This note was originally published May 10, 2013 at 12:32 in Retail
The True Religion (TRLG) sale to TowerBrook Capital is mostly a net positive to FNP, but we need to consider both sides of the valuation argument for Lucky. On one hand, it shows that the appetite for mid-sized apparel brands remains hot, and TRLG is just about the closest comp for Lucky that we can find. With FNP being very vocal about finding another home for Lucky, this supports the high level of interest in the brand speculated on in the general press.
On the flip side, the valuation multiple for TRLG is an even 7.0x EBITDA. That's something we'd put in the 'good, but not great' category. If we apply the same multiple to Lucky, we're looking at $308mm on 2013 EBITDA, and $371mm using 2014. There's nothing wrong with those numbers, as the midpoint is enough to complete wipe out FNP's debt -- and that's without monetizing any part of Juicy. But it is lower than the $400mm+ levels that have been thrown around by Wall Street M&A publications.
All of that said, we could argue a premium to TRLG for a few reasons. 1) TRLG is a less basic brand that carries more fashion risk. In its push to become a lifestyle brand, it's EBIT margins have slipped from 25% to 17% in 5-years' time, and EBIT has been stuck between $70mm-$80mm during that period. There's no indication that margins are stabilizing, which hardly warrants a premium valuation.
Lucky is the polar opposite from a financial perspective. We've got EBIT margins clocking in between 3-4% this year on a fully-loaded basis. They're on the rise as the brand regains momentum, sales productivity improves, and the company enters into higher-margin accessories categories. Given that estimates are likely too low for Lucky and margins and returns are both solidly improving, we can justify a premium valuation to TRLG. If we assume a 20% valuation premium, it suggests 8.4x EBITDA. That's $300mm using TTM EBITDA, $370mm using 2013, and $445mm on 2014.
When all is said and done, we remain comfortable with our view that FNP could net a minimum of $600mm for Lucky and Juicy combined. (See our 5/3 note. FNP: Where Do We Go Now?)
FNP: Where Do We Go Now?
Takeaway: If you own FNP for a transaction, you should get out. The call is bigger than that. The upside is there under both scenarios.
The single greatest takeaway from this FNP quarter is that the 17% top line growth rate is the highest we've seen out of the company since March 2003. We cringe every time an analyst congratulates a management team on a conference call (do any of us get publicly congratulated for doing our jobs?) -- but we gotta hand it to McComb. This quarter was a big step forward for FNP.
All of that said, this stock has been one of the best performers in the market over the past 6, 12, and 24-month time periods. It's been one of our favorites all along. But with the stock at $21 we need to step back and really re-evaluate where we can go from here. The answer, we think, is 'higher'.
We think we need to tear apart the model and look at two scenarios. 1) FNP as is today, with Juicy and Lucky as part of the portfolio, and 2) what the model will look like on that day the company announces that it's selling 55% of its revenue (but only 25% of next year's EBITDA). We think many people will be surprised to see that the profitability levels don't look dramatically different under both scenarios. The difference, however, is in the flexibility to maximize and optimize the amount of capital allocated towards highest-return businesses.
SCENARIO 1: FNP REMAINS INTACT
Contrary to what many people think, we're not against FNP abandoning its efforts to sell Juicy and Lucky. Yeah, the stock would take a hit due to people renting it for the deal. But here are our assumptions...
a) Juicy: The reality is that we're convinced that Juicy has hit a bottom, and the new initiatives coming down the pike over the next 12 months (like outlet redesign and Juicy Sport -- it's answer to Lululemon) have very minimal downside for the brand and its cash flow. Even if we assume that it stabilizes comps, adds minimal square footage, and returns to a (still paltry) sub-8% EBITDA margin, we get to a 5-year EBITDA growth CAGR of about 25%. It's not a slam dunk, as we need to see the new org chart at Juicy execute on the hype. But we think that our assumptions are hardly heroic.
b) Lucky: This is a brand that we think has meaningful upside under FNP's umbrella. We think that having a sister brand like Kate pave the way to grow outside of traditional denim categories could take productivity well above management's stated goal of $600/square foot. After square footage shrank over the past three years, we think we're finally going to see a reacceleration in store growth, and will see the company once again break through the 10% EBITDA margin mark.
c) Kate: There's not much that hasn't been said here. Management subtly took up square footage growth goals on this conference call (10 outlets for this year up to 10-12, and 30 US Specialty stores up to 30-35), which is a drop in the bucket relative to the 300 stores that the company is likely to add globally over a 3-4 year time period. Seriously, the store growth potential here is very difficult to find in retail. We're often asked what gives us the confidence that it can grow at this clip -- and one of our answers is that it is currently running at just a low double digit operating margin. Brands like Coach and Kors are hovering around 30% (ie we need to ask the question of whether they are investing enough capital to sustain brand momentum and allure). Same goes for other high margin concepts like LULU. But this is not the case with Kate. In fact, after it is done with its multi-year investment phase, we should see EBITDA margins climb past 20% (EBIT margins still in teens), which should make profitability explode. In short, we have Kate's EBITDA going from $94mm in 2012 to $425mm over a 5-year time period, with comps and unit growth fueling the early years, and margin improvement (up to 22% EBITDA margins) driving the back-end of the model.
d) Total Company: Bottom line, EBITDA from $106mm to nearly $500mm over 5-years . It will not have the cash flow to start paying down debt until 2015 given the step-up in capex in 2013 and the absence of what would likely be $600mm+ from the sale of Juicy/Lucky. But on the flip side, it still likely has a good three years until it has to pay cash taxes due to NOL carryforwards, which serves as a big offset to interest expense. On a fully taxed basis, FNP should break-even this year excluding streamlining charges, and then ramp at a precipitous rate thereafter -- with an extra $0.40-$0.60 per share in earnings per year through 2017. Perhaps the most telling statistic is FNP's RNOA. It has not earned its cost of capital since 2006 -- and that was a fluke due to the operating environment. Previous peak RNOA was 17%, which happened when the company was using a low cost of borrowing to roll up the industry. But over the next 5-years, the new FNP should see its returns in the 70-80% range. Not a bad return on capital by any stretch.
SCENARIO 2: FNP SELLS JUICY AND LUCKY
We think we can safely assume that FNP sells both Juicy and Lucky for a combined $600mm. We're going to ignore what the press is saying for the time being (which would get us to a higher valuation) -- as we don't want to fall victim to bankers negotiating a transaction through Deal Reporter or Women's Wear Daily. If we look at 2013 numbers, we think that $300mm-$350mm is fair for Lucky, and $250mm is fair for Juicy. Interestingly enough, when all is said and done, the earnings numbers don’t look much different whether FNP owns these two divisions or not. The offsets to losing Juicy and Lucky's EBIT are a) $383mm in debt goes away, which saves about $50mm in interest expense, b) D&A comes down by about 40%, and c) both stock-based comp and unallocated corporate costs come down by 10-20%.
So the question then, is 'why do the deal'? The answer comes down to the balance sheet, as eliminating $383mm in in debt definitely means something. In addition, at any given point, the company has over $100mm in capital tied up in inventories at Juicy and Lucky, as well as what we think is $10-$20mm in maintenance capex in those two concepts. In the end, this is not a balance sheet killer for FNP. But when you're painting a picture of a $4bn ultimate brand roadmap, there's something to be said about keeping capital flowing towards the highest margin and highest return opportunities.
WHAT TO DO WITH THE STOCK
If you're in it for a transaction, then we'd suggest that you get out. It's not the right reason to own it at this point in time. You should be buying FNP today for one reason…and that's because you think that the Kate Spade brand can triple its store size globally, build out its e-commerce business, and layer on additional concession shops at a rate such that revenue grows 4-5x in 5 years without having to make assumptions that Kate ever prints an operating margin above 20%. With this kind of brand growth, we should see the company handily beat consensus whether they sell Juicy/Lucky or not. Would we rather see the brands go? For the right price, yes. But it's not imperative to the underlying call. Until the Street realizes our modeled earnings power and EBITDA trajectory, we're not concerned about valuation. It is trading today at 30-35x next year's earnings. Yeah, that's high. But for a company growing earnings well in excess of 30% while the balance sheet continues to de-risk itself and returns head from 0% to 70%...we'd give pretty big pushback to anyone who is short and making a valuation