Quick summary: Alco is getting acquired for less than its net current asset value. With 30 days to find a higher bid, and a balance sheet so asset rich that a bidder could finance a deal with no equity, it seems the market is dramatically undervaluing the potential for a higher bid.
Every investment I make has, at its core, one simple question behind it: do I think the company I am investing in is worth more than it is currently trading for?
Of course, value can take many forms. For example, in the case of a company with "hidden" assets, the value comes not from the company in its current form but in some dormant asset that could be unlocked for shareholders' benefit. In a merger arbitrage, the value is not as a standalone company, but the value of the company's assets in the hands of a potential acquirer.
My favorite place to look for value is in "net nets." These are companies trading for less than the value of their net current assets less all liabilities. A company trading this cheaply has literally been left for dead, as it's selling for less than its theoretical liquidation value.
The problem with net-nets is there often is a reason they've been left for dead. In some extreme cases, the business is undergoing drastic changes that call into question the value of its assets (think of a tech company where the assets are wholly comprised of equipment that could rapidly become obsolete). In others, the company has a ton of assets but is generating losses so quickly that they'll likely burn through their assets in the next year or two absent a drastic turnaround (think a biotech burning cash).
But in many cases, the problem with net-nets is that the market simply thinks management will use the company's abundant assets to enrich themselves and not shareholders. This was exactly the problem with a net-net I looked at earlier this year, Alco Stores (NASDAQ:ALCO).
However, the great thing about net-nets is that they're so heavily discounted that even the slightest bit of good news is enough for investors to realize market beating returns. And every now and then investors get more than just a bit of good news and they realize huge returns. In this case, the good news came in early July when the board decided to properly align their interests with shareholders by granting, in total, roughly 50k options to acquire Alco shares at $11.10 per share. And with their interests finally aligned with shareholders, it took them only three weeks to announce a sale of the company for a nice premium at $14 per share.
(Since Seeking Alpha doesn't have a sarcasm font, please note there's more than a little sarcasm in this paragraph regarding the timing of options issuance and the subsequent sale of the company.)
Normally, an acquisition represents the end of the story for a net-net. But in Alco's case, I think it's just the beginning. The company has a 30-day go-shop period that I think is very likely to result in a higher bid.
Remember, all investing comes down to a simple question: is the company worth more than the price you're buying the stock for? And with Alco, it's hard for me to see any way that the company isn't worth substantially more than the $14 deal price. And, because of how undervalued and asset heavy Alco is, it's tough for me to believe a higher bid isn't coming. The fact is, at $14 per share, Argonne (the group buying Alco) will be able to buy the firm without using any of their own money.
But we'll get to that. Let's first discuss why Alco is so cheap at the deal price.
Alco's book value is $30.89. Its NCAV (net current assets less all liabilities) comes in just under $14.30 per share. I've seen firms get sold for prices I considered much too cheap before, but I've never seen a profitable firm get sold for this big of a discount to book value and NCAV. In fact, I've followed net-nets for almost four years, and this is only the second deal I can remember where a company has sold themselves for less than NCAV, and that firm was losing money and coming off the heels of a federal investigation. Alco, obviously, has none of those issues.
Obviously, book value means little if the company is doomed to operate at low ROEs for an extended period of time. To put it into simple terms, if a company was going to earn a 1% ROE for the next fifty years, it clearly wouldn't be worth anywhere close to book value. And many will note that Alco was earning barely more than 1% ROE and is getting acquired for an aggressive ~9x EV / TTM EBITDA.
But I think that multiple is deceiving. Alco does almost $500m in sales per year and generates $14.5m in EBITDA, or under 3% EBITDA margins. Consider this: gross margins have come down from 32.3% in 2010 to 30.3% in the TTM. A simple reversion to 2010's margins would add almost $10m to EBITDA, and reduce the EV / EBITDA multiple to less than 5x!
I think there are plenty of other opportunities on the margin front. For example, the company notes that its "shrinkage" is 2.4-2.5% of sales, while better run companies are typically under 2%.
Yes, there are reasons to believe that both of those analyses are much too simple and that the company won't be able to fully hit either of those targets. But the point here is simple: small incremental improvements will drive huge returns for the P/E buyer, and there are reasons to believe that Alco has many of those small incremental opportunities.
There's one last reason to believe that these higher forecasted earnings levels are reasonable. When pressed on their last earnings call, management stated that they believed an ROE of 7.5% was achievable within a reasonable period of time. A 7.5% ROE would imply net income of $7.5m, which would imply Alco is selling itself for a P/E of ~6.25x. Assuming a long term tax rate of 30%, interest expense of $3.5m, and D&A of ~$9m (roughly consistent with fiscal 2013 results), that would imply EBITDA in the $23m range, implying the company is selling itself for less than 6x normalized EV / EBITDA.
So we've discussed a few of the operating opportunities the company can realize. And I think those alone are enough to think the company is selling itself much too cheap. But I think the true extent of undervaluation is revealed through an analysis of the balance sheet and financial engineering type transactions available to the company.
The key here is that, for a company so small, Alco controls a huge amount of assets. For example, at its most recent balance sheet, Alco owned almost $191m worth of inventory. In addition, it has $50m worth of PP&E on its books.
As we will discuss below, these assets represent two distinct opportunities for a financial buyer, but both opportunities boil down to one thing: they can be turned into cash after the deal closes to reduce the amount of equity a potential buyer needs to put into a deal. In fact, I think a savvy buyer could actually buy Alco and, through clever engineering, immediately pay themselves a dividend greater than the equity purchase price.
A potential buyer could turn the assets to cash in one of two ways. First, they could simply turn Alco's inventory over faster. Alco has been plagued for years by inventory turnover that was well below its potential. Slow inventory turnover leads to higher markdowns, higher borrowings, unnecessary interest expense, and less cash flow. The company has known about this problem for years and, per its most recent quarterly conference call, recently installed systems that it feels will allow it to reduce inventory levels by year end (note that the cost of these systems are paid for upfront, meaning they temporarily depress EBITDA, but the benefits are realized in the future. In other words, the company's trailing EBITDA is depressed by these costs but the potential buyer will reap the benefits). The company has also noted that it will close 8 unprofitable stores this year, with a target of $11m in cash freed up from store closures. Also keep in mind that while these balance sheet based initiatives are mainly aimed at freeing up cash, the combination of closing unprofitable stores and reducing inventory (and thus markdowns) will also increase margins, driving EBITDA higher and lowering the multiple a buyer is paying.
The combination of freeing up cash from closing stores and reducing inventory should easily free up ~$15m, or roughly 1/3 of the equity value in today's deal. Note that these are relatively easily attainable targets that don't require much incremental improvement on Alco's part. Larger improvements could yield significantly more cash. For example, Alco turns its inventory over roughly 3x per year. Family Dollar and Dollar General both turn their inventory over almost 7x per year, and Wal-Mart turns its inventory over more than 10x per year. Maybe Alco can't quite hit those levels, but I see absolutely no reason why it should lag this far behind. Simply increasing inventory turns from 3x to 4x would free up over $40m, while increasing it to 5x would free up more than $65m. These are, quite obviously, huge numbers that dwarf the purchase price.
Even without these balance sheet type improvements, a buyer could turn these assets into cash and thus buy the company for free through simple financial engineering. Remember, the great thing about assets is they can be borrowed against. In fact, Alco has a $120m revolving credit agreement that allows it to borrow against its inventory and credit card receivables that currently has $40m in availability.
Now, Alco's credit docs currently won't allow them to draw that down and fund a dividend or share repurchase. But I could easily imagine a situation that looks something like this: the P/E buyer buys the entire company for $47m, then goes to the bank and offers to raise the interest rate on the revolver by 1% in exchange for waiving the change of control clauses and allowing them to use the proceeds to fund an equity dividend. The bank happily agrees, as they get a nice interest rate increase and are still secured by tons of assets, and the P/E buyer gets the whole company for just $7m in equity.
But a sharp P/E buyer wouldn't be done here. Alco owns three of its stores, in addition to an almost 500k square foot distribution center in Kansas. To put it simply, there's no reason Alco needs to own these properties. Any acquirer is going to buy the company and immediately consider either 1) borrowing against those assets or 2) selling those assets and entering leases for them. It's extremely difficult to determine exactly how much these assets are worth without having access to Alco's internal financials, but Alco has $35m in PP&E on its books free and clear of any mortgages or debt (the revolver is guaranteed by the inventory and receivables only, and Alco has another $15m in PP&E supported by capital leases). I think it's a safe bet that a bank would be willing to lend at 50% of book value, or give them at least $17.5m mortgage for those properties.
Add that $17.5m to the borrowing from inventories we mentioned above, and a buyer at $14 per share could buy the entire company for $47m and immediately borrow enough to return all of their equity in addition to paying themselves a $10m dividend, or an immediate return of 20% while still retaining control of the business and all of the upside from margin expansion.
Lest you think I'm too crazy for suggesting this line of thinking, note that the press release announcing the merger specifically mentions Alco being a clear fit with Argonne's current portfolio of companies and real estate investments. That's a very clear indication Argonne is considering something with Alco's real estate, and given management's constant mention of inventory on their conference calls, there's no way something isn't planned with the inventory as well.
Hopefully, at this point you've come to the same conclusion I have: Alco is getting sold much, much too cheaply. But one of the problems with hoping for a better deal in merger arbitrage is it literally takes three to tango - i.e. there needs to be another interested party willing to bid higher for all of this to mean anything. And, with the merger proxy (which contains history of the deal) yet to be filed, how can anyone be confident there's another bidder out there?
I think the simplest answer is any P/E shop worth their salt is going to do an analysis very similar to this one and at least consider putting in a bid. After all, if you can finance the entire thing with Alco's assets and put no equity into the deal, why not do it? Zero downside, pure upside.
But investors don't have to just buy and blindly hope that another P/E firm figures out what a bargain Alco is. Everbright, a Chinese company, has purchased over 17% of Alco and filed a 13-D noting they had contacted Alco three separate times in the past three months to discuss strategic partnership opportunities, a potential investment, or an acquisition. Now, it is important to note that the bulk of Everbright's investment was acquired at $7 per share, which is obviously well below today's price. And I'm as skeptical of Chinese investments / investors as anyone. But it's hard to imagine that there's not some chance of Everbright coming up with a topping bid, especially given that their 13-D implies there could be some synergies between their core Chinese business and Alco's.
It's also worth noting that Alco's earnings calls have been filled with value investors and small cap activists. This is pure speculation on my part, but I have to think there's a chance one of them considers buying up shares in the company and pushing for a higher deal or even going for appraisal rights. It's hard for me to see how a company could justify selling itself for less than net current assets in an appraisal case, but I'm certainly no lawyer and I think most parties would rather see the bid get raised higher to something more in line with fair value than pursue costly appraisal rights.
To sum it up, I like limited risk and high reward from the investment in Alco. Shares are trading at a >1% spread, indicating the market is giving basically no chance of a higher bid coming. Most studies I've seen show that go-shops yield a higher bid somewhere between 5-10% of the time, and given dramatic undervaluation and potential to finance the deal completely with the company's own assets, I obviously think the odds are much higher here.
Disclosure: I am long ALCS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.