Finding hidden value in Billabong

The recent sale of its Nixon business freed up Billabong's balance sheet, but more importantly suggested the market has seriously undervalued the surfwear retailer.

With private equity giant TPG reaffirming its willingness to consider an offer of $3 a share, Ted Kunkel and his colleagues on the board of Billabong International have an interesting and difficult decision to make.

TPG re-tabled its non-binding and indicative proposal to acquire Billabong before the sharemarket opened today, at the same price and with the same conditions – access to due diligence and availability of financing are the key ones – despite Friday’s announcement of the sale of majority interests in one of the surfwear group’s key brands for net proceeds of $US285 million. The TPG initial approach was conditional on there being no major asset sales.

As with any board approached by private equity, Billabong now needs to decide whether or not to allow access to due diligence. Without that access, and the support of target company directors for a scheme of arrangement offer, the lenders to private equity firms won’t lend and a bid will evaporate.

The decision isn’t straightforward. Friday’s deal, involving the sale of 48.5 per cent of Billabong’s Nixon youth accessories brand to a US private equity firm and another three per cent to Nixon’s management, doesn’t just release badly-needed cash to Billabong, but implied an enterprise value for Nixon of $US464 million.

Billabong decided to go ahead with the sale of the interests in Nixon despite the approach from TPG as the deal was in its final stages because it needed certainty and it needed to defuse the threat to its stability posed by its $526 million of net debt.

The Nixon sale has stabilised its balance sheet, put distance between it and its bankers and dealt with the vulnerability that could have driven it into TPG’s arms at whatever price that group was prepared to offer, although that latter benefit wasn’t the motivation for completing a deal that any company in Billabong’s circumstances in today’s retail environment would have done.

Before the Nixon deal, and TPG’s approach, Billabong shares were trading at just under $1.80. Today they were more than a $1 a share higher, at $2.84.

That could mean investors/traders were punting on the TPG offer being made and being successful, although at $2.84 and taking into account the time value of money for a proposal that could take months to complete, the market appears to be signalling an expectation of something above $3 a share.

Billabong shares would have spiked even without TPG’s presence, given that the sale of the Nixon interests didn’t just raise a big lump of badly-needed cash but demonstrated that even in today’s difficult conditions the brand could attract a big valuation.

Nixon is only one of about a dozen brands in the Billabong portfolio that surround its core brand.

Selling just over half of one brand for the equivalent of more than $1 per Billabong share, while retaining an exposure valued at $US225 million by the terms of the deal, is a pretty clear signal to the market that it has completely misread – undervalued – that portfolio. That one brand is worth more than the value at which Billabong shares were trading earlier last week.

Without that sale and the $1.90 or so per share of value it implies in the Billabong exposure to Nixon – about $1.07 of it in cash – TPG’s $3 a share would have looked enticing.

Post-sale it should be significantly less appealing to Billabong shareholders, given that it suggests that they/their board could sell off the non-Billabong brands themselves and, if the Nixon valuation is any guide, probably end up with the equivalent of materially more than $3 a share in cash and continuing scrip even in today’s retail conditions.

Access to due diligence is one of the two significant pieces of leverage target company boards have in dealing with private equity. The other is their endorsement and support for a scheme of arrangement.

Different boards have different philosophies in responding to private equity, but using both those levers to get private equity to raise its original indicative offer price is defensible strategy.

In the current environment, where institutional investors appear to be less concerned about the size of takeover premiums than they are in ensuring that they do receive an offer and can generate some positive equity portfolio returns, denying due diligence in the absence of a higher offer isn't necessarily an easy decision for a board to take.

Directors are mindful that, rather than helping the Spotless board get $2.80 a share for them, that company’s institutions threatened to requisition an extraordinary meeting to kick Spotless’ chairman, Peter Smedley, off the board if it didn’t grant Pacific Equity Partners access to due diligence. Spotless was forced to fold.

Billabong, like most retailers and manufacturers exposed to retail conditions, is struggling. It will close between 100 and 150 of its 670 retail stores in response to a steep downturn in retail spending globally. When even much-admired retailers like JB Hi-Fi are disappointing and others, like Specialty Fashion Group today, are seeing earnings absolutely plummeting, it’s a tough time, and a vulnerable time, to be a retailer.

The Nixon deal, and the five-year time horizons of most of the larger private equity groups, helps explain Billabong’s appeal to TPG – the brands have real and realisable value even in today’s environment that wasn’t previously appreciated.

That deal has reduced the vulnerability of the business to the current conditions and given the board a stronger base from which to negotiate, or not, with TPG. It may help convince shareholders that there is more than $3 a share of value latent in the group, but it ultimately doesn’t reduce Billabong’s vulnerability to the impatience of its own institutional shareholders.

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