Oversold

Billabong will go on the casualty list of this year’s earnings season, with the stock suffering a wave of selling following the result. Looking at the share price movement alone, one would assume that the company had failed miserably last year. In actual fact, the result was only marginally below management’s previous guidance and it was a weaker than expected outlook that really concerned the market.

The upshot is that the reinvigoration of the company’s sales growth that we had expected to be getting underway by now is simply going to take longer to occur. With more significant growth out of sight for now, the stock’s pullback essentially represents the market carving off some of its growth premium. There is also some concern over management’s ability to execute the vertical integration strategy, although we view the push into retail as a positive step which should enhance both volumes and margins.

The stock’s post-results sell-off has in our view been overdone and we consider Billabong undervalued at its current 2011 consensus price to earnings ratio of around 12.7 times and dividend yield comfortably in excess of 5%. Billabong isn’t some start-up with lofty plans but no track record. There is significant value in the company’s portfolio of brands, whose life cycle is frequently extended through new additions.

Before we get into that though, let’s first examine Billabong’s performance through the year to 30 June 2010. Management reiterated guidance for 5% earnings growth on a constant currency basis back in February 2010. Constant currency results simply use the same exchange rate for both the previous and current year’s numbers. This removes the impact of exchange rate movements to give a clearer picture of the company’s operational performance.

In terms of which, management expected a considerably stronger second half performance to drive Billabong’s 2010 constant currency earnings to a still modest 5% growth. The second half was indeed far stronger than the first. But even so, Billabong’s $146 million full year earnings came in only 3.1% ahead of the previous year, after removing the impact of 2009’s impairment charge.

Billabong’s sales of $1.4823 billion was essentially flat on last year’s $1.4826 billion in constant currency terms. In reported terms though, which incorporates the impact of the stronger Australian dollar, group sales fell 11.2% from $1.6691 billion. Net earnings fell 8.9% on this basis.

Regional Performance (in constant currency)

The Americas

Billabong’s most significant geographic area is the Americas (78% US), which contributes 48% of the group’s sales. The region’s sales gained 3.2% in the second half, bringing the total to $712.6 million and just 1.2% below the previous year.

The US retail environment has been particularly difficult following the GFC, but Billabong’s second half performance there provides firm evidence of sustainable improvement. Indeed, ordering patterns have begun to normalise, with brand perception becoming more important than simply price. This has been to the benefit of profitability with operating margins in the US rising from 11.9% to 13%.

The margin expansion easily overpowered the sales decline, driving operating earnings ahead by 5.4% to $92.3 million. In light of the West 49 acquisition, we were encouraged to see Billabong’s 111 company owned stores in the region deliver 9.2% sales growth.

Management expects the retail environment across the Americas to continue to improve through the year ahead, which should drive further margin and earnings expansion.

Australasia

The region’s sales fell 1.9% to $425.7 million, or about 29% of the total, again marking a strong second half performance given that sales were down 14% through the first half. Operating earnings slipped 10.3% to $89.2 million on the back of a 1.7 percentage point margin contraction to 20.9%.

The importance of margin growth is ably demonstrated by the headline numbers for both Australasia and the Americas. While the latter accounts for almost half of group sales, its contribution to operating earnings was only an additional $3.1 million. The Americas’ upside potential is therefore considerable and management’s push into greater control over distribution through more company owned retail outlets is a central component of achieving this.

Meanwhile, Australia is the most significant element of the Australasian region, contributing 58% of its sales. As such, the cycling of the Government stimulus package was a factor in the weakness, but so too was the broader Australian consumer slowdown which occurred in the three months to June.

If there’s one lesson every retailer had hammered home to them through the GFC, it’s not to be left holding excess inventory. Retailers are as a result especially sensitive to any indication that future demand may be weakening. This saw forward orders for Billabong’s wholesale summer products pull back by some 20%. Nevertheless, it is likely that many retailers will find they have been overly cautious and will end up chasing product, particularly given Australia’s economic resilience and the stronger than expected retail sales numbers that were released today.

Europe

The European region would more accurately be described as France, given that the country accounts for 83% of its sales. At any rate, full year sales lifted 5.2% to $344 million, supported by growth in France. Operating earnings gained 5.1% to $69.8 million, with a healthy operating margin of 21.2%.

Once again the operating margin smashed that of the Americas. As we mentioned above, margin growth is a key goal of management’s push into retail. This is both in terms of physical bricks and mortar stores and online distribution channels. With regards to the latter, Billabong has a stake in the ground through its ownership of swell.com and its interest in surfstitch.com.

The effect of opening up more distribution channels is to put more control over distribution into management’s hands, rather than rely on third party retailers. This will enable management to maximise the value of Billabong’s diverse range of brands. Not only can products be channelled through to their most receptive markets, but younger brands can become more quickly established in new markets.

An example of this is the recent acquisition of RVCA, which is very strong in California, but less well-known elsewhere. The brand nevertheless has enormous potential and is not unlike a younger version of Volcom. We would expect Billabong to make significant inroads in new markets with RVCA, all of course to the benefit of earnings and shareholder value.

In terms of the outlook, management set a fairly wide and uninspiring range of 2-8% earnings growth in constant currency terms. While the outlook was a significant factor in Billabong’s share price weakness, we believe it is a conservative estimate. As a result, we view the prospect of further disappointment as low, while there is also the possibility of an upgrade.

Turning to the charts, Billabong failed to break above the 50 period moving average (green line) around the $9.00 region. Since breaking below the July 1 low of $8.28 Billabong continued to decline, reaching an intraday low of $7.31 on August 26. The RSI is now very oversold. This coupled with the ‘rounding pattern’ that has formed suggests that buying pressure will emerge over the near term.

The weekly chart depicts the downtrend in place since May 2007. Solid downside support is located between the $6.00 - $7.00 region. Should Billabong find support within this vicinity, we would anticipate a swift move higher to test resistance at the 39 week moving average (green line) at $10.03 over the longer term.

Billabong’s share price performance has been very disappointing, but is in our view not justified by the underlying fundamentals. The deferment of significant growth for another year is disappointing, but Billabong’s balance sheet is in good health, its portfolio of brands is very strong and management’s push into retail is a logical strategy that has the potential to unlock the company’s potential value.

We continue to recommend Billabong as a buy to all Members around $7.60.