Sun rises on Billabong wipeout

It seemed like a good idea at the time. Surf brand Billabong International was making good margins wholesaling its merchandise to retailers. Wouldn’t it make even more by becoming a retailer itself and selling direct to customers?

Evidently not. The company’s expansion into high streets and shopping centres was ill-timed and poorly managed. By the time the debt-fuelled expansion came to a head in the middle of last year, earnings had fallen from 86 cents per share in 2008 to 47 cents in 2011. Falling earnings, overpaying for acquisitions and poor free cash flow eventually endangered the company’s financial position.

The effect on the share price was catastrophic, rendering earlier upgrades of the stock including Billabong positioned for prosperity on 8 Jul 10 (Long Term Buy – $8.57)) a clear error. We finally recognised it as such and sold in The Billabong wipeout from 22 Aug 11 (Sell – $3.75), before the share price fell a further 71%.

It’s difficult to buy back into a stock that has cost you—anchoring to a previous experience makes fresh analysis difficult, at least psychologically. But that’s what we’re about to recommend you do if you’re comfortable investing in turnaround situations.

The problem with turnarounds is that they often fail miserably. In Billabong’s case, the company still carries debt and long-term leases, it’s vulnerable to weak consumer spending, over half its revenues come from deeply indebted economies such as Europe and the US, and its brands have suffered since the global financial crisis as retailers discount products to clear stock in a weak economic environment.

For this reason Billabong isn’t suitable for conservative investors or those focused on income (see our Buy list for more suitable opportunities such as ASX or Woolworths). But if you’re prepared to accept higher risks in the pursuit of potentially higher returns, then Billabong might make an interesting addition to your well-diversified portfolio.

Billabong wipes out

When we sold Billabong there were two main issues—debt and management—that needed solving. Firstly, in December 2011, Billabong had $526m of net debt, plus $86m of earn out payments, the side-effect of acquiring 11 brands and over 600 retail stores in the space of 11 years. As earnings softened, interest cover fell from 8.8 times in 2010 to 4.2 in early 2012. Action was needed.

In response, in early 2012 Billabong sold around half of its successful Nixon business through a joint venture with Trilantic Capital Partners, releasing US$285m in cash. It wasn’t enough, and incoming chief executive Launa Inman triggered an extremely dilutive 6-for-7 entitlement offer to raise $225m at a price of $1.02 per share. These measures brought interest cover back to about eight times and net debt, including earn outs, to a more manageable $170m.

Secondly there have been changes to management. Long standing chief executive Derek O’Neill—the architect of the debt-fuelled expansion strategy—was, in May, replaced by Launa Inman, previously managing director of Target Australia. Inman led an incredible turnaround in this business, where she ended excessive discounting, refocused the brand, reinvigorated the womenswear department and returned the company to profitability. It looks like an astute appointment.

Inman has only been in the job since May and is yet to announce a detailed plan, although she quickly fingered debt, complexity and ‘inefficient’ retailing as the source of the company’s troubles. The first of those issues has already been addressed. The other two will be covered in a more detailed plan to be released on 24 August.

Inman’s plan

What can we expect? Store closures are a certainty. Of the company’s 677 stores, 140 have been deemed unprofitable and scheduled for closure by 2013. Assuming sales then fall 10% to around $1.4bn (excluding sales from Nixon), this should help stabilise earnings before interest, tax, depreciation and amortisation (EBITDA) margins at around 7%. Billabong should then earn at least nine cents per share by 2014 (see Table 2), putting the stock on a forecast PER of 12 (post-capital raising).

The costs of store closures and write-offs mean Billabong should report losses in 2012 and return to meagre profitability in 2013. Nevertheless, this is an expense that needs to be carried. Closing unprofitable stores, however, isn’t the only tool at Inman’s disposal.

The company’s gross margins have barely budged from their five year average of 54%. EBITDA margins over the same period have fallen from 20% to around 6%. Billabong clearly has a cost problem. Whilst we don’t expect the company’s EBITDA margins to return to the 20% levels achieved as a wholesaler during a global credit boom, Inman has already identified at least $30m of savings which could help boost EBITDA margins back to 10%. This would add another seven cents to earnings per share, reducing the PER in 2014 to seven.

Inventory management could also be tightened. Currently, Billabong turns over its inventory 4.8 times a year. Better run businesses like Nike, Quiksilver, Gap and JB Hi-Fi manage six to nine times. This may not boost earnings but could release cash to pay down debt or invest in store refurbishment.

The in-store experience needs improvement as well. Billabong currently operates retail stores under numerous brands, each offering a reasonable-but-not-fantastic experience. By reducing the number of brands, re-energising the store environment or adjusting the stock mix earnings could be boosted even further.

It is in the area of branding, though, that Billabong endures the greatest problems. Newer brands such as RVCA, Nixon, Von Zipper and Sector 9 are increasingly important to the company but the Billabong brand still generates 50% of sales (see Table 1).

Table 1: Brand portfolio

Brand	Category	Estimated % of sales
	Surfwear/streetwear	50
	Skatewear	7
	Bags	7
	Watches	3*
	Skate/surf/streetwear	3
	Skateboards	3
	Eyewear	2
	Women's swimwear	2
	Wetsuits	2
	Footwear	1
	Wax	1
	Surfwear	1
*Adjusted for recent sale

Unfortunately, Billabong has suffered from ‘brand stretching’, a marketing term where a brand expands from its core product offering into new categories. Disney’s expansion into theme parks demonstrates it can work. Harley Davidson’s venture into perfume shows it often doesn’t. Billabong’s problem is that its major brand features on too many products, from drink bottles to backpacks and streetwear to surfwear, in too many different styles. This creates a confused and diluted brand identity.

Inman should refocus the brand on its authentic board-sports core and tackle the wider market with other brands in the stable, or by creating sub-brands like rival Quiksilver, which successfully markets its female sub-brand, Roxy.

Rejuvenating and repositioning a brand is tricky but not impossible. Successful examples include Bonds, Gap and Levi's, and we recently discussed in our international stocks special report how AB InBev turned Stella Artois from a cheap local beer to a global premium beer. If we could in future add Billabong to this list, EBITDA margins of 12% are certainly achievable. Earnings per share in 2014 would then be 25 cents, putting the stock on a PER of under five, despite assuming no sales growth.

Inman’s targets

All up, that’s about five different areas—store closures, costs, stock management, retail experience and branding—that, if remedied, could make today’s price a steal.

Another way to value Billabong is by deducting the value of Nixon. We estimate Billabong’s share of Nixon will generate around $17m EBITDA in 2012. On a multiple of seven to nine times (Trilantic Capital Partners paid a multiple of 9.2) EBITDA it’s worth between $119m and $153m. On that basis you’re getting the remaining Billabong business for around $517m-$551m, or 5.9 to 6.3 times forecast 2012 EBITDA of $88m, which could prove to be a low point if the global economy doesn’t deteriorate further.

Fixing Billabong will be messy and time consuming but, critically, with so many areas in which the company could improve, Inman only needs to succeed in one of them to vindicate an investment today. Indeed, value might emerge more swiftly if a takeover bid occurs (something now supported by key shareholder and founder Gordon Merchant).

This turnaround play isn’t suitable for risk-averse investors, as permanent capital loss remains a possibility. But you don’t typically have the opportunity to double your money unless a stock is on the nose, and few have inflicted as much pain as Billabong recently. With the debt down and a new and experienced management team in place, Billabong is suitable for up to 2% of a risk tolerant portfolio. SPECULATIVE BUY.