Elie Rosenberg is a value investor based out of Dallas, Texas. He is the founder and editor of Value Slant.
Talbots (TLB) is a struggling specialty retailer of women’s apparel that has become an interesting risk arbitrage situation.
The stock closed at $1.56 on Tuesday. After the close the company revealed that 9.9% holder Sycamore Partners had made an unsolicited bid of $3 a share in cash for the entire company. The stock has since traded between $2.39 and $2.80. As the stock has been trading well under $3 it appears the market thinks that either TLB won’t sell or Sycamore won’t be able to complete the deal.
Background
TLB was taken public in 1993 at $9.75 a share and hit over $50 in the 2000 stock market bubble. It traded between $20 and $40 between 2001 and 2007. Growth began slowing in 2007 and to maintain a growth trajectory the company decided to redirect the brand towards a younger look as well as diversify beyond their core women 50 and up demographic. The company brought in Trudy Sullivan from Liz Claiborne as CEO to execute the new strategy. Then the recession hit and same store sales plummeted double digits in both 08 and 09. This forced the company to close the men’s, children’s, and international businesses and sell off the J. Jill brand. 08 and 09 were rough years given the economic climate for specialty retail and the brand restructurings and saw $-98.4 million and $-8.7 million in EBIT respectively. In 2010 TLB merged with a SPAC to get a cash infusion of $350 million, which they used to pay down debt and buy out a majority shareholder. Performance in 2010 was still poor despite the improved economy. SSS still fell 3.4% off of extremely weak 09 comps.
2011 has been disastrous, with same store sales comps down 7.3% through three quarters. Gross margins have fallen off a cliff to almost 09 levels as merchandise has been discounted. EBIT for the first three quarters is $-49 million. TLB is also running into liquidity issues. They put in $40 million of payables financing in Q3 and have expanded the use of their $200 million revolver YoY from $68.7 million to $124 .9 million. Q3 results were released on December 1st with warnings that holiday season results were going to be poor as well. On December 5th the company announced that they are searching for a new CEO and current CEO Sullivan will be “retiring” once a successor is appointed.
On August 1, Sycamore Partners filed a 13D revealing that they had acquired a 9.9% stake in Talbots at a $2.97 per share cost basis. The next day Talbots instituted a poison pill and hired Perella Weinberg to serve as financial advisor to the company. On Tuesday, Sycamore sent its letter with the cash offer to the company. Talbots responded that it will review the proposal with its advisors Dewey & LeBoeuf and Perella.
Who is Sycamore Partners?
Sycamore Partners is a private equity firm headed by former Golden Gate Capital executives Stefan Kaluzny and Peter Morrow. Kaluzny and Morrow left Golden Gate in January to set up Sycamore. Kaluzny specializes in buyouts of struggling retail brands, having worked at Golden Gate on the Express, Eddie Bauer, Zales, and J. Jill buyouts among others. Notably, J. Jill was bought from Talbots in 2009 so Kaluzny was very familiar with the Talbots prior to this engagement. Media reports have said Sycamore raised $300 million in an initial fund and is looking for $750 million to $1 billion in capital.
Sycamore’s first deal, which closed in November, saw them buy a 51% stake in Mast Global Partners from Limited Brands for an estimated $150 million. Mast Global is a third party apparel sourcing firm. A Deal Pipelinearticle quoted a source as saying that the deal was driven by Sycamore’s desire to use Mast Global as a sourcing partner for future apparel acquisitions, i.e. Talbots. In his letter to TLB, Kaluzny notes a partnership with Mast Global as one source of value that Sycamore could bring to Talbots.
Given this background it is obvious that Sycamore is looking to do more than just protect their current $20 million investment in Talbots. Sycamore appears highly motivated to take over Talbots given the time and money already invested and their view as expressed in their letter that Talbots still has much potential value and this sort of turnaround is something that plays to their skill set. Perhaps more importantly, a good deal of their reputation is at stake. Their fund has just launched and they want this now very public bid to work out.
How Much Can Sycamore Pay?
What might Sycamore be willing to pay for Talbots? We have the $3 offer on the table as a starting point, and Sycamore has said they will be willing to bump their offer upon due diligence – “If the Board were to provide us with access to information, we could potentially get to a position where we would consider increasing our offer for the Company.” The strategy involved in turning around specialty retailers is not complicated- get the merchandising right, improve margins through sourcing well, rationalize real estate expense and SG&A- but executing the strategy often is. Sycamore has a track record of these turnarounds and clearly they think they can get Talbots to respectable profitability.
Sycamore will probably need to do an asset backed lending arrangement given the current state of Talbots, which means they will probably not be able to put on as much leverage as they would like. Talbots has $161 million in receivables and $209 million in inventories. At 90% against the A/R (or they might do an outright sale of the portfolio) and 50% against the inventory, Talbots could put on $250 million in debt. (Another option they may pursue to reduce the equity contribution is a sale/leaseback of the company’s large headquarters and distribution center.)
Talbots is currently doing about $1.2 billion in revenue. 7% EBIT margins by 2014 seems like a very reasonable target given comps like Chico do 9-10% and in its heyday TLB averaged around 10%. (TLB management in their ill fated turnaround proposal from 2010 were targeting 12% EBIT margins by 2013.) Add $55 million in run rate depreciation and that would be a conservative target of $139 million in EBITDA. Comps like CHS and ANN are currently trading at about 5X EBITDA, a depressed multiple for specialty retailers reflecting macro concerns, but let’s go with that as the exit multiple. That would put a $695 million enterprise value on TLB upon a theoretical Sycamore exit in three years.
Here is a table of the potential buyout offers per share and Sycamore IRR at different levels of Sycamore equity contribution with the above assumptions about the financing and exit value:
Sycamore could put in 40% equity and still get a great return even assuming a moderate EBIT margin and EBITDA exit multiple. I think it is very reasonable that Sycamore would consider paying up to $4 a share to close the deal.
What about Talbots?
Will Talbots play ball? On one hand, the company being in such bad shape increases the downside risk if no deal goes through, but on the other hand I think it greatly increases the odds a deal gets done. Talbots currently has no head merchandiser (he was fired a few months ago), and effectively no CEO. The operating results are terrible and the company is running out of liquidity. It will take a few months to find a CEO, another few months to get his or her team in place and map out a strategy, and then another six months before merchandise reflecting the new approach hits stores. So Talbots is looking at over a year before the effects of a new approach kick in. Talbots no longer has the luxury of time if they wish to preserve some value for shareholders. The board could kick around some numbers and draw up yet another turnaround plan that shows how the stock could be worth $15 dollars in a few years. But Talbots has had its chance to execute the turnaround since 2007 and has failed. It seems very strained to argue that the remaining value in hand from a buyout should be risked for yet another turnaround attempt with a board that failed in its oversight of management in the last go around.
I don’t think management will protest a buyout. The CEO is already leaving and will get the same severance with a change of control. The other management will also get paid well on a change of control, and in any event they probably would end up getting fired when the new CEO comes on.
Perella Weinberg will certainly support a buyout because a deal equals big fees, and what’s even better is that in this case a deal actually does make sense from the standpoint of fiduciary duty to shareholders!
The only group on the TLB side that might have a hard time are shareholders who have accumulated at prices well north of $5 and will have a hard time locking in a loss. On the other hand, 25% of the shares have turned over in the last two days and there will probably be many large shareholders agitating for a sale.
Scenarios
I think the most likely scenario is that the board on the advice of Perella decides to negotiate with Sycamore, shops the company (I don’t think there will be any other takers), and a deal gets done with Sycamore in the $3.50-$4 range. If the board really wants to keep their posts and stiffs Sycamore I don’t think Sycamore will go away that easily with their reputation and investment on the line. I would not be surprised if Sycamore at that point goes hostile and brings the deal to shareholders. If Sycamore does back out because they find something amiss in their due diligence or for some other reason, then the stock might fall back to $1.60 where it was before the Sycamore offer. Given how carefully Sycamore has planned this out and Kaluzny’s familiarity with TLB it seems highly unlikely they back out willingly.
I have bought TLB shares in the low $2.60 range. From there you get a 15% return even at the $3 buyout offer. You then have potentially 50% upside with a bump in the Sycamore offer. You have to be comfortable with the potential downside under $2 if no deal gets done, but I think that is a low odds scenario. The stock has run up a bit to over $2.70, but is probably still attractive at that level.
Disclosure: I own shares of TLB.
