What would you pay for Pacific Brands?

Locally-owned Australian brands are hard to come by these days. Vegemite, Tim Tams, Holden, and Victa lawn mowers are long gone. Qantas remains but no one in their right mind would buy it (see For the love of Qantas, sack Joyce on 14 Jan 14 (Avoid – $1.12)). But what about Bonds, Sheridan, Hard Yakka, KingGee, Tontine, Dunlop and Berlei, all owned by Pacific Brands?

With the All Ordinaries up 25% over the past two years and Pacific Brands share price down 11%, and down 36% since 19 Mar 13 (Hold – $0.84) perhaps there’s an opportunity here, especially with the share price hovering near the Buy price of that review.

Being a leading brand is no guarantee of profitability, though. So let’s put our private equity hat on, and examine Pacific Brands’ constituent parts to see what a private buyer might be willing to pay for the entire business.

The Workwear and Brands Collective segments includes Hard Yakka, KingGee and Hush Puppies, plus dozens of smaller footwear and workwear brands, mostly sold direct to businesses or wholesale. Together, they contributed $580m in revenue over the last 12 months, 45% of the company’s total revenue, and $30m in earnings before interest and tax (EBIT).

After removing the proportional share of corporate costs and interest expenses, this unit makes about $11m in adjusted net profit. That’s a margin of 2%, which speaks for itself. In fact, it’s worse than that. Sales fell 5% this half, while EBIT fell a whopping 44%. Market share has been falling for years due to increasing competition from foreign brands, aided by a high Aussie dollar.

Also, more than 70% of sales are to just a few powerful customers like David Jones, Target, Big W and Woolworths, which are now promoting their own private labels. Potential private equity investors would look at this business and utter four simple words: Get rid of it. We’re ascribing a nominal value of $50m (a PER of just 4.5), which is largely tied up in the few key brands.

Sheridan-Tontine

To the gems: In Australia, manchester means Sheridan and Tontine. This isn’t a particularly large part of Pacific Brands, contributing $212m in revenue over the past 12 months. And these brands aren’t particularly profitable either, delivering just $17m in EBIT, or $6m in adjusted net profit. But they are growing, and profitably so. Sales increased 11% this half and EBIT grew 33%.

Driving this was a change in strategy introduced in 2013 by new chief executive John Pollaers. In 2009 his predecessor moved manufacturing overseas. But the benefits of cheaper labour costs were snared by the department stores, not Pacific Brands. That led the company to open its own retail stores and improve its online offering.

The results are impressive. Over the past year EBIT margins have increased from 6.8% to 8.1% and the store rollout will help drive sales growth, although probably not at the current high rate. With $6m in net profit and a PER of 12.5, we estimate this business to be worth about $75m.

Bonds   

If Sheridan and Tontine are gems, Bonds is the Hope Diamond. This division, which also includes brands like Berlei, Jockey and Explorer, generates $476m and $77m in EBIT (excluding $11m from the sale of property), down 4% compared with the previous period. That’s an adjusted net profit of $41m and a profit margin of 9%, which in retail is unusually high.

Bonds’ sales are growing strongly, too, up 20% this half, due to improving online sales, a retail store rollout and new categories such as Bonds Kids. Unfortunately, the smaller brands in the Underwear division, with the exception of Berlei, are mostly in decline, which dragged down overall sales growth to 10%.

There are problems, though. A 25% increase in the price of cotton and the Aussie dollar’s decline increased manufacturing costs, which couldn’t be passed on to customers and offset the benefits of a 10% lift in revenue. And the sales growth came at a price. To achieve $17m in overall additional sales, the company spent an extra $16.5m on marketing.

This is a formidable brand in a dying industry. Like Sheridan-Tontine, the Underwear segment operates in a hotly competitive mature market. The shift to a direct-to-consumer strategy is sensible but expensive to implement. It’s hard to imagine earnings growing by much more than 4-6% a year over the long term. With $41m of earnings, we think Bonds and the rest of the underwear business is worth about 13 times earnings, or $520m. 

Summation

Adding the three divisions together, that places a value on Pacific Brands of $650m, or a bit over 70 cents per share. So, with the current share price of 54 cents and dividend yield of 8.4%, it’s a slam-dunk, right?

Err, no. Management has done a commendable job in reducing net debt to $170m and cutting out dead brands, but more needs to be done (see Chart 2). And store rollouts, as Billabong’s recent experience attests, can go horribly wrong. It remains to be seen whether Pacific Brands’ management can pull it off.

The biggest risk, though, is the dreaded overseas expansion. Sheridan is now sold in China and has stores in London, while Bonds is distributed in New Zealand, Canada, USA, Singapore, the UK and China. The possibilities are endless, and so are the risks.

When a teenager walks proudly down the street with his pants around his knees to show off his new Bonds underwear it may seem ridiculous to the rest of us, but it’s that brand loyalty that allows Pacific Brands to charge a premium price. With no overseas brand recognition, Chinese and US teenagers probably won’t be prepared to pay a premium in the same way that Aussies are. There’s every chance the money spent overseas will be a dud investment.

On the face of it, Pacific Brands looks cheap. But the new strategy calls for a larger margin of safety, which is why we're lowering the prices in our recommendation guide. Should the price fall bellow $0.45, we'll take another look but for now Pacific Brands is a HOLD.