Levi Strauss 8.625 Bonds
December 31, 2008 - 9:42am EST by
bondo119
2008 2009
Price: 55.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 2,201 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Levi Strauss’ 8.625% Euro bonds, due in 2013, are trading in the mid-50s, with a yield-to-maturity of 27% and a simple yield of nearly 16%. I believe that, in the worst case scenario – bankruptcy – buyers of these bonds will receive a large enough stake in the reorganized company such that the downside is limited. In a more reasonable case – which is really any non-bankruptcy case – the YTM is very attractive, and the return will likely be even higher as spreads tighten before maturity.
 
For those who aren’t familiar with the name, some basic facts: Levi’s is a 155-year-old producer of jeans and other branded apparel. The company generated 4.4bn in LTM revenue, split across three brands: Levi’s (the flagship; 73% of revenue), Dockers (business casual wear; 21% of revenue), and Levi’s Signature (low-priced jeans sold at places like Wal-Mart; 6% of revenue). Distribution is primarily via chain retailers and department stores, with the largest customer, JC Penney, accounting for 9% of revenue. The company also operates 245 of its own stores, accounting for less than 10% of revenue. Geographically, sales are split 54/46 between the Americas and Europe/Asia.
 
** Two Things That Stand Out **
 
Levi’s doesn’t really fit the stereotype of a dying, near-bankrupt retailer. In fact, a review of the history of the company reveals two pretty admirable qualities:
 
First, selling branded jeans is a surprisingly steady business. Perhaps Levi’s reputation for offering relatively standard cuts at reasonable prices insulates it from the volatility of fashion trends. Perhaps Levi’s customer base, which is 72% male, is less fickle. Whatever the case, the result is 80+ quarters, or 20+ years, without an operating loss. Through the recession of 2001-2002, Levi’s generated operating margins of 9.4%. Through the recession of 1990-1991, Levi’s generated operating margins of 15%. And, although my data is less reliable going back to the 70s and early 80s, through the recession of 1973-1974, as well as the recession of 1981-1982, Levi’s was solidly profitable, with operating margins of at least 4-5%. This consistency is not specific to Levi’s either. If you look at VF Corp, Levi’s closest comp, their jeans-wear business is also remarkably stable.
 
Interestingly enough, when Levi’s does struggle, the source is almost always industry and/or company-specific. For example, in 1999, operating margins fell to 6.4% on poor managerial execution, including a complete miss of the baggy-legged jeans craze. In 2003, the culmination of several industry trends resulted in margins hitting a low of 4.7% (after backing out a one-time gain).
 
The silver lining here – and this is the second of the admirable qualities that a reading of the history reveals – is the hard-to-kill nature of the business. Going back through old magazine articles is particularly revealing in this regard. For example, in 1999, Forbes published a piece entitled, ‘How Levi’s Trashed A Great American Brand.’ The author paints a picture of complete internal chaos and a company, “[coming] apart at the seams.” Yet in the nine years since that article was written, Levi’s operating profits increased by 78%, averaging 439mm per annum.
 
While it is indeed true that Levi’s is not as hot of a brand as it once was, it isn’t going away either. Yes, revenues, after peaking at 7.1bn in 1996, have fallen to (and stabilized in) the 4bn range. Yes, operating profits are lower today than in the 1990s. But it is important to put these numbers in the proper context, especially in light of the fact I am recommending the bonds – which will work out as long as the company just stumbles along – and not the equity.
 
** More Numbers… **
 
Levi’s generated LTM EBITDA of 650mm, versus a current interest obligation of 139mm, resulting in an EBITDA interest coverage multiple of 4.7x. LTM EBIT was 580mm, resulting in an EBIT interest coverage multiple of 4.2x. To offer some long-term perspective in relation to these figures, I’ve include the historical record of sales, EBIT and associated margins below:
 
Sales
 
1990 – 4.2bn
1991 – 4.9bn
1992 – 5.6bn
1993 – 5.9bn
1994 – 6.1bn
1995 – 6.7bn
1996 – 7.1bn
1997 – 6.9bn
1998 – 6.0bn
1999 – 5.1bn
2000 – 4.6bn
2001 – 4.3bn
2002 – 4.1bn
2003 – 4.1bn
2004 – 4.2bn
2005 – 4.2bn
2006 – 4.2bn
2007 – 4.4bn
LTM – 4.4bn
 
EBIT (Margin)
 
1990 – 622mm (14.8%)
1991 – 750mm (15.3%)
1992 – 677mm (12.1%)
1993 – 852mm (14.4%)
1994 – 969mm (15.9%)
1995 – 987mm (14.7%)
1996 – 948mm (13.4%)
1997 – 853mm (12.4%)
1998 – 691mm (11.6%)
1999 – 329mm (6.4%)
2000 – 473mm (10.2%)
2001 – 398mm (9.3%)
2002 – 388mm (9.4%)
2003 – 192mm (4.7%)
2004 – 413mm (9.9%)
2005 – 548mm (13.0%)
2006 – 544mm (13.0%)
2007 – 557mm (12.8%)
LTM – 580mm (13.2%)
 
The recovery in margins from 2003 to today is in part due a painful internal restructuring that resulted in the firing of tens of thousands of domestic workers and the shifting of all manufacturing offshore.
 
If we take the average margin since 1997 – 10.2% – and apply it to the current level of sales, the resulting EBIT of 449mm corresponds with an interest coverage ratio of 3.2x. If we take the lowest margin recorded – 4.7% – and again apply it to current sales, the resulting EBIT of 206mm still covers interest expense by 1.5x. For Levi’s to be unable to meet its interest obligations, EBIT margins would have to fall significantly below 3.2% – down more than 75% from today’s level – and remain there for several years. I think that the probability of such an outcome is low because, although this time might truly be different, the history shows that even in severe recessions, margins have trended higher than 3.2%.
 
Currently, Levi’s not only easily covers its interest obligations as a going-concern – 3Q08 EBIT alone was 147mm, versus annual interest expense of 139mm – but the company also has ample liquidity reserves, including revolver availability of 302.3mm and cash on hand of 125mm.
 
** Capital Structure **
 
Levi’s capital structure consists of 230mm in secured and short-term debt, 1.68bn in unsecured notes, and 294mm in pension and post-retirement obligations. The unsecured notes are broken down into several issues (including the 8.625s featured here), all of which are pari passu. Levi’s has no publicly-traded equity, as it is family-owned.
 
Debt Breakdown:

Capital Structure

As of 8.24.08

 

 

 

Face Value

Capital Leases

             9,622

 

 

ST Debt

           23,589

 

 

Secured Debt

 

Senior Revolving Credit Facility

         196,844

Notes Payable, at Various Rates

               131

Total Secured

         196,975

 

 

Total Above Unsecured

         230,186

 

 

8.625% Euro Senior Notes Due 2013

         374,141

Senior Term Loan Due 2014

         322,949

9.75% Senior Notes Due 2015

         446,210

8.875% Senior Notes Due 2016

         350,000

4.25% Yen-Denominated Eurobonds Due 2016

         183,226

Total Unsecured

      1,676,526

 

 

Pension Obligation

         146,024

Post-Retirement Obligation

         148,588

 

 

Total Obligations

      2,201,324

 
 ** The Worst Case Scenario **
 
Let’s consider the worst-case scenario in detail. Suppose that Levi’s has a terrible 2009, is unable to meet its interest obligations, and goes bankrupt. What would the bonds be worth in a reorganization? The valuation of course depends on what the creditors decide ‘normalized’ EBIT is. I think that 240mm is a conservative figure. That equates to a 6% margin on 4bn of revenue (compared to 13.2% and 4.3bn today). Of course, interested readers can construct their own sensitivities. Capitalizing 240mm at 7x (which is what VFC is valued at today, after falling 40% from early September) results in a total enterprise value of 1.7bn. Assuming a complete drawdown of the revolver, 100mm in DIP and administrative expenses, and a full recovery for the senior secured debt, there is still nearly 1.05bn in value left over for the unsecured bonds. This implies an eventual recovery of more than 50 cents on the dollar (including the 294mm in pension obligations).
 
** Loose Ends/Conclusion **
 
The biggest risk to this idea is indeed bankruptcy. Even if the ultimate capital loss is limited, I would not invest if I thought that Chapter 11 was anything but a very remote possibility. I hope I have conveyed why I think this is the case, but of course I could be wrong.
 
To keep this write-up at a bearable length, I will leave many of the details related to the business fundamentals for the discussion thread (if anyone is interested). For example, I think that an interesting matter is the health of Levi’s largest customers and the correlation (or lack thereof) in performance along the supply chain. I also think it is interesting that VF Corp – nearly half of their business is jeans – is still projected to grow earnings into 2009 and 2010, while Levi’s is being priced to fall off a cliff.
 
Finally, I would note that Levi’s has several other actively traded bonds, including the 9.75s of 2015 (which management is buying back in the open market) and the 8.875s of 2016. Both are priced in the 60s-70s, yielding roughly 17% to maturity, after tightening significantly over the past few weeks. I find these issuances interesting as well, although the Euro bonds discussed above are more favorably priced. After going through the relevant docs, I don’t know why – apart from crazy technical factors – the Euros trade ten percentage points wider than the others, especially as all are pari passu.

Catalyst

See above.
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