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After the Buying Binge, Luxury Groups Forced to Deal With Debt

With the era of empire building over, it’s time for the empire builders to pay down the mounds of debt they ran up during their rampant expansions.

Patrizio Bertelli ceo of Prada one of many companies feeling the burden of debt amassed through acquisitions in recent years

Patrizio Bertelli, ceo of Prada, one of many companies feeling the burden of debt amassed through acquisitions in recent years.

Photo By WWD Staff

MILAN — Few would argue that the grand multibrand empire building of past years has come to an end — at least for now. Instead, a new, much less fun era is upon us — in which the empire builders must pay down the mounds of debt they accumulated during their rampant expansions.

Amid unresolved tension in the Middle East, the SARS epidemic and weak retail sales in the U.S. and Europe, this is hardly a time to bank on booming sales to cover amounts due. But the money needed to open flagships in high-rent districts or invest in new brands has to come from somewhere.

And that means even more debt.

Overall, the high-margin luxury goods business appears better placed than some other sectors, such as telecommunications and car manufacturing, when it comes to debt loads. But there have been casualties — the most recent example being Cerruti parent Fin.part. Its mounting losses and crippling levels of debt amassed from a buying spree prompted auditing firm KPMG to reject the company’s accounts last month.

Will there be other victims? The experts say it is too early to panic, but it’s important that luxury goods firms watch their balance sheets and trim as much fat from operating expenses as they can to compensate for the continuing drop in demand. As for selling assets or brands, companies hoping for a quick buck may have difficulty getting favorable valuations, even if they can find interested buyers.

“This doesn’t seem like the right moment to be opening stores,” said Andrea Paladini, an analyst with Centrosim in Milan. “Having an overabundant number of stores than the market requires just for a matter of image doesn’t make sense.”

Still, at least some luxury goods companies continue to spend even as they sell assets they now deem nonessential. LVMH Moët Hennessy Louis Vuitton went through a several-year-long buying spree of brands and accumulated losses at some of its units, like duty-free store chain DFS and the U.S. arm of its cosmetics retail business, Sephora. Yet its net debt of $6.69 billion at the end of 2002 remains dwarfed by its current market capitalization of $23.91 billion. (Dollar figures have been converted from the euro at current exchange rates.)
And the world’s biggest luxury goods company is still paying top dollar for some of its acquisitions. In the first quarter of the year, LVMH paid $219.1 million for an additional 17.2 percent stake in Fendi, a fashion house it already controlled. All in all, LVMH has paid a presumed $1.11 billion for 84.1 percent of Fendi, a company that is posting losses on an estimated annual sales volume of $305.6 million. (Although it is important to remember that LVMH struck its initial deal to buy Fendi in tandem with Prada at the apex of the luxury goods M&A boom in 1999.) Fendi has said it will break even next year.

Selling off noncore assets like champagne house Pommery helped LVMH reduce its net debt by $2.08 billion over the course of 2002, thus cutting its interest expenses to $339 million from $529.3 million the year before.

Similarly undaunted on the spending front is Fin.part. Despite a debt pile approaching the size of its $528.1 million in 2002 sales, its Cerruti unit earlier this month opened the doors on a plush flagship on Rodeo Drive and stores in Paris and Moscow are planned to open later this year. Shortly before stepping down as chairman amid the KPMG-induced crisis, Gianluigi Facchini said Fin.part would succeed with efforts to recapitalize and sell off real estate and manufacturing assets.

Yet others aren’t sure that strategy will be enough. “There are indebted companies where there is a core cash-generator, like Prada, and there are companies where there isn’t a core cash-generator, like Fin.part,” noted one fashion insider.

The situation is even tougher for the smaller privately held companies that dominate much of Europe’s fashion landscape. Andrea Ciccoli, vice president of Bain & Co. in Milan, said these emerging players are “all under a lot of pressure.” With the prospects for initial public offerings high and dry and few investors willing to finance emerging brands, the small fries are best off remaining niche players with lean retail networks and low cost structures, he said.

“I think there will be a structural change in the way to conduct business,” he said. “Those with the cash are king. Those who didn’t already spend a lot will have better growth possibilities.”
At the same time, it’s a delicate balancing act between cost cutting and damaging the image of a brand. Some in the market warn that drastic advertising cuts and a dated, disorganized store network could ultimately do more harm than good.

“Opening stores always weighs on the balance sheet in the short term, before they break even, but in the longer term, having directly controlled stores means internalizing higher margin sales and having better control of the image than wholesale sales,” noted one analyst.

Another company familiar with high debt is Prada. It has been looking to chip away at the pile it accumulated as it transformed itself from a Milan fashion house to a multibrand player by buying labels like Jil Sander and Helmut Lang, as well as shoemaker Church’s & Co.

Selling its 25.5 percent stake in Fendi to LVMH helped Prada lower its net debt to $807.2 million at the end of last year from $1.15 billion at the end of 2001. That compares with a 2002 sales volume of $1.81 billion.

Plans for a real estate spinoff should help lower the load to just above $576.6 million by the end of 2003, a spokesman said. In another cash-generating move, Prada last month sold 45 percent of Church’s to private equity fund Equinox Management Co. SA for an undisclosed sum.

Citing weak market conditions, Prada last summer postponed its planned initial public offering for the third time. Prada chief Patrizio Bertelli has said the group will consider the stock market again, but it could come as late as 2005 when $807.2 million worth of its convertible bonds expire. Prada has to repay the bonds in cash if it doesn’t carry through with an IPO by then.

“The steep acceleration of the [drop in demand] was particularly harmful for our company,” Bertelli told Il Sole 24 Ore in an interview last February. At the middle of last year Prada “found itself in a tough spot with no IPO and a lot of debt acquired through buying brands and expansion in production and distribution.”

But while Prada’s debt situation is cause for some concern, observers agree that the company generates enough cash and has enough leverage with the banks to keep itself afloat.
“It seems as though the family has already invested all the capital that it can afford to,” said Armando Branchini, vice-president of fashion consultancy InterCorporate. But he was quick to add that Bertelli’s substantial debts, which translate into lucrative work for the banks, actually grant him negotiating power to set the agenda.

“Bertelli will decide [when to go through with the IPO],” Branchini said. “Not the banks.”

Prada should manage with its cash-generating Prada and Miu Miu brands but it needs to continue trimming operating costs and sell off some parts of the business even if at a loss, one industry watcher suggested. Prada has denied recurring speculation that it is shopping around various parts of the business, including Jil Sander and Helmut Lang, although speculation about the future of Jil Sander within the group only increased last week with Prada’s announcement that Sander and Bertelli had buried the hatchet and the designer was returning as creative director of the company that bears her name. Prada last week repeated its denial that it planned to sell Jil Sander, although it has sold a minority stake in the business to the designer.

French retail giant Pinault-Printemps-Redoute also has learned a thing or two about debt. Last April, Standard & Poor’s downgraded PPR’s debt rating to one notch above junk bond status over concerns about its balance sheet in light of a commitment to buy all outstanding shares in Gucci come 2004. Standard & Poor’s reiterated its rating earlier this month when PPR said it will issue a $980.1 million to $1.27 billion five-year convertible bond for further financing.

“Despite the substantial divestments completed recently, PPR is unlikely to achieve in the near term a financial profile commensurate with a higher rating,” said Standard & Poor’s credit analyst Hugues de la Presle.

However, PPR on Wednesday saw its upcoming Gucci burden lightened further when the luxury group announced plans to return $1.58 billion, or $16 a share, to shareholders this fall. The plan will in turn reduce the price PPR will have to pay to buy the rest of Gucci by $16 a share, to $85.22 (for full story on the Gucci announcement, see page 3). The plan will still leave Gucci in a strong financial position, with estimated net debt of $237.2 million to $355.8 million.
PPR already has sold off a number of assets to meet its Gucci commitment. As of the end of 2002, PPR had $5.7 billion of net debt compared with a current market capitalization of $9.49 billion. Since then, it has struck deals to sell its remaining stake in office supplies business Guilbert for $939.8 million, as well as all of its wholesale timber business Pinault Bois et Materiaux, the company on which François Pinault built his initial fortune, for $651.5 million. Proceeds from both divestitures went entirely toward cutting debt.

Bit by bit, PPR is transforming itself into a strictly luxury goods and retail player. In what will be its most challenging divestiture to date, PPR has said it plans to sell its electrical components distribution business, Rexel. With a market capitalization of $1.54 billion, Rexel is posting losses amid a slump in the construction industry in the U.S. and Europe.

Meanwhile, the PPR-owned Gucci has accumulated a stable of brands — like Yves Saint Laurent, Sergio Rossi and Bottega Veneta — but has done so without incurring any net debt thanks to PPR’s cash injection of $2.9 billion when the French retailer bought its initial 40 percent Gucci stake in 1999. On Wednesday, Gucci chief Domenico De Sole said the group could make the planned payout to shareholders because it didn’t plan to make any further acquisitions but instead focus on organic growth.

Compagnie Financière Richemont SA — owner of such brands as Cartier, Montblanc, Dunhill, Piaget and Van Cleef & Arpels —also has managed to keep its debt situation under control and is working to keep costs down in these trying times. The group issued a profit warning in March, citing depressed economic conditions and the negative currency impact of a weak dollar and yen against the euro. To limit losses, it will scale back Dunhill’s retail operations in the U.S. and reorganize distribution of the French leathergoods brand Lancel in certain markets.

Net debt for the year ended March 31, 2002 stood at $1.68 billion, but one analyst estimated the company can reduce it to $1.38 billion for this fiscal year. Richemont, with a market capitalization of $7.98 billion, is also in the throes of a leadership shakeup. Alain Dominique Perrin stepped down as ceo earlier this month and executive chairman Johann Rupert is expected to take over his responsibilities.
Some industry watchers also cite Bulgari as a company that has done well to combat its debt burden by reducing its inventory in 2002 by 13 percent to $550 million from $630.8 million.

“They reexamined a little the growth rate of the market,” noted one analyst, who said Bulgari wasn’t as studious on production and warehouse efficiency in the boom years of the late Nineties. “They never looked at those things before.”

Bulgari said tinkering with inventory levels enabled it to more than halve its net debt to $156.8 million at the end of 2002 from $327.5 million the year before. Bulgari’s current market capitalization stands at about $1.52 billion.

Among other operating cost cuts, Bulgari sliced its advertising and promotional expenses in 2002 by 25 percent to $87.6 million. The company said it chose to spend less on ads because it didn’t have as many new products to launch as in years past. But some analysts warn that fewer pages in glossy magazines could relegate Bulgari to the back of customers’ minds.

Advertising cuts or not, it looks as though Bulgari is going to have to stay lean for now. Last month, chief executive Francesco Trapani warned shareholders that the SARS outbreak could cause the jeweler to miss its financial targets for 10 percent profit and revenue growth this year.

Bulgari may be one of the first companies to admit SARS will hurt its business, but most in the market agree it won’t be the only casualty if the epidemic spreads further.

“For 2003, we had forecast a positive result and until just recently we were in line with those objectives,” Trapani said at the group’s annual meeting. “But now there are fears that it could go differently.”
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