LULU – Chip Away

Takeaway: This Chip/Advent deal has positive strategic implications that are far greater than the $845mm suggests.

Conclusion: Chip Wilson’s sale of half of his stock to Advent is spot-on with our investment thesis for many reasons. Our point when we turned positive on LULU in June was that Wilson has started on a path of activism that he structurally cannot win, which will lead to a stock sale, reorganization, acquisition, LBO, or a combination therein – all of which will ultimately create value and rescue shareholders from the otherwise destructive path of its core business. The reason for his near-certain failure is due to the barriers that he himself put in place during his reign as LULU’s Chairman in order to prevent anyone from gaining undue influence over the company.  He ultimately became his own worst enemy, and he knows it. This transaction is the first of many steps in the right direction that could finally fix one of the biggest mismatches between brand strength and organizational infrastructure that we see in retail today.

We Think There Are Three Options Here For Advent

1) Restructure this company (including firing CEO Laurent Potdevin), and upgrade the infrastructure, information systems, outlet network, and possibly even explore a meaningful wholesale operation (though we’re still on the fence there). Ultimately, it’s creating an organizational infrastructure that will take the sales base from $1.8bn to $4bn and earnings to $4.00+. But today, the company has a $1bn infrastructure at best. Fixing this will take time, and will be costly – likely to near-term earnings. But could catapult the revenue and earnings stream to a level that will support a triple digit stock.  This is the best bet for a long-term shareholder.

2) The major near-term option is still very viable – which is to sell the company outright. We don’t think that’s Advent’s game. In fact, there is a ‘no-shop’ clause in the deal that prohibits either party from shopping for an acquisition for 18 months. But in actuality all Advent would need is Board approval and this could be overturned. Chip does not control the Board – not even close. In other words, if Advent or the Board wants LULU sold, it gets sold. We still think that a deal up to $70 makes financial and strategic sense to Fast Retailing, and $60 for Adidas or Kering. These companies are all likely interested in owning LULU (see analysis below).

3) Of course, a third possibility is that Advent invested in LULU because it thinks that the current operating plan is one that will play out profitably. The problem there is that – unless anyone can prove to us otherwise – we don’t think that an operating plan even exists at LULU.

Some Important Considerations

Advent is no stranger to LULU. In 2005 it bought 48% of the company together with Highland Capital at a valuation of $93mm. It admittedly sold at the wrong time in June of 2009, but not before netting a 400% return on its initial investment. Most importantly, the foremost stipulation of Advent’s participation in the deal pre-IPO is that Wilson remove himself as CEO. Advent knows what it’s up against with Chip better than anyone.  The press release might sound like these two parties have an 18-month love affair ahead of them, but make no mistake. Advent is all business. There’s absolutely no reason why it would be investing $845mm in LULU today (it has a $32bn portfolio) if it did not think that value was headed meaningfully higher. Its track record is rather impressive.

Conversely, there’s no reason Wilson would be selling half of his stock and diminishing his influence inside the company even further from where it is today (i.e. he’s banned from LULU’s HQ, is no longer Chairman, does not have a majority of the Board, has no special voting power, and is no longer its largest shareholder). Wilson’s wife and son just started an apparel company (LINK), with the opening of a retail store this week – and Chip has been unable to participate to the extent he wants due to his non-compete.  It’s likely that the guy wants out 100%. His current diminished ownership leaves him ‘half-pregnant’. Chip is an all-or-nothing guy.  The reality is that Advent needs him during a transition period to help with what could be considerable organizational change. This makes sense to us. If Wilson gets in the way (which he probably will), we think Advent is likely to lift the burden of his remaining 20mm shares of stock, or find someone who will invest alongside them – as they did back in 2005.

Transaction Mechanics

The Support Agreement connected to the transaction tightened the reins on Chip. Yes, he got to keep his Board seat, and you could argue that he has a few more friends in Vancouver tonight when compared to yesterday. But, he had to give up half of his nest egg and agree to stringent oversight in order to keep any semblance of influence inside the company.

The Board even put a clause in the Agreement restricting Chip from disparaging his colleagues in a public forum. In any other circumstance we’d characterize that as excessive, but Chip is a loose cannon and Advent knows that from their last transaction in 2005. One of the key provisions of that deal – Michael Casey would replace Chip Wilson as CEO of the company. Clearly they believed in the man’s vision, but had doubts about his ability to run the day-to-day operations of the company.

Key points that we found notable.

Future Purchases

1)      20% - Restricted without prior BOD approval if such deals take either Advent or Chip’s stake over 20%.

2)      $30.00 – That restriction is lifted if at any time if the 5 day moving average falls below $30 and a subsequent purchase is made at or below $30 threshold.

 

Standstill

1)      Proxy Fight - Advent and Chip are prohibited from soliciting proxies until the day after the ’16 annual meeting or 7/31/16. Whichever comes first.

2)      Solicitation – Each party is prohibited from soliciting an acquisition for 18mnths following the closing of the deal.

Gag Order

1)      No more Bloomberg interviews. At least for 18 months.

Board Dynamics

1)      Seats – Advent holds the right to nominate two members to the BOD as long as the firm owns more than 10% of the outstanding voting stock, and only one if they fall below the 10% threshold but maintain a position somewhere between 6.75% and 9.99%. Chip has the right to nominate one member (i.e. himself) to the BOD as long as his position remains above the 8% threshold.

2)      Co-Chair Designation – Advent has the right to have one or its sole nominee serve as a co-Chairman of the Board, as long as stake is above 6.75%. This is a critical component.

3)      Shareholder Approval – Due to LULU’s classified Board Structure, Directors need only be approved by a majority of shareholders every three years. Advent’s two seats are designated Class I and Class II. Chip’s seat Class III. Each requires shareholder approval in the following years: Class I (2017), Class II (2015), and Class III (2016).

4)      Size - The size of the board is now fixed at 12. Unless approval is obtained by both Mussafer and Collins - that is as long as Advent holds a position that exceeds or meets 10% of the outstanding voting stock.

5)      Resignation – Three possible scenarios could result in forced resignation. i) Advent holds less than 2% of voting stock, ii) Chip holds less than 4% of voting stock, or iii) if at any time Chip or his ‘designee’ is found to be in violation of the Standstill Agreement.   

Voting Agreements

1)      New Directors - Advent and Chip must vote all outstanding voting stock in support of the BOD in all future nominations or future reappointments of Board approved Directors.

2)      Termination – The agreement last for 18 months following the closing of the deal. Or, i) either Advent or Chip no long holds enough voting stock to nominate a Director. ii) The public announcement of a tender offer.

06/25/14 11:09 PM EDT

LULU – Cliff Notes of Our Best Ideas Call


Takeaway: Here’s why we think Chip’s activist campaign will fail miserably, and why it’s ultimately good for shareholders.

Conclusion: Today we hosted a conference call to discuss the rationale behind why we added LULU to our Best Ideas list as a long after the stock’s latest collapse. As we’ve said before, the call right now has nothing to do with our confidence in the business or the team running it. This is a company in a defendable category with an outstanding brand, a $95bn addressable market, and a realizable $4-$5bn revenue stream over 5-years. But the catch is that it’s still sitting on a $500mm management team and operating structure.  The good news is that never in LULU’s history has there ever been a path to creating value, and that’s due to the sometimes painful, and usually embarrassing presence of its founder, Chip Wilson. But we think that the Board structure that he created will ultimately lead to him outright failing in his current attempt to regain control of the company. That is likely to be a catalyst for one of many forms of change, which we explored in our presentation and deck.  We plucked out a few of the more salient slides that we think are worth considering. Let us know if you’d like the replay and the full materials.

The LULU Bracket

This diagram is noisy. It’s supposed to be. Start reading it on the left with the decision of whether or not Chip Wilson wins control of the Board We very generously gave him 20% probability. But in reality he’ll be lucky to get 10%. If he loses, which he will, we think that one of two outcomes is most likely; a) he sells his stock (35% chance) – representing 27.7% of shares outstanding, or b) there’s a deal – 10% likelihood of a buyout, or 20% chance of an acquisition. When all is said and done, about 80% of the outcomes get us to a price well above $41.

LULU – Chip Away - chart1

Outcomes, As We See Them

1) Management Team Upgrade (49% probability): Each scenario results in a potential management upgrade, but the biggest likelihood is if Wilson sells his stock. All in, we get to a 49% chance of a meaningful change in management (including putting in place a high caliber CEO). This company needs better executives, and a lot more of them. This is a team that we think would proactively invest in systems needed to more appropriately discount product – something LULU sorely needs – and tackle its competitors head on instead of clinging on to a ridiculous hope of a perma 55% Gross Margin. The way it is being run today, the company is on its way to becoming Coach. We firmly believe changing that path is not a very difficult one. All in, this scenario gets us back to the discussion of $3-$4 in earnings power, or a $60-$100 stock (20x $3.00, and 25x $4.00).

2) Deal (30% probability): The biggest barrier to a deal getting done in the past has been that Chip didn’t want it to happen. Now he’s likely searching for one. Our sense on Wilson is that he feels handcuffed by LULU. He’s not allowed to participate in anything having to do with the company aside from attend Board meetings, but he’s too big a shareholder to go off and start another brand (something he’s actually very good at) due to his non-compete. If he can’t gain control, he could look to get the company sold. We think that a buyout with a PE partner is not very likely – as there’s not a ton of private buyers that would take out a high margin company at 15x EBITDA. But we think that the set of strategic buyers is a) far more expansive and b) less price-sensitive.

3) Status Quo (21% probability): This outcome pretty much stinks. The reality for LULU is that a status quo management team and status quo operating plan results in a far less than status quo stock price. We see about $10 downside to $30-32 if this is the case ($1.50 in EPS – 15x p/e and 10x EBITDA). This is the outcome that would cause us to pull the plug on our call – though we don’t think this will come to fruition.

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Board Considerations

There’s a few reasons why Chip will likely not regain control of the Board.

1) Giving up the title of Chairman in late 2013 is the worst thing Chip could have done. We think that was one of the final moves in a game of chess the real Board was playing with him. He agrees to step down from being Chairman if Laurent Potdevin gets the green light to be CEO. Potdevin is likely not the guy for this job, but it was a great move in hindsight by the Board.

2) Why? Only the CEO, Chairman or a majority of the Board can call a special vote at LULU. Chip cannot do it. He literally has a better shot at selling the company outright than he does in calling a simple special Board meeting.

3) There are 10 Board members, and three are clearly on ‘Team Chip’. But the Board has an offensive weapon in that it is authorized to have between 3 and 15 Board seats. All the Board needs is a simple majority (which Chip likely will not be included in) and it can appoint up to five new Directors -- none of whom are likely to be aligned with Wilson.

4) Better yet, there are staggered seats with three year terms. So if Board members are appointed today, he or she doesn't have to be voted on by shareholders until 2017.

5) All in, Chip’s ownership has been steadily shrinking, but his influence has been shrinking faster. He knows this. All the more reason to make a move to get out.

 

LULU – Chip Away - chart3

Who’s A Buyer?

We think that there’s a lot of companies that want to own LULU, but unfortunately, not a lot of companies can afford to do the deal at $8bn. We calculated the leverage for a host of suitors pre and post transaction, and also looked at year 1 accretion and dilution for each company. The punchline for us is that LULU is not likely to be bought by an American company. We’re thinking German, French or Japanese.

a) Nike: NKE won’t buy what it thinks it can build for less money. Whether you agree with them or not is irrelevant. They think they can beat LULU organically, so they won’t buy it.

b) Adidas: AdiBok needs it, can afford it, and couldn’t care less about near-term dilution. This makes a ton of sense.

c) UnderArmour: This makes zero sense strategically or financially. I’m surprised I’m asked this so often.

d) VFC: This would be a big nut for VFC to digest, but they could afford it – barely. VFC has gotten less value-conscious in recent years (i.e. TBL) so maybe it’s a possibility. But a dark horse for sure.

e) PVH: This is a company that needs a deal like LULU, but it would crush PVH financially. Tough luck Manny.

f) Fast Retailing: The Japanese owner of Uniqlo is looking to aggressively expand into the US, and needs to diversify away from its mall retail fashion push. The fit makes sense, the accretion is a no brainer even past $70, and let’s not forget that Fast was almost on the hook for buying J Crew in March for $5bn until it saw how bad Mickey’s business was trending.

g) Kering: CEO is on the tape saying he wants to buy sports brands to augment Puma, Tretorn and Volcom. KER could digest LULU in a heartbeat. French company might keep Laurent on board, as well.

h) GPS: This one is another consideration – albeit a long shot. It would take GPS’ debt to total capital to about 65%, which is likely far above the Fisher family’s comfort level. Perhaps GPS will be content chipping away at LULU with Athleta, which is crushing it.

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