CFA Melbourne Investment Research Challenge PageBack in Black We forecast Pacific Brands to bounce back from 2009FY lowsand be in the black for 2010FY with a NPAT of $32.11 million,2011FY and 2012FY will see NPAT increase further to $130.48and 173.72 million respectively EPS is expected to fall to as sales decline due to divestment in2H10 as well as the retail sector expected to slow. However dueto cost savings measures, profitability is on the rise withEBITDA margin increasing to 11% Net Debt is expected to decline significantly in 2011FY and2012FY as profits increase to get Net Debt to Equity to 13% in2012FY from 36% in 2009.BUYTarget Price: $1.60Price: $1.4322nd October 2009FinAnalysis: PBGCapital IQ: ASX:PBGMarket Data52 Week range: 1.90/ 0.14Avg Daily Volume:Beta: 1.36Shares Outstanding (m): 929.3Market Cap. (m): $1,328.9Institutional Holdings (m): 426.96Insider Holdings (m): 6.2Source: Capital IQ2009E Student ResearchPacific BrandsRetailing&WholesaleThis report is published for educational purposes only bystudents competing in the MelbourneInvestment Research Challenge, part of the CFA InstituteGlobal Investment Research Challenge.23rd October 2009 FundamentalsTotal Revenue (m)EBITDA (m)EBITDA MarginNet Income (m)ROAROENet Debt (m)CashFlow per shareCurrent RatioWorking Capital (m)Net Debt to EquityInterest CoverEPSEPS excl AbnormalsP/E2008A2009A2010E2011E2012E2,129.83 2,012.38 1,952.00 1,991.04 2,060.73253.0312%116.565%9%739.610.332.57457.7256%3.290.200.2111.9230.0711%-234.48-11%-19%450.650.181.93337.6936%3.08-0.400.175.9241.2712%32.111%2%424.240.052.07338.8333%3.420.030.1211.9293.6815%130.486%9%339.770.122.13378.5023%4.550.140.168.7313.6515%173.728%11%215.490.182.24400.7813%5.780.190.197.6 CFA MeInvestment Summary On 22nd October, Comsec had PBG’s PE ratio at 8.43, meaningthat it will take less than 9 years to recoup ones capital.1 This iswith an earnings ratio per share of around 17 cents, which is veryrough guess considering PBG will have not have a profit until2010. With the share price remaining the same the PE is today 9.25,which is a bit closer to the mark; but it is still low, since the industry average is 14.73.2 And when looking at PE graph besidewe can see that PBG is very low indeed, next to JB Hi-Fi, DavidJones, Harvey Norman, and Billabong. But what appears most enticing about the prospect of getting intoPBG is that other retail companies about same size are selling for$10 or even $20 a share, so in order to hold a 1000 shares in thecompany one would have to spend 10x or 20x as much to buy in.Thus when the market begins to surge and all the shares go up50cents the PBG investors will only have had a capital outlay 10or 20% of those with the higher priced shares. Thus one can afford a lot more shares than many of their competitors can offer for the same capital outlay. Consequently it isworth while buying in until the share hits about $1.60 and thenhold for 12 months, since when Pac Brands delivers on theirpromises to cut costs, over the next 1 to 2 years we should seesome very interesting profit margins, which could send the pricewell above $2, and the investor will see good capital returns inthis period providing PBG continue their current trend of cuttingcosts and growth in their main brands.Aussie Dollar to Hold The Australian dollar has been on the rise since the lows in2H09, this has been on the back of Australia’s solid GDP growthand has continued doing so well into 1H10.We expect the AUD to keep climbing and into 2H10 with interest rates said to reach 5.5% by 1H11. 3The RBA has stated the dollar could go as high as $1.10 against the $US.4 We believe in 2H10, the AUD will go above parityhowever as global economies begin to recover, this will fall backto the $0.90 mark and will stay around this mark into 1H11. With now 90% of its purchases coming from overseas, PacificBrands hedges its purchases, so the impact of the dollar islagged.After JP Morgan’s reportwas released PBG’s shareprice jumped 22%0102030DJSJBHPBGBBGHVNPrice Earnings RatioPERCFA Melbourne Investment Research Challenge Page 3 Since falling from its 12.1 peak in June 2009 consumer confidence,has began to recover with September’s figure up 1.5 points as Australiaoutlook becomes more promising.Heading into 2H10, we expect consumer confidence to be slightly down as unemployment continues to rise. Similarly as interest ratescontinue to rise, further strain will be put on families as household debtis predicted to rise, which is already among the highest in the world. Heading into 2H10, we expect consumer confidence to be slightlydown as unemployment continues to rise.Similarly as interest rates continue to rise, further strain will be put on families as household debt is predicted to rise, which is alreadyamong the highest in the world.Earnings Explanation The first half of the year showed strong retail confidence as theAustralian economy flourished. Leading into 2010, which has manyeconomists uncertain of its outcome; we see retail’s falling in conjunction with rising unemployment and interest rates set to increase to5.5% by 1H12. In 2010FY we see total revenue declining by 3%, this reduction in sales considers the expected decline in retails sales during2010, a rise in household debt, as well as the divesture of brandsLee, Merrell and Wrangler. As the world economy starts to strengthen and consumer demand increases, we see revenue rising by 2%, followed by a further 3.5% rise as Pacific Brands asset’s gain market share and itscost saving’s are fully recognised. A big part of Pacific Brands restructuring was its cost savings, $150 million by 2011, with the full impact being recognisedin their EBITA.Our forecasts indicate, that due to their cost savings, initiatives there would be some savings, however we project that there will besavings equalling $86 million by 2012FY.2010FY going to seeconsumer confidence down$86 million to be receivedthrough cost savinginitiatives0.0050.00100.00150.00200.00250.00300.00EBITACFA Melbourne Investment Research Challenge Page 4Profits on the Horizon In terms of profitability, the 2009FY’s NPAT was submersed by restructuring and write-down costs equating $334 million after tax,turning a potentially profitable year into a significant loss.Restructuring costs equating to $79.2 million after tax will be incurred in 2010 as the 2010 strategy comes into place.Leading into 2011FY as consumer confidence recovers we expect overall profit and cash flows from operations to increase, this is expected to continue into 2012FY. Repayments of debt due will slightly peg potential profits from 2010-2012FY as net debt is reduced to 13.26% of equity at the end of2012FY.Revenue Breakdown As we look at the break down of Pac Brands main products underwear and hosiery, outerwear and sport, home comfort and footwearthe annual report for 2009 assures us that though they have contracted overall due to the GFC, some areas such Tontine and Berliehave grown or at least increased their market share. From thegraph below it can be seen that 2009 has tightened the belt onsales, but such is the case globally.Geographic Breakdown The geographical segments are the earnings from each country,based on the 2009 figures and assuming sales percentage per countrywill remain constant Our analysis has determined that Pacific Brands receives 87.63precent of its total revenue from Australia, 7.24 percent of its totalrevenue from New Zealand, and 5.13 per cent of its revenue fromother countries.Net Debt to be reduced over2010 to 2012Percentage of Australiansales set to increase Millions201020112012AustraliaNew Zealand1,710.54141.33100.131,744.75144.15102.141,805.82149.20105.71OtherTotal Revenue1,952.001,991.042,060.73 ‐250.00‐200.00‐150.00‐100.00‐50.000.0050.00100.00150.00200.002008A 2009A 2010E 2011E 2012EReported NPATCash from Ops.0200400600800F09 F08Underwear& HosieryOuterwear& SportHomeComfortFootwearTotal Sales of PBGsMain ProductsCFA MeDCF Valuation Our valuation was based off our DCF model, using a WACC of13.1% (1.36 beta, Rm 14,5 Cost of equity 17.24) Price to Free Cash Flows averaged over the last four years (2006to 2009) P/E Valuation Our P/E valuation used the average P/E over the four year whichequated to 10.83x.This is traditionally less then what it had been, with PacificBrands normally trading at a 25% discount to the P/E of Small Industrial Stocks, equating to a P/E of 12 with the Small industrial stocks trading with a P/E of 15. With a P/E currently of 8.6x, we can see they are trading lowerthan there historical average. This lower than average P/E can beput down the 2009FY, with all therestructuring costs andthe collapse of their share price dropped their P/E to 5.9x.Using the average P/E over the last four years it turned out $1.3,while using the traditional P/E showed $1.43, both using our forecasted EPS Excl. Abnormal of .12ValuationPacific Brands normallytrading at a 25% discountto the P/E of SmallIndustrial Stocks,DCF Valuation EBITDA241.27Tax RateTaxDepreciation & AmortisationTax Shield on DepreciationChange in Working CapitalCAPEX27.20-65.6325.907.04179.80-22.00Other AmortisationTax on Other AmortisationFCFDCF @13.11%FCF per shareP/FCF AvergageShare Price2.40-0.65368.14327.400.354.541.60 CFA Melbourne Investment Research Challenge Page 6RisksOur target price of $1.60, has the possibility of being effected by somefactors: The ability of Pacific Brands to achieve its cost savingsTarget and translate the savings into EBITA Changes in the Australian economy, in terms of retailand consumer confidence measures Further backlash from closing factories in December2010 Changes in strength of the $AUD against the $USCompany Description Pac Brands was born in 1893 through the decision of theDunlop Pneumatic Tyre Company to establish a branch herein Melbourne 6. John Dunlop was a veterinarian that invented the first inflatable bicycle tyre. The branch was soldand eventually became Pacific Brands Limited in 20047. It deals in goods such as socks, hosiery, underwear, intimateapparel, sleepwear, bed linen, bedding accessories, bedding,carpet underlay, foams, lifestyle apparel, corporate uniforms,footwear, work wear, street wear, and sporting goodsmarkets8. The main brands are Berlei, Sheridan, Sleepmaker, Tontine,Holeproof, Clarks (children’s), Everlast, Grosby, Hush Puppies, Mooks, Mossimo, Slazenger, Bonds, Dunlop, King Geeand Yakka9.Industry Description Pacific Brands has moved from outsourcing 70% of its products in 2008 to outsourcing 90% in 2009. It is evolving frommanufacturing industry to becoming one of Australia’s biggest retailers. But unlike David Jones, Myers, and HarveyNorman they have nothing that is direct to the public, exceptselling through the internet. It basically supplies its majorbrands to retail stores and can be seen as a distributor orwholesaler, however is classified as under Retailing.CompanyDetailsPBG know how toadvertiseCFA Melbourne Investment Research Challenge Page 7Restructuring Managing supply chain issues and sourcing materials efficiently. This has meant the closing of 9 factories here and inNew Zealand, and ceasing several brands, which brought lessthan 1% of total revenue. Thus enabling PBG to consolidateand focus on those brands with high sales, streamlining theiroperations, with J.I.T. inventory and utilizing value addedprocedures10.Suppliers Pac Brand would appear to have established itself with a fewwell placed suppliers in China. This is a plus when considering how loyal the Chinese are to those in their circle of“guanxi”12. However, the question should be asked, how easyis it for the Chinese manufacturers to go around Pac Brandand deal directly with Pac Brand customers? The answer is adifficult one since Myer and all the big retail outlets are already sourcing various products in China. Not many customers would be able to move the volume thatPac Brands demands from its Chinese suppliers. The realityis that it could be done on the slow slippery slop of buildingcontacts and underbidding Pac Brand type products to knownsuppliers here in Australia. But why bite the hand that feeds,in that the Chinese suppliers will not want get one of theirmain customers like PBG off side.Buyer Power Pac Brand is planning to increase profit by lowering costs.But this begs the question how long will PBG be allowed torecord fantastic gains before their powerful Retail outlets suchas Coles – Myer and Woollies start to look at their figures andclaw back some of PBG’s new found profits. However, fornext 12 month period Pac Brand has a very firm hold on a significant market share. We will not see the end of names likeBond, Berlei, Sheridan, Hard Yakka and King Gee from ourmarket shelves, as long as the quality and value for moneythey deliver continues.Porter’s AnalysisPat Rafter SellsCFA Melbourne Investment Research Challenge Page 8 What is fantastic news is the ability PBG in being able toimplement such huge cost saving strategies. By concentratingits efforts on its main brands, divesting itself of unprofitablemanufacturing sites, reforming supply chain procedures,restructuring capital and basically reorganising the whole giant, that Pac Brands have become over the last 100 years13.Competitive Rivalry The reality is that there are many competitors in the retail industry, Pac Brands have learnt the hard way over the last 2years that by manufacturing here and in New Zealand labourcosts will not allow them to stay competitive. When the CEOSue Morphet announced PBGs decision to go offshore shesaid, “with few exceptions it was no longer competitive tokeep making clothes in Australia.”13 The question becomes why is Pac Brands still in business atall, and the answer is that very few have the size of theiroperation, in that they supply high quality products to consumers that trust their brands. This makes it more less indispensable to Chinese manufacturers who need to move theirproducts efficiently on the overseas markets. But they toomust nibble away at PBGs profit margin, since labour costsare escalating at 10% per annum10. If we look at the chart below it tells us the total revenues forPBG, and four of their competitors, and it reveals to us thatPBG is up there with the Big Boys, which is David Jones,thus they hold a major share of the retail market. What should be understood is that if we look at the chart for“cash from operations” then we can see that Harvey Normanis out stripping them all. What is it about Harvey Normanthat allows them to be below 1.5 billion in total revenue, butabove $400 million for the cash from operations? PBG wouldanswer sourcing their merchandise from China, which is correct in part. We would predicate that in part it is David Jonesand Harvey Norman’s ability to enable their stores to havedirect faces to the public, thus enabling them to set the priceand manner of sale.Restructuring is hard but itworth its weight in gold.PBG have a figure in the pieof what we wareCFA Melbourne Investment Research Challenge Page 9 What is interesting from the two charts above is that total revenues show PBG as having a market share equivalent to the best inthe industry, however, the cash from operations has them as oneof the worst. Thus if they can retain their market share and reduce its costs, improving its cash from operations, then they canjoin JB Hi-Fi with their record breaking turnaround, which sawthem in negative figures in 2005. And then maybe they will havea chance to head towards Harvey Norman who has done outstandingly in the Cash from Operations. But top HRN it mayneed more direct to public exposure.Threat of Substitution: Every retail outlet has been acquiring some or all of theirproducts from overseas for years undercutting the Australiancompetition. And though Pac Brands offer some uniquequalities in their product range giving them an edge in the department stores, still comparable brands have been slowlychipping away at their market share. What makes Pac Brandsstand out is their brand names of Bonds, Berlei, Sheridan,Hard Yakka and King Gee, which have been around for decades and will not fail as long as the quality and value formoney continues. And their 2009 report states that they aresetting aside other opportunities to focus these main 5 brands.PBG did not spare anyexpense when it came toretraining the workers ithas had to let go.Pac Brand cares aboutAustralians at work, spendsan extra $3,000 per personto retrain.01000200030002004 2005 2006 2007 2008 2009MillionsPacific Brands BillabongDavid Jones Harvey NormanTotal Revenue for PBG and Competitors‐50.00.050.0100.0150.0200.0250.0300.0350.0400.0450.02004 2005 2006 2007 2008 200933.7143.594.9152.7114.9103.7190.8288.2230.7355.1411.6442.5Pacific BrandsBillabongDavid JonesHarvey NormanJ B Hi‐FiCash fromOperationsfor PBG &CompetitorsCFA Melbourne Investment Research Challenge Page 10Threat of New Entry: On some levels it may be relatively easy to get entryinto the retail market, since anyone can go down to thelocal market and sell socks, if they been to China to pickup a load of product. However, to cover the variety andquality of products that Pac Brands offer it is far to competitive to operate at these low margins of profit.CFA Melbourne Investment Research Challenge Page 11End Notes1 Comsec 22/10/09 http://www.comsec.com.au/Info _FrameSet.asp?Page2 Comsec 22/10/09 http://www.comsec.com.au/Info _FrameSet.asp?Page3 Zachariahs, C 2009, ‘ A ussie Will Reach U.S. Dollar Parity in 6 Months, Barclays Says’ , Bloomberg, October 16th4Stutchbury, M 2009, ‘ A ustralian dollar could soon be worth $US1.10 ’ ,Bloomberg, October 16th5 Brealey. R … ( et al. ) 2000, ‘ P rinciples of corporate finance’ , Sydney :McGraw-Hill, 1st Australian ed6 Capital IQ at https://www.capitaliq.com/CIQDotNet/Company.aspx?companyid=13642207 Dunlop site at http://www.dunloptyres.com.au/centric/about _dunlop.jsp8 Capital IQ at https://www.capitaliq.com/CIQDotNet/Company.aspx?companyid=13642209Capital IQ at https://www.capitaliq.com/CIQDotNet/Company.aspx?companyid=136422010See “ 2009-Full-Year Results-Announc.pdf ”11See “ 2009-Full-Year Results-Announc.pdf ”12 “ guanxi” is a system of relationships enabling businesses ( u sually betweenco-reliant relationships, with one partner in a superior position ) to survive theharshest of political and economic pressures. http://www.jstor.org/pss/416545813The Age website: http://www.theage.com.au/national/work-heads-offshore-aspacific-brands-axes-jobs-20090225-8hxk.htmlCFA Melbourne Investment Research Challenge Page 12Income StatementMillions 2008A 2009A 2010E 2011E 2012E Operating Revenue2,119.26 2,002.67 1,942.24 1,981.082,050.4210.30Other RevenueTotal Revenue (Ex. Int)Operating Expenses10.579.719.769.962,129.83 2,012.381952 1991.04 2060.7264-1,876.80 -1,782.31 -1,710.73 -1,697.36-1,747.08313.65-18.90-5.80-24.70288.952.00-50EBITDADepreciationAmortisationDeprec & AmortEBITInterest RevenueInterest Exp. incl. Cap Int.Capitalised InterestNet Interest ExpenseEBT Before Abs.Tax ExpenseOutside EquityNPAT Before Abs.Abnormals Before TaxTax on AbnormalsNet AbnormalsNPAT253.03-20.50-6.46-26.96226.013.46-68.610.00-65.15160.93-43.80-0.57116.56230.07-21.31-6.48-27.78202.282.44-65.640.00-63.20139.08-38.80-0.02100.09241.27-19.81-6.09-25.90215.372.00-63293.68-19.28-5.92-25.20268.482.00-59-61.00154.37-43.07-57.00211.48-59.00-48.00240.95-67.22111.30-90.0010.81-79.1932.11152.48-25.003.00-22.00130.48173.720.00 -380.570.0046.000.00 -334.57116.56 -234.480.00173.72 Source: Company Data, Student EstimatesCFA Melbourne Investment Research Challenge Page 13Balance SheetSource: Company Data, Student EstimatesMillions 2008A 2009A 2010E 2011E 2012E Cash And EquivalentsAccounts ReceivableOther ReceivablesInventoryPrepaid Exp.Total Current AssetsNet Property, Plant & EquipmentLong-term InvestmentsGoodwillOther IntangiblesOther Long-Term AssetsTotal AssetsAccounts PayableAccrued Exp.Other Current LiabilitiesTotal Current LiabilitiesLong-Term DebtCapital LeasesMinority InterestPension & Other Post-Retire. BenefitsOther Non-Current LiabilitiesTotal LiabilitiesCommon Stock104.8246.425.9357.014.3748.4204.91.5992.4515.124.12486.4150.672.767.3290.6844.41.83.74.315.11160.01218.6126.5231.521.3311.48.3699.1144.4112.9260.034.0350.014.0770.9140.0227.4262.036.0324.011.0860.4165.0291.6265.021.3349.013.0940.0180.0863.8457.560.72225.5117.464.0180.0361.4577.11.34.06.811.8962.41469.5863.8382.646.62203.9130.068.055.4253.4537.11.34.06.840.7843.31469.5863.8300.344.02233.5134.070.070.0274.0447.11.34.05.011.0742.41469.5863.8257.950.02291.7140.073.076.0289.0317.11.34.04.511.0626.91469.5Additional Paid In CapitalRetained Earnings136.1-141.0-108.921.6195.3Treasury StockComprehensive Inc. and OtherTotal Common EquityTotal EquityTotal Liabilities And Equity-28.31326.41326.42486.4-65.41263.11263.12225.51360.61360.62203.91491.01491.02233.51664.81664.82291.7 CFA Melbourne Investment Research Challenge Page 14Cash Flow StatementMillions 2008A 2009A 2010E 2011E 2012E Net Income116.56(234.50) 32.11130.48(19.28)(5.92)(25.20)173.72(18.90)(5.80)(24.70)Depreciation(20.50) (21.31) (19.81)AmortisationDeprec & Amort(6.46)(6.48)(6.09)(26.96) (27.78) (25.90)Other Amortization(Gain) Loss From Sale Of Assets2.380.002.380.49344.781.36154.4834.252.400.5090.001.40146.0030.002.400.3025.001.40150.0030.692.400.10Asset Writedown & Restructuring Costs –Stock-Based CompensationProvision & Write-off of Bad debtsOther Operating ActivitiesChange in Acc. ReceivableChange in InventoriesChange in Acc. Payable2.43148.6555.041.40160.0033.45(122.50) (140.90) (140.90) (120.90) (100.90)(12.80) 16.78(13.00)24.0060.00(43.90)234.27(30.00)65.00(43.90)236.5720.84(57.00) (31.00)Change in Other Net Operating Assets (52.60) (43.90) (43.90)Cash from Ops.182.51103.7147.71Capital Expenditure(25.30) (22.50) (22.00)(30.00)0.50(42.00)Sale of Property, Plant, and Equipment 0.840.451.00Cash AcquisitionsDivestituresInvest. in Marketable & Equity Securt.Net (Inc.) Dec. in Loans Originated/SoldOther Investing ActivitiesCash from Investing(6.50)6.12(29.50)(42.00)(24.80) (22.00) (21.00)Short Term Debt IssuedLong-Term Debt Issued Total Debt IssuedShort Term Debt Repaid Long-Term Debt RepaidTotal Debt Repaid(97.70) (270.00) (40.00)(97.70) (270.00) (40.00)(90.00)(90.00)(130.00)(130.00)Issuance of Common StockRepurchase of Common Stock248.60Common Dividends Paid(85.40) (42.70)Total Dividends Paid(85.40) (42.70)Special Dividend PaidOther Financing ActivitiesCash from Financing–(0.50)–(0.30)(0.30)(90.30)(0.30)(130.30)(0.30)(183.60) (64.40) (40.30)Foreign Exchange Rate Adj.Net Change in Cash(7.90)4.414.414.41114.474.4164.27(33.80) (21.70) (13.59) Source: Company Data, Student EstimatesCFA MeDisclosures:The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company.The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the contentor publication of this report.Receipt of compensation:Compensation of the author(s) of this report is not based on investment banking revenue.Position as a officer or director:The author(s), or a member of their household, does not serves as an officer, director or advisory board member of the subject company.Market making:The author(s) does not act as a market maker in the subject company’s securities.Ratings guide:Banks rate companies as either a BUY, HOLD or SELL. A BUY rating is given when the security is expected to deliver absolute returns of 15% orgreater over the next twelve month period, and recommends that investors take a position above the security’s weight in the S&P 500, or anyother relevant index. A SELL rating is given when the security is expected to deliver negative returns over the next twelve months, while a HOLDrating implies flat returns over the next twelve months.Investment Research Challenge and Global Investment Research Challenge Acknowledgement:Melbourne Investment Research Challenge as part of the CFA Institute Global Investment Research Challenge is based on the Investment Research Challenge originally developed by the New York Society of Security Analysts.Disclaimer:The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) doesany representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by aor entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considerrecommendation by any individual affiliated with Melbourne, CFA Institute or the Global Investment Research Challenge with regard to this company’s stock.Ownership and material conflicts of interest:
