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Michael Ross Seeley
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Mike is a licensed CPA with the State of Utah, and the Director of Tax at a public company. As the President of Seeley Financial Services PC, Mike provides out-sourced Tax Director services to public and private companies along the Wasatch Front. As the Managing Member of Axinite Financial... More
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  • SEARS SPIN-OFF: Orchard Supply Hardware Stores, Part II
    By: Mike Seeley, CPA
    Part I of this article outlined several pertinent aspects of the Sears-Orchard spin-off transaction, along with an overview of Orchard Supply Hardware Stores Corporation's ("OSH") operations. In Part II we will seek to estimate the fair value of Orchard. This is done only to identify whether the post spin-off trading price represents a sufficient discount to the fair value of the underlying business to justify a more detailed examination. Or in other words, at what price must the shares trade for us to consider an investment and compel us to dig a little deeper?
    Estimation of Fair Value
    Registration Fees
    As was reported in June 2011 when Orchard first filed Form S-1, the Company incurred an SEC Registration Fee of $9,020.20.[i] This fee denotes an $82 million registered value when applying the SEC Section 6(b) fee rate applicable to the registration of securities in fiscal year 2011.[ii] With just over six (6) million common shares outstanding, this valuation indicates that in June of 2011 Management was projecting the shares should trade at approximately $13.67 per.
    A number of significant events occurred subsequent to the initial registration (namely the property sales discussed below), but these events appear to have been anticipated at the time of Management's fair value calculation. Although we do not know what deviations may ultimately have existed in the details, we may at least take a small level of comfort in knowing Management had foreseen the need for these asset sales when valuing the Company.
    "Ares" Investment
    During November 2005, Ares Management LLC, through an affiliate, provided Orchard with $58.7 million in cash in exchange for 19.9% of the Company's voting stock, along with a three-year option to acquire additional stock. That option ultimately expired unexercised. We raise this to highlight the fact that the Ares recapitalization implied a value of at least $295 million one or two years prior to the bottom falling out of the housing market. Although this doesn't help us much now, it does at least serve as a reference point.
    Industry Comparison
    Orchard considers its true benchmark companies to be True Value and Ace Hardware, but as public data is available for the big-box stores, a comparison of Orchard's financials has been made to that of The Home Depot, Inc. (NYSE:HD) and Lowes (NYSE:LOW) below. With the exception of Orchard's 2010 financials, which were obtained from the Form S-1, the following financial results are derived from the most recent quarterly filings for each company.
    Revenue (ttm)518.9M648M49.06B69.51B
    Gross Profit (ttm)172.5M226.4M17.15B23.30B
    EBITDA (ttm)27.1M605.27B8.09B
    Net Income (ttm)(7.2M)7.2M1.79B3.7B
    Net Profit %5.22%9.32%10.74%11.64%
    Revenue Per Share (ttm)86.33107.8037.6843.87
    Earnings Per Share (ttm)1.2(d)1.201.372.32
    Book Value Per Share (mrq)15.1516.3113.3411.53
    P/E (ttm)TBDTBD18.5818.12
    PEG (5 yr expected)TBDTBD1.231.24
    Shares Outstanding6.01M6.01M1.25B1.54B
    Share Price (mrd)TBDTBD25.3842.04
    Market Capitalization (mrd)TBDTBD31.79B64.81B
    Enterprise Value (12/27/11)TBDTBD37.44B73.36B
    Debt (mrq)246.5M271.5M6.62B10.78B
    Debt Per Share (mrq)$ 41.01$ 45.17$ 5.30$ 7.00
    Debt as % of Market Cap300.61%331.10%20.82%16.63%

    *Represents pro-forma amounts from FYE January 29, 2011 as only trailing three months of stand-alone data is currently available. Pro-Forma reflects new terms under the Brands and Appliance Agreements entered into with a subsidary of SHLD as a part of the spin-off.

    **Represents YTD FY 2011 amounts (39-weeks ending October 29, 2011)
    A review of the respective companies' gross margin percentages reveals remarkable parity, though Orchard's gross margins have been depressed 2011 year-to-date due to increased markdowns to move inventory and increase sales. Thru 2010, the companies' EBITDA percentages were comparable, though Orchard's EBITDA came under tremendous pressure in 2011. A couple percentage points may be explained by the recognition of the $14.6 million loss Orchard incurred on the sale of its Tracy distribution center, but there has also been a marked decline in operating results. Of course, as discussed earlier, the Company's excessive debt-loads have significantly reduced Orchard's net income relative to its competitors, but when removing the loss on sale of assets, Orchard remains surprisingly profitable. [Note the debt numbers for Orchard above represent only its debt, and do not take into account the Company's sizeable capital and operating lease obligations, which adds another $70 million.]
    Back-of-the-Envelope Valuation
    We will merely run a quick calculation to double-check Management's estimation of fair value for purposes of its registration fee. By adding back $20 million of interest expense to the Company's 2011 YTD income, and excluding the one-time loss on sale of the Tracy distribution center, we see that a more reasonable debt-load would allow Orchard to report net income of roughly $27 million. This result is fairly similar to the result we would obtain if using the 2010 annual numbers, and as the Company's lease expenses will increase materially in 2012 (see note on property sales below),we will forego annualizing the result to approximate go-forward earnings. By applying the same trailing-twelve-months (P/E = 18) and forward (P/E = 15) multiples enjoyed by Lowes and Home Depot, we would arrive at a value in the range of $408-$490 million. If we then were to pretend the Company assumed the current debt and capital lease obligations of $320 million, and subtract that number from the results, we would arrive at a market capitalization somewhere between $86-$170 million. Therefore, we have reason to expect that Management's fair value estimation of $82 million is reasonable, and perhaps conservative.
    With 80% of shares held by Insiders, trading is apt to be volatile initially; therefore, it may be prudent to await an initial equilibrium. If the shares settle in the mid-to-high teens, we will be incentivized to take a closer look at projecting normalized future earnings and analyzing the Company's balance sheet in an effort to value its real estate holdings.

    Balance Sheet Method
    An investor may seek to value the Company using a Balance Sheet method to determine the fair market value of the Company's real assets. To determine the fair value of the Company's real estate, we have available to us a number of very recent sales. For the one store sold on December 12, 2011 and the three stores sold on December 20, 2011, the Company received $36 million. At an average price of $9 million per location, one might identify the number of the 89 stores in operation for which the Company still owns the real estate and then multiply accordingly. One would then add the balance of the net assets, perhaps reserving the inclusion of intangibles, and take into account any necessary adjustments (for instance, the Company employs the LIFO method for calculating its inventory and a $1-2 million adjustment would be required to arrive at liquidation value, etc.). Finally, one may subtract the debt, contractual obligations, such as the capital and lease obligations, the value of the preferred, and arrive at a reasonable fair value. As we have not yet found the necessary information for the Company's real estate holdings, and as we don't wish to expend the necessary time and effort at this stage, we have not taken this approach.

    A Note on Debt and Refinancing Efforts
    If Orchard's market capitalization does indeed fall in the $82 million range, the Company will have a debt load roughly three times (3x) the value of its shares; whereas Lowes and The Home Depot have debt loads of 21% and 17% of their market capitalizations, respectively. This leverage presents the most likely near-term opportunity in the shares, as a relatively small percentage improvement in the value of Orchard's assets will have a significant upward impact on the price of its shares. Then again, the reverse will also hold true.
    Thus, an investment in OSH is likely to hinge on 1) the Company's ability to service its debt while progressively deleveraging, and 2) a lack of further deterioration in Orchard's financial performance. As both of these conditions are uncertain, it would be prudent to insist on a sizable margin of safety. If this margin of safety cannot be found in the Company's operations, assets, or competitive position (we have certainly not discovered it thus far); we must insist it exist in the purchase price of the shares.
    Refinancing and extending the maturity of the senior secured term loan is critical. To that end, on December 12, 2011 the Company closed the sale of its Hollywood store, and a short-term lease was subsequently entered into for the property. On December 20, 2011 the Company closed the sale of three additional stores to another purchaser via a sale-long-term-lease-back transaction. These last stores were Pismo Beach, Cottle Road (San Jose), and Capitol Expressway (San Jose).
    $21.6 million of the proceeds for the four stores and the Tracy distribution center were used to pay down principal on the Real Estate Secured Term Loan. The remaining proceeds of approximately $36 million before fees, will be used to pay down the Senior Secured Term Loan. Orchard 'expects' to be able to use that prepayment to negotiate an extension on the maturity of the bulk of the remaining Senior Secured Term Loan principal until December 21, 2015. [It is important to note Orchard will incur $3.2 million in additional rental expense annually as a result of the "leaseback" portion of the four store sales, and an additional $1.7 million for the Tracy distribution center. This added expense will further depress prospective operating results.]
    Investment analysis is the process whereby we determine how best to strategically allocate scarce resources. While this applies to the allocation of investment funds, it is also applicable to how one chooses to allocate their time, which is in similar short supply. Thus, this article is not meant to represent an exhaustive technical analysis or enterprise valuation. The discussion above is intended merely to represent a back-of-the envelope, rough approximation of the Company's value in order to determine whether, or more precisely at what price, the operations and assets of Orchard deserve further consideration and analysis.
    I do not hold a position in SHLD, OSH, HD, or LOW; nor do I intend to establish a position in any of those shares within the next 72 hours.

    [i] S-1, Part II: Information Not Required In Prospectus, p. II-1.
    [ii] Fee Rate Advisory #5 for Fiscal Year 2011

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Tags: OSHWQ, SHLD, LOW, HD
    Jan 03 8:54 PM | Link | Comment!
    By: Michael Seeley, CPA


    In order to expand our previous article on Grupo Prisa ("PRISA"), we are releasing a more detailed analysis in a three-part series. In Part I, we will review in greater detail PRISA's corporate profile, recent reorganization, and capital structure; in order to highlight the built-in protection mechanisms associated with the preferred class (PRIS-B) of American Depository Receipts ("ADRs").
    Company Profile
    Promotora de Informaciones, S.A ("PRISA"), was founded in 1972 by Jesus de Polanco, and is now a media powerhouse operating in Spain, Portugal, Latin America, and the U.S. Hispanic Community. Its investments include some of the largest media companies in these markets, including substantial print media, cable television, original television and movie content, radio, and an education/textbook business.[i]
    Due to an unbridled acquisition spree, PRISA found itself excessively leveraged in late 2009, with debt of approximately eight times (8x) earnings before interest, tax, depreciation, and amortization (EBITDA). In this precarious financial state, PRISA entered into negotiations with Liberty Acquisitions Holdings Corp ("LIBERTY")[ii], a publicly traded Special Purpose Acquisition Company ("SPAC"), or a "blank check" organization,[iii] to affect a much needed capital injection.
    LIBERTY's investment triggered the trading of PRISA American Depository Receipts ("ADRs")[iv] on the New York Stock Exchange ("NYSE"). This newly created access to the U.S. stock exchange injected highly valuable liquidity in the underlying PRISA shares, and attracted the attention of such stock pros as Whitney Tilson and Glenn Tongue, whose T2 Partners, holds a significant portion of its assets in PRISA ADRs; David Marcus of Evermore Global Advisors; and most recently, Carlos Slim, the billionaire Chairman of Telmex, and the wealthiest man in the world.[v]
    Improved Corporate Governance
    Pursuant to the LIBERTY-SPAC transaction, PRISA elected LIBERTY's two founders, Nicholas Berggruen and Martin Franklin[vi], to the PRISA Board after the transaction was finalized in late 2010. In addition, the Company installed independent directors to its 13-member Board, such that the independent directors now constitute a majority of Board members.[vii] This overhaul of the PRISA Board not only inserts a much needed strategic discipline, but also protects against a reversion to the types of behavior that first led the Company into financial difficulties; namely, rampant acquisitions at excessive prices.
    In the Spring of 2011, PRISA installed a new Executive management team and has embarked on an aggressive de-leveraging plan using the Company's free cash-flow, proceeds from the exercise of warrants at above-market strike prices by the LIBERTY founders and the Polanco family, and the sale of non-core assets to place the Company on more solid financial footing. By the first quarter of 2012, it is expected that PRISA's debt will be reduced nearly fifty percent (50%) from its high in 2010 to four times (4x) EBITDA or less.
    Capital Structure
    The 2010 recapitalization resulted in an interesting opportunity to invest in PRISA.
    The Class-A ADRs (NYSE:PRIS) and the Class-B ADRs (PRIS-B) each consist of four shares of the underlying class types. For that reason, they trade at an USD-equivalent four times (4x) the price of the shares traded on the Madrid stock exchange. The Class A common shares carry voting rights, while the Class B preferred shares are non-voting, cumulative, convertible counterparts to their Class A siblings. Furthermore, the Class B shares possess highly valuable traits, such as the €0.70 cumulative annual dividend on the ADRs (roughly $0.98, or nearly a 20% annual yield on $5 per share), payable June 30, 2014.[viii] Thus, by acquiring the Class-B ADRs at under $5 per share, the discerning investor may secure a cumulative dividend over the next 30-months equivalent to a total yield of 50% or more over that time.
    In addition to the cumulative dividend, additional protective measures against principal-loss are built into the Class-B ADRs via a conversion preference. The Class-B ADRS convert automatically into Class-A ADRs on June 30, 2014. Provided the Class-A shares trade in excess of €2.00 per share (€8.00 per ADR, or approximately $11 per ADR in USD), the conversion ratio is a simple one-to-one (1:1) exchange. However, if the Class-A shares trade at less than €2.00 on or before the conversion date, the conversion ratio will be a fraction, the numerator of which will be €2.00, and the denominator of which will be equivalent to the 20-day trailing average price. That said, in no case will the conversion ratio exceed 1.33 Class-A shares for each Class-B share. Alternatively, the conversion ratio may be one-to-one (1:1) with an amount of cash equal to the difference between A) €2.00 and B) the 20-day trailing average price; not to exceed €0.50 per Class-B converted share.[ix] Put another way, the conversion ratio will not be reduced below 1.33:1 until the PRIS-B ADRs have appreciated above €6, or approximately $8.25 per ADR, which would connote a minimum capital gain of 65% ($8.25 - $5.00 = $3.25 / $5.00), before accounting for the cumulative dividend of $2.76 per ADR. Thus, if the shares have not appreciated by approximately 100% just prior to June 30, 2014, the PRIS-B investor will receive a significant stock/cash kicker.
    Assuming the risk of bankruptcy is successfully avoided, which we feel relatively confident of given the most recent events and regulatory filings by the Company, and before consideration of either appreciation or depreciation in the price of the shares, an investor in PRIS-B ADRs at current levels may realistically expect to achieve an 83% return on investment over the next two-and-one-half years. At the very least, the cumulative dividend and conversion preference serve as a welcome margin-of-safety on the shares in a debt-heavy, Spanish, media company.
    Axinite's Managing Member is Long shares of LMCA and PRIS-B, and does not hold a position in either JAH or PRIS.

    [ii]The 'Liberty' thus referred to should not be confused with the 'other Liberty' that may immediately spring to mind via John Malone's Liberty Media Corp. (NASDAQ:LBTYA) / Liberty Capital (NASDAQ:LMCA) / Liberty Interactive (LINTA). John Malone's Liberty Media empire is, however, an interesting benchmark demonstrating the value potential of Grupo PRISA.
    [iii]A SPAC is a public company holding only cash that is established for the express purpose of identifying an attractive target business, often, but not necessarily experiencing some particular hardship and in need of highly capable Management and/or capital to survive and turn-around. In this way, a SPAC is not unlike a Private-Equity Fund that employs its entire fund to acquire control or significant influence in a portfolio company. It is this attribute that invites the term 'blank check' company; because the SPAC founders effectively solicit a 'blank check' from investors to be employed by them under terms and conditions outlined in the corporate charter.
    [iv]American Depository Receipts (ADRs) are the preferred mechanism for U.S. persons to invest in the securities of international entities without incurring unwelcome tax liabilities such as foreign withholding taxes on dividends and capital gains.
    [v] T2 Partners recommended PRISA class-B ADRs at upwards of $10 per share, and the author agrees the shares represented significant value at that price. As reported in The Wall Street Journal, Carso SA de CV, a company controlled by Carlos Slim, established its stake after the shares shed more than one-half their value in 2011.
    [vi] As the CEO of Jarden Corporation (NYSE:JAH), Martin Franklin has presided over a company which has seen its stock rise more than 10-fold over the course of his tenure.
    [vii] Amendment No. 6 to Form F-4 SEC Registration Statement, p. 112
    [viii] Amendment No. 6 to Form F-4 SEC Registration Statement, p. 303
    [ix] Amendment No. 6 to Form F-4 SEC Registration Statement, p. 304

    Disclosure: I am long LMCA, PRIS.B.

    Additional disclosure: I have not positions in JAH.
    Jan 03 11:05 AM | Link | 1 Comment
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