New equity capital was a matter of ‘safety first’​

In the latest Nordea On Your Mind report 'Coronavirus: Plan B', Viktor Sonebäck interviews Stein Eriksen, CFO of listed Norwegian sporting goods retailer XXL, about the multiple challenges of having embarked on a major working capital reduction programme after a debt build-up, and suddenly facing COVID-19 lockdowns keeping customers stuck in their homes. The decision to do a third equity issue in six months (the three in total raising NOK 900m) was natural to safeguard the viability of the business and helped by a long-term focus and support from major shareholders and the company's banks.

You have been early and proactive in securing new capital and funding with both a NOK 400m rights issue and new bank funding of NOK 1.45bn in May. Could you share some of your thinking about your needs to strengthen your capital base, and what ultimately made you decide to raise new capital? How important were immediate short-term issues versus the upside potential from having long-term strategic flexibility?

Stein: To answer this, I think we need to go back a little in history to get some perspective. XXL was listed on the Oslo Stock Exchange in 2014. It was founded in 2001 and has been a consistent growth machine. Growth requires working capital. Organic growth means new store openings, and new stores all have inventory. In the period 2015-18, the company generated some NOK 250m in operating cash flow but paid out some NOK 1.1bn to its shareholders. This was clearly not a sustainable trend and led to a build-up of debt. When revenue growth started stagnating in 2017, profitability suffered, which ultimately led to challenges with the company's debt covenant of a maximum net debt/EBITDA of 3.5x.

Working capital efficiency was also suffering, with working capital to sales rising from 16% in 2015 to just below 25% by the end of 2019, which was massively above retailer peers and twice as high as that of our closest peer. And this was more or less entirely owing to our inventory levels, which had a corresponding rise from 25% to 38% of sales by the end of 2019. Looking at peers, H&M has been criticised for an inventory of 18% of sales. We were at more than twice that level. Inventories were driven up by a complex supply chain and an explosion in the number of products in our assortment since 2016. A thorough analysis showed that the top 15% of SKUs (Stock Keeping Units) represented 80% of our revenue, while the bottom 42% of SKUs only represented 1% of revenue. That is very costly complexity. The long tail of products needs to have product testing, be returnable, be kept in inventory, be shown on our website, and so on.

To address these issues, we started a working capital optimisation project in Q2 2019. After a somewhat slow start, I think it is fair to say that we really got it kicking from Q4 2019 and onwards. It has really been an impressive effort by the whole XXL organisation, strongly supported by the owners and the board of directors.

To sum up, the measures we have taken to strengthen our balance sheet are:

• A NOK 400m equity issue in Q4 2019
• A subsequent NOK 100m equity issue in Q1 2020
• Inventory reductions since Q4 2019
• Further NOK 400m equity issue in Q2 2020
• NOK 1.45bn new loan facilities in Q2 2020

We have reduced our purchasing budgets by NOK 1.8bn and reviewed our assortment, and we ran a big Nordic clearance sale in February and March. This boosted our cash generation after a very weak winter sports season, which was helpful when COVID-19 lockdowns kept customers at home and unable to visit stores from March. In our Q2 report, we showed that we have reduced inventories by NOK 1.1bn, helping drive down our net debt to a mere NOK 300m by the end of Q2, versus NOK 2bn a year earlier.

In March, we realised that the COVID-19 pandemic meant we were facing a 'black swan' event. Our first priority was to establish crisis teams to decide on measures deemed necessary to protect the health of our employees. Our second critical priority was the health of XXL itself. Our revenue declined over 20% during the second half of the month. In Austria, a full shutdown forced us to close our stores, and we did not know what would come next in our Nordic home market. Our cash flow projections at the time showed that if we would have been forced to close our Nordic stores, we would have faced a default within weeks, perhaps surviving for a few months if we froze all spending and investments. We temporarily laid off some 1,000 staff and had plans to do more if we faced a full lockdown in the Nordics. We negotiated payment terms with suppliers and landlords. We cut marketing costs. And we secured additional funding and raised new equity capital.

Was it challenging to align the interests of shareholders and other stakeholders, weighing the costs of diluting shareholders against the benefits of securing financial strength to weather the COVID-19 storm?

Stein: Our shareholders initially wanted to keep a new equity issue as small as possible, of course preferring non-dilutive strengthening of our balance sheet by clearing inventory. But when we found ourselves in the lockdowns of March, it became obvious how quickly the cash burn would drain capital, and we also had to consider the views of our banks, as we had already highlighted a risk of a debt covenant breach in Q4, prior to the COVID-19 outbreak. We had to prioritise ensuring that we had the financial strength to weather whatever pressure COVID-19 would bring to the business. It was a matter of 'safety first'.

It would be a stretch to expect that a proposal to raise another NOK 400m of equity, after having raised NOK 500 the year before, would be popular. But I experienced very strong support from both major shareholders and from our banks. We were in a highly uncertain and challenging situation, and there was general agreement that decisive action was needed. A strong commitment from big shareholders who have been with us for a long time, like Altor, Ferd, Odin Fondene and Arctic, has been very helpful. And our rights issue was oversubscribed.

What sorts of scenarios have you been considering when evaluating your capital needs? V-shaped, U-shaped or L-shaped recoveries from 2019 demand? Or other scenarios?

Stein: Looking back to when the crisis materialised in March, I have to say that the actual outcome so far this year is better than any of the scenarios we were envisaging at that time. As long as we would be able to keep our stores open, we could also be helped by travel restrictions forcing consumers to spend their holidays at home. And we have now seen demand for sporting goods grow 28% in Norway and 17% in Sweden in the month of June. We did not dare to hope for anything like that in March.

As for the nature and shape of a recovery further out, in the coming years, the honest answer is that we simply do not know. It will depend so much on how the pandemic evolves.

Do you think the COVID-19 lockdowns and restrictions could bring permanently changed consumer behaviour? Online versus offline retail sales? Gainer and loser categories from more time spent in our homes?

Stein: In the early phase of the crisis, from March to mid-May, we saw a strong surge in online sales. In-store sales started to catch up from mid-May to June. Our online share of sales has been around 15%. In Q2, our online revenue grew 60%, which pushed the online share above 20%. We expect the accelerated migration to e-commerce to persist. We are also noting that customers no longer go to our stores for window shopping. They have typically browsed and decided what they want beforehand. The average basket for our customers has accordingly increased.

We have seen a shift among categories towards those playing into the 'staycation' theme, with strong demand across the Nordics for outdoor products like tents, sleeping bags and bicycles. Water sports revenue has doubled, including for products like canoes and kayaks. Hiking boots is another strong category. There has also been strong interest in home gym equipment, with gyms being closed for periods through our home region.

I think the increase in online shopping has given more consumers a taste for the experience, and comfort that it works well. It is hard to imagine that they would suddenly stop browsing and shopping online if the pandemic blows over. The benefits of shopping online will be there every bit as much for them in a more normal market environment.

The shift among categories towards outdoor may not be as permanent. Those who have bought a tent may be able to use it for some years, and if vaccines or effective drug therapy resolve COVID-19 health risks, I suspect people will resume international travel.

How do you view your supply chain after the COVID-19 experiences so far? Could your sourcing footprint change? Is it robust enough to withstand potential disruption or diminishing free trade?

Stein: At the start of the year, when COVID-19 was predominantly a Chinese issue, our focus was on establishing a very close dialogue with our suppliers to evaluate risks of delays or supply shortages. We have been fortunate that our supply chain has fared well, with effects limited mostly to a week or so of delays for certain categories. Our suppliers have generally been very supportive and flexible.

We source predominantly externally. Only 9% of our revenue is from private label goods, mainly bicycles. This is the main part of our supply chain where we interact directly with the factories. Over the years, there has been a clear trend towards bigger and bigger factories, centralised production to drive down unit costs. This has paid off well, but also carries risks from putting all your eggs in one basket, in case of any disruption. And COVID-19 has been such a disruption. It is clearly something for us to think about, particularly when we have come out of crisis management mode. We obviously do not know what changes our suppliers will consider doing to their sourcing. But we can note that disruption during the COVID-19 pandemic has so far been quite limited.