Fredrick's of Hollywood and Movie Start Inc.: Reverse Merger Mania

Dec.26.07 | About: Frederick's of (FOH)

It is merger time! My favorite micro-cap reverse merger is going to happen in just one month. Movie Star Inc. (NYSE:MSI) [$1.63 0.00%, market cap: $25.6M] will buy the larger, private Fredrick’s of Hollywood. I previously wrote about this transaction back in August when MSI’s stock price was around $2.20 per share. It currently trades at $1.60.

After everything is done, the combined company will have no net debt (or net cash), $215 million in annual sales, and 55.75 diluted shares outstanding (including conversion of preferred stock). Given the current price of $1.60, the implied diluted market cap is $89 million. There is a rights offering in mid-January that will raise $20 million. This offering is priced at $1.76 (only shareholders as of late November can participate). At that price, the implied diluted market cap of MSI/Fredrick’s is $98 million.

Given the combined company’s proforma price to sales ratio of .41, it seems a bit cheap. For comparison, Limited (LTD) [$19.04 0.00%, market cap: $7.621B] is priced at .65. However, considering that $64 million (30%) of the combined company’s sales will come from the low-margin manufacturing / distribution business of MSI, the company seems to be price about right (subtracting out the sales of MSI, the P/S ratio rises to .6).

In terms of earnings, I come up with estimated proforma earnings for the year ended last June for the combined company of $2.8 million. I do not include the preferred stock dividend because I assume conversion to common stock (this will not happen, but I must avoid double counting the cost of that preferred stock and I count it as diluted common stock). I also take out all direct merger-related costs, and do not include interest expense (most of the debt will be paid off, and there will be $20 million in cash on the balance sheet when the merger goes through).

This gives a proforma P/E of 32. However, it is likely that there will be some significant cost savings of the merger. Assuming that SG&A is cut by just 5% (a modest assumption), I come up with proforma earnings of $5.5 million and a proforma P/E of 16.2. This is a reasonable multiple, especially considering the growth the company should see.

Here are the drivers of growth in sales:

  • 50 anticipated new Fredrick’s stores over the next three years will increase the number of stores by 38%.
  • Organic growth in same store sales and online/catalog sales will be about 8% per year as old stores are remodeled, Fredrick’s brand regains some cachet, and concentration of stores increases as the store total increases. Fredrick’s only averages about $400 in annual sales per square foot. This should increase to at least $500. For comparison, Victoria’s Secret averages somewhere between $600 and $700 per square foot.
  • Furthermore, costs should decrease:

  • Cost of goods should decrease as the company’s greater size increases its bargaining power with suppliers and as Fredrick’s sources more of its product from MSI.
  • SG&A as a percentage of sales should decrease due to cost cuts and an increased number of stores, and greater sales per store.
  • MSI/Fredrick’s still remains a risky play. That being said, Fredrick’s has a well-known brand, and it is available on the cheap to the public markets for the first time in about a decade.

    Disclosure: I am long MSI, and am also a customer of Fredrick’s.