Destination Maternity (DEST) – Merger Arbitrage – 34% upside

Current Price –$3.49

Offer Price - $4.6

Upside – 34%

Expiration Date - Q3 2017 (expected)

Destination Maternity is due to merge with french Orchestra Premaman (KAZI) and the spread is 34%. The main official rationale for the merger is revenue synergies as both companies are selling complimentary products in different geographies.

Merger document

This is a merger arbitrage idea suggested by one of the members – thank you Vladimir. I do not have any position in this trade at the moment, but thought it might be interesting to some of the readers.

Background

Destination Maternity is due to merge with french Orchestra Premaman (KAZI). The main official rationale for the merger is revenue synergies as both companies are selling complimentary products in different geographies – maternity/nursing wear for DEST and childcare and clothing products for KAZI – so cross-selling opportunities might be large. Usually revenue synergies a very hard to achieve, so I am quite skeptical it will happen in this case. I am tempted to think that the actual reason for the merger is simply for KAZI to enter the whole of US market in one go through Maternity Destination’s 1,220 locations across the nation. For further info on merger rationale and expected prospects please this presentation and this conference call.

Merger will be structured as an all stock transaction and each share of DEST will be converted into 0.515 shares of KAZI. Current spread (using 0.92 EUR/USD exchange rate) stands at 34%. Merger is expected to be completed by Q3 2017. There are a few reasons for this spread to exist:

- No possibilities to hedge by shorting KAZI as there is no available borrow (at least on IB). So this trade only works out if the spread is closed by DEST shares moving upwards rather than KAZI shares moving downwards. This is especially concerning keeping in mind that KAZI share price declined by 36% since the merger agreement.

- Merger still needs to be approved by shareholders of both companies. KAZI approval should not be an issue as controlling shareholder owns 68% of the shares. Outcome of DEST shareholder vote is more uncertain.

- KAZI is listed on Paris stock exchange. One of the conditions of the merger is for KAZI to obtain US ADS listing, so that existing DEST shareholders would receive KAZI shares listed in US rather than on European exchange. This US listing is still pending.

Why merger is likely to close?

The main reason why I expect this merger to close is KAZI determination to acquire DEST. The saga started in Oct 2015 when KAZI issued a non-binding proposal to acquire DEST at 45% premium (also mostly all-stock transaction with only $25m in cash). DEST board declined the offer. Then in Dec KAZI filed 13D indicating 13% position and reiterated the request to start merger discussions. The proposal was again rejected by the board. Then in Feb 2016 KAZI increased the cash portion of the deal to $37.5m (equivalent to $2.67 per DEST share). This led to the start of discussions between the companies and confidentiality agreement was signed in Mar 2016. Discussions took quite a while and culminated in Dec 2016 with the current merger agreement. The announced deal terms were far inferior to anything reported till then - cash portion of the deal was gone and the premium of only 5% remained – DEST management still announced 34% premium to ‘unaffected’ price by using 52-week-low for ‘unaffected’ price. The only positive was that KAZI agreed to ADS listing in US. This caused sharp (-25%) drop in DEST share price following the announcement.

The deal terms were likely changed as DEST operations deteriorated significantly in the meantime. Same store sales declines are accelerating (-2.7% in Q2, -5.2% in Q3 and -7.8% in Q4) mostly caused by mall based locations and declining mall traffic. The turnaround plan so far seems to be lagging behind and unprofitable store closures do not seem to be happening fast enough. The company is still generating small positive operating cashflow (negative after capex), however that is unlikely to last if the current trends continue. KAZI in turn is performing better and still expanding its operations, albeit almost all the growth comes from increased store count and floor space.

Thus, DEST board had a weak negotiating hand. If the board agreed to far inferior deal terms compared to the ones rejected before, I am guessing this merger proposal is the lifeline for DEST without which the company would continue to struggle (management will also get large bonuses with change of control clause). If DEST shareholders view it the same way and if current spread prevails, then securing DEST shareholder approval of the deal should not be an issue.

What is the combined company worth?

Without possibilities to hedge by shorting KAZI, this bet on merger arbitrage is essentially a bet that the combined company is worth more per share than the current DEST share price. Combined company will do $1.1bn in sales, $76m in adjusted EBITDA and will have debt of c. $270m. DEST shareholders will own 28% of the merged company. At current DEST share price the combined company trades at P/S=0.4 and EV/ad.EBITDA=7. The P/S multiple is quite low and compares to P/S of 0.6x-0.7x for clothing retailers like GAP and Urban Outfitters (worth noting that a more struggling ANF trades at P/S=0.2). Keeping in mind niche target market (maternity and baby clothing), high growth of Orchestra revenues and optionality for Orchestra to have fast-track in entering US market, a reasonable argument could be made that DEST/KAZI should deserve higher multiple relative to larger peers. All eventually depends on what profitability levels the combined company will be able to achieve as on EV/EBITDA metric the company is already trading in line with larger US peers.

So I do not find that the current DEST share price obviously undervalues the combined company. With no possibilities to hedge, that is the main reason I am skipping on this seemingly juicy M&A spread.

33 COMMENTS

    1. dt

      If the combined company sales multiple would drop to 0.2, then i would definetely be interested.

  1. FM

    How will fluctuations in exchange rates affect the deal terms? Say, if the Euro appreciates significantly over the next quarter.

    1. dt

      If euro appreciates, then for every share of DEST, you would be getting more value in USD terms. So eur appreciation would be favourable for DEST holders.

  2. over2u

    In my opinion, merger is very likely also given that “either the Company or Orchestra may be required to pay the other party a termination fee of $5.0 million” and it is a lot of money for such small cap companies.
    Sucess of the merger will hugely depend on the ability of KAZI to return DEST EBITDA margin to at least 4-6% level (historical level was in the range of 8-10%). So I guess without the ability to hedge, the opportunity looks like the value stock investment rather than pure Special situation.

  3. greg lia

    Sold Friday at the close, nice two week gain. Still 20% upside remaining by my calculations, but KAZI setting new 52 week low every day. I’d like to see it stabilize before taking new position. Impressive day yesterday for DEST in spite of KAZI, deal perhaps gaining wider exposure.

  4. greg lia

    Follow up to my post from Friday. I exited Friday at 3.68 after taking a position at 3.41. Orchesta had closed for the day at 8.00. Today Orchesta made a major move up from 7.94 to 9.00 on tremendous volume, a gain of 13%. The stock was at 9 when US opened for trade and for the first hour or so DEST traded as though there were no derivative relationship with Orchesta. Despite Orchesta being 13% higher than where it was Friday, I was able to take a position at 3.65 three cents less that my previous exit. Dest did end up showing some strength after the first hour and gained 4.72% for the day, but did not match the Orchesta percentage gain. Anyone else following this know of any news that would have driven the stock up 13 percent on such strong volume? I could not find anything. I peg the current value right at 5.00, which suggests 35% upside from current Dest price, but concerning that such a wide spread still exists.

  5. greg lia

    Finally found this press release from yesterday which likely is the reason for the 257K volume and 13% price move up

    Montpellier, 9 May 2017
    New international partnership agreement signed with AL-OTHAIM
    Group
    The Orchestra-Prémaman Group announces the signing of an international partnership
    agreement with AL-OTHAIM Group, one of the main companies in the Kingdom of Saudi
    Arabia, which is involved primarily in commercial activities (hypermarkets,
    supermarkets, fashion stores) and real estate: a franchise and merchandise
    procurement agreement aimed at developing a network of multi-format stores in Saudi
    Arabia.
    The 10-year development objectives aim to develop a network of some thirty stores,
    with half being textile stores and half mixed stores/megastores, (including 4 textile
    stores under the Orchestra brand which will be purchased from the current operator),
    enabling this new partner to generate potential revenue of around €60 million.
    This transaction falls under the Group’s stated goal of prioritising development of its

  6. greg lia

    Orchestra up another 25% at the moment following yesterdays’s 13% move up. If it holds will see if DEST is slow to react as it was yesterday for the first hour

    1. dt

      Interesting trading indeed. I still struggle to understand how this contract with Saudi entity is in any way accretive to KAZI as there are limited number of details provided. The mere fact that at some point (its a ten year plan) the partner will be able to generate EUR60m of revenues from KAZI merchandise does not really warrant much of the incremental value. KAZI will simply be generating royalty fees and some profits from the merchandise procurement (part of which will simply be a transfer from the current operator rather that new revenue streams) and all of that still in distant future. Majority of the market move can probably be attributed to low liquidity of the stock.

  7. greg lia

    Dest up 15% over last two sessions with no corresponding move in kazi price or volume. Still 40% upside based on current Kazi price. of $10.29. Not sure if recent move related to possible news of listing in US or just traders stumbling upon an opportunity with 50% upside potential over a few months.

  8. greg lia

    Yet another up day for DEST with a 5% gain. I exited my position today at 4.46 after getting back in at 3.65 two weeks ago. Still 30% upside remaining based on current KAZI price, however KAZI volume down at a 1000 shares a day is concerning. After a 3 day move from 3.68 to 4.45, I will be on the sidelines looking for an opportunity should the spread widen during the trading day.

    1. dt

      Greg, congrats on a good trade with this one. There was an SA article that highlighted the same large spread, but argued that the spread is more likely to close by DEST appreciating towards KAZI than visa-versa. I did not find any of the valuation arguments very convincing. Author is using expected synergies to come up with 5.4x EBITDA multiple (vs. 7x in my analysis), suggests that KAZI is a success story due to revenue growth (all of it driven by unit growth rather than same store sales) and also seems to be mixing up eur and usd in the EV/EBITDA calculation (I arrive at 6xEBITDA using his figures).

      Not saying his valuation estimates a wrong (except for usd/eur mix-up) – valuing unprofitable apparel retailers is quite hard these days.

      In any case, 35% return over a month is great and that is all that really matters.

  9. greg lia

    Moved back into DEST a few days ago given the recent strength of KAZI and not much price reaction on the part of DEST. KAZI up another 5-6 percent as we speak. Granted earnings from DEST yesterday were not stellar, but nothing to suggest a rethink of the merger. I calculate based on today prices and exchange rates a merger adjusted DEST price of $6.60. A current DEST price of $4.79 suggests 37% upside. Both companies have come out in last week and stated merger is on track, see June 2 press release for details. Lastly, deal expected close by end of q3 is DEST fiscal q3 which is end of November.

  10. Freedomist

    02:49 PM EDT, 06/30/2017 (MT Newswires) — Destination Maternity’s (DEST) merger partner Orchestra-Premaman slumped into a loss in the last fiscal year, weighed by rising provisions for its various operations.

    The childcare products specialist posted a net loss of 33.6 million euros in the 2016/17 fiscal year to June 30, compared with a net profit of 17.7 million euros, even though revenues improved nearly nine percent to 608 million euros.

    The company said net provisions increased from 31.9 million euros in the previous year to 48.4 million euros, driven partly by depreciation and amortization on investments, restructuring of its headquarters in Belgium, closure of stores in China and Turkey and the reorganization in Saudi Arabia.

    The companies announced their merger in December last year, with Destination shareholders receiving 0.5150 of an Orchestra-Premaman share. Destination said this month that the process was on track and expected the deal to close in FQ3.

    Destination shares fell 31% on Friday.

  11. over2u

    While the market reaction was brutal to the news, it seems that most of items were accounting in nature or related to transaction with DEST. The only worring sign is a sharp increase of operating expenses related to aggresive rollover of owned stores, which hopefully will be catched up by the revenue growth. All the rest items related to restructuring.

    1. Makarid

      Indeed, i found it very strange that the stock lost 25% of its value because of that. They want to shift their business to larger mega-stores and this has of-course caused higher than normal expense levels. I am considering buying DEST here – qne thing i didn’t like so much is that the inventory amount is getting bigger.

  12. Freedomist

    DT, do you think it’s undervalued and worth buying now? What do you think about the situation now?

    1. dt

      I did not have the position before (which retrospectively looking would have been a very nice ST trade) and I do not have a position now – mainly because there were no possibilities to hedge by shorting KAZI.

      With the drop in Orchestra share price, the spread has narrowed to 8% instead of 34% at the time of the write-up, so clearly I do not find this attractive now from the special situation perspective.

      I do not have a strong opinion whether the sharp drop in the share price of Orchestra is warranted, as I have not looked deeper into it and there is quite limited info in English to fully grasp the situation. From op cash flow perspective performance seems to be quite in line with last year (especially if one time items are added back), so large losses are mostly driven by accounting only entries + one-time items related to merger with DEST. The company is selling at c. 0.4x-0.6x revenue (depending on how much cash one deducts from EV calculation), which some might consider cheap for a growing apparel retailer. However, this growth comes only from store expansion – store space increased by 12.7% whereas revenues have grown by only 8.7%. Same store sales are not reported, so it is hard to judge what is the trend here, but at least for now it seems that company is investing in unprofitable growth with the hope that situation will improve some time in the future.

      1. over2u

        Sorry, didn’t really understand why spread has narrowed? 1 DEST share will be converted to 0.515 KAZI share, that based on the current spot gives us:
        EUR6.68* 0.515 * FX1.1423 = US 3.93 vs current DEST spot 3.2 (c. 23% premium)

        1. dt

          My mistake – skipped Eur conversion in my calculation above. Spread is at 20%+, which is still lower than at the time of initial write-up.

  13. over2u

    Destination Maternity (NASDAQ: DEST) and Orchestra-Prémaman S.A. (ENXTPA: KAZI) today announced that the merger agreement, entered into by the parties on December 19, 2016, has been terminated.

    Despite substantial and sustained efforts by both parties since execution of the merger agreement in December 2016, and in light of the challenges of satisfying applicable securities regulations in France and in the U.S. as well as the uncertainty as to whether those regulatory requirements could be satisfied without unreasonable effort and expense, particularly in connection with the completion of the registration and listing of Orchestra securities in the U.S., where such securities previously have not been publicly traded, the parties determined that it was in the best interests of their respective stockholders to terminate the merger transaction. Orchestra has agreed to reimburse Destination Maternity and Destination Maternity has agreed to reimburse Orchestra for certain costs incurred by each of them, respectively, in connection with their effort to implement the merger agreement.

    1. dt

      DEST now seems to be priced for bankruptcy even-though my understanding is that bankruptcy is still a remote possibility.
      - Currently DEST trades at 0.15xRevenue, which is low even for distressed apparel retailers. DEST is not in distress yet.
      - Same store sales are negative, but management is closing down unprofitable locations and SG&A is decline almost in line with revenues.
      - Sales are being hit hard by the wind down of Sears and Kohl’s relations. So with these locations closed down, going forward sales trends might stabilize, unless the brand concept is completely dead.
      - Operating lease and debt repayment schedule seems to be manageable (see page 45 of 10-K) and company is using cash generated by leaseback transactions to deleverage. Almost half of the leases expire over the next two years, which will give optionality to close down unprofitable stores without breaking the lease agreements.
      - There still seems to be $15m liquidity available under the Credit Facility agreement.

      I am speculating that Friday’s -41% share price move was market overreaction and result of arbitrageurs unwinding their positions. So this might be good entry opportunity for short term trade (I intend to open a small position).

      However, the real reasons of why the merger was cancelled are still not known (PR release was full of fluff). It is quite likely that DEST operations continued to deteriorate (maybe even more so) during Q2 and that KAZI decided to skip on the transaction because of that. Judging by price reaction KAZI’s shareholders also believe that merger cancellation was a smart move.

      It is also not yet clear what kind of strategy will management pursue now that the merger is off the table. My guess that strategic review will be announced during Q2 earnings release.

  14. Andrew Davis

    DEST took another hammering today. At these levels ($1.40), I’d be interested in hearing your thoughts re valuation i.e. Do you think this sell off has created a buying opportunity?

    1. dt

      I currently have a small speculative position (at $1.5) – do not have much to add besides what I have already written in the Jul 31′st comment above. I might be trying to catch a falling knife here, but in my opinion DEST is not facing bankruptcy yet and it is priced as if the bankruptcy is imminent. It is definitely possible that bankruptcy will come eventually, but before that I would expect some sort of strategic review to be announced. It would be strange if management would simply let the business run to the ground without doing anything.

      Despite declining sales and store closures over the last year company managed to produce positive FCF and reduce debt balance. Sears store closure might continue to weight heavily on the results in the coming quarters, so I do not expect miraculous business recovery shortly.

      So far 2.3m shares changed hands after the merger cancellation was announced and volumes are still much (10x) higher than before. So I am guessing there is still a lot of selling pressure and share price might not reflect the true realities of the company.

      My thoughts only and would suggest to do your own due diligence before investing. This is definitely a speculative ST trade with relatively low conviction, and the outcome depends on the actions management will announce or not.

    1. dt

      A few positives:
      - Sales decline has somewhat stabilized;
      - Company continues to generate cash and pay down debt;
      - There seems to be sufficient excess liquidity in the business.

      I would not consider CEO resignation such a negative as perceived by the market. Since his appointment in 2014 DEST performance has been a disappointment – stock declined from $20 to $1 now. Recent merger failure was probably the last straw that pushed BoD to make the change. While having DEST in multiyear turnaround without permanent CEO is not ideal, I do not see how it could be worse than Tony’s performance over the last three years.

  15. Freedomist

    What’s happening with DEST? Seems like there’s a big positive news.

    1. dt

      Over the last month there has been an intense and quite ugly proxy fight between DEST and Orchestra (owner of 13% and previous acquirer). Orchestra was willing to stop reelection of all 4 directors without nominating any new directors and Destination was accusing Orchestra of acting in self interest rather than in the best interest of all DEST shareholders. There were also accusation of Orchestra ‘blackmailing’ DEST in taking on Orchestra’s products in it’s US stores. Overall it seems that the merger negotiations did not end on a friendly note and there is still no indication why the merger was cancelled and which party was responsible for the cancellation. In general it seems that Orchestra is still interested in DEST (or at least parts of it) and this might be the key driver behind the run-up in share price.

      On the 16th of Oct company also issued operational update, which only talked about accelerating e-commerce sales and expected run-rate savings. No hard numbers were shared. Since this update stock is up by 75%, but I do not think there was anything substantial in it to warrant such price move.
      https://www.sec.gov/Archives/edgar/data/896985/000119312517310921/d430165ddefa14a.htm

      Proxy culminated in re-election of all four directors.
      https://www.sec.gov/Archives/edgar/data/896985/000119312517315767/d477916d8k.htm

      I am up 100% on my DEST position established after the merger cancellation and will be looking to closing it out.

      For further details see the below full chronological exchange of proxy letters from both parties:
      https://www.sec.gov/Archives/edgar/data/896985/000119312517303520/d466668ddefa14a.htm
      https://www.sec.gov/Archives/edgar/data/896985/000101359417000730/dmc-defc-101017.htm
      https://www.sec.gov/Archives/edgar/data/896985/000101359417000733/dmcdfan14a-101217.htm
      https://www.sec.gov/Archives/edgar/data/896985/000119312517309708/d391482ddefa14a.htm
      https://www.sec.gov/Archives/edgar/data/896985/000101359417000739/dmcdfan14a-101617.htm
      https://www.sec.gov/Archives/edgar/data/896985/000119312517310921/d430165ddefa14a.htm
      https://www.sec.gov/Archives/edgar/data/896985/000101359417000742/dmcdfan14a-101717.htm

  16. dt

    I have closed out my DEST position. The technical sell-off after the failed merger made DEST very cheap even for a struggling retailer. Bankruptcy was clearly not on the table and the company was priced as if the bankruptcy is imminent. After I initiated the position the shares continued to slide down reaching the low of $1 (compared to my entry at $1.5).

    With share price move over the last week my return is at 90% over the period of 3 months.

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