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Volcom Inc. (NASDAQ:VLCM)

Q4 2007 Earnings Call

February 21, 2008 4:30 pm ET

Executives

Richard Woolcott- President and CEO

Doug Collier - CFO

Jason Steris - COO

Hoby Darling - VP of Strategic Development and General Counsel.

Analysts

Jeff Klinefelter - Piper Jaffray

Eric Tracy - BB&T Capital Markets

Mitch Kummetz - Robert Baird

Jeff Mintz - Wedbush Morgan

Jeff Van Sinderen - B.Riley

Presentations

Operator

At this time I would like to welcome everyone to the Volcom, Inc, 2007 fourth quarter financial results conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks there will be a question and answer session. (Operator Instructions)

I would now like to introduce Mr. Hoby Darling, Vice President of Strategic Development and General Counsel, Volcom Inc., to begin the call. Go ahead Mr. Darling.

Hoby Darling

Thank you, Sumika. Good afternoon, everyone, and thank you for joining us today to discuss Volcom's 2007 fourth quarter and year end financial results. Joining me on the call today are Richard Woolcott, Volcom's President and Chief Executive Officer; Doug Collier, Volcom's Chief Financial Officer; and Jason Steris, Volcom's Chief Operating Officer.

First, some housekeeping items before we start. If you would like to be added to Volcom's e-mail distribution list to receive company information or if you'd like to change your contact information, please contact David Stankunas at Pondel Wilkenson at 310-279-5975. In addition, please be advised that this conference call is being broadcast live on the internet at www.volcom.com as well as www.earnings.com. A playback will be available for one year and may be accessed on the internet at both websites.

Please also note that all of the information discussed on today's call is covered under the Safe Harbor provisions of the Litigation Reform Act. The company's discussion today will include forward looking information reflecting management’s current forecast of certain aspects of the company's future. In particular, statements about the future regarding our guidance, outlook for future business, margins, financial performance, customer demand, growth and profitability, all constitute forward-looking statements. These forward looking statements are all based on management's current expectations, but they do involve a number of risks and uncertainties. Actual results could differ materially from those stated or implied by these forward looking statements, due to risks and uncertainties associated with the business.

The company disclaims any intent or obligation to update these forward-looking statements except as required by law. All forward looking statements from today's call are qualified in their entirety by the foregoing cautionary statement. With that being said, it's my pleasure to turn the call over to Richard Wolcott, our President and Chief Executive Officer.

Richard Woolcott

Thank you, Hoby, and good afternoon everyone. I’d like to first take a moment to thank the Volcom team for making 2007 such a productive and exciting year. Even with the challenges of an economic slowdown, we still managed to post solid results, launch a successful operation in Europe, and strengthen our foundation for future growth. I’m proud of our accomplishments this year and look forward to capitalizing on the brand’s current momentum in 2008.

First, I would like to briefly review some financial highlights for the past year. Our financial results for 2007 fourth quarter were solid and inline with our earnings preview we issued in January. Total revenues were $69.1 million, up 22% over the last year.

Net income was $7.1 million, translating to diluted earnings per share of $0.29. For the entire year, our company had shown strong growth with revenues up 31% to $269 million and net income up 16% to $33.3 million compared with last year. Earnings per diluted share for the year were $1.37, compared with $1.18 in 2006. Doug will go into more on the numbers and our outlook for 2008 in a moment.

It is important to note that many of the growth initiatives put in place within the past year have already started to payoff. And with many of our new product categories like Girl, Swim, Creedler and kids just starting to hit their stride, a full year of contribution from Volcom Europe on the horizon and a new young brand like Electric as part of our growing family, we are very excited about the opportunities that we have.

We believe there are many growth opportunities for our company and today, we would like to layout our strategy for 2008 and beyond. The core elements of our plan center around a focus on diversification and are aimed at maintaining brand integrity, increasing shareholder value and promoting a healthy balance within the company as we grow.

We plan to achieve these goals as follows: Number one, maintain our brand strength in the Action Sports industry, which ultimately serves as a foundation for everything we do. Number two, diversify our product line by developing our new categories as well as building on and strengthening our existing ones.

Number three, diversify our distribution domestically by nurturing our newly opened accounts, growing with our existing accounts as they open new doors and expanding our own retail program. Number four, expand our geographic reach by continuing to grow our brand in Europe as well as investing in other key international territories. And number five, diversify our company across categories and markets through potential strategic acquisitions such as Electric.

Throughout the course of my comments, I would touch on each of these five points and how we intend to execute our plan. One of the greatest assets we have is the Volcom brand. Our brand has drawn along side the entire boardsports industry and over the past 16 years we have built a deep connection with our customers. Obviously, great product is key to our success, but I also believe that our unique marketing approach is just as important.

We've always invested significant amount of time, money, and intensity into our marketing efforts and I believe this is one of the main reasons why the brand is so strong today. Serving as a key component to our growth strategy, we will continue to invest in our relentless marketing attack through our athlete programs, Let The Kids Ride Free contest, our music label Volcom Entertainment, our film division Veeco Productions, the Volcom featured artist series and a multitude of tours and events we sponsor throughout the year and throughout the world.

I would now like to take a moment and share with you some of the current brand excitement. We just recently completed our January trade show season, which included ASR, Surf Expo, SIA and ISPO the reaction to our Fall line and our new outerwear collection has been very good. This is great news and I believe it is a testament of the strength of our product and the power of our brand.

One comment we heard from retailers at the shows was that Volcom experienced very strong sell through during the holiday season. This is further evident in the just realized Baird Board sport report where Volcom was once again ranked as the hottest men's and women's apparel brand for the holiday season.

We've also been hearing that Volcom is selling well on the floor right now for spring. This is all very motivating as we enter 2008 and we see this as a sign of opportunity to gain market share.

Okay, let’s now turn to our second point, which is product. A major component of our growth strategy has been developing new categories and strengthening our current product line. Over the past year and a half, we have introduced three major categories, Girl's Swim, Footwear and Kids to our product mix. We have also made significant progress in strengthening our outerwear and our boardsport collections. These categories have been important areas of growth for the company and we plan to continue investing in them in 2008.

And now with our recent acquisition of Electric, which I will discuss in a moment, we have further diversified our product portfolio into eyeglass and google category. I would like to point out that product quality and the creativity of our company are a major force across all departments involved in the designing and building of our garments and accessories. We are striving harder than ever to make sure that we deliver the best product possible every season, on-time, at the right price and at the highest quality. This mindset is instilled in our designing production teams and it’s what our retailers and consumers have come to expect from us.

Now let’s take a look at our third growth initiative of how we are diversifying from the distribution standpoint, focusing on our US business. We believe diversifying our distribution will reduce the concentration risk of any one customer, while fueling growth at the same time. A primary focus is to expand distribution through our existing accounts as they open new doors such Zumiez and Tillys.

We also believe there is still opportunity within our current accounts for further growth with our existing product offerings and new categories. And finally, we are also working closely with our newly open accounts such as Macy’s, Dillard’s and Sport Chalet and believe they will not only act as growth drivers, but will also broaden our reach to certain underserved markets.

To give you a quick update to where we stand with some of our new accounts, we are currently in a 106 Macy's West and Northwest stores with our Men’s, Boy’s and Creedlers categories.

We also just introduced our Girl’s product to 80 Macy's stores this past holiday season. We are now on 53 Dillard stores primarily with our Boy’s category, but are right in the middle of building our Men’s and Girl’s business with them. Additionally, we just open Sport Chalet last November with 19 doors across all our categories.

Moving forward, we see opportunity with all of our new distribution, both in geographic expansion and store penetration. However, it is crucial that as we diversify our reach, we do so in a manner that will maintain brand integrity. Our number one initiative within this distribution strategy is to do our best to support our specialty retailers and to maintain our strength at the core level.

With our distribution platform now in place, I believe we have a well rounded group of retailers from our core specialty, two department stores that can grow the brand correctly over the long-term.

In addition to supporting the wholesale business, our Volcom branded retail program is another one of the exciting new areas of distribution growth for our company. We believe our stores are a great way to showcase the Volcom experience and merchandise our products. There is no question in my mind that these stores have tremendous value as a brand building vehicle. Additionally, these stores have also shown they can be a solid channel distribution.

We opened three new stores in 2007 for a total of six domestically. We currently have plans to open four new domestic doors in 2008, including locations in New York, Boulder, Colorado and Waikiki, Hawaii. We also have plans to establish a new retail location in Europe to go along with our store in Hossegor, France, which will reopen under our control in March of this year.

In addition to our company owned stores, three new locations were opened in 2007, one in Tokyo, Japan by our distributor, one in Durban, South Africa by our licensee and one in Sau Paulo, Brazil by our licensee. We also have plans to open two more locations in 2008, one in Thailand by our distributor and one in Indonesia by our licensee.

We're very excited about our Volcom brand retail program and believe that overtime it should provide a favorable financial boost to our operations. By injecting Volcom brand retail stores into our distribution mix, we effectively add a significant new account over which we have complete control. Our plans for 2008 include a methodical expansion and more of an intense focus on developing the right operating procedures and efficiencies that can serve as a template for a potentially broader program in 2009.

Let me now turn to our fourth strategic point of growing business geographically. Launching Volcom Europe was an incredible undertaking for our company and I can now say with full confidence that we were successful in our goal. In its two quarters of full operations, Volcom Europe performed beyond our expectations. The reception from our distributors, retailers and customers has been great and we're excited about the opportunities that lay ahead.

A major growth focus in 2008 for Europe, will be to work with our distributors and reps to improve penetration within our existing accounts; partnering with our distributors, we will build greater brand awareness at the retail level through stores and store concepts, racks and displays, stronger marketing initiatives, events, tours and advertising.

Ultimately, we believe our business in Europe could some day reach the same level as our business in the US. The action sports industry is already a major player in the world market, Volcom is one of the top brands in this category and we envision ourselves competing at the global level. It will take some time, but we believe having a significant international presence is an important component to prolong the growth.

Outside of the US and Europe, we are particularly focused on two key areas. At the moment we intend to work very closely with our licensee in Australia and our distributor in Japan. Our goal is to help them develop and optimize their businesses. So, within time, we could bring these territories in-house. We also see opportunities for growth in Asia and parts of South America where we are investing in now.

And finally, I would like to talk about our fifth strategy which is acquisitions. As we continue to grow our company across a multitude of product categories and markets, we’ve identified certain areas of opportunity in the action sport space that may not make sense for the Volcom brand specifically, but might make sense for the company as a whole.

One of the most exciting things we're working on, is the integration of Electric Visual into our product offering. Acquiring Electric this past January served two key objectives. We were able to immediately expand our product line by adding eyewear and goggles and we were able to diversify our portfolio with one of the hottest brands in action sports.

Electric is a young, powerful brand with a coat like customer following and a management team that is smart, hardworking and creative. We see strong potential for this brand not only in eyewear and goggles, but also in soft goods and accessories. Beside boardshorts, the Electric brand also transcends into motocross and NASCAR.

With this acquisition, we now diversify our company across two strong brands. This will allow us to grow our business, while minimizing the risk of over saturating the market with any one brand. Electric is in its infancy compared to its potential and we believe that by leveraging Volcom’s expertise and resources, it can growth into a major player in action sports and add significant growth and bottom line earnings to our company.

We look forward to reporting progress on the integration and more specific growth initiatives on future calls. In terms of additional acquisitions, we have a lot on our plate right now, integrating Electric into the Volcom family, but we would consider other opportunities if the culture, product, growth strategy and timing fit our parameters.

In summery, I believe there is an ample amount of opportunity for Volcom, especially now as we are becoming a truly global company. However, there is no denying the tough economic environment we are experiencing creates a challenging time for retailers and manufactures alike. But while this economic slowdown may temporarily restrain our numbers, I believe that the overall health of the company and the power of the brand is very strong. Our foundation is solid and we have many seeds planted for future growth.

As I've outlined today, we believe that focusing on a diversifying growth strategy is not only good for our long-term sustainability and shareholder value, but will also help us weather this tough environment and emerge stronger than ever when this climate changes.

As always, I'd like to thank the entire Volcom family, our athletes, retailers and shareholders for their continued support and commitment to the brand. And now, I'd like to turn the call over to our CFO, Doug Collier, to review our financial results for the quarter and provide some guidance for the 2008 first quarter and full year, Doug?

Doug Collier

Thanks Richard and good afternoon everyone. As Richard mentioned, Volcom operated in a challenging retail environment in the latter part of 2007. Despite that challenging environment for the year, we were able to achieve 31% revenue growth, solid profitability, maintain a strong balance sheet and generate cash. Also, these results were achieved while we financed the establishment of our new European operation.

While our results of the year were below our initial expectations we believe that this was due primary to the soft retail environment. Volcom remains one of the hottest brands in the thriving action sports sector. Now I’ll go through some details for the fourth quarter.

For the fourth quarter ended December 31st 2007, total consolidated revenue increased 22% to $69.1 million, compared with $56.6 million in the fourth quarter of 2006. Now that our operation in Europe has been established, we will break out revenue detail for both our US segment and our Europe segment. Please note that the US segment includes revenue from Canada, Japan and most other territories outside Europe, as well as our retail operation. Also, for the Europe segment comparisons to the prior year are not useful, as this segment did not began full operation until Q3 of 2007.

First let’s look at some details for the US segment revenue. Total revenue including royalties from our US segment increased 8% at $58.9 million, compared with $54.6 million in Q4 of 2006. In the US segment, product revenue increased 9% at $58.1 million The PacSun, our largest customer, which decreased 15% is excluded. US segment product revenue increased 20%. Also in the US segment, royalty income decreased 34% to $717, 000. This decrease in royalty income was due to our taking direct control of the brand in Europe and the related termination of the prior license agreement.

A breakdown of the US segment product revenue in Q4 by category is as follows. Our Men's product revenue increased 17%, at $32.1 million for Q4, compared with $27.5 million for the fourth quarter of 2006. Revenue from our Girl’s product decreased 11% to $16.5 million versus $18.6 million in the fourth quarter of '06. The decrease in Girl’s revenue was due to a difficult comp and a changing environment with PacSun.

In Q4 of 2006, we recorded revenue of $7.3 million, our largest quarter ever for Girl’s revenue of PacSun. Excluding PacSun, our Girl’s business increased 12% in Q4 of 2007. Boy’s revenue, which includes our Kid’s line for boys aged 4 to 7 increased 63% to $5.3 million compared with $3.3 million in 2006. This growth is encouraging and confirms that our recent focus on this category has been effective.

Revenue from our Snow division decreased 33% to $1.4 million for the quarter, down from $2.2 million in Q4 of 2006. The decrease in Snow for Q4 primarily reflects the timing of Snow product shipments. Overall for 2007, revenue from Snow increased 8% to $16.2 million. While this increase was slightly below our initial plan, it is noteworthy that Volcom Snow business increased to year-over-year. This increase was achieved in the difficult snow selling environment, following the terrible snow conditions of the 2006, 2007 snow season.

Revenue from Footwear was $1.1 million for the fourth quarter, down from $1.7 million in Q4 of 2006. This anticipated decrease is primarily due to a shift away from the closed-toe, vulcanized portion of our footwear category. Moving forward, we will be focusing primarily on our sandal and bedroom slipper categories. We are pleased to have gained floor space with these categories, due to our unique product offering and the strong sell-thorough at retail.

Revenue from our new Girl swim line was $1 million for the quarter; we did not recognize any revenue for our Girl swimwear category during the same period in 2006. We continue to be encouraged by the reception of this new category, both by our retailers and end customers.

International product revenue that is reported as part of our US segment, which consist primarily sales in Canada and Japan and does not include licensing revenue, increased 10% to $11.3 million or 19% of our US segment product revenue for the quarter, compared with $10.3 million or 19% for the comparable period in 2006.

Looking at our revenue by distribution channel, revenue from our five largest accounts decreased 6% to $25 million in the fourth quarter, representing 37% of US segment product sales. Revenue from PacSun ,our largest customer, decreased 15% to $14.4 million for the quarter or 21% of US segment product revenue compared with $16.9 million or 31% of our US segment product revenue for the comparable period in 2006.

Excluding PacSun, revenue from our next four largest accounts increased 11% during Q4. For the full year of 2007, revenue from our five largest accounts was approximately flat compared with 2006. Excluding PacSun, revenue from our next four largest accounts increased 13 % in 2007 when compared to 2006.

In Q4, revenue from our other accounts, which represented 49% of total US segment product revenue for the quarter increased 23% to $33.2 million. For the full year of 2007, revenue from these accounts represented 51% of US segment product revenue and increased 26% to $136.2 million. We continue to be encouraged by the strong growth outside our five largest accounts, as they include independent stores that are geographically diverse and tend to cater to influential customers that can drive growth in other distribution channels.

Now let’s look at revenue from the European segments. Product revenue from Europe totaled $10.2 million for the fourth quarter of 2007, a portion of this revenue was due to samples. Please note that the revenue in Europe is seasonal and is concentrated primarily in Q1 and Q3.

In Q4, the Europe segment revenue by category is as follows: Men's was $6.1 million and 60% of Europe's segment revenue. Girl’s was $2.2 million representing 21%, Boy’s was $1.8 million representing 18% and the other product categories made up the remaining 1% of Europe's segment revenue for the quarter.

Turning to gross margin on a consolidated basis, Q4 gross margin as a percentage of total revenues was 43.4%, compared with 47.2% in the same period in 2006. Looking specifically at the US segment, gross margin on product decreased 360 basis points to 43.7% from 47.3% in the Q4 of 2006.

US segment gross margin was adversely affected by the sales to off price channels due to the soft retail environment. During the quarter, we liquidated approximately $6 million of product at or close to our costs. This liquidation was spread across most of our products categories.

In Europe, gross margin was 37.6% reflecting sample costs spread over the expected low revenue base due to the seasonal nature of the European business.

Consolidated selling, general and administrative expenses were $19.3 million for the fourth quarter of 2007, versus $15 million for the same period in 2006. As a percentage of sales consolidated SG&A expense were approximately 27.9% of total revenue for the fourth quarter of 2007, compared with 26.5% for the same period in 2006.

For the US segment Q4 SG&A expenses increased 10% to $15 million from $13.5 million in Q4 of 2006. For the Europe segment, SG&A expenses in Q4 were $4.3 million in 2007, compared to $1.4 million in Q4 of 2006. Please note that during Q4 of 2006, Europe was still on a startup phase. For Q4 of 2007, Europe was a fully operating business.

Consolidated operating income for the fourth quarter decreased 8.3% to $10.7 million, compared with $11.7 million for the same period in 2006. Consolidated operating margin was 15.5% for the quarter, compared with 20.6% in the fourth quarter of 2006. For the US segment, operating income for the fourth quarter decreased 12.7% to $11.1 million compared with $12.8 million for the same period in 2006.

Operating margin was 18.9% for the quarter, compared with 23.4% in the fourth quarter of '06. In Europe, the operating loss for the fourth quarter decreased 59% to 450,000, compared with $1.1 million loss for the same period in '06.

On consolidated basis, the company recorded a provision for income taxes for the fourth quarter of this year using a 38.9% tax rate, resulting in an annual effective rate of 39.4%. Net income for the fourth quarter of 2007 was $7.1 million or $0.29 per diluted share, compared with net of $7.6 million or $0.31 per diluted share in the fourth quarter of 2006.

Turning to the consolidated balance sheet, the company had nearly $93 million in cash, no significant debt and stockholders’ equity of approximately $173 million. Consolidated accounts receivable increased $24.1 million to $58.3 million at the end of the quarter compared with $34.2 million at December 31, 2006.

The consolidated receivable balance at December 31st represents day sales outstanding of 79 days. It should be noted that of the $24.1 million consolidated increase, $15.6 million was an incremental increase related to Europe. Excluding Europe AR increased 26% and days sales outstanding was 66 days.

Consolidated inventory totaled $20.4 million at December 31st, 2007 compared with $13.2 million at December 31st, 2006. The inventory at the end of Q4 includes $6.3 million of incremental inventory related to Europe accounting for most of the consolidated increase. Including Europe, this calculates to an inventory churn rate of 8.2 times per year or once every 44 days. This continues to be well above industry averages.

I’ll now turn to the financial guidance for the first quarter and full year of 2008. In putting forth this guidance, please bear in mind our comment on general caution we are hearing from retailers, given the overall soft retail environment, our estimate that PacSun business will be down approximately 10% for the year, Europe will be fully operational for the entire year versus the second half of 2007 and the contribution of Electric to our 2008 projections.

With this back drop consolidated, 2008 first quarter revenue is expected to be between approximately $69 million and $70 million or an increase of approximately 36% to 38%, this includes anticipated revenue of approximately $43 million to $44 million from the US segment, approximately $21 million from our Europe segment and approximately $5 million from Electric.

In Q1, we expect revenue from PacSun to be down approximately 40% compared to Q1 of 2007. This projected decrease is due primarily to a decrease in the Girl’s business. We project the Girl’s business to decrease significantly, because the timing and seasonality of some orders are not consistent with historical sales. Also, we had some misses on Girl’s product delivered during Q1 of 2007, which we believe resulted in lost business during Q1 of this year.

Additionally, there is pressure on the Girl’s business as PacSun appears to be increasing its focus on private label girl's product. However, we do see the Girl's business picking up in the back half of the year as Volcom historically performs well with programs such as fleece and sweaters. Also, for the remainder of the year, we anticipate that our Men's product will continue to perform at PacSun. So with this in mind, we project that our PacSun revenue will be down approximately 10% for 2008 when compared to 2007.

Also in Q1, we expect Electric to be approximately $0.01 dilutive. In Q1, we project that Electric's operating income will be slightly more than offset by non-cash amortization expense associated with acquired intangible assets, particularly amortization expense related to acquired backlog. EPS for the first quarter of 2008 is anticipated to be between approximately $0.20 and $0.21.

For the full year of 2008, we now project consolidated revenue of approximately $339 million to $344 million. Broken down by business segment, this includes projected revenue of approximately $241 million to $244 million in the US, approximately $70 million to $72 million in Europe, and approximately $28 from Electric. The US segment estimate includes a projected year-over-year revenue decrease of approximately 10% with PacSun.

In 2008, we will incur approximately $2 million of incremental expense as we transition into our new warehouse facility in Irvine, California. Of this incremental amount, approximately $1 million is non-cash depreciation expense of capital equipment that has been purchased and paid in full. We expect to be fully transitioned into our new warehouse by the end of 2008.

At this time, we will close our existing warehouse facility and we project to realize full operational efficiencies. This new warehouse is expected to meet all our domestic warehouse needs for the next 10 years. EPS for the year is expected to be in the range of approximately $1.50 to $1.53. It is anticipated that Electric, on a consolidated basis will be earnings neutral in 2008.

We expect the Q1 and full year 2008 tax rate to be approximately 36.5%. Fully diluted share outstanding for the first quarter and full year 2008 are expected to be approximately $24.5 million. In putting forth this outlook, we want to remind everyone of the complexity of accurately assessing future earnings and revenue growth, given the difficulty in predicting the sales of our products by key retailers, including PacSun, changes in fashion trends and consumer preferences, sourcing costs and general economic conditions.

With that, we'll open the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instruction) Your first question is from Eric Tracy with BB&T Capital Markets.

Eric Tracy - BB&T Capital Markets

Eric, are you there?

Operator

Eric has withdrawn his question. Hold one moment for your next question. The next question is from Jeff Klinefelter from Piper Jaffray.

Jeff Klinefelter - Piper Jaffray

Hi, guys. A couple of questions for you. The first is on Europe and thank you for all the great detail on the call by the way. That's very helpful for modeling. But in terms of the first quarter guidance from Europe; about $21 million, that's comparable, last year it was still a licensed business, but that would be comparable to, would be roughly $15 million, $16 million last year. Is that the kind of increase you're looking for?

Doug Collier

Yeah. I think if you just take that royalty number that we reported for Europe last year to wind up by 6%.

Jeff Klinefelter - Piper Jaffray

Right.

Doug Collier

I think that gives you ….

Jeff Klinefelter - Piper Jaffray

Just over $15 million I think.

Doug Collier

Yeah. So it's not apples-to-apples, but that give us some idea of the growth; but it wasn't in our control back in the Q1 of ‘07.

Jeff Klinefelter - Piper Jaffray

Okay. So that's pretty healthy growth. I mean it is not quite apples-to-apples, but it looks to be pretty strong growth. Can you give us some sense of where that's coming from, is it a particular category, is it particular country, are you getting some new distribution now in the spring? Maybe just a little feedback on both quantitative and qualitative, in terms of what progress you've made with certain customers since you have owned it for half a year?

Richard Woolcott

Hey, Jeff, this is Richard here.

Jeff Klinefelter - Piper Jaffray

Hi, Richard.

Richard Woolcott

Good afternoon. Yeah, with Europe and particularly what you're seeing with the first half of the year, I mean that's mainly due with our spring goods that we're delivering right now and that's with the majority of all our existing retailers and the countries that we're managing 100% under our own umbrella. So there is no big change of distribution. What I feel is that now you've got an operation over there. There is a 100 % focus on Volcom, that's investing in the brand, that's a very incredible team that we've seen, you know how they built up the company over the last year, we've got over 100 people and they are working very well together and executing very well, and we're staying very close to them in terms of how the operation is moving as we go into this New Year.

And so far, so good, and really what we're seeing is just we put that team in place, the product is very strong over there right now, it's being expected, it's got good sell through, we're delivering on-time. I think part of this growth that we are seeing is because of the improved efficiencies, because it's our own operation. And that was really part of our strategy, to get in there and if we can hit the nail on the head, we're going to get organic growth just by doing that and also investing in this territories beginning to do our build-outs as we partner with our distributors and just attacking our existing account base.

Jeff Klinefelter - Piper Jaffray

Okay. So Richard, by controlling your business yourself and maybe improving the efficiency of the selling process, you're finding that your existing base that you had last spring, largely speaking, is just ordering that much more product from you this spring?

Richard Woolcott

Yeah. I think so. I think, by taking advantage of the entire window and the entire delivery day and getting in there early. And managing that reorder business and just having a little more of an infrastructure to support the business.

I mean what we talked about last year was for fall and Holiday, getting it up was -- first just get it up and running and try to build some confidence out there. And we've done that. And now what I think we're seeing that people are going to say, okay, these guys made the transition. This brand is really strong at retail.

Now I feel comfortable investing more in the brand, giving the brand more floor space. And really this is the first time that we've aggressively gone in and said, all right, now it's time to build floor space with our build-outs and this program will happen over a course of time but we are focused on it right now. And I think all of those factors together is why we are seeing an increase in our business.

Jeff Klinefelter - Piper Jaffray

Okay. And a couple other question about Europe. So, in terms of the economic situation and climate, what you can tell from your sales force over there? How would you contrast to the US, are we not hearing about anxiety at this point from the retailers? And secondly in terms of margins, once we get to a true apples-to-apples margin, like for the full '08 and I apologize, if you said this already, but what is the gross margin you're assuming for Europe as opposed to the US for all of '08?

Richard Woolcott

Jeff, I'll jump in with the overall economics over there and then I'll let Doug follow-up on the margin. In terms of the economy, we are starting to hear a little bit of a concern over there, there is a macro concern and I think that this is trickling into the actions sports accounts. But, what we are hearing is, gas prices. We hearing subprime over there. People are a little bit cautious because of the US is in a election year and Europe is being affected by the slowdown here in the US.

I don't think it is bad as what's going on over here. We've got our eyes on it. Right now, we've got our fall and our snow product out on the road with our reps and distributors. And we will, in the next six to eight weeks have a better read of what the retailer is feeling as they are going into their back half of the year.

But so far of what we've seen, there is even pressure on the economy over there. Volcom in particular, is selling very well in the stores and competing well against the other competition. But we have heard, we were starting to hear a little bit of that economic sensitivity and we’ve just got our eyes on it. So that’s kind of a picture, a up to-date picture over there so far.

Doug Collier

Yeah Jeff, this is Doug. And regarding the gross margin I mean, we don’t guide specifically to any margins. We just give revenue and EPS and we try to break that down by each of our segments; but what I can tell you is just looking at the back half of last year it’s a little bit more normalized and has been controlled for a few quarters; the gross margin was a little bit about 51% and I think we mentioned that that we all know that it’s our first time over there and we think we can get a little bit more efficient from that figure; so I think that may be the downside of that and hopefully we can do a little bit better in 08.

Jeff Klinefelter - Piper Jaffray

Okay and just one last thing in terms of the Electric that you have modeled in for ‘08, is there any apparel in that for ‘08 or is that more ‘09?

Richard Woolcott

I would say the apparel that’s going to be under our control but where we can really see gained efficiencies and an increase in sales, that’s more in ’09. Where we are right now is in 08 with Electric is really just rolling up our sleeves with the team and diving in and see where we can immediately add some leverage and some efficiency. So as we go through the process with Electric we'll keep you guys updated on where we are at. But right now, we just brought them in house and we're just kind of starting to get ramped up with how we're going to move forward with them.

Jeff Klinefelter - Piper Jaffray

Okay thanks guys. Good luck.

Doug Collier

Hi thanks Jeff.

Operator

Your next question is from Eric Tracy from BB&T Capital Markets.

Eric Tracy - BB&T Capital Markets

Hi and at this time can you hear me?

Richard Woolcott

Yeah.

Doug Collier

Yes, Eric.

Eric Tracy - BB&T Capital Markets

Fantastic, I have trouble pushing buttons apparently. Again, let me add that I do very much appreciate all other details and in terms of laying out the growth strategy, I thought that was extremely helpful.

Then maybe if we could follow by category, what is taking place. Obviously, the overall macro environment is very weak. But by Men’s and Girl's if we look at the business as sort of ex PacSun, can you provide a little bit of detail on beating Zumiez some of your other key core accounts; how those both in Men’s and Girl’s are performing.

Jason Steris

Hey, Eric. This is Jason, how is it going?

Eric Tracy - BB&T Capital Markets

Fine. How are you?

Jason Steris

I am doing great thanks. So outside of PacSun, you want a little overview on the Men’s and the Girl’s business?

Eric Tracy - BB&T Capital Markets

Yeah, I mean obviously we have heard of PacSun's strategy on the Girl’s side increasing their private label. Then maybe get of sense of beyond what the Girl’s is doing and maybe an update on Men’s as our [channel indicates, things are still quite strong domestically?

Jason Steris

Yeah, absolutely. Well I can tell you on the Junior side of things, specifically with Zumiez, we are their number one brand right now on the Junior side and we are seeing really good sell-through. We had good sell-through for holiday and we are seeing good sell-through for spring. And we had a good year with them and we continue to do good business with that team over there. I see in this category, the strengths would be t-shirts, denim, and fleece; and we are gaining a lot of momentum with our accessories program. So kind of on a chain store level.

And then I think at the core level we still remain to be sort of in the top three brands across the US. But I think something that we have seen a little bit is the Junior’s business maturing at the core level in terms of floor space allocation and it is more about competing for that floor space. And the company with the best products is going to win at that point. And so it is a little more competitive there in terms of the floor space and the growth of the actual division. But I think there is a lot of a potential for us, now we’ve added our swimwear, which has helped round out the program and our teams are focused from designs and sales to compete at the level to maintain and continue to grow that business. So, we continue to invest back into that division

And on the Men's side of things, I can report right now, we probably feel stronger than ever about our product and what we are out there with. Our fall lines had a great reception all the way through SurfExpo, ASR, the trade shows, the report that's are starting to come out from the reps. And in terms of bookings seasonal, that -- we'll know a lot more on our next call when we are close to our order deadline. But, I feel really good about our product mix right now. I know the recent report that just came out, that report had voted us number one in Women's and Men's again and that's at the core level.

So I think overall, the Men's program is really strong, again at the core level, we're doing a lot with the little guy with our Stone Age program. So it's kind of just the general overall of just the Men's and the Junior's. And then on the Boy’s side, which continues to be one of our strongest growing categories, and that's the Men's or at the Boy's and the Kid’s combined. It definitely is one of our fastest growing categories and we continue to see a lot of opportunity there.

Eric Tracy - BB&T Capital Markets

Okay. Thanks. And then Richard, if you could follow-on that, in terms of expanding the distribution with some of these new accounts. Maybe talk about the balance of growing. Is there any chance that you could segment a product, layer in product to those accounts that would be different from some of the core channel? And then secondly on that, just talk about Sports Chalet being the new account and what the opportunity and potential growth is there in the near term?

Richard Woolcott

Let's talk about the product differentiation; I think the biggest one that Jason said is really as we have expanded our distribution, we're really putting a lot of focus back into making sure that our core accounts have got something special that they can have on their own to be able to compete as some of the other bigger retailers maybe move into particular territories and that’s where the Stone Age comes in.

So from a product focus, we're really making sure that we've got special product for that core retailer, so they have the tools to be able to compete as these markets evolve. In terms of some of the other retailers, we do have our SMU team here and we're investing in that team for special makeup's when those requests are coming up from some of these retailers, such as we all know about the SMU programs with PacSun and we've other retailers who would ask for that type of special product too.

So I feel pretty good, I feel in the existing line from a design standpoint, from a price standpoint, I do believe that some of these different distribution tiers can find particular pieces in categories that will work within their segments, then maybe another segment that isn’t working with as much. So I think we've got enough diversification in our product mix and then the second question, you're talking with Sports Chalet. We just opened those 19 doors across all categories and Jason, do you want to give a little bit of color on…

Jason Steris

Yeah we opened Sports Chalet for the fourth quarter of last year and we tested as Richard said all categories and the response over the holiday was good and we're just in the beginning stages of building that account and kind of nurturing the business and figuring out where our strengths are, but overall the initial response and sell through was good. And we are really executed about working them particularly in the outerwear and just with the potential new doors that we could open overtime as well. So primarily, right now, we are in the Southern California 19 doors and that’s going to be a good account for us.

Eric Tracy - BB&T Capital Markets

Okay. And maybe Doug if you could just talk a little bit about the margins obviously pressured at the gross margin, are there levers to be pulled at the SG&A level and how should we think about that particularly given probably still some investments in Europe from an in-store fixturing standpoint?

Doug Collier

Yeah, on the SG&A, I think we are talking about going out into 2008, obviously our domestic and our US segment growth isn’t where we want it to be, and mainly due to the environment. When we look at our SG&A there were some programs that we could cut back on, but there were also growth initiatives that we've proceeded with, things like the warehouse and some of our marketing things. And we’ll continue to keep an eye on those as we go through the year, there is flexibility where things turn worse or whatever we can adjust. But right now we'll still be profitable next year and we'll still be in good shape financially, so we’ve gone ahead with some of those programs.

Eric Tracy - BB&T Capital Markets

Okay, and then just lastly, I will let someone else. In nearly $4 a share in cash, I realize in this environment probably want to keep some in the war chest, but any sort of thoughts on how to best put that to use over the next say 12 to 18 months?

Richard Woolcott

Hey, Eric, this is Richard here.

Eric Tracy - BB&T Capital Markets

Yeah.

Richard Woolcott

Yeah, I think our first use of cash was just recent, in the Electric acquisition and we feel very good about that. We do have additional cash in the war chest right now and I think it's important that we hold on to that right now through these times and also within time, other opportunities could come up that I think could be a great long-term play for the company. So we want to have those resources available to act when opportunity comes up.

So we feel comfortable with it right now and you guys have just heard about our growth strategy and our initiative. And I think with everything that we've laid out from the excitement of the brand, from our new acquisitions and our diversifications I feel really good about us going into '08 and being able to whether the storm that's out there. As we all know, there is an economic environment that is very challenging but we've got a very strategic plan in place and we have a very strong brand. I like having that cash, just in case there are opportunities that come up and things that we need to do to keep us moving forward. So, right now we feel good about, how everything is laid out.

Doug Collier

And just I am sure you know just that, $4 a share that's at December 31, correct. And we've already since then, spent 228 something like that on the Electric acquisition. So, it has come down even since December?

Eric Tracy - BB&T Capital Markets

Fair enough, fair enough. Thanks guys.

Doug Collier

Alright, take care.

Richard Woolcott

Thank you.

Operator

Your next question is from Mitch Kummetz from Robert Baird.

Mitch Kummetz - Robert Baird

I got a number of questions for Doug; I'll try to get through this quickly as possible. Starting with Europe, what where the sales and gross margins in that business in Q4 of '06? I know it's not comparable, but I just want to kind of pull that out of the overall margin?

Doug Collier

Sales where what we said, I mean, its based on -- are you talking our segments?

Mitch Kummetz - Robert Baird

I am talking about the European sales in Q4 '06? I want to see them, maybe like $1 million or 900,000 something like that. I am not talking about what licensing business.

Doug Collier

Yes, about $2 million.

Mitch Kummetz - Robert Baird

$2 million, okay

Doug Collier

Yeah

Mitch Kummetz - Robert Baird

And what was the gross margin on that?

Doug Collier

Gross margin on that was about 16%.

Mitch Kummetz - Robert Baird

16%, okay, that’s just going to help me kind of strip out these numbers. And then European margin, I haven’t had chance to calculate the numbers in the back half of '07, but I want to say that the operating margin was somewhere around kind of mid-twenties. Does that sound about right, I think you said the gross margin was 51%?

Doug Collier

Yeah, that sounds about right, but I haven’t calculated that, so don’t hold me to that.

Mitch Kummetz - Robert Baird

Let me ask as you think about that business in '08. I know you had mentioned in response to Jeff’s question that there could be some gross margin opportunity in that business. Would you expect the operating margins to kind of be around the same level for full year '08 that they were in the back half of '07?

Doug Collier

Yeah, we haven’t guided to that specifically Mitch, but it was just more of the question. We did go back and look at specifically with the gross margin and just looking at that being our first two quarters that we're operating we think we can probably do a little bit better this year in '08.

Mitch Kummetz - Robert Baird

On the gross margins.

Doug Collier

Yeah.

Mitch Kummetz - Robert Baird

Okay and the reason I asked the question is because if I think if you assume sort of a low twenties to mid twenties operating margin in the European business, that would suggest that there is some pretty significant deterioration in the operating margin of the US business. I guess I am a having a little bit of a tough time understanding that. I mean, if there is pressure on the operating margin in the US business in a way is it likely to come more in the gross margin, more on the SG&A side as you're not expecting the sales volumes to be up significantly? How should we be thinking about the margin assumptions?

Doug Collier

I think it becomes, and you know really in that US segment where we're not projecting that same growth that we had in the past but we're proceeding with some of our growth initiatives and some spending there. So it's more on our SG&A and then the last would be the growth on the topline.

Mitch Kummetz - Robert Baird

Okay. So more on the SG&A. All right. Let's see, a few more things. On the inventory, it sounded like if you strip out Europe the inventory was sort of flattish. I know you had mentioned that you guys had about $6 million in off price. Are you still sitting on any excess goods? Are you feeling pretty good about where your inventory level is at yearend?

Doug Collier

No, that's a good point. We did make the call in the fourth quarter and got rid of most of it. So we're coming into 2008 looking really clean.

Mitch Kummetz - Robert Baird

Okay. All right. See, a few more things. On the packed outlook for Q1, as you said down 40%. So like it was mostly on the girl side. Could you kind of break out guys, girls in the changes there. I mean is it all girls? I mean is guys, do you expect guys to up or is it, how you do you break it up between guys, girls in Q1.

Jason Steris

Hi, Mitch. How is it going? This is Jason here.

Mitch Kummetz - Robert Baird

Hi, Jason.

Jason Steris

Yeah, the majority of that is in the Girl's business and like Doug had mentioned, there is some seasonality of some of the orders at the timing of historical sales. One thing that we did point out is there is some, there were some styles in '07 of Q1 that where new categories for us into the brand getting involved with PacSun, mostly on likely dresses and some specialty tanks, where we did have some fit issues, which we're calling style messes in terms of just not hitting that customer fit need across the board.

Since then, we have been working much closer with them to fine tune our whole process and making sure our fits are on course with their customer. However, we do believe we'll probably miss some potential business in 2008 just due to that those categories maybe not being as favorable as the PacSun.

Mitch Kummetz - Robert Baird

Okay.

Jason Steris

And then the other part of it was just being another shift in the private label that potentially, could be part of that. That's really hard for us to quantify though.

Mitch Kummetz - Robert Baird

So, it sounds like maybe you guy's flat in the first quarter and all of the hit from the girl's side?

Jason Steris

It's pretty close to that, without kind of breaking it out exactly, I mean it's--

Mitch Kummetz - Robert Baird

And then…

Jason Steris

And then kind of looking at the junior side, though, looking at the back half, we're working really close with the teams right now on our fleeces and our sweaters and our accessory program. And we definitely see Women's business picking up in the back half.

Mitch Kummetz - Robert Baird

Okay. So, I would think that you would expect business for PacSun as a whole to be up in the back half and if you're down 40 in Q1. I am not sure what you are expecting for Q2, but you are expecting to be down 10 for the year. It kind of sounds like you would expect to be up in the back half of that?

Jason Steris

That's about right.

Mitch Kummetz - Robert Baird

Okay. And then real quickly on Electric, could you talk a little bit about what the margins look alike for that business, maybe just an operating margin numbers and then what you might be able to do the margin on that business.

And then maybe a little bit on the seasonality, you are seeing 28 million sales for the year, five for Q1. So obviously Q1 is the small quarter, which is why it's going to be penny dilutive. How should we think about the quarters on Electric, the accretion, dilution on electric for the year, in terms of the quarters and then just kind of the overall margins of that business on annual basis?

Doug Collier

Yeah. Mitch, I think you know where you can get some real good information on that. We filed an 8-K and that's actually got some pro forma adjustments to the nine months numbers from last year. I know some highlights of that. Their gross margins are pretty good. They are about 58%. And then that also shows for the nine months, there is about a $3 million pro forma adjustment with the amortization and interest and things like that. So that gives you some pretty good ideas, maybe to almost annualize that and that can give you a picture of what their margins look like.

Mitch Kummetz - Robert Baird

Okay. All right. That's helpful. Thanks a lot good luck.

Doug Collier

All right. Thank you Mitch.

Jason Steris

Thank you, Mitch.

Operator

Your next question is from Jeff Mintz from Wedbush Morgan.

Jeff Mintz - Wedbush Morgan

Great. Thanks. Doug, just a couple of follow-up questions on the guidance. If I look at it correctly it looks like if I take out Q1, you are looking for a pretty significant growth in earnings at the back three quarters. And I am just wondering is there something unusual going out in the first quarter that's slowing down the earnings? Or is it that there is some expense there or what's happening that's causing the growth to be much more significant in the back three quarters?

Doug Collier

Well, you just got the dynamics of Europe. And Europe, that's primarily a Q1 and a Q3 business, that's going to definitely skew your topline.

Jeff Mintz - Wedbush Morgan

Okay.

Doug Collier

And then we've got the PacSun revenue down in Q1, significantly down, we're expecting approximately 40% so that effects it as well. But the SG&A is actually spread pretty evenly across the year.

Jeff Mintz - Wedbush Morgan

Okay. And does that include the $2 million for the new DC, is that quite evenly spread?

Doug Collier

Pretty much, yes.

Jeff Mintz - Wedbush Morgan

Okay. Great. And then on the Electric visual. Can you talk a little about what the impact of currency could be for that? I know they make their product in Europe and obviously the dollar has been wakening against euro for a while, what’s the impact in and how are you handling that situation?

Doug Collier

Yes, they are definitely exposed to that as they manufacture primarily in Italy for their sunglasses. So that is something we're going to address with them whether or not we choose to hedge or not, whether its something we'll get together and discuss with the that team. The impact we already have and it might make sense to do something like that. Those are the kinds of the resources that we can bring to the table for them. I think they have had, their team has been pretty mean and didn't have - they are more focused on their branding efforts. So it's exactly those kinds of things that we think we can help them out with.

Jeff Mintz - Wedbush Morgan

Okay. And then, finally, this is for Jason. But on the snow business, I mean it looks like you guys had a decent year in a tough environment for snow. Can you talk a little bit about how '08 is starting to shape up, I know that it's just getting started with a early orders, but what are you seeing about potential for '08 with a pretty decent key season in this year?

Jason Steris

Yeah. How is it going Jeff? We've got a fair amount of verbal information coming on the sales meeting, both here in the U.S and in Europe. And then first run of tradeshows through January, get a lot of feedback from our dealers. The majority of the feedback is coming from SIA and the ISPO Show. Order business at those shows is usually talking about our inventories, and our sell through and how the season was and so on and so forth.

And overall, the Volcom brand sold through well. There is not a lot of inventory out there. It was very positive. So we definitely had our fingers crossed going in these trade shows of how the snowfall was going to be. And I think the snowfall, overall, helped out, especially at that tail end of the season and the product sold through.

So that was a positive note and then looking into '08, I think our teams should just hit a home run with the product across the board from the Europe team to our domestic team, the Canada team, Japan. Everyone's very excited about the product, we've got a great featured artist program in there that a lot of our professional athletes actually did the art work on. So that’s just a really exciting product launch coming out right now. And it’s a little too soon to tell exactly what the orders look like or the deadlines in the mid of March, but we are optimistic about the business and overall the tone is really good. So I feel good about the program.

Richard Woolcot

Yeah Jeff, I will be able to give a clear picture on that on the next call. I think, outside of the response from our product, the biggest plus in all this is we're having a great season with snow across country and even in Europe too. So that just builds the confidence back in the retailer's mind as they are looking at these lines right now, trying to make their buys and thank goodness that Mother Nature is cooperating this year and we'll see how it all unfolds. But the momentum is with us far, so we feel good so far.

Jeff Mintz - Wedbush Morgan

Okay, great. Well thanks very much and good luck.

Jason Steris

Thanks, Jeff

Richard Woolcot

Thank you.

Operator

(Operator Instruction) Your next question is from Jeff Van Sinderen with B.Riley.

Jeff Van Sinderen - B.Riley

Good afternoon, I wonder aside from the $2 million that you're investing in the new DC, if you can talk a little bit more about some of those specific investments that you are making to develop the business this year, your thought processes in choosing to make those investments and then I guess, how you expect them to back the business going forward?

Richard Woolcot

Hey Jeff, this is Richard here. Basically if you look at that growth plan that I've laid out, that's the strategy that we have and in that, you've got the investments and I don't want these investments to be perceived like they are greater than what they've been in the past and Doug had mentioned earlier the real issue that we have right now is the domestic business and the growth that we projected for ’08 for the domestic is just lower than what its been, but we felt it important to continue with our initiatives moving forward from an investment standpoint; and when I look through this, there are marketing initiatives in there and also even probably more importantly than anything, making sure that we’ve got the strongest product possible. So we add into our strength and our product teams. So I would say between product and between our marketing initiatives and that’s where you see Volcom investing and that’s for down-lines for the future and I strongly believe when that business turns around in the US market, we’re going to see a lot better balance in the company.

Now as Doug had mentioned earlier too, if we get a month or two down line and the economy worsens and the picture out there gets worse, we're definitely going to adjust to it. In terms of making sure the number one goal right now is to ride through this slow down and keep the ship healthy.

So we might go through this for the next three months. Hopefully the business gets better. We’re going to have a great read on that, on the second half of the next call and if the business doesn’t get better we’re going to adjust accordingly. But so far, I feel very confident in our planned attack and we’re just investing in areas that we need to invest in. So there’s nothing that sticks out, other than what Doug had mentioned with the warehouse. This is just a normal course of business to make sure that we’ve got the best product and the strongest brand possible out there in the market.

Jeff Van Sinderen - B.Riley

Okay that’s good to hear and then I know it’s a small number of units in terms of your company owned stores but can you talk a little about how your company owned stores performed for Holiday, I know that was part of the issue, albeit a small one, and then what your are seeing in your company in stores in early 2008?

Richard Woolcot

Well the store, I think that is a great question because for us it is very interesting for us to have that segment of the business because we can very quickly get a feel of what is going on at retail. Through Holiday, you know Holiday was tough. But still you know the brand performed very well.

We are satisfied with what the company stores are doing especially now as we move in to '08 and it is interesting because just looking at last weekend, I think Friday, Saturday and Sunday saw a little bump in activity overall in the stores, which tells me that as we are moving in to President's day weekend, we are moving in to Easter. Hopefully there is confidence. Hopefully it continues where there is confidence out there with the retailer, as they go out of town and as they are traveling during these holidays.

And I think this is an interesting year because Easter is coming early and I think that is a good thing for us right now, particularly in the economy that we are in. I think it will continue to help move things along as we get in to the second half of the year.

So, so far stores are doing well. I think they are a great indicator for what's going on at retail and they are very productive in terms of marketing and presenting our brand. So, so far so good. We are very happy with our stores.

Jeff Van Sinderen - B.Riley

Good to hear it. Thanks very much and good luck this quarter.

Jason Steris

All right, thanks Jeff.

Richard Woolcot

Thank you.

Operator

At this time there are no further questions.

Richard Woolcot

Okay, well I would like to thank everybody for joining us today on the call and thank you for the support. And we look forward to sitting down with you in a couple of months on the next call. So have a good day. Thank you.

Operator

This concludes today's conference. You may now disconnect.

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Source: Volcom Inc. Q4 2007 Earnings Call Transcript
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