MARKET WATCH: Volcom’s Annual Report

Jeff Harbaugh

• March 23 2009
• 1,279 views
• 3 comments

IT’S ALL SO CLEAR

When you read Volcom’s 10K for the year ended December 31, 2008, you know immediately why they are successful. There are no wasted words or unnecessary complexity. There’s a consistent focus that makes their strategy clear and the coordination among the pieces obvious. You know it’s been carefully thought out. Even the Foreign Currency Risk and Derivatives footnote is easy to read. That never happens. Where do they find these lawyers and accountants with literary talent?

My favorite parts are their descriptions of their business and their advertising and promotion.  “We sell to retailers,” they say, “that we believe merchandise our products in an environment that supports and reinforces our brand and that provide a superior in-store experience.”

That seems so obvious that you would think they wouldn’t even have to say it. But consider the power of actually evaluating new and existing retailers on this basis. It would be some work if you really did it- much more than the sentence suggests. But consider how it’s self reinforcing for the brand and helps manage the issue of distribution.

Self reinforcing is a good phrase, and it’s what I see in their description of their advertising and promotion as well. They do all their advertising development and event management internally. They divide the description of advertising and promotion activities into team rider, branded events, print advertisements, music, film, featured artist series, retail (they have 13 full price branded retail stores), the Volcom Pipehouse, and online marketing (they don’t sell directly on their site).

The short descriptions of these activities use various phrases to describe how they promote the brand image in a coordinated way that is consistent with the company’s history and positioning. And I couldn’t help but notice, though they don’t really discuss this, that a number of these activities have the potential, at some point, to be money makers. But for now they are largely meant to “reinforce our brand image and enhance our marketing efforts.”

There’s a consistency of purpose and focus in this document that I don’t often see in a 10K.  It’s so pervasive I don’t think it can be anything but accurate. Think of the management advantage of having everybody who works at the company understanding that purpose and focus. It makes building and running a company much easier.

I know I may be reading too much into a bunch of fine print, but I don’t think so.  It will be interesting to see how Volcom will maintain this focus with further growth.
Numbers

Let’s dispose of the easy stuff first. The balance sheet is solid and has actually strengthened some since December 31, 2007. It includes only about $11 million in intangible assets and goodwill in an asset base of $222 million.  I like to see that.  As a reflection of the economy, as well as of growth, the combined allowance for doubtful accounts and product returns has grown from $2.8 to $7 million. Also related to the balance sheet, Volcom was able to increase its credit line from $20 to $40 million in September of 2008.  There were no borrowings under the facility at the end of the year.

Revenues grew 24.5% to $334 million during the year.  However, $24.2 million came from the Electric acquisition that closed in January of 2008.  European revenues increased from $40 to $73 million as a result of the “…transition of our European operations from a licensee model to a direct control model…”  United States revenues (excluding Electric) grew from $228.5 to $237.1- up 3.8%.

For the first three quarters of the year, revenues were $80, $72, and $112 million respectively.  For the fourth quarter ended December 31, they were $70 million ($69 million for the fourth quarter in the previous year).  Net income for the first three quarters was $9.3, $4.8, and $16.3 million respectively.  In the fourth quarter, Volcom lost $8.7 million.

That fourth quarter loss includes a noncash asset impairment charge of $16.2 million which was included in operating expenses.  “…it was determined that the goodwill and non-amortizing intangible assets associated with the 2008 acquisitions of Electric and Laguna Surf & Sport were impaired, as the carrying amount of the reporting units, including goodwill, exceeded the fair value of the reporting units.”

You’ll notice that these charges, which we are seeing in a lot of companies, are included in operating expenses rather than being shown separately below operating income.  That’s because the tests used in determining the impairment include estimates of future cash flow and current market values.  It may be noncash right now, but it is a measure of reduced future cash flow and earnings which is very real.

Volcom derived 28% of its revenues from its five largest customers in 2008.  That’s down from 33% in 2007 and 44% in 2006.  PacSun represented 16% of revenues in 2008, down from 18% the previous year and 26% the year before that.  Some of the decline in concentration is driven by the Electric acquisition and taking over its European distribution.  Volcom expects the decline to continue.

Gross profit margin improved from 48.4% to 48.8% for the year.  It was 44.4% during the fourth quarter.  Product gross margin (ignoring royalties as part of revenue) increased from 47.7% to 48.4%.    In the U.S., overall gross margin decreased to 46.0% from 48.3% the previous year “…primarily due to additional discounts that we believe were the result of the soft domestic retail environment.”

Margins in Europe were 55.6% “…due to strong full-price sell through and foreign currency gains during 2008.”  They warn that they may have to offer more discounts if “…the current economic downturn persists or worsens in 2009.”

Operating expenses increased 62.1% to $129 million.  The increase included the $16.2 million noncash impairment charge referred to earlier.  Ignoring that charge they were up 41.6% to $112.5 million.  Of the remaining increase, $8.0 million was the result of the going direct in Europe, and $14.7 million were Electric expenses.  Without the impairment charge, operating expenses as a percent of sales grew from 29.6% to 33.6% of sales.

As a result, operating income fell 32.1% to $34.4 million and net income was down 34.9% to $21.7 million from $33.3 million the previous year.

Here’s the link to the complete filing. I want to suggest you go take a look at Volcom’s risk factors starting on page 14. Their risk factors are neither unusual nor unexpected.  But a number of them relate directly to current economic circumstances and the potential for problems arising from protectionism, disruption of production in China, and the impact of the recession. You will see lots of similar statements from other companies, but often not so well written and easy to understand.

Volcom has a strong balance sheet and a good market position, but has been impacted by the recession.

Damn, I’m saying that a lot lately.

Jeff Harbaugh is a consultant for the action sports industry and works with companies to identify and focus on critical business issues and opportunities fundamental to the bottom line. For more information, visit www.jeffharbaugh.com.