Do you hear the pitter-patter of little feet, Liz Claiborne (NYSE:LIZ)?
No, it's not a precious bundle of joy coming your way -- just the sound of private equity firms angling for a closer look at your company.
So I've changed my mind...
I know I've been critical about some of the names in the "they could go private" rumor mill, given the popularity of private-equity transactions. I'll also admit that I'm purely speculating on this one. Still, I think Liz is creating a great case for private equity to come in and "help" this struggling company create some value for shareholders.
Missed opportunities
Liz Claiborne's problems are much deeper than an ugly miss that seemed to catch lots of investors off-guard. Liz has great products that match up very nicely against those from competitors such as Jones Apparel Group (NYSE:JNY), Ralph Lauren (NYSE:RL), and Guess? (NYSE:GES). Unfortunately, it's frittered away the wonderful gross margin improvements it's made over the last five years.
|
FY2001 |
FY2002 |
FY2003 |
FY2004 |
FY2005 |
FY2006 | |
|---|---|---|---|---|---|---|
|
Gross Margin |
41.4% |
43.6% |
44.6% |
46.2% |
47.4% |
47.8% |
|
SG&A |
31.3% |
32.9% |
33.5% |
35.2% |
36.2% |
37.4% |
For every point of increase in gross margin, there's been an almost equal increase in SG&A costs. That's no good. In the consumer-products and retailing industry, leveraging SG&A costs is an important way to create value -- which the company simply hasn't done.
No free cash flow growth
You know what I'm going to say next, right? Because operating margins haven't increased as fast as they could have, operating cash flow hasn't been able to rise as fast as it could have, either, despite the company's strong working capital management. With relatively flat operating cash flow growth, and rising capital expenditures to build out a retail presence and acquire new brands, free cash flow has declined, even as the company's sales grew.
Nothing for shareholders
That would be OK if the company were plowing its money back into projects that generated big return-on-capital spreads -- spending a dollar today to get two dollars tomorrow. But Liz isn't. Returns on invested capital (ROIC) have been declining over the same five years in which the company has grown.
At least management is starting to feel the sting of declining returns as well. According to the most recent proxy, managers had to achieve 11.4% ROIC and $2.58 in EPS to earn their bonuses. They didn't. That's cold comfort to shareholders, but at least management wasn't rewarded for the value it failed to create.
A changing marketplace
Liz is also in a power struggle with retailers such as Dillard's (NYSE:DDS), Federated Department Stores' (NYSE:FD) Macy's, and J.C. Penney (NYSE:JCP), which are demanding exclusive styles and quicker inventory replenishments. Translation: Give us your best stuff, give it to us exclusively, and ship it in smaller batches. Adapting to this changing landscape will take time for Liz Claiborne, and the public markets may not be patient enough.
Why going private may be a good solution
I'm betting that the private-equity guys are salivating right now. Liz Claiborne clearly has operating efficiencies to wring out, and plenty of challenges ahead of it, but it's still generating cash. Here's why I think Liz may be better off keeping her dirty laundry out of the public eye.
As a private entity, the company can work harder to cut the fat and rationalize brands that aren't working, without worrying about meeting quarterly earnings projections or fending off other distractions. Private leadership can implement a more stringent capital allocation process, with a higher bar for cash flow and ROIC targets. After all, the private equity guys want to return the company to Wall Street one day. With returns similar to the 17% Ralph Lauren generates, and rising free cash flow, that could ultimately create a big payoff. And if the private equity guys can't make these changes, they won't get paid -- much like shareholders aren't getting paid now.
Sure, there are different control provisions to worry about with Liz's new CEO and management team. That new team will also need time to get its plans in motion. But the new folks had better get things going pretty quickly; I still think the private equity guys are circling.
Only small-f fools rush in
I'd never recommend buying a stock based solely on speculation that it may be taken private. We should buy when stocks are mispriced. Signs suggest that Liz Claiborne will be cheap if -- and it's a big if -- it can get its act together and start generating some value (and some actual profits) from all that growth.
Liz's current price has very little growth baked into it: 4% per year by my calculations, with a 10% discount. By regaining control of its brands, reducing its costs, and increasing and improving its retail presence, Liz could easily surpass those expectations. That's yet another reason why the private equity guys must be drooling to make Liz a sweet deal that she can't refuse. Now, where's the "outperform" button in CAPS ...?
Turnarounds are an important tool in the value investor's toolbox, one lead analyst Philip Durell uses to outperform the market at Inside Value. For a free 30-day trial subscription, simply click here.
Retail editor and Inside Value team member David Meier hates doing laundry, but loves a good bargain. He's ranked 905 out of 28,309 in CAPS, and he does not own shares of any of the companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.
