Strong hands for Pacific Brands

Under KKR management, Pacific Brands could see out the current economic cycle while continuing its restructuring, meaning an offer may be the best option for the consumer brands group.

The confirmation from Pacific Brands that it has been approached by KKR raises the very real possibility that for the second time in less than a decade the consumer brands group could find itself in private equity hands. That wouldn’t necessarily be a bad outcome for shareholders or the business.

While the discussions with KKR are said to be at a very preliminary stage, the nature of the two groups means the only real issue involved is price. KKR has no history in this market of overt aggression – it puts its best price on the table and walks away quietly, without recriminations, if it is rejected – while Pacific Brands chairman James MacKenzie is a pragmatic veteran of takeover activity.

MacKenzie would be very mindful that, for the past two years, Pacific Brands’ share price has gone nowhere and, with the group already foreshadowing lower sales and earnings this year, that situation is unlikely to change any time soon.

That’s despite herculean efforts from a completely refashioned management. Indeed, since chief executive Sue Morphet announced her controversial transformation plan in 2008, the group has been transformed at every level. Plants have been closed and sourcing shifted offshore, brands sold, the 20-odd standalone businesses she inherited now operate within three main divisions and she has taken more than $150 million out of the cost base a year ahead of the original schedule, albeit at a cost now approaching $200 million.

Had it not been for that traumatic program, Pacific Brands probably wouldn’t have survived. Today, at an operational level, the group is in a stable shape, holding the sales of its continuing businesses and improving their margins and cash flows. The destabilising debt levels have been significantly reduced, the group has resumed paying dividends and it was even able to announce a share buyback last year.

The problem for Pacific Brands is that its dramatic reshaping has occurred, and continues to occur, in the worst external environment for decades. As a consumer products group Pacific Brands is completely exposed, directly and indirectly, to the retail environment, which has been dreadful and shows no signs of recovery.

It hasn’t helped that, while it has a portfolio of mark-leading brands in primarily clothing and footwear, those brands are mass market products whose major customers are the big discount department stores.

Kmart’s strategy of 'de-ranging' to focus on driving high volumes of a smaller range of discounted products has particularly hurt Pacific Brands’ key Bonds brand, along with footwear and sporting goods, but more generally the intense competition between the embattled discount retailers and the ensuing price deflation has created very tough conditions for wholesalers. Pacific Brands has also been squeezed by rising cotton prices.

Morphet has responded by continuing to reduce costs, continuing to finesse the brand portfolio and broadening the group’s distribution network to boost its own retail presence and its online channels. The strength of the group’s brands makes proprietary channels a very viable safety valve from the pricing power of the discount department stores.

KKR, which has a number of big retail and retail-exposed businesses within its global private equity portfolio, would no doubt believe it could bring some experience and capabilities and perhaps some synergies within Pacific Brands’ global sourcing arrangements to bear.

As a firm, KKR tends to be quite patient with investments, which would enable it to see out the current economic cycle while continuing the restructuring process.

The market leadership of the brands within the Pacific Brands portfolio – Bonds, Yakka, Holeproof, Sheridan, Clarks and a host of others – would be the primary reason for its interest. They provide both significant downside protection as well as considerable upside if conditions improve.

By KKR’s standards, a bid for Pacific Brands wouldn’t be a major deal, with the group valued at a little over $500 million before news of the approach leaked. The group also has nearly $400 million of debt.

Despite all their efforts, in the absence of a significant improvement in the external environment, Morphet and her team – and Pacific Brands shareholders – face a tough near and medium-term future of continuing to grind out small gains just to stand still rather than generating strong growth.

The market is unlikely to reward the group for its efforts unless and until the general climate and Pacific Brands’ top line growth improves significantly, which is why MacKenzie is likely to be very open-minded about the possibility of getting his shareholders value that they might not otherwise see for some years, if at all.

The negotiations are at a very early stage and nothing may come of them. Unlike some dealings between listed companies and private equity, however, it is likely that the discussions will be reasonably amicable and the target board will be quite open-minded.