Perhaps the philosophical gulf between "Mr. Market," and Graham-Buffett followers isn't so wide after all. Yesterday, after Jones Apparel Group Inc. (NYSE:JNY) announced it was no longer for sale, the shares wound up back where they were mid-March, just before the company retained Goldman Sachs to help it seek a suitor. Apparently, the private equity players who balked saw pretty much the same thing as did public-market participants.
When looking at Jones, both camps could easily see a company whose earnings have not been growing — Reuters pegs "normalized" diluted earnings per share from 2001 through 2005 at $2.23, $2.71, $2.48, $2.39 and $2.30, with estimates for 2006 and 2007 coming in at $2.22 and $2.49 — and which has been generating lackluster returns on capital.
On July 31st, while the while buyout was still on the table, Virginia Genereux of Merrill Lynch hit the bull's eye in a research report wherein she reiterated a view she first expressed in April to the effect that "a Jones LBO did not make much sense" and that "[t]he big uncertainty is the value of Jones' apparel brands, given recent deterioration and uncertain outlook for 'undifferentiated' wholesalers in department stores." Given consolidation among department stores, vendors such as Jones have fewer stores to sell to, as redundant locations close, and fewer but larger buyers with more bargaining power. Jones is in the department store business itself, through its purchase of luxury merchant Barney's, but that's not enough to offset the pressure being felt in its wholesale operations.
Pegging 2005 as a normal year for Jones, our quantitative buyout analysis starts with the $425.3 million in pretax income it generated that year. Assume a private owner would be willing to use much of that sum to pay interest on borrowings incurred to finance a takeover of the firm. If the rate on such debt is 8.5 percent, that would mean a buyer could afford to borrow up to $5 billion. If that's the overall price, it comes to $44 per fully-diluted share.
But even under the best of circumstances, private owners are not likely to be inclined to operate on such a skin-of-the-teeth basis.
During the old junk-bond era, there was some willingness to accept skimpy, or even negative, interest coverage on day one if buyers expected to rejuvenate the businesses such that the company could grow into its debt burdens, so to speak. So much the better if initial interest payments could be made in kind — i.e., by issuing more securities in lieu of cash — or if the balance sheet could be quickly altered by selling some assets.
Even to the extent such conditions may exist today, Jones would not appear to be the sort of firm that could qualify, given its lack of recent growth and the business challenges that suggest no quick silver-bullet solution. Instead, this likely would have to be a buyout based on the market's unwillingness to adequately value the operation as it exists today.
Before locking in on the first-pass $44-per-share tally as indicative that such a situation exists here, we'd need to build in some sort of cushion, a positive interest-coverage ratio. If we assume 1.2 times coverage — a very skimpy level — the per-share price would fall to $36.75, which would have afforded little premium to the price Jones reached after the company brought Goldman Sachs into the picture.
If we assume an interest coverage ratio of 1.5, still narrow, the per-share value falls to about $29, which is where the stock is at present and where it was before the company put itself in play.
In The Warren Buffett Way, Robert Hagstrom describes Mr. Market as being "emotionally unstable," quoting "a very high price" for a business on one day, and on other days, "a very low price." Perhaps Mr. Market isn't always perfect. But in the case of Jones, we see that he has a calculator and knows how to use it.
JNY 1-yr Chart
At the time of publication, Marc H. Gerstein did not own shares of JNY or GS. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.
Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.