8/20/2010
By Brian Sozzi, Research Analyst

More Articles by Brian Sozzi

All of this deal activity is beyond exciting!  Potash (POT). McAfee (MFE).  It wasn't too long ago I came into the office on Monday morning and by the time the opening bell sounded, a half a sheet of paper was filled with announced, or proposed, deals.  "Merger Monday" juiced my spirits, juiced the wallets of deal teams, and juiced a market that was ga-ga for buyouts by way of cheap debt.  More buyouts, or so went the line of reasoning, meant that higher valuations on risk assets could go on unabated.  Forget the fact private equity, or competitors in a specific sector, will have had to refinance the paper that was loaded onto an acquired company's balance sheet; easily obtained funds were here to stay, the U.S. was on a path to perpetual prosperity, and international markets were roaring ahead.  In the end, we are fully aware how this once euphoric tale ended...badly.  I won't waste time addressing the house of cards the world was sitting upon, one that we are still attempting to sift through.  What I do want as a key takeaway for you clients is that recent deal activity is different than from 2005-2007, and I believe the flow is healthier for our markets.

1. Though credit markets have healed (check out the offerings from IBM and McDonald's), we aren't seeing a reckless amount of LBOs that serve to flood the debt markets with toxic paper.  Acquirers are utilizing the almost all cash transaction method first or are accessing a reasonable level of debt financing, in the hopes of expanding operations of the acquired company (this is a positive for long-term economic growth).  In 2005-2007, it was show me the special dividend or asset sell-off plan (see Gordon Gecko's business plan for Blue Star Airlines for an example from yesteryear...).
2. Premiums have been reasonable as acquirers try to be opportunistic in the face of earnings misses, future global economic unknowns, and the retrenchment in stocks.  The absence of exorbitant premiums supports healthier bids for comparable peers, instead of inflated valuations that stand to drop off a cliff should economic conditions turn sharply south.

I follow the equities markets extensively, studying economic data like a hawk, with a concentration in the retail sector.  The retail sector indeed was the de facto place to be from 2005-2007 if one was an astute trader.  The LBO rumors were flying around with ease.  Private equity wanted into retail, a sector that had generally clean balance sheets, strong cash generating characteristics, and management teams that wanted to cash in on booming equities prices.  The thought process on the part of private equity was straightforward; get in, leverage the balance sheet, earn profits from stronger operations and the tax deductibility of debt interest, and get out.  Between 2006-2007, 91 LBOs totaling $48 billion in value were announced from the retail sector.  Linens N Things was gobbled up.  Michaels Stores was removed from the public eye.  Toys R Us started it all in 2005, getting bought for $6.6 billion.

Private equity must be licking their chops following two years of watching retailers shutter underperforming stores and brands, consolidate manufacturing capacity, and invest in technology to drive efficiencies.  Retail is sitting on a boatload of cash, which is being used to buyback shares instead of reinvesting for long-term growth (this does not hold true for every retailer).  With credit markets healed somewhat, retail balance sheets robust, and private equity out of the scene for a while I fancy recent murmurs of the sector being in play are credible.  I caution investors, however, that this is not 2007.  The consumer outlook is a major consideration in any deal for a retailer, and currently it's difficult to project  revenue and earnings 3-5 years forward as tax hikes and structural labor changes, in addition to other likely outcomes, are in store.  As such, the valuations a retailer could fetch will be constrained in my view, and will not mirror the type a company such as Potash could obtain.

Three Names to Watch

American Eagle Outfitters (AEO)
* Takeover probability: medium
* Reason for: opportunistic valuation
* Reason against: teen apparel chains ebb and flow in the popularity column

As background, the stock has been a beaten down dog for much of 2010, and it has all been deserved.  The company had product misses in its spring assortments (actually holiday 2009 was infused with slow moving product), average unit retail prices are being lowered to compete with department stores and off mall operators, and too much inventory was ordered for back to school as management became euphoric with positive sales trends in the early warm months.  All in all, it has been a sad season for the American Eagle team.  Better yet, it has been a sad two years for the company, which has consistently disappointed on product and is falling behind with new store concept development and international expansion.  The stock is trading on a P/E multiple 11.2x consensus 2011 forecasts, a 26% discount to our specialty apparel coverage universe, and a 15% discount to the current S&P P/E multiple.

Let's briefly examine why a private equity shop may be circling the company:
1. Stock has been hammered.
2. Stock is at the lowest multiple in the teen apparel sector, minus Aeropostale.
3. Lots of cash.
4. No bank debt (I consider leases debt, just not bank debt).
5. Viable concepts (American Eagle Outfitters, aerie, 77 kids).
6. A management team that has not executed properly (merchandising and the fact they have been behind peers on international expansion).  I think the poor execution the past three years makes it easier for a private equity to dive in and change things up.

BJ's Wholesale Club (BJ)
* Takeover probability: high
* Reason for: steady cash flow generation
* Reason against: slow growth model

The company has the lowest debt to equity ratio in the big box retail sector.  Private could come in there and (1) leverage the balance sheet and pay themselves a dividend (assumes buyout); (2) push management to cut back on tech spending and take cash flow and do a dividend and share repo program (assumes shareholder friendly action, no buyout).  BJ's has historically driven lower returns on equity and assets compared to Costco (COST), and are well below Target (TGT) and Wal-Mart (WMT).  Most importantly is the business model of the company.  The company finances the bulk of its inventory using vendor financing and turns inventory quickly, meaning they don't have to pay suppliers quickly.  Private equity, if they buyout, could take that cash flow from selling merchandise, make investments that earn a return, and then pay suppliers.  Suppliers would get paid with that cash and PE would make a nice return.

La-Z-Boy (LZB)
* Takeover probability: high
* Reason for: lean operating structure and formidable brand name
* Reason against: furniture sales mired in sluggishness

With the stock down a whopping 55% from its March 2010 52-week high, and trading a stone's throw from book value, I believe the risk reward is very favorable for a long-term investor (aka private equity).  La-Z-Boy has done a fine job on reining in excess manufacturing capacity, re-engineering production processes, stabilizing the retail store base through improved selling techniques, and paying down debt (net cash now at $53 million).

Brian Sozzi
Wall Street Strategies