Tuesday, March 21, 2006

Don't Forget about Private Equity!

This morning, Jeff Matthews’ blog has an exceptionally interesting post about private equity buyers and their influence on the stock market.

Score—Financial Buyers, Five; Strategic Buyers, Nothing

He discusses a small, unpretentious, unknown company that had put itself up for sale. A total of 105 buyers wanted the “book.” Only 15 of those were strategic buyers or buyers who were from that industry. The remainder were all financial buyers, i.e. generally private equity buyers who analyze cash flow projections, determine ways of improving cash flows and reducing costs, and determine a comfortable price that provides a decent internal rate of return. Ultimately, an exit strategy is also considered, often recycling the business back to the public via initial public offering, or simply selling to another private equity buyer.

The relevance of this to public markets should not be underestimated.

There is, in my view, an interesting confluence of factors in today’s markets that one must recognize:
  1. In recent years the combination of strong earnings and controlled capital spending has left many companies with significant cash surpluses. This leads to sub-optimal capital structures and hence sup-optimal returns on capital.

  2. Private equity capital is readily accessible and available in seemingly unlimited amounts.

  3. There is a rise in corporate activism that has not been seen to this extent since the junk bond days of the Drexel dominated dealing of the mid-80’s.

Though in aggregate, I find the overall market to be quite expensive, there remain “jewels” of value that could easily be prone to a leveraged buyout.

Michael’s Stores (MIK) is a case in point that Jeff Matthews mentions. Return on invested capital of 17.7%, and long term debt of zero. Annual capex of about $100 million with cash flow from operations $364 million for Jan 2006 FY and $428 for FY 05. EV/EBIT even at today’s price is less than 13 times.

It seems easily financeable based on the numbers. What is the competitive landscape for this company? It looks fairly benign in my opinion:

Jo-Ann Stores (JAS) has a ROIC of about 4% and long term debt of $290 million, representing 41% of capital and negative free cash flow. Capex has exceeded CFFO (which YTD have been negative) and capex is up 50% from last year’s levels.

A.C. Moore (ACMR) has a ROIC of 4.5% and almost $3.00 per share in cash with LT debt to capital of only about 11%. EV/EBIT is about 18 times. Capex has significantly exceeded CFFO in the last few years.

Just last night, I saw a tiny company with a flawed expansion model. The company as it was, in my estimation had a value that was some 30% higher than its current market value. Its value-eroding expansion plans were subtracting!

Remain cognizant of these opportunities. Don’t get mesmerized by the aggregate levels of the market. Debt financing is still pretty cheap whether Mr. Bernanke has rates at 5% or 5.25%.

The private equity guys are actively looking for places to put dough! Get there before they do.


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