It Is Too Early To Hitch Your Wagon To Quiksilver

| About: Quiksilver, Inc. (ZQK)


Teen retailer Quiksilver has continued to struggle to produce profit growth in FY2014.

The company's poor financial performance has led to a downward trajectory for its stock price.

Relatively low profitability and a leveraged balance sheet makes Quiksilver a risky bet for investors.

Despite worldwide brand name recognition and a global store base, teen-focused retailer Quiksilver (NYSE: ZQK) has had trouble turning its popularity into a stream of growing profits for investors, reporting an 8.7% drop in adjusted operating income in the first six months of FY2014, a performance that has led to weak momentum for its stock price. The company was hurt during the period by a relatively poor sales performance in its Americas segment, which includes the U.S., anecdotally due to the negative effects of a competitive and promotional selling environment, a trend that has also hit the fortunes of competitors, like Tilly's (NASDAQ: TLYS).

On the upside, though, management seems to be on the right path toward creating a more profitable enterprise, having recently embarked on cost savings initiatives that have included reducing its sponsorship/marketing programs and exiting non-core businesses, highlighted by its December 2013 sale of its Mervin snowboard manufacturing unit. So, at its discounted price, is Quiksilver a good bet for investors?

What's the value?

Quiksilver is a major player in the teen retailing sector with a wholesale distribution network of over 100 countries, the byproduct of wide popularity for its trio of action-sports brands, Quiksilver, Roxy, and DC. The company also has a major presence in the retail channel, operating more than 600 stores around the globe, with the majority located in international markets. Quiksilver's significant scale of operations, though, has done little for its profitability lately, as the company has had to support its corporate overhead with a declining annual sales tally, leading to a generally downward trajectory for its adjusted operating profitability.

Case in point was Quiksilver's performance in its latest fiscal year, where it posted a 6.8% top-line decline that was a function of across-the-board sales weakness, led by an 8% decrease for its wholesale segment. While the company's retail segment generated relatively better results, including flat comparable store sales growth, Quiksilver's need to engage in promotions in order to drive overall sales helped lead to an 80 basis point decline in its adjusted operating margin, culminating in a 16.3% drop in operating income. Not surprisingly, Quiksilver's cash flow generation remained at a sub-optimal level during the period, below the level of its spending on capital expenditures, thereby requiring the use of debt financing in order to fund its growth initiatives.

Looking into the crystal ball

The question for investors is whether there is a reasonable likelihood of profit growth in the foreseeable future for Quiksilver, which would underpin a higher market valuation for the company. Unfortunately, while management was initially optimistic about better results in FY2014, no doubt emboldened by an increase in adjusted operating income during the company's fiscal first quarter, its optimism faded after poor results in the fiscal second quarter, highlighted by sales declines across all major geographies and a 33% decrease in adjusted operating income. Quiksilver's gross margin improved during the period compared to the prior year period, thanks to slightly positive comparable store sales growth and better pricing in the retail channel, however it continued to be hurt by sizable sales declines in its wholesale segment, down 15% for the period. The net result for Quiksilver was the aforementioned decline in operating income, a trend that led management to push out the date for delivering on its profit improvement plan to FY2017, clearly a negative for prospective investors.

It's tough all over

Of course, Quiksilver is hardly alone in its current business challenges, as its competitors are almost universally exhibiting similar profit pressures. Fellow action sports-oriented retailer Tilly's has had a similarly disappointing financial performance in FY2014, evidenced by a 6.8% decline in comparable store sales in its latest fiscal quarter, a data point that management blamed on weak customer traffic volumes and a competitive pricing environment. Not surprisingly, the company's lower average store productivity was a drag on its operating profitability, down 260 basis points during the period, helping to produce a 71.8% decrease in operating income. More importantly, Tilly's lower operating profitability led to weakened cash flow generation, putting into question whether management could or should continue expanding its store base at the current double-digit rate of expansion.

Even category standout Urban Outfitters (NASDAQ: URBN) has been revealing some chinks in its armor lately, primarily due to a weak comparable store sales performance at its Urban Outfitters unit, down roughly 10% in its latest fiscal quarter. While Urban Outfitters' Free People apparel brand unit continued to impress during the period, reporting a 21% increase in comparable store sales, the unit's size at approximately 16% of total sales wasn't enough to offset the lower sales tally at the much larger Urban Outfitters unit, which had to engage in promotions in order to move merchandise, helping to propel a 200 basis point decline in the company's overall gross margin. The net result for Urban Outfitters was an 11.9% decline in operating income, a performance that was in line with expectations, but below the double-digit profit growth that the company delivered in the prior year period.

The bottom line

Quiksilver is certainly cheaper than it was at the start of 2014, after losing more than half of its market value. Given management's forecast of a decline in adjusted operating profit for the current fiscal year, though, there seems to be valid justification for the negative price action. Quiksilver certainly has some franchise value, due in part to the staying power of its brands among its target demographic, but it still has significant work to do in order to get its profitability more in line with an industry player like Urban Outfitters that enjoys a double-digit operating margin. As such, prudent investors should take a pass on this teen retailer.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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