Pacific Brands in decline
Recommendation
- Bonds and Sheridan face increasing margin pressure
- Shift to retail and international expansion carries extra risk
- Aussie dollar a headwind. No margin of safety; Sell
Locally-owned Australian brands are scarce these days. Vegemite, Tim Tams, Holden, and Victa lawn mowers have fallen into foreign hands, and those left behind like Qantas hold little interest for value investors. While Pacific Brands owns iconic brands Bonds, Sheridan, Tontine and Berlei, we're tossing the company into the too hard basket.
Iconic brands are no guarantee of profitability these days. An increasing array of choices, increasing internet sales and a high Aussie dollar have made foreign products more popular and attainable. While some of Pacific's brands are growing and churning out cash, like Bonds and Sheridan, others like Rio have barely made a dollar in years.
This hasn't been lost on Pacific Brands' fourth chief executive in seven years, David Bortolussi, who has done a commendable job stripping down the company.
The Workwear and Brands Collective segments, which include Hard Yakka, KingGee and Hush Puppies, plus dozens of smaller footwear and workwear brands, were sold to Wesfarmers and a private equity firm in November netting $175m and $39m respectively. These divisions contributed close to half of Pacific Brands' total revenue, however, so let's find out if there's anything of value left in Pacific's closet.
Sheridan-Tontine
In Australia, manchester means Sheridan and Tontine. In 2014 combined sales for the division increased 12% to $220m and now account for around a third of Pacific Brands' total revenue.
Unfortunately these household names aren't particularly profitable. Earnings before interest and tax (EBIT) fell 21% to $14m this year (a margin of just 6.3%) due to an expensive marketing campaign that still failed to offset increasing competition.
Sheridan and Tontine products are also mainly sold through just a few powerful customers like David Jones, Myer and Big W, which are increasingly promoting their own private labels and demanding better prices from Pacific Brands. Adairs used to be a major customer, but with Brett Blundy as a major investor the company is also focused on its own brands as they produce much higher margins despite the lower quality.
Sheridan-Tontine may be able to grow revenue, but intense competition from home brands is undermining margins.
Bonds
The Underwear division, which includes brands like Bonds, Berlei, Jockey and Explorer, had a similar experience to Sheridan-Tontine. Annual revenue in 2014 increased 8% to $489m, yet EBIT fell 19% to $64m.
Bonds' sales are growing strongly – up 20% for the year – due to improving online sales, a retail store rollout and new categories such as Bonds Kids, which have been supported by expensive television advertising campaigns. In contrast, the smaller brands in the division, with the exception of Berlei, are mostly in decline.
The underwear market is competitive and mature so Pacific Brands is using the old fashioned way to reach customers; it's opening stores. It's too early to judge its success, but it's an expensive and risky bet and the 25% increase in cotton prices and falling Australian dollar are shredding margins. $25m in extra marketing this year increased sales by a mere $58m, but after stripping out manufacturing costs it probably produced a loss.
Risks
Lower earnings and store rollout costs have also increased net debt from $159m to $249m, about half the company's market value. That excludes $184m of non-cancellable future lease payments that are quasi debt. Still, it's not as bad as it looks, though, as sale proceeds from the workwear business will cut net debt to $75m.
Perhaps more worrying is the company's overseas expansion plans. Sheridan is sold in China and has stores in London, while Bonds is distributed in New Zealand, Canada, USA, Singapore, the UK and China. Unfortunately you're unlikely to find too many Chinese kids proudly displaying the iconic Australian brand of their jocks by wearing their jeans around their knees. Without the same brand loyalty margins will be lower and the money spent abroad could be wasted.
Finally, let's consider the currency. In 2009 then chief executive Sue Morphet shifted manufacturing to China and sacked 1,850 employees to cut costs. It didn't help margins, though, as department stores keep pushing for cheaper prices. The falling Aussie dollar only compounds the problem, as it increases manufacturing costs.
It's hard to imagine earnings growing by much more than 4-6% a year over the long term. After making adjustments for corporate costs and the sale of Workwear and Brands Collective, underlying EBIT for the year came to roughly $60m. Deduct $5m of interest expense on the reduced debt and taxes and you get to an underlying net profit of roughly $38m, putting the company on a price-to-earnings ratio of 12.
That might sound cheap, but management expects operating earnings 'to be down materially' in 2015 so the underlying PER is likely much higher. Given increasing competition from home brands and the internet, a lower Aussie dollar and the risky overseas expansion, we're throwing this company in the too hard basket. SELL.