Current Price –$3.49
Offer Price - $4.6
Upside – 34%
Expiration Date - Q3 2017 (expected)
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.
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.