3 Retail Stocks Sitting in Activists’ Crosshairs

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If you’re the CEO of a public company there’s one thing you dread more than anything: Activist investors and their quest for shareholder value. Nothing’s worse than your board receiving a letter asking it to explore strategic alternatives — code for “putting itself up for sale.”

retail stocks buyoutsLately, it seems retail stocks are facing the ire of activist investors more than other stocks.

On August 25, Engine Capital LP and Red Alder LLC, two investment firms that own more than 1% of the stock in ANN Inc. (ANN), sent a letter to its board requesting that it explore all opportunities to unlock shareholder value. A day later, Reuters reported that ANN has retained JPMorgan Chase (JPM) to do just that.

Retail stocks have experienced an extremely promotional business environment for more than a year now; in many instances, those promotions are gnawing on margins and profits. As a result, ANN isn’t the only retail stock catching the eye of activist investors. Several others are also in the hot seat.

The question is whether any of these retail stocks are worth buying in anticipation of a takeover offer from private equity or one or more strategic buyers.

Let’s weigh the odds for each of these three retail stocks:

Retail Stocks — Ann, Inc (ANN)

When it comes to buyout-target retail stocks, retail stocks buyoutsthe best bet has to be ANN for no other reason than it has already hired an investment bank. The clock is ticking; every day this process remains open hurts the company’s focus, making it even tougher to pull itself out of the hole it’s in.

So, who might buy ANN?

Golden Gate Capital is the the obvious front runner, with a 9.5% ownership stake in the company. While Golden Gate currently views its investment as passive in nature, its letter in March to ANN’s CEO, Kay Krill, left the door open for something bigger, stating that the firm is a long-term holder with a multi-year horizon.

Why is that so important? Well, ANN’s Q2 report was a major disappointment, with same-store sales declining 2.3% due to serious weakness at its Loft brand. With flat year-over-year same-store sales growth expected for the entire 2014, compared to 2.3% growth the previous year, things aren’t looking so hot.

Considering Golden Gate had been singing the praises of ANN in March — the stock had posted same-store sales growth of 6% over each of the last 16 quarters — its investment just got a lot shakier.

If anyone should step up to the plate, it will be Golden Gate because there’s no indication any other party will be willing to pony up a serious premium to buy ANN. Golden Gate paid $35.70 per share and currently sits on a 15% gain in the five months since its 13D announcement in March. That’s a good return (36% on annualized basis), but I don’t think that’s what its investors had in mind … especially when you consider most of that return has come due to speculation about ANN putting itself up for sale. Any further increase in its share price is unlikely a deal is announced.

One-third of Golden Gate’s invested capital is in retail. That focus, plus a little self-preservation, suggests it will be talking with JPMorgan.

Retail Stocks – PetSmart (PETM)

retail stocks buyoutsWhen it comes to retail stocks prime for the picking by private equity, PetSmart (PETM) has to be near the top of the list. A little more than a week ago, PetSmart announced that it had also hired JPM to explore strategic alternatives, including a possible sale.

Jana Partners, a firm known for activist investing and the owner of 9.8% of PETM stock, has been on the board’s case since July to put itself up for sale and now it could be in play. Obviously, Jana owns as much as it does because it believes PETM stock is undervalued.

So, who would buy it? Almost any large private equity firm with an interest in retail.

Although its sales growth has slowed — Q2 2014 comps were down 0.5% with overall revenue growth up a scant 1.4% — earnings are still pretty darn good. It expects to generate at least $600 million in operating cash flow in 2014, about where it was a year earlier, which should result in about $450 million in free cash flow.

Its current enterprise value is $7.34 billion based on $7.08 billion in market cap and $268 million in net debt. Assuming the buyer pays roughly a 40% premium to the August 27 closing price of $70.94, the acquisition would cost a potential suitor $10 billion. The typical private equity fund will invest 30% or so in equity with $7 billion in financing to close the deal, leaving a cushion of approximately $100 million in free cash flow after interest expense.

And that’s before anything is done to reduce costs, bump revenues, etc.

From personal experience (my wife and I have five rescue cats with one from PetSmart itself), I can see plenty of ways it can improve its business. For instance, we buy four cases of Innova (now owned by Mars) wet cat food each month for C$2.50 per 13.2-ounce tin. PetSmart charges C$3.29 per tin (30% more), so we buy it elsewhere.

However, we still buy our litter and treats there; you’d think a big box would want to match prices to gain market share and control more of our pet spend per month. A new buyer could lower the price to $2.50, and we’d instantly spend an additional $1,400 annually at PetSmart. Profit margins might be lower, but ultimately they’d be victorious based on increased revenue growth.

In many ways PetSmart is a more attractive takeover target for private equity than ANN.

Retail Stocks — Chico’s (CHS)

retail stocks buyouts

This one’s more of a long shot.

Chico’s (CHS) announced Q2 results August 27, and the numbers were anything but rosy. Same-store sales increased just 0.3% in the quarter with a 31% decline in net income. Even more troubling was the $4.4 million decrease in year-over-year sales for Boston Proper, its most recent acquisition from September 2011, when it paid $214 million for the online women’s retailer.

Although Boston Proper represents just 3.7% of Chico’s overall revenue, it’s disturbing that a business acquired in large part because it added a significant online presence to Chico’s overall business, is losing ground despite adding 10 stores since the opening of its first location in March 2013. This, more than anything, points out why Chico’s is in need of a major overhaul.

And that’s where private equity comes in for retail stocks. Let’s go back to ANN for context.

In its letter to ANN’s board, Engine Capital and Red Alder pointed out that ANN stock trades around 5.5 times EBITDA, compared to recent transactions for specialty retailers that went for eight or more times EBITDA. Recently, Leonard Green acquired Lucky Brand Jeans for $225 million in February of this year, paying about seven times EBITDA and 0.5 times revenue. CHS stock currently trades for about 7.4 times EBITDA and 0.9 times revenue.

Activist investors have pushed Chico’s to buy back stock, which it has done, reducing its share count since fiscal 2010 by 14% or 25 million shares. There’s little it can do at this point to move the stock higher. Someone like Leonard Green, who owns 1.3% of CHS stock, could be a buyer, although I doubt that it or any other private equity firm will pay a 30% premium as has been speculated in the press.

As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.


Article printed from InvestorPlace Media, https://investorplace.com/2014/08/retail-stocks-activist-investors/.

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