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Web Street Golf Daily Pulse
BREAKING NEWS
Tuesday, December 7, 2010

WHERE THERE IS SMOKE, OFTEN THERE IS FIRE: Sometimes to understand your true value it takes an outside presence. That was the case for Fortune Brands (FO: NYSE), which announced today that it intends to split the company into as many as three separate businesses under a plan approved in principle by its board of directors, according a report in the Wall Street Journal. The company intends to spin off its home and security unit to shareholders in a tax-free transaction, and to either sell or spin off its golf division, according to people familiar with the matter as reported by the Wall Street Journal. It’s believed that Fortune Brands will remain an independent, publicly traded company focused on liquor brands. The move comes two short months after activist shareholder William Ackman's hedge fund disclosed it had taken a significant stake in the conglomerate.

The story began in early October when a Securities and Exchange filing revealed hedge fund, Pershing Square Capital Management made a significant bet (an 11% stake of roughly 16.6 million) on Fortune Brands. Once the investment was made public, through the filing, the stock was already a winner for Pershing. The filing date regarding the accumulation by Pershing of Fortune’s shares was October 4. Fortune Brands stock price closed at $49.60 on that day but finished at $55.50 on October 11th, a 12% appreciation by the time the financial markets or perhaps the company itself, became aware of the what was going on.

For those who may recall fondly the movie Wall Street (the original), the basic premise (without Hollywood’s dramatic effect) is that someone believes a company is undervalued and after taking a position in it, begins (for obvious and selfish reasons) to unlock what it considers are the obstacles for the company’s elevated valuation. The entire premise of the exercise is capitalism in its rawest form, which also happens to be its harshest for the sake of the lives potentially affected by it. An updated syrupy version of the same basic story came in Pretty Woman with Richard Gere. Nevertheless, the point behind the exercise is that the sum of the parts is worth more than the total. It might sound at first blush, counter intuitive to how financial markets operate, but there are always exceptions to the rule. Since Pershing made its intensions/investment known, Fortune Brands stock price was “in play” as they say, and it became a chess match between the two sides in determining what the next move might be.

The leading figure behind Pershing Square Capital Management is its CEO, Bill Ackman, the figurative equivalent of Gordon Gekko (Michael Douglas) or Edward Lewis (Richard Gere). Where Fortune Brands diverted from Hollywood’s script is that it didn’t resist Ackman for dramatic effects. After all he represents their largest shareholder and any board of directors worth its salt should be aligned towards uncovering “shareholder value.” So first Fortune Brands hired Credit Suisse to act as its financial advisor and then listened to what Ackman/Pershing had to say about what its theoretical valuation might be. In the meantime, the stock price continued to move higher, thus signaling something was going to have to happen and in turn likely forcing the hand of Fortune’s Board of Directors.

For those not completely familiar with Fortune Brands’ business it operates in three categories: Sprits; Home and Golf. The golf segment represents the smallest portion of the overall revenues and operating income contributions back to the parent company. The Acushnet Company (Titleist, FootJoy and not too long ago also Cobra Golf) is a recognizable force in the golf industry. Titleist has and remains, the 800 lbs gorilla in the equipment side of the industry, while FootJoy commands a dominant market share in shoes and gloves. In turn due to its size, Acushnet more often than not gets interchanged with Titleist (no disrespect intended to FootJoy).

In some ways, it could be argued that Fortune Brands has a bit of an identity crisis, which may have lead it to Ackman’s involvement and in turn the company’s decision today. Was it a spirits company? It owns Jim Beam, Courvoisier, Canadian Club, Laphroig, Effen Vodka, Sauza Tequilla, Cruzan and Maker’s Mark on the super premium brands side of its portfolio. But it also has Knot Creek, The Small Batch Bourbon Collection, and Windsor Canadian among others, rounding out its booze portfolio. In 2009, revenues from the division totaled $2.47 billion and it provided operating income of $484.7 million. Clearly Fortune Brands’ Board of Directors has made that decision going forward that this is its new direction.

Under its Home business segment, it owns Moen, #1 faucet brand, Therma Tru doors, #1 brand of residential entry doors in the US, Master Lock, MasterBrand, the second largest manufacturer of kitchen and bath cabinets. In 2009, revenues for the division were $3 billion but its operating income was only $87 million. The golf division’s revenues in 2009 by contrast were $1.2 billion and its operating income contribution was $91.5 million. Today 70% of Fortune Brands’ bottom line are delivered from its Spirits business, which no doubt influenced the ultimate decision. It is believed that the brown spirits industry worldwide represents a $40 billion dollar opportunity. The Home division of Fortune Brands competes in a $200 billion dollar market, while Golf (Acushnet Company) is an industry leader (and profitable) but the total golf industry is much, much smaller compared to Spirits and Home, at $7 billion worldwide. So while the golf component is a big fish in a relatively small pond, the spirits and home business easily represents the lion’s share of opportunities in dollars and cents to Fortune Brands and its shareholders.

A quick look back in time shows that holding companies such as Fortune Brands, Textron, Tyco, ITT, etc., came about in the 1960’s/1970’s when single product category companies (in categories with few competitors) grew to possess sizable market shares, accumulated large amounts of free cash and then began to diversify their portfolios. The argument was diversification would provide insulation against maturing industries and cyclical trends, yet allow for growth rates that shareholders or financial markets often expect. One could argue that when American Brands sold off American Tobacco in 1994 and that this was the start of the American Brands (now Fortune Brands) transformation, which has lead it back to the decision today to divest its diversified holdings.

Since the Spirits division represents the bulk of the annual profits (70%) of Fortune Brands’ and Wall Street prefers “pure plays,” the decision also makes sense going forward. There are many who think of Fortune as a balanced holding company or a cyclical industry Home business based company but there are just as many that have questioned why these three businesses are bundled together and when they might be split apart to unleash the value in each individual business. Today with the decision by the Board of Directors the company is taking the steps to alleviate this. At the same time the investment world (those that cover and recommend stocks) have become industry specific and prefer to follow and recommend “pure play” stocks (electronics, autos, financial services, distilled spirits, etc), which should influence future forecasting of financial models and in turn valuations based on growth rates on earnings. Holding companies like Fortune Brands are trickier to predict since the diversification component from within the business forces analysts to cover multiple industries for the purposes of forecasting the company’s prospects. It also fosters the notion that even within the investment community, Fortune Brands has an identity crisis. Pershing Capital, a hedge fund, sees the world the same way (preference for pure plays versus holding companies and a history of shareholder activism), which may in turn, ironically, have been part of its reason for its investment position in Fortune Brands.

However, selling off some of the brands isn’t as straightforward as it might appear on the surface. The Wall Street Journal reported a potentially unattractive tax bill would result if Fortune sold certain brands or split up the company because it has held the assets so long that they have appreciated significantly in value. The potential tax liability due to the increase in value might cause Fortune to demand a higher price for its assets in order to cover Uncle Sam’s cut. Fortune Brands’ Golf businesses have been accreted (significantly) in value over time and sales of either of these businesses could potentially trigger a significant capital gain tax obligation (known as tax leakage).

Meanwhile, since early September the stock price has increased from $45 per share to over $61.37 per share. But during this time there hasn’t been any change to the fundamentals of the underlying businesses in the company’s portfolio. For the sake of the golf division, Acushnet’s fate appears for the time being unknown but there are a couple of options.

Potential strategic buyers linked in the past have included Callaway (ELY: NYSE), Nike (NKE: NYSE), Adidas, Bridgestone and Sumitomo Rubber. However, all of these potential suitors present significant antitrust issues. Adidas and Nike, for example, are #2 and #3 respectively in golf footwear and acquiring FootJoy in the #1 position would imply a major advantage to the successful buyer. Callaway and Bridgestone are #2 and #3 respectively in golf balls and acquiring Titleist and its dominate #1 position in market share would equally set off a series of complaints from those that lost out in a potential deal. Similarly Callaway, Bridgestone and Sumitomo represent golf ball product category intellectual property right antitrust issues. An alignment between Titleist and anyone of those three would give the combined entity 40+% of the golf ball Intellectual Property Rights landscape. Navigating through antitrust issues would slow up any sale process and could require divestitures. Although there would be some financial synergies with any strategic buyer, the antitrust risks and delay coupled with the integration costs could outweigh those benefits along with the tax consequences that may influence the final sales price.

The Acushnet Company makes money (and is one of the leading companies in the golf industry) thus it would be seen as an attractive investment for the private equity crowd. It is an industry leader, has high visibility and has good demographics for its brands. It might also be seen as trophy by some within the private equity arena, who may be associated in belonging to the elite private facilities in the northeastern portion of the United States. At the present time most private equity funds are flush with cash and it would appear to be a logical option. Acquiring Acushnet in the current financial environment, which isn’t known for promoting top dollar on any transaction would be intriguing with the expectation of perhaps spinning it back as a stand alone public company when the economy is on higher ground. It at least offers an exit strategy to a private equity fund that could be too compelling to overlook.

The next area for growth in the game in centered on the Pacific Basin region. Presently several equipment companies are racing to gain a foothold in Korea and China, for example. Its safe to say that in golf, Asia is the next frontier. By 2020 it is expected that 40% of the world of golf will be Pac Basin centric. This fact and the reality that golf is seen, as an upper middle class status industry in Asia will prompt some potential Asia based suitors in the private equity front and may offer it the greatest leverage for realizing its full value.

The Acushnet Company’s net sales in 2009, as state previously, were in excess of $1.0 billion. According to Fortune Brands’ annual reports from the past five years, the Acushnet Company operating income is probably in the neighborhood of the $70-80 million range. Its annual earnings before interest, taxes, depreciation and amortization are easily in the range of $100-120 million. These numbers will be critical to determine fair market value for the company along with the ultimate selling price that Fortune Brands will demand for its Golf business. Its unlikely the strategic buyer will come from within the golf industry in part since the asking price will be steep and many within the peer group are already aware of the challenges at present in growth with their respective businesses let alone justifying a reasonable return on investment that would require several years to achieve. For now the rumor mill will swirl but it remains to be seen what the next move will be in either the sale or spin off of Acushnet.