Quiksilver: An Undervalued Turnaround

By Daniel Sparks - August 26, 2012 | Tickers: AEO, COLM, NKE, ZQK, UA | 0 Comments

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Every once in a while good businesses make mistakes and get over-punished by Mr. Market. A sentencing disparity (or unjustified treatment) is no good in law. But a sentencing disparity in the financial markets is absolutely wonderful, at least for the value investor looking for bargains! Quiksilver (NYSE: ZQK) has found itself in a sentencing disparity.

The Crime . . .

In 2007, Quiksilver's revenue peaked amid favorable economic conditions across nearly every one of its geographical segments. Investors were hungry for more. But they had no idea what was about to hit them.

Quiksilver thought it could expand revenue and profits by entering new, unfamiliar markets. It acquired Rossignol and Cleveland, two hardgoods brands (a much different breed than the softgoods brands it was used to). Upper management figured they could apply their excellent brand management and marketing to these new businesses to create more value for shareholders. But this was a big mistake.

Quiksilver's golfing brand, Cleveland, turned out to be an operational headache as Quiksilver failed to reach profitability with its hardgoods. So, in 2007 Quiksilver had to sell its Cleveland business.

In 2008, as the recession appeared on the horizon, Quiksilver's problems were magnified: It turns out that Quiksilver sacrificed a great deal of operational efficiency as a result of investing in its hardgoods brands. To this end, Quiksilver turned right around and divested its hardgoods ski brand, Rossignol.

Turns out Quiksilver picked a very wrong time to take on a leveraged expansion in hardgoods brands that were much different than their three core, profitable softgoods brands: Roxy, Quiksilver, and DC.

The Verdict . . .

Mr. Market was angry. Quiksilver's stock was punished severely:

ZQK Market Cap data by YCharts

Mr. Market's sentiment hasn't improved much since Quiksilver's hardgoods "crime" and the storms of the recession.

The Opportunity . . . 

Since Quiksilver management divested its hardgoods business, things have paid off quite handsomely. It's been able to decrease liabilities and make more effective use of its assets:

ZQK Liabilities data by YCharts

In 2004, Quiksilver made one of the smartest acquisitions in its history when it purchased DC. DC happens to be a fast-growing cash cow that continues to represent a larger and larger portion of Quiksilver's revenue. During this year's back-to-school program, DC should pay off some good results that should increase year over year numbers for the back to school quarter very handsomely. Robert McKnight commented on this idea in last quarters earnings report:

"We expect the second half of fiscal 2012 will compare favorably to last year as we anniversary higher input costs that we began to see in Q3 of 2011 and as we begin to deliver goods for our highly anticipated back-to-school season, particularly for DC" (source: sec filing).

As you can see from the chart below, DC is becoming a larger and larger portion of Quiksilver's total revenue. This means that positive comparables for the DC brand will have a greater effect on Quiksilver's overall comparables.

Here is a visualization of Quiksilver's turnaround based on several key factors:

ZQK Revenue data by YCharts

As you can see in the above chart, Quiksilver's revenue has been generally consistent for the last 5 years. But its book value, debt to equity ratio, and market value suffered amidst its challenges during the recession. But now its debt to equity ratio has returned to much lower levels and its book value is on the rise again. As Quiksilver's turnaround takes place, financial health metrics are returning to normal.

But here is where my favorite part of this opportunity lies. Quiksilver's brands possess superior pricing power to competitors and other comparable apparel brands. This shows the power of Quiksilver's stronghold as the leader of outdoor sports apparel. Quiksilver has considerably higher gross margins than Nike (NYSE: NKE), Under Armour (NYSE: UA), Columbia Sportswear (NASDAQ: COLM), American Eagle Outfitters (NYSE: AEO), and Buckle.

ZQK Gross Profit Margin data by YCharts

 Superior margins like these means several things:

1. More cash to pay off debt and improve Quiksilver's financial position.
2. High levels of free cash flow available for shareholders when Quiksilver finally does return to profitability.
3. Higher levels of earnings to boost the stock price when Quiksilver returns to financial health.

Valuation

Quiksilver is cheap by several measures. The most appealing measure is its price-to-sales. By this measure it's a bargain, especially considering its gross profit margins. Once again, take a look at Quiksilver in comparison to competitors and comparable apparel brands:

ZQK Price / Sales Ratio data by YCharts

And it's also cheap as measured by price to book value. Nike, Under Armour, and Buckle are in a far better financial position than Quiksilver, so I left them out of the chart entirely. Their price to book values are so much higher that it would be hard to see the difference between Quiksilver, American Eagle, and Columbia Sportswear:

ZQK Price / Book Value data by YCharts

Yes, Nike's brands are much more diversified; Nike, American Eagle, Buckle, and Columbia Sportswear all pay out nice dividends; and Under Armour's revenue is soaring higher each year. But Quiksilver has the greatest pricing power of them all. Plus, its brands are sold all over the globe, it's the leader in outdoor sports apparel, and DC is a hidden jewel. I'd say there is some great value here!

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