Description

Company:                    J.Crew Group (“JCG”)

Security:                      BANK DEBT: Senior Secured Term Loan due March 2021

Recommendation:      Long

Current Price:             60c / 7% CY / 20% YTW

Enterprise Value:        $1BN (market value through the bank debt; assumes secured bonds senior to the bank debt are worth par and preferred stock/private equity junior to the bank debt are worth zero)

 (Note: I had to put in a share count and market cap for VIC submission purposes but this is a private company with public debt.) 

Executive Summary

Post the recent liability management transaction, the Senior Secured Term Loan ("TL") of J.Crew Group, Inc. is trading near the downside of my recovery range of 54c to 83c. Here is why I think the risk/reward of the TL is compelling at 60c with 5-10 points downside / 20-25 points upside in my estimate:

(1) Improved liquidity profile - the company has termed out its debt maturity profile until 2021 in order to give itself more time to execute its restructuring program. JCG also has +$360MM in liquidity (cash and $350MM availability) and is expected to be cash flow positive in 2017.

(2) Turnaround plan - led by an impressive new management team focused on returning to profitable same-store sales growth, reducing costs and improving capital allocation/pruning stores. 

(3) Madewell brand – strong performance in the separately managed Madewell brand gives the company several options to unlock value including a potential sale of the brand.

(4) Fraudulent conveyance litigation - a cheap option on the recent exchange offer (which arguably expropriated value from the banks) being unraveled in 2018.

(5) Attractive valuation – through the market value of the TL (60c), the company trades at ~4.3x EBITDA on a SOTP basis, with a 7% current yield and 20% YTM (a +1x multiple discount to The Gap). 

The prior management made several strategic missteps in its attempt to create a fashion powerhouse, and EBITDA declined by ~50% over the last four years as a result. The obvious risk with this investment is that the new management team is unable to execute on it’s the multi-year turnaround plan and financial performance continues to decline. However, given the current valuation (multiple and YTM) with the TL at 60c, I believe investors are adequately compensated for the risk. 

Brief Description 

JCG is a multi-brand apparel and accessories retailer that designs, markets and sells its products under two principal trademarked brands, “J.Crew” and “Madewell”. The company sells its assortment of men’s, women’s and children’s merchandise primarily through retail and factory stores, websites and catalogs. JCG has ~575 retail and factory stores located in the US, Canada, the UK, France and Hong Kong. In FY2017 (ended 1/28/2017), the company generated $2.4bn in revenue and $189MM in Adj. EBITDA (7.8% margin). This is a meaningful decline from the company’s peak EBITDA in FY2013 when JCG reported $2.2bn in revenue and $370MM in Adj. EBITDA (15.2% margin). 

JCG was acquired in March 2011 by private equity firms TPG Capital and Leonard Green & Partners for ~$3bn (~$1.2bn equity contribution) or ~11.7x FY2012 EBITDA (with 7x leverage). 

Recent Events (a quick recap)

In July 2017, the company completed a series of interrelated liability management transactions involving the J.Crew parent company ("Chinos Holdings, Inc", also referred to as "Parent") and certain subsidiaries. The goal was to term out its debt repayment schedule for the 2019 notes, reduce the principal amount of the claim and improve liquidity while considering operational strategies to refresh the J.Crew product line, stem the decline in same-store sales (and ultimately grow) and improve profitability. The details of the liability management transactions were as follows:

• Exchange the $566 million 7.75%/8.5% Senior PIK Toggle Notes due 2019 (issued at Chinos Intermediate Holdings A, Inc - a wholly-owned subsidiary of the parent) for: (1) $250 million 13% Senior Secured Notes due 2021 - secured by the US intellectual property (“IP”) assets held by subsidiary J.Crew Domestic Brand, LLC ("IPCo"), (2) 190,000 shares of Parent's 7% (5% cash/2% PIK) non-convertible perpetual series A stock (with an aggregate liquidation preference of $190 million), and (3) 15% of Parent's common equity (~17.4 million shares of Parent's class A common stock);

• Amend the company's TL facility credit agreement (issued at J.Crew Group Inc.) to enable: (1) pay down $150 million principal amount of the $1.52 billion TL outstanding, (2) transfer the remaining 27.96% ownership in the IP rights of the J.Crew brand to IPCo (72.04% ownership was transferred in the December 2016 under the credit facility's limitation on investment carveout), (3) new money investment and issuance of an additional $97 million of the 13% notes due 2021, and (4) additional borrowings of $30 million under the TL facility provided be the equity sponsors.  

• The exchange relied on the transfer of the J.Crew brand IP, which was valued at $347 million, from J.Crew International Inc. to J.Crew Domestic Brand LLC (“IPCo”). Several "non-consenting lenders" have filed litigation against the company for the transfer of the IP to IPCo - discussed further in the "Fraudulent Conveyance" section.

   

  JCG Corporate Structure

Capital Structure 

Why does the opportunity exist? Why is the bank debt trading at distressed levels? 

From a fundamental business perspective, the simple answer is: a) a series of tactical missteps (temporary), and b) declining mall traffic (secular). Between FY2014 and FY2017, the former management team led by Mickey Drexler (CEO and effective Head of Merchandising) and Jenna Lyons (Head of Design) failed to predict and meet the changes in consumer buying patterns. While fashion can certainly be fickle, these tactical missteps ultimately led to several self-inflicted wounds in key drivers of business value including same-store sales, merchandising margins (gross margins excluding rent) and changes in working capital. 

According to a June 2017 article in Retail Dive: “…by 2015, comparable sales slumped 8.2% in the year as Drexler blamed J.Crew’s problem on cardigans and quality issues, and vowed to bring the brand’s beloved basics back. That never happened, and Lyons slipped further into her own brightly-hued fever dream of expensive and unsellable fashions that consumers steadily turned away from.” Unfortunately the company’s problems didn’t stop at cardigans and quality – “the company… was bloated with several hundred retail locations it was loathe to shutter”, all during a time when mall traffic was declining. 

Manik Aryapadi, a retail consultant at AT Kearney, offers the following opinion: “J.Crew made a gamble on upscale millennials by moving away from the ‘preppy basics,’ which had been their brand cachet, and carrying more premium merchandise. This move backfired and alienated their core customers….This problem was further exacerbated by J.Crew’s erratic pricing strategy, with uneven promotions and discounts that further devalued their brand.”  

The company also missed the mark on athleisure and casualization of the office place. Aryapadi does, however, provide some reason for optimism for J.Crew: “the success of brands like Vineyard Vines shows that there is still an appetite and market for this (‘preppy basics’) strategy. J.Crew needs to rediscover its roots and focus on its core strengths.” 

One can surmise that the business declined for the two major aforementioned reasons: management failed to (1) deliver the right merchandise to its core customers - moved away from or alienated their core customer; and (2) anticipate the changes in technology that would alter the retailing landscape: kept their approach the same in the face of dramatic changes in buying/selling behavior resulting from technological and the supply chain advancements. 

So it looks like the company has a lot of problems, why is it interesting/mispriced? 

In my view there are five main reasons why the TL is mispriced and attractive at current levels: 

1. Improved debt maturity profile – as part of the recent liability management transactions, the company has addressed its nearest term maturity and reduced overall debt leverage. As a result the company has postponed its repayment schedule by two years to 2021 which should give the new management team sufficient runway to implement its operational restructuring plan. As this event has already occurred, the assumed benefit of a "longer runaway call option" is presumably well-understood by the market but it is worth noting that without any maturities for the next four years, the management team can squarely focus on improving operations. The company now has a healthy liquidity cushion with ~$360 million in cash and availability, and should generate positive net free cash flow this year. 

    

2. Turnaround plan led by an impressive new team:

a) ‘New’ management team:

1. James Brett – appointed CEO and Board Member in June 2017; +25 years retail experience most recently as President of home furnishings company West Elm where he successfully orchestrated a turnaround (brand had yet to turn a profit and was closing stores when he joined in 2010) and grew sales from ~$250 million to over a $1 billion during his seven year tenure; prior to that he was the Chief Merchandising Officer at Urban Outfitters and the merchandising manager at Anthropologie.

2. Lisa Greenwald – named Chief Merchandising Officer of the J.Crew brand in April 2017; she has been with the firm since 2004, most recently in the role of SVP of Merchandising for Madewell.

3. Somsack Sikhounmuong – promoted to Chief Design Officer in April 2017; he has been with the company since 2001 in various design capacities, including Head of Design for Madewell.

In my due diligence process I have spoken to former employees of JCG and employees of competitors in the industry – here are some select takeaways on the new team:

• Lisa and Somsack are apparently very good, “they are the real deal, they are the reason for the success of Madewell”.

• “The problem with the J.Crew brand has been the breakdown in design (formerly Lyons) and merchandising (Drexler). They moved away from the core customer”.

• “Lisa (now head of merchandising) has good taste and a good sense of what the customer wants. She also has a good working relationship with Somsack which is key”.

• “Jim Brett is smart, capable, personable and energized, and is apparently willing to do what it takes….but it is too early to tell what kind of impact he will make but if he can let Lisa and Somsack do their job without much interference, it will be very positive”.

• “Moving a guy like Drexler to the sidelines is a big signal that the sponsors are very serious about the turnaround”.

b) Turnaround plan – "we have launched a multi-year transformation effort designed to create an even faster, more nimble organization focused on delivering value across all channels" (company management on Q1-2017 conference call). In order to dissect this general statement, there are generally three drivers that matter in evaluating a retailer:

i) Same-Store Sales: since 2012 comp sales for JCG have been declining, driven largely by the J.Crew brand. While the Madewell brand has demonstrated robust growth, company-wide comp sales dropped precipitously from +12.6% in FY2012 to -8.2% in FY2015. Comp sales continued to languish in the negative 6-7% range in FY2016 before dropping further to -9.0% in Q1-2017 at which point the aforementioned management changes were introduced. Comp sales recovered slightly in the most recent quarter to -4.8% driven in large part by Madewell which now makes up 17% of total sales (vs 6% in FY2012) and grew comp sales 11.2% year-over-year.

JCG is largely a J.Crew brand revenue stabilization story where the new management team has to go back to fashion basics and offer the right assortment of SKUs at the right price point. While the J.Crew brand has consistently generated revenue in the $2.0-2.3bn range in the last five years, total square feet of store space increased 28% between FY2012 and FY2016 and J.Crew sales per square foot dropped 24% during that time period. It appears that management gets the seriousness of the message, and on its recent conference call, the company made it clear that the top three priorities in its turnaround plan were merchandising, design and pricing (i.e. the main drivers of top line growth). While comp sales are notoriously hard to predict for a fashion house, especially for one in need of a makeover, under disciplined and visionary leadership, struggling brands can be resurrected. In the last decade fallen brands such as Coach and Tommy Hilfiger have recovered, and J.Crew itself has been in a similar position twice in the last 20 years. It is also noteworthy that new leaders of the J.Crew brand, Lisa Greenwald and Somsack, grew total sales 160% and sales per square foot 16% between FY2012 and FY2016 at Madewell. The appointment of Lisa and Somsack is clearly positive and provides a sense of confidence that the right leadership is in place but it may take six months (Spring 2018 collection) before we see the impact of any changes they make on product assortment at the J.Crew brand. As the Retail Drive article implies, former management tried to create a fashion powerhouse and made several strategic missteps with merchandise. It appears that there is low hanging fruit to improve product lineup – i.e. stop selling +$1,500 J.Crew brand cardigans and jackets that core customers are not interested in buying. According to my recent discussion with the new CFO, Vincent Zanna: “focusing on the high end is icing on the cake, not our core”. While some customers have been disenfranchised and no longer shop at J.Crew, with +$2bn in ‘run-rate’ revenue, there is clearly a clientele base that values the brand and one that the new management team can focus on.

ii) Expense Management: In Q1-17, management disclosed its cost restructuring plan which an estimated ~$50 million in annualized expense savings from lower product costs and improvements, principally in sourcing and supply chain management (basically merchandise margins). Based on Q2-17 numbers, the company showed good financial management of cost variables within its control, including:

• Gross margins - increased ~300bps from 35.7% a year ago to 38.6% in Q2-17, the highest level since Q3-15. Merchandise margins (essentially gross margins excluding rent) were up 250bps in the quarter and adj. EBITDA margins also improved to 11.3%, the highest level in two years. Of the ~$18 million in COGS reduction in the quarter, $14.5 million came from merchandise margins (mostly sourcing, some from less clearance) and $3.5 million from occupancy.

• Working Capital / Inventory management – improved 22% in terms of inventory to sales in Q2, with further improvement expected going forward. The company currently sources most of its product from China which is considered the least efficient and most expensive country to source from in the region for the fashion industry. Management is looking to make some geographical shifts and consolidate some activities with the hope of reducing production cycle time (from 11-12 months currently to 6-9 months). The company has hired a new sourcing manager and is the process of evaluating/hiring new agents.

• SG&A – the company has guided to $30 million (~4%) in costs savings at the SG&A level primarily through overhead cost reduction. In Q2-17, the company terminated 150 full-time employees and plans to make further adjustments to the workforce.

iii) Lease Flexibility/Rent Expense: the company currently has 575 physical locations: 274 J.Crew retail stores (primarily located in large upscale malls), J.Crew factory stores (mainly outlet malls) (456 total J.Crew) and 119 Madewell stores (large upscale). According to some consultants I have spoken to, JCG is considered an important ‘anchor’ tenant for many mall landlords and seems to have a ‘co-tenancy clause’ in its lease agreements which means that if JCG leaves the mall at the end of its lease, other tenants can break their lease or obtain a reduction in rent. With 20% of leases rolling off every year, the co-tenancy clause gives JCG significant leverage and flexibility to renegotiate terms if it decides to keep the store open. The company has made no secret that it is proactively looking to close underperforming stores and cut rent expense while expanding points of distribution through other channels. As part of the recently established ‘financial pruning strategy’, the company has established an EBITDA threshold specifically tailored to each store which is based on generating cash flow net of working capital (essentially inventory).

3) Madewell – the denim-oriented women’s brand was introduced in 2006 and has been a huge success. Using the company’s description: “Madewell is the modern women’s denim brand with workwear roots. Denim is at the core of everything Madewell does. We describe our brand as effortless, cool, artful, and unexpected”. Over the last ~5 years, revenue has grown +180% from $132MM in FY2012 to $372MM in Q2-17 ($93MM annualized). It is estimated that Madewell is generating ~$45-50MM in annualized EBITDA, which would imply an EBITDA margin of ~13-14% for Madewell in 1H2017 (and ~7% for the J.Crew brand). Aritzia, a fast growing women’s fashion retailer in Canada, is often cited as a comp to Madewell: ~90% revenue growth between FY2013 and FY2017, 14% comp sales in FY2017, and +15% EBITDA margins. Aritzia went public about a year ago on the TSX, currently has a TEV of ~C$1.5BN and trades at ~11x ‘FY18e EBITDA. At a double-digit EBITDA multiple, it seems clear that there is sufficient investor appetite for growth-oriented and profitable fashion brands, even in the current retail environment. This backdrop gives JCG multiple options to potentially monetize Madewell that would be accretive to the TL holders and investors at junior layers of the capital structure. Based on my recent discussion with the CFO, the Madewell business is run separately and, while a sale (full or partial) is not currently contemplated, “nothing is off the table”.

4) Fraudulent conveyance litigation – how is it that the 4 year new IPCo secured paper traded up 20 points to 120c, or 7% YTM, immediately after the exchange and the company's TL of the same duration trades at a 20% YTM? Admittedly the TL has a 'proxy 2nd lien' on the J.Crew brand but has a 1st lien on everything else (including the Madewell brand and operations). The simplest explanation is that the IPCo bonds are hugely over-collateralized and the brand is worth significantly higher than the $347 million value used to enable the liability management transaction. It is therefore no surprise that a minority group of TL holders is seeking recourse. The 'Eaton Vance and Highland group', also known as the 'non-consenting lender group', represents about 12% of the TL and is seeking damages for fraudulent conveyance. They have hired an IP valuation expert – Navigant’s Intellectual Property team - and filed a claim in the County of New York against the company. Navigant has submitted its valuation analysis and affidavit to the court, saying: “The IP Assets transferred in a series of transactions, and ultimately to Domestic Brand on December 5, 2016, had a value of approximately $971 million to $1.086 billion , with a mid-value of $1.028 billion”. In terms of process, per Judge Kornreich, the following deadlines apply: fact discovery by 2/9/18; expert depositions by 5/11/18; and trial-ready by 5/18/18. At a YTM of 7% for the IPCo bonds and 20% for the bank debt, the market is assigning a very low, if any, probability that the banks prevail and the Judge reverses the transaction. Shorting the IPCo bonds seems like an attractive asymmetric bet if you want to isolate the litigation event as they are unsecured and subordinated if their collateral is stripped – worth cents on the dollar.

5) Valuation

Catalyst

• Progress on turnaround strategy showing up in same-store sales and EBITDA
• Value crystallization of Madewell
• Fraudulent conveyance litigation