Description

If the economy remains stable, even at its current level, Liz Claiborne (LIZ) stock should increase 60% to 100%+ over the next eighteen months from its current price of $2.95 (market cap $280M). The next two quarters (Q2,Q3) will be bumpy, but evidence of a turnaround should begin to manifest itself by Q4/Q1 as merchandising and cost cutting initiatives begin to gain traction.

The upside drivers for the stock are:

1)  A revived core Liz Claiborne label as designs by celebrity designer Isaac Mizrahi flow into stores over the next twelve months; early evidence based on limited shipments suggest this relationship between LIZ and Mizrahi is going to be successful

2)  Continued focus on the well-regarded labels Juicy Couture, Lucky Brand, and Kate Spade, labels I suspect many may not realize are owned by LIZ

3)  Returning the European label Mexx to profitability by getting designs back on track in the short term and in 2010 by the addition of a new CEO (CEO starts October)

4)  Divestiture of stale, negative growth legacy labels

5)  Ongoing cost cutting

Like most retailers, Q4 and Q1 was a disaster for LIZ, unfortunately Q2 has not been any better given that as Q2 winds down management issued $90M in 6% convertible bonds in order to cover what was clearly becoming a tight liquidity situation. The move ultimately dilutes existing shareholders by a painful ~25%. In announcing the debt deal, management noted that Q2 trends were no better than the weak Q1. With the liquidity situation addressed for now, I believe the company will have the time and cash to more fully implement their cost cutting measures, to see some traction from their merchandising initiatives, and return to a cash flow positive state in order to avoid another liquidity squeeze.

Given that LIZ will report a dismal Q2 I would not be surprised if additional cost cutting measures are announced. Though Q3 may offer some of glimmer of light, Q4 holiday is what really matters and I believe by then they are likely to show the top line is stabilizing and margins are recovering. Before identifying the specific positive events that should occur beginning in holiday 2009, let first me outline the company’s business segments

1)  Domestic-Based Direct Brands which includes the wholesale and retail revenue from Juicy Couture, Lucky Brand, and Kate Spade and was ~30% of 2008 revenue.

2)  International-Based Direct Brands which consists of the retail and wholesale revenue from the Europe-based Mexx line. Mexx has 142 locations in Europe and 94 in Canada. Mexx also sells into department and other stores in Europe.

3)  Partnered Brands consisting of various Liz Claiborne lines, DKNY Jeans, accessories and other. Over the years, the various Liz lines became stale and were losing floor space in the U.S. department stores.  In response, Liz hired high profile designer Isaac Mizrahi away from retailer Target to redesign a portion of the line. Some impact should be felt in 2009, but it should have a big effect in 2010 when it is completely rolled out. Partnered Brands was ~40% of 2008 revenue. A number of legacy brands in this segment are well into the process of being discontinued, sold, or licensed. Leveraging Mizrahi and recovering lost floor space is a big opportunity to increase sales even if the retail landscape remains difficult.

Operating margins in 2009 will be negative as the company spends a full year at the revenue run-rate they experienced in Q4’08 and Q1’09, but still has not downsized the business to fit the revenue.  During this period they are working off old inventory in all segments and downsizing the business to become profitable again. Ideally, they should exit the year demonstrating that the business is running at a cash flow positive rate on an annual basis and that they can generate both cash flow and earnings in 2010.

As noted, evidence of a turnaround should begin to show in Q4’09. The specific catalysts include:

1)  Domestic brands: Juicy/Lucky/Kate Spade are valuable brands that were growing prior to the recession, both through their own retail units and via wholesale. However, when sales fell off a cliff during last year and especially at the end of last year, the doors into which they sell wholesale (department stores) got stuck with significant excess inventory. Beginning late last year and into this year the department stores began slashing the prices on the excess goods to whatever price would clear the shelves, this in turn caused LIZ to have to do the same in their retail stores, even though Liz could have held on to some of this inventory without slashing prices to sell it. As inventories rebalance across all retail channels and they lap this margin disaster, some level of profitability should be achieved. In addition, they are rapidly adding more SKUs at affordable price points in order to keep and attract buyers.

2)  International Brands: Mexx was once a high growth European retail/wholesale brand that has lost its way in recent years. Then, on top of that, the fall designs strayed too far from what their core consumer expects. They are already returning to their core styling for fall ‘09 and this alone should give them some small level of relative recovery on the top line. The potential for greater improvement exists in 2H’10 as by then Mexx will have its first full holiday season under the leadership of a new CEO, Thomas Grote, hired from competing European retailer, Espirit. Grote starts in October ’09. If he can inspire market share gains then there is upside. I am only counting on him to stabilize the business by reclaiming share lost due to the recent fashion miss and then taking actions that begin to restore margins. Management has much higher hopes based on Grote’s strong record as a manager and they see his hiring as something of a coup. I hope that is the case, but my thesis only assumes that he achieves the most meager of recovery between now and the end of 2010.

3)  Partnered Brands: Snatching away celebrity designer Isaac Mizrahi from Target to design a new line for the Liz Claiborne label was a real coup. I believe it will make a material difference for this company as designs for Liz Claiborne New York by Isaac Mizrahi flow into stores. Spring 2009 is the first season in which his designs are hitting the floor, but sell-in is extremely limited, hindered by the excess old-LIZ inventory and by the fact that department stores are testing the merchandise to see how it sells. Even LIZ itself does not have Mizrahi merchandise in their own stores. Only 12 of LIZ’s 92 Liz outlets have any Mizrahi product. However, where product has flowed in it is selling well with AUR (average unit retail, or retail sales price per item) up 40% over the old-Liz product and generating improved orders for the fall line. Management believes the revenue recapture opportunity (in terms of reclaimed Liz-label floor space) is in the neighborhood of $200M.

Regarding Mizrahi, on the Q1 call management also provided some insight into how they plan to roll out and promote his line through events. It should also be noted that Bravo network fashion critic and celebrity Tim Gunn is the Liz Claiborne creative director (more a fashion ambassador than a designer) and he is part of the promotions. Gunn is one of the hosts of Bravo’s Project Runway and has his own shows on the network from time-to-time. Mizrahi also began a Bravo series in May, entitled The Fashion Show. Below are some quotes from management from the Q1 call regarding how the promotions for the new LIZ are going:

“We have scheduled, for the balance of the year, over 200 personal shopping events with our stylists out in the field. We have done about 80 of those in the first quarter, and we have seen… sales increases from 25% to 300% by door. Some of these events are as simple as invitations going out, setting up a table with wine and cheese, et cetera. It is an evening out for the girls and they come in. We help them -- 30 minutes, we'll give you three outfits is really how we are talking to the consumer about it…  It was unbelievable. When you layer on nuclear weapons like Isaac Mizrahi and Tim Gunn you are talking about doors up by thousands percent increments. They are doing a week in two hours. Events we have done at Macy's, at Bonton in Yorktown, at SouthPark in Belk, we will continue to lay out. About one per month is what we can manage right now because it takes a lot to get those done. I think more importantly than those, it is what can we do locally in more doors, over 400 or 500 doors, that is really moving the needle focusing on increased revenue and meeting expected sales plans and profits.”

The bottom line is the Liz Claiborne label has real value, but that value has been buried in poor designs and share has been lost. I think they’re taking the right approach. They’re not just dusting it off, but they are also really adding pizzazz that should cut through (that is, as much as a department store label can). Department stores desperately need labels that will bring in the consumer (in general and back from specialty retail). If the LCNY by Mizrahi works, I am very confident it will take floor space.

LIQUIDITY

LIZ should have the following debt when they report Q2:

Euro 350M 5% Notes, due July 2013          $468M

Revolving credit, expires May 2011         174

Convertible debt, 6%, due 2014               90

Total Debt                                 732M

Revolver was $264 as of Q1, but will be paid down by $90M from proceeds of the $90M convert.

Coming out of Q2 they should have roughly 256M in availability on the revolver, more than enough to get to Q4 when they should be cash flow positive again. However, the key is that they have a cash flow positive ship by the end of the first half of 2010. Should the economy or execution or both prevent this then they they’ll be facing some new form of dilution.

Like every other consumer discretionary company, LIZ has been cutting costs and instituting layoffs. The effort continues. In addition, in Q1 the company entered into an agreement with Li & Fung, an Asian sourcing agent, to handle most of the companies buying (Li & Fung already was handling Mexx). The nice thing about apparel makers is that they can keep cutting the wholesale operation down in size until it is profitable again. As for their retail operation, they could need to close stores. They opened a lot of Juicy/Lucky/Spade stores in the past couple years. I suspect before the year is out we’ll hear about some closures and some associated charges. This is pretty standard operating procedure for apparel makers when they foray into retail. However, this time I think the brands they are trying to retail (Juicy/Lucky/Kate) are valuable and will sell no matter what the channel and do warrant the existence of some level of company-owned retail.

FINANCIALS

What does an investor get if everything goes as planned; that is, they experience even modest top-line growth and some normalization of margins? First, 2009 is a bust. The objective is to become cash flow positive by the end of the year. Next year, 2010, is when the picture should brighten as they lap the worst of their problems (such as excess Domestic Brand inventory in the channel) and flow in the new Liz Claiborne line.

I’m calling my two scenarios for 2010, “Crawl” and “Walk”, because they assume so little in terms of top line growth and margin normalization. “Crawl” assumes 1.8% in top line growth in 2010, while “Walk” assumes only 3.4% in top line growth. The strongest growth is weighted to Juicy/Lucky/KateSpade. I am assuming operating margins (EBIT) return to between 3.1% and 5.8%. Historical operating margins have been between 7.5% and 12%, though usually between 9% and 12%. (This excludes some early high growth years in which margins were higher.) In 2001, a minor recession, the depressed EBIT margin was 8.7%. For the purposes of this analysis I am assuming margins never even rise up to recession levels, much less to anything on par with their prior “normal”.

·         I am fully taxing earnings, but NOLs will shield income from taxes for a couple years, adding to cash flow. NOLs were roughly $190M at end of Q1.

·         Interest and net income includes roughly $10M a year in non-cash amortization of deferred financing fees.

·         2010 share count includes all options, including those far out of the money (assumes they’ll be repriced) and adds shares from the convertible note. (conversion price of $3.576)

·         2010 debt does not include the convertible note in the debt because I have added the shares, but it does include the interest expense.

·         Most cash generated is applied to pay down the revolving credit facility.

VALUATION

I am valuing LIZ at 4.5x EV/EBITDA, a little arbitrary, but a turn or two below what they would receive if they can demonstrate growth as opposed to merely stabilization.

There probably won’t be much in the way of good news for a while and the market has nothing to go on until they update the Street with Q2 earnings. In the meantime the stock is an orphan. It trades just under $3.00. Though I have no idea exactly what the stock will do in the short term, it is worth noting that it repeatedly bottomed under $2.00 after the crash (in Nov, Feb and Mar). I would not be surprised to see it tag under $2.00 again.

RISKS

The economy rolls back over, revenue trends remain negative into 2010 and liquidity becomes a problem again.

The economy stays stable, but LIZ brands fail to recover any top line growth and, once again, liquidity becomes an issue.

LIZ achieves some level of top line growth, but fails to resize the business enough to return to profitability.

Catalyst

Juicy/Lucky/KateSpade inventories in the channel clear and new inventory sells at more normalized margins. Mexx gets fashion back on track and returns to at least some meager level of profitability. Liz Claiborne New York by Isaac Mizrahi revives the Liz brand and enables it to reclaim some of the floor space lost in recent years. These efforts, combined with an economy that has bottomed and cost cutting allow the company to begin to, but not quite, approach normalized margins. A true return to normalized margins (9% to 10%) would be significant upside from what I have laid out here.