Volcom designs, markets and distributes action apparel, mainly focused on the
snowboarding, skateboarding, and surfing crowd. The majority of the company's
business is in the United States (over 55%), while Europe contributes about 30%,
and Canada, Japan, and Australia fill out the geographic picture. Volcom apparel
is sold through lifestyle retailers such as Pacific Sunwear (PSUN) or Zumiez
(ZUMZ), as well as many small, independent surf shops and a few of it's own
retail stores (currently under 20 locations). The company went public in 2005.
Volcom has a lot of positive attributes, despite being in a classic no-moat
business like youth apparel. For one, the brand has a lot of cache appeal in
it's niche. The founder and CEO, Richard Woolcott, was a professional surfer for
Quiksilver (ZQK) in the 1980's. His unique outlook has no doubt protected the
authenticity of the brand. Woolcott has resisted the temptation to push the
brand into wide distribution channels (like department stores), which would
destroy the company's image. Management has also built the brand through
grassroots efforts like sponsoring popular skateboarders, hosting events, and
producing videos. Not only are these more effective at reaching the core
customer, but also much lower cost than more traditional advertising
channels.
This is just one example of the solid business sense this company is being
run with. Volcom has expanded smartly overseas. Instead of throwing millions of
dollars into advertising and new distribution channels in Europe, Volcom instead
licensed it's brand to existing apparel makers. This effectively built up the
brand name while the company earned money by taking a small cut of the
profits. Then, once the licensing contract expired, the company then began
directly controlling their European operations, benefiting from the brand
strength built through the licensing agreement. This strategy will likely be
followed in other geographical locales, which is key to continuing the robust
growth Volcom has been experiencing (30% annual growth in operating earnings
since 2003). The company recently purchased sunglass brand Electric earlier this
year, another avenue for growth.
Like many well-run youth apparel companies, Volcom is in excellent financial
health. The balance sheet shows over $70 million in cash, and no debt. Operating
margin has averaged in the 18-20% range, well above the 13-14% average for the
sector. I have a few concerns here, though. Gross margin, operating margin, and
MFI return on capital have been trending down since the IPO in 2005. MFI return
on capital has declined from over 130% in 2004 to slightly above 55% today, a
pretty significant drop. Also, earnings to free cash conversion has been pretty
weak, under 75%.
