Could A Merger Be What Saks Needs?

May.28.13 | About: Saks Incorporated (SKS)

Retailer Saks (NYSE:SKS) has been stealing headlines over the past week, but it has little to do with the company's performance. In fact, its first quarter results weren't great-though bottom line results were in-line with estimates and top line consensus expectations were exceeded. On Tuesday morning, the company posted 5% year-over-year revenue growth on a 5.9% same-store sales growth for total sales of $793 million. Adjusted earnings per share were flat year-over-year at $0.19.

Even though sales growth is great to see, the company continues to recycle the excuse that 2013 will be a "transformational" year. In reality, gross margins were flat year-over-year at 44.4%, and pre-tax operating margins actually declined 120 basis points year-over-year to 7.4% when adjusted for impairment charges. While we acknowledge the company is working to launch its "Off5th" website, we still believe the company will have a difficult time materially improving profitability. Ultimately, the company is guiding to flattish earnings, which implies a forward P/E multiple of 37. Management has often promised improved operating margins, but we've yet to see results.

However, the firm has identified Goldman Sachs (NYSE:GS) to explore "strategic alternatives." We've heard this before from a number of firms, and occasionally, as the case was with former Best Ideas Newsletter holding Collective Brands, such a deal can be highly profitable for shareholders.

After this announcement hit the tape, two large ideas started circulating: the first being the possibility of a sale to a private equity firm like KKR, and the other being the idea that the company could merge with rival Neiman Marcus.

Selling to private equity immediately strikes us as an interesting idea. We think private equity firms would be more motivated to improve cash flows. Further, a privately-owned Saks could be more willing to explore creative ways of monetizing assets by extracting capital from the firm's existing real estate portfolio. We've seen figures estimate the real estate value of the flagship New York location at $1 billion-more than half of the company's current market capitalization. A new owner could also seek a more aggressive expansion of the outlet business, similar to what we've seen Nordstrom (NYSE:JWN) pursue over the past few years.

A merger with Neiman Marcus could yield some synergies by combining back-office operations and sourcing. A combined entity could be in a better position to negotiate deals with luxury brands, which in turn would essentially have a competing buyer taken out of the market. However, we're not crazy about this idea. For one, Neiman Marcus and Saks already operate in many of the same markets-if not the same street. Saks went through a "right-sizing" throughout the prior decade, so we gather that a merger would result in net-store closings.

Further, we do not believe it would make a lot of sense to combine the two brands under one umbrella. We don't think changing the brands would necessarily have a lot of blowback. Just a few years ago, Macy's (NYSE:M) acquired iconic retailer Marshall Field's, and many shoppers swore off ever shopping at Macy's before the shops were rebranded. Ultimately, these threats dissipated, and we believe Macy's has done quite well in the former Field's stores. However, Saks (or Neiman Marcus) wouldn't be entering new markets like Macy's did via Field's, so consumers might be more willing to try a competitor like Bloomingdale's or Nordstrom.

Ultimately, we think it would be more prudent for Saks to invest internally via a better omni-channel retail experience and aggressive outlet store expansion. Expanding a brick- and-mortar full-line store business seems to complicate the future of the business rather than simplify operations. On a discounted cash flow value, we're not at all attracted to Saks; in fact, we think shares are too expensive. However, the potential for higher net asset value attributable to monetizing the firm's real estate portfolio (the firm owns 60% of its full-line locations) leads us to believe that shares may ultimately be worth a number in the teens (near the high end of our fair value estimate range).

Though we aren't interested in adding the company to the portfolio of our Best Ideas Newsletter at this time, we certainly won't be opening a put position, even if shares are modestly overvalued.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.