In June, Eddie Lampert, Chairman of Sears, was ruminating a possible buyout of Restoration Hardware and sought to speak to Gary Friedman, Restoration’s Chairman, President, and CEO. However, due to busy schedules, they did not meet until early October. At that meeting, Sears made no offer, even unofficial.
When Lampert and Friedman spoke again in late October, Friedman surprised Lampert by informing him that Restoration was considering a management buyout. Lampert then, on behalf of Sears, swiftly made an offer of $4.00 per share, a 39% premium to the most recent closing price at the time of $2.87. Despite the hefty premium, the offer was rebuffed by Restoration’s management as too low.
Then, on November 8 th, the private equity firm Catterton Partners, which apparently had been looking at Restoration behind the scenes for at least a few months, made an official bid of $6.70 per share for the company. Friedman was going to participate as an investor in this proposed transaction as part of a management buyout.
To counter Catterton, Sears fought back by buying more shares of Restoration, at an average price of $6.45 per share, and in late November announced its buyout interest at $6.75, contingent on conducting its own due diligence. Shares of the tiny retailer subsequently sold at around $6.75.
However, in the last two weeks the share price of Restoration has collapsed to just under $4.00, due to speculation that the Sears buyout would not go through, primarily because Restoration reported disappointing quarterly results over the important holiday season.
Such a large difference between the proposed buyout price and the market price of the shares has created an opportunity. To see why, the questions that the investor needs to answer are: 1) the likelihood of the buyout; 2) the length of time to complete the transaction; 3) the buyout price.
To address the likelihood, it is important to understand that Sears is in a tight position as a retailer. It is caught between the efficient discount retailers like Wal-Mart and Target on the low-end, and the likes of Kohl’s and JC Penney on the higher-end. A strategy that involves targeting the lower versus the higher end has a higher probability of failure because it would be very difficult, if not impossible, to replicate the low-cost position of the discounters. One of the ingredients of a successful higher-end strategy would involve differentiating its product line, moving into higher quality products with recognized brands, especially proprietary ones. Having Restoration’s product line would help considerably in this regard as it is an upscale retailer of home furnishings. Sears could implement a “store within a store” concept and either keep or shut down the existing Restoration stores. Although Sears does not break down its gross margins by specific product line, it is almost certain that Restoration has higher gross margins than Sears’s for comparable merchandise. What’s more, Sears could leverage the higher gross margins through its more efficient operating cost structure. At an enterprise value of $335 million and net revenues of $670 million, Sears would be paying $0.50 for every $1.00 of Restoration’s sales, which is not expensive, especially for full control of the company. And consequentially, Sears would upgrade its image and increase its chances of appealing to the younger consumers it seeks to attract.
It seems logical that Sears would be interested in pursuing this acquisition, but if by some chance it does not, there was the Catterton Partners’ bid of $6.70 a couple of months ago that may still have interest. Although financing conditions have since become more difficult, this would hardly be a large purchase to swallow. In essence, the Catterton bid could provide a protective backstop for the investor.
Given how far the market has sold off since Sears proposed its latest offer, it also makes sense to wonder whether Sears would try and negotiate a lower price with management. This scenario, however, does not seem too likely because of the fear that Catterton, or somebody else, would swoop up the company instead. Does Sears, sporting a $13.7 billion market cap, want to risk losing a potentially important strategic acquisition to save perhaps an extra $35 million or 0.0025 of its market cap? The odds are against this.
In terms of the timing of a potential deal, it makes sense that the small nature of the target would imply that it would not take long to complete the deal. A conservative estimate would be between six months and one year, but would more likely take between three and six months. Either way, the consummation would not take long.
Now for some numbers. Although there is no definitive right answer, a reasonable conclusion can be drawn as to the attractiveness of the opportunity by estimating probabilities of a deal occurring or not and a corresponding stock price in either scenario. If the probability of a deal occurring at $6.75 per share is 85% and the probability of no deal is 15%, in which case the stock would probably fall to below the price it had before the bids, say 15% below, so $2.45 per share, then the mathematical expectation for the current stock price should be: $6.75 * (85%) + $2.45 * (15%) = $6.10 per share.
Restoration’s stock price is currently $3.86 which implies an expected return of 58.0% if the deal closes in one year. If it takes six months, the expected annualized rate of return would be double that, or 116%.
If there were twenty equally good risk arbitrage opportunities similar to this, a portfolio constructed with 5% in each situation would most likely lead to very satisfactory returns. Unfortunately, such circumstances, to absorb the random misses, do not exist. Nonetheless, the odds seem very much in favor of making a decent profit on this risk arbitrage situation.
William Pappas is Managing Partner of Pappas Management LLC, the investment manager for Pappas Investments, and can be reached at [email protected]