the call over to David Nichols to discuss our product and marketing initiatives.

David Nichols

In March, we officially launched our positioning of the K-Swiss brands to the California Sports Company to consumers with a new marketing campaign. We think that our progressive, creative, and playful California attitude towards sports and lifestyle will connect with consumers around the world.

We see the California Sports Company as the bridge that connects our California heritage in classics and tennis products, our performance in running and training efforts, and more youth driven California lifestyle products like skate that will continue to evolve.

Our new global TV advertising that just launched depicts the day and the life of the California Sports Company. K-Swiss pro triathletes, tennis players, skaters and young Californians are seen having fun in the sun. Warming up, competing, winning, and enjoying themselves. And we added an energetic and contemporary remake of the hit song California Sun to connect with consumers. Our K-Ona and Tubes running shoes, Defier DS tennis shoe, the Classic, and our apparel are featured in the TV spot. It ends with a message Have an Awesome Day followed by Designed in California under the K-Swiss shield.

The goal for the campaign is for consumers to view us as a true sports brand and having a California point of view. This new advertising ran in the United States, Canada, Europe, Asia, and all over the web. Another new media placement is our K-Swiss logos on the roof of the Dodgers team store just behind right field which can be seen if you are in the stadium or watching Dodger home games on TV. It’s the largest branded sign in Dodger stadium.

Tennis is our heritage and we continue to build in this sport. This year we added four new tennis pros to our team. Sam Querrey, the number 2 American tennis player, who is ranked number 23 in the world. Bob and Mike Bryan, who won the Doubles Championship at the Australia Open and just last week at the Italian Open. And they are two wins away from beginning the winning away from becoming the winningest doubles team in history, eclipsing some K-Swiss champions. And soon, we will announce another great addition to our team, an international player, a grand slam potential and crossover field. Sam, Bob, and Mike are featured in our current TV print and online advertising.

Running is an important to K-Swiss being the California Sports Company and we continue to focus on developing innovative fresh products. In 2008, we began this initiative in a strategic move to get the brand into running by connecting with triathletes and triathlons. In two years, we have developed a leadership presence in this community of athletes. Our team of pro triathletes has gone from 30 last year to 42 in 2010 and they have already this year one 11 major titles and 31 positions on award podiums this year.

Now that the 2010 triathlon season is fully underway, our sports and marketing team will be onsite at 32 Ironman events around the world. We did 16 last year, leveraging our Ironman global footwear apparel licensing agreements. We are also partnering with the leading performance bicycle brand in the world to create the Trek K-Swiss triathlon team of nine world class triathlete champions that are out winning events every weekend.

Marathon runners are also very important to what we want to accomplish in running. Our brand presence was very strong at the LA Marathon as its presenting sponsor and its official footwear and apparel partner last March and we will continue to leverage this partnership globally. We had a special insertion on the insight cover of April’s Runners World Magazine, which included a two-page K-Swiss running print ad, plus a one page full fold advertorial out about our sponsorship of the LA Marathon.

We also recently added elite marathoner Josh Cox to our team. Josh is the 50K American Record Holder, a 4-time Olympics qualifier and just recently won the 5K Race at the Boston Marathon. Our running product has received awards in many publications to two recently. Our new Keahou II tied for the Best Neutral Shoe and our new Konesic won Best Debut. Our running print ads are running in many running magazines around the world and online. We will continue to target running specialty accounts with unique product and marketing campaigns as this grows.

Our Tubes running shoes are an important initiative as we continue to invest in the running and training categories. With this in mind, we are excited to have Jillian Michaels, the world class fitness expert, bestselling author and TV’s toughest trainer as a brand ambassador for K-Swiss Tubes product. Jillian will be wearing Tubes and we expect her celebrity status, the visibility and athletic authenticity to connect with consumers. She is a true California trainer as well.

Also, for Tubes, we executed promotion with 24-hour fitness centers to see our Tubes products with their top fitness instructions in the US and advertise their employees and members online and via email blast during April and May. The same time, we launched Tubes train for summer train for life program with high school athletes and four major cities and 75 schools, that includes donations to each school’s athletic program and we expect to expand this program to about a 1,000 schools in 2011.

The California Sports Company concept is real for Classic footwear too and we are creating events and online content that support Classic product. April was deemed the California Music Month by K-Swiss and through some unique media placements, this message was carried on MTV, Yahoo! Music, Rhino Records, and many more sites and outlets. California Music Month began as a series of five custom videos presented by K-Swiss and celebrating California music artists, who influenced music in each of the five past decades that K-Swiss has been in California and has been influenced by music as well as everything else in California. These video ran online in a restaurant network of 1,800 dedicated TV screens.

Last week, we formally launched our new Vintage California footwear collection at an event at Kitson’s Malibu store and have built window and wall displays at some great LA retailers, including Conveyor at Fred Segal’s Santa Monica location. Also for consumers online, we are redesigning kswiss.com and turning it into more of a global hub where consumers can interact with the brand. This new redesigned site will go live later this month and we are seeing significant growth, Facebook fans and Twitter followers as we revamp all of our social media resources and online updates about our brand.

Now, I will turn the call over to George for a few minutes will go into financials in more detail.

George Powlick

Thanks David. Revenues were $65.9 million which is a 11% below the prior-year quarter, and down 26% in the volume of footwear sold. At once business for the quarter was 26% compared with 13.4% a year-ago. The company reported a net loss of $4.698 million or $0.13 per diluted share compared with a loss of a $1.093 million or $0.03 per diluted share a year-ago.

For the K-Swiss brand the average wholesale price per pair increased to $27.21 for the first quarter of 2010 compared with $23.84 in the prior-year period. The volume of footwear sold was 1.9 million pairs in the first quarter compared with 2.6 million pairs in the first quarter of 2009.

Including the K-Swiss and Palladium brands, the average wholesale price per pair increased to $28.20 for the first quarter of 2010 compared with $24.43 in the prior-year period. The volume of footwear sold was 2.1 million pairs in the first quarter of 2010 compared with 2.8 million pairs in the first quarter of 2009. Overall gross profit margin as a percentage of revenues was 43.5% in the first quarter compared with 38.2% in the prior-year period.

Our SG&A measured as a percentage of revenues was 53.5% compared with 40.5% a year-ago, and in terms of dollars $5.3 million above the prior year. We had an operating loss of $6.6 million for the first quarter compared with an operating loss of $1.7 million in the prior-year period. Our income tax benefit rate was 28.1%.

Turning to the balance sheet at March 31, 2010 working capital was $251.7 million compared with $278.9 million a year-ago. Accounts receivable were $40.5 million or 55 days outstanding compared with 60 days the previous year. Our inventories were down 36.7% compared with March 31, 2009. And we ended the quarter with approximately $183.1 million or $5.21 per share in cash and investments, and $5.7 million in short-term debt.

The total backlog of $72.5 million at March 31, 2010 is comprised of a 6.5% decrease in the second quarter 2010 futures orders to $30.7 million and a 2.3% increase in the third quarter 2010 futures orders to $41.8 million. These backlog figures were as of March 31st. Q3 backlog as of now is down approximately 3%. And as we noted earlier, the unexpected loss of our contract manufacturer in Thailand subsequent to quarter end could lead to some cancellation in shipments in both quarters.

Turning to our guidance for the year, we expect consolidated revenues for 2010 to be 5% to 10% less than 2009. On a year-over-year basis, we expect a decline in revenues in Q2 and Q3 and hopefully an increase in Q4. Consolidated gross margins is expected to increase to approximately 43% compared with 35.8% in 2009, due to expected lower close-out sales during 2010 compared to 2009.

Selling, general, and administrative expenses are expected to raise to $143 million to $148 million due to increased marketing expenditures. These expenditures will be continually evaluated and could change over time, including the possibility of even greater marketing expenditures depending on available branding opportunities.

Other expense will be charged about $3.7 million in the second quarter due to the amendment to the Palladium purchase agreement. The tax benefit rate is projected to be approximately 25%. Should we be unable to substantiate evidence for realizing the benefits of our deferred tax assets in the second half of this year, we might be required to establish a reserve of $10.9 million, plus any deferred tax assets established during the remainder of 2010 if any.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question is coming from the line of Jeff Van Sinderen from B. Riley. Please proceed with your question.

Jeff Van Sinderen – B. Riley

Good morning. Can you guys talk a little bit more about the manufacturing facilities situation and how you are addressing options to replace that capacity and then also how did that impact your futures?

Steven Nichols

Over the mid to longer run, there is virtually unlimited capacity in Asia. In any quarter, there is not much it can do. We have a factor that relatively unexpectedly went bankrupt. This happens all the time in Asia.

They are contract – I think over the years this might be the first time it happened to us, but we always see these things happening. I think there has been widely reported that a 1000 factories closed in China over the last 18 months and things like that. So this was in Thailand and they were mostly making vulcanized canvas shoes for us.

We will have no problem replacing this factory. We will have a huge problem replacing the factory next quarter. So this is a case of the toast always falls the buttered side down. It was the absolute worst time this could happen, but it happened. Bad news in the short run, there were people that gave us orders, and they are not going to get their shoes. The good news is that there is not a retailer we know of that hasn’t heard this story before.

We are in the process of diversifying into more factories to mitigate the chance of one factory having an impact like this. The other factories that we are in, we have been in for years, we find them very financially stable as best we know. And don’t expect any other short-term problems in the long run. We will have no problem replacing this production. Hope that answers it.

Jeff Van Sinderen – B. Riley

It does, yes. I was just curious to know also if – I think George mentioned that your futures were up in international at the end of the quarter but now they are trending down. Was that a result of the factory?

George Powlick

No. No, that’s just a movement in the futures orders, no. What we said was, we think there is about $5 million worth of orders at risk. We don’t know how many of them we are going to lose. We may lose a portion of them, but we are now going to start working with the retailers, notify them of the later availability, and then they will choose whether they want to choose to take the product later or to cancel. So we really don’t know how much of $5 million we will lose at this point.

Jeff Van Sinderen – B. Riley

Okay, got it. And then your domestic futures are running up. Can you give us any more detail or color on what’s driving that and I guess how you expect that business to trend? Do you expect that to accelerate going forward and such?

Steven Nichols

Yes, we are bouncing along the bottom of what’s our brand worth at retail and what can we – what’s the bear minimal we can expend. We have literally spent three years trying to figure out how to present our brand or what the products people will want. And many of that we have reported quarter after quarter that we were proceeding with.

So we spent 2.5 years getting involved in running and we finally have excellent running products. The running products keep winning awards for new products coming out. So we are very competitive in running and now it’s a question of marketing and getting the message out. We have developed some technologies first with something called miSOUL, which was very technical interchangeable function shoes aimed at specialty running and that’s kind of positioned us as a high-performance running company.

We then came out with a product called Tubes, which is less costly at retail price, men’s and women, about $75, very visually dramatic, and is priced very competitively in the marketplace versus other similar visible technologies. We had great difficulty landing this and getting it in the first year and we made our first deliveries almost a year-ago in July. And it was, “Hey, who are you guys, you are a cup sole tennis company. What are you doing in running? We had to overcome that.

Pretty much wherever we have delivered the shoes, they have retailed very, very well. I will take it back. They have retailed well and with no marketing behind it. We have now made a major commitment to market this Tubes technology with the signing of Jillian and with committing to in-store and ads. And this will all ramp up to some degree at back-to-school. But the real, real, push will have to be in 2011.

And the reason would be that there is a not a very large amount of these Tubes shows at retail. Our dream would be that by the beginning of August, there is not one pair of Tubes left at retail, at which point, all the customers that bought these from us would have experienced great sell through, and the big payoff would be Q1 2011. And that’s our bet on Tubes.

We are following Tubes with another technology called Blades. And again, it’s visual, it’s priced under a $100. We are confining it at the moment to running specialty shops and that will – we will deliver that late summer this year and sell it all through fall and winter. For Q1 2011, we expect to take that to a broader audience. So we have got some great product innovations, priced very aggressively, yet still yielding us acceptable margins. These are simple technologies that are easy to understand and explain. And we are going to ramp up marketing behind all of this.

One of the humongous bets that we are making in 2010 is that we have great products and we have innovative products and now we just have to bring that message to the consumer, so we are spending very disproportionately this year in hopes that we will create tailwind for 2011.

Long answer.

Jeff Van Sinderen – B. Riley

Okay. It is a long answer but that’s a good answer. Let me ask you this. So is the increase in futures is that a result of an increase in the core channel or is that the initial push of Tubes into the volume channel?

Steven Nichols

I think the futures that we are reporting now is based very loosely on Q4 selling, because that’s when we were writing futures. And I think our brand did a little better at retail, the pushes moved up a little bit towards the end of the year and maybe the beginning of this year. So retailers always buy looking in their rear view mirror. And futures are a direct benefit or affected negatively by how you are doing that week at retail. And I think we edged up just a little bit.

Jeff Van Sinderen – B. Riley

Okay. Fair enough. Thanks very much and good luck for the rest of the quarter.

Steven Nichols

Thank you.

Operator

Thank you. Our next question coming from the line of Sam Poser from Sterne, Agee. Please proceed with your question.

Sam Poser – Sterne, Agee

Good morning. Just a few – first of all, on the Q, there was a commentary about a tax issue going on with the IRS.

George Powlick

That’s correct.

Sam Poser – Sterne, Agee

Could you go into that and tell us where – that’s – none of that’s in your guidance, correct? You are fighting that?

George Powlick

We will fight that. None of that is in the guidance. When it gets resolved, it will be significantly into the future.

Sam Poser – Sterne, Agee

So this is going to take some time.

George Powlick

Yes.

Sam Poser – Sterne, Agee

Okay.

George Powlick

This issue was brought up once before in 1993 and it was resolved in 2000. I don’t expect it to take that long, but it will not be in one or two quarters resolved.

Sam Poser – Sterne, Agee

Okay. And then in the revenue guidance of down 5% to 10%, does that take into account the loss of the $5 million?

George Powlick

Yes, it does.

Sam Poser – Sterne, Agee

So if ends up not hurting you as bad, you would think you would go to the higher end of that, you would err on the higher end of your guidance.

George Powlick

I think that would be correct.

Steven Nichols

But we are not confident that everything ugly that could happen to this. It’s a double – will not happen. We think it will happen.

Sam Poser – Sterne, Agee

Yes, I understand. But I just wanted to understand if it was in there.

Steven Nichols

There is not a lot of upside and this problem. This is a real problem and it’s not going to go away.

Sam Poser – Sterne, Agee

But you – but when we look at the $42 million of international futures backlog, we should be deducting – I mean in reality you deduct $5 million, because it’s never going to ship.

George Powlick

We don’t know if not’s going to ship. But as Steven said probably.

Sam Poser – Sterne, Agee

Okay.

Steven Nichols

We could still pull a rabbit out of the hat, but we don’t bet on that stuff.

Sam Poser – Sterne, Agee

Alright. In the quarter, I mean in dollars your SG&A seemed to come in pretty close to what we were expecting. You didn’t guide by quarter but then you raised the full-year SG&A spend quite significantly basically from – you raised it from I guess 14% to 18% over the last year to about 21% to 25% if I am just doing the math correctly.

George Powlick

Yes, you are correct.

Sam Poser – Sterne, Agee

Can you talk about what – where those additional dollars are going and what happened in the last three months that made you add those dollars and where the biggest chunks of that spend is going to happen. Maybe that’s a David question?

Steven Nichols

No, I will hang in there. We are making a bet this year and the bet is that this product that we have called Tubes is moving out into the marketplace. We have overcome the first objections to us bringing Tubes out. And the first objections were from retailers, saying, “Hey, this was a running silhouette, you are not a running company.” And the way we have answered that was getting them to test small amounts, just give us a shot, pretty much this has worked.

The comments that we get on this whole new technology from consumers is absolutely excellent. So we have put on people around the United States to get these – this technology into fitness and training clubs, to get them on people’s feet. We have given them to retailers. And this is the kind of product with the first five steps, you just feel it’s different and terrific. Once we have had that feedback that confirm that we have a $75 shoe that is visually different to look at, you can tell what it is, and has instant feedback from the consumer and it’s positive, now we started doing things.

We signed this Jillian Michaels who has spent about a – an hour a week on NBC for the last five, six years. She is a true television personality, but a performance personality. She will start her own program on NBC June 1st, an hour a week. And she actually came to us. She found a pair of Tubes, absolutely loved them, she loved the performance aspect of them, she loved that were what she calls affordable at $75. And we have a long-term arrangement with her that’s very expensive. But we think that this will put Tubes on the map.

We started developing many other ways to bring tubes out and this one has happened in the context of the time that we are defining ourselves as the California Sports Company. To many people this was somewhat news and will take a while to get this message out. But it passes the smell test. We were founded in California 44 years ago, actually in an area called Van Nuys, we then moved to Pacoima, California, Chatsworth, and I am speaking to you from Westlake Village, California. We are the Southern California Sports Company.

Once we decided that we are going to emphasize our California roots, then getting the largest sign in Dodgers stadium was somewhat mandatory, sponsoring the LA Marathon was somewhat mandatory, triathlon was invented in California, there is a lot of spirit in California. Their spirit is encapsulated in companies like Apple and Disney and all the innovation that goes on in California.

It’s very interesting that virtually, a vast majority of the people work for the company in California were born in California. And I have lived here for 24 years now. And most Californians do not understand what it means. It’s where they live and they go to work and they sit in traffic jams. To the rest of the world, California is the Hollywood sign. And we started floating this idea, people in California said it was interesting. The people in Asia and Europe started jumping and up and down said it’s the most exciting thing I have ever heard in my life. So California has meaning around the world and we passed the smell test.

We are a California company. We have reintroduced some retro shoes from the ‘60s that are California based. And we think that we have a one, two, three punch. The first punch is the branding K-Swiss in its California heritage. The second punch is absolutely spectacular running and running derivative products. And the third is a bigger investment into tennis. And yes, we have signed a bunch more tennis players and have got more aggressive.

For Q1, we will release our best tennis line ever. So we have got a lot of stuff happening. Good news, bad news. The bad news is, it will not happen in 2009, all we are going to do in – I am sorry, in 2010. All we are going to do in 2010 is spend a lot of money. Will the payoff happen in 2011? We are betting on it. But it’s just a bet. Sometimes you win them and sometimes you lose them.

Sam Poser – Sterne, Agee

That was a detailed response. You still have your New York accent, though.

Steven Nichols

And I love it.

Sam Poser – Sterne, Agee

One other thing if I can. In the guidance of the negative 7% to 10%, where do we stand –like when we look at the other businesses, the Palladium business versus the K-Swiss business, how should we think about the growth and the dollars that you are looking at in Palladium versus the turnaround of the K-Swiss business?

Steven Nichols

Good one. Two separate, separate issues. We feel that Palladium is kind of where K-Swiss was – when I bought the company in 1987, it’s hard to get my head back all the way back that far. It’s essentially one product. It’s essentially very, very simple. It’s confined to the highest quality retailers, almost around the world. The brand is significantly better known among retailers and consumers.

The strategy with Palladium is really new and unique. Marketing we are spending – virtually a 100% of our marketing dollars in two ways. On Internet versus – younger people who live and breathe the Internet. And number two, getting endorsements from retailers and the endorsements are, they allow us to bring in very, very large displays, point-to-sale pieces, windows. And when you get a great retailer, and in California, we just had Kitson and Fred Segal put stuff in, and New York major retailers, in Chicago major retailers.

We are only going into the absolute best retailers and saying, “Give us X square feet or linear feet of your walls and your floors and not a lot of people have the shoes for you.” And the shoes are retailing very, very well. We are not soliciting and selling major chains.

This is still a brand positioning, setting the stage for this brand to have terrific growth. But again that will not happen in 2010. We are not scheduled planning. The turnovers, the sell throughs we have had with the retailers we have done business with has been excellent. But it’s still a cloister, confined brand.

Sam Poser – Sterne, Agee

I mean, you had a nice quarter. Again, you picked up some revenue in the first quarter. I mean of that – within that – how should we think about the dollars within the guidance, because it’s not going to be down because there’s nothing – it’s not up against very much, Steven?

Steven Nichols

Right.

Sam Poser – Sterne, Agee

So I mean is it going to be $10 million, $20 million and then we take the rest out of the other?

George Powlick

Palladium is roughly 10% of our revenue globally.

Steven Nichols

This is a very interesting thing, because it’s a little bit misleading in Palladium that off the Palladium revenue, a very big part is of the French company we bought. They have been doing business in France for many, many years. It’s a stable business, profitable business. But probably that business is not going to double and triple.

The rest of world, where the business is – I am going to say Asia, Europe, and the United States right at the moment does equal to about France, very approximately. That business could increase geometrically. So it’s a much smaller business outside of France than you would imagine, a much bigger business in France than you would imagine. France, it’s get kind of stale and been around forever and the rest of the world is moving exciting.

Sam Poser – Sterne, Agee

Okay, great. Thank you very much. Good luck.

Steven Nichols

Thank you.

George Powlick

Thank you.

Operator

Thank you. Our next question is coming from the line of Brad Hathaway from Jay Goldman. Please proceed with your question.

Brad Hathaway – Jay Goldman

Hi, guys. I just had a quick question. I am trying to understand the Thailand issue. In your release you mentioned that you had 700,000 units that were kind of lost to this problem, yet only mentioned $5 million in revenue. I am just a little confused given that the wholesale price of your shoe is about roughly let’s say $25 a shoe, how we can kind of tie those numbers, because they don’t seem to kind of come together. Are you getting production from other factories to kind of pick up the slack or is there something else going on?

George Powlick

No, the 700,000 pair were not all destined for customers. A lot of it was destined for inventory as well. So the part that was destined for customers, it totals about $5 million.

Brad Hathaway – Jay Goldman

Okay, great.

Steven Nichols

Okay, and they were primarily vulcanized shoes which it would be our least expensive shoe per unit. So that would be below, significantly below our average price.

Brad Hathaway – Jay Goldman

Alright excellent. That’s all I had. Thank you.

Steven Nichols

You’re welcome.

Operator

Thank you. Our next question is coming from the line of Chris Svezia from Susquehanna. Please proceed with your question.

Chris Svezia – Susquehanna

Good morning, gentlemen and good morning, David. How are you doing?

David Nichols

Hi Chris.

Chris Svezia – Susquehanna

So I guess George first for you. Just on the SG&A, spending any color at all on the flow? Was it more immediate, second and third quarter, less fourth quarter? Just any color you can add to how that might flow out in terms of the increases in what you are looking at.

George Powlick

One of the reasons we did a little bit better than guidance this quarter is, we had actually expected to spend about $3 million more in marketing in Q1 that got deferred to Q2. So Q2 will be higher than Q1 by about I don’t $7 million, $8 million is our present plan. Q3 will be higher than Q1 by about $4 million. And then Q4 will be down from Q1. So – but these things shift from quarter-to-quarter, so that’s why we did a little bit better. We are not going to not spend that $3 million. We have just delayed it to the following quarter.

Chris Svezia – Susquehanna

Okay, alright, helpful. And then just on – I guess a broader question maybe for you, Steve. Just when you think about sourcing costs and as this year is sort of what’s going on in Thailand and finding additional capacity and whatever cost you to find additional capacity and just pricing inflation in general in terms of what you are seeing out there. Any color you could add to that?

Steven Nichols

Sure, what’s going on where most of the shows, athletic shoes of the world are made is in Southeast China. And they are getting competition from better value added industries of the electronics, ethical drugs and auto and it’s following the pattern that shoes have followed for my entire lifetime, they keep moving to a lower cost areas.

In this case, the lower cost area would be moving further inland in China and getting new labor supplies as almost inexhaustible supply of people. This movement when I first started making shoes was Korean and Taiwan, virtually no shoes are made in Taiwan or Korea today, and it moved to China. But there were will be five or six Chinas, because it’s so huge. There will probably in the midterm, the higher prices paid for labor, higher prices paid for raw materials, that’s the bad news.

The good news, it’s a level playing field and there is no athletic footwear company that can buy rubber, leather, or labor for appreciably lower prices than we are paying, so we are competitive with the costs. This is a rising tide. It will rise all boats. So if prices do go up so will everyone else’s. So we will remain competitive in the marketplace. And as far as inflation and raw material costs, your guess is as good as mine.

Chris Svezia – Susquehanna

Okay. But you have the flexibility to take care of your pricing up somewhat to mitigate – I guess that’s what I am asking. What can you do in your sort of situation to mitigate some of the pricing inflation?

Steven Nichols

There are many things we can do and we do them every day, but so do all our competitors. In the end, if leather is going to go up 20% or labor go up 20%, some ways along the way that will get passed on. We are in very efficient factories, we have got a very efficient operation. The biggest thing that we can do and have done for more than a decade is we manage our markdowns. And generally, a lifecycle of our shoes are intentionally longer.

They are most of is, it’s all part of the 360 degrees of us not selling highly promotable retailers of doing everything we legally can to maintain prices at retail, which allows retailers to carry our shoes longer, the longer lifecycle means, a less design engineering, expense and less markdown expense. So – and it gets you better quality.

So our whole cycle is to maximize margins through the things we can absolutely manage that could be unique to us. And the cost of manufacturing and raw materials isn’t unique to us, that’s just a open secret that everybody figures out where the most efficient factories and labor resides and goes there. So then it’s – what do you when the stuff comes out at a factory. And traditionally we have managed it very well.

Chris Svezia – Susquehanna

Okay. I have a – I guess a strategic question. I have followed you guys for long time, so I kind of know where you have been and where – essentially where you are trying to go with the business but –

Steven Nichols

Yes, you have. You have followed us a long time.

Chris Svezia – Susquehanna

An inflection point, I mean you are spending all this money and I understand to a degree obviously why you are doing it. And I guess when I sit here and I kind of look at some of these numbers, you look at your performance footwear category which is your tennis and it’s your running and Tubes I know has been out there and was only up 2%. And then you look at the backlog trends and while hopefully you are kind of bouncing along on the bottom here, not showing meaningful improvement even with some of this product out there.

And then if you look at the Classic business which is in the Lifestyle category and continues to be down pretty significantly. I guess at what point in time do you really think all of this stuff that you are doing is really going to start to be reflective in the futures numbers particularly on the performance side, because it seems like where you are placing your bets right now.

So I am just curious where do we start to actually see that? Because at the moment, when you look at some of these numbers at first blush and look at your guidance in terms of how the trends line is now going relative to second quarter – or excuse me relative to the fourth quarter, it’s actually seems like it’s going the other direction. So just give us some thoughts on that.

Steven Nichols

Well, I spend more time thinking about this than you do, I promise.

Chris Svezia – Susquehanna

I am sure.

Steven Nichols

So there are two acid tests coming up. Acid test number one is going to be when we report futures for Q1 2011. And acid test number two will be futures for Q3 2011. So the extra spend in the last 2.5 years of engineering new products and new brand positioning will have to show itself in Q1 and Q3 next year, and that would be the earliest. And I don’t know that it’s any different from what we have been saying that we have been doing long-term things, the payoff will not be instantaneously. We will overspend this year.

And possibly by next year, not have to overspend, maybe spend a similar amount next year, but it will be a more intelligent percentage of revenue. So let’s sit tight. We will have our Q1 sales meeting in June. People will go out and start selling shoes in June, July, and August. And when we report our futures for Q1 ‘11, the bet that we are making now and it’s a very expensive bet is that this will show some very strong progress. And that strong progress then should kind of become even stronger for Q3.

Chris Svezia – Susquehanna

And Steve, just one last thing. Is it consistent in Europe as well as in terms of what you are doing in the US whether it’s Tubes and what you are doing in the Classic business, et cetera. Is it consistent in Europe or is that lagging behind six, nine months in terms of – are you seeing the same things in Europe that you are doing in the US or is there US first and then we will address Europe?

Steven Nichols

Good question. The Tubes got the same answer everywhere in the world. “What the heck are you doing? You are not a running company.” The reason we lusted to get into running, it’s about 30% of the marketplace, the running silhouette versus tennis being about 5%. So we had a – we decided we have to get into this running silhouette. And yes there was great opposition.

The question was how do we break through? And we are getting a tremendous worldwide recognition in Ironman and in triathlon. But 97% of the world doesn’t even know anything about that. So we are in year three building our reputation there and it’s excellent.

Now how do we get this out to everyday people? And I think we were stronger and tougher on Tubes and kind of put more pressure on our sales force and called in more chips to get a little toe end of water in the United States.

Europe and Asia lagged behind, but once they saw it could be done they are going gangbusters with it in very in teeny, eensy-beensy place in Europe we are getting tremendous sell through, emphasize eensy-beensy-teensy places. In Asia, May 1st, all the company stores and all the retail stores have gone Tubes. So Asia could go blowing past us, because of the retail position they have.

But right now, I was just in Hong Kong and Taiwan, these stores are teed up to sell Tubes in May, June and July. So the proof of the pudding will be in the eating. Yes, Asia and Europe will catch up real quick.

Chris Svezia – Susquehanna

Okay. I look forward to the second quarter call and best of luck.

Steven Nichols

Thank you.

Operator

Thank you. There appears to be no further questions. Mr. Nichols, I will now turn it back to you for closing remarks.

Steven Nichols

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

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Have a great day.

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