K2 Inc. continues to see its model come together as it merges more operations and realizes strong synergies on the winter hardgoods and apparel side that are having a very positive impact on the bottom line. After several quarters of integration, a new apparel distribution facility, and a large investment in brand building for several new apparel brands, K2 made it all come together to boost gross margins by over 180 points and operating margins by 140 basis points.

Recently, speculation has arisen over K2’s ability to continue to see operating improvements on this scale, mainly because the company has not completed a major acquisition in over a year. However, during a conference call with analysts, Richard Heckman, K2’s chairman and CEO, said that K2 is waiting on foreign government approval on the recently announced Sevylor deal (SEW_0643) and it has another acquisition that is in the due diligence phase. He described both brands as “leaders in their industries,” fueling more speculation over who the second candidate could be.

The Sevylor deal is expected to help K2 balance out its seasonality somewhat, although exact numbers for the deal were not disclosed due to non-material acquisition regulations. If the deal is approved during Q4, K2 expects it to be slightly dilutive to earnings because it is a seasonal, first half business.

The Action Sports segment, which includes all of the winter sports hardgoods brands, improved sales by only 2.4%, but operating profit for the third quarter was $33.1 million, a 26.6% increase compared to the operating profit in the third quarter 2005. This boosted the division’s operating income margins from 17.9% to 22.2% in the quarter due to improved manufacturing efficiencies at Volkl’s German facility and K2’s Asian facility. Shipments of winter sports hardgoods increased 4% during the third quarter due to strong sell-in of K2 branded skis and Ride Snowboards. New product growth continues to be driven by women’s specific skis, free ride skis, twin tips, all-mountain skis, and free ride snowboards, bindings, and boots.

The Apparel and Footwear division saw strong sales gains during the quarter, but gross margins and operating profit declined. For the third quarter, the division’s operating profit was $5.8 million compared to $6.4 million in 2005. The decline in profitability was caused by on-going investments into new apparel brands as well as higher G&A expenses associated with K2’s new apparel distribution center.

Much of the sales growth was caused by the new brands under the K2 apparel platform, but Marmot also saw some strong organic sales growth from increased penetration into existing accounts as well as some incremental growth with new specialty accounts. Management said that they are seeing a reduction in the number of apparel brands at retail, with “the larger, more successful, more powerful brands getting larger, and the smaller brands starting to go down.”

K2’s skate apparel and footwear is experiencing a mixed market right now, with core dealers and “one large chain” experiencing weakness, while regional and specialty chains are seeing strength. Overall, K2 management feels that the skate market is going through an inventory reduction at retail. However, management is still confident that their skate brands will meet plan for Q4 of 2006 and H1 2007.

Marine and Outdoor sales were relatively flat, with only a 2% increase for the quarter and operating profits slipping 16.2% to $8.3 million from $9.9 million in 2005 due to lower gross profit as a percentage of sales and higher SG&A expenses as a percentage of sales. Higher gas prices depressed the marine and boating market, but domestic tackle shipment increased 38% during the quarter. Pfleuger reels and Ugly Stik kits and combos also contributed to a strong Q3 performance in fishing.

Team Sports, which includes Rawlings, Worth, K2 Licensed Products, and Brass Eagle, saw a slight sales increase, but the division was able to cut its operating loss in half, thanks to improved profitability in the paintball and souvenir and promotional product lines, and a one time gain of $1.1 million relating to the sale of some long standing shares from the K-mart bankruptcy. The operating loss was $3.0 million in Q3, compared to a loss of $6.1 million in the 2005 period. Paintball sales have finally started to bounce back for K2 with shipments up 11% for the year and sales and profits ahead of plan for the first time in over a year.

In spite of stronger-than-expected Q3 results, K2 maintained previous guidance for the full year, but said that they expect to hit the high end of the range. This is partially due to the possible dilution from the Sevylor deal and partially due to uncertainties surrounding snow and snow sports hardgoods sales. KTO is also seeing raw material pressures in China and wage increases throughout Asia, but the rate of increase for both is slowing.