Maybe Buying Gucci Was Too Much of a Luxury

As profits plunge, investors are wary of debt-laden parent PPR

In better times, the Oct. 2 opening of Gucci Group's newest Paris store could have been a victory celebration for French tycoon Francois Pinault. The sumptuous two-story boutique is just a few doors down Avenue Montaigne from the lair of luxury magnate Bernard Arnault, who in 2001 lost a bitter battle with Pinault for control of Gucci. Now, Pinault's family-controlled conglomerate, Pinault-Printemps-Redoute (PPR), is trying to position Gucci as a global rival to Arnault's LVMH Moët Hennessy Louis Vuitton. With PPR's backing, Gucci is polishing its portfolio of acquired brands--including Yves Saint Laurent, Balenciaga, and Bottega Veneta--and spending nearly $200 million this year to open or refurbish 70 stores.

But so far, Gucci is causing more headaches for Pinault than for his rival. On Sept. 27, Gucci reported that second-quarter profits plunged 55%, to $42 million. The global economic malaise and the downturn in travel pushed sales down 7%, even as the company was spending heavily on expansion. "The reality is that this is a very difficult time," says Gucci Group Chairman and CEO Domenico De Sole.

True, LVMH and other luxury groups are suffering, too. But what's especially worrisome for PPR is the prospect that, 18 months from now, it may have to shell out $4.8 billion to buy the 48% of Gucci it doesn't already own. When he bought out Arnault, Pinault promised that if Gucci shares were not trading above $101.50 in March, 2004, PPR would buy out the rest of Gucci's shareholders at that price. Gucci is now trading at only $84. CEO Serge Weinberg of PPR says he's optimistic that the price will rebound but insists that PPR can handle the buyback if necessary. "This is not a gamble," he says.

Maybe not--but investors are certainly antsy. PPR's shares are down 58% this year, compared with a 29% drop for European retail in general. The fear is that PPR is in no condition to swallow the rest of Gucci. Over the past five years, the French conglomerate has more than doubled in size, gobbling up acquisitions such as European office-supply company Guilbert, while at the same time expanding its existing properties, such as books-and-music seller FNAC, across the Continent. PPR is now Europe's biggest distribution company, with annual sales of $27 billion.

Trouble is, that expansion was financed with debt because Pinault didn't want to dilute his family's control. PPR's debt stands at $6 billion, and Standard & Poor's recently downgraded its debt rating to a notch above junk status. Meanwhile, weak consumer spending is crimping profits: First-half income fell 2.9%, to $350 million.

PPR is working hard to calm investor jitters. In August, it renegotiated $2 billion in short-term debt and netted $825 million from the sale of part of Guilbert to Staples Inc. Still, PPR shares remain stubbornly low. "It takes more than one set of reassuring numbers and an asset sale to restore confidence," says Merrill Lynch & Co. analyst Aymeric Poulain.

Stay tuned for more sale announcements. A prime candidate for disposal is PPR's 72% stake in U.S. electrical equipment supplier Rexel, which could yield more than $1 billion. Sell-offs alone would not raise enough cash to acquire the rest of Gucci. But PPR could probably get loans to buy out the remaining shareholders and then raise new cash by relisting Gucci. But if Gucci's underlying business does not improve, floating new stock will be tough.

Gucci, for its part, is betting on a rebound. "A year and a half in the business universe is eternity," says De Sole. Indeed, industry watchers say that Gucci has made impressive strides in turning around Yves Saint Laurent, the venerable but money-losing fashion house it acquired in 1999. Creative director Tom Ford's ultrafeminine fall collection for YSL, along with must-have Gucci accessories such as the Mombasa leather handbag, are flying out of stores. De Sole expects Yves Saint Laurent to break even by yearend 2003, but he cautions that Gucci's recovery could be derailed by a prolonged global downturn or war with Iraq.

What about Arnault? As he passes the new Gucci store on his way to work, he might still regret that he didn't get his hands on the company. On the other hand, he pocketed $2 billion when he unloaded his 20% Gucci stake last year. That's almost 20% more than it would be worth today. Pinault may have won the battle for Gucci, but it's too soon to say who won the war.

By Carol Matlack in Paris, with Gail Edmondson in Rome

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