Description

Summary

We believe Global Brands Group (GBG), a recent spin-off of Li & Fung (L&F) listed in Hong Kong, is an attractive short sale candidate. Normally we would look at spin-offs as potential long opportunities for all the reasons well known by members of Value Investors Club. However, we believe the GBG spin-off was specifically engineered to de-risk the core L&F group by unloading an underperforming, capital-consuming, low-return, and unpredictable business. We also believe the market mistakenly ignores the large acquisition related payables which have been amassed and which will provide a significant drag on cash flow in future years. We see goodwill impairment and capital raisings as likely negative catalysts in the next 6-24 months. The stock is expensive at 29x tailing Core Operating Profit / Enterprise Value (inclusive of acquisition payables) with little organic growth, despite a more reasonable looking headline P/E multiple of 16x. The P/E multiple is misleading, however, because it does not factor in acquisition payable liabilities and even includes non-cash income from the write-back of terminated acquisition payables.

Description

GBG designs, develops, markets, and sells branded apparel, footwear, accessories, and home products across a portfolio of more than 350 licensed brands and 10 controlled brands. Customers are primarily large US retailers including Kohl’s, Nordstrom, Macy’s, JC Penny, Wal-Mart and Target. The top five customers accounted for 46% of sales in 2013. 85% of sales in 2013 were from the US and while non-US revenues have been growing faster, this is likely to remain a US-centric business for the foreseeable future. Note that GBG is listed in Hong Kong but financials are reported in US$. Therefore all numbers in this write-up are in US$ unless otherwise noted.

Approximately 82% of sales are from licensed brands, which typically have a license period of 1-8 years. Some key licenses include Disney (apparel and accessories), Sanrio / Hello Kitty (apparel), Calvin Klein (footwear, belts, small leather goods), Coach (footwear), Daisy Fuentes (apparel), Ellen Tracy (activewear, handbags, and belts), Michael Kors (belts and cold weather accessories), Nautica (children’s apparel), Tommy Hilfiger (children’s apparel and home products), and Sean John (sportswear and activewear). 35% of group turnover was from the top ten licenses in 2013.

The other 18% of sales are from Controlled Brands, which are either owned outright or operated through long-term licenses which allow for significant control over design and marketing. Key Controlled Brands are Frye (owned), Spyder (long-term license for sportswear, footwear, and accessories), Juicy Couture (long-term license for women’s and girls’ apparel and accessories), Rosetti (owned), Tignanello (owned), and Aquatalia (owned). Frye’s is the most important Controlled Brand, accounting for 5.5% of group sales in 2013 and likely a higher percent of profit.

For licensed brands, GBG is generally required to achieve minimum net sales and pay guaranteed minimum royalties, as well as specified royalty and advertising payments based on a percentage of sales.

GBG uses sourcing agents including L&F. GBG has agreed to use L&F for no less than 50% of sourcing requirements for three years from the listing date. Typically there is a 3-5 month design and development phase for a product and then an additional 3-5 month lead time from order placement to delivery at the customer.

Background

The GBG business was formed within L&F, the largest sourcing company in the world. It began back in 2005 when L&F established a wholesale business to broaden its relationship with customers. The business was built through a series of acquisitions which initially focused on character licensing (Hello Kitty, Disney, etc) and then expanded into fashion apparel, footwear, and home products.

The amount spent assembling GBG likely exceeded $3.0b, evidenced by the $3.3b of intangible assets on the balance sheet at YE13, of which $2.5b is goodwill. This excludes $0.6b+ of acquisition payable liabilities, discussed below, which could take the total acquisition cost to nearly $4.0b.

L&F went through a very difficult period in 2012-13 with numerous operational downgrades and several capital raises which caused the stock to fall from a 2011 high of HK$21 to a December 2013 low of less than HK$8.  While the sourcing business, which now comprises the bulk of the post spin-out L&F, did experience some challenges, the majority of the operational downgrades and the capital shortfall were related to the GBG business. GBG is effectively the former “Distribution Network” division of L&F excluding the private label business and a few other “Excluded Businesses” described in the prospectus.

During 2012-13, the GBG business took $90m of restructuring charges, $63m related to marked down payments and unsold products, and the remaining $27m in additional operating expenses for early termination of licenses and staff costs.

L&F announced the decision to spin-off GBG in March 2014 and it was completed on July 3, 2014. Immediately post spin-off, L&F had a market cap of $11.3b and GBG had a market cap of $1.9b. The Fung family retains a 32.8% shareholding in GBG. GBG did not sell-off immediately as is often the case with spin-offs and has only recently declined below the post spin-off price.

Spin-Off Rationale

Management’s stated rationale for the spin-off is that the private label and brands businesses are very different in nature, requiring a different expertise and management focus. Management also believes that brands business may increasingly compete with the sourcing customers. While true to a certain extent, we think the unstated rationale is more important.

As discussed, GBG accounted for the majority of the group’s operational challenges during 2012-13. GBG is also a capital hungry business that had consumed $1.2b of cash during 2011-13 and likely in excess of $3b since formation. This $3b+ of capital has produced a business with about $3.3b of sales and peak core operating profit of $164m. And as we will discuss later, GBG has also amassed $0.6b of acquisition payables (“earn-outs” and “earn-ups”) which threaten to consume even more cash over the next few years (acquisition payables are all due within five years, and the majority within three years).

Despite all of these acquisitions, the group does not appear to be growing much, if at all. Sales grew +1.4% in H1 2014 but 3.7% of sales were from acquisitions made during the half, so organic sales growth was negative. Similarly, sales growth in 2013 was only 3.1% excluding the impact of acquisitions made in mid-2012 and 2013.

The spin-out announcement seemed rather sudden, which raises the question of why management decided to do it in 2013. In the 2014 interim results, L&F (post spin-out) reported normalized earnings down 11% y/y. GBG however reported a widening core operating loss in 1H14 of -$63m (vs. -$25m in 1H13) and a wider adjusted net loss of -$53m (vs. -$19m in 1H13). Had these results still been consolidated within the pre-spin out group, the combined group would have experienced a 27% decline in core operating profit and 36% decline in adjusted net profit. This would have been a huge miss and may have caused another credit rating downgrade.

The spin-off allowed L&F to reduce credit risk from GBG but still maintain the lucrative related-party sourcing business. Immediately post spin-off, GBG repaid a $594m loan to L&F (which was previously an intercompany loan) by taking out a $727m credit facility. As previously mentioned, GBG entered into a contract with L&F that guarantees they will source a minimum of 50% of product from L&F for a period of three years. We estimate that GBG sourced > 75% of product through L&F in H1 2014 which may have generated a gross profit of as much as $50m for L&F. Not a bad deal.

It’s also interesting that L&F retained some “Excluded Businesses” from the spin-off, which include branded Food, Healthcare, Beauty, and Cosmetics. These appear to be some of the more attractive parts of the business, since management has historically referred to these as the higher growth, higher margin categories.

Finally, we think it is telling that Spencer Fung, son of William Fung, took over as CEO of L&F while Bruce Rockowitz, former CEO of L&F during the GBG acquisition period which led to the group’s troubles, left (was forced to leave?) to run GBG. The majority of the key management at GBG are the very same people who have been running this troubled business in recent years.

Acquisition Payables

GBG was assembled through a series of acquisitions of companies that were typically private companies run by entrepreneurs. The acquisitions are usually structured with an upfront cash payment and contingent payables based on formulas of the acquired businesses achieving their respective base profit targets (earn-outs) or achieving certain growth targets (earn-ups). There is nothing wrong with this and in fact it seems like a logical way to structure deals.

However, we think that analysts typically ignore these contingent liabilities when analyzing the company. In the four initiation notes we have read, these acquisition payables are either not mentioned at all or barely mentioned and are not explicitly factored into target prices, which are typically P/E based.

This ignores a significant and very real liability. It is true that the entire $629m of acquisition payables will probably not turn into cash payments. This is because some of the earn-out and earn-up targets will not be met, and the contingent payments will be reversed and recognized as a gain in the income statement. While this does lessen the cash flow burden, a write-back clearly means that the acquired assets are underperforming which is most likely not a good thing.

GBG’s acquisitions are showing signs of strain. During the past 2.5 years the group has written back more than $200m of these contingent payments, with write-backs of $108m in 2012, $75m in 2013, and $20m in 1H14. During the same period, reported earnings were $27.7m in 2012, $113.5m in 2013, and $98.1m in 1H14 for a cumulative total of $43.1m. Said differently, in the past 2.5 years the company’s reported $43.1m of headline earnings includes more than $200m of write-backs.

Balance Sheet, Cash Flow, and Goodwill

As of 6/30/14, GBG had $727m of gross debt and $163m of cash, for a total of $564m of net debt. This left the group with only $50m of unused limits on bank facilities. Net debt equates to 2.0x trailing EBITDA but if we include the $629m of contingent acquisition payables, then the total amounts to 4.2x trailing EBITDA, which is a considerable amount.

Between 2011-13, over $1b of capital was injected into the company by L&F. The prospectus states that this was made for “attractive” new opportunities. However, capital for new opportunities accounted for only $444m with the remainder used for prior year acquisition payables and working capital, which highlights how much capital the business has been consuming. GBG net cash flow before new acquisitions in 2011, 2012, and 2013 was $1m, -$85m, and $15m. This is all on a revenue base of over $2.5b-$3.0b. In addition, while the pace of large scale brand acquisitions may slow to preserve cash, the day-to-day license business will inevitably require continued investment and accrual of additional liabilities. The majority of the high profile licenses such as Coach, Disney, and Michael Kors are for only 1-2 years. As these licenses roll off, they will need to be renegotiated on new terms or more acquisitions will be necessary.

Intangibles are $3.4b of GBG’s $4.8b of assets and 1.5x shareholder equity (net tangible assets are negative $1.1b). The group has managed to avoid any major impairments of goodwill, but with normalized ROE of 3.1% and ROA of 1.5% and recurrent write-back of acquisition payables that comprise the majority of reported earnings, we wonder if a write-down is inevitable. We also wonder if L&F’s management saw this risk and wanted to distance themselves from the group before the write-down occurred.

A goodwill impairment could potentially trigger a covenant breach. According to the prospectus, the bank loan covenants require that total equity must be at least $1.75b (currently $2.31b) and net debt including earn-out contingent liabilities divided by total equity must be less than 45% (currently 32%). This may seem comfortable, but we estimate a goodwill write-down of more than $550m-600m would violate covenants. This would represent a write-down of only 15-17% of total intangibles. While we don’t have any particular insight into when a write-down could occur beyond the observations above, any further operational challenges could be the catalyst. A corollary to this is that the company could be more inclined than not to raise dilutive equity to create a more comfortable buffer. This could very well be another reason for the spin off – management was aware that the cost of equity in this business is vastly different than that of the parent’s.

Valuation

GBG trades at a trailing normalized P/E of 22.5x. Trailing EV/Core Operating Profit is 22.6x excluding contingent acquisition payables, or 29.1x including these payables. This is broadly inline with comparable company P/E multiples but significantly higher than comp EV/EBIT multiples. Furthermore, we think GBG should trade at a steep discount given the poor operational history and dramatically worse cash flow characteristics.

Risks

Seasonality

The business is highly seasonal with H1 typically loss making and all profits booked in H2. The second half is highly dependent on the back-to-school season in early fall and the holiday shopping season at the end of the year. GBG has 350 brands which makes it difficult to track sales with any degree of accuracy.

The company only reports results semiannually, in-line with Hong Kong reporting requirements. They did however issue a press release on November 20 commenting on Q3 results, saying that turnover was $1,029m and core operating profit was $113m in Q3. The company has never provided quarterly historical results and they chose not to provide a comparison for last year, so it’s very difficult to determine whether this was an improved result. Last year in H2, the group had $1,958m of sales and $159m of core operating profit. We know that most of the back-to-school season orders would be shipped during Q3 and at least part of the holiday orders but the typical seasonal split between Q3 and Q4 is unclear. This data point might indicate that the probability of a disastrous H2 result is low, although we think cash flow will be the more important metric to analyze.

Finally, there are mixed observable data points about key customers and end markets. Some of the key licensed brands have clearly been struggling (Coach, Sanrio/Hello Kitty) but general US retail indicators have been better this holiday season, evidenced by the share prices of a number of GBG’s largest customers. It’s probably fair to say that while the US retail market is not booming, it seems to be doing better than consensus had expected several months ago.

Frye / Hit Brand Risk

With over 350 brands and numerous acquisitions, at least some fraction of the brands are likely to perform well. With Frye, GBG may have found a star-quality brand. Frye is an American boot manufacturer founded in 1863 which has been growing rapidly in recent years. Sales grew from $92m in 2011 to $180m in 2013 (5.5% of group sales), and sales growth was 20% in 1H14. While we don’t think the success of Frye is likely to single-handedly derail the short thesis, it does highlight a few risks. First, Frye (or other brands) could be sold to a third-party at a higher than group multiple which could unlock value and free up cash to recapitalize the balance sheet. Second, although we think Frye is rather unique within the portfolio, it does highlight the risk that another hit brand emerges and improves the overall group fundamentals.

Catalyst

Operational miss, goodwill write-down, capital raising