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Retail Ventures (RVI) owns DSW (DSW) and not much else. Strangely, RVI is selling for about 30% less than DSW, even after accounting for RVI’s extra liabilities. You can take advantage of this either by buying RVI shares outright, or by creating a stub: Buy 1 RVI share and short 0.57 DSW shares for a credit of $3.88 per RVI share.

Background

A very similar take on RVI was written up on ValueInvestorClub in May, 2005 and received a fairly high rating (6.1). At the time, RVI was just about to spin off DSW. RVI also owned two other businesses: Filene’s Basement and Value City Department Stores. Unfortunately, these two businesses turned out to be value destroyers and RVI lost over 70% since the original write-up.

What’s Changed?

The risk/reward ratio for this idea has improved significantly. First off, we have a couple of years of financials to help us value DSW. Second, RVI sold its two other businesses, keeping only DSW. Specifically, it sold Value City in January 2008, and Filene’s Basement in April, 2009. These two businesses are now bankrupt: Value City filed in October 2008 and Filene’s Basement filed in May 2009, shortly after being acquired.

At this point, RVI consists of DSW plus some RVI corporate overhead. The corporate overhead includes some extra assets (cash, NOLs, etc) and certain obligations to Value City and Filenes, which presumably were necessary to offload these entities. More on those below. The key question is: Does the corporate overhead justify the discount priced into RVI over its DSW stake?

Valuation

RVI owns 62.9% of DSW. RVI’s balance sheet consolidates 100% of DSW assets and liabilities and reports the remaining 37.1% of DSW owned by the public as an equity account called “Noncontrolling interests” as per FAS 160. We can isolate RVI’s “corporate” assets and liabilities by comparing RVI’s and DSW’s balance sheets. We can then create an “economic” balance sheet for RVI as follows:

So RVI should be worth about $250m, but it is trading at a market cap of $171m. The margin of safety is about $79m or 32%.

Note: RVI technically owns super-voting B-shares in DSW which give RVI control over 93.1% of DSW votes. However, we did not give RVI any credit for its “control premium” in the valuation above.

Here is how we arrived at the value of DSW’s stake:

Incremental RVI Corporate Assets and Liabilities

Here is how we arrived at Incremental RVI Corporate Assets and Liabilities:

RVI’s incremental assets are primarily extra cash ($31m) and the value of the conversion feature of its long term debt ($73m).  The debt is interesting: It has a face value of $144m, an annual coupon of 6.625% and it matures on September 2011. At that point, it is “mandatorily exchangeable into Class A Common Shares of DSW.” The exact conversion ratio depends on the price of DSW stock at the time. If DSW trades for less than $27.41/share, bondholders get 1.8242 DSW A shares in exchange for $50 of debt. If DSW trades higher, bondholders get fewer shares. At the current DSW price of $12.70/share, bondholders would get $23.16 for every $50 in debt, about 46 cents on the dollar. So, if DSW rises in price, so does this liability, and vice versa. The debt should act as a partial hedge for DSW equity.  RVI also has a cash settlement option for the debt, so it can avoid diluting DSW shareholders if it feels DSW shares are undervalued as of the conversion date.

RVI apparently thought the debt was a bargain: On October, 2008 it spent $5.6m to retire $10m of face value debt, recording a $1.5m gain on the repurchase. At that point, DSW was trading around $13/share. Presumably, the debt is just as much of a bargain now.

Aside from the debt, RVI Corporate also has some remaining obligations to Filene’s Basement and Value City. These include mostly shared-services like payroll administration and IT, and are provided in exchange for weekly payment, so there should not be too much credit risk even though the payers are bankrupt. These obligations are on the balance sheet at 12.7m for Value City and 44.3m for Filene’s Basement.

There are no other “off balance sheet” liabilities.

Risks

The biggest risk I can see is that RVI continues to maintain its corporate overhead and does not liquidate. There should be some shareholder pressure to the contrary, since DSW is now the only holding, but the company is controlled by the Schottenstein family and may not yield. Also, RVI may be barred from liquidating if it has to keep providing the obligations above (although it may be able to assign these to DSW for a fee). In either case, the chief concern would be: what will RVI’s burn rate be while we wait?

The burn rate should consist of salaries to RVI staff (executives) and the costs of providing shared services to Filene’s and Value City, net of changes to debt value as described above. RVI has taken some steps to reduce executive compensation: it fired the CEO, Wilansky, who made about $1.6m in 2008, and eliminated a couple of other positions.

The exact burn rate is tricky to estimate, because 2009Q2 includes a lot of one-time costs and benefits related to the disposition of Filene’s Basement, but it should not be significant: RVI losses from continuing operations before taxes in 2009 Q2 were 51.2m. This includes bad-debt expense related to Filene’s bankruptcy filing of 57.9m. According to the filing, this debt was “fully impaired,” ie written down to zero. The expense should not repeat, and without it, EBT would have been positive.

Another potential risk is that RVI ends up owing more to Filene’s and Value City than estimated. Some Value City creditors are petitioning to examine RVI’s assets to see if they can get more. However, no one has sued RVI yet.

Stub Construction and Logistics

There are two ways to take advantage of this situation: Construct the RVI Corporate stub or buy RVI outright. To construct the stub, buy 1 RVI share and sell 0.57 DSW shares for a credit of $3.88 per RVI share. You would be taking on a liability worth $2.26/share with a margin of safety of $1.62 per RVI share, as per the calculation below:

Alternatively, you could just buy RVI shares and get DSW for 30% off, kind of like the shoes in the stores. DSW is trading at 1.2x book versus an average of 2.2x book for an index of 46 other apparel companies. It had positive earnings and free cash flow over the past 12 months, unlike about half of its competitors and may not be a bad value in its own right.

Catalysts

• No one-time charges related to dispositions in RVI’s next quarterly financials
• Reduced RVI executive compensation (CEO let go)
• Liquidation of Value City and Filene’s Basement completed

References

ValueInvestorClub 2005 Writeup for RVI: http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/1788

Value City creditors asking to see RVI’s assets: http://bankruptcy.law360.com/registrations/user_registration?article_id=105317&concurrency_check=false

Thanks to Saj Karsan for this article which got me thinking: seekingalpha.com/article/154702-retail-v...

Disclosure: No positions