Billabong's road to recovery

‘Sure there are potential fatalities’, advised famed investor Peter Lynch, ‘but turnaround stocks make up ground very quickly ... and the occasional major success makes the turnaround business very rewarding’.

Lynch, for example, made 15 times his money investing in Chrysler. Rewarding indeed. Like Lynch, this analyst is excited by turnarounds.

Washed up brand-owner-come-retailer Billabong International, which we upgraded recently, is a perfect candidate (see Sun rises on Billabong wipeout from 9 Jul 12 (Speculative Buy – $1.09)). Since that upgrade, two takeover bids have come and gone, brokers have downgraded the stock, and the press is bleating panic.

Amongst it all, the share price has traded as high as $1.47 and as low as 74 cents before settling down 22% at 85.5 cents. Yes, it’s been a busy few months.

Indeed, as we highlighted in Billabong International: Result 2012 from 28 Aug 12 (Hold – $1.36), this is a business with serious problems. Billabong, even after its recent capital raising, has $94m of net debt, $131m of earn out payments from past acquisitions, over $400m of lease obligations, and is facing a deteriorating retail environment. This may explain why private equity got cold feet.

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.

Still with us? Good. Using an adjusted 2012 profit of $25m as a base, let’s unpack how management’s turnaround plan might boost earnings.

Profit booster 1:  Strip out costs

Retail is a business of discipline, and previous management lacked it. Chart 1 illustrates the vast difference in costs between Billabong and its competitors, as measured by ‘operating expenses to gross profit’.

Different business models explain part of the variation. Country Road, for example, incurs higher expenses renting physical stores, a burden that wholesale focused companies, such as Nike, don’t face.

Still only 50% of Billabong’s business is retail, and it should incur costs more towards the ‘Nike’ end of chart.

Small changes here can significantly boost profits; a 1% fall in expenses would result in a $5m boost in profit.

For example, we estimate rent costs are 10% too high. By closing loss-making stores we estimate that Billabong could swiftly save $10m-$15m per year. Store closures will also reduce staff costs.

Other areas of analysis are limited by disclosure, but there are clues. For example, 34% of product lines represent only 1% of sales (see Chart 2). Cutting unpopular lines can profoundly impact business efficiency, and profits, as supermarket giant Aldi has proved. There’s $5m-$10m a year of savings to be made here.

Profit Booster 2: Improve retail

Integrating online and traditional ‘bricks and mortar’ stores is critical to contemporary retail success. Billabong’s ‘Surf Stitch’ and ‘Swell’ online stores are credible but remain well behind industry leaders such as Burberry and Nike in terms of functionality and engagement.

Longer term, reducing the number of retail brands and refreshing the store design should help improve sales. Management recently increased sales by 12% in its Surf Dive 'N' Ski store in Warringah Mall just by reducing clutter; even small changes can have a sizable impact.

Fixing the retail business will take a couple of years at least, but the sheer ineptitude of the current performance presents huge opportunity for improvement. A boost of $10m-$20m to profits is very achievable.

Profit booster 3: Tighten supply chain

The links in the supply chain have also become weak.

Leading retailers, such as Zara, can take a new product from concept to shop floor in 3-5 weeks. It takes Billabong 8-12 weeks. This means the company is less able to respond to inter-seasonal changes in demand.

Supply chain costs are also 10% higher than the industry average. Improvements here could save at least $5m per year.

Profit booster 4: Build the brand

Finally, let’s focus on Billabong’s brands more broadly. Here are a few practical examples of what the company could be doing differently.

Youth fashion brands—in particular surf brands—rely on the perception of authenticity. It’s extremely difficult to remain ‘authentic’ whilst expanding sales.

Starbucks developed an effective way of solving this problem. By combining standardised global systems with self-directed local staff, Starbucks was able to achieve continuity of service delivered in a distinctly local and authentic way. For Billabong this may mean engaging local artists to paint murals in stores, sponsoring grass roots events—rather than international pros—or releasing specific products that coincide with events such as ‘Schoolies week’.

More generally, Billabong could more effectively use new marketing channels, such as social media (Facebook, Twitter, Pinterest). Adventure brand The North Face, for example, demonstrates what’s possible. It’s built a 3m strong community of engaged fans that helps the company better understand its consumers and provides it with selling opportunities.

Billabong needn’t doing anything untested; it can draw on the rich experience of other successful consumer brands. Adding a further $15m-$25m to profits is very achievable.

Striking value

All up, that’s adjusted earnings of between $70m-$100m which, once the Nixon equity stake is included, equates to around 16-23 cents per share, or an implied price to earnings ratio of between 3.7 and 5.4. This is a reasonable price to pay considering the risks (see Table 1).

These numbers are deliberately less optimistic than management’s predictions. We’ve also focused solely on conservative profit boosters that are within management’s control, and we haven’t incorporated the possible increase in profits from a lower Aussie dollar, higher sales or improving economic conditions.

Patience, though, is required; it will take a couple of years before we start to see a major improvement. To track performance, we’ll be keeping a close eye on cash earnings, as write-offs in the 2012 result (see Billabong takes a bath) mean accounting profits are likely to obscure the economic reality.

Still, with Mr Market running scared, directors buying in, and a share price that hasn't changed since 12 Oct 12 (Speculative Buy – $0.85) Billabong remains a SPECULATIVE BUY.

Note: The model Growth portfolio owns shares in Billabong International