Fila Korea: The Falcon Is Now the Falconer

Big things can sometimes come in small packages

Take, for example, 8th-grade Chinese golf prodigy Guan Tianlang. The 14-year-old announced his presence to the golfing world this spring by becoming the youngest-ever participant in the sport's most prestigious tournament: The Masters. And he became a hero at home in China by making the cut and finishing a respectable 12-over par for the tournament, despite being penalized for slow play.

Why does this matter? Because the event was a huge boost to golf in China, where it is in its infancy, but is set to grow. Chairman Mao himself banned golf as a bourgeois pastime and tore up all the golf courses in China. But with the birth of a voraciously consuming upper class in China, golf is back. The first modern course was built in 1984 and the number of courses has tripled in the last decade to approximately 600, with 1000 projected by 2020 (the US has 15,000 courses, Japan has 2,500) . There are about 400,000 regular golfers in China today, a number that could double by 2020. In 2016, golf we be reinstated as a medal sport in the Olympics, and China's powerful state-run sports machine is pouring resources into the sport unparalleled anywhere else in the world.

Big brands can also sometimes come in small packages

Fila Korea (081660 KS) is a 666 billion KRW ($598m USD) market cap company that owns and operates the Fila sportswear brand. In May 2011, in a consortium with financial partners, Fila Korea paid $1.23 billion USD to buy Acushnet, a collection of golf-related brands from American spirits giant Beam Inc. (then called Fortune Brands). Acushnet brands include arguably the best golf brand in the world: Titleist, as well as Footjoy, Pinnacle and others.

Fila Korea is a small company with a big opportunity and ambition to match it. The management has proven its ability with the leveraged buyout and turnaround of the Fila sportswear brand and now has a considerably more powerful brand in its arsenal with Titleist. While the company is financially levered, it is generating a free cash flow yield in excess of 10%, a stream of cash flows that I believe will show accelerating growth between now and 2016, when Acushnet is likely to be IPO'd.

In 2016, post-IPO, Fila Korea will own 33% of what I expect will be a $2 billion market-cap company. Combined with the modestly growing and cash-generative Fila business, the Fila Korea is undervalued by a range of 43%-121% today.

Fila Korea History
Fila Korea was founded in 1991 by current CEO and Chairman Gene Yoon to operate as a brand licensee. Korea was a good market for Fila and it became by far the most successful of all the global licensees of the brand. Fila Korea was uniquely allowed to continue to operate the business after the Cerberus purchase in 2003. Yoon and his team built Fila into a strong retail sportswear presence in Korea, which now occupies the #2 spot in the market, behind Nike but ahead of Adidas.

In 2007, eager to own the brand outright, Fila Korea completed a leveraged buyout of Fila Global, including all global brand rights, for $400m USD. With apologies to Yeats, the falcon had become the falconer.

The Turnaround
Fila Korea management took two important steps. They immediately set a goal of resuscitating the wholesale channel in the US. The ill will created by the Cerberus abandonment of the channel was difficult to overcome. Fila Korea management describe pleading with former retail partners to stock the brand again. After three years of restructuring and five consecutive years of losses, Fila USA is now 100% wholesale and is profitable. 90% of Fila USA sales come from shoes.

Second, they took the licensee business model that had worked so well for them and extended it to other parts of the world, teaching licensees the techniques that had fared so well in Korea. Today all global sales with the exception of Korea and the USA are executed on a brand license basis. This is an attractive business model: Fila Korea receives 6-8% of all revenues, with minimum hurdles. The company has no exposure to margins, does no manufacturing and has no capital spending. Fila Korea receives a cash payment from the licensee on a quarterly basis based on target sales levels. The company has 31 licensees and describes many as still immature. Royalties are only 10% of global Fila brand sales, but represent 30% of profits. The Fila brand in China is managed by a joint venture with Chinese sportswear firm Anta (2020 HK), of which Fila owns 15% and receives a 3% royalty payment.

The Acushnet Deal
In summer 2011, as part of a breakup of the American conglomerate previously known as Fortune Brands, a consortium led by Fila Korea acquired Acushnet (Titleist, Footjoy and other brands) for $1.225 billion cash, for an EV/Sales multiple of slightly less than 1x.

Fila invested $100m in the equity portion of the deal and received call options for warrants to purchase an additional $173m of common stock in the 5 years prior to an IPO of the holding company. The other players and their equity investments are a Korean investment bank's private-equity vehicle Mirae Asset Global Investments ($544m), Blackstone ($130m) and the Korean Government Pension Service's private-equity vehicle Neoplux ($45m). The combined equity investment was $819m, which was supplemented by a $500m term loan from the Korea Development Bank.

The other players are financial investors and will exit in an eventual IPO. Fila Korea will ultimately invest an additional $173m and post-IPO will remain the dominant shareholder with 33% of equity. With Mirae, Neoplux and KDB on board, the success of this LBO literally has the full support of the Korean government.

The Opportunity for Titleist/Footjoy
Golf, like other seasonal sports, has historically had a problem with retail. The seasonal nature of demand forces brands to accept an equipment-led wholesale model, which in turn limits the brands' ability to build a soft goods franchise. Fila Korea management, which turned Fila into a prized sportswear retail brand in Korea, believes that Titleist, particularly in Asia, will be able to surpass this limitation.

China's apparel market has grown at 12% per annum over the last 5 years and sportswear has grown faster than that. The growth opportunity for Titleist in Asia, and particularly China, is not simply the regular golfers mentioned at the outset, per se. It is that golf is growing in popularity, that national heroes are being created as foreign golf tournaments are shown on television, and that golf is unequivocally aspirational in nature. Fila sees an opportunity to take an existing brand with enormous appeal and create an aspirational apparel brand in China that is rooted in golf, but also transcends it.

The Titleist apparel brand was launched in mid-2013. Production is based in Thailand and is ramping while retail expansion in China has been reportedly well-received. It is too early to make any data-based observation.

Valuation
In the simplest terms, for the year ending December 2012, Fila Korea earned 121b KRW, of which 61b was equity-affiliate income from Acushnet. With 9.94 million shares outstanding this is EPS of 12,423/share on a stock price of 66,600/share, which results in a 2012 P/E multiple of 5.4x. 2012 was a weak year for Korean retail sales and Fila's sales and operating income fell by 12% and 11% respectively, so the company cannot be said to be over-earning in 2012. As a sense check: the company recorded sales of 68,000/share in 2012 (1.0x sales), and 6,421/share in free cash flow (~10% FCF yield).

As is often the case in value investing, however, the simplest terms are not always the most accurate or informative. Equity method gains are likely to prove to be volatile due to gains and losses on Acushnet's debt, and meanwhile Fila Korea's capital structure can only be understood in the context of its current capital investment in Acushnet (100b KRW) and further future commitments (173b KRW).

The most straightforward and accurate approach, then, is to value the operating component of Fila Korea as a slow-growing, cash-generative standalone entity, project a value forward for Acushnet at IPO in 2016, and net out the further capital commitment for Fila Korea to maintain a 33% equity position in Acushnet.

By 2016, if Fila management can execute in Asia with the Titleist apparel brand, Acushnet will look considerably more like global athletic lifestyle brands than it does a pure golf play like Callaway or Acushnet circa 2011. This should result in an EV/Sales multiple ranging from 1.2x (Adidas, Asics) all the way up to 2x (Nike, VF Brands). At the mid-point of this range (1.6x), with the same assumptions and discount rates, Fila's stake in Acushnet could be worth $727m today, or 810b KRW, 121% of today's market price. If we wanted to get really rosy, we could use Nike's 2x multiple, but let's not get carried away.

Conclusion
Fila Korea, by itself, is a global brand managed in two markets by a proven, strong operator and benefitting from a growing, asset-light royalty stream from the rest of the world. I think that much is in the price today. I believe the market is ascribing zero or possibly even negative value to Acushnet, a wonderful set of brands primed to exploit strong and growing demand in Asia. An IPO will crystallize this value in 3 years. Fila, Titleist, Footjoy, Pinnacle; these are big brands. At less than $600m in market cap, Fila Korea is a small package.