Billabong: reflections on a wipeout

Before getting into the gory details of Billabong International’s downfall – the share price has fallen 80% since Sun rises on Billabong wipeout from 09 Jul 2012 (Speculative Buy – $1.09) – two little bits of colour that, with hindsight, have taken on a little more significance.

To save money, in February 2012 Billabong reduced the prize money for an annual surfing contest at Jeffreys Bay, South Africa. The decision was described in the media as ‘the equivalent of removing Wimbledon from the world tennis circuit.’

Then, in March this year Billabong’s CFO commented to this analyst that he saw his ‘number one job’ as putting a bid in front of shareholders. What once suggested conviction now looks more like desperation.

Tuesday’s announcement downgraded full year earnings expectations from earnings before interest, tax, depreciation and amortisation (EBITDA) of $74m-$81m (excluding any profits from the Nixon JV) to $67m-$74m. Even on previous guidance Billabong probably wasn’t making any money. Now it’s doing far worse than that.

Grave concern

Falling sales in Australia – typically a strong market for the company – are a matter of grave concern. Store sales are down 5.4% on the prior period. In Europe, weak economic conditions are hurting sales while the US remains a bright spot, relatively speaking; sales are merely flat.

This is the third downgrade in a year, assisted by the fall in profits from the Nixon division, from an expected $4m to $1m. It’s now affecting Billabong’s financial footing.

Bank debt, which was $152m as at 31 Dec 2012, is likely to have increased. Lower sales will have boosted inventory and increased working capital, meaning more cash tied up in unsold T-shirts and boardies. Billabong may no longer be producing any free cash and we estimate interest cover at barely two times, well below what might be considered prudent.

The company also has around $67m^ of earn out payments related to previous acquisitions and around $400m of lease liabilities. No wonder the company is considering selling assets like its online businesses (SurfStitch) and 100-store Canadian chain West 49, which has struggled since Billabong purchased it in 2010.

Although it’s hard to know what form it might take, a capital raising or some kind of restructuring is now far more likely. That means existing investors are likely to be heavily diluted because the company’s debt exceeds its current market capitalisation.

The potential private equity bidders, who more than most investors know what’s good for them, have headed for the exits. They know that retailers have a lot of operating leverage; small falls in revenue can wipe out profits. With Billabong’s precarious financing and the growing chance of a recession in Australia, home turf probably won’t carry this business through.

The two former bidders, VF Corporation/Altamont and Sycamore (which was working with ex-US Billabong boss Paul Naude), are in discussions to provide financing but the chance of a private equity takeover bid at a decent price is now close to nil.

The cards have fallen against us and chief executive Launa Inman. She’s spent nearly a year on the job negotiating potential takeovers, which in turn has delayed any possible turnaround and absorbed the cash needed to make it happen.

Her turnaround plan remains sensible, as explained in Billabong’s road to recovery from 25 Oct 12 (Speculative Buy – $0.86), but she hasn’t had time to implement it and the situation has dramatically deteriorated.

Dilution risk

Even if a turnaround is achieved, who knows now what might be left for current investors?

A private equity deal could dilute existing shareholders and asset sales may significantly reduce the size of the business. As for the staff, why bother making that extra sale when they have no idea if the company’s going to be around next week, or who’s going to own it?

To summarise; Billabong’s profitability is rapidly deteriorating; its balance sheet strength is now severely depleted to the point where it needs to sell assets; and the turnaround, if it comes at all, has been delayed again, which reduces the returns we anticipated. The risks are so dire that to hang on is to court significant dilution or a total wipeout.

That, in essence, is why we’re getting out now, crystallizing a painful 79% loss, with the small benefit of at least being able to bank the tax loss credits within the next month. There’s a slim chance Billabong can muddle through without diluting existing shareholders too much but compared with the downside, hanging on isn’t a risk worth taking.

What we can take though, are some investing lessons. Here, the pickings are rich, especially through the golden hue of hindsight. So, let’s indulge in a little self-flagellation.

Lessons

The first and most obvious lesson is that while turnarounds usually seem attractive, they're extremely difficult.

In this case, the company's turnaround plans haven't even had a chance to be implemented. We could have reduced that risk by being more patient. Rather than jump in at the earliest point – Launa Inman hadn’t even announced what she planned to change when we upgraded – we could have waited to see some results.

That would almost certainly have meant forgoing some share price upside but it would have given more comfort to our assessment that the company could turnaround. This is a lesson we’ll apply to future risky, speculative situations. 

Second, we could have given more weight to the notion that retail turnarounds are inherently more risky than other business turnarounds. That’s because retailing is a very tough, demanding industry. When retailers stumble, they often struggle to pick themselves up. More discretion regarding the type of turnaround is required.

Lastly, this failure emphasises the importance of portfolio limits and the nature of speculative investing. Here’s a quote from that first review where we recommended this stock: ‘This is a speculative investment, not a stock to bet the house on. If you’re considering diving in we recommend reading Speculation: No ordinary gamble first.’

That statement seems all the more prescient now. We have had some speculative successes lately, including Sirtex Medical, Cellestis, RHG and Integra Mining but investing in situations like these remains a bit of a crap shoot. Some will work out, some won’t, and you won’t really know which is which until it’s too late.

If you’re not prepared for that, it might be better to avoid speculative recommendations altogether. As former research director Greg Hoffman said in 2008, ‘You can live a rich and rewarding investing life without ever going near a turnaround situation in the sharemarket.’

As for this one, we recommend you SELL Billabong and move on, but probably not to a retailer in the midst of a turnaround.

^An earlier version of this article incorrectly referred to earn out payments of $131m, this was the June 2012 figure rather than as at December 2012.