Description

Introduction

             GIII presents an opportunity to invest in a very well-run business in the market’s most hated sector. The company is run by a CEO who has been with the firm for 43 years, owns ~10% of the outstanding shares, and has delivered exceptional results managing the business for the long term. Shares are off ~65% from July 2015 highs due to several issues depressing near term earnings. In this report, I argue that these issues are temporary and as clarity around the company’s earnings power improves, shares have the potential to appreciate considerably.

Business Overview

GIII designs, manufactures and markets a wide range of apparel, including outerwear, dresses, sportswear, swimwear, women’s suits and women’s performance wear, as well as handbags, footwear, small leather goods, cold weather accessories, and luggage. The company sells products under its own proprietary brands which include, DKNY, Donna Karan, Vilebrequin, G.H Bass, Weejuns, Andrew Marc, Marc New York, Eliza J, and Jessica Howard. GIII also sells an extensive portfolio of well-known licensed brands including Calvin Klein, Tommy Hilfiger, Karl Lagerfeld, Levi’s Docker’s, Kenneth Cole, Cole Haan, and Guess?. The company’s products are sold through retailers such as Macy’s, TJX, Lord & Taylor, Saks Fifth Avenue, Dillard’s, Nordstrom, and JC Penny. GIII also distributes apparel through its own retail stores. As of Jan. 31st 2017, the company operated 190 Wilson Leather stores, 163 GH Bass stores, 50 DKNY stores, 5 Calvin Klein stores, and 3 Karl Lagerfeld stores.

The company reports two segments: wholesale (84% of total revenue) and retail (16% of total revenue). A substantial majority of sales are made in the United States. International, which includes Canada, Europe, and the Far East, accounts for 9% of total revenue. The company reports on a fiscal year that ends January 31st. We are currently in the company’s fiscal 2018 reporting year.

Why does the opportunity exist?

Shares of GIII have fallen ~65% from a high of $73 in July of 2015 to the current price of $26. The share price decline can be explained by several factors. First and foremost, has been a deterioration in the company’s retail segment. Like much of the retail world, GIII’s Wilsons Leather and Bass stores have struggled to attract traffic. Compounding the weak traffic for Wilsons Leather has been relatively warm fall and winter months over the past several years. Two thirds of Wilson’s sales are coats. Shares took another leg down in July 2016 following the company’s announcement that it was acquiring DKNY for $650m. Due to expenses related to the brand transition and revamp, the deal is dilutive to near term earnings. The street did not react favorably to the near-term dilution sending shares from ~$50 down to the mid $20s where they trade today.

At current levels, I believe the stock is incorrectly reflecting permanent challenges rather than transitory resolvable issues. Recent results demonstrate several important aspects of the thesis. First, management is proactively taking steps to mitigate the on-going challenging environment in retail through store closures and expense rationalization. Second, DKNY and Donna Karan are on track to hit management’s longer-term earnings accretion targets. Lastly, the wholesale business continues to demonstrate consistent and profitable growth.

Consistent Wholesale Results Masked by Weakness in Retail

 GIII has built a broad and deep portfolio of over 40 licensed and proprietary brands. The company has established itself as a licensee of choice for well-known brands, as demonstrated by partnerships with Calvin Klein, Tommy Hilfiger, Karl Lagerfeld, Levi’s, Dockers, and others. The company holds a leadership position in women’s wear, dresses, and outerwear and has built a diversified distribution base that includes high end retailers such as Macy’s, Lord and Taylor and Nordstrom, lower end stores like Burlington and Ross Stores, and e-commerce retailers such as Amazon. These factors have contributed to a 5-year segment revenue CAGR of 10% with growth in each year. Margins in the segment declined in fiscal 2017 (calendar 2016) due to increased SG&A spending related to the launch of additional Karl Lagerfeld and Tommy Hilfiger business (increased facility costs, hiring additional personnel, supply chain tech investments).

Wholesale Revenue Reaccelerating

GIII’s recent fiscal 1Q18 earnings report suggests a reacceleration in wholesale revenue for fiscal 2018 (calendar 2017). Despite the continued challenging environment for the company’s department stores partners, GIII posted wholesale revenue growth of +18.5% overall and +8% organic ex-DKNY/Donna Karan. Robust results from Tommy Hilfiger, Calvin Klein, and Karl Lagerfeld contributed to the strong performance. Management noted on the call that bookings for Tommy Hilfiger have nearly tripled last year’s level and Karl Lagerfeld bookings are up nearly 2x. For the full year, management expects segment growth to be +18% overall and up mid-to-high single digits ex-DKNY/Donna Karan.

Achieving these targets depends on the company’s execution. 1Q is relatively light from a seasonal perspective. The heavy lifting comes in the second half of the year. Nonetheless, management’s comments are encouraging especially considering the much maligned “retail apocalypse”. Discussing the on-going sea-change in the department store retail environment, CEO Morris Goldfarb stated, “everybody’s fleet of stores is being called down and what you get I believe [is] greater efficiencies, concentrated good inventory, and better performing stores…there will be less department stores to trade with but better department stores to trade with.” While acknowledging this as “optimistic CEO speak” there does appear to be an opportunity for GIII to absorb space from distribution resets at Michael Kors and Ralph Lauren.

DKNY/Donna Karan: “Full Steam Ahead”

             GIII closed its acquisition of Donna Karan International (DKI), the parent company of Donna Karan and DKNY, in December 2016 for a purchase price of $650m. After the announcement, the company was criticized by analysts for paying a steep price compared to previous deals. The purchase price of $650m equates to roughly 2.2x trailing sales, above the ~0.5x average GIII has paid in past deals. Explaining the deal rationale, management laid out the following projections for DKI implying a significant ramp in sales and EBIT:

             Management clearly sees substantial potential for the brand. DKI was previously owned by LVMH. When LVMH purchased the brand in 2001 for $643m, DKI did north of $625m in sales and was profitable. For LVMH, DKI was a drop in the bucket, accounting for less than 1% of sales. With a renewed focus and strategy, it is likely that GIII will succeed in growing the brand. At the time of the acquisition announcement with the stock at $50, a plausible argument could be made that GIII overpaid given near term earnings dilution and the uncertainty surrounding growth and execution. However, with shares at $26 today, I argue that risk surrounding the deal is more than priced in and execution should lead to significant share appreciation.

             Management’s update on the most recent earnings call noted that the transition and wholesale launches for DKNY and Donna Karan are moving full steam ahead. The response and initial bookings from customers have been encouraging and the DKI business will become profitable in the second half of this year as new products hit the market. New Yorkers may have noticed a new DKNY advertising campaign around the city over the past few months with model Emily Ratajkowski. The CEO commented that the campaign was one of their most successful market initiatives ever combining billboards in NYC with digital advertising to capitalize on Emily’s 13.5m Instagram followers. Additionally, in March, the company announced an exclusive agreement with Macy’s for DKNY women’s apparel and accessories. Beginning in February 2018, Macy’s will serve as the exclusive US department store for DKNY women’s apparel, handbags, and shoes. The agreement also plans for increased and enhanced DKNY shop-in-shops in Macy’s stores. GIII believes this partnership demonstrates renewed interest in the brand. Macy’s CEO stated, “By offering exclusive access in key categories, we are confident that DKNY will quickly become one of our top brands.”

             The ultimate success of the DKI transaction remains an unknown. At the current stock price, the market appears to be giving very little credit to management’s growth targets. Recent commentary suggests the company is executing to plan. Longer term, the CEO has said he believes DKI can be a $1bn brand. If GIII is successful in achieving even half of that goal, shares should rise considerably.

Right Sizing the Retail Segment

             Recent performance in the retail segment has been bad. The segment primarily consists of Wilsons Leather and Bass stores. On a same store sale basis, Wilsons began comping negatively in fiscal 3Q16 (calendar 3Q15) and has continued on a downward slide into the most recent quarter. Bass began to struggle in fiscal 1Q17 (calendar 1Q16) and posted negative comps throughout all last year and into this year. The company attributes the weakness to reduced sales in cold weather products, lower customer traffic at locations frequented by international tourists, and a highly promotional outlet and retail environment. These factors contributed to a fiscal 2017 (calendar 2016) revenue decline of 7.7% and an EBITDA loss of $50.3m.

             Acknowledging the challenging retail environment, management announced in the beginning of this year that the company is reducing its retail footprint by one-third and embarking on an expense reduction plan. The company started the year with 353 Bass and Wilsons stores. In the first quarter, GIII closed 28 stores and plans to close an additional 41 through the rest of this year. Next year the company expects to close an additional 45 locations bringing the total to 114 closed stores.

In addition to the store closures, the company is repurposing locations from Bass and Wilsons to DKNY outlets. Late last year, 4 locations were repurposed and an additional 15 will be repurposed this year. While it is still early, the locations repurposed last year have seen strong early sales growth and are forecasting annual sales gains of 40%+. On the expense side, the company eliminated $4m of run-rate expenses and expects to have eliminated $12m by year end. In total, the company expects a $15-20m improvement in retail operating profit loss this year.

I expect retail to remain challenged and my thesis is not dependent on the segment returning to historical levels of profitability. Instead, through a reduced and improved store footprint, I believe the company can eliminate losses by fiscal 2019 (calendar 2018).

Large CEO Ownership + Recent Open Market Purchase

             GIII is run by CEO Morris Goldfarb. He has been with the company for 43 years and is the son of the founder. Goldfarb owns about 10% of the shares outstanding. Over the past 20 years he has delivered ~14% compound annual returns to shareholders versus ~7% from the S&P 500. In April, Goldfarb bought ~$900k worth of shares in the open market.

Putting It All Together- Building the Model

             Earnings in fiscal 2018 (calendar 2017) will be negatively impacted by the revamp and transition of the DKI business. This business is expected to turn profitable in the back half of this year. In the below model, I haircut management’s fiscal 2019 targets for DKI by 25% and project mid-single digit growth in the rest of the wholesale business. In the retail segment, I model flat EBITDA by fiscal 2019 (calendar 2018) as management continues to cut costs. This results in fiscal 2019 (calendar 2018) EPS of $2.30 and EBITDA of $260m. Below are my base earnings model and key assumptions:

Key assumptions:

·        Revenue

o   Fiscal 2018

§  Wholesale- I model 18% revenue growth in line with management’s guidance on most recent conference call

§  Retail- Revenue continues to struggle with segment declining 10%.

o   Fiscal 2019

§  Wholesale- I model ex-DKI wholesale revenue growth of 5% and model 75% of management’s fiscal 2019 growth target for DKI. This equates to 13% growth for the segment

§  Retail- I model revenue -3% on continued retail weakness

·        EBITDA

o   Fiscal 2018- I model EBITDA in line with management’s guidance with margins essentially flat YoY.

o   Fiscal 2019

§  Wholesale

·        I model 75% of management’s operating profit target for DKI and mid-single digit growth for the rest of the business. Margins increase 80bps YoY due to positive mix shift from DKI business.

§  Retail

·        I model essentially flat EBITDA on the assumption management can cut expenses to stem losses

Valuation Scenarios

             Shares currently trade at 20x consensus fiscal 2018e EPS estimate of $1.28. However, this EPS estimate includes ~30c of operating losses associated with transitioning the DKI business. Excluding these costs, which are expected to begin to cease in the back half of this year, shares trade at ~16x “normalized” EPS of $1.58

On today’s price, shares trade at ~11x my fiscal 2019 (calendar 2018) base case EPS estimate of $2.30. Over the past 5 years, shares have traded at an average PE multiple of ~16x, with a high of 24x and a low of 8.3x. Below is a bull, base, and bear case scenario for fiscal 2019 EPS and multiples.

Bull case- I give management 100% credit for their targets for the DKI business, layering on the full $55m of operating profit in fiscal 2019. Additionally, I assume retail segment can stem revenue declines in fiscal 2019 return to modest profitability. These assumptions yield $2.60 in EPS and $282.8m in EBITDA.

Bear case- Management fails to grow DKI business from current sales levels. The rest of the wholesale business slows to 2% growth and margins are flat from fiscal 2018 levels. Retail segment sales continue to decline and the segment remains a money loser. This scenario yields $1.74 in EPS and $216m in EBITDA.

The below matrix examines the three scenarios with various multiples:

             Looking at valuation on an EV/EBITDA basis tells a similar story. Over the past 5 years, the company has traded at an average EV/EBITDA of 9.3x, with a high of 14.6x and a low of 5x. At the end of the most recent quarter GIII had $425m in net debt which is included in the below EV calculations.

With the stock at $26 today, this analysis produces a favorable distribution of return outcomes ranging from -20% to +107%

Where I could be wrong/ Risks

The major risk to GIII remains the uncertain macro environment for retailers. The company also has some customer concentration risk with significant exposure to Macy’s. Sales to Macy’s represent ~20% of total revenue. GIII is certainly not immune to the on-going department stores closures and shift away from traditional shopping experiences to e-commerce.  While this represents only a single data point, GIII’s first quarter wholesale results (sales +18.5% YoY) were especially encouraging given the difficult backdrop. Macy’s sales were down 5% in 2016 and were down 7% in the first quarter of 2017. While, CEO Morris Goldfarb’s theory regarding surviving stores holding higher quality inventory may have some merit, it is irrefutable that continued department stores weakness poses a risk to GIII’s business.

While I believe the company is taking proactive steps to improve the retail segment, GIII’s exposure to brick and mortar retail through its own stores remains a risk if the macro environment were to deteriorate further. Most of the company’s retail stores are located in larger outlet centers with a variety of other stores and brands. Risks that could further negatively impact GIII’s stores include increased competition and increased promotions in the outlet environment, a downturn in foreign shoppers in the United States, and continued migration away from brick and mortar retail. Wilsons Leather continues to be exposed to fluctuations in weather due to its high percentage of sales coming from outerwear.

Integrating and revamping a relatively large brand like DKI presents a host of potential challenges. At the time of acquisition, due in large part to restructuring decisions made by LVMH, DKI was experiencing declining sales and significant net losses. To realize the benefits projected by GIII’s management team, the operations must be successfully integrated in GIII’s operations and the brand must be reinvigorated to drive sales. While GIII’s management team has significant experience in fashion, including with brands with similar distribution networks, the successful integration and execution is by no means a sure thing. GIII’s management has had to revise down initial fiscal 2018 expectations from $325m in sales and a loss of $10 in operating profit to $290m in sales and a loss of $31m in operating profit (equates to a loss of $11m in EBITDA). Management’s targets for fiscal 2019 and beyond have remained unchanged. If management were to “move the goalposts” on the DKI targets, the multiple will likely remain depressed.   

Fashion is an intensely competitive industry which rapidly changing customer taste and preferences. While the management team has significant experience in the industry, maintaining a strong competitive position and attractive consumer brands is always a risk.

GIII arranges for the production for most of its products from independent manufacturers located primarily in China, and to a lesser extent, Vietnam, Indonesia, India, and Bangladesh. If the United States were to enact a border tax, it could pose a risk to GIII’s business.

GIII is dependent on sales of licensed products for a substantial portion of total revenue. In fiscal 2017, licensed products accounted for 60.7% of total revenue. The company is generally required to achieve specified minimum net sales, make specified royalty and advertising payments, and receive prior approval of the licensor as to all design elements of a product prior to production. GIII has significant exposure to PVH through licenses to sell Tommy Hilfiger and Calvin Klein. These two brands constituted 44% of the company’s sales in fiscal 2017. Any adverse change in the relationship with PVH would have a materially negative impact on GIII’s operations.

Catalyst

-Earnings