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Summary

  • Michaels Companies has seen a disappointing public offering.
  • The company is rock solid, yet private equity sponsors have saddled Michaels with debt.
  • Leverage limits are not appealing at the moment, in my opinion, however, I will keep the company on my watchlist.

Michaels Companies (NASDAQ:MIK) is the largest arts and crafts specialty retailer based on its store count in Northern America, operating a total of 1,263 stores. Last Thursday, the company witnessed a disappointing public offering.

Back in 2006, private equity firms Bain Capital and Blackstone acquired the company in a $6 billion deal. Given the very favorable conditions in both the stock and credit markets, both companies decided that now might be a good time to create an exit opportunity.

This disappointing offering might be attributed to the heavy debt load for Michaels, which is a direct consequence of the transaction in 2006. While the underlying business is solid and equity valuations are fair, the added leverage creates risks if things turn for the worse. I remain on the sidelines.

The Public Offering

Michaels is best known for its Michaels stores, inspiring customers and enabling customer creativity. It also operates also Aaron Brothers stores, which offer mostly picture framing supplies. The company carries a deep assortment of arts, crafts, scrapbooking, hobbies and seasonal offerings to satisfy a wide range of customer demands. The company furthermore has developed an online platform to share tips, ideas and marketing efforts.

Michaels sold 27.8 million shares for $17 apiece, thereby raising $473 million in gross proceeds. All shares in the offering were sold by the company with no shares being offered by selling shareholders. It can be reasonably expected that its private equity sponsors will seek to reduce their stakes in subsequent follow-on offerings.

The pricing of the offering took place right at the low end of the preliminary $17-$19 offering range. At $17 per share, equity in the business is valued at around $3.45 billion.

The underwriting syndicate for this offering consisted of JPMorgan (NYSE:JPM), Goldman Sachs (NYSE:GS), Barclays (NYSE:BCS), Deutsche Bank (NYSE:DB), Bank of America/Merrill Lynch (NYSE:BAC), Credit Suisse (NYSE:CS), Morgan Stanley (NYSE:MS) and Wells Fargo Securities (NYSE:WFC), among many others.

Valuation

Michaels operates in a growing but fragmented arts and craft industry. A CHA Attitude & Usage study reckons that the size of the market totaled $30.3 billion in 2011, excluding the important custom framing business. The industry is still very much fragmented, resulting in large opportunities for consolidation. Michaels, as a leading firm in this specific sub-segment of the retail market, should be well positioned to benefit from this.

This sector in particular is being impacted by the changes as a result of the internet. Many customers source ideas through retail websites or social media websites in order to find their creative inspiration. The website Pinterest is, for example, a huge source of creativity for many users. The company's private brands, which make up nearly half of total revenues, are a key differentiating point as well, not being available in competing stores.

For 2013, Michaels posted revenues of $4.57 billion, which is up 3.7% compared to the year before. Net earnings were up by 21.5% to $243 million at the same time.

Growth accelerated in the first quarter with sales of $1.05 billion, up 5.9% compared to the comparable period the year before. Earnings were actually down by $1 million to $45 million for the time period. The main reason for the lower earnings is the increased interest expenses. The company has grown its total store base to 1,262 over the past year, which is up 2.2% on the year before. The remainder of topline revenue growth is explained by comparable store sales growth.

Given the private-equity buyout, Michaels operates with just $115 million in cash and roughly $3.69 billion in total debt, which results in a nearly $3.6 billion net debt position. The company spent $57 million on interest payments in the first quarter, which results in an effective interest rate of 6.2% on its debt position.

The $473 million net proceeds will lower the net debt position to about $3.2 billion. These proceeds will be used to repay loans carrying a 7.5% interest rate, allowing Michaels to reduce its annual interest rate bill by some $30 million.

At $17 per share, Michaels is valued at roughly $3.5 billion. This values the equity in the business at roughly 0.8 times sales and 14-15 times annual earnings as reported for 2013.

Investment Thesis

As noted above, Michaels' public offering has been disappointing. Shares were offered at the low end of the preliminary offering range, and have traded around the $17 mark in the first days following the public offering.

I believe that Michaels is actually quite a solid business. The company is well known and has performed relatively well in recent years. This is even during difficult economic times, which have pressured discretionary spending. As a testament to the company's strength, operating margins exceeded 13% in 2013. This combined with a 15 times earning multiple creates a reasonably appealing valuation.

Yet the biggest problem is, of course, the debt load after being taken private by its two private-equity sponsors back in 2006. The high debt position is the main risk of this offering on top of the online threat, seasonality and reliance on Chinese manufacturers.

Fortunately, most of the debt will only mature between three and five years from now. Given that it is very unlikely that operating cash flows allow for the repayment of debt given the current profitability, Michaels will have to rely upon capital markets to refinance its debt ahead of that time.

The pay-off of existing debt with the IPO proceeds and potential refinancing moves should allow Michaels to save about $50 million per annum in interest payments before paying taxes. As such, earnings could be pushed forward to roughly $275 million, resulting in an earnings multiple of 12-13 times for this high quality player.

Even in such a scenario, interest expenses remain high, and debt continues to be the company's biggest enemy especially if the economy deteriorates.

I like the business and the valuation, yet the debt load is simply too high for me at the moment. I will keep the company on my watchlist to see if shares might experience a sell-off while monitoring operational progress down the road.

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

Source: Michaels Companies - Not Much Appeal For Private Equity Leveraged IPOs These Days