The latest rumor mill (and virtually all major newswires) went out with a potential Coach/Burberry merger on Friday. We think it’s both financially, strategically and logically unlikely to happen. Whether you buy into the merger or not, it does raise interesting questions about where we are in the M&A structure of high-end (if you want to call Coach that) retailers/brands. We still think that the next deal is any of four companies buying KATE by year-end 2017.
1) First off, Coach is terrible at acquisitions. That does not mean it won’t do more of them, but they are more likely than not to be a very bad idea. Keep in mind that COH bought Stuart Weitzman in 2015 for $575mm – only four years after Jones Apparel Group bought it 77% lower and subsequently underinvested in the asset. By the time push came to shove and the brand needed growth capital, Sycamore Capital sold it to (an oblivious) COH. Coach’s debt to total capital went from 0% to +26% overnight, and with the addition of $300mm in revenue, operating cash flow has declined by $150mm since the deal. Go figure. We think that the real cost of the Weitzman deal was closer to $750mm (2.5x sales). Again, Coach is lousy at small acquisitions. It’s probably REALLY lousy at big ones.
2) Size Matters. This is a rumored merger – but would be more of a merger of equals (in size – not cache).
- COH Revenue/EBITDA/Return on Capital = $4.5bn/$970mm/11% ROC
- BRBY Revenue/EBITDA/Return on Capital = $3.6bn/$780mm/18% ROC
3) Tough Mechanics. The mechanics of this deal would make it tough for the transaction to go through without some dilution to the acquiring entity, in this case Coach. At the rumored takeout price (£18.50 a 24% premium to Friday’s closing price), that would assume a deal value north of $9bn for the BRBY asset. On that, the combined entity would be butting up against a debt/EBITDA ratio close to 4x, and we’re hard pressed to model anything but dilution in year 1. On TTM numbers maybe you can get there, but this looks through the potential/likelihood of a material change in currency or a snap back in current trends at BRBY. Mind you, if anything comes to fruition, Burberry is not being bought, but rather is being sold. It would not be looking for a suitor if the core business was healthy.
4) If BRBY Sells, It Is A BIG Tell As To The Cycle. BRBY is a company that has picked its spot at the high end, and largely stayed there. It has stiff armed suitors in the past. Why now, would it say yes to the tarnished brand that is Coach? It is, for the most part, a mono brand company that has stuck to its knitting. The CEO is also the creative Director (kind of like we have seen at other creative companies with heavy-handed CEOs like RH, Ralph, and Nike). This is in stark contrast to other European lux companies like LVMH and PPR that have each diversified into portfolios of product at multiple price points. If this deal were to happen – regardless if it financially could be stomached, it would be a dramatic (negative) turn of strategic direction for Burberry.
5) Luxury Mergers DO NOT WORK! We’ve never really seen a merger in the luxury space that made any sense. Keep in mind that there are virtually no Brand synergies. No real estate synergies. And no buying synergies. As equity investors, do we want to buy a luxury merger for cost cuts? We’d run for the door (i.e. the short call) if that was the pitch.
6) Probability of a Deal. High, but Not This Deal. Does a deal between COH and BRBY go through? Probably not. We rarely, if ever, make a call on take-out potential unless the asset is seriously distressed. COH is tarnished, but not distressed. That being said, if any deal is to happen in this space, we think it will be either KORS/COH/PPR/LVMH buying KATE. We think it’s more likely than not that we’ll see that by year-end ’17. The punchline there is that KATE should not be a public company, and we’re increasingly of the view that someone who should be (and is) public should step in. This is still a brand very early in its life cycle, with about a $2bn retail footprint ($1.2bn reported on the P&L), and EBIT margins 20%-25% points below KORS or COH at the peaks. Between category expansion, new store openings, and international we think there are plenty of levers there 20%+ EPS growth. At a sub-10x EV/EBITDA number we think it looks very attractive.
7) And let’s spend a minute on timing. The reality is that we’re a lot closer to the end of the economic cycle than we are at the beginning. We always see two things picking up at the end – bankruptcies, and deals. Consider the bankruptcy trends alone (which goes hand in hand w trends in M&A). With three months (of reported data) left to go in the year, we’re already within spitting distance of the highest bankruptcy rate in 20 years. Only 2008 was worse, but not by much. Keep this in mind if you think that we’re not late cycle.
Source: Factset, Census.gov, Hedgeye
