LIZ: Tremendous Call Option

Only 3 weeks after an 8% workforce cut, LIZ is selling a cost center for cash. I’m also gaining confidence that the debt covenants will not be breached, and top line pressure (though not integral to the story here) is easing on the margin. By late 2009, I think that investors will be eyeing EPS closer to $0.75. I maintain my view that this company will remain solvent, and that the stock under $3 is a tremendous call option.

1. LIZ announced this morning that it is selling its sourcing operations to Li&Fung for up to $83mm in cash. This makes perfect sense to me, as LIZ has invested way too much capital in its internal sourcing arm over the past 10 years with negative cumulative return. Not only will this take a cost center off of LIZ’s P&L, but they’ll get paid cash for it. Will LIZ see higher FOB costs on its apparel? Yes. They’ll need to pay Li&Fung for execution on orders. But I’ll take that any day for LIZ. With the transaction, net debt comes down by 8%, and EBITDA goes up by 10% using even the most conservative estimates.

2. Watch the top line. LIZ is not a top line growth story. I repeat…It is not a top line story. But with sales of its Partner brands (40% of total) falling by over 30% over the past 3 quarters, let’s keep an eye on changes on the margin. Specifically, Kohl’s recently launched Dana Buchman as an exclusive from LIZ, and the company finally launched the long-awaited Mizrahi redesigned Liz Claiborne line. My digging suggests that this is actually performing well relative to expectations. I still think that LIZ should take the Claiborne brand and sell/license the whole thing to Wal*Mart while it monetizes its other brands like Juicy, Lucky and Kate Spade. That’s probably not in the cards soon – but it does not need to for a $2.33 stock to work.

3. Debt covenants look good. Even before this morning’s announced sale to Li&Fung we’d been getting warmer on LIZ’s ability to hold the line on its debt covenants. The bottom line is that we need to justify that margins are down 450bp in ’09 in order to breach. I find it tough to logically, or mathematically, get there. A few considerations on the EBITDA coverage calculations that give a bit more cushion that I think many are currently looking for…

a. There is $150mm of cash restructuring added back in ’08 and up to $60mm in ’09 in the numerator.
b. The lenders are not counting ~$100mm in CapEx in F08 that was spent on store growth, which is being deducted out of the numerator.
c. In the Interest calculation, cash taxes and dividends are added as well so with the dividend suspended and no cash taxes paid, there is no impact from these lines.



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