Description

Description:

The Warnaco investment thesis is one that I have pitched several times on VIC. In essence, I don’t much care for the business but I believe I have found an INVESTMENT that has a reasonable margin of safety assuming a worst case, and from 30% (if the company just exists) to 100% upside (if the company does what I think they will do, without much of a leap of faith) over the next 12-18 months. Warnaco is reemerging from bankruptcy as a forgotten entity and scarred by Linda Wachner, but the balance sheet is clean, there is room for (and there already has been) operating improvement, and the stock is very reasonably valued. The catalysts are not as apparent here, but value is value, and doing $1.5 billion in sales, reemerging from bankruptcy, and sporting a FCF yield of 10-15% is in my experience often its own catalyst.

Warnaco has always had solid brands and a strong reputation for quality, but it was saddled with debt and was run very questionably (I say politely) by Linda Wachner. Wachner’s exploits are fairly well known. Her compensation package was criminal. Her use of the company as a self-promotional vehicle absurd. But what may not be as appreciated is the opportunity that her (lack of) integrity created. For example, through some very simple turnaround techniques, interim management (Tony Alvarez, with whom many of you are familiar) has been able to suck working capital out of the company, reduce unnecessary SG&A, reorganize divisions, etc. Very basic stuff. Thus, while many apparel companies have had a difficult time in 2001-2002, Warnaco (after a very difficult period in 2000-2001) has been able to quietly stabilize sales and to improve margins and returns on invested capital after declaring bankruptcy in 2001. The turnaround is well under way, the crisis management team will be replaced shortly by permanent executives, and life begins again as Warnaco has just emerged from bankruptcy.

Business:

As usual, please refer to company documents for further detail. The company operates in three segments -- Sportswear and Swimwear (50%+ of revenues, reasonably profitable), Intimate Apparel (30%+ of revenues, very profitable), and Retail Stores (<10% of revenues, getting smaller, and unprofitable). The Sportswear and Swimwear segment designs and manufactures sportswear, accessories, and active apparel under a variety of brand names, including Chaps, Calvin Klein, Catalina, Speedo, Authentic Fitness, Ralph Lauren, etc. The Intimate Apparel segment designs and manufactures intimate apparel for women under a variety of brand names including Warner, Olga, Calvin Klein, and Lejaby, as well as men's underwear under the Calvin Klein brand name. The Retail Stores segment consists of full-price retail stores under the Speedo/Authentic Fitness name, as well as outlet stores. When all is said and done, the company will continue to operate approximately 45 Speedo/Authentic Fitness stores, while all of the domestic outlet stores will be closed. The sportswear and swimwear segment is similar to hundreds of other apparel companies, maybe not as valuable nor as well run as Jones NY or Liz Claiborne, etc., but clearly with identifiable assets, a significant operating history, and significant critical mass. The intimate apparel business has always been core for Warnaco and represents their most differentiable store of value. The retail segment is essentially meaningless.

If this investment story rested on an analysis of Victoria’s Secret (although due diligence can be fun again) or on whether Chaps was having a good season or on whether manufacturing margins were getting squeezed, I wouldn’t be involved. I do not want to do TOO MUCH business analysis here. Rather, I prefer to identify a range of extremes and to then determine whether the potential reward given “business as usual” justifies the risk of the downside case. I will be gathering more information over the next few weeks but I wanted to bring this to everyone’s attention now given the recent emergence from BK. I have no interest in making a “fair” investment in LIZ or in RL at these levels (although they may be inexpensive here) because its not really what I do. Rather, I am more interested with the “informational” arbitrage that seems to appear as companies reorganize.


The Investment:

I suspect that Warnaco’s projections are conservative. However, I focus initially on downside protection. Particularly, I would make the following observations:

• This is a real company that will do approximately $1.5bn in net revenues this year. And this is balanced across several brands, labels, and licenses. Certain lines are more important (i.e. Calvin Klein Jeans, Speedo, Warner’s Olga’s, etc.) and certain themes can be analyzed (warehouse club expansion [or reduction]), turnover in licenses, etc. but my belief is that this investment is not about NEEDING to perfectly identify and understand these moving parts. Rather, I look at this as a portfolio of assets (including a balance sheet, an improving operating structure, good cash flow generation, etc.) that will either serve as a catalyst for value realization over the next 2 years or will not, in which case, please refer to the next paragraph.

• The balance sheet is clean – the company has emerged from BK with approximately $250mm in debt, whereas it had almost 10x as much when it entered BK. Book value is approximately $10 per share, tangible book a bit lower due to some goodwill, but there is approximately $4 per share in net current assets. As well, the liquidation analysis included in the BK document presents a plausible scenario (with all of the standard haircuts to assets based on liquidation) of approximately $8 per share. Today’s price of $10+/- (EV = ~$750mm, mkt cap = ~$500mm) is well supported by these values.

• As it relates to the prior point re a value cushion, the company is expected to generate approximately $155mm in EBITDA in FY 03. A more thorough cash flow analysis reveals modest uses for working capital (significant improvements have been made here – Wachner used to demand that tons and tons of inventory be produced and given that she pillaged the company personally for cash, let’s just say that working cap was not a focus) and cap ex (approximately $55 million between the two in FY 03), and cap ex runs significantly less than depreciation. That leaves approximately $100mm for taxes and interest, which will be approximately $40mm combined in FY 03. The remainder can be used to pay down debt. The numbers vary from 2003-2005 and there are lingering effects of the BK (legal fees, severance, etc.) but the conclusion is simple – the company will be generating significant free cash which it can use to pay down debt, repurchase shares, etc. The BK document shows approximately $100mm in debt being paid down by 2005. I think this is conservative. Ultimately, as with several other slower growing apparel companies, the FCF yield of 10%+ provides a significant cushion.


As it relates to upside potential, there are a few ways to look at this. I suspect that certain VIC investors have already done more work than I have. Please contribute if that is the case. In the meantime, I attempt to “frame” the opportunity.

• The reorg document projects EBITDA margins of 10%-11% going forward. This is at the low end of comparable companies and I suspect it represents a conservative estimate. Industry margins vary depending on, obviously, strength of brand, cost of manufacturing, admin, etc., and, whether a company is a licensee, licensor, the specifics of a license, etc. If Warnaco is able to improve margins to still well-below industry average levels (i.e. 12% vs. 14-16% for JNY, LIZ, RL, TOM, NAUT, COLM, etc.), then it will never need to get a multiple for this to be a very good investment (i.e. every margin point is worth over $1.50 in stock price assuming a flat multiple, no benefit from paying down debt, other improvements, etc.). Given that the only company in the area with sub 10% margins is PVH, a company that is down for the last decade (vs. solid appreciation for JNY, LIZ, etc.), my sense is that there is an opportunity. Particularly given my experience with bankruptcy plays, and my prior understanding of how Warnaco was operated. However, I acknowledge at this that point that my analysis is a bit superficial and that some of the low hanging fruit have already been picked.

• Warnaco was always penalized re valuation because Wachner was a bit out of her mind. Many value investors shied away from Warnaco due to its apparent conflicts with Authentic Fitness, the way that Wachner ruled, etc. I suspect that Warnaco will now be viewed as fair game for investment, particularly since many improvements have yet to be reflected in operating margins and because there just aren’t THAT many 10%+ FCF yield companies out there (and when there are, they don’t stay that way for long). Of course, there will also likely be the requisite new coverage on Wall Street. Prior to the problems that led to its BK, to pissing off Wall Street, etc., Warnaco was as closely followed as JNY, LIZ, etc.

• Ultimately, this may not seem like a particularly exciting investment if you view it as simply trading at 5x EBITDA (I think we went through this with Carmike at the time). However, in conjunction with excess depreciation, the opportunity to improve margins out of BK, and further working cap improvements, “real cash flow” (and returns on invested capital) by 2004-2005 could be significantly higher than the “apparent” $175mm EBITDA projection in the reorg document. I think there is a very reasonable chance for at least a double with nominal downside risk from here, particularly if you are able to buy opportunistically as creditors sell shares.

• I hate making price projections because we all tend to fit data to reach a conclusion, but my rough expectation is as follows: $1.7bn in 2004 revenues, ~ plan), 11% EBITDA margins, ~ $100mm in FCF (and by the end of 2004, about $125mm of debt has been paid down). Valuation is a tricky animal here so I tend to think about it more generally. For example, if you look at the history of LIZ or JNY, you will notice that every few years (1995, 1998, 2001, now), the stocks get hit, then seem to stabilize, then begin to appreciate again. This has essentially gone on for the last 20 years. Yet over the past 20 years, these companies have returned between 10-15% annualized. Essentially, what happens is that every now and then someone loses a license or spending slows for some time. There is an overreaction or a mini-trend. And then stock prices retreat to some very interesting level – usually at a point where the FCF yield is north of 10% -- and this is when you buy. You do not buy JNY when it has a FCF yield of 5%. But at some level, you have to buy because these are not really fashion companies -- they generally don't disappear. I think we may have that kind of reasonable opportunity here. If I use $100mm as my FCF target and use a 10% yield, I get $1bn in mkt cap, minus the debt of ~ $150mm in 2004, or approximately $17 per share (right now, WRNC is trading, it appears, at a 12%+ FCF yield). If things get interesting in the market again, maybe the required yield is lower and the target becomes $22-23. And what’s the downside? It really does seem to be somewhere in the $8-10 range (and in this case, I’m inclined to attribute some value to intangibles, so I am comfortable with book of $10), at worst. If creditors dump shares, wonderful. I suspect that my worst case will be a flat to down 20% investment for 2 years with a reasonable shot for 75-100%+ appreciation.


Risks:

1 Dead wood.

2 Apparel is tough business, period.

3 Losing a multiple point in this environment is just as easy as getting one. However, we are getting close to real asset value support on the downside here.

4 Lots of creditors will sell stock. This could put pressure on the stock for awhile. I consider this more volatility than risk. Buy here or buy at $8.50, but don’t get too cute I think is the point.

5 Interim management squeezed the hell out of the company to move on to the next assignment.

6 Losing licenses.

7 A skeleton in some closet.

Catalyst

1 Emergence from bankruptcy and lowball bankruptcy estimates.

2 Wall Street coverage/General media coverage.

3 High profile permanent CEO hiring.

4 Deleveraging.

5 Margin improvement.

6 The magical 10% FCF yield barrier.

7 Sale???