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Quiksilver Inc. (NYSE:ZQK) the company behind the well-known brands Quiksilver, Roxy, DC, as well as several smaller brands, has seen its share price rise 77.5% in the past year, from $5.07 in January 2013 to $9 in November 2013. The catalyst behind the bullish ride was a heavy dose of optimism for the aggressive turnaround plan laid out in May 2013 by the new CEO, Andy Mooney. In this article, I will explain why I believe the bullish ride isn't warranted. Though the turnaround initiative laid out by Mr. Andy Mooney appears to have raised everyone's expectations, in reality, the new management was handed a ship on the verge of sinking.

(click to enlarge)

ZQK chart from January 2013 to January 2014. Shareholders are optimistic that the company will be turned around.

Short Thesis

Based on my valuation, the implied intrinsic value of ZQK is in the range of $2 and $5 per share. This implies that the company is overvalued by at least $3 per share. This represents a 37.5% slide in the stock price. On the high side, if management turns around the company according to their proposed plan the share price will be worth $10 in 2016. This potential 25% upside over the next two years does not compensate for the risk of investing in brands at the end of their life cycle. Turnaround plans in the fashion business are high risk affairs where the chances of succeeding are slim. I'm confident Mr. Mooney will slash costs and eliminate non-core brands, but there isn't much in his plan to reboot his three dusty decaying brands. I would approach this stock with caution and a dose of skepticism. I think the share price has run up too fast, too quickly and therefore, a short position can be taken.

The Plan

This is the main portion of the plan proposed by the new management in May 2013. The goal is to have a slimmer, more focused company with three solid brands:

The company expects that the plan, when fully implemented in 2016, will improve EBITDA by approximately $150 million, of which approximately one-half will come from supply chain optimization and the other half primarily from corporate overhead reductions, licensing opportunities, net revenue growth and improved pricing management, compared with 2012 results. More specifically, the plan calls for improvement, over the same period, in the following areas:

Net revenues: compound annual growth rate of approximately 2.5%

EBITDA: increase to at least 13 percent of net revenues

Take a closer look at the statement, we can first deduce that with the plan being so heavily centered on cost cutting, we can expect it to create a morale problem for the company leading to lower productivity from their existing employees, not to mention that in the short term they are also likely to pay out additional cash in severance and employee restoration expenses. Secondly, even if Mr. Mooney succeeds at repositioning the internal finances of the company, if their brands are dying and their sales are falling, it still does not put them in a better place. Sales are on the downside at $1.8 billion. Analysts have a consensus of $1.9 billion in sales for 2016. I'm not sure how sales will increase if they are downsizing the company, divesting of brands and closing underperforming retail stores.

Mr. Mooney does mention this, regarding sales in the turnaround plan:

Sales Growth

  • Reprioritization of marketing investments to emphasize in-store and print marketing along with digital and social media
  • Continued investment in emerging markets and E-commerce
  • Improving sales execution

It doesn't sound convincing, it's very vague, and it's literally very bullet point. The focus of this company is on cutting cost, not increasing sales.

Another part of the plan is to improve net revenues at a CAGR of 2.5%, which is not spectacular by any standards, and their latest quarterly report ending October 31, 2013 showed a continued decrease in net revenues. Now, I am well aware that a single quarter can certainly not be a barometer by which to judge a company's turnaround plans; however, historically turning around a company where sales are dwindling is a lot more difficult that turning around a company where sales are growing or steady. In addition, the fashion retail industry is known to be a difficult industry to turn a company around in with the more recent example of Billabong (OTCPK:BLLAY) giving it a shot and failing miserably. Unfortunately, ZQK's turnaround plans are alarmingly similar to BBG:

Ms Inman said rival Quiksilver's new strategy was similar to Billabong's. It is aiming to consolidate the back-end of the business and supply chain, offer fewer styles and keep the "DNA of the brands", confirming that her strategy was right..

10 Year Sales, Profitability and Cash Flows - Millions of USD except per share data:

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Revenue

1267

1781

2362

2426

2265

1978

1838

1953

2013

1811

Gross Margin %

45.6

45.4

45.8

46.3

49.5

47.1

52.6

52.4

48.7

48.2

Operating Income

132

181

184

-16

139

69

124

42

57

3

Operating Margin %

10.4

10.2

7.8

-0.6

6.1

3.5

6.7

2.1

2.8

0.1

Net Income

81

107

93

-121

-226

-192

-10

-21

-11

-233

Earnings Per Share

0.68

0.86

0.73

-0.98

-1.8

-1.51

-0.07

-0.13

-0.07

-1.39

Operating Cash

131

-1

-8

124

72

206

203

54

-14

27

Capital Spending

-52

-71

-98

-116

-94

-55

-43

-90

-66

-52

Free Cash Flow

78

-72

-106

8

-22

152

160

-35

-80

-25

Revenues have grown at a cumulative annual growth rate of 3.64% (2004 to 2013), however, since the year 2008, revenues have been falling at an annual rate of -4.09%. Gross margins on the other hand have been steady across the years yet operating income has fallen significantly from the 2008 levels. The company has not generated any net income since fiscal 2008. Earnings and Free cash flow have been negative for the past few years, so we can see from the data above that the company is neither growing its revenues nor its earnings. If we look at the revenue and profitability highlights from the latest quarter ending on October 31, 2013, we can see that their sales are either flat or declining, and though they have made some strides in regards to increasing their EBITDA through cutting costs ultimately with sales consistently declining, I am quite skeptical about whether new management can turn the fortunes of ZQK around or not.

Valuation

In this section, I will be attempting to value ZQK using both an earnings-based approach as well as an asset-based approach. Under the earnings-based approach, I will be using the Enterprise Value/EBITDA approach, given the company has had negative earnings and free cash flow over the last few years.

The discount rate is assumed to be 10% and the perpetual growth rate is assumed to be 3%. Both of these are my own estimates and as such, you may or may not agree with them, with some inherent subjectivity required in making such a forecast.

Speaking of inputs, as I mentioned before, I chose 10% as the cost of capital for ZQK. Basically, the way I think of the cost of capital is by determining an acceptable annual rate of return. I believe 10% to be a fair discount rate given that ZQK is still a relatively small company at $1.4 billion in market cap and factoring in that the company is still barely profitable. Some may prefer a higher discount rate to provide more of a margin of safety but I feel a 10% annual return on assets is reasonable to expect from ZQK. A higher discount rate would produce a lower fair value, holding all else equal, in order to provide a larger margin of safety while going long. Regardless, this is something every investor must determine for themselves.

5 Years EBITDA - Millions of USD:

2009

2010

2011

2012

2013

EBITDA

112

183

97

112

53

5 Years Average EBITDA

N/A

N/A

N/A

N/A

111.40

Valuation - Earnings based Approach:

VALUATION - EV/EBITDA

TTM EBITDA $53MM

5 Yr Average EBITDA $112MM

Enterprise Value

$758,000,000

$1,600,000,000

Net Debt

$774,000,000

$774,000,000

Equity Value

N/A

$826,000,000

# of shares outstanding

169,710,000

169,710,000

Share Price

N/A

$4.86

Valuation - Asset based Approach:

Book Value

$370,000,000

Intangibles

$137,000,000

Goodwill

$262,000,000

Tangible Book Value

($29,000,000)

# of shares outstanding

169,710,000

Book Value Per Share

$2.18

Tangible Book Value Per Share

(0.16)

Valuation - Based on Management's Optimistic Plans:

Sales 2016 - 2.5% CAGR

$1,950,000,000

EBITDA - 13%

$250,000,000

Multiple

10

Enterprise Value

$2,500,000,000

Net Debt

$774,000,000

Equity Value

$1,726,000,000

# of shares

169,710,000

Share Price

$10.17

Valuation - Based on Current Market Price:

No. of shares outstanding

169,710,000

Price of common shares (Jan 10, 2014)

$8.31

Market Cap

$1,410,290,100

Net Debt

$774,000,000

Enterprise Value

$2,184,290,100

Enterprise Value to EBITDA Ratio

41.21

Enterprise Value to 5yr Average EBITDA Ratio

19.61

Price to Book Value Ratio

3.80

Price to Tangible Book Value Per Share

N/A

Conclusion

If we value ZQK using the Enterprise Value to EBITDA approach, we can see that ZQK is significantly overvalued as of today, the likely value of this company is somewhere south of the $1 billion mark, which would in turn result in a share price of less than $5.

ZQK's book value is around $2.18 per share, and in my opinion if the company is generating profits higher than their cost of capital, it is justified to value them at above their book value, however in ZQK's case the company is not generating profits that are higher than their cost of capital. Therefore valuing it at $8.30 per share is unjustified. The potential upside while going long on the stock is roughly 25% over 3 years if all goes well. We all know there are always a few blips on the road to recovery if at all. On the short side, the profit potential is north of 35% and in all likelihood risks definitely outweigh the rewards of going long this stock.

Source: Has Quiksilver Run Up Too Fast, Too Quickly?

Additional disclosure: I am short ZQK via bear call spreads.