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Quiksilver, Inc. (NYSE:ZQK)

F2Q10 (Qtr End 04/30/10) Earnings Call

June 3, 2010 4:30 pm ET

Executives

Bruce Thomas – VP, IR

Bob McKnight – Chairman, President and CEO

Joe Scirocco – CFO and COO

Steve Tully – President, Women’s Division

Analysts

Todd Slater – Lazard Capital Markets

Jeff Van Sinderen – B. Riley & Company

Jim Duffy – Thomas Weisel Partners

Claire Gallacher – Capstone Investments

Mindy Sioni [ph] – JPMorgan

Mitch Kummetz – Robert Baird

Grant Jordan – Wells Fargo

Operator

Good day, ladies and gentlemen. Thank you for standing by. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. Instructions will be provided at that time. (Operator instructions) I’d like to remind everyone that this call is being recorded. I would now like to introduce your host, Bruce Thomas, Quiksilver’s Vice President of Investor Relations, who will chair this afternoon’s call.

Bruce Thomas

Thanks, Nathan. Good afternoon, everyone, and welcome to the Quiksilver second quarter fiscal 2010 earnings conference call. Our speakers’ today are Bob McKnight, our Chairman, President and Chief Executive Officer; and Joe Scirocco, our Chief Financial and Operating Officer.

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

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

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

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

Bob McKnight

Thank you, Bruce. Good afternoon, everyone, and thanks for joining us for our second quarter conference call. Throughout this past two years, we laid the foundation for a new Quiksilver. Our goal was to create a leaner organization that presents the horsepower to expand our global leadership of the action sports industry while providing the flexibility to adapt to changes in the worldwide marketplace.

Significant financial restructuring was necessary to fortify the foundation while substantial changes in senior management and deep cost cuts were key to fundamentally improving the framework of the company. I am proud to say that after successful restructuring efforts and improvements to our capital structure, a new Quiksilver is emerging and the changes we’ve made have enabled new levels of performance.

While making these changes, we were careful to preserve the creative engine that have driven our great brand to their respective market leadership position, and the Quiksilver, Roxy and DC teams continue to develop great products and reach out to customers in new and inventive ways. Because we make great product space on our deep understanding and loyalty to our customers and to the markets we serve, we are in a prime position to benefit from improvement to consumer spending and future improvements in the world economy.

And although consumer spending remains inconsistent on a global basis, and in some places it’s still very tough, our business is operating at a high level on many fronts and we are delighted that the changes we’ve made in the past two years are evident in our financial results.

Let’s now turn to the high level financial highlights from the second quarter in which we delivered better than expected performance in nearly every measurable way. These results demonstrate solid execution and considerable progress driven by the bold steps we have taken over the past several quarters to improve our operations.

The first highlight is in regards to EBITDA, which has become for us an increasingly important measure of our progress. Pro forma adjusted EBITDA in the quarter was $62 million compared to $45 million in the second quarter of fiscal 2009 despite a 5% revenue decline. Next, gross margin improved 600 basis points to 53.2% compared to 47.2% in the second quarter of fiscal 2009, led by 970 basis point improvement in the Americas.

Our third highlight comes from Europe, our most profitable region. Operating income in Europe was 18.8% of revenues, as gross margin improved 320 basis points to 59.9% from 56.7% in the second quarter of fiscal 2009. And fourth, in regard to our improving balance sheet, net debt at quarter’s end was $733 million, reflecting the reduction of $201 million compared to a year ago.

To complete the high level picture of our financial performance, we are also pleased to report that inventories remain in very good shape and the level of clearance activity has been greatly reduced compared to last year. During the quarter, we further reduced SG&A expenses by $6 million in constant currency terms, excluding special charges.

In total, we generated income from continuing operations of $16 million or $0.11 per share compared to income of $7 million or $0.05 per share in the second quarter a year ago. This result was substantially better than we anticipated when the quarter began.

Let me now take a moment to focus on our brand. I’ll start with Quiksilver, which as you know is by far and away the biggest and most respected action sports lifestyle brand. Within the action sports apparel market, the highest visibility opportunities include seasonally popular item and, in particular, our performance boardshorts. Quiksilver boardshorts are the gold standard of boardshorts in the world.

During the quarter, we officially launched the new Cypher Boardshort Campaign, which includes extensive video, online, in-store and print advertising promotions. The product focus is based around Quiksilver’s Cypher technical franchise and showcases Kelly Slater, Dane Reynolds, Julian Wilson, and Jeremy Flores in each of their signature boardshorts, all featuring the innovative four-way stretch, non-rashing Diamond Dobby fabric.

The print ads are featured in all the major surf publications. And one of the most important elements of the campaign is our innovative, high-definition film work that we are calling Cypher Vision. This includes four commercials featuring each writer as well as a 14-minute Cypher Vision short film that has been viewed over 340,000 times on Surfline and You Tube. It is also on our Quiksilver website. So you should go there and check it out.

We are pleased to report that the new series has demonstrated strong sales at retail. In addition, seasonal items such as walk shorts, t-shirts, wovens and sandals are all selling through well. Around the world, our Quiksilver offering at retail is currently very, very strong. After launching in the first quarter, our Quiksilver Core Surf Collection has been receiving strong reaction and support in our Core accounts.

This offering is a range of exclusive products that can only be purchased in the best surf shops and select Quiksilver stores, including an offshoot of our Cypher series, a line inspired by Dane Reynolds photography and the Mark Richards collections. We support this Core collection with unique point-of-sale visuals and a Core Surf Collection websites that features the products and direct customers to the surf shops that carry them.

Now turning to Roxy, which is the largest, most respected and the most recognized girls’ action sports brand in the world. Fast fashion and price-point driven goods continue to challenge the branded segment of the juniors market for all surf, skate and snow companies. Retailers continue to order cautiously and are planning their businesses in such a way that allows them to react to in-season trends. Because the Roxy brand offers a broadly diversified product line, we compete in many different segments around the world.

Our overall ongoing performance in Roxy appears to be in line with current market trends, especially with regard to seasonal items such as dresses, sandals, accessories and fashion knits, which are selling well. In addition, we have seen some better performance in California and Florida lately, and Canada was slightly better than the trend. The sportswear category continues to be challenging at retail.

The comprehensive core market strategy for Roxy that we launched in the first quarter continued to gain traction in Q2 and we saw instances of slightly better sales as a result. The plan for this program includes viral marketing, in-store presence, additional marketing within the core community, and other customer facing initiatives. And we have recently launched a re-designed Roxy.com that, among other updates, leverages our extensive Roxy video library and helps us sustain touch with our Facebook fans whose numbers have grown to more than 400,000.

For the time being, the juniors market continues to be a challenge for branded girls surf apparel. Nonetheless, we will continue to create exciting and innovative products and reach out to our loyal customer base in new and interesting ways while partnering with our core accounts. And we will remain true to the Roxy brand heritage as we write it out.

Turning now to our powerful and incredibly popular brand, DC. Focused on innovation and a thorough understanding of the skate, snow and street and moto markets, DC continues to impress retailers with their new products and their ability to attract potential. Like Quiksilver and Roxy, DC rolled out a core shop strategy in the first quarter and has followed through on its focused effort to return to its heritage and a leading position within the skate shop community.

The portions of the program dedicated purely to skate and another set of objectives aimed at street wear. We are pleased to report that we have seen strong year-over-year increase in sales within the core shops particularly focused on apparel, wovens and denim. And in addition to our new vulcanized shoe model, which has sold well everywhere. We look forward to continue the strong traction within this key segment of our distribution.

We also continue to see strong demand for products from our multi-logo TeamWorks collaboration. This complete range of integrated footwear and apparel features action sports athletes such as professional rally driver Ken Block, Motocross icon and rally driver Travis Pastrana, and BMX legend Dave Mirra. Sell-through has been strong for these items and their ability to generate additional traffic retailers has been amazing.

Before we move on to the financial details, I’d like to mention a few of our athletes who did such a great job of boosting our worldwide exposure through their inspiring performances and dedication to excellence. I have to begin by talking about Kelly Slater. Our legendary Quiksilver team rider who has once again vaulted himself to the top of the ASP world surf ranking and a second place finish in Brazil and a gutsy win at Bells Beach, surfing with a hairline fracture on his right foot.

Kelly continues to amaze us and he attracts loads of attention towards Quiksilver. In that light, Kelly’s 3D IMAX movie, the Ultimate Surf Wave Tahiti, has been a great success for the company. In addition to the movie’s critical acclaim and endorsement from the educational community, the whole project has brought additional interest to the sport of surfing and of course to Quiksilver.

Over the past few weeks, Kelly traveled to Paris for the film’s European premiere, capping a tour that began in Los Angeles for the world premiere and after which he supported the movie during the Australian lag of the ASP tour.

Driven by the smashing success of his hit show in Paris last November, which helped us commemorate Quiksilver’s 40th anniversary, the Tony Hawk Show will make stops in eight European cities this summer. Tony is a great ambassador for skateboarding and for Quiksilver. He is very well connected to today’s youth through his website and his enormous Twitter following. He is easily the most widely recognized of our athletes and is perhaps the most visible and globally recognized action sports star ever.

Also attracting significant attention for Quiksilver this quarter was surfer Clay Marzo, one of our Hawaiian team riders and a great kid who has a form of autism called Asperger's syndrome. Clay uses surfing to help him cope with the challenges of his disability and he has become one of the world’s most creative and exciting young surf stars. In late April, Clay was featured on ABC’s Nightline, which reached an average of nearly 4 million viewers each evening. And later in the same week, Clay was profiled in Rolling Stone Magazine, which has a circulation of about 1.4 million copies.

I’d also like to congratulate Enni Rukajarvi, our new Roxy team rider from Finland, who became the TTR World Snowboard Champion by winning the Roxy Chicken Jam at Mammoth Mountain here in California in March. We are proud of the broad appeal of our brand and our relationships to these unique athletes who help make the action sport big sell that’s so inspiring and it make our products look so good.

We are fortunate to have made many great choices in selecting our athletes to represent us over the years, and as our business continues to improve, we will be looking for new and interesting ways to leverage the exposure that they create for us. So in summary, we are delighted that our hardware and the bold steps we have taken to improve our business continue to pay off and have again helped us to deliver better than expected results.

Joe will now take you through the financial details.

Joe Scirocco

Thanks Bob. Good afternoon, everybody. As reported, consolidated net revenues declined 5% to $469 million in the second quarter from $494 million in the second quarter last year. Note that we translated the euro at $1.30 last year versus $1.36 this year, and the Australian dollar was translated at $0.68 last year versus $0.91 this year.

Revenues in the Americas were down 13% compared to last year, with contraction in the wholesale channel being slightly offset by modest growth in our retail stores. This result was slightly better than we expected a quarter ago. Our Quiksilver and DC brands were approximately flat when compared with last year, while Roxy was down in the quarter consistent with the continued challenges that the juniors business represents for us and our peers in the industry.

Our own retail store comps in the US were modestly positive overall in Q2, and we were encouraged to see strong in-store gains in the Quiksilver and DC brands. Note that we closed a net of 12 underperforming company-owned retail stores in the Americas since the end of the second quarter 2009.

European revenues in constant currency were down 5% for the quarter, slightly ahead of our prior expectations. Within Europe, the DC brand continued to grow well, partially offsetting declines in both Quiksilver and Roxy. Much of the world’s recent economic spotlight has been focused on Europe in recent weeks and consumer spending remains a concern in key markets such as Spain and the UK. However, we are confident that these current economic pressures are not threatening our leading market positions in Europe.

Our retail comps were down only slightly for the quarter. We opened a net of three new company-owned shops and concessions in Europe in the second quarter and a total of 19 net new shops and concessions over the last year.

Asia-Pacific revenues, as reported, again appear to be better than they actually were when compared with last year due to sizable shifts in the yen, the Australian dollar and the US dollar in relation to each other. It was a similar situation last quarter. In reality, our Asia-Pacific business was down in the high-single digits on a percentage basis, primarily due to softening trends throughout the region. New store openings helped our retail business grow revenues in comparison to last year.

For the entire region, we added a net of two new shops in the quarter and 32 net new shops, concessions and in-store shops since the end of the second quarter a year ago. We expanded consolidated gross margins by 600 basis points to 53.2% for the quarter, as we continued to control inventories in line with demand amidst somewhat improved US market conditions, resulting in even lower levels of discounting and clearance sales than we had expected.

For the second consecutive quarter, our Americas business delivered the largest improvement in gross margins, 970 basis points, while Europe also benefited from lower levels of discounting in both wholesale and retail distributions and a reduced volume of clearance. In addition, we continued to deliver better initial product gross margins as a result of our progress on key stores and initiatives.

We reduced pro forma SG&A expenses in Q2 by $6 million in constant currency, excluding restructuring charges, the gain on the sale of the Raisins trademark, and the $5 million charge for unplanned stock compensation expense on the Kelly Slater brand. Just to clarify on that last point, we treated this non-cash charge as a special item because it resulted from the unexpected increase in our share price, which more than doubled in Q2 alone. We continue, however, to absorb normal and recurring charges for employee stock compensation expense in our P&L.

In the Americas, we reduced expenses by $8 million compared to Q2 last year, excluding special items. These items include restructuring charges and the aforementioned gain on the sale of the Raisins swimwear trademark. This sale is another example of how we continue to remove distractions and inefficiencies from our business so that we can focus on our core brands.

Expenses in Europe were higher in constant dollars compared to last year, primarily due to cost associated with stores opened during the past year and some additional bad debt expense. As a result of these factors, we generated pro forma operating income of $43 million in the second quarter, better than 9% of sales, which is up from $33 million or 6.6% of sales in the same quarter a year ago. And as you know, we are very focused on EBITDA as perhaps the key measure of our performance this year. So we are very pleased that we generated pro forma EBITDA of $62 million, 13.3% of sales compared to $45 million or 9.2% of sales a year ago.

Interest expense was $21 million in the quarter, up from $14 million last year, but below what we anticipated a quarter ago. This improvement over our forecast is largely attributed to tighter control over working capital and concurrent improvements in cash flows. It is also important to note that approximately $7 million of interest in the quarter was non-cash.

Our tax provision in the quarter was $9 million. After interest and taxes, our pro forma consolidated income from continuing operations for the second quarter was $16 million or $0.11 per share compared to pro forma income of $7 million or $0.05 a share in the same quarter a year ago.

I’d now like to turn your attention to the balance sheet for a few moments and in particular our execution of another strong quarter of improvement in working capital. Receivables at $333 million are 19% lower than for the same period last year and down 21% in constant currency. On an overall basis, DSOs decreased by 10 days to 60 days this year compared to 70 days in the second quarter a year ago.

Additionally, inventory at quarter-end was $226 million, down 26% as reported and down 30% in constant currency compared to the same period last year. Our Americas business accounted for approximately three-quarters of the reduction. As evidenced by our performance, particularly over the past two quarters, we continue to successfully reduce inventory on a global basis, bringing supply and demand into balance. CapEx was $10.5 million during the quarter, down 14% in constant currency from Q2 last year and in line with our plans.

Finally, we have approximately $155 million of availability under our credit lines and approximately $145 million of unrestricted cash at the end of the second quarter. And importantly, we reduced our total debt to approximately $878 million, which is about 4.5 times our last 12 months EBITDA of $195 million compared with 4.8 times a year ago.

We reduced our debt by $177 million over the last 12 months, even with a $14 million foreign currency effect headwind. Looking at another way, we’ve reduced our net debt by more than $200 million over the last 12 months from $934 million last year to $733 million this year, a very much better shape.

Now let’s turn our attention to the outlook. We expect third quarter revenues to be down in the low-teens on a percentage basis after accounting for a fall in the value of the euro versus the US dollar and some softening in the Asia-Pacific region. This estimate reflects our remaining summer and back-to-school order books and takes into consideration the fact that we bought the seasons very tightly, sacrificing potential upsides in favor of reducing inventory risk.

Considering that our inventory levels are well aligned with demand and given our continued progress on the initial gross margin initiatives, we expect to be able to deliver between 450 and 500 basis points of gross margin improvement in the third quarter compared to last year’s margin.

Operating expenses in the third quarter are expected to be as much as 5% lower than in the third quarter of fiscal 2009. And we are anticipating interest expense of about $21 million in the quarter. Summing the parts, therefore, we expect to generate earnings per share on a diluted basis in the low-single digit range.

For the remainder of the fiscal year, considering the continuing challenges presented by the juniors market, estimating foreign currency headwinds and our order books, we now believe that full year revenues will be down in the high-single digits on a percentage basis when compared to fiscal 2009. However, with respect to gross margins, we now believe that by delivering on the initiatives we have outlined for some time, we can achieve the high end of our previously communicated range of 300 and 400 basis points of improvement overall for the year.

We expect SG&A expenses for the full year to be slightly below last year’s level. And we are now estimating that our interest expense will be approximately $85 million for the year, which is lower than prior estimates due to our cash flow management and the effects of foreign currency exchange.

Our ability to predict our provision for income taxes in future quarters continues to be complicated because we are operating so close to breakeven. However, we are modeling our tax provision at approximately $8 million to $9 million per quarter for the remainder of the year. Our current plan calls for us to open a net of 17 new company-owned stores in fiscal ’10, with most of them being concession shops, and we’ve already opened eight net new stores as of the end of Q2.

Our CapEx budget for the year remains at roughly $50 million, down from $55 million in 2009. Depreciation and amortization is expected to be around $54 million, and we plan to continue to control working capital in line with revenue trends as they develop. Before concluding, let me reemphasize, as I did last quarter, that although interest and taxes dampen our EPS estimates from modeling our business, it’s important to focus on the significant improvements we are making in operating profit.

Taking into account our second quarter performance, our outlook, and the stated assumptions, we now expect our pro forma EBITDA to be at the high end of our previously communicated range of 20% to 25% higher for the full fiscal year 2010 compared with 2009. To be clear, we have over-delivered on Q1 and Q2, and we are maintaining our outlook for the second half of the fiscal year despite foreign currency headwinds and some softening in the Asia-Pacific region.

We would look to update our outlook when we report the results of our third fiscal quarter in September. And with that, I’ll turn it back to Bob for closing remarks.

Bob McKnight

Thanks, Joe. We are delighted to deliver second quarter financial results that again exceeded virtually all expectations. This performance shines a spotlight on the significant changes we have made over the past two years to align our business with today’s markets while positioning our sales for future opportunities.

We have enabled higher levels of operating efficiency that are driving dramatic improvements in execution. These steps have positioned us well to deliver improved financial performance and we are poised to benefit even further from any sustained upturn in discretionary consumer spending. Through it all, we have continued to produce great products through innovation and an intimate understanding of our markets.

I am proud of the Quiksilver team and our continued leadership in the action sports market driven by our great Quiksilver, Roxy, and DC brands. And I’m especially proud that we have emerged from the last two years of adversity a much stronger company, executing at a high level and focused on delivering even higher levels of financial performance in the future. Thank you.

Bruce Thomas

Operator, that concludes our prepared comments. We are now ready for the question-and-answer session.

Question-and-Answer Session

Operator

(Operator instructions) And our first question will come from Todd Slater with Lazard Capital Markets.

Todd Slater – Lazard Capital Markets

Hi. Great job, everyone.

Bob McKnight

Thank you.

Joe Scirocco

Thanks, Todd.

Todd Slater – Lazard Capital Markets

I guess, Joe, sort of maybe you could give us a little bit more color on how you are addressing or how we should be thinking for the puts and takes related to the weaker euro and sort of the benefits – obviously the negative impact on revenue, but what are the positives, if any, and so it sounds like you are maintaining your guidance despite those puts. So I'm just wondering if you could just give us some of the offsets as well. And also how have comp trends in Europe – how have they been since the end of the second quarter? I wonder if you could give us a little bit of color there as well.

Joe Scirocco

Sure. I’ll take the last question first. I mean, during the quarter, we had slightly negative comp store sales in Europe and it’s down just like one or two points. Since the end of the quarter, May has been a little bit tougher, but still a mid-single digit decline for the month of May over there. More broadly, talking about the euro, a couple important things to recognize. One is that with respect to the way our business is operated regionally, we do not plan on any repatriation of earnings from our various regions. So profitability or profits in Europe are reinvested there. They service debt there, and they pay for new store openings and that kind of things. So any loss on translation of European profits is really of no operational consequence to the company although it does affect EPS.

Secondly, just to put it in some context for you for modeling purposes, Europe earns somewhere in the range of 35 million euros on an after-tax basis. So when you think about the movement of, let’s say, a nickel in the currency, it means about a penny to us in EPS, plus or minus, if you want to think about it that way. The really important thing about the European business, which is a huge positive for us, is that the hedging program we have in place calls for us to hedge forward generally on the order of 15 to 24 months.

And so if you look at our 10-K and 10-Q disclosures, you will see that at the end of the quarter, we own somewhere in the range of $275 million US dollars forward. And most of that is out of Europe, but some of it is also out of Asia-Pacific. So it means that for the vast majority of apparel purchasing that’s done in US dollars were well covered through 2011. And we feel very good about that because it gives us assurance with respect to the cost of our goods as it affects gross margin in the region. And that’s really the economic factor that drives profitability of the business much more so than the simple translation of the euro into the US dollar when we consolidate the financial results. So overall, I mean, it’s – we'd love to translate European profits at higher value. But the fact is that our business is generating huge returns, 18.8% in the quarter coming out of Europe. It is well protected with respect to currency through 2011, and we feel very good about it.

Todd Slater – Lazard Capital Markets

Okay. And what is it – just help us also understand on the benefit potentially on the translation on the debt and the interest expense. I think that's one of the reasons you cited for lower interest expense for the year?

Joe Scirocco

Yes. So if you – so our European debt is on the order of $350 million to $400 million. So when we translate that balance into US dollars, we have a benefit as the euro falls. And similarly, interest on that, which you could probably think about a range of, I don’t know, 6 to 9 – as high as that. Yes, okay. So, think about something, let’s say, in the 8% range for interest on that debt is coming back over in lower US dollars as well.

Todd Slater – Lazard Capital Markets

Yes. Okay. That's about what we were thinking. That's good. And then just also how is the – give us a sense on the wholesale side in Europe, what you are seeing.

Joe Scirocco

Well, we’re seeing a couple of very good things. I mean, one of the things that we’ve done in the course of the year, as we – we know this is going to be a tough year and our guys took the opportunity to say, fine, let’s concentrate on quality sales. And so it’s nothing about driving the volume. When you see the results, they reflect the strong gross margin improvement, really reflects a lot less clearance, a lot fewer mark-downs. We have been very disciplined about discounting in the wholesale channel, and that’s been the driver of gross margin. So we’re willing to tolerate the lower top-line in return for that.

I think in terms of some of the various markets in Europe, while, as Bob said in his opening remarks, sort of Spain and the UK, I mean, are tougher markets, but there is a certain level of stability in spending in some of the major markets in Europe like in France. A lot of that could be driven by social schemes and payments, which provide continuity of income and that kind of thing. And we have leading market positions there. So in the wholesale channels, we feel very good about our positions. In some of the newer markets like Germany and Italy and the Czech Republic, we have plenty of opportunity for growth. I mean, we are not pushing the growth in this market, but it’s certainly there. And we’ve been able to turn some of those businesses to profitability a lot faster than we would have expected to, like in Russia, for example. Bob, I don’t know, maybe if you just want to comment on the sales meeting?

Bob McKnight

I was just going to say, we just got back from Europe. We were there last week for a number of days during our sales meeting. We have over 30 countries coming to these meetings and well represented from all of the places in Europe. They were, for the most part, really positive about business and looking forward to the new line. They love the new ranges that we have. We showed – we inaugurated a building while we were there, which was really exciting. And I think for the most part, the consensus was very upbeat and they were pretty positive about how the business is going right now and how their new future looks. So we think that the wholesale business will be fine, as Joe talked about.

Todd Slater – Lazard Capital Markets

So France was stable. That's like – France is one of your biggest markets, right?

Bob McKnight

Yes.

Todd Slater – Lazard Capital Markets

Okay. And then lastly, just on Roxy, you mentioned a slight tick-up. Maybe we're starting to see a plateauing there. When do you think you really start to monetize the changes that you've made to that business?

Steve Tully

This is Steve Tully, Todd. Yes, we – I think the short story is we need a little more time in the past. As Joe mentioned and Bob mentioned, we are in line with the marketplace. We’ve got several turn-on initiatives going on from products and marketing and so forth. It’s really going to take place with the release of the spring ’11 line. We have a refresh of the brand, certainly refresh of the product. But we have an ongoing commitment to improving that business. There are segments of the business that are doing well, and we mentioned this as well, our sandal business particularly and footwear business is fairly good. Our accessories business is decent. There are some areas of swimwear that are good. But I think all things considered, we are seeing the course. We’re focusing on product development, and we are looking at a refresh of the whole marketing image, beginning with the spring ’11 season.

Todd Slater – Lazard Capital Markets

All the best things to you guys.

Bob McKnight

Thank you.

Operator

And we’ll take the next question from Jeff Van Sinderen with B. Riley & Company.

Jeff Van Sinderen – B. Riley & Company

Hi, good afternoon. A couple of things. If we could follow up a little bit on trends that you are seeing in your own retail stores in the US, both in Q2 and in May, and then also if you could just comment on what you saw in terms of sales of seasonal merchandise in April and May, if you think there was a weather impact there?

Steve Tully

I’ll make some comments. But I think we – and again, Bob said in his remarks, we are seeing an uptick in seasonal merchandise, in particular, things like boardshorts and sandals and walk shorts and t-shirts, things that you would expect, dresses and sandals and some junior swimwear. On the DC side, some vulcanized footwear and of course some TeamWorks t-shirts and some fleece. So all of that is what we expected and what we are in a position to sell. Sitting here a few days after Memorial Day weekend, I’m very pleased to report that most retailers around the country, particularly on the Eastern Seaboard, had a very, very good Memorial Day weekend with our merchandise. The weather cooperated there, and we found the same results in our stores by region. Business decent on the West Coast and very good in Hawaii as well. So I think fairly predictable and seasonal trends, and we’re pleased to report that coming out of Memorial Day, we had a pretty good weekend.

Jeff Van Sinderen – B. Riley & Company

Okay. And – I know you mentioned Roxy, and just wondering if there is any more color you could give us in terms of initiatives that you have been working on and where you're seeing progress, what kind of feedback you are getting from some of your retailers. And then also, does it make more sense? I guess this is sort of a general question since it seems like you're tightly controlling inventory overall. Does it make more sense to perhaps in some categories that age well to have a little more inventory on hand, so you can chase a little bit of business?

Bob McKnight

In terms of Roxy, keep in mind that Roxy is a great brand. It’s been around for a while since certainly the sort of the area leader in action sports anyway. So – and keep in mind also it’s a $550 million business. So it’s larger than most of our competitors, just in the sales. So it’s still very, very successful, and we still have great aspirations for it. It’s just challenged right now because consumers with less money to spend are gravitating towards fast fashion, the H&Ms of the world and Zara’s and Forever 21, people like that. They are experiencing nice business while there are also sort of trending away for brands. We don’t think that lasts forever. We’ve gotten back to history, and girls in particular move around quite a bit. And we think that they will come back to brands that represent something to her very soon.

So we’re committed to stay the course and the way we do that is just keep designing great, great products, which we are, or adjusting as we go because trends are changing and looks are changing. But we are committed to Roxy. We think that – we are already experiencing some upticks around the world in certain pockets. And in some areas, it’s still very, very difficult. So – but to give you an exact what we are doing and how we are fixing it, really it’s just about product and staying true to the marketing and just trying to wait for the consumer to come back to more branded business. And everybody in our industry is experiencing the same difficulty. So it’s just something we ought to stay the course.

Jeff Van Sinderen – B. Riley & Company

Got it. And then if you could just comment on how you are handling inventory versus demand at once?

Steve Tully

Yes. We have – as far as our operational improvements that we’ve mentioned a few times on the calls, we’ve organized a better approach to demand planning and anticipating demand here within the company. I think you mentioned this earlier in your question. We are now taking a look at perhaps little more liberal in product categories that we anticipate having some good in-season sales on. So things like sandals, things like boardshorts, things like burnout fleece, we are getting a little more liberal and are positioning and maybe going out there a little bit more than we have in the last 12 months.

Jeff Van Sinderen – B. Riley & Company

Okay. Good to hear. And then if you can just comment on how you are viewing sourcing costs going forward?

Joe Scirocco

Well, everybody has been reading the same papers with respect to China. And so obviously that’s an issue that the industry will have to deal with. In our case, our product is brought forward at least through holiday. We are in the process of negotiating spring buys at this point. So we understand where we are through the fourth quarter. We think we can manage spring. And beyond that, we will see how it develops. But obviously, there is some upward pressure on what’s coming out of China. Fortunately, we are pretty globally diversified and so our various region-sourced products in many cases, more locally. And we have reasonable balance between the various countries.

Jeff Van Sinderen – B. Riley & Company

Got it. Okay, great to hear. Thanks very much and good luck.

Bob McKnight

Thank you.

Operator

And Jim Duffy with Thomas Weisel Partners has our next question.

Jim Duffy – Thomas Weisel Partners

Thanks. Thanks for taking my question. Again, very nice progress with the gross margin. This is kind of a follow-up to that last question. Given the factors influencing sourcing costs, would you expect to be able to continue to deliver improvement in gross margins in local currencies, I guess, Joe?

Joe Scirocco

Yes. I think to some degree, we would. It really depends upon where the consumer is in 2011 and what kind of pricing power we and our competitors have in terms of being able to pass some along. I think outside the US, one of the really great sense we have is the hedged currency position, which enables us to know with certainty the dollar rate at which we will be buying goods. So we’ve removed a very significant risk factor from the equation. In the US, our inventories are very lean. And so we are in a position of – we have not over-supplied the market in 2010. So we are not – we have not hurt ourselves at this point in time. I think in terms of the competitive landscape and pricing power, it may be different by brands. I mean, Bob just described some of the pricing pressures in the juniors market, and we’ll see how they develop in 2011. It’s a bit early yet.

Jim Duffy – Thomas Weisel Partners

As you look at your market share position with the Quiksilver brand, for instance, would you consider yourself a price leader? Or is the share so fragmented that it's difficult to take that role?

Joe Scirocco

No, I think we try to be competitive within our share. We’re neither ahead of the path, nor behind. But we try to operate efficiently enough to make a healthy initial gross margin or at that level.

Jim Duffy – Thomas Weisel Partners

Okay. And then on the inventory levels, can you speak a little bit about inventory levels by region? You mentioned buying back-to-school very tight. In which regions, specifically, would you wish you had more inventory, if any?

Joe Scirocco

No, I think we feel good about where we are. And I think what Steve was saying is that we will opportunistically look to increase categories as we go forward and take a little bit more of an in-stock position than we would have in 2009 and 2010.

Jim Duffy – Thomas Weisel Partners

Okay. And then, Joe, final question, how much of the $54 million D&A is associated with the Americas business?

Joe Scirocco

About $25 million?

Bob McKnight

$13 million, $13.5 million.

Joe Scirocco

That’s it? Or is it $15 million? Hang on one second. Yes. About $20 million to $25 million.

Jim Duffy – Thomas Weisel Partners

Okay. Thank you.

Operator

(Operator instructions) And we’ll go with Claire Gallacher with Capstone Investments.

Claire Gallacher – Capstone Investments

Great. Thank you. I had a follow-up question on your juniors business. I'm just wondering, do you find the trend in Europe tends to follow the trends that are happening here in the US? And what I'm wondering is if you start to see sales turn here in the US, would it be likely that Europe would then follow one or two quarters later?

Bob McKnight

I really don’t think there is any sort of analysis you can make between America and Europe in terms of that. I don’t really think it follows or leads or anything. I mean, the market is very different in Europe and very different country-to-country in Europe. So it’s hard to kind of look at it like that.

Claire Gallacher – Capstone Investments

Have you seen the same degree of weakness in the juniors market in Europe that you have seen here?

Bob McKnight

Yes. I think it’s comparable.

Claire Gallacher – Capstone Investments

Okay. Okay. And then just a quick question on free cash flow. Joe, are you still comfortable with the $75 million that you talked about last quarter?

Joe Scirocco

We are comfortable with it. I would say at this point, given our performance recently, it looks like it will be closer to $100 million.

Claire Gallacher – Capstone Investments

Okay, great. Thanks a lot.

Joe Scirocco

That’s an upturn.

Operator

And Carla Casella with JPMorgan has our next question.

Mindy Sioni – JPMorgan

Hi, this is Mindy Sioni [ph] for Carla Casella. What euro rate are you using in your expectations for third quarter sales to be down in the low teens?

Joe Scirocco

Well, we don’t usually put that fine a point on it in terms of disclosure as well as our budgetary assumptions. But we – let's just say, we changed forecast recently and we’ve changed it based on current rates in terms of prevailing rates today, let’s say.

Mindy Sioni – JPMorgan

And how much of the gross margin improvement was from less clearance versus better margin on inventory buys or sourcing?

Joe Scirocco

We feel that on the initial gross margins around the world, we’ve had probably between 100 to 200 basis points of improvement just on the pure sourcing initiatives, with the remainder of the improvements coming from a combination of pricing, meaning less discounting this year on in-line merchandise and the balance coming from lower levels of clearance sales. It’s the combination of the three.

Mindy Sioni – JPMorgan

Okay. And what about the reason for the gross margin declines in Asia-Pacific?

Joe Scirocco

The Asia-Pacific business has been tough for some time, but it’s been stable. I mean, there was a recent downturn in February and it seems that that has persisted. So the consumer has become a lot more cautious, particularly in South Pacific. And the gross margin is a reflection of that pricing.

Mindy Sioni – JPMorgan

I'm not – I'm not sure if I missed this. Did you mention what debt you paid down during the quarter?

Joe Scirocco

During the quarter, we did two things. And we paid, out of the top of my head, like $49 million or so was the final payment on the Rossignol deal. That was reserved in restricted cash last quarter, and we finally paid that off this quarter. In addition, we had amortization under the French cut. I forget how much it was for –

Bob McKnight

(inaudible).

Joe Scirocco

Yes, sort of somewhere in the range of 14 million to 20 million euros, something like that.

Mindy Sioni – JPMorgan

Okay. And this is a follow-up to that. How much to do you have to pay for debt amortization payment for maturities in the remainder of the year?

Joe Scirocco

For this year, on a full year basis, I think in the remainder of the year, it’s probably less than – it's certainly less than $50 million. This year and the next two – sorry. 2011 through 2013, we have on the order of $100 million in annual amortization payments to be made. Yes. So $45 million remaining this year and somewhere around $100 million in each of the next three years, 2011 through 2013.

Mindy Sioni – JPMorgan

Okay. And –

Joe Scirocco

By the way, I should point out that all of those payments are scheduled payments under the European club deals. And as we said, our European business had quite a record in the past 12 months in terms of its cash flow generation. They generated somewhere on the order of 100 million euros. So we feel okay about all of that.

Mindy Sioni – JPMorgan

And how many more stores do you expect to close for the remainder of the year?

Joe Scirocco

In the US, about seven stores. And then outside the US, beyond one or two. But in the main restructuring program here at the US, it will be about seven.

Mindy Sioni – JPMorgan

Okay. And how far out do you have visibility into your sourcing costs? Do you see costs increasing considerably in 2011?

Joe Scirocco

Well, we are going into the market for spring 2011 buys. So we will find out soon how we’ve done for spring.

Mindy Sioni – JPMorgan

Did you mention how much you sold Raisins business for?

Joe Scirocco

We –

Bruce Thomas

Yes, it’s in the press release. We’ve noted –

Joe Scirocco

Yes, we’ve recorded a net gain of, like, a $1.3 million on the shelf.

Bruce Thomas

Right. We’re going to need to move on to another question. Thank you.

Operator

And that would come from Mitch Kummetz with Robert Baird.

Mitch Kummetz – Robert Baird

Yes, thanks. Just a follow-up to that last question before on the gross margin, Joe. I think you said it was 100 to 200 basis points on the quarter from your sourcing initiatives. Is that correct?

Joe Scirocco

Yes. So that – again, it varies by brand, varies by regions.

Mitch Kummetz – Robert Baird

So how much of the – I think you said 300 to 400 basis point pickup for the year, year-over-year, and you are thinking now at the high end of that range. How much of that is from sourcing versus the other – the better pricing and the fewer closeouts and everything else?

Joe Scirocco

I don’t know that we’ve put that fine a point on it. I would tell you that over each of the past four or five quarters, we’ve improved our sourcing cost just through sourcing initiatives. And it’s been at least on the order of 200 basis points in the prior several quarters. We have a little bit of law of diminishing return on that at this point. So as we go forward, an increasing amount is coming from the quality of sales and it’s our ability to sustain price and do more too less fares.

Mitch Kummetz – Robert Baird

Well, I guess my next question is, beyond this year, how much runway do you still have in terms of those sourcing initiatives?

Joe Scirocco

We have some. I mean, we have remaining initiatives to move beyond China, to move beyond the impact of Quiksilver Asia sourcing, which is our in-house agent operating primarily in China. And we have initiatives in Vietnam and Indonesia and other places around the globe to concentrate buys of our factories and among our various regions. So there is more room, but again I think it’s premature to put too fine a point on that.

Mitch Kummetz – Robert Baird

Okay.

Joe Scirocco

Lot will develop in the next –

Mitch Kummetz – Robert Baird

And then your sales outlook for Q3 and for the full year, you are looking for sales to be down low-double digits for Q3, and I think based on your full year guidance, down high-singles. That also implies something in the neighborhood of down low-doubles in the fourth quarter. So how would you expect that to shake out by region? I mean, obviously you get hit with the euro in the back half, sounds like there has been some softening in Asia-Pac. So how should we be thinking about that low-double digit decline over the balance of the year by region?

Joe Scirocco

I think two things changed from the last time we spoke. The first is that our Asia-Pacific business has softened. I think that’s a part of it. And the rest, it’s really fine in the euro. So if we think about last quarter, second quarter, we were at an average exchange rate of $1.36 for the euro. Obviously, now we are somewhere in the low 1.20s. I think you can apply that factor to the European business and consider that to be the principal cost of the reduction in the estimate. And the metrics in Asia-Pacific, it could be the balance.

Mitch Kummetz – Robert Baird

Does that mean – I think what – Europe was down mid-single digits in constant dollars in the second quarter; is that right? I mean, should we assume that sort of run rate over the balance of the year and then just being worse than that because of the currency?

Joe Scirocco

I don’t – I don’t know what your starting point is, as I’ve kind of lost your –

Mitch Kummetz – Robert Baird

Okay. Never mind. Let me ask you one last question then. On – Joe, you talked about the Q3 outlook that it reflects kind of where the order books are coming in. Could you just talk a little bit about the fall orders versus the spring orders? Are you seeing some sequential improvement in the order book going from spring to fall when you look at the year-over-year?

Joe Scirocco

Steve, you want to –?

Steve Tully

Yes. I think we’ve talked about the challenges in the juniors marketplace, but those challenges notwithstanding I think in the other brands. It would be fair to say that we’ve seen some sequential improvement, Mitch.

Mitch Kummetz – Robert Baird

Okay, that's good to hear. Thanks, guys. Good luck.

Bruce Thomas

Okay, Operator, we’ve got time for one more question I think.

Operator

And that would come from Grant Jordan with Wells Fargo.

Grant Jordan – Wells Fargo

Great. Thanks for getting the question in. Just one clarification, Joe, whenever you're talking about the $100 million of free cash flow, is that before the required amortization on the bank debt for this year?

Joe Scirocco

Yes, it is.

Grant Jordan – Wells Fargo

Okay. And then I believe on the last call you talked about looking at various options to maybe opportunistically take care of the Rhone high-coupon piece of debt. Has there been any progress along those lines?

Joe Scirocco

We continue to look for opportunities to de-lever and are considering that in the context of the capital markets today. So, yes.

Grant Jordan – Wells Fargo

Okay. Great. Thank you.

Bruce Thomas

Okay. That concludes today’s call. On behalf of everyone here at Quiksilver, thank you for participating and we look forward to providing our third quarter results in September.

Operator

And the replay for this call will be available starting today at 6:30 PM Central Time and will be available until June 10, 2010 at 11:59 PM Central Time. You may call the replay toll-free at 888-203-1112 or internationally at 719-457-0820 and use passcode 3411773. That does conclude today’s presentation. Thank you all for your participation, and have a great day.

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