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Tiffany Montgomery
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Quiksilver default unlikely, analyst says. Also, the case for VF as a Quik buyer

By Tiffany Montgomery
December 05, 2008 8:10 AM

I received an in-depth research report from KeyBanc Capital Markets stock analyst Brandon Ferro this week, which makes the case that it is unlikely that Quiksilver will default on its loans. Brandon, who just launched coverage on Quiksilver, Volcom, PacSun and Zumiez, also outlines in great detail why he thinks Quiksilver is a good acquisition target for VF Corp. 

I pulled out pieces of his report and shortened it in some cases, though it is still long. It makes for interesting reading, however.

Brandon FerroHere are excerpts from Brandon's report:


While understandable, we believe concerns over the Company's liquidity situation are overly pessimistic. We believe the possibility of liquidity and/or default-related events are lower probability outcomes.

For one, many of the 11 banks that support the Company's $300 million asset-backed revolver in the United States also back the "at risk," short-term, uncommitted lines in Europe. If the banks call obligations or eliminate availability on short-term lines in Europe, forcing a liquidity crisis, it could impair the group's ability to maximize the value of its claims on outstanding long-term debt balances in the same region or on the asset-backed revolver in the United States. Ultimately, a forced default is not the best way for banks to maximize the value of their claims against ZQK given the value of the Company's brands.

Continuing to extend expiration dates on short-term lines or ensuring their availability, turning them into long-term lines, refinancing long-term debt, private equity capital or an outright sale of the Company would be far better value-maximizing propositions to banks, in our view, given ZQK's position as a profitable, free cash flow positive company. ...

However, given an uncertain global retail environment, general risk aversion at banks and frozen debt capital markets, we acknowledge that it is possible to envision a scenario where ZQK's bank group invokes call options on the aforementioned short-term lines or refuses to renew them as they expire through 2009 or turn them into long-term, committed lines. Further, it is reasonable to assume that ZQK is unable to raise debt capital and/or refinance its 2010 long-term debt.

Lenders will be gambling on a combination of global retail fundamentals bottoming in 2009 and improving thereafter, aiding ZQK's ability to pay off a portion of future obligations through operating cash flow and an improvement in global credit markets, allowing the Company to refinance long-term debt maturing in 2010.

While an obvious issue, the inability to finance near-term liquidity needs at the bank level is not the end of the story given other alternatives. Some are more likely than others; however, ultimately, all of them, if/when announced, will eliminate what we view as the greatest source of downward pressure in the shares.


This leads us to ZQK's October 31, 2008 press release in which the Company announced that in addition to traditional bank financing, it has hired Morgan Stanley to entertain private equity and "other" strategic alternatives to improve its liquidity profile. If the Company's bank group is unwilling to negotiate, then ZQK could just as well utilize private equity as a source of liquidity. This would obviously result in some form of dilution to common-stock holders. Dilutive or otherwise, any announcement surrounding new
liquidity should cause a significant rally in the stock given our contention that the issue is of paramount concern to investors and the largest source of downward pressure in the shares.

Additionally, we believe private equity capital carries with it long-term benefits, all of which greatly outweigh the effects of near-term dilution, in our view. It would eliminate the uncertainty associated with short-term, uncommitted lines, eliminate the need to sell either the Company or any of its successful brands at depressed valuations, and potentially bring with it a firm that has experience in the retail world that could lend expertise to ZQK in the areas of manufacturing, sourcing or retail, thus driving an improvement in long-term fundamentals.

We estimate that ZQK could need $450 million-$500 million in incremental capital to take care of 2009 and 2010 liquidity needs. Our analysis contemplates a roughly $65 million working capital increase from 1Q09 into 2Q09, the need to pay the 55 million Euro line of credit on March 14, 2009 along with all other remaining balances outstanding on European short-term lines of credit (i.e., $225 million) and the need to pay down all long-term debt maturing in 2010, less $100 million in available liquidity.

Our worst-case scenario dilution analysis suggests a fair value for the common equity ranging from roughly $1 up to $5 based on our Street-low 2009 estimates.


Outside of private equity, we believe "other" strategic alternatives include an outright sale of the Company. In that event, we believe the most likely strategic buyer could be VF Corp, which we view as both willing (interested) and able (capacity) to purchase ZQK. In this case, again using conservative comparable transaction multiples, ZQK's equity could command a selling price in the range of $3-$9.

VF Corp is very profitable, throws off lots of free cash and has significant balance sheet capacity to make acquisitions. As of 3Q08, VFCorp had $226 million in cash on its balance sheet along with $1.3 billion in domestic and international lines of credit.

Additionally, the Company generates roughly $650 million-$700 million and $550 million-$650 million of annual operating cashflow and free cashflow, respectively. Our acquisition analysis suggests ZQK's equity could fetch a $7 selling price (low of $3; high of $9).

ZQK fits well with the Company's long-term growth strategy. Specifically, ZQK directly fulfills at least two of the Company's six strategies (arguably the two most important ones) for sustainable growth, including building more global lifestyle brands and expanding its direct-to-consumer retail business.

The Company considers its Outdoor, Sportswear and Contemporary segments as housing its lifestyle brands. ZQK fits perfectly within the Outdoor segment. Outdoor is VF Corp's second largest segment and includes brands such as The North Face (performance-oriented apparel, footwear and outdoor gear), Vans (skateboard-inspired footwear and apparel) and Reef (surf-inspired footwear and apparel) among others. ZQK's long-term revenue growth goals for each of its three brands also align well with VF Corp's goals of generating long-term revenue growth in the mid single-digit to low double-digit range in its higher growth Outdoor, Sportswear and Contemporary segments.

Another growth strategy VF Corp is employing is the expansion of its direct-to-consumer business, especially company-operated retail locations and e-commerce. VF Corp already operates more than 600 company-owned retail locations and is eying more within its existing stable of brands. ZQK would facilitate this goal as it already operates more than 600 company-owned or licensed locations and has plans to roll out additional locations in the future. Further, as part of its retail strategy, VF Corp could probably use ZQK's retail locations to layer in new growth opportunities for its own brands by adding floor space in Quiksilver Boardshops for the North Face, Vans and Reef.

As anecdotal support to our acquisition thesis, we note the story regarding VF Corp's acquisition of The North Face, as the deal's circumstances resemble the events that have unfolded at ZQK.

In early 2000, The North Face found itself in the position of seeing its bank lines expire as its losses from operations and working capital needs were escalating. The Company had one line expire on March 31, 2000, which was extended to April 15 as negotiations with lenders and strategic alternatives were under taken.

Unfortunately, there was enough doubt about the Company's ability to survive as a going concern that it was forced to announce on April 6, 2000 that it would sell itself to VF Corp for $2 per share (64% premium) or just 0.5x on an EV/Sales basis. We acknowledge that the sale of The North Face was not exactly ideal for investors given the deal utilized an unfavorable transaction multiple on top of a stock price that had lost nearly all of its value.

However, despite the similarities between North Face's situation then and ZQK's today, the latter offers VF Corp far greater potential revenue and cost synergies. For one, ZQK already generates substantial earnings, EBITDA and operating cash flow, while The North Face did not. ZQK possesses an extensive network of retail locations, which can generate incremental revenue synergies for existing VF Corp brands, while The North Face does not. Lastly, the cost synergies generated by combining VF Corp and ZQK, including back office, manufacturing and sourcing-related ones, would be much larger.


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