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Risk Arbitrage: Sears Holdings’ Purchase of Restoration Hardware (RSTO)

January 23, 2008 | About:
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William Pappas

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Sears Holdings (SHLD) owns 13.6% of Restoration Hardware (RSTO) and on November 23, 2007, Sears announced its interest in purchasing the remaining shares of the home furnishings retailer for $6.75 per share in cash.

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 wp@pappasmanagement.com.

About the author:

William Pappas
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Rating: 3.9/5 (21 votes)

Comments

blakeday
Blakeday - 6 years ago
Why isn't Sears continuing to purchase in the open market at today's prices? Are they not allowed to for some reason?
adamcz
Adamcz - 6 years ago
Great post. I've never made an arbitrage purchase, but I follow Sears and agree with this author's stance on the likelihood of a deal. I think I'll commit a percent or two of my portfolio to this just for fun. I had no idea RSTO's price had fallen so far. Five stars for you.
wp31
Wp31 - 6 years ago
Blakeday,

Sears signed an agreement with Restoration that it would not purchase shares in the open market. The document was filed with the SEC, I believe in December.
Dean83
Dean83 - 6 years ago
I have one current risk arbitrage play and that's BCE in Canada. The FCC cleared the aquisition by a group of investors (Ontario Teachers, Providence Equity, Merril etc). The takeout price is 42.75 and earlier this week shares where in the 34 dollar range. The deal is supposed to close in the 2nd quarter. Numerous rumors have come up over the last couple of weeks but have slowly been dismissed. Any thoughts or comments?

Thanks

spedian
Spedian - 6 years ago
I've been watching this one myself and agree the risk/reward is very attractive. My only question is how does one come up with: probability of a deal occurring at $6.75 per share is 85% and the probability of no deal is 15%?
adamcz
Adamcz - 6 years ago
There's no mathematical way to arrive at the probability - you should just use your own personal judgment. Is it almost a certainty that the deal will complete, or closer to 50/50? I personally think it's very likely, which is why I bought shares this morning.
blakeday
Blakeday - 6 years ago
Congratulations everyone who bought this morning :).
wp31
Wp31 - 6 years ago
correction to #3 above. The document states that Sears could purchase or sell more shares.
adamcz
Adamcz - 6 years ago
I'm going to wait a day or two to sell, and give Lampert a chance to respond.
blakeday
Blakeday - 6 years ago
If Sears was able to continue purchasing but did not, I would not expect Lampert to respond favorably.
delgado001
Delgado001 - 6 years ago
I HAVE ALOT FAITH IN lAMPERT HE`LL DO SOMETHING
valuemodel
Valuemodel - 6 years ago
http://biz.yahoo.com/ap/080125/restoration_hardware_mover.html?.v=1

Price has changed (down) to $4.50, see the link above.
adamcz
Adamcz - 6 years ago
I sold at the end of the day today, at $4.27. Only another 5% to go if the Catteron deal is completed, and still some chance that the deal falls apart. I waited a week to see if Sears counter-offers, but it's very unclear what their plans are at this point. Best of luck to those who wait longer.

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