Talbots Is A Good Merger Arbitrage Play

Jun. 1.12 | About: The Talbots, (TLB)

Outside some random, unpredictable event, I believe there is a 99% chance that the Sycamore Partners acquisition of Talbots (NYSE:TLB) will be completed. Add 3% risk for random weird situations that could happen that would sabotage the deal, and that puts the odds at 96%.

This makes the stock worth:

.96($2.75) + .04($1) = $2.68

$2.68 - $2.68 (.05*5/12) =$2.62 per share

The first equation assumes that if the deal completes, Talbots shareholders will receive the full $2.75 per share. If the deal falls through, the stock would probably fall to about $1 per share.

The second equation accounts for the time value of money of holding the investment until the likely date of the acquisition in about five months, using a 5% rate.

The Back Story

On December 6, 2011, Sycamore Partners offered $3 per share for Talbots. At the time, Talbots concluded that the proposal was inadequate and undervalued the company. Talbots then looked for other buyers. In early May, Sycamore offered a slightly higher price of $3.05 if it could look through Talbots' internal books, and Talbot let Sycamore look through them.

Since it started looking, the Company hasn't found any other buyers. Sycamore partners then took the deal off the table on May 25th, in which the stock tumbled from $2.56 to a low of $1.30. At that point, Talbots asked Sycamore to reconsider the deal for $3.05. Sycamore and Talbots agreed to a final price of $2.75, after which the stock moved back up to $2.47 on 5/31/12.

Investors are still wary of another delay in the acquisition, which might be one reason the stock is trading 10% below the acquisition price. Some investors are concerned about the shareholder lawsuits, which I don't believe is a risk. I also don't believe Talbots will get more than the $2.75 per share. If they were going to negotiate for a higher price, they wouldn't have agreed to the $2.75 per share buyout price so quickly after Sycamore pulled its $3.05 per share offer.

3 Reasons why Sycamore Partners won't back out of the deal:

1. Sycamore Partners has had its eye on Talbots for awhile, ever since it took a 9.9% stake in the company last year. Stefan Kaluzny is a retail veteran who heads newly formed private equity firm Sycamore Partners, and the investment in Talbots was its first. Kaluzny has a plan of action to turn Talbots around and probably has some specific ideas and innovations that no one has considered yet. That's why Sycamore Partners is the only interested suitor - no one else has a plan for a turnaround. It's likely Sycamore will return to Talbots' core customers, mature women, and attempt to regain their loyalty.

2. Sycamore Partners is happy to be buying Talbots for $2.75 per share, as the previous offer was at $3.05, 11% more. It wouldn't look good for Sycamore Partners' reputation to back out of this deal now, as that would make the company look indecisive. Sycamore's earlier threat of walking away doesn't look bad because it was a negotiating tactic.

3. Sycamore partners has already looked into Talbots internal books, and has thought about this deal for many months since its offer in December. It has probably inspected everything about Talbots from top to bottom, and considered all the possible risks, so there should be no surprises for Sycamore between now and the acquisition date which is expected around October.

3 Reasons why Talbots won't back out of the deal:

1. Talbots thoroughly asked around for five months, and found no other buyers interested in the company. It knows that it's either selling to Sycamore Partners or there will be no deal with anyone. If there's no deal, the stock will fall to around $1 per share. Now the company must accept $2.75 per share, about 10% less than the original offer. That's the risk Talbots took on when looking for another suitor. That verified to Sycamore Partners that there really is no other suitor interested in the company, so now they must take the lower offer. If Talbots went ahead and accepted the original bid, they wouldn't be in this situation.

2. If there's no deal, then later this year Talbots will need more financing as it only has $22 million in cash as of April 28, 2012. Last year during the quarter ended October 28, 2012, it burned $52 million cash in operating activities alone, and things don't look like they'll be much better this year. The Company will likely need to issue stock, or convertible debt, since a creditor probably wouldn't want to take the risk to issue non-convertible bonds. The risk versus reward isn't enough for a creditor to issue non-convertible bonds since Talbots is at risk of going bankrupt in a year or two. Any equity issuance would be at a much lower per share price than what Sycamore is offering.

3. Talbots CEO, Trudy Sullivan, is leaving no matter if the company gets bought out by Sycamore or not. Her strategy of changing Talbots' clothing line to appeal to a younger demographic hasn't worked. For the company to keep her around if they back out of a deal with Sycamore wouldn't make sense. The company would have to hire a new CEO and revamp its strategy. That's all at a high risk of eventual bankruptcy that I doubt shareholders would want to take as opposed to a sure thing with the buyout.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.