It takes a special type of management team and board to reach new lows for corporate governance when such “benchmarks” of fiduciary duty and competence are established by companies such as Hewlett-Packard (HPQ) and MF Global (OTC:MFGLQ) but the executive team and Board at Talbots (TLB) is working hard to exceed those benchmarks. As it currently stands, Sycamore Partners (SP) – a significant shareholder of TLB – is offering to buy out the entire company for at least $3/share. This is good news in so far as that it validates there is considerable value above the $1.56 closing price the day before the unsolicited offer. However, it also demonstrates how much value TLB’s management team and board have destroyed in recent years, particularly in 2011, and the need for shareholders to demand more either in terms of an entirely new board/executive team and/or buyout from SP.
It’s important to address Sycamore’s offer and its likely strategy in turning TLB around because as a previous and now current shareholder of TLB, I think a turnaround should have been more than achievable by a competent management team. There is major low-hanging fruit that SP will likely capitalize on that investors need to be cognizant of – meaning that TLB should fetch more than $3/share. However, before doing that TLB shareholders should review the track record of the board and executive team for several reasons. The first is to demonstrate broad managerial incompetence, the second to highlight major lack of fiduciary responsibility to TLB shareholders by rebuking prior overtures by SP, and lastly, perhaps to develop a case that shareholders could suspend/freeze any termination payments and packages due to the outgoing management team.
History of executive incompetence: Outgoing CEO Trudy Sullivan became CEO of TLB on August 1, 2007. At the time TLB’s share price was $22/share. Since Ms. Sullivan’s tenure, TLB’s share price has declined from $22 to $1.56 as of December 6, 2011, representing a decline of 93% over essentially five years. As an investor, once can recognize stock volatility can sometimes “decouple” from fundamental performance. However, Exhibit I demonstrates that TLB’s stock performance very well seems to be tied to the underlying performance of the company with sales, gross margins, and operating margins all steadily deteriorating since Ms. Sullivan took over.
EXHIBIT I: TLB SUMMARY OPERATING PERFORMANCE SINCE SULLIVAN BECAME CEO ($MM)
There is no room to quibble, in every meaningful area TLB has performed poorly since Sullivan’s appointment as CEO. Sales declined, gross margins have steadily declined, and operating expenses have been deleveraging despite aggressive cuts due to poor sales and weak pricing of TLB merchandise. However, while Sullivan and her cronies have been able to aggressively cut a number of operating expense areas, one area that has been spared has been her compensation. Despite this abysmal performance, Ms. Sullivan reaped significant financial rewards as illustrated in Exhibit II (source TLB Form DEF14A).
EXHIBIT II: TRUDY SULLIVAN COMPENSATION ($MM)
Keep in mind that this does not include those on her executive team including CFO Michael Scarpa and others, all of whom have reaped significant gains for being little more than “yes-men/women.”
Board served Ms. Sullivan’s Interest and Not Shareholders: The illustration of TLB’s operating performance, stock performance, and Ms. Sullivan’s compensation demonstrate that TLB’s board ignored its duty to shareholders, allowing Ms. Sullivan and her team to essentially pillage the company, extracting unjustifiable compensation and impairing TLB’s operations. Aside from the historical negligence of the board during Ms. Sullivan’s reign, the board also recently cost TLB shareholders by rebuking earlier overtures by SP. SP acquired shares of TLB from June through July 2011 at what looks to be an average share price of $3.09. According to Reuters SP was considering the possibility of acquiring TLB in August 2011, after establishing its stake.
At that time, TLB had LTM EBITDA (LTM Q2 2011) of roughly $65MM. The company now is at roughly $25MM in LTM EBITDA (pro forma for restructuring and M&A charges), representing a decline of over 60%. Considering SP’s average cost basis was $3.09 and that TLB had better operating performance earlier in the year, it is very conceivable that SP could have offered at least $4.50+ to acquire TLB, especially since shares in August touched $4 in anticipation of a buyout. This would represent a 50% increase from SP’s current offer and about another $100MM in value that the board could have secured for investors. However, the board chose to protect Ms. Sullivan and the rest of the executive team by implementing a poison pill. At the time, shares traded well over $4 in anticipation of a buyout offer by SP.
Now, after Ms. Sullivan’s strategy or lack of strategy has resulted in further deterioration of TLB’s share price and operating performance, the Board has at last decided to remove her, although having no replacement in mind. This follows Ms. Sullivan’s decision several months ago to remove its chief designer while having no replacement for him. Notwithstanding the egregious compensation Ms. Sullivan secured since her tenure for overseeing a 93% decline in TLB’s share price, the Board has agreed to “reward” Ms. Sullivan for the following:
“The Separation Agreement provides that, pursuant to Ms. Sullivan’s existing employment agreement with the Company, dated June 28, 2007, as amended June 16, 2009, she will receive the following payments and benefits following the Retirement Date: (i) cash severance of $5,000,000, which equals two times the sum of her current base salary of $1,000,000 and target bonus of $1,500,000, payable in equal installments over the 24-month period following the Retirement Date; (ii) a pro rata annual bonus for the fiscal year in which the Retirement Date occurs; (iii) continued medical, dental, disability and life insurance for up to 24 months following the Retirement Date; (iv) accelerated vesting under the Company’s Supplemental Executive Retirement Plan; (v) accelerated vesting of stock options; and (vi) 24 months of continued vesting of restricted stock. The severance payments and benefits are subject to Ms. Sullivan’s execution and nonrevocation of a release of claims against the Company. Ms. Sullivan continues to be subject to post-employment non-disclosure, non-solicitation of employees, vendors and suppliers, non-disparagement, non-competition and cooperation covenants. The Separation Agreement also contains other customary provisions.”
The Board has no shame given the lack of any positive achievements during Ms. Sullivan’s tenure. TLB currently has $105MM in net debt during a challenging and promotional holiday shopping environment. The Company intends to finish 2011 with $40MM in capital expenditures and a weak holiday season may result in TLB becoming somewhat cash flow constrained. Nonetheless, the Board, despite Ms. Sullivan’s pitiful performance as CEO, has seen no issue or cause to revoke or adjust the termination agreement to benefit shareholders.
There is a massive lack of fiduciary representation and it is unfortunate that TLB shareholders have not worked together in an effort to better align the company. Even in an environment of significant litigation, it is hard to not see that the Board and executive team should have some personal liability for this atrocious and blatant disregard of investor rights. Nonetheless, SP has moved on to offer $3 to acquire all of TLB and this gives TLB shareholders a few things to consider.
Current Situation: SP is offering $3/share for TLB but as indicated in its 13D letter that it could offer more than $3/share. First it’s important to understand that SP’s founders have a track record of buying undervalued assets and turning them around, particularly during their time at Golden Gate Capital (“GGC”). At GGC, SP’s principals invested in retailers such as Express, Eddie Bauer, Zales Corporation, and J. Jill.
J. Jill was purchased by TLB in 2006 for about $366MM and sold to GGC for about $75MM in 2009. In just two years GGC was able to sell J. Jill to Arcapita and while terms were not publicly available, it seems a turnaround in less than two years involved a lot of low hanging fruit which GGC seized upon. This is what TLB shareholders should consider.
As it currently stands, TLB has just one problem – merchandise. It’s a huge problem in the context of being a fashion retailer but consider that in 2008 TLB was struggling with underperforming J. Jill, a heavy debt load, a men’s and children division, and an international segment. At this point TLB has just one core focus – women 55-75 y/o – and the main problem facing TLB is that the company “spiced up” its clothing too much to attract younger shoppers while alienating its core customer. This is an achievable turnaround if not for the incompetent executive team TLB shareholders had to tolerate and I believe SP will probably seize on a number of low hanging items to immediately boost the company’s performance.
First, investors should keep in mind that TLB gross margins should improve in 2012. The last half of 2011 was a merchandising disaster for TLB and the fire sale prices for TLB merchandise have crushed gross margins. However, heading into the holiday season it appears that the company had a nice return to classic apparel that resonated with its core customer. In addition, TLB has been working to close poorly performing stores and as those are shuttered, the aggregate gross margin drag should diminish. TLB’s 2012 same store sales figures should also improve off weaker 2011 numbers. These factors alone could very well yield gross margins of roughly 32% compared to what could be 28.5% in 2011. What should be noted is that TLB gross margins were nearly 38% in 2010 and except for 2009, the current year and my modest projection for 2012 would be the next two lowest years for gross margins.
SP knows this, as should any informed TLB investor. Another tailwind for TLB will be the implementation of a $50MM expense savings program which will reduce SG&A. On a business that generates about $1.1B in sales, this translates into an operating margin boost of 4.5%. This means that TLB will be near roughly break even on an EBIT basis and close to $50MM on an EBITDA basis for 2012. These calculations are fairly conservative and are what TLB investors could achieve with a mediocre executive as opposed to the current team.
I would guess the next item SP would work on if they could take over TLB would be to improve the company’s sourcing model. Competitors such as Chicos FAS (CHS) and Ann Inc. (ANN) generate gross margins in the 50% level compared to at best mid to high 30% for TLB. The discrepancy can probably be tied to sourcing of material, product pricing, and product mix. For example, while CHS has a number of retail concepts, it is known for doing well in terms of selling accessories and not just apparel at its flagship store. SP has already hinted at assisting TLB with sourcing through Mast Global Fashions, of which SP is a part owner along with Limited Brands. Implementing changes to sign on with a better sourcing agent and making efforts to push increased sales of accessories are not transformative changes yet can allow TLB to generate some improvements on a relatively easy basis.
Another likely change by SP will be to halt the company’s spending on existing store refreshes and accelerate the build-out of outlet locations. According to TLB management, sales per square foot at TLB outlet locations is $400 compared to $290 at normal TLB retail locations. When one considers that rent at outlet locations is typically cheaper compared to normal retail locales, the return on invested capital for expanding the outlet base is very appealing. TLB management believes that there is a ~100 outlet store opportunity for TLB. This is significant compared to the roughly 450 (net of expected closures) store base TLB maintains. Compared to other retail peers, TLB is under-represented in the outlet space and should focus on that given the attractive capital return metrics.
As can be seen, there is a lot of low hanging fruit that SP can take advantage of that frankly should be executed on by current shareholders that could remove the current board and management team and find even a mundane management team as opposed to the atrocious one currently at the helm. Fixing the easy items alone will allow TLB to start generating stronger operating profit and then simply hiring a designer that has resonated with the core customer would be the next step. With fashion retailers, value is driven by gross margins. If the merchandise is on target, the retailer can charge the appropriate price to drive operating leverage. Expanding outlet stores, improving sales of accessories, obtaining a better sourcing company, the rolling off of closed stores, and implementation of the $50MM expense savings plan could all contribute 5-7% in operating margin for TLB. SP probably knows this as should existing TLB investors. Stabilization of TLB operations alone can get a share price of about $4.50-$5.00.
However, if one can find a halfway decent designer with historical success targeting TLB’s core customer, gross margins could meaningfully expand beyond 32%. If a good designer could drive store sales and margins even closer to historical levels, TLB could be worth much closer to $7-9. The problem is that Ms. Sullivan has so thoroughly wrecked TLB that a current buyout from a financial sponsor like SP would likely be an asset backed financed deal as opposed to a cash flow deal. On an ABL basis, the max SP would offer without over-equitizing a deal would be under $5. However, I would not be surprised to see SP successfully execute on the items listed above and refinance an ABL deal into a dividend refinancing and new, typical leveraged finance deal once operations stabilize.
SP is positioning itself as the only potential buyer but there have been other investors in the retail space. Leonard Green & Partners is renowned for investing in retail companies. TLB could also be attractive to a strategic buyer, specifically CHS. CHS owns a number of concepts including Chico’s, White House|Black Market, Soma Intimates, and recently acquired Boston Proper. TLB could fit well into CHS given that the Chico’s brand targets a similar demographic. CHS could acquire the stores, bringing them onto their superior operating platform while eliminating redundant SG&A. CHS acquired Boston Proper for $213MM and still has $240MM in net cash. Through 2011, CHS has generated $244MM in LTM operating cash flow, $113MM in capex, and then returned $33MM to shareholders in the form of dividends and another $153MM in share repurchases.
Basically, CHS has the cash flow capabilities, credit quality, and balance sheet to easily acquire TLB and leverage a solid brand across its platform. As a strategic buyer, CHS would also have the ability to likely shed much of TLB’s SG&A. Shedding 50% of TLB’s SG&A would reap about $200MM in savings for CHS. Exhibit III assumes a 50% savings rate on SG&A to illustrate what TLB’s figures would look like to CHS on an acquisition basis.
EXHIBIT III: TLB 2011E PRO FORMA TO CHS
Recognizing TLB’s current situation and ability to achieve those SG&A savings could warrant a conservative EV/EBITDA multiple of 3.0x Pro Forma 2011E EBITDA. With about $100MM in net debt, this would translate into a share price of $6.50 or about 6.5x pro forma 2011E EPS.
In either case, the Board’s responsibility to shareholders would warrant that it shops TLB to all potential buyers to evaluate the company. Given the Board’s track record, TLB shareholders may wish to push for an emergency general meeting to consider outright removal of the board and management, suspension of termination contract terms for existing management, and work to have legitimate shareholder representation on the Board to either push for a full blown auction of the company or find a management team that can execute an achievable turnaround. As it stands SP’s offer at $3 establishes a valuation that a clever and judicious investor would offer, but given the easy value creation levers that will occur in 2012, legitimate sale discussions should be much closer to $4.50-$5.00 with a financial sponsor, let alone a strategic buyer.
At $5/share, TLB would be valued at 0.4x EV/LTM Sales while peers such as ANN and CHS trade at 0.55x and 0.73x EV/Sales. Given TLB’s current depressed operating margins, EV/S is an appropriate metric to gauge value and a $5/share price is still a significant discount to more profitable peers. If the holiday season can lead to a reduction in TLB’s revolver, the overall enterprise value could be closer to $400MM. As discussed, with no changes beyond what has been covered in conference calls and TLB filings, the company could very well generate $50MM in EBITDA in 2012, implying a EV/EBITDA multiple of 8.0x, representing a depressed EBITDA multiple. SP’s ability to bring Mast Global Fashions and generate additional margin could also drive EBITDA higher leading to an actual lower purchase price multiple than 8.0x.
In either case, the Board should recognize that without a head designer and a lame-duck CEO, it should seek a way to maximize value for existing shareholders.
Disclosure: Author manages a hedge fund and managed accounts long TLB.