Harry & David is an Attractive, Little-Known Post-Bankruptcy Opportunity - HARR

Harry & David Holdings is an attractive post-bankruptcy situation. The company has successfully shed its bad assets and is now poised for continued margin expansion and possibly, a recapitalization.

Harry & David is a brand name that will be familiar to many readers. Founded in Oregon in 1910, the company sells its gift baskets and other edible gifts through its catalogs and company-owned stores. The company's products are somewhat pricy and are targeted toward middle and upper middle class consumers.

A typical Harry & David gift basket.

Harry & David was passed among multiple owners for 20 years before being bought by private equity firm Wasserstein & Co. in 2004. Wasserstein proceeded to pile on debt by the hundreds of millions, and expanded the company's product lineup and the number of company-operated stores.

Trouble started in 2008. The weakening economy took a bite out of revenues, as customers cut back on discretionary purchases. (Expensive fruit and cheese baskets may be the very definition of "discretionary purchases.") In 2010, Wasserstein replaced Harry & David's long-time CEO with its own choice, Steve Heyer. Heyer instituted many changes, the results of which only served to alienate customers, discourage employees and increase costs without building revenue.

From a Bloomberg.com article:

"Heyer hit Harry & David like a hurricane, according to former executives there. He fired many of Bill Williams’s managers and brought in his own. He often called Harry & David workers 'idiots,' two former employees say."

...

"One of Heyer’s biggest blunders, former employees say, was rearranging the contents of Harry & David gift baskets. He had workers lay out samples of all the baskets in a warehouse, and he went down the line, adding and removing items, one former worker says. The changes made it impossible for returning customers to easily repeat an order from the year before on forms that the company sent out, former employees say, and many customers didn’t buy."

By late 2010, Harry & David was in deep trouble, and the company defaulted on its interest payments in mid-2011.

In the course of the bankruptcy process, Harry & David shed its debt load and offloaded its pension obligation in return for payments of cash and newly-issued shares to the PBGC. The company also reduced its cost structure, shuttering unprofitable company stores and simplifying its product line-up. Wasserstein lead a group of bondholders in backstopping the bankruptcy process, agreeing to lend $55 million to the restructured company. Harry & David exited bankruptcy in September, 2011.

Harry & David recently reported its fiscal 2013 results, and things are looking up.

Revenues are up modestly over 2012, despite the fiscal 2013 having 52 weeks and fiscal 2012 having 53. Additionally, the number of company-owned stores declined from 56 to 49 in the course of the year. The company's gross and operating margins rose significantly, evidence that cost-reducing initiatives have been effective. Adjusted EBITDA rose 17.41% year over year and adjusted operating income rose 61.10%.

Note that the adjusted EBITDA and adjusted operating income figures above are not GAAP numbers and are based on adjustments provided by the company. Normally, I am extremely skeptical of adjusted figures, since they tend to exclude only "bad stuff" that represent very real economic expenses. My personal income statement would look much better if I could exclude "one-time items" like that brake caliper that froze on my car last spring and the 45 Euro I lost to the shady hotel clerk who short-changed me in Rome last week.

However, in Harry & David's case, these one-time items are largely associated with the lingering expenses of bankruptcy, such as shutting down unprofitable stores and compensating turnaround consultants. Not adjusting for these temporary expenses would disguise the company's earning power, which is increasing rapidly.

Harry & David's stock is illiquid and the company does not publicize its earnings reports, which contributes to a very modest valuation. The company has fewer than one million shares outstanding, and the large majority of these are held by the company's former bondholders, including Wasserstein.

The "Debt/Re-Org Liabilities" figure requires some explanation. As part of its bankruptcy agreement, Harry & David was required to make periodic cash payments to the PBGC and other claimants. As of June 30, 2013, the remaining claims are $7.86 million, which will be settled almost entirely in fiscal 2014.

Harry & David's balance sheet shows no debt at fiscal year end, but that will change dramatically as the holiday season approaches. Because its business is so seasonal, working capital needs swing widely throughout the year. Harry & David uses a line of credit to finance inventory purchases prior to its busiest sales period, then pays down the line of credit as inventory is sold and receivables are collected. The current net cash figure of $7.73 million is conservative, as net cash actually averaged $15.57 million in fiscal 2013.

At an enterprise value of just under $114 million, Harry & David trades at 4.2x EBITDA and 7.2x operating income.These are attractive multiples, and investors purchasing at this valuation will likely do well simply through the earnings yield and eventual appreciation to more reasonable multiples. However, that scenario does not account for the possibility of value creation through a modest recapitalization of the company.

At present, Harry & David's balance sheet is "lazy," carrying no debt beyond its re-org obligations and its periodic inventory financing. Shareholder returns could be improved significantly through a modest debt issuance and a special dividend.

From 2006 to 2009, Harry & David's debt load was in excess of 4x EBITDA. Obviously that level of leverage was unsustainable and ultimately wrecked the company. However, a smaller debt issuance would reduce the company's cost of capital and could fund a sizable special dividend.

Harry & David's owners are private equity veterans and are undoubtedly aware of Harry & David's capacity to support debt. In my view, they are waiting to pursue a recapitalization until the re-org liabilities have been completely discharged and the company has shown a sustained period of profitability and margin expansion. At that point, the company could likely issue debt on attractive terms.

Ultimate exits for Harry & David's owners include an uplisting/IPO or a sale to another entity such as a retailer or retail-focused fund. Any such transaction would likely take place at a valuation well above today's depressed multiples. At 6x trailing EBITDA, a sale would yield $183 per share. At 7x, it would yield $212 per share.

It could pay to wait on Harry & David.

No position.