QUICK TAKE: VOLCOM INC (VLCM)
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%. Most Top Buy picks convert well over 100% of earnings to free cash flow. Instead, Volcom's cash is being tied up in ever increasing inventory and accounts receivable tallies. This is a red flag that indicates weakness in it's distribution channels. Indeed, Volcom's biggest customer, Pacific Sunwear, has been having serious problems and is in the process of closing down 40 or more locations.
However, the biggest thing keeping Volcom out of the Top Buys list is the business itself. There are no moat qualities. Customers can just as easily buy competing brands such as Quiksilver, Billabong, or Body Glove. Youth tastes are very fickle, and always in flux. While true surfers or skateboarders may show some loyalty, part of Volcom's success is selling to those who want to act or feel a part of this lifestyle (called "poseurs", at least in my time). This group of customers is much more likely to go through a phase and then stop buying Volcom's products for good, which puts Volcom at risk of being a fad - something to always avoid in a MFI pick. Even if management avoids these landmines, there is still a ton of competitors that limit margin potential. I'm worried that we are already seeing the brand weakening as margins and return on capital trend down.
One thing mitigates a lot of these concerns: an almost ridiculous 36% earnings yield, one of the highest on the entire screen. At this price, a lot of risk is priced into this stock. And despite the risks outlined above, Volcom still grew sales at a 20% clip in Q3. This looks like far too low of a price for a company with strong financial health, proven management, and strong growth trends. I believe Volcom outperforms the market from the current price level under $10, perhaps significantly. It makes for a better than average Magic Formula pick, but not quite a Top Buy.
Date: Jan 20, 2009
Competitive Moat: D
Financial Health: A
Opinion: No-moat business, but Volcom looks extremely undervalued relative to growth potential.
Steve owns no position in any stocks discussed in this article.