Surfwear bid raises issues of risk and reward

If Billabong's senior US executive Paul Naude presses ahead with his plan to mount a $1.10 a share, $527 million takeover of Billabong, the surf and leisurewear group's board will conduct a familiar cost-benefit exercise.

The numbers they feed in are less encouraging after Wednesday's profit guidance downgrade however, and that means Naude's approach will be difficult to reject.

The questions the board needs to answer before deciding whether to let Naude in to do due diligence for a possible cash offer are the same as the ones they faced when private equity offers at $1.45 a share were proposed and then withdrawn a few months ago.

US private equity outfit TPG decided against offering $1.45 a share for Billabong on October 12 after conducting due diligence, and another private equity group, Bain Capital, briefly considered offering the same amount before withdrawing on September 20. Billabong also rejected a $3.30 share takeover proposal from TPG in February, but that occurred before structural and operational problems forced a deeply discounted share offer that almost doubled the group's issued capital, and is not a relevant benchmark today.

Several questions were raised by the aborted $1.45 a share approaches, and are raised again by the latest approach at $1.10 a share by Naude and a US private equity firm, Sycamore Partners.

The first is what should be done to renovate Billabong's global business and restore its profitability and market value. The second is how much extra value a renovation can create - the potential reward - and a third is how much execution risk any owner of Billabong is taking on with a complicated and lengthy recovery plan.

The final question that hangs off the first three is whether a takeover pitched at $1.10 balances risk and reward between buyer and seller, enabling a recommended takeover to occur. The price that works will discount the value a renovation could create for execution risk, give some of what is left to existing shareholders and pay them a premium for control, and leave enough potential upside on the table to reward the buyer who takes over the renovation project.

Naude's proposal is pitched below the other approaches Billabong has fielded, but it will be taken seriously, because the execution risk is high, and the headwinds Billabong faces have strengthened.

Naude stood aside as a director of Billabong and head of the group's Americas division in mid-November as he developed his buyout proposal. He wants to conduct due diligence, but already has an insider's insight into the group, and was presumably aware of the trading downturn in Canada that lit the fuse on the latest earnings guidance downgrade.

His consortium told Billabong last Friday that its indicative, non-binding and conditional proposal would be withdrawn if confidentiality was breached, but even though media reports detailed the proposed takeover before it was confirmed, Billabong said yesterday that the confidentiality condition had been dropped. A condition that there be no material adverse changes at Billabong was also tested by Billabong's decision on Wednesday to lower earnings guidance, but Naude is still knocking at the door. He seems confident that at $1.10 a share, he has headroom.

The renovation task at Billabong will be similar regardless of who undertakes it. Weak retail trading conditions around the world in the wake of the global crisis have exposed the group as an untidy amalgamation of bolted-on businesses, brands, distribution channels and information technology systems that must be rationalised.

The group has some strong brands, but at the end of August this year it was generating 80 per cent of its sales from just 22 per cent of its 25,239 styles. It had 500 suppliers, and 19 of them accounted for 85 per cent of purchases.

Billabong chief executive Launa Inman unveiled her plan to cull styles, suppliers, stores and brands and create common distribution and information technology platforms at the end of August, and said earnings before interest, tax, depreciation and amortisation (EBITDA) could rise by 2.5 times or about $155 million if the plan works, from $84 million in 2011-2012 to about $239 million by 2015-2016.

Billabong's share share price was 74¢ just before the first reports of Naude's interest surfaced on November 19. That was about 10 times 2011-2012 net earnings of $33 million, and using that as a guide, Billabong shares should be above $1.50 if the renovation succeeds, perhaps comfortably so.

Naude's price of $1.10 is below that. But it is 48 per cent above Billabong's low of 74¢ before he emerged as a potential bidder, and the renovation project is complicated and lengthy, leaving Billabong exposed to adverse trading conditions.

That was highlighted on Wednesday when Billabong confirmed Naude's interest, but also downgraded its EBITDA profit guidance for 2012-2013, from between $100 million and $110 million to between $85 and $92 million. On that outlook, Billabong will be spending the first year of its renovation project pretty much standing still.

Naude is not a bird in the hand. His offer is subject to due diligence, and if it goes ahead will be conditional on 90 per cent acceptances, making the attitude of Billabong founder and 14.5 per cent shareholder Gordon Merchant crucial (TPG would probably have invited him to join its consortium).

The days early in the year when Billabong dismissed TPG's first approach and Merchant said even $4 a share was not enough are long gone, however. The lowest purchase price Billabong has fielded might be the one that succeeds.

mmaiden@fairfaxmedia.com.au