Quick Pitch: LL Flooring Holdings (LL)

LL Flooring Holdings (LL) – Activism/Potential Buyout – 31% Upside

 

An intriguing potential buyout setup is unfolding in the US flooring retail sector. LL Flooring Holdings is a $140m market cap specialty retailer of hardwood, laminate, vinyl and other flooring in the US. Recently, the company’s founder and ex-CEO, Thomas Sullivan, increased his stake in LL from 4.9% to 9.4% and made a non-binding buyout offer at $5.76/share. The intention behind the offer is to merge LL with its private peer, CTG, which is also owned by Sullivan. The management of LL is currently reviewing the offer. Shortly after, a group of activists, led by prominent businessman and capital allocator Howard Jonas, has emerged with a combined stake of 5%+. The activist group is pushing LL to engage in a sale process and argues that the proposed price of $5.76 per share is a fair starting point for acquisition discussions. Howard Jonas, the founder and chairman of IDT Capital, is considered by some to be “one of the greatest capital allocators of all time”. Under his leadership IDT stock compounded at a 49% CAGR from 2011 to 2021. Jonas’ involvement here is very unusual as he doesn’t normally engage in activism campaigns around potential buyout situations. Thus, it’s an important positive element for this setup.

LL’s stock saw only a slight 16% pop on the potential buyout news, however, the spread remains wide at 31%. Apart from the non-binding nature of the proposal, the market’s skepticism primarily arises from two key factors. Firstly, there are concerns related to Sullivan’s previous buyout intentions in 2019, which have left some investors wary. Secondly, there is uncertainty surrounding whether LL’s management is currently open to selling the company. However, there are several counter-arguments to address both of these risks.

Buyout intentions in 2019
LL was previously targeted by Sullivan four years ago and the whole episode ended up with investors being left with a sour taste in their mouths. In August 2019, Sullivan also increased his stake from 1.3% to 6% and started talking about potential buyout scenario or a combination of LL with CTG. Some LL investors (6% combined stake at the time), led by Mario Rizzi, supported the founder’s intentions. However, within a month, following a 50% surge in the stock price, Sullivan abruptly withdrew and sold off a significant portion of his stake with 48% gain ($5m in dollar terms), claiming that LL was “no longer undervalued”. The share price went into a downtrend after that.

Nonetheless, it’s difficult to believe that Sullivan would actually attempt to repeat the same move again with the current proposal. As outlined by Matt Levine in his overview of LL’s buyout situation in 2019, such a trick of bidding up the share price can only be executed successfully once. The second time, not only the stock pump will not work, but legal repercussions are also bound to follow:

The first time you announce that you might take your old company private, the market will tend to take you at your word and the stock will go up; if you quickly take profits and abandon the buyout, the market will be disappointed; if you do it again no one will fall for it. Also, though, the first time you do this, regulators will tend to take you at your word: You bought stock because it was undervalued, you considered a takeover, the stock got too rich and you sold it and abandoned the takeover, just like you said. If you do it over and over again, they are going to start thinking that you’re trying to fool the market into bidding up the stock.

Furthermore, the current buyout attempt appears to be significantly different from the situation in 2019. In the previous instance, Sullivan merely mentioned the consideration of a buyout, allowing him to easily walk away without any major repercussions. However, currently Sullivan’s intentions appear much more serious. He has already specified a potential buyout price and has submitted two letters of intent to the board. The second letter, released on June 9, reaffirmed the intention to acquire LL and indicated that the buyer has engaged an investment bank and a legal advisor. The second letter also mentioned the buyer’s financial capability to proceed with the transaction despite a concerning environment. As a result, the level of commitment and potential accountability for the actions taken seems significantly higher this time.

Moreover, the current offer seems to have a much stronger opportunistic angle than the last time. Sullivan’s proposal comes just a few weeks after LL’s stock price reached its all time lows of $2.75/share in early May. The offer’s also values LL at $216m, which is substantially below the $300m and $420m EV valuation at which Sullivan bought and sold the stake in 2019. Worth noting that the company’s asset base has remained mostly unchanged while the number of stores have even slightly increased since 2019. However, part of this valuation gap is explained by weaker financial performance of LL due to the industry headwinds amidst the housing/home repair market backdrop, demand pull-forward from COVID, and certain other operational issues of the company.

Hence, it looks like the current proposal might actually be real and I would be very surprised if it turned out that Sullivan has decided to completely destroy his reputation and risk a serious backlash from the SEC only to try making a few millions on the stock pump again.

Will LL’s management agree to sell?
The rejection of the buyout by LL’s management is another, and probably the biggest, risk here. Management owns insignificant stake and is quite generously compensated. Management also had some bad history with Sullivan/CTG in 2019 (prior to the buyout intent) when the companies entered into a dispute over CTG breaking its anti-competition agreement and starting to sell flooring products before the 2020 deadline. The episode ended with a settlement. Also, LL’s response to the current proposal seemed a bit strange as an unusually large portion (more than half) of the press release was dedicated to pushy promotional language on how strong LL is and how confident management is in the company’s future prospects. Overall, the market’s skepticism regarding LL’s management incentives is also illustrated in a recent comment on Seeking Alpha, made by Rizzi Capital, the same activist that supported the buyout in 2019:

The re-brand was a disaster, more than half the stores are located in less-than-desirable industrial locations, but that fit the Lumber Liquidators marketing strategy of driving a little bit out of your way for a good deal. now with $4 gas you drive out of your way for overpriced gray floor. Seriously, 60% of the SKUs look the same.

I agree with you about company’s response. In that paragraph they scream loud and clear how clueless they are by telling investors that they are confident in their “high touch service” combined with a national brand. Yeah, a brand that nobody knows because they got rid of the logo and name that worked.

I am sure they will reject Tom’s offer and fail to provide investors with any kind of viable path forward.

However, there are several arguments to suggest that the market might be overstating the risk of offer rejection:

• Contrary to what could’ve been expected, management hasn’t rejected the offer outright and has already been reviewing it for over 3 weeks now.
• LL is facing significant operational struggles and besides the current industry headiwnds, has been consistently losing market share to its larger peers like FND. The company’s transaction volume has dropped over 30% in the last 5 years with revenue decline somewhat offset by the pricing increases. However, the earnings have seen a much stronger hit and as the temporary COVID boost subsided last year, the 2022 results soured dramatically with the bottom line flipping into losses again. This year’s Q1 results were even worse due to a spike in costs and continued decline of demand. In comparison, peer’s results have been much more stable and again significantly outperformed LL. Howard Jonas has summarized the situation as: “If anything, LL Flooring’s record of underperformance suggests that failing to sell now could threaten further value erosion for stockholders. In our view, a sale now, at this price or above, whether to the F9 Group or to an alternative bidder, would provide stockholders an attractive opportunity to obtain immediate liquidity at a fair valuation in excess of what LL Flooring, with its management as currently constituted, can be expected to achieve”.
• The current setup puts a massive pressure on the management to entertain the sale scenario and finding excuses to reject the current bid will be very difficult. The offer price comes at 2x premium to the recent lows and 64% premium to pre-announcement prices. Howard Jonas also approved the proposal price as fair, so a potential claim of the bid being “undervaluing” will simply not pass.
• The strategic rationale of merging with CTG also makes sense and basically looks like a lifesaving deal for LL. CTG is a direct peer with high geographic overlap between CTG and LL’s locations. A number of the companies’ stores are located literally next door (see here). Sullivan claims that the combined company would have significant synergies on the SG&A front, which would help the company to withstand the current operational and industry headwinds. Worth noting that substantial SG&A expense increase as % of revenues has been one of the main recent concerns for LL. Thus, it’s not like management would be able to easily brush off the combination as unattractive either.

Overall, I think that offer rejection in the current context would basically be equal to an invitation for activists to ramp up the pressure and oust the board in the next elections. Hence, I think there is a chance that sale negotiations will eventually start and it will be interesting to see how this setup will develop.