Investors in G-III (GIII) are not very happy with the announced purchase of Donna Karan from global luxury giant LVMH. G-III is paying a steep revenue multiple for a business which holds strong brands but is in a state of restructuring and actually reports unspecified losses.
For that reason both the market and myself are very skeptical about the deal. The purchase of a loss making firm at a big revenue multiple, the addition of a lot of leverage, and little information provided about the margins of the firm and the actual turnaround plan make it easy to be skeptical. The ball is now clearly with management who has to deliver on its rosy projections.
G-III will acquire Donna Karan, best known of its namesake and DKNY brand, for a total consideration of $650 million. G-III's Chairman Morris Goldfarb praises the strength of the brand and sees scale and diversification advantages resulting from the deal.
The transaction, which is supposed to close by the end of this year or early 2017, will be financed with debt and a $75 million share offering. The deal will be dilutive in the first year but is expected to bring accretion in the year thereafter, although this has not been quantified.
On the conference call, management revealed that Donna Karan currently generates about $300 million in sales and is posting unspecified losses. As a matter of fact, LVMH has been acting very secretive, as G-IIIs management does not appear to be fully informed about the actual size of the losses. Executives stress the strong brand equity and potential in a deal which has been in the making for nearly two years.
Organic Growth Complemented By Deals
G-III has delivered on very impressive growth over the past decade. Sales have grown from little over $200 million in 2005 to $2.3 billion in 2016. This impressive growth has largely been completed by organic growth, although the company made a few smaller acquisitions as well over the years. That said, pretty much all of these deals were smaller than $100 million.
The $650 million deal is an outlier to this strategy, being much larger to what investors and management have been used to. Investors worry about the large size of the deal, the fact that Donna Karan is losing money and is undergoing a turnaround.
Despite these concerns and challenges, management believes that the business could contribute $600 million in sales in three years time. This suggests that the current revenue multiple of little over 2 times sales is expected to fall toward a 1 times multiple by 2019, if everything goes according to plan. Problematic is that the plan is not really defined yet. While the brands are currently in a restructuring mode, G-III has not yet indicated if they continue to stick to those plans once the business is owned by the company.
The Pro-Forma Company
G-III posted trailing sales of $2.37 billion, accompanied by operating profits of $178 million, for margins of 7.5%. Donna Karan will add $300 million in sales in the near term as management expects this sales contribution to double in the coming year. The trouble is that Donna Karan is losing money, so the EBITDA contribution is flat at best or potentially negative as well.
G-III has roughly 47 million shares outstanding and will need to issue little over 1.5 million shares to LMVH as part of the deal. The $575 million incremental debt will be added to the balance sheet which now shows a net cash balance of $95 million. Following this deal, net debt stands at $480 million. With EBITDA of the stand-alone operations coming in at around $200 million, and Donna Karan having an expected contribution of zero, leverage is seen around 2.4 times.
Including the shares which will be issued to LVMH, G-III has 49 million shares outstanding which have plunged to $43 per share in response to the deal. This values equity of G-III at $2.1 billion and the overall business at $2.6 billion, being equivalent to 1 times pro-forma sales.
The Market Has Its Doubts, So Do I
Shares of G-III plunged by more than 14% in response to the deal. This should not be a major surprise as the deal looks pretty poor on paper, with management having a lot to prove.
The more than $7 drop in the share price is equivalent to $315 million in shareholder value going into smoke. The market suggests that the company is paying way too much for the assets in this $650 million deal. The company is happy to pay a 2 times current sales multiple which marks a 100% premium compared the valuation of its own assets which are actually very profitable.
Not only does management have to prove that sales can double in such a short period of time, margin improvements are needed as well. If losses are not quickly stopped, the deal could put further upward pressure on leverage ratios as the balance sheet became quite leveraged overnight.
The conference call with the analysts is highly amusing as multiple analysts congratulated management on the deal, followed by questions which suggest that they are skeptical on the deal as well.
The dilution in the short term and high leverage position could be justified if the acquisition was a bargain, but that does not at all appear to be the case. The company is buying a turnaround play at a high valuation as the deal even has the potential to cause debt overhang concerns for the entire G-III business in an adverse scenario. The decision to pursue this deal, even as management does not even know all the details of the business, is a big concern to me.
All of this being said, G-III has created a lot of shareholder value over the past couple of years as management has done a great job at organic growth and some bolt-on deals. But management has a lot to prove. While the steep price decline has already lowered expectations following this expensive deal, shares are not an automatic bargain at these levels.
I remain very cautious at current levels awaiting more news regarding the deal before considering to go bottom fishing.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GIII over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.