Billabong rides rough retail surf

Shares in reeling retailer, Billabong, soared today. Critical to the future of the retailer is the question of whether that was due to the outcome of its strategic review of its capital structure or its confirmation of a $765 million takeover approach from private equity firm, TPG.

Ever since Billabong warned the market last year of a steep fall in earnings, which triggered a dramatic fall in its share price, it has been evident that it was under mounting pressure to do something about its debt levels if it weren't to be at the mercy of its bankers.

With net debt of $526 million, its interest coverage collapses and its gearing blowing out, it needed to raise capital, not an ideal position for a retailer in this environment let alone one of the most heavily-shorted stocks in the market.

The solution Billabong and its adviser Goldman Sachs have devised is to sell a big slice of a key asset, the group's Nixon youth accessories business. By selling 48.5 per cent of that business to a US private equity firm, Trilantic, and 3 per cent to Nixon's management, Billabong will extract a net $US285 million of cash while retaining its own 48.5 per cent exposure to the brand.

That will achieve two significant outcomes. The most significant is that it will reduce net debt to $258.7 million and improve its net-debt-to-EBITDA (earnings before interest, tax depreciation and amortisation) ratio from 2.9 times to 1.9 times, putting some distance between the company and its lenders while avoiding a distress capital raising.

Given that TPG is circling, it also sends a message to the market about the value of Billabong's collection of brands even in the current hostile environment for retailers. It acquired Nixon in 2006 for $US55 million and a deferred payment of about $US76 million that fell due this financial year.

The deal with Trilantic places an enterprise value of $US464 million on the business and represents a handsome EBITDA multiple for a partial sale of 9.2 times. Billabong retains a significant exposure to Nixon's upside and has locked in a long term supply agreement to maintain access to the brand for its retail network.

Along with the sale, Billabong has also announced plans to close between 100 and 150 of its 677 company-owned stores to reduce rents by $20 million to $30 million a year and improve EBITDA by $5 million to $10 million a year as part of a broader cost reduction program which includes 400 job losses that bit hopes will cut costs by $30 million a year.

Billabong was hit hard by the retail downturn that accelerated through last year and the very weak Christmas trading, a predicament compounded by the strength of the Australian dollar and its inability to pass on rising cotton prices.

There are those in the market who also believe that the group didn't have the retail skills to implement its strategy of vertical integration through the creation of its own retail network to complement its traditional wholesale business, even though the structure is not uncommon for lifestyle brand owners and should provide both flexibility and better margins, although the 71.8 per cent dive in first half earnings disclosed today, to $16.1 million, doesn't support that case.

The partial sale of Nixon wasn't specifically designed to thwart TPG's overtures – Billabong has been negotiating with Trilantic for months and given the usual non-binding and conditional approach private equity firms favour Billabong had no real option if it wanted to stabilise its balance sheet and secure its immediate future but to lock in the deal and the dollars it will release.

Whether ceding a majority of a core brand deters TPG, or causes it to re-think its pricing (the approach was at $3 a share) will presumably become clear at some point in the not-too-distant future.

The valuation of Nixon, however, does enable Billabong to provide the market will a real transaction that underscores the value of its brands even in an environment where, globally, retailers and their suppliers are under pressure. That's a much better platform from which to deal with TPG if it has to than it had before today.