Since the talk of the prospective LBO of Dell, Inc. (DELL) began at the beginning of the year, the lists that I remember so fondly from 2007 (and the few years before) speculating on potential LBO targets are starting to emerge, with analysts and market watchers debating which companies are best suited to go private. Unfortunately, those lists of companies are generally populated by those who (1) have no idea how private equity works, (2) have no idea how the credit markets work and (3) are simply offering up a speculative perspective on companies that appear undervalued based upon conventional market screens. As such, I would not put much credence into these guessing games. One such example that hit the wires yesterday was a research analyst guessing on the attractiveness of Kohl's Corp. (KSS) as an LBO candidate. Let's run through the math here and see if a prospective LBO could make sense.
What is KSS, and what is the company worth?
KSS is a big box, family-oriented department store. The company sells (from the website): apparel, shoes & accessories for women, children and men, plus home products like small electrics, bedding, luggage and more. The company operates 1,146 stores across 49 states, in addition to an online business.
Based upon multiple stores visits across four states, here is my opinion on KSS:
- KSS stores are generally clean and pleasant, with a wide-array of reasonable quality brands offered.
- KSS has no edge in driving store traffic, in that most of what KSS sells can be purchased online or other stores, at comparable (or even better) prices. KSS is not a discount retailer, and not competing on price.
- KSS does not sell consumables, another limitation to store traffic.
- The KSS online business is not high marginal add. There is no reason to go to KSS over Amazon.com Inc. (AMZN). While sales (and eroding margin to move inventory) can at times capture share (I ran a check the last several days, and on certain sale items, KSS is more competitive than AMZN), broadly speaking, there is no reason to go to the KSS website as the company doesn't specialize in anything.
- The bottom line is that KSS is an overall pleasant shopping experience for apparel for families, and if you live near one, you might go there from time to time for clothes and stuff, but over time, it is hard to imagine KSS finding real relevance in the future.
KSS is currently trading at 5.41x, on an EV/EBITDA basis, against the consensus $2.744 billion of EBITDA. The company had, as of 10/27/12, $4.4 billion of debt, $550 mm of cash, and 233 mm diluted shares outstanding. As of this writing, the company has an enterprise value of $14.7 billion.
Does going private work?
Let's work under the following assumptions:
- The company is for sale at 6.5x, a multiple that is in-line with the high end of the peer group.
- Let's assume a run rate EBITDA of $2.8 billion. I am not giving them much in terms of growth expectations (as the business isn't growing, really) and am in-line with the consensus.
- At 6.5x, the enterprise is being valued at $18.2 billion.
So, let's now take KSS private as the analyst quoted yesterday suggests. To do so, let's work under the following assumptions:
- The High Yield markets remain open, bank debt (especially priority debt) is available and the credit markets are not particularly risk averse at the moment (dangerous assumption, as I continue to believe credit is available to only those who need it, but for the purposes of this exercise, let's just say that KSS could get a deal done). Let's lever KSS 5.0x in this transaction, with a cost of debt of around 5.0% (between bank debt and public market debt). As the company is already 1.56x levered, that means there is capacity to borrow another $12.4 billion or so (I am going to leave the cash out, and on the balance sheet, for inventory management and working capital purposes). Knocking out the new debt from the $18.2 acquisition price, the sponsors will need to come up with $5.8 billion of equity.
- How does the KSS financial condition look, post the new debt? Well, right now, the company does $2.8 billion of EBITDA and has $325 mm of interest expense. Adding $12.4 billion with 5.0% debt would add $620 mm of interest expense, so now, KSS has $1.9 billion of pre-tax Operating Income, and at a 30% rate, keeps $1.3 billion in net income. After $900.0 mm of capital expenditures (holding flat, could be lower, or higher, depending upon the ambitions of the sponsor), KSS would be generating $400.0 mm or so of Free Cash Flow, giving the sponsors a Free Cash Flow yield of around 6.9% (not overly attractive). Further, who knows if KSS could get the cash up to the sponsors, as being 5.0x levered is a big number, and the credit commitments (and debt financing) will have covenants and restrictions about borrowing. With a 25% hurdle rate, the unclear actual return to the sponsors and the multiple of money back (as well as the lack of runway and time to get capital out) gets pretty murky, at least for a while.
- The murkiness is especially true in light of the lack of significant ownership by current management (leading to question why management would go private, especially in light of the view that the management likely thinks of the business as undervalued now), the unclear future for the business (earnings and cash flow are stagnating, and KSS is, in my view, an unnecessary business with, at best, modest forward prospects for growth in light of the aforementioned factors) and (3) the lack of a clear exit strategy, as the sponsors will need to question the time it will take to exit a highly levered retail business that lacks relevance (and a clear path to relevance), with limited Free Cash Flow post transaction to pay down debt. Private equity wants to invest in business that will lead to a 2x multiple of money. Not sure how clearly a transaction in KSS gets you there.
The bottom line: it is pretty easy to look at companies, call them cheap, banter about the Free Cash Flow and pitch the prospects for an attractive buyout based upon qualitative measurements, the reality is that when you run even just the back of the envelop numbers, the premise becomes less clear.