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Quiksilver, Inc. (NYSE:ZQK)

F2Q 2014 Earnings Conference Call

June 2, 2014 04:30 PM ET

Executives

Robert Jaffe - IR

Andy Mooney - President and CEO

Rich Shields - CFO

Analysts

Taposh Bari - Goldman Sachs

Erinn Murphy - Piper Jaffray

Christian Buss - Credit Suisse

Dave King - Roth Capital

Jeffrey Van Sinderen - B. Riley

Mitch Kummetz - Robert Baird

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Quiksilver Incorporated Fiscal 2014 Second Quarter Financial Results Conference Call. At this time all participants are in a listen only mode. Following the presentation we will conduct a question-and-answer session. (Operator Instructions). I would like to remind everyone that this conference is being recorded.

I'd now like to introduce Robert Jaffe, Investor Relations for Quiksilver, who will host this afternoon's call.

Robert Jaffe

Thank you, operator. Good afternoon, everyone, and welcome to the Quiksilver fiscal 2014 second quarter earnings conference call. Our speakers today are Andy Mooney, President and Chief Executive Officer; and Richard Shields, Chief Financial Officer. We are conducting this conference from Quiksilver’s office in Europe where the Company is hosting its spring 2015 sales kickoff meeting with the European sales reps.

Before we begin, I'd like to briefly review the Company's Safe Harbor statement. 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. Actual 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 and in our Quarterly Reports on Form 10-Q. All forward-looking statements made on this call speak only as of today's date, June 2, 2014, 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 on our website at www.quiksilverinc.com.

With that, I'd like to turn the call over to Andy Mooney.

Andy Mooney

Thank you, Robert. And welcome everyone, and thank you for joining our call today. I'll begin with comments on our financial performance and then discuss progress made on our Profit Improvement Plan during Q2. Rich will then discuss the Q2 financial results in more detail, and I’ll provide an update on our longer term view on the Profit Improvement Plan.

During Q2 we again witnessed SG&A. Sales in our direct to consumer channels in emerging markets increased. We generated positive comp store growth and improved gross margins. This was more than offset however by decreased revenues in our wholesale channel, particularly in North America and Europe and led to lower pro forma adjusted EBITDA versus prior year.

As mentioned on our Q1 call, our wholesale business in North America and Europe faces multiple challenges of both a systemic and cyclical nature. Our core multi-brand apparel retailers faced competitive challenges from larger vertically integrated players in the lifestyle segment and pure play online retailers in both core and lifestyle segments.

Over the last 12 months in the U.S. alone we have seen approximately 20% of our smaller wholesale accounts close. This trend has also been evident in Europe where smaller core retailers face the added pressures of weak economies and higher youth unemployment. Demand for such snow and skate lifestyle apparel remains robust and demand for Action Sports footwear is particularly strong. In apparel, the demand for lifestyle apparel is increasingly being met by fast-fashion vertically integrated apparel retailers at price points significantly below those currently offered in Action Sports.

Our brands compete well against vertical retailers in our owned and operated retail and e-commerce channels and we have restructured and re-priced the lifestyle component of our apparel offering to be more competitive in both core and lifestyle multi-brand wholesale going forward. We took a significant step forward with our fall ’14 and completely re-engineered the line for spring. But selling for fall ’14 particularly for Quiksilver apparel has been obviously affected by current poor sale through. With 70% of the media being spent in the fall and less inventory in the wholesale channel, we anticipate sales growth for Quiksilver apparel for fall ‘14 to improve, and those improvements to continue on into spring.

As referenced in prior earnings call, the decline in DC footwear is largely a result of poor execution, distribution expansion in the U.S. Again with less inventory in the wholesale channel, sell through for DC footwear is already beginning to improve modestly. But it will be spring ‘15 before the line is fully re-engineered and re-priced.

In contrast to the decline in wholesale sales, our emerging markets and e-commerce channels showed continued strength. And constant currency revenues from the emerging markets increased 28%. E-commerce revenues grew 23% and global same-store sales increased 1%.

Gross margins also increased in Q2, driven by improvements in our wholesale segment and increased sales in our retail and e-commerce channels. We continue to lower SG&A in Q2 by reducing headcount primarily in America’s and in EMEA.

We further trimmed the size of our athlete roster and feel great about the quality of the athletes that we have to work with and are pleased with our plans to support them with increased levels of marketing activation, particularly in digital and social media to extend the reach.

As you are aware, Kelly Slater decided to pursue a different path after a very successful 23 year relationship. We wish Kelly well and we’ll always consider him part of the Quiksilver family. The current plans include expanding athlete product collaborations, currently underway as the largest collaboration in the Company’s history with the Nyjah Houston footwear collection. This shoe will be launched in the current fiscal quarter and supported by a significant marketing campaign.

The supply chain was seeing the results of improvements to our global planning and buying processes and inventory management. The plans in this area will allow us to better leverage our global purchasing scale and further reduce inventory levels. We held the Global Vendor Summit in Hong Kong in March and continue to focus on purchasing volume across a narrowing list of key vendors. On the distribution and logistics side of supply chain, we moved to 3PL in Mexico and Brazil, which we believe will better control in service.

From a systems perspective, we recently went live with SAP in Australia and Indonesia. We implemented learnings from EMEA SAP rollout, and the APAC Go Live has been very smooth and we’ll extent a special thanks to our staff working on this key project.

We launched our new AG47 line for Quiksilver. We believe the AG47 board short product is the best-in-class product in terms of performance design. Feedback from customers and athletes has been overwhelming enthusiastic with a YouTube video and the product launch already at 700,000 views. We’re supporting sales of AG47 with a substantial integrated marketing campaign currently.

Using licensees with better reach and expertise in peripheral product categories was a key theme of our product improvement plan. We licensed the Children’s Quiksilver and DC Apparel business in North America last year and our transitioning of that business to a partner fall 2014. Our licensing team recently finalized the number of agreements for Roxy Children’s Apparel in North America, Global socks and hosiery and various soft accessories. All these product categories are scheduled for licensee launch in spring 2015.

And with that, I'll now turn the call over to Rich to discuss our financial performance in more detail.

Rich Shields

Thanks, Andy, and thanks, everyone, for taking the time to join us this afternoon. My comments will refer to our continuing operations, which as noted in our press release retroactively reincorporate Surfdome.

Second quarter net revenues were $408 million, down 9% or $42 million in constant currency. That revenue decline was focused in the wholesale channel where revenues decreased by $50 million. Most of this decrease was in the Americas and EMEA regions where aggregate wholesale revenues decreased by $47 million.

The product lines that we discontinued in 2013, Quiksilver Women’s, Summer Teeth and VSTR, contributed approximately $9 million to revenues in Q2 last year versus none in the current year. These items are not part of our discontinued operations and, therefore, compromised approximately a fifth of the total $42 million revenue shortfall primarily in the wholesale channel.

Focusing on the Americas wholesale channel, Quiksilver brand revenues decreased by 9%, Roxy brand decreased 14%, and DC decreased 35%. To expand on Andy’s comments regarding retail pricing, we feel our initial pricing has been too high for the last few seasons. This is resulted in poor sell through, high markdowns and returns, a significant reduction from initial gross margin to final gross margin and lower wholesale pre-bookings for subsequent seasons. We believe that by being more competitive with initial pricing that sell in and sell through will improve along with subsequent reductions and markdowns in returns. We believe this change will support improved wholesale channel performance and we anticipate being able to hold our final gross margins.

Moving to the EMEA wholesale channel, Quiksilver brand revenues decreased 9%, Roxy brand decreased 4% and DC decreased by 12%. Looking at our larger markets within EMEA, France revenues decreased 2%, Spain decreased 12%, Germany decreased 15%. UK sales were up 12% and Russia sales were up 27%. My earlier comments regarding our product pricing are applicable to the developed markets in Europe as well and we will tailor our plans to each market individually. APAC wholesale channel revenues decreased by 6% with falloff in all three brands. Decreased revenues in Australia overshadowed growth in North Asia.

Moving to our retail stores, our retail stores generated positive comparable store sales growth of 1% in the second quarter. Comp sales were positive in the Americas and well positive in Asia Pacific but modestly negative in Europe, mostly in factory outlet locations. We ended the second quarter with 28 additional stores versus Q2 last year with most of those new stores located in our Asia-Pacific region. The new stores in the APAC region are primarily shop and shop configurations which were smaller footprint locations.

Revenues in our e-commerce channel increased 23% with double-digit sales growth in all three regions. We’re making significant investments in our America’s website infrastructure to further support online revenue growth in that key market. Revenues from our emerging markets increased 28% with strong growth in Brazil, Russia and Mexico continuing in Q2. Emerging market revenues increased in all three brands.

Moving to gross margin, which increased 280 basis points to 48.7% of sales. Margins in the wholesale channel increased in each region, with greater growth in the Americas and APAC regions with most of the increase in the Quiksilver brand.

Wholesale margins were favorably impacted by lower levels of clearance activity in the second quarter. Margins were basically flat in ecommerce channels and were favorable -- excuse me -- were unfavorable in the retail channel predominantly in the Americas region due to higher promotion levels in the factory outlet location and some clearance of winter product early in Q2.

Of the 280 basis point increase in gross margins, approximately 120 basis points was driven by the sales mix shift and the direct to consumer channels and toward the EMEA region. The remaining 160 basis points of gross margin improvement was driven by improved wholesale margins.

SG&A decreased by $3 million. Q2 SG&A included $9 million of severance and other restructuring cost this year versus $4 million in Q2 last year. Excluding those items, SG&A was down $8 million versus Q2 last year. This decrease was driven by reduced staffing, reductions in sponsored events, timing of planned advertising which shifts toward the second half of this year and lower wholesale selling commissions.

Much of these expense savings were offset by an increase in bad debt expense of $11 million. This was driven by two rather unusual distributor situations and not indicative of a broader issue with our receivables. In our first quarter call, I noted that our SG&A, excluding restructuring and special charges was down by $15 million year-over-year. Looking at our Q2 results, I think it’s fair to say that we remain on that general pace, with SG&A excluding restructuring down by $8 million and then normalizing for the unusual situation in our bad debt expense.

In upcoming quarters, our year-over-year SG&A comparisons may be less favorable as we annualize against the periods of heavy staff reductions last year and we move into a period of heavier planned advertising in the second half of 2014. Q2 assets impairment included non-cash charge of $15 million to write down goodwill and intangibles related to our investment in Surfdome.

Q2 pro forma adjusted EBITDA of $12 million decreased by $6 million compared to the second quarter of last year, as improved gross margins and SG&A reductions were more than offset by the decrease in wholesale revenues and the increase in bad debt expense.

Moving to the balance sheet, inventory decreased by 10% or $34 million versus last April. However our inventory days on hand increased by seven days to 138 days. Our past seasons inventory is down modestly from a year ago, even with the lower recent clearance volume. Regarding liquidity, we ended Q2 with $210 million of available liquidity, including $64 million in cash, $56 million in restricted cash and $91 million available on our credit facilities including letter of credit capacity.

Lastly, some perspective on our expectations for current full year results. We expect to see key sales trends in the first half of the year continue into the second half of fiscal 2014. Our year-to-date revenues have declined by 5%, driven by 12% reduction in our wholesale segment due to reduced revenues in EMEA and North America.

That wholesale revenue shortfall has been partially offset by growth of 20% in both our ecommerce business and our emerging markets. Retail channel sales have been up modestly year-to-date. We expect these general sales trends to continue into the second half of the current fiscal year. We expect to be less favorable in SG&A in the second half of this year due to the timing of marketing campaigns and annualizing against the expense reduction initiatives implemented last year. Consequently we expect fiscal year 2014 pro forma adjusted EBITDA will be below prior year results, with Q3 comparisons being more impacted than Q4.

With that, I’ll turn the call back over to Andy.

Andy Mooney

Thanks Rich. Before moving to Q&A, I would like to provide some insight on our Profit Improvement Plan progress and outlook. In May of last year we announced a Profit Improvement Plan. As we anniversary that announcement I would like to share what we’ve accomplished, what we’ve learned and what adjustments we’re making moving forward. We said we would centralize product merchandising and design into two global centers. We have now essentially centralized one global M&D center for apparel in France and one global M&D center for footwear in the U.S. We learned that some additional process changes will be required to link apparel and footwear M&D with global marketing and supply chain and are now implementing those refinements.

We said we would exit or divest diverged eight nonstrategic plans. We exited seven of these businesses and after further evaluation decided that it is in our best interests to maintain our investment at Surfdome. We said we would rationalize our investment in sponsored athletes and events. We have already fully achieved our initial targets in that initiative. We said we would license peripheral product categories and are executing well on that initiative. We said we’d close underperforming retail stores, reduce headcount and product sales, reorganize our wholesale sales production trim on spending to decrease SG&A. We have fully achieved our initial SG&A target through these initiatives. I learned there is more opportunity here which we are now attacking.

We said that we would reorganize the supply chain to drive cost savings and redeploy some of those savings into an improved customer value proposition. We are executing the plan on this initiative and have determined that we need to redeploy most or all of the initial savings in order to support revenue growth.

We validated our assumptions that our direct to consumer channels in emerging markets offer strong revenue growth opportunities. Our revenue in North America and Europe wholesale channel is no more cautious than it was a year ago when we announced the Profit Improvement Plan.

We continue to be confident that we can achieve the primary goal of the Profit Improvement Plan, improving adjusted EBITDA by approximately $150 million compared with fiscal 2012. We are adjusting our growth strategies to increase investments in DTC channels primarily in emerging markets to be much more competitive in core specialty and more focused on fashion right, price right, SMU programs for large and non-core wholesale channels in North America and Europe. We anticipate that these strategies will take more time to implement and consequently now anticipate achieving our PIP profit target by the end of fiscal 2017.

As mentioned earlier within, France we held a kickoff event with the European sales team this afternoon to present spring 2015 product line. The sales team got a chance to view the complete lines, see the marketing campaigns supporting the spring line, and here where we are setting pricing to support strong sell through. We have narrowed the line, significantly improved the product in those strong go-to-market sales plans. I look forward to reporting back on our results.

And with that I’ll turn the call over to Robert.

Robert Jaffe

Thanks, Andy. Operator, we're now ready for the question-and-answer session.

Question-and-Answer Session

Operator

(Operator Instructions). We will take our first question from Taposh Bari with Goldman Sachs.

Taposh Bari - Goldman Sachs

I guess the first question I had was just -- there seems to be a major disparity in your business between, what you’re seeing in your own direct channel particularly with your same-store sales up 1%, and the sell through commentary that you’re setting at wholesaler at large. So can you just help reconcile that for us?

Andy Mooney

Yes. It’s a very good question. I feel that the consumer is going into multi-brand retailers, is much more discriminating in terms of price than those he choose to go into our own branded retail, brick and mortar operations as well as the e-commerce sites. If they’re coming and crossing the threshold of own stores or on e-commerce sites, they’ve basically already made the brand decision. What I think a lot of consumers are going into multi-brand stores, and doesn’t if it is high end, department stores like Macy’s or a mom-and-pop core soft retailer, they are very price aware. There are looking for promotions and for price. And I guess you see that the current performance of our line has really driven some pre-bookings for a fall ’14 line.

Taposh Bari - Goldman Sachs

And can you help us understand -- so you’re largely a wholesale business. Help us understand in more detail what’s going to take to kind of stem that kind of bleed because you have been talking about the wholesale channel having this bleed for quite some time. And I’m just trying to understand at what point -- what it’s going to take and when you see that actually reversing because I don’t think we’ll ever get to a point where your direct to consumer business will compensate for the wholesale struggle. So just trying to get a better idea; how likely end when you think that that challenge will start to abate.

Andy Mooney

Yes, sure. I think if you look at the -- Rich can help me if I am quoting -- make sure am quoting the numbers accurately here but on retail, the direct-to-consumer business is roughly 30% of total revenues compared to the wholesale business being roughly 70%. Within our wholesale segment, we also have a number of licensed retail stores. So if one were to define direct to consumer as being mono-branded as it were, probably the breakeven is closer to 60% multi-branded wholesale and 40% mono-branded direct to consumer.

Within the multi-brand -- the 60% number, we’re continuing to see very robust growth in emerging markets. So Russia, Brazil in particular -- as I mentioned on previous calls you’re not seeing a dollar of revenue registering on published results from Mainland China, which is the second largest Action Sports market in the world. That is an opportunity we believe is important for the future.

And we’re also seeing what I would say as bottoming out of the decline in Asia-Pacific, particularly in Australasia. But the market in the G5 and North America in particular is very, very price competitive; very, very price promotional; and I would say largely for apparel generally as essentially evolved into sale or return business. It really doesn’t matter whether it’s a high end department store or a small independent mom and pop store.

The industry has become accustomed to selling in and marking down, accepting with turns in both regions, both North America and the U.S. and our observation has been that the industry tends to price products too high and go through this very inefficient cycle of then marking them down or accepting returns, and there being a very significant gap between initial gross margin and gross margin, we feel that it’s much more beneficial to be priced right to the market in those two geographies, to go in with lower initial gross margin, to drive higher sell throughs, to be more price relevant in the market and to minimize the markdowns and returns of the backend.

To answer your question we believe that our product lines, we made progress and fall ’14. We have fully reengineered and re-priced the lines for spring ’15 in footwear and apparel. So this would apply to all three brands, footwear and apparel, including DC and the footwear site. So the lines are positioned to generate growth in spring ’14 but I have to caution on the caveat to see that sell in is severely influenced by current sell through. So our current sell through in Quiksilver Apparel in the developed markets in DC footwear, you see footwear is improving modestly, Quiksilver Apparel is still quite poor. So despite the fact that we made, I would say enormous improvements in Quiksilver Apparel for spring ’15 and DC footwear for spring ’15, I would expect hopefully to stem the tide in the developed markets in spring ’15 and to look for some improvements in fall ’15 and beyond.

Operator

And we’ll now take our next question from Erinn Murphy with Piper Jaffray.

Erinn Murphy - Piper Jaffray

I guess Andy for you, if you could just talk a little bit more about the profitability plan. I mean you pushed it out a year -- should we still think about some of the original components and getting to that kind of $2.2 billion in sales. If I’m just quickly doing the math and if we were to see the second half of this year remain similar to the trend in the first half of this year, it would suggest some reacceleration to the kind of that 8% to 9% rate for the next three years? So just maybe help us understand kind of what are those key sale drivers to kind of see that reacceleration? And how much more from just a spending perspective or kind of reengineering some of that demand creation to get there.

Andy Mooney

Well we’ve -- so let me breakdown the various component parts. In essence the key elements of the profit improvement plan, we still firmly believe and are holding intact. I think the variables that we’re seeing -- actually I should stay back a little. We’ve essentially made most of the changes that we plan to make in marketing in terms of realigning the budget, to put more fuel in the tank as it were particularly in digital media.

That will take effect as early as fall ’14, significant uptick there. We -- on a supply chain we continue to see the gains that we planned being realized in terms of having a narrower product line with just SKUs, not factory based. We are getting our factory price improvements. But what we’re finding is that we’re having to on initial gross margin devote more of those to being competitive at retail going in at the sell in process rather than going through this convoluted process of being overpriced and then going through mark downs, returns, et cetera, et cetera.

We still believe that that will generate revenue growth and the gross margins after markdowns and returns will hold steady relative to a plan, but as I say we don’t really anticipate sales growth to start to take effect. We anticipate through mix trying to generate sales growth in spring, but the wholesale side of the business, we would not expect in the developed market to see sales growth until fall of ’15.

Erinn Murphy - Piper Jaffray

Just to that end on the sale, can you just help us think between those three brands -- which brand you feel like just from some of the initiatives you’ve already been able to affect should kind of base and see some sales improvement first as we get into that kind of fiscal ’15 timeframe?

Andy Mooney

So, DC is a footwear brand. The big initiative that we have in place there of course is to aggressively enter the largest single segment of the market, which is the accessibly priced vulcanized Canvas footwear. That market is narrow at 200 million per market globally. Were we to attain only 5% share of that market, DC as a brand could double in size. We have never competed in that segment before but we will complete in that segment aggressively from spring ’15.

So we have the line in place, we have the marketing programs in place, the product looks great. So we’re poised from a product design perspective, from a marking perspective to take advantage. It’s all going to be a question of how the retailers respond to the product line and how ultimately if they respond, how the consumer respond, but I feel that the product line is in shape to really grow.

On Quiksilver, what we’ve really done there I think is kind of focused on the key categories, the must wins categories to improve the quality of the product, the priced value of the product, and the fundamental design of the product. I think (indiscernible) in Europe has done a great job there with the design team and I think the key components of our product line, shops in particular which 60% of the North America business over the course of the year to spring 15, the line is great. But as I said I think sell end is predicated by sell through. As I mentioned earlier in the call, we anticipate the fall ‘14 sell throughs will continue to improve and those improvements will become even more profound in spring. To what degree that affects spring sell end is you have to be determined because the reps have got to go out on the road over the next 90 to 180 days.

But in our modeling, we feel very confident that by the time we get to the fall ‘15 on the apparel side of the business we’ll be in really great shape. Roxy sell throughs continue to be really quite good. A lot of the decline that we’ve seen in our Roxy revenue that has been really more systemic decline in the number of open accounts that are in business in the core channel. Roxy is more concentrated in the core channel than any of our three brands and I think really the contraction of stores there in the core channel has had more of an effect on them than the other brands. So really the challenge there is to think about channel expansion and we are actively thinking about that as well as market share growth within the remaining core.

Erinn Murphy - Piper Jaffray

Okay, thank you. And then just one last follow-up. As you think about fall 14, you’ve talked about just some of the weakness in the pre-bookings. Is it orders that you didn’t see materialize as the booking season came to an end that is kind of putting some pressure there or are you actually starting to see cancellations for fall 2014, just given kind of the overall tepid environment?

Andy Mooney

No, it’s -- the booking season for fall 14 is complete. So we have a good picture on sell-in which is why we’ve modified our guidance really for the back half of the year. Of course, we could improve upon that as sell through is really significant and because at once orders picked up. But again I think why we’re being very cautious is that we really haven’t gambled in terms of putting inventory in the floor to accommodate that. So we drive again into a situation where we’re selling through strongly. 70% of the marketing dollars are concentrated in Q3 and Q4. The marketing campaigns look great. Product line is solid. We’d like to get some solid sell-through in fall. It would be wonderful for us to run out a product in fall. We like to have some solid sell-end for spring and even better sell-throughs in spring and continue some positive momentum in developed markets into the fall 15 sell-end cycle.

Operator

And we’ll now go to Christian Buss with Credit Suisse.

Christian Buss - Credit Suisse

So I was wondering if you could talk a little bit about your inventory positioning and flexibility you have in the model now in light of an order book that didn’t come in quite as anticipated?

Rich Shields

Yes, Chris, this is Rich. First I think you you’ve seen the results of improved inventory management. So inventory, down significantly over April last year, you’ve also seeing -- in the wholesale area you saw reduced clearance and even with reduced clearance the quality of inventory improved. So the percent of our total inventory that’s made up of aged inventory is down by over 200 basis points.

So I think that you’re seeing the results of some of things we talked about in the profit improvement plan regarding reengineering process and globalizing process to look at inventory as a global inventory pool as opposed to three separate regional inventory pools. And at the same time we think that there is still a lot of opportunity here. We’re at 138 days of inventory. That’s still well above what I would consider appropriate targets in peer group norms, but also importantly when we look at inventory as a source of cash, inventory was a significant source of cash for the first six months of this year versus use of cash last year. So there is a lot of room to go on inventory but I think that we’re heading to the right direction.

Christian Buss - Credit Suisse

That’s helpful. And then with respect to the incremental marketing initiatives. Could you give us some perspectives on what you are planning for?

Andy Mooney

Yes. Historically the Company has spent its marketing dollars primarily on traditional endemic media which is a very important medium for the core channel but has very low reach and frequency, and has spent a lot of its money on both events and a large number of -- a large number of events and a very large athlete roster. We have spent the last 18 months reducing our athlete roster and then reducing our event participation to move money into digital media.

So we estimate that the campaign that we’re putting together for 2015 for example -- full calendar 2015, will essentially create 400 million impressions, on social networks if you like us in terms of defined by attributes like Facebook likes is -- our Facebook fans are significantly higher than anyone else in our space in Action Sports. We believe that we really have an opportunity to convert those engaged fans into retail buyers. So all of those initiatives really began, they really started to begin here in -- started to begin the last days of this month, carry forward through into three and four. And we’ll continue to invest in social media digital media in much higher degrees in the future.

Operator

And we’ll now go to Dave King with Roth Capital.

Dave King - Roth Capital

I guess a follow up to Erinn’s question. I’m curious as it sounds from your comments there Andy that you’re still kid of expecting a return to high single-digit top line growth as we look out towards the out years but that’s still predicated on positive retailer response, improved sell through and sell in as a result. Is that a fair assumption and then I guess along those lines, if that ends up not being the case and some of that stuff doesn’t come through, at what point do you start to re-evaluate some of other line items in terms of potential for more meaningful cost savings or other ways that you can try to drive margin if those revenues don’t come through. And maybe can you talk about some of the things that you’re thinking about currently that might be able to help us out. Thank you.

Andy Mooney

So if you begin at the top line and watch from a 60-40 wholesale to direct to consumer split, as I said we feel very confident in direct to consumer portion of a business. So that’s -- 40% of our business we feel confident in that we can deliver sustained growth particularly in emerging markets and particularly in those emerging markets where we literally don’t even show up on the radar currently.

So then that leaves the 60% of wholesale growth is global in nature. There are component parts of that wholesale growth that again we feel very confident that we will grow in, again emerging markets. So regions like Brazil, Southeast Asia, Russia. So it really narrows down to G5 and North America. So in a scenario even when we remain flat in those regions which might well come surpass over the next few quarters, we would still grow. We would still grow the top line as a function of us growing a wholesale business in emerging markets and our direct to consumer business overall.

So we still feel good about the growth scenario. It’s really a question of how quickly we can realize the opportunity that exists in emerging markets and we’re going to very aggressively go after that opportunity in Brazil. We’re doing it now, but – we’re very aggressively doing that short-term now that we own brands 100% of that market; similarly Mexico, similarly in Russia. And as we work through litigation with our partner in China, we hope to be able to develop that market there as quickly as we possibly can.

On the SG&A side, we have realized all of the gains that we have planned to realize at this point. There are further gains to be realized, and we intend to go after those, no matter what, because we feel that the gains are there to be made and we would rather either realize those and drop them to the bottom line or redeploy those gains into market and to drive topline.

Dave King - Roth Capital

And then maybe just a follow-up to a couple of parts of that. Then is it fair to assume that, let’s say the DC Vulcanized Shoe initiative doesn’t go as well as planned because it is predicated on retailers adopting it et cetera, you still are confident you can hold revenues in North America flat I guess will the first part of that. And then, second, as we think about the SG&A, is there sort of an optimal level as a percentage of sales where you guys think you can be? Is there -- looking at peers or looking at your own books et cetera; just give us some guidance on where you expect to be in fiscal ’17?

Rich Shields

On the profitability side, as Andy mentioned, I want to just kind of mirror he said that we don’t look at SG&A savings as either/or. We look at them as -- we think there is opportunities in the supply chain that we are going to go after. There is opportunities in SG&A that we’re going to double down that initiative. I think that the original Profit Improvement Plan talked about moving our EBITDA to peer group normal about 13% and with the scale that we have got today we think we can move there and obviously as we move scale up with sales growth, we can achieve it at higher levels as well.

Operator

We will now go to Jeffrey Van Sinderen with B. Riley.

Jeffrey Van Sinderen - B. Riley

I think you mentioned positive comps and then as well positive margins in your e-com business, but just wondering about contribution margin in your own retail stores. Maybe could just touch on that; gross margin there? And then could you give us more color on your merchandise margins generally in -- in your own stores; what the drivers were there and also were you more or less promotional discounting up or down your own stores?

Rich Shields

Maybe I’ll get started on that and Andy can move into the merchandising piece. First, yes we saw a good sales growth in the e-com business. There is fixed cost involved in the e-commerce business. So our sales growth leverage those costs. So we’re seeing increasing contribution there. I mentioned that the retail margins were a bit down in Q2. That’s really driven in North America, largely in the factory outlet stores where we have been running some promotions which are basically designed to increase the average unit per transaction. So they don’t cost us any gross margin dollars, but it does injure gross margin percent a bit. And early in Q2 we did some clearance through the factory outlets in North America on some leftover winter parts. So margins were down a bit and we feel very confident and comfortable with the contribution from our retail stores. And Andy on the merchandising pieces.

Andy Mooney

As you can imagine, when you’re looking at the aggregate gross margin level, you’re looking at a blend of wholesale and retail. Retail gross margins, although we don’t break the note as an individual line-item, we’re on at levels that you would anticipate a vertical retailer to run at. And as we have continued to run a retail organization, both globally and more efficiently and that has become a larger portion of our business, we’re starting to get leverage on the fixed cost basis, not really an improvement on the margin side per se. It’s more of an improvement on the net margin as a function of getting leverage over the fixed cost base.

On the wholesale side we are seeing -- we have been experiencing improved factory pricing as a reduction of reducing our SKUs and narrowing our factory base. We would expect to see that to continue. But as mentioned earlier in the call, I think particularly from spring 15 and beyond, we want to really apply a lot of that to being more competitive at first sale and then having the product be priced right, market right when it hits the floor to generate higher sale through, less markdowns, less returns. That process is a very inefficient process for all concerned. We want our wholesale partners to experience better sell through than they have to date and not go through the hoops of asking for markdown money or shipping products back to the warehouse?

Jeffrey Van Sinderen - B. Riley

Okay and what are you seeing as far as sort of the picture for markdown money and such as this point? Is that starting to level out or is that -- what’s the quality that right now?

Andy Mooney

I think probably every multi brand retailer in the world, regardless of industry would see that they are facing challenges right now. And I think particularly in the apparel side of the business they’re probably facing challenges from three distinct areas. There is pure play e-com retailers where they are both analytically driven and very price promotional and probably working on narrower margins than most retailers are in the industry. There’s the case of apparel, the fast fashion vertical retailers, where on the lifestyle component of the segment they are introducing products like board shorts or swimwear where it used to be the norm and still is the norm to say sale a pair of board shorts in a specialty surf shop at $60. Increasingly a lifestyle variation of that product could be sold at an account like H&M for $20.

So that is the significant chasm between two price points. So I think if you’re going to be with the mall-based specialty retailer in the lifestyle segment, we don’t intend to be a $20, but we probably have to be much less than $60. So that’s possible to make money and design good quality products at that price point, but you have to engineer into that product, you have to be fashion right, you have to price right, you have to be brought to market at fast pace. All of those changes we put in place to accommodate those retailers that have historically enjoyed the lifestyle component of the surf and skate market.

Jeffrey Van Sinderen - B. Riley

So I guess this is a follow-up to that, just maybe a little more on how you think about reducing price points because it seems like you’re being maybe little bit aggressive on that initiative, maybe more how you think about that versus quality and features and product differentiation?

Andy Mooney

The interesting -- the paradox if you like is -- historically we’ve gone with the very high initial goods margins with high prices; good quality product, high gross margins, high prices. It doesn’t sell at first blush. It gets markdown, unusually truly it the season and the leftovers then get returned to us which we then it put through the normal factory outlet system or if it’s a larger quantity, it goes through clearance channel; very-very efficient. And we believe with an identical product, identical quality, just simply by going in with lower IGN, we will get more consumer acceptance, higher sell-throughs, less markdowns, and make the same gross margin as we would have going through these -- this kind of convoluted process.

So I actually believe -- in fact I know in spring ‘15 that the quality of our product will improve, particularly when you look at it from a price to value perspective because we’re basically plowing much of not all of the factory price improvements that we’re getting through reduced SKUs and a narrower factory base into product quality and sharper pricing to drive the top-line growth again and drive sell-throughs in our wholesale channel.

Jeffrey Van Sinderen - B. Riley

Okay. But it sounds like you have a much more efficient process and avoid all the high-low pricing game. It sounds like a good strategy?

Andy Mooney

That’s exactly our expectations and it will take us a season or two to really understand the ebbs and flows of the decisions that we’re making now, but we feel confident in the strategy and we’ll see how the results play out over the next few quarters.

Rich Shields

And Jeff maybe one additional kind of a way to look at the markdown question is to think about the inventory situation. So we see our inventory improving. We see clearance volume reducing and I think that our sense is that we see we’re in a better position in terms of channel inventory as well. You’ve asked about velocity on markdowns. Andy mentioned that we’re seeing some improvements on DC and certainly on the DC brand, we’re seeing less drainage from requests or discounting on channel inventories that we’ve seen in the past. That’s one of the reasons that gives us some confidence about some improvements on the DC side.

Operator

And we’ll now go to Mitch Kummetz with Robert Baird.

Mitch Kummetz - Robert Baird

Just couple of questions. One; I know a year ago you guys seemed pretty optimistic that trends would improve with fall 2014 product and obviously that now doesn’t seem to be the case given where you’re saying your pre-books are. I’m just wondering what happened? Was it that fall ‘13 sell-throughs ended up being worse than what you’re anticipating? Were you not anticipating a year ago that pricing would as significant as what you now are seeing, which is giving you the optimism that things will get better by fall ‘15? What’s really that the issue here?

Andy Mooney

Its two things, I think. One that you’ve just articulated, which is we did not anticipate that the sell-throughs would be as weak as they have been. But I think the other is the just fundamental erosion in the fringes if you like of the core channels with 20% of the doors closing. But certainly we anticipated some minor erosion of door closures on the fringes. We did not anticipate a decline in the store count of that magnitude.

Mitch Kummetz - Robert Baird

And the how did DC Vulcanized book for fall ‘14? Because I think you’d already made some price adjustments there; didn’t you? Going into the fall 2014 line?

Andy Mooney

We did two things in the fall 2014 line. We introduced a $70 signature product around Nike shoes which booked in higher levels than any other new style in DC history. So that shoe has yet to get to retail but we feel very good about that product and we have a full blown marketing program to support that product happening when the product launch switches over the next number of weeks. And we’re going to carry forward that invest into the spring. We re-priced because that was really the only option that we have from a time perspective in fall. We re-priced the couple of styles that were $55 down to $50 for fall. It was candidly a little bit of a band-aid operation. We got some moderate success with it, but not enough to get basically right -- not enough to convert us to growth for fall.

For spring, we have product in the line that has been specifically engineered to be at $45 retail, which is really -- that is the sweet spot for product, $45 to $50 retail. We have a particular product call Beatrice that it comes in multiple options, supported by a very creative marketing campaign that involves credit sourcing on the design side. They offer a margin opportunity for a retail partners which we did not have before that gives the retailer a reason to display some of the competitive products that are in that price zone. So reception to that from a retail partners or sales organization -- we went through it today -- has been a very good. Time will tell whether we realized the opportunity that we believe is possible, but all of the -- as I said to the sales guys on the stage today, we’ve given them every possible opportunity to grow on the DC side for spring. The line is right, price is right, design is right. It will be well marketed. So we’re optimistic.

Mitch Kummetz - Robert Baird

Rich, can I ask you a quick question on margin?

Rich Shields

Sure.

Mitch Kummetz - Robert Baird

You mentioned that 160 basis points on of the 280 increase was better wholesale, less clearance. How should we be thinking about going into the back half of year? I can't remember what kind of the comparisons were versus clearance last year. Should you see as much benefit on the wholesale margin as you saw this quarter based on that or?

Rich Shields

I think we’ll see the margin from the second half improve but not to that not to the 280 basis point extent that we saw in Q2. I think that you’ll -- although the two drivers that we saw in Q2, which is continued strong sales growth in the e-commerce business and our direct-to-consumer business which has higher margins than the wholesale business, that trend will continue. And we will see anticipated -- we will see improved margins in the wholesale business. But I wouldn’t think that the aggregate will continue to run at 280 bps favorable for the entire second half.

Operator

And we’ll take a follow-up question from Taposh Bari with Goldman Sachs.

Taposh Bari - Goldman Sachs

Thanks just had a quick question. Just going back to the 60-40 split Andy that you had mentioned several times. So the 40 is mono-branded. Of the 60, can you breakout the domestic market versus emerging market mix on the wholesale side? Just try to isolate the problem area.

Andy Mooney

Just to clarify when we talk about 60, right now we’re at 70% wholesale, 30% retail or direct-to-consumer. We’ve seen the direct-to-consumer sales mix continue to increase and we anticipate that we will continue to invest both in the e-Commerce platforms and expanding the e-Commerce peripheral or the periphery into new markets where we’re not currently selling to our consumers that way and we’ll continue to invest in retail stores. And so moving from the 70-30 to 60-40 is a target that we anticipate.

Taposh Bari - Goldman Sachs

That was including your franchise stores in that 40?

Andy Mooney

Yes. The 10% swing from the 30 to 40 is driven largely by shopping shops, franchise retail stores that exist primarily in Southeast Asia but also to a lesser extent in Russia, Japan, a few other places. I don’t think we’ve broken out the -- I don’t know that we’ve broken out our wholesale from retail segments between Europe and America at this point, Taposh.

Taposh Bari - Goldman Sachs

Okay. Another follow-up for you is this idea of competing with fast fashion or vertical retail, you mentioned the fact that they have a faster supply chain, sharper prices et cetera -- I guess the question we’re trying to get at is how well is the Company, Quiksilver equipped to compete in that kind of climate today or over the next 12 months for that matter in your opinion?

Andy Mooney

We’re quite low because we invested a lot of energy over the 12 months to do exactly that. So when you consider the product types that are important to us, again for North America for example, 60% of the business is in shorts. I think a buyer in the specialty channel who I have a lot of respect for made a very interesting comment to me a couple of weeks ago where he said that if H&M is selling board shorts at $20 and essentially non-brand, even non-authentic, he felt he can readily sell fashion right board shorts at $40 but not $60. That seems completely logical to me. We can engineer $40 shorts. We can get them to market very quickly and it’s a category I think that we can be very competitive in that I would say the same on tees, tanks, a lot of the categories that are important to us.

Let me give an example of tees for example, that before we went through the reorganization of the Company into global supply chain and global M&D centers, we were a large buyer of T-shirts. We were buying those T-shirts across 55 different factories in the world, some of which had the capability to do faster product delivery, but we never took advantage of it. For spring 15, we’ll be in five T-shirts factories globally, all of which will have fast turn capability. With those factories being strategically centered geographically so that we can provide fast response to both Europe and to the Americas from places like Mexico or Turkey in the case of – or in the case of Europe. So we’ve set ourselves up to take advantage of this. We’re going to have to earn our keep with those retailers and demonstrate that we can in fact deliver on it, but we’ve organizationally and structurally set ourselves up to be very competitive in this space.

Taposh Bari - Goldman Sachs

And just final one for you guys is looking at fall ‘14 sell-through as kind of an indication of how spring sell-in will kind of transpire -- I guess the question we’re trying to address is here, fall ‘14 at least largely is an outwear cold-weather business for you with the exception of obviously Australia, whereas spring is most spring summer. Spring ‘15 will be mostly summer and spring. So help us understand how the two seasons are connected as we think about that transition?

Andy Mooney

Sure, so it does vary quite dramatically by regions. So if you were in Europe, we’re basically a 50-50 warm-weather, cold-weather revenue split, and we definitely have a significant outwear business in the fall season in Europe. In the U.S. our short business really starts to peak pick from 525 really through about 725. So what we would characterize as fall is actually the height of the season for a lot of short business that we do in North America. And we do very little outerwear business at this point. It’s an area that we’re trying to really develop for it. And of course as you’ve mentioned in Asia-Pacific it’s contra-seasonal. So we would be right in the middle of our short sales peak during Q3 and Q4.

Operator

That concludes today’s question and answer session. Mr. Jaffe at this time, I’ll turn the conference back to you for any additional or closing remarks.

Robert Jaffe

Thanks, Angela. That concludes today’s call. On behalf of everyone here at Quiksilver, thank you for participating and we look forward to providing our fiscal 2014 third quarter results in September.

Operator

Ladies and gentlemen, this concludes today’s conference. We thank you for your participation.

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Source: Quiksilver's (ZQK) CEO Andy Mooney on F2Q 2014 Results - Earnings Call Transcript

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