January 07, 2014 - 1:44am EST by
2014 2015
Price: 8.57 EPS -$1.43 n.m.
Shares Out. (in M): 194 P/E n.m. n.m.
Market Cap (in $M): 1,663 P/FCF n.m. n.m.
Net Debt (in $M): 774 EBIT 51 0
TEV ($): 2,437 TEV/EBIT 48.2x n.m.
Borrow Cost: NA

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Short - Quiksilver (ZQK)

Link to version with charts and financials -https://drive.google.com/file/d/0ByBNCkJEkQSDbzBZOS1HQ1dSTFE/edit?usp=sharing


Business overview: distributor of branded apparel, footwear, accessories and other related products. 97% of the company’s revenues are derived from the brands Quiksilver, Roxy and DC Shoes.

Valuation: the company’s valuation already incorporates a flawless execution of the recently announced Profit Improvement Plan (“PIP”).  Trading at 25x LTM PF Adj. EBITDA (and ~9.0x the management turnaround Upside Case), there is a great deal of downside risk underappreciated by the market, especially for a company that has 6.6x Net Debt / LTM Financing EBITDA (w/ stock-based comp and restructuring add-backs).  For comparison, Billabong currently trades at 6.5x forward TEV/ EBITDA. 

Investment thesis: the company is facing a secular decline in action sports participation (its core market), as well as competition from emerging brands and private label.  In addition the company earns unexciting returns on invested capital (negative incremental ROICS over last six years), but has never paid a dividend or repurchased shares and has no plans to initiate either in the near future. 

Additional catalysts: missed sell-side analysts’ topline estimates in each of the last 7 quarters.  The company has also missed PF Adj. EBITDA estimates in the majority of the trailing 8 quarters (which is surprising, since the company’s PF Adjusted EBITDA contains subjective restructuring add-backs). Without the restructuring add-backs, the company would have missed EBITDA estimates in 7 of the last 8 quarters.  With sell-side analysts still optimistic about the company’s turnaround, continued retail weakness may result in additional earnings misses.

Price target: assuming the management team can stabilize revenue (-10.1% in FY ’13), achieve an 11% EBITDA margin (5.6% average ’12 and ’13), and applying a 9x EBITDA multiple (high end of historical range), the company would be valued at ~$5.25 per share (-39% from current).

Company Overview

Quiksilver (“ZQK”) designs, develops and distributes branded apparel, footwear, accessories and other related products associated with action sports.  The company’s three core brands, Quiksilver (40% of FY ’13 sales), Roxy (28% of FY ’13 sales) and DC (30% of FY ’13 sales) are deeply rooted in the culture of surfing, skateboarding and snowboarding.  The company’s products are sold in over 100 countries through a range of distribution points (including wholesale accounts (~71%), retail (i.e., Quiksilver stores; ~25%), and e-commerce (~4%).  The company’s products are distributed through active lifestyle specialty chains (Zumiez, Tilly’s, Famous Footwear, PacSun, Go Sport, etc.), department stores (Macy’s, Kohl’s, etc.), and small, independent surf and skate shops.  As of October 31, 2013, the company owned 631 retail stores (Boardriders Club, Quiksilver, Roxy and DC) in various markets and had licensed 243 stores to independent retailers (total of 874 locations). In FY 2013, ZQK generated $1.8bn of sales and $96mm of Pro Forma Adjusted EBITDA (adding back one-time restructuring costs).    

Thesis Summary

ZQK has not turned a profit since 2008, trades at 25x LTM PF Adj. EBITDA (and ~15x a very optimistic 2014 sell-side analyst consensus estimate), and has experienced alarming gross margin degradation and sales declines since 2012.  The company has never paid a dividend or repurchased shares and has been free cash flow negative since 2012.  Even giving management credit for the Profit Improvement Plan (long-term EBITDA margin target of 13%), the company still appears expensive.  I believe that a more reasonable valuation, still giving management credit for a turnaround, would be ~$5 per share (decline of ~40%).  Since peaking in 2006 at ~$17.50, the stock has languished.  In early 2013, CEO and co-founder, Bob McKnight, stepped down and was replaced by Andy Mooney, the former chairman of Disney Consumer Products.  Prior to spending 11 years at Disney, Mooney was at Nike for two decades running various apparel and equipment businesses.  Although the company’s prospects certainly appear brighter under Mooney’s leadership, the company is priced for perfection.  Current valuation is only justified if Mooney and his team can execute flawlessly.  If there are any hiccups in executing the Profit Improvement Plan, the stock will decline significantly.  During the mid-2000s (pre-crisis), ZQK traded at an average forward P/E of ~16x (while growing revenue and profitability). Applying a 16.0x (9.3x TEV / EBITDA) multiple to my estimate of “normalized” upside earnings of $0.50 per share, you arrive at a price of $7.93 (decline of ~7%).  If you only give management credit for right-sizing the cost structure (doubling EBITDA margin to 11%) and stabilizing sales, you arrive at an EPS of $0.30 per share.  Applying a 9.0x EBITDA multiple (~18.0x P/E), you arrive at a price of $5.25 (decline of ~39%).   

Action Sports Apparel Industry

Skateboarding culture is in secular decline.  Since peaking in 2002, the number of active skateboarders has declined by a third (see below a link to an excellent summary report published by the FT in August 2012). 


Using Google Trends analysis, it’s clear that interest in skateboarding has declined dramatically both globally and within its four major strongholds (Australia, Canada, US and UK).  Based on the Google Trends search topic “Skateboarding” (which includes all search terms related to skateboarding such as “skateboard”, “Tony Hawk”, etc.), interest as of December 2013 is approximately 25-30% of the level in January 2004.  The graph below charts the interest in ZQK’s major action sports since 2004 (when Google Analytics started aggregating data).  Note that “Skateboarding” is a Google Topic, which is currently a beta feature that accurately measures overall search interest by including related search terms.  “Snowboarding” and “Surfing” were unavailable as Google Topics, so only the search terms are presented below. Not surprisingly, the action sports industry is highly correlated.  According to the Google Trends data, the correlation coefficient between interest in Skateboarding and Surfing is 0.95 and the correlation between Skateboarding and Snowboarding is 0.96 (after adjusting for seasonality).

 [see link at top for PDF]

An analysis of ZQK’s major brands (“Quiksilver”, “Roxy” and “DC Shoes”) show similar disappointing historical trends (correlation coefficient between Quiksilver and Surfing is 0.83). Not everyone in the action spots industry is facing the same pressure.  Brands such as Vans and Nike SB are rapidly gaining share and the enthusiasm from retail (both in-store and related by major retail managers through earnings calls) is obvious.  According to VF Corp publically disclosed data, Vans sales grew 23% in 2012, 23% in 2011 and 20% in 2010.  YTD 2013 revenue growth for the brand is 18% (compared to DC’s latest quarter of negative 25% revenue growth). Vans are clearly eating into DC’s market share and appear to be the new skateboard shoes of choice.   Skateboarding is not the only action sport facing pressure.  The Denver Business Journal recently reported that the number of new people learning to ski has declined an average of 3% annually for 10 years.  In addition, Snowboarders visited national slopes an average of 7.6 days per season 15 years ago vs. 5.9 days in the 2012-13 season (decline of 22.4%). Finally, the report stated that minority participation in skiing and snowboarding is down in recent years, especially among children, and the income disparity among participants is widening (household participations is increasing for families earning more than $150k and declining in households earning less than $50k). None of these trends bode well for long-term growth in apparel brands associated with action sports.  Although the lifestyle associated with action sports may eventually become detached from the sports themselves (and to a degree it already has), it is not necessarily beneficial to the brands that were originally perceived as stewards of the sports.  Without that attachment, a window of opportunity opens for emerging brands with limited or no association with action sports per se, but a strong association with the lifestyle.  At the risk of sounding too philosophical, it’s unclear what competitive advantage a skateboard brand (DC) has versus a lifestyle brand (Vans) that more accurately captures the West Coast zeitgeist of the 2010s. 

Recent Performance

The company’s recent quarterly financials are presented below.  Note how the company was able to grow sales in 2012 by heavily discounting their merchandise (2012 GM% degradation of ~370bps YoY).  In 2013, the company tried to hold the line on price, with the result of significant sales declines. My channel checks (unscientific and anecdotal) seem to indicate heavy promotional activity in Q1 ’14 with many locations offering large store-wide merchandise discounts.  This is in-line with commentary from retailers that have stated this season is likely to be particularly competitive and promotional.  Also note the higher inventory days.  Despite making progress reducing “aged” inventory from ~15% to ~6% of total inventory, there still looks to be room for improvement in reducing overall inventory levels.

      FY 2012 FY 2013
      Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
      Jan '12 Apr '12 Jul '12 Oct '12 Jan '13 Apr '13 Jul '13 Oct '13
Total Revenues          $ 449.6        $ 492.2        $ 512.4        $ 529.2        $ 431.0        $ 458.7        $ 495.8        $ 475.9
% Change YoY            5.4%          3.0%          1.8%        (2.9%)        (4.1%)        (6.8%)        (3.3%)      (10.1%)
Constant Currency Rev. Growth                
Quiksilver                  n/a            4.0%           3.5%         (5.0%)         (7.0%)       (10.0%)       (10.0%)                 -
Roxy                  n/a            5.0%           4.6%           2.0%         (7.0%)         (4.0%)           1.0%                 -
DC                  n/a          13.0%         15.5%         18.0%
          1.0%         (1.0%)       (25.0%)
Total               6.0%           5.0%           8.0%           3.0%         (3.0%)         (5.0%)         (3.0%)         (9.0%)
Gross Margin %  
        49.2%         49.5%         45.6%         51.0%         46.0%         49.4%         47.0%
YoY Change   -170 bps -560 bps -119 bps -640 bps 30 bps -320 bps -10 bps 140 bps
Days Inventory            171.1          129.2          138.9          104.4
         131.7          146.3          123.2
Change YoY             30.8             9.9             3.7         (17.8)           11.4             2.5             7.4           18.8
Management PF Adj. EBITDA         $ 20.1         $ 41.2         $ 51.6         $ 32.4         $ 13.3         $ 18.9         $ 55.6         $ 35.3
SG&A            $ 230.4        $ 224.0        $ 225.8        $ 227.4        $ 225.3        $ 218.2        $ 216.6        $ 220.4
Less: Restructuring Charges            (2.5)            (3.6)            (4.3)            (1.7)            (3.0)            (6.8)           (13.3)           (12.5)
Adjusted SG&A          $ 227.9        $ 220.4        $ 221.5        $ 225.6        $ 222.3        $ 211.4        $ 203.3        $ 207.9
YoY Change              15.4
            0.3         (14.3)           (5.7)           (9.1)
% of Sales            50.7%        44.8%        43.2%        42.6%        51.6%        46.1%        41.0%        43.7%

Summary Financial Information

[see link at top for PDF]

Since 2008, ZQK has earned an average ROIC of 10.8% (1.5% in 2013).  However, returns on incremental capital have been very disappointing.   Since ’08, ZQK has invested approximately $400mm in capital expenditures.  During this same time period, sales declined by ~$450mm (and management’s adjusted EBITDA by over $150mm). Regarding regional sales and profitability, the Americas has experienced a -3.4% ’08-’13 revenue CAGR (’13 revenue of $893mm; -10% YoY; 42% GM%), EMEA has experienced a -7.5% ’08-’13 revenue CAGR ($632mm; -11% YoY, 57% GM%) and Asia Pacific has experienced a 1.3% ’08-‘13 revenue CAGR ($282mm; -8% YoY; 51% GM%).  It is concerning that the region that has performed worst (EMEA) is also the highest margin segment, blending overall gross margin down. 

Multi-Year Profit Improvement Plan

In May 2013, the company announced a multi-year Profit Improvement Plan (“PIP”), designed to accelerate growth and operational efficiencies. The plan has a focus of prioritizing the three core brands, globalizing key functions and reducing cost structure. The company expects when the PIP is fully implemented by the end of fiscal 2016, Adjusted EBITDA will be improved by approximately $150mm over fiscal 2012 Adjusted EBITDA (i.e., ~$250-300mm).  Half of this gain is expected to come from supply chain optimization and the rest from corporate overhead reductions, licensing opportunities and improved pricing management, along with modest net revenue growth compared to fiscal 2012 results.  The plan calls for net annual revenue growth of 2.5% and pro forma adjusted EBITDA margins of at least 13%.  Components of the PIP include centralizing global responsibilities for key functions, reprioritizing marketing spend to in-store and print marketing, closing underperforming retail stores, supply chain optimization, reducing SKUs by 30-40%, divesting certain non-core brands, and clarifying the position of the three flagship brands (i.e., discontinuing Quiksilver women’s product line).  Part of the reprioritization of marketing spend is cutting athletic sponsorships and allocating the marketing savings toward “demand creation.” Management has stated they have already exited or canceled “most event sponsorships” and released a “significant number of sponsored athletes” (100+).  Over time, the company expects to further reduce the number of sponsored athletes and events.  The marketing savings would be redeployed into permanent and seasonal in-store display, print advertising and social media.  In addition, a major focus of the PIP is to change the structure of the ZQK organization, from three regional teams doing work in isolation (i.e., creating product catalogs in each region that are different from the ground up) to a global team that does work in one region and pushes the product out to the other two regions (two design hubs – Huntington Beach, CA and Biarritz, France).  Moving forward, the company expects to reduce SKU count by 30-40%.

Although in theory, these strategies seem reasonable, there is considerable execution risk that the market may be missing.  Recall JCP and the troubles they encountered when they tried to change the company’s DNA.  Turnarounds are extremely difficult and there is limited evidence to-date that ZQK’s will be successful.  Notwithstanding, sell-side analysts have lavished praise on ZQK management for the turnaround, despite the fact that the costs coming out of the business are barely enough to keep pace with the operational deleveraging.  In the company’s Q1 2013 earnings call, ZQK management stated they expected FY 2013 SG&A as a % of sales to decline by 150bps from the 2012 level.  In reality, it came in 20bps higher (after removing one-time restructuring charges; inclusive of those charges SG&A was 190bps higher).  The ERP system for the Americas was implemented late in 2012, and the European ERP system was implemented mid-2013, so the vast majority of the ERP savings are already being captured (Asia is scheduled for spring 2014, but only represents ~15% of revenue).  It is important to note, however, that some of the improvements such as vendor aggregation (from 630 to 200), style rationalization, and marketing reallocation won’t be felt until spring or fall of 2014, at which point there should be an improvement in the top line.   I personally think the PIP will be modestly successful.  Andy Mooney and his team are clearly very talented managers and much of what they are doing on the SG&A front is already bearing fruit.  In my opinion, it’s not a question of if there will be an improvement, but rather to what degree.  The market seems to believe that the PIP’s goals are conservative (vs. my assessment as aggressive).

This is not the first profit improvement plan in ZQK history.  The previous CEO, Bob McKnight initiated a similar, more ambitious plan to increase revenues ~50% to $3bn within 5-years (announced in 2010) and increase EBITDA to $350-400mm.  Despite the plan’s disappointing results, McKnight was able to get the ball rolling on some cost-cutting measures and the new SAP system (implemented in 2013).  On the Q4 2012 conference call, McKnight announced, “in the third quarter of this year [2012], we reduced staff, which resulted in significant savings to SG&A in the fourth quarter [quarter ending Oct. 31, 2012].  Also in the fourth quarter, we closed several underperforming retail locations… we are looking to improve efficiencies and streamline processes and procedures.  To that end, we recently completed the rollout of our new ERP system in North America and expect Europe to be fully up and running by the summer. We have begun the planning process for implementing the ERP system in Asia Pacific.  In addition, we are in the process of globalizing our design and development function and strengthening our global supply chain team.”  Although investors tend to get very excited about turnaround plans, the reality is that this is not the first time ZQK has attempted one of these. 

What Retail is Saying

If you walk into a PacSun or a Zumiez (or visit their websites) and ask the employees about what is selling, they will direct you to several emerging brands.  Although this is obviously anecdotal, channel checks suggest that in both the footwear and apparel categories, the customer is moving away from the traditional skate brands and toward trendier, newer brands.  Both Nike SB and Vans have been crushing DC Shoes (-25% sales growth YoY in latest quarter).  And in apparel, a shift toward emerging brands (i.e., Diamond Supply Co.) and private label has been hurting Quiksilver and Roxy.  See below commentary from retailers’ recent earnings calls.


Pacific Sunwear (PSUN), a major action sports apparel retailer, continues to emphasize the company’s new strategy which is to push emerging brands.

 “In our Men’s business, emerging brands, footwear and accessories continued to perform well, yet we ended up just short of a flat comp at a minus 1% for the third quarter.. overall, I continue to believe that our Men’s assortment continues to strengthen, led by a number of great brands in apparel, footwear and accessories.. Brands continue to be at the forefront. And when I walk into our stores and see the brands in the Men’s side of our business, from Nike SB to Hurley, RVCA, Vans, Diamond Supply Co., Crooks and Castles, Been Trill, Modern Amusement, Neff, Volcom, Young & Reckless, I think it gives us a very unique and compelling assortment.”  - PSUN Q3 2013 (December 5, 2013)

Notice that the Quiksilver brand was conspicuously absent in that statement.  Later in the conference call, Schoenfeld (PSUN’s CEO), is asked how footwear is trending.

“So we continue to be really pleased with our Men’s footwear.  Really, Vans and Nike together continuing to just drive that category for us. And I think it anchors the store appropriately, the customer loves it, and I continue to be pleased with the number of exciting initiatives that we’re doing with both of those brands.”  - PSUN Q4 2012 (March 20, 2013)

 “So we don’t break out specific brand performance. I think the most significant trend that continues – that we’ve alluded to before and again is the distinction of new emerging brands and our footwear brands led by Nike and Vans, really driving the growth in our Men’s business and the mix of heritage brands that were the drivers of our business when I got here three years ago, that has changed in a pretty profound way.  I think that if I were to look at our top 10 brands three years ago versus today, I think that out of the top 10 at that time, Hurley and Volcom would continue to be top 10 brands as we look ahead to 2013.  But those would probably be the only two that would make the top 10 in 2013 from that list back in ’09.  And conversely, you’re seeing a new group of brands plus Nike and Vans really drive the Men’s business going forward.”  - PSUN Q4 2012 (March 20, 2013)

Regarding the Women’s business, Shoenfeld does mention that Roxy and Billabong continue to have a presence, but emphasizes that brand is not as important on the Women’s side – style and fashion being a more important selling point. He also mentions that there is increasingly a crossover of emerging Men’s brands into Women’s.

Zumiez (ZUMZ)

Zumiez (ZUMZ), another action sports apparel retailer, discusses fast fashion.

“I think that while fast fashion is still huge and driving a lot of volume, I think there is a trend back towards young women wanting to see more brands, perhaps better quality, in some of the clothing that they wish to purchase.” - ZUMZ Q2 2013 (September 5, 2013)

“I mean, we’re thinking about the way we can communicate with our customer to try to present to them with unique products that are – will entice them to come in and purchase… I think it’s kind of young men tend to buy, which is still the predominant piece of our business, tend to buy based on need.  And I don’t think there is a lot of unique fashion for young men right at this point in time and while we have a lot of brands that we’re very excited about, up-and-coming brands that we see great opportunity with and some well-established brands that continue to perform well, there just hasn’t been a lot of newness in that side of the business. - ZUMZ Q2 2013 (September 5, 2013)

Zumiez emphasizes the shift away from established brands toward emerging:

“Well, and I guess I’d challenge you to find much product in our store that is from those large, well-established action sports brands.  In most cases, we move beyond them pretty significantly.  So you won’t find a very big presentation, if any, at all. - ZUMZ Q1 2013 (May 23, 2013)


Tilly’s (TLYS), an action sports apparel retailer describes their dynamic merchandising model and the importance of bringing in new brands.  The company also mentions in their Q2 ’13 earnings call (not posted below) that they are moving toward a broader assortment and broader brands (which is the opposite strategy espoused by ZQK, which is curtailing assortment by 40%).

“Yes. And so it’s the term we use [dynamic merchandising] and probably I use it a little too much, but it is the best way to describe the process that happens throughout the entire merchandising and planning and allocation organizations around bringing in newness from hundreds of brands we have a strong relationship with brands that we've grown up with, located in -- 90% of them are located in Southern California. It's the epicenter of the action sports industry. We've grown up together with these brands and our destination that brands who want to break on to scene want to come and be a part of Tilly’s experience and growth. We leverage those relationships that are built out of executing the business in an incredibly quality way with great deal of respect for the brands and for our own brand.  That is then led to incredible partnerships that leads to our ability to be very flexible with what we offer and then how quickly we can react to at the style level react to things that are happening and then connecting the dots and saying, "Wow, we're seeing this trend emerge from multiple brands, now we can maybe exploit and expand that trend even further with our own proprietary product that we source in also a very short lead time," and then make sure that supports at various price points and styles and colors trends that emerge through this compelling branded offering.”  - TLYS GS Global Retail Conference (September 11, 2013)

My Own Observations

After visiting a handful of specialty retail locations in multiple geographies, my own research seems to verify what the managers stated above (granted, this is anecdotal and not statistically significant).  By and large, the three major action sports apparel retailers (Pac Sun, Zumiez and Tilly’s) that I visited carried very little ZQK inventory.  Roxy was the most prevalent, followed by DC; I saw virtually no Quiksilver.  Employees consistently stated that emerging / non-heritage brands (Diamond Supply Co., Asphalt Yacht Club, Crooks & Castles, etc.) were what customers came in asking for and what sports participants were wearing.  With regards to skate shoes, there was very little DC inventory at any of the locations I visited.  In fact, at the MoA Pac Sun location, the only brands available were Vans and Nike SB.  The store manager stated the MoA store stopped carrying the brand before Black Friday (“Pac Sun is moving in a more progressive direction” he stated), but noted that the store often participated in experiments before corporate pushed the strategy out to all locations. A visit to the Pac Sun website seems to corroborate this trend, with availability of DC men’s shoes at only 4 SKUs vs. 59 for Nike SB and 42 for Vans.  I’ve visited enough stores to be fairly confident that ZQK’s brands are in rough shape (at least in the Americas). 

Share Count Misunderstood

One final point to flag before diving into valuation is the share count.  It appears that most sell-side analysts are not correctly calculating fully-diluted shares.  Since the effect of including additional shares issued in relation to stock options, RSUs and warrants would be “anti-dilutive” when the company has negative net income (i.e., lower the net loss per share), for GAAP purposes, they are excluded.  However, based on where ZQK is trading today (~$8.60 per share), these options and warrants are very much in the money and the effective market cap of the company is significantly higher than what is implied in sell-side research and CapIQ. Based on my calculation and application of the treasury stock method, the correct share count should be ~194mm (vs. ~170mm in virtually all sell-side research).  The most significant piece missing is the 25.7mm warrants issued to Rhone Capital (in exchange for a term loan guarantee in July of 2009) at an exercise price of $1.86 (net 20.1mm additional shares at today’s stock price).  One way to sense check this assumption is to look at the company’s Q3 ’13 10-Q, which presented the true diluted share count figure (190.6mm) due to positive net income.  The difference between the company’s share count and my share count is a combination of including only exercisable vs. issued (I assume all time-vested options vest) and a lower share price for purposes of the treasury stock method.  The Rhone Capital warrants expire on July 31, 2016, so the exercise of the warrants is unlikely to be a near-term catalyst.  That said, sell-side research analysts may soon wake up to the fact the warrants are deep in-the-money and reduce their EPS forecast accordingly.  Furthermore, if the turnaround is successful, the performance RSUs will vest, creating an additional ~11.7mm shares (plus ~20mm new shares from the Rhone warrants).  In the table below, I summarized the impact on consensus EPS, assuming the company earns consensus net income (which I believe to be optimistic).  The share count presented below in the upside case assumes i) all performance units vest and ii) treasury stock method at $8.57 per share.

  2014E 2015E
Consensus Net Income $22.2 $53.9
EPS Normalized $0.13 $0.30
Consensus Share Count - Normalized 170.8 179.6
My Share Count Estimate (Upside Case) 194.0 206.0
Implied Normalized EPS $0.11 $0.26
Delta vs. Consensus (12.0%) (12.8%)

In the upside case [see PDF], I assume that the performance-related restricted stock units and stock options issued to Mooney and his team vest (triggered upon stock price reaching $12.50 per share for 30-consecutive days).  Although I’m skeptical that level can be sustained long-term, I would not be shocked if short-term momentum were to take the price there long enough for the units to vest (assuming successful execution of upside case). As an example, one prominent sell-side analyst that currently has a $10 price target and Outperform rating on the stock stated that the methodology he used was to apply a 14x multiple to 2017 EPS (he used a 170mm share count) and discount back at a rate of 9%.  Correcting for the share count (~206mm shares in 2017) and using the same methodology, his new price target would be ~$6. 


Although the business has been under pressure the last two years, I am optimistic that there will be some semblance of a turnaround.  However, I remain unexcited about the industry and after the initial rebound, it is unlikely this company will trade at a premium multiple given its volatility and lackluster long-term growth prospects.  I think a reasonably underwritten case would be stabilization of revenue and a normalization of the EBITDA margin to something closer to the long-term rate.  Although it’s unclear exactly what portion of the EBITDA margin recovery will result from gross margin expansion (target >50% vs. 48% in FY’13) vs. SG&A optimization (targeting low 40% vs. 47% in FY’13), I think it’s reasonable to assume significant future cost savings.  The upside case reflects successful execution of the PIP with a significant revenue uplift.  The downside case reflects a disappointing execution of the PIP with EBITDA margin recovery to 9% (still a significant uplift from ‘12/’13 average of 5.6%) with continued decline in revenue, perhaps reflecting one of the two following outcomes i) products designed in one region (i.e., Americas) are rejected by consumers in another region (i.e., Asia) whereas before the PIP, each region more or less designed its own product catalog or ii) due to the reduced SKU count, the wholesale channel orders fewer items, emphasizing assortment and style diversity.  Simply optimizing the corporate organizational structure and materially reducing SKU count doesn’t necessarily mean customers will embrace the result.

[See PDF for Upside and Downside Cases]

Base Case

  • 2015 Revenue - $1,811mm (stabilized at 2013 level)
  • 2015 EBITDA margin % - 11% (vs.5.6% '12-'13 avg.)
  • 2015 EBITDA - $199mm (stabilized)
  • Less: D&A - 50mm (2013 level)
  • Less: Interest Expenses - 73mm (run-rate 2014)
  • EBT - 77mm
  • Less: Taxes @ 25% - 19mm (lower effective tax rate due to intl. mix)
  • Net Income - $54mm
  • FD Shares Outstanding - 194.0mm
  • Base Case EPS - $0.30
  • Current Price per Share - $8.57
  • Normalized P/E Ratio - 29.0x
  • TEV / EBITDA - 12.2x
Target TEV / EBITDA - 9.0x (based on high end of historical trading range)
Implied P/E - 17.8x
Target TEV: $1,793mm
Less: Net Debt $774mm
Equity Value: $1,019mm
Implied Price per Share: $5.25 (-38% from current)  


Earnings Surprises

Below I’ve summarized the company’s earnings surprises for the trailing eight quarters.  Although the fundamentals have continued to deteriorate, the stock has risen ~300% from its low of $2.20 reached in July of 2012, indicating that price action has been driven by rising expectations rather than improving fundamentals.  Note that the company may have already reached the inflection point on EBITDA improvement, with ’13 Q3 and Q4 PF Adjusted EBITDA (adding back one-time costs) slightly higher than the previous year.

      Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4    
      Jan '12 Apr '12 Jul '12 Oct '12 Jan '13 Apr '13 Jul '13 Oct '13   Average
Consensus       $ 437.4    $ 495.1    $ 527.2    $ 566.4    $ 465.1    $ 505.4    $ 505.0    $ 508.7    
Actual         $ 449.6    $ 492.2    $ 512.4    $ 529.2    $ 431.0    $ 458.7    $ 495.8    $ 475.9    
Surprise %         2.8%    (0.6%)    (2.8%)    (6.6%)    (7.3%)    (9.2%)    (1.8%)    (6.4%)       (4.0%)
Pro Forma Adj. EBITDA                    
Consensus         $ 18.0     $ 44.8     $ 50.4     $ 59.0     $ 13.5     $ 43.3     $ 42.3     $ 43.4    
Actual           $ 20.1     $ 41.2     $ 51.6     $ 32.4     $ 13.3     $ 18.9     $ 55.6     $ 35.3    
Surprise %       11.6%    (8.1%)      2.3%  (45.1%)    (1.2%)  (56.3%)    31.6%  (18.7%)     (10.5%)
Adjusted EBITDA                      
PF Adj. EBITDA         $ 20.1     $ 41.2     $ 51.6     $ 32.4     $ 13.3     $ 18.9     $ 55.6     $ 35.3    
Remove Mgmt. Add-backs          (2.5)        (3.6)        (4.3)        (1.7)        (3.0)        (6.8)       (13.3)       (12.5)    
Adj. EBITDA         $ 17.6     $ 37.6     $ 47.3     $ 30.7     $ 10.3     $ 12.1     $ 42.3     $ 22.8    
Surprise %   (2.1%) (16.1%) (6.2%) (48.0%) (23.5%) (72.1%) 0.2% (47.6%)     (26.9%)
Average Stock Price         $ 3.55     $ 4.21     $ 2.62     $ 3.19     $ 4.54     $ 6.29     $ 6.91     $ 6.50    
% Increase QoQ   (3.3%) 18.8% (37.7%) 21.6% 42.2% 38.7% 9.7% (5.9%)    

Investment Thesis

  • Secularly Challenged Industry.  Action sports are significantly less popular now than they were in the mid-2000s.  Engagement continues to decline and emerging brands are taking share from incumbents.
  • Valuation. The company trades at a very rich valuation (even giving management credit for the turnaround).  Assuming a successful execution of the PIP, the company still trades at a significant premium to Billabong (~9.0x TEV / Upside Case EBITDA for ZQK vs. 6.5x for Billabong). 
  • Highly Levered.  ZQK currently has 6.6x Net Debt / LTM PF Adjusted EBITDA (adding back SBC and restructuring charges).  Excluding the restructuring add-backs, the company has 9.4x Net Debt / LTM Adjusted EBITDA.  Although I do not anticipate any near-term problems with debt covenants (ZQK does not have maintenance covenants), the interest expense is a major drag on profitability (~$70mm per year).
  • Asymmetrical Return Distribution. With the execution upside already largely priced in, there is an asymmetrical distribution of outcomes with a tail toward the downside if management is unable to meet analysts’ high expectations. 
  • Effective Diluted Share Count Misunderstood.  When the sell-side analysts catch on, they will have to modify their share count upwards to ~190-200mm.  Assuming they hold their target TEV / EBITDA or P/E multiple constant, it would imply a lower share price.
  • Negative Earnings Surprises.  The company has disappointed in the last 7 of 8 quarters on revenue and 5 of the last 8 quarters on EBITDA. 

Investment Risks

  • Management. Andy Mooney and his team are very talented and there is a chance they execute the PIP flawlessly and even exceed expectations.  Notwithstanding, I think that this business will be challenged on the top line for the foreseeable future, simply given more macro trends in the action sports industry.
  • Timing.  The market has been very patient with this company and certainly given the new management team the benefit of the doubt.  Despite habitually missing analyst forecasts, the stock rallied 113% in 2013.  Market psychology is mercurial and there is no telling when it might turn.
  • Action Sports Comeback.  ZQK will benefit if there is an uplift in action sports popularity. However, given the prevalence of cheaper, trendier Vans shoes and fewer snowboarders hitting the slopes each year, it’s hard to envision a scenario with strong industry tailwinds.
  • Acquired by Private Equity.  You never know.  Hot Topic was acquired by Sycamore in 2013 for 8.3x TEV / EBITDA.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.


  • Diluted share count is corrected by sell-side analysts
  • Excitement for new management team wanes 
  • Additional negative earnings surprises
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