Australia | Aug 23 2010
By Chris Shaw
Full year earnings for leisure wear group Billabong ((BBG)) came in at $146 million, a result largely in line with expectations. The problem for the company and for investors is weak guidance for FY11 accompanied the result, this guidance causing cuts to earnings forecasts across the market.
As JP Morgan points out, earnings guidance for FY11 in constant currency terms was for net profit after tax growth of 2-8%, while market consensus was for growth of around 20%. The lower guidance reflects weak forward orders in Australia and some margin compression, while the broker also expects margin recovery in the US will take longer than had been expected.
This suggests to JP Morgan that management's guidance of a return to better than 10% constant currency earnings growth by FY12 is something of a stretch, particularly given the number of macroeconomic, industry and company specific challenges Billabong is facing at present.
According to Citi, the changes in market conditions mean Australian margins will now be permanently lower, as the market is now increasingly mature and increasingly reliant on the retail customer. As an example, Citi estimates group margins will decline from 20.9% in FY10 to 18.1% in FY11.
This is creating some company specific challenges, which management is attempting to counter by something of a change in strategy. As RBS Australia points out, the new approach will be to go head-to-head with fast fashion competitors via the creation of a vertically integrated business model.
RBS notes there are number of elements to this approach, including strengthening direct-to-consumer capability, improving the speed with which products get to market, and streamlining ranges to reduce the complexity and costs involved.
In RBS's view achieving such goals will be tough given Billabong has a complex range of brands and retail stores, though if successful it expects the approach will create a more sustainable footing for future growth.
On the plus side, as Macquarie points out, six months ago Billabong didn't have the capacity to operate in the fast fashion sector in the surf market in particular. A new global product life cycle management system will allow the company to compete on a more even footing going forward.
The strategy has some execution risk attached to it and, as new guidance provided with the full year profit result indicates, means a recovery in earnings is not expected in FY11. To reflect this brokers have been harsh in cutting estimates, with RBS Australia lowering its net profit forecasts by 7% in FY11 and by 12% in FY12.
JP Morgan has been even tougher, cutting net profit estimates in FY11 by 18% and in FY12 by 21.3%. In earnings per share (EPS) terms this means JP Morgan is forecasting 60.5c in FY11 and 66.1c in FY12, against RBS at 63.7c and 74.4c respectively.
Macquarie cut its EPS forecasts by 12% for FY11 but lifted its FY12 number by 2%, its forecasts now standing at 58c and 70c respectively. Consensus EPS forecasts according to the FNArena database now stand at 61.4c in FY11 and 71.2c in FY12.
The changes to earnings forecasts have been matched by some significant cuts in price targets, Macquarie dropping its target to $8.39 from $10.66 and UBS dropping its target by $2.50 to $8.60. The average price target according to the database is now $9.19, down from $10.66 prior to the result.
Ratings have also been adjusted post the result, both Macquarie and Credit Suisse downgrading to Neutral from Outperform and to Underperform from Neutral respectively post the profit result and revision to earnings guidance.
For Macquarie the problem is when companies suggest they are entering a transition year it often means lower growth is coming. The uncertainty about a recovery to Billabong's earnings in FY12 is enough for the broker to turn more conservative.
According to Credit Suisse the transition year indicated by management poses the question of what Billabong is in fact transitioning to, as the strategy doesn't appear particularly clear to the broker. It suggests likely consequences are a higher capital base and lower returns, all of which are negatives for valuation.
Others continue to show faith, Citi expecting the company will develop the retail strategy successfully enough over time to allow retail earnings margins to improve over the next five years. RBS Australia takes the view even though Billabong's new strategy has risks the stock offers enough value to compensate for these risks at current levels, so its Buy rating is retained.
Overall the FNArena database shows Billabong is rated as Buy three times, Accumulate once and Hold and Sell three times each. Shares in Billabong today are weaker and as at 12.30pm the stock was down 34c at $7.69.
This compares to a trading range over the past year of $7.66 to $12.32 and implies upside almost 14% to the average target in the FNArena database.
