Description

With a series of cash-raising corporate divestitures, the company has transformed itself overnight from an overleveraged, marginally cash flow positive and negative EPS business with sales dominated by brands in secular decline into an appropriately leveraged collection of brands with growth prospects ranging from fantastic to respectable.  The company was highly shorted on the thesis that the leverage and the brands in secular decline could ultimately lead to the unraveling of the company, but with these divestitures and the cash they raised, both legs of the short thesis have been killed.  The company was underfollowed by the sellside after several years of decline in sales, earnings, market cap, and market relevance.  But sellside coverage and buyside awareness has improved, and people are starting to realize this is now a growth business, and growth retail concepts are in short supply.

The series of corporate actions allowed the stock to trade out of the $5-6 trading range that it had been in for most of 2011.  The October 2011 announcement that they were selling the Liz Claiborne brand to JC Penney for $268 mm was the beginning of a 6 month run that took the stock from $5 to its peak on 4/26/12 of $13.88.  The rally was fueled in March by news reports that private equity had been looking at the company with a possible acquisition price of $20.  Since April, general macro and retail sector specific concerns have led to a 30%+ pullback in the shares, which makes this an interesting time to look at the stock. 

It’s pretty easy to get to a $14 fair value target based on the current business, but two of the three remaining businesses are in turnaround mode, so there is a lot of optionality on the stock being worth a lot more if the turnaround efforts are successful.  With successful turnarounds of the two underperforming businesses, it’s easy to see a valuation of $17.50 or higher.

History:

Fifth & Pacific, prior to 5/15/12, was known as Liz Claiborne.  Liz Claiborne dates back to the 70s when its namesake brand was a hot commodity.  In the years following its 1981 IPO, it acquired a number of brands and entered into a number of manufacturing licenses, leading it to become a diversified conglomerate of apparel brands.  Throughout the 90s, LIZ, like its public apparel company peers, embarked on a transformation from a manufacturing company to a marketing and design company, outsourcing the actual production of its products to foreign non-owned factories.  The company was long thought to be a well-managed industry leader, but lost its way in 2000s by being too acquisitive.  All the acquisitions led the company to build up leverage, at the same time that department stores were under assault from specialty retailers and discounters.  In particular, the “better” and “bridge” categories at the department stores started to go into secular decline as department stores switched focus to the emerging “contemporary” category in apparel, as well as highly productive non-apparel categories like accessories and footwear.  While the company had been run debt-free and was a big cash generator in the 80s and 90s, by 2000, it was running with several hundred million in debt, which was not a problem until later in the decade when the legacy brands started falling off a cliff.  Several years ago, LIZ went through a series of divestitures of brands they had picked up along the way (smaller lines like Laundry and C&C).  But after EBITDA negative years in 2009 and 2010, it was clear that something more drastic had to be done.

After several years of losing square footage in Macy’s and other major department stores, LIZ decided to make JCP the exclusive department store partner for the Liz Claiborne brand (taking a page out of the Tommy Hilfiger playbook, which exited all department stores other than Macy’s when its brand went into decline domestically).  In 2010, LIZ got a big tax refund from the government and closed a large number of outlet stores.  Earlier in 2011, LIZ sold the Curve fragrance brand to Elizabeth Arden for around $60 mm, and impressively managed to sell the loss-making international business Mexx to a JV sponsored by the private equity group Gores Group for a shocking $85 mm.  Because the Mexx business had been troubled and loss-making for some time, it was expected any price paid for it would be nominal.  Instead, LIZ got a good sum of money for it and was allowed to retain an 18.75% interest in the JV without having to make any future cash commitments.  This was a fantastic accomplishment, and led the stock to run from $5 prior to 9/2/11 announcement up to $6, only to then fall back into the mid $4s when the markets got rocky in September and early October.

On 10/12/11, LIZ shocked the street by announcing that they had sold the Liz Claiborne and Monet brands to JC Penney, Kensie brand to Bluestar Alliance, and Dana Buchman to Kohl’s for a total of $328 mm.   Sales were done at an extremely attractive multiple of 8x projected EBTIDA, a very healthy multiple for brands with negative growth.  The $268 mm that JCP paid for the Liz Claiborne brand far exceeded the $75-$150 mm various analysts had expected them to get.  Coming into the transaction, they had about $550 mm in debt, so the transaction would allow them to reduce their corporate debt by about 60%, even though the disposals were only about 40% dilutive to 2011 EBITDA and 30% dilutive to 2012 EBITDA.  LIZ had $382 mm in NOL carry forwards at the end of 2010, greatly mitigating the cash tax impact of the divestitures.

After these divestitures, LIZ was left with three primary businesses – Kate Spade, Lucky, and Juicy – so on May 15, 2012 it changed its name to Fifth and Pacific.  The name was chosen to evoke the New York and Los Angeles heritage of their remaining brands.  The full name of Kate Spade is actually Kate Spade New York, and Lucky began as an LA-based jeans company.  In conjunction with the disposals of the legacy businesses, FNP embarked on an extensive cost rationalization program.  There were also a series of key hires made at Juicy and Lucky to execute the turnaround, including Juicy Couture Co-President and Chief Creative Officer LeAnn Nealz, Juicy Co-President David Bassuk, and Lucky President David DeMattei.

With all the changes outlined above, FNP has essentially transformed itself from a model where they were a wholesaler of apparel to midrange department stores to one where they are an aspirational retailer with global potential and a focus on higher margin areas such as accessories, in addition to traditional apparel categories.

Assessment of Retained Businesses:

Kate Spade

Kate Spade started as a handbag line and has expanded into other categories such as shoes, stationery, and apparel.  It is a high growth business which has been posting positive same store sales since December of 2009, and has extremely strong current growth and future prospects (58% comp in 4Q11 and 38% comp in 1Q12).  Kate Spade is underpenetrated in terms of stores domestically, and has barely made a dent internationally.  Category expansion beyond handbags and small leather goods is in the early stages.  The design DNA and brand’s identity are both very specific and strong in my opinion, and the department store representatives I have spoken with are very excited about the brand.  This is a brand that any number of larger luxury goods companies would love to own.  2011 sales were $313 mm.  To put that into perspective, Coach does over $4 billion in sales with very similar price points.  Management thinks this business can eventually do over $1 bn in sales and have 15-20% margins (versus low double digits now).  This seems like a reasonable multi-year goal.  The company has almost no presence internationally now but could potentially do >50% of sales outside the US.  Kate Spade would be a lot bigger already, but financial constraints at the old LIZ have limited investment up to now.  Kate Spade is currently at 80 stores but management sees the potential for 600, with 65% of them abroad.

Lucky

Lucky is a denim-driven specialty apparel business and also sells wholesale into department stores.  The company went off the rails a few years ago and is substantially below prior productivity levels, although comps have started to turn in the last year and progress seems to be being made in terms of product and traffic.  I don’t think the brand was permanently impaired by its stumbles, and is also rather immature with 219 domestic stores.  Management thinks there is potential for 250 full price stores and 100 outlets, which seems reasonable.  The current store base is 219.  Below are the recent same store sales results for Lucky, which indicate a definite stabilization and possible turn in their business.

Juicy

Juicy is the most troubled of the three retained businesses, but also probably the one that has the most upside potential to the valuation of LIZ.  Juicy experienced explosive growth early in the 2000s on the back of its terry track suits, which were hard to avoid for many years.  In 2003, it was acquired by LIZ after doing $47 mm in sales in 2002.  The purchase price was around $50 mm plus a number of contingent payments that got the price up to the $100-200 mm range.  At the time, it had distribution in 840 boutiques and 280 department stores, and did not have its own stores.  LIZ greatly expanded the brand by entering into a strategy of owned retail stores, expanding third party doors, and product line expansion.  They evolved beyond the track suit into many different women’s categories, and also started children’s and men’s businesses.  The business grew a ton, and will do about $550 mm in sales this year (off a previous peak probably at least $100 mm higher).  In recent years, the brand has had a number of fashion missteps which have hurt margins.  One could also argue the brand got over distributed.  Despite the missteps, there is still a lot of brand equity in Juicy.  There is a lot of potential for growth here if they can get the fashion right, but it is a “show-me” story for now.  Comps have remained in the negative mid single digits, but management is optimistic that they can achieve positive comps in the second half of 2012 due to changes in the merchandising team and division management.  It is not until the second half of 2012 that the stores will carry inventory full reflecting the vision of Co-President LeAnn Nealz.  Management’s stated long-term goals for this business are $1.5 - $2.0 bn in sales, mid-teen operating margins (versus current mid-single digit margins), and growing sales from 18% international to 50% international.  Management may be being overly optimistic here, but if the business is doing $30 mm in EBITDA on $550 mm in sales now, I don’t think doing $80 mm on $800 mm in several years is overly aggressive.  So management thinks this can be a $250 mm EBITDA business at maturity, it’s doing $30 mm now and $80 mm might be a more conservative bet.  In my base case valuation, I have this business valued at an EV of around $250 mm, which could be quite low if the turnaround takes hold.  The brand still does $661 per square foot in its 129 stores, which is evidence there is still a good business there.  There are currently 129 Juicy stores, and management sees potential for 500, with 50% of them abroad.

Short interest:

The most recent short interest, reported 7/13/12 was 13.7 mm shares, or about 13% of the float.  I would estimate that as much of 50%-65% of the short interest was possibly related to the outstanding convertible bonds.  While the short interest has come down somewhat since the announcement of the JC Penney transaction (from around 21 mm shares), the short interest is still elevated.  The short thesis was about the company having too much debt and about not being able to sell the brands.  The brands are sold, and leverage based on 2012 EBITDA guidance is under 2x, so the short thesis has been debunked. 

Upcoming Events and Potential Catalysts:

• Same store sales and realized margins will be critical for Lucky and Juicy.  To the extent that Lucky continues to trend in the right direction and that Juicy starts to show signs of improvement, these businesses could start getting a turnaround multiple, as opposed to the 5.5-7.5x EBITDA I am giving them in my valuation.  The important thing to remember is I think neither of these businesses is mature and they are both currently under earning.  I have more confidence in Lucky than Juicy turning around in the short term, although I think Juicy remains a far more powerful brand with bigger potential globally, so if it turns, the upside from it could be very large (beyond what I have outlined in my bull case valuation).
• All three concepts are at very low store saturation levels versus other retailers, and store growth is very scarce among the publicly traded companies
• International exposure is currently an overhang for retail and apparel stocks, and FNP is in the currently envious position of having <5% of sales made internationally.  International expansion however remains a substantial opportunity.  Right now, the company’s international investment focuses primarily on Kate Spade.
• Private equity could come back (or rumors of private equity)
• There has been speculation that Kate Spade could be ripe for a spin off, although there are no plans to do so at this time.  If valued on a similar price/sales ratio as KORS, Kate Spade would be worth $2.1 bn in EV, which is about $16.75 per share.

Potential Risks:

• The primary risk here is macroeconomic risk.  These three brands all appeal to a high end consumer, so a big pullback in the stock market could ultimately affect demand.  In the near term, a derailment of consumer spending in the US would be more of a problem since most of the sales are here. 
• Fashion risk, always present for apparel companies.  Probably highest at Kate Spade since it is firing on all cylinders now and lowest at Juicy, since it has already experienced fashion-related issues.  The lack of a fashion turn at Juicy would of course derail their turnaround prospects.
• Stock looks expensive on a PE basis because of the immaturity of the Kate Spade business as well as the turnaround nature at Lucky and Juicy.  These are growth brands and I am using a growth investor methodology to value them.  If you value them on more traditional metrics such as current PE or current free cash flow, then the stock looks expensive.  At $9.35, it is trading at about 7x 2013 EBITDA.  You are paying for potential here more than for current results, so the investment is speculative in nature (but also has the potential for outsized returns).
   

Note this valuation ignores the value of:

1. Minority interest in the Mexx JV (a call option at this point)
2. Value of the retailed legacy businesses: Monet Jewelry international, exclusive royalty-free license for Liz Claiborne/Monet/Dana Buchman jewelry domestically, royaly-free license to sell LCNY on QVC through 2012 (small businesses – maybe $10 mm in combined EBITDA)
3. Value of the NOLs (approximately $1.00-$1.50)

Catalyst

1. Same store sales and realized margins will be critical for Lucky and Juicy.  To the extent that Lucky continues to trend in the right direction and that Juicy starts to show signs of improvement, these businesses could start getting a turnaround multiple, as opposed to the 5.5-7.5x EBITDA I am giving them in my valuation.  The important thing to remember is I think neither of these businesses is mature and they are both currently under earning.  I have more confidence in Lucky than Juicy turning around in the short term, although I think Juicy remains a far more powerful brand with bigger potential globally, so if it turns, the upside from it could be very large (beyond what I have outlined in my bull case valuation).
2. All three concepts are at very low store saturation levels versus other retailers, and store growth is very scarce among the publicly traded companies
3. International exposure is currently an overhang for retail and apparel stocks, and FNP is in the currently envious position of having <5% of sales made internationally.  International expansion however remains a substantial opportunity.  Right now, the company’s international investment focuses primarily on Kate Spade.
4. Private equity could come back (or rumors of private equity)
5. There has been speculation that Kate Spade could be ripe for a spin off, although there are no plans to do so at this time.  If valued on a similar price/sales ratio as KORS, Kate Spade would be worth $2.1 bn in EV, which is about $16.75 per share.