Description

Long Perry Ellis (PERY).  A substantially undervalued/under-earning set of assets with a strong catalyst to realize their potential.  PERY is a wholesale apparel manufacturer based in Miami, whose business includes the following key components of value: (i) a significant and growing $30mm stream of license revenues, and (ii) a $900mm apparel business (almost entirely wholesale) consisting of the namesake Perry Ellis brand, Original Penguin and others.  PERY is run by George (father) and Oscar (son) Feldenkreis, who bought the Perry Ellis brand in 1999 – the business has been mismanaged over the last 15 years and consequently earns by far the lowest EBITDA margin in its group of comparable companies.  Despite its mismanagement, we think there is no damage done to the brand equity of PERY’s important brands – rather, the mismanagement has manifested itself in an extremely bloated cost structure (something that even management has acknowledged in recent months).  In short, PERY is fixable to the extent that there is a catalyst to push for such change.  On July 17^th, Legion Partners, an activist hedge fund backed by the California State Teacher’s Retirement System (CalSTRS), disclosed a 5.9% stake in the Company.  With a relatively low profile in the activist investor world, we think that the 13D filing went largely unnoticed, yet it represents a game changing inflection point for this substantially undervalued business.  Over the last 10 years PERY has been a significant underperformer relative to its comps and as a consequence we believe the asset trades at a level where it is substantially undervalued relative to its assets and comp set.  Legion is an experienced activist investor, whose founders have run numerous campaigns and successful proxy contests at Legion and also at the Shamrock activist fund (most recently at RCM Technologies).  We believe that their involvement in PERY represents a much more significant catalyst for realizing value than the market currently understands, and that PERY stock over the coming months is likely to transition to a special situation as opposed to a sleepy value stock that has been mostly a value trap for years.

Before we embark on the full blown investment thesis, I’d like to frame the investment thesis with the following riddle:

The 4 great American fashion designers for men are?

           R _ _ _ _   L _ _ _ _ _

            P _ _ _ _  E _ _ _ _

       C _ _ _ _ _   K _ _ _ _

         T _ _ _ _    H _ _ _ _ _ _ _  

Most readers probably think it an absurdity to compare Perry Ellis to Ralph Lauren or Calvin Klein, but the riddle (and suggested answer) was not created by the author.  It is a New York City billboard advertisement developed by a brash young Tommy Hilfiger in the 1980s, trying to develop his fledgling young brand, comparing it to his view of the great American menswear brands, Ralph Lauren, Perry Ellis and Calvin Klein.  Hilfiger’s operation was a fledgling entity at the time, but his vision ultimately proved correct.  That Perry was once on par with those other brands is a fascinating anecdote and an interesting starting point from which to present our investment thesis, as it reflects the brand potential and the degree to which comparable brands have outperformed over the past decade. 

Here is a link to a picture of that billboard in real life:

http://www.mediafire.com/view/576ze3dyb039b67/Billboard.jpg

With that as a backdrop, lets embark on our investment thesis.

Business Description

PERY’s key business segments are wholesale apparel, direct to consumer (retail and internet) and license.  The breakdown of revenue and EBITDA for these segments is shown below (based on 1/31/2014 numbers):

Below is a full “map” of PERY’s revenues, broken down by segment, and then further broken down by brand.  Many of these numbers are estimates but I think this is directionally quite accurate and will be a helpful reference guide as the analysis continues.

A few other bullet points about the business:

-          Revenues from branded apparel represent approximately 80% of revenues (with 20% coming from licensed brands such as Callaway, PGA Tour and Nike swim)

-          The Perry Ellis brand represents about 34% of the overall business

-          PERY is primarily a men’s business, with the problematic women’s business representing just 15% of the total

-          From a distribution perspective, the business is diversified across the department store, sports, specialty, mid-tier and mass channels.  The biggest customers are Macy’s (10% of revenues), Kohl’s (11% of revenues) and T.J. Maxx (<10% of revenues).

Discussion of Valuation

Please refer to the comparable company analysis linked below for the detailed comp set that we will refer to in this analysis.

http://www.mediafire.com/view/ch33jfy9ccsqrvo/CompSet.Summary.xls  (note you may have to click the “download” button to get the excel file)

Over our medium term investment horizon (2 years), we foresee the following range of outcomes from a valuation perspective: 

-          Base case value of $36 per share (97% upside), which assumes a continued significant discount to the comp set.  This scenario assumes some degree of corporate governance reform, modest cost cuts and PERY’s valuation trading in line with distressed wholesale businesses such as The Jones Group

-          Upside case value of $65 per share (256% upside), which assumes more significant progress is made and the business is sold to a strategic buyer at a valuation similar to that of GIII Apparel (GIII), which trades generally at the low end of the range for the comps.

-          Downside case of $22.50 per share (23% upside), which assumes the status quo of the business trading at a severely distressed price representative of a liquidation value.  This number assumes the license revenue stream gets a market multiple for a healthy and growing business and the wholesale/retail operations are valued at net working capital + real estate value, which also corresponds to about .33x revenues, vs the low end of the comp set at 1x revenues.  We think this valuation scenario is likely to play out with the presence of an activist investor, even if that investor makes minimal progress in effecting substantial change.

Valuation Paradigm:

Here is how we think from a big picture perspective about PERY’s current market valuation.

PERY is currently trading at an EV of $437.1 million (note that the Company ended Q1 with an unusually high working capital balance that will reverse over the remainder of the year – we adjust for this in our enterprise value calculation).  We think that the licensing business alone is worth a little over $200 million based on the valuation of Iconix, Cherokee and M&A transactions in the space.  More to come on the license revenue stream, but we think it is very strong, growing, and has opportunities for continued growth.  Thus, the market is valuing the remaining wholesale/retail business at $225.6 million.  This is an $877 million revenue business, with $294 million of tangible book value (net working capital + real estate).  PERY’s owned real estate includes both at its Miami corporate headquarters as well as its Tampa distribution center which we conservatively value at a little bit over $40mm.  Hence, we view the current valuation of the business as essentially a “net-net”, or implying a liquidation value being ascribed to the wholesale/retail operations.  As we will discuss, we don’t think the wholesale business is anywhere as close to as bad as the market is implying, in fact we see real pockets of strength in that business and significant value.  We think the current valuation is reflective of a business and a management team that has disappointed for years and an investment and analyst community that has just lost interest.  We think that is a great setup for an activist to come in and shake things up.

The detailed calculation of this math is shown below. 

Let’s dig a little bit deeper into these components of value:

License Revenue Stream: 
PERY’s license revenue stream has been really the sole bright spot for the Company (which in and of itself speaks to the opportunity here - that their only success has been when they let others manage their brands).  Since 2011 the license revenue stream has grown modestly from $26.4mm to $30.2mm on an LTM basis.  In the past 4 quarters, that growth has accelerated to about 10% on a YoY basis.  The Perry Ellis brand represents about 65% of the licensing business in niche categories such as fragrances, ties, footwear, watches and international retail.  Original Penguin is the next largest component of license revenues at about 20%.  Relationships with licensees are excellent and management sees continued growth in the license revenue stream.  The recent uptick in growth came along with the key hire of Stanley Silverstein who is charged with maximizing PERY’s license revenue potential.  Given the large stable of owned brands in the PERY portfolio and the relative lack of focus on this business historically we think that there is significant low hanging fruit in the license stream and an easy opportunity to exploit this with a solid hire in this area.  As such, we think that the PERY license stream is at least as good on average (and likely quite a bit better) than that of Iconix Brand Group (ICON) and anything they have acquired in recent years.  We value the license revenue stream at a modest discount to that of ICON. 

For more background, here is a brief blurb about Stanley Silverstein:

http://www.licensemag.com/license-global/perry-ellis-gets-pvh-exec

Wholesale Business
We don’t think you are really paying anything for this business and as such, our goal is to show that there are a few pockets of strength and that the business should probably be at least as valuable as the low end of the comp range, probably quite a bit better – all of which would imply massive upside for PERY shares.  Here is some food for thought:

-          Original Penguin is a crown jewel.  The brand is growing, has solid potential and earns strong margins.  This business is only about $80mm overall for PERY today, but given the incredibly low valuation ascribed to PERY’s wholesale business, it is interesting to note that this tiny sliver (6% of wholesale revenues) might be worth $100+ million (the going rate for growing brands with solid margins).  This tiny sliver of PERY’s business alone could be worth about half of what the market is valuing the overall wholesale business.

-          Golf, about a quarter of PERY’s wholesale biz, is actually doing quite well for PERY and has significant growth potential from here.  In fact, management has a slide in their investor deck which describes golf as a “$350mm sales opportunity in three years”, up from $225mm currently.  The growth opportunity comes from a few different sources.  First, and the one thing I will say to management’s credit, they managed to do a great acquisition of the Ben Hogan brand (acquired from Callaway).  Ben Hogan launched in Wal-Mart as a lower tier golf brand and has performed quite well – this will represent about $25mm of incremental revenue in 2014.  Second, the biggest licensed brand is Callaway and this has been a big success – both for PERY and for ELY.  So much so, that PERY just recently won the Callaway license for apparel in Europe as well.  Callaway Europe just started to rollout in Q4 2013 and as such will be a key contributor to growth in the golf business in the year ahead.  Third, PERY just recently became licensee for the Jack Nicklaus golf brand which they are rolling out over the course of 2014.  Overall, PERY has assembled a very nice business in golf – in fact you might even call them the leading golf apparel vendor at this point.  We think this is an attractive franchise overall, especially when viewed in the context of the overall valuation of the wholesale business.

-          The Perry Ellis brand.  Our view on the namesake brand is that it is basically an old stalwart, which has been preserved through selective distribution, has great potential and strength in a few basic categories.  While management has not done a good job with Perry Ellis, they have not ruined the brand either – they have kept distribution fairly disciplined in better department stores while sending lower tier brands such as Axist into more moderate chains such as Kohl’s.  The Perry Ellis brand is strong in pants (which is obviously a big category), is the number one brand in belts in department stores, and is the number 2 brand for wallets in department stores.  Perry Ellis Is distributed broadly in North America and given its strength in a few niche categories we view this as a strong franchise.  We also see this brand as having some optionality given its history and broad appeal – especially in the hands of a better operator like a PVH or VF Corp.  While we are not banking on anything, the upside in a brand like Perry Ellis we think is pretty much unlimited if you look at the scale of other classic men’s brands like Calvin Klein or Tommy Hilfiger.

-          Women’s businesses.  This is where the real problem lies in the wholesale business.  Rafaella, Laundry and C&C were collectively acquired between 2008 and 2011 for about $110mm.  We think that these business have struggled under PERY’s watch and there is value to be had from some combination of (i) selling these businesses, (ii) moving to a license model or (iii) simply shutting them down.  We think that any of those alternatives will be value enhancing to the Company and management has recently suggested a willingness to sell these businesses “at the right price”.

 Overall, we think that PERY’s wholesale business has pockets of strength and a few fixable problems.  As we look at the comp set, we think that a valuation towards the lower end of the range is appropriate – we highlight GIII and OXM as the best comparables, followed by PVH.  That being said, any valuation that is remotely close to the comps suggests extraordinary upside for the stock and we think the current depressed valuation below tangible book value is an incredible bargain. 

Direct to Consumer

This part of the business is obviously a dog.  The only things I can say on a positive note are that it’s a small part of the business (<10% of revenues), and we think that the losses can be reversed since they are confined to Original Penguin retail stores which were opened without discipline or strategy.  Aside from Original Penguin, the direct to consumer business is actually a profitable business.  That being said, this is another area where shareholders will benefit from better capital allocation.

Comparables

Again we point you to our analysis of comparable companies which can be found here:

http://www.mediafire.com/view/ch33jfy9ccsqrvo/CompSet.Summary.xls  (note you may have to click the “download” button to get the excel file)

From our perspective the most notable aspect of the comp set is PERY’s underperformance on margin.  Whereas the median gross and EBITDA margin of the comp set is 48% and 15%, PERY’s margins on an LTM basis come in at 33% and 4%.  In fact PERY’s gross and EBITDA margins are the lowest of the entire comp universe, next to G-III Apparel, which comes in with a 34.4% gross margin and an 8% EBITDA margin.  The benchmarking comparison vs. GIII we find to be particularly interesting because a) GIII does not generate any license revenue whereas PERY generates significant license revenue at a 100% gross margin and b) GIII’s business is primarily dependent on licensed brands (~80% of revenues) as opposed to owned brands (~20% of revenues) vs. the opposite mix for PERY.  Clearly, owned brands should generate a higher gross margin than licensed brands. 

In fact, we show below PERY’s gross margin profile without the benefit of 100% gross margin license revenue.  On an adjusted basis, PERY’s gross margin slips even lower, to 31.0%, well below the lowest margin in the comp set who generates the vast majority of its revenues from licensed brands. 

To us, all of this reflects an extreme underperformance in PERY’s business as compared to comparable companies and manifests itself in a very low valuation of the overall business due to an inability to earn margin.  On an EV / revenue basis, PERY trades at .48x revenues vs. a median of 1.5x and a low in the comp set (G-III) of 1.0x.  If you strip out the value of PERY’s license revenue stream as described earlier in the writeup, the implied revenue multiple on the wholesale business falls to 0.26x as compared to the comp set at 1.5x.  I’d ask the rhetorical question, in a strategic sale is it crazy to think that PERY should get a similar revenue multiple to G-III?  After all, PERY should be a higher margin wholesale apparel business than G-III because they own their brands as opposed to having to license them.  Just for fun, let’s say PERY got a market multiple for its growing license revenue stream and managed to achieve a revenue multiple of the lowest of the comp set – what stock price would that imply?  The answer is $57/share!  To ask another rhetorical question, what might GIII pay to acquire PERY and would they be interested in doing so?  GIII has a good track record of turning around underperforming brands and they have also been trying to build up their portfolio of owned brands, and unquestionably could derive enormous synergies and cost cuts in an acquisition of PERY.  Would an acquisition at $35 / share make sense to them?  We think it would be a home run at that price, massively accretive.  Would they be interested?  Take a look at the following excerpts from their most recent earnings conference call:

Erinn Murphy, Piper Jaffray & Co. - Senior Research Analyst, Global Brands

So one of the kind of big picture themes result for your story is on the acquisition front. You've made some very successful acquisitions in the past. Some have been turnaround stories. And how are you viewing the opportunities out there today for your kind of next edition to your portfolio?

Neal Nackman, G-III Apparel Group, Ltd. - CFO

We actually just got out of a conference call and we spoke about the fact that there's a lot of effort into one of these acquisitions that we do. And our book is not to be a $2 billion company. We think that the deals that we're looking at need to be of more size and more significance to us. So we're looking at larger opportunities ideally, things in the $100 million to $500 million zone are really kind of the starters for us in terms of things that we'd look at.

Now, we've been good at really taking properties that have kind of--need some work. And we now have a little bit of a history of starting to be successful at turning those things around. But we're looking for things that have good growth potential and that can move the needle a little bit.

Erinn Murphy, Piper Jaffray & Co. - Senior Research Analyst, Global Brands

So just maybe touching on the qualitative side of things you talked about, kind of your history with some kind of turnaround stories. Wilsons been a great example of that. G.H. Bass is one that you're now working to effect. I mean, should we think about an acquisition qualitatively more from the perspective of a turnaround, kind of disrupt retail, or is it more kind of like the Vilebrequin, the kind of larger scale or potential for a larger scale kind of global brand?

Neal Nackman, G-III Apparel Group, Ltd. – CFO
When we look at our wholesale business we're still about two-thirds licensed. So one of the--one of our focuses is brand development. So I think brand development first is something we'd like to see, a brand that we can continue to exploit.

You get the picture…I think PERY is right in the wheelhouse for these guys.  Other comps that we find interesting to look at are both The Jones Group / Sycamore Partners and Lucky Brands / Leonard Green deals.  Each of these M&A transactions represents the price a financial buyer has paid for a struggling wholesale apparel business.  We think these transactions represent a “fire sale” price to a financial buyer who would execute a turnaround and salvage the pieces.  Both transactions to us imply a value for PERY of around $40/share.

We would also note that PVH, owner of Calvin Klein and Tommy Hilfiger and current licensee of Perry Ellis, is a logical buyer due to their ownership of comparable brands and familiarity with Perry Ellis as a current licensee.  Given the scale of PVH and comparable business model, we think the synergies in such a transaction would be enormous.  As we look at the comps and the business mix of the comparable universe, we actually think that PVH is the most comparable business to PERY as it has a nice license revenue stream as well and has a similar weighting to owned brands and wholesale revenues. 

Why are margins so low and how will they improve?

The argument we make above is that PERY is massively under-earning its potential as a branded wholesale apparel business with a significant license revenue stream.  Ultimately the question therefore becomes, is it reasonable to believe that PERY on its own or in a change of control transaction can be fixed and improve its margins?  And the related question, why are margins so low and are they structurally low for some reason such that it will be impossible to reverse?

The reason the business is under-earning from a margin perspective is in both the COGS and the SG&A line items.  Ultimately, the reason for both of these issues is the same – the business has been mismanaged and is not run efficiently; rather it is run like a private company for the benefit of the Feldenkreis family.

COS:  The Company’s underperformance on the COS line can be attributed to an inefficient design, sampling and sourcing process.  One of the key issues is that the Company has suffered from a very long product design cycle which can range from 12-15 months, a huge disadvantage compared to the competition.  The long product design cycle results in higher costs and more mistakes going to market (not having the right product available, missing fashion trends, etc.), resulting in greater markdowns and lower selling prices.  Another key area of inefficiency is in the design process, where the Company has an extremely low “hit rate” on products in development that actually make it to market as compared to peers.  Further there are opportunities to improve in sourcing and logistics in order to become more efficient.  The Company readily admits this and has engaged Kurt Salmon Associates to try to identify and implement the changes necessary to achieve performance improvement on the gross margin line.  The Company has stated that gross margins should be at least 36% (300bps improvement from here) and that KSA has already identified about 3-4% of costs that can come out of the COS line (which at the midpoint represents $21 million in cost savings). 

SGA:  PERY is run very much like a private company.  There are an enormous number of related party transactions, nepotism (both the son and daughter in senior management positions), excess compensation to the Feldenkreis family, family friends are given jobs, private jets – all of the classic things that you see in a Company with poor corporate governance.  All of this results in a bloated cost structure but ultimately it is this culture that is the root of all of the bigger problems at the Company.  The Company has stated that they have identified about 1.5% to come out of SG&A (as a % of sales) but I suspect there is quite a bit more to come out than that.  A few of the comments we heard as we diligence the business are worth repeating:

-          “the company has never really been run by the numbers…they do not run by a budget”

-          “it really run like a family company, they like ‘yes men’, we did not agree on what was best for the company and shareholder value”

-          “a lot of decisions were made based on emotion”

-          “George thinks if you are not part of the family, you are nothing”

-          “the board is all friends, very close buddies”

A few other relevant facts and figures

-          Executive compensation as a % of revenue and EBITDA is well above peers despite weak performance

-          There have been significant “transaction bonuses” paid to Oscar upon closing M&A transactions (including the Rafaella deal), despite their poor performance

-          There are significant related party transactions including i) the Company licenses brands to Oscar’s father in law, ii) PERY leases real estate from George Feldenkreis, iii) PERY buys insurance from Fanny ‘s (George’s daughter) son and iv) PERY leases a private jet from George and Oscar.

Management believes that they can achieve a 36% gross margin and 10% EBITDA margin over time – as we look at the comparable businesses, we think that goal sets a pretty low hurdle.  That being said, achieving that goal would obviously result in a huge return from the current valuation, even at the very low end of the EBITDA multiple range.

Calling in the Cavalry

Based on everything we have discussed above, we think that there is enormous value in Perry Ellis.  That being said, we think that a change in management at a minimum and perhaps an overall change in control is the path to achieving that value.  On 7/17, a Los Angeles based activist firm, Legion Partners filed a 13D on PERY.  While the Legion name is not well known, we think that their involvement is the first step in a transformation at PERY which will ultimately result in a shakeup at the board level and ultimately a change in control.  Per the 13D, Legion is backed by the California State Teacher’s Retirement System (CalSTRS), the largest teachers’ retirement fund in the United States.  As such they have serious capital behind them (CalSTRS has a $189 billion investment portfolio).  Legion is a newly set up shop, whose principals were with the Shamrock Activist Fund (the activist investment firm created by the Disney family in the early 2000s).  While at Shamrock, this team waged several campaigns and proxy contests.  Recently, Legion ran a successful proxy contest and replaced the management team at RCM Technologies (RCMT) as well.  Given that they are a newly set up firm and this is their largest and highest profile investment, we think they are extremely motivated to see this process through to a successful outcome.

We think the market largely ignored this development, which is interesting to us given that it is exactly what needs to happen to realize the value inherent in the Company.  Further, while we had always seen good value in PERY it was all an academic exercise without a catalyst for change – that is why we think PERY is such a timely opportunity right now.

Conclusion

Perry Ellis is a Company with attractive brands and assets which has underperformed for years and has been a major disappointment for investors.  As such, the stock is largely ignored and trades at an incredibly depressed valuation.  We see massive upside in value in a change of control situation.  We think that the business can be fixed and potential acquirers will be interested in acquiring the business at a substantial premium in order to capture some of that upside.  We think that recent shareholder activity went largely unnoticed and will be the necessary catalyst for change to achieve the desired outcome.  

Catalyst