Bon-Ton: Market Overreaction To Bankruptcy Risk Has Resulted In 34% Upside!

| About: The Bon-Ton (BONT)


Bon Ton is a national retailer with 267 stores and $2 billion plus in sales with a market capitalization of only $18.75 million.

The WSJ reported that Bon Ton was one of the ten most likely retailers to default this year.

Which brings us to the question of the day. Is the market over or underreacting to the possibility of a Bon-Ton bankruptcy? Spoiler alert it has.

Bon Ton (NASDAQ:BONT) is a national retailer with 267 stores and $2 billion plus in sales with a market capitalization of only $18.75 million. Implying a 0.009375X Price/Sales multiple versus 0.15 for the peer set. BONT like her brethren had not entered my investing weltanschauung…until last month. When Khadeeja Safdar of the WSJ reported that Bon Ton was one of the ten most likely retailers to default this year. Bon Ton stood out from the crowd as a possible outlier. The firm has $2 billion in sales and ~50% of the Class A shares are held by insiders. Thus, if the firm were to be in danger of default, they may not be as eager to spring for Chapter 11 as others.

When I started to kick the tires I realized that it was a Sisyphean task to assess if I should include the stock in my core portfolio: a long/short event driven value portfolio that is highly concentrated (less than 15 stocks). However, I could in short order determine that:

The market has mispriced the risk of default this year. It deserved a seat on my bench (my foothold portfolio whose members often enter the pantheon of securities in my core portfolio).

I was able to do so my using publicly available information. Furthermore, since my explicit forecasts are 100% subjective, I realized that I stumbled onto an objective answer on whether BONT was oversold or overbought. Spoiler alert it was oversold.

There were two overhangs hovering over the stock earlier this year. Firstly, it was facing a potential delisting from the Nasdaq; it fell short of two requirements for continued trading on the index:

  1. The firm's total publicly traded market capital was below $15 million for 30 consecutive days. The firm's share price was lower than $1 over the same time span.
  2. The second was the maturity of its $730 million ABL credit Tranche A facility in December of 2018. Both clouds have lifted. On March 17th 2017the firm reported that the Nasdaq has withdrawn its notification of potential delisting as the market capitalization has crept above $15 million to $18.75 million currently. Providing a 20% buffer against delisting. Since the annual standard deviation of the stock market is ~10%, the risk of potential delisting now stands at 34%. BONT also pushed back the maturity of its $730 million ABL credit Tranche A facility to April 2022.

Source: Google Finance

While the stock has shown some signs of life earlier this month however it still resides firmly in the doldrums. Which brings us to the question of the day. Is the market over or underreacting to the possibility of a Bon-Ton bankruptcy? The table below summarized the possible outcomes and associated probabilities, payouts, and the expected payoff of investing in the stock.

Probabilities and payouts

Source: Google Finance, S&P, IMF, Moody's

The table is collectively exhaustive and will serve us well for our purposes without confounding the intuitive story in play. I didn't pull any one of the probabilities out of a hat. Jim Edler, director of risk services for the S&P, put that number at 10.48%. I took the S&P's estimate as gospel for my back of the envelope evaluation. In such an event the stock price would zoom to zero, resulting in a -0.60 loss per share (based on the close price as of May 26th 2017.)

The probability of the "Unable to Refinance" scenario is based on the probability of a recession occurring in the US.

Source: IMF

The IMF publishes their estimate of the probability of a recession occurring in the above countries and regions. The current risk of a recession occurring in the next year stands at 21.6%. For those who are averse to probabilities, that implies that the arrival rate of a recession in the USA is once every 4.63 years. That number falls in nicely with the maturity date of BONT's revolver. Why recession probabilities? I believe that given the firm's success in extending the maturity of its revolver despite its financial performance-it has posted losses for six years running, banks willingness to lend will not sour until the economy does.

The probability of the "Turnaround" scenario is ripped directly from Moody's four-year migration matrix based on credit rating. Specifically, the probability that junk bonds will migrate to a B rating. Once again, the probability estimate fits well with our timeline and my intuition for the best case scenario for BONT.

The final scenario is the current flight path the firm is on. At one point the sales will bottom out and the firm will not go bankrupt. It has the highest weight since given no foresight it seems to be the most likely outcome. Another way to think about it is that since all probabilities must add to one knowing the probabilities of the other three scenarios gives us the probability of the last one.

Probabilities and payouts

Source: Moody's, S&P, Google Finance, IMF

Next we have to break down the payouts associated with each outcome. The most intuitively obvious are scenarios one and four either outcome will result in a share price of zero. The payout given secular decline is the share price of the firm right before the disappointing full year results were reported in March. Their earnings were affected by unseasonably warm weather. The turnaround scenario has the highest payout and it is derived based off a 50% discount of the comp set based on Price/Sales ratio of 0.15-to account for BONT's higher leverage which is not reflected in the Price/Sales ratio. Once again simply using public data. As a point of reference the stock reached an all-time high of $56.54 in 2006.

Now it is time to put it all together. The value of $1.30 is the expected share price based on the probability weight outcomes. Assuming that equity had no required return this should be the share price today. However, equity does have a required return.

Typically, a firm's beta is a good place to start. Yahoo Finance reports BONT's regression data as 2.21 compared to a harmonic average of 0.60 for the peer set that's a 3.68X difference. To value the firm correctly we need to extract the true beta of the firm.

The regression derived betas contain the impact of news about the firm. In most cases this is exactly what we want the beta to reflect, however, if one wants to assess whether the current news surrounding the firm is accurate then deriving and then levering the harmonic mean of the firm's competitors is the correct treatment.

Beta U Inputs

Source: Google Finance, Yahoo Finance

Based on my analysis the unlevered Beta for the firm is 1.62. Note that I used the Miles-Ezzell Weights as opposed the market value based capital structure for the analysis. Miles-Ezzell argued that firms have an ideal capital structure that they strive towards. Their assertion has been academically verified, conforms to intuition and serves to remove the noise inherent in stock prices.

Beta U derivation

Source: Investopedia

Unlevered Beta output

Source: Google Finance, Yahoo Finance

Now it is time for the litmus test. Has the market over or under reacted to the possibility of bankruptcy?

Probability weighted payoff

Source: Moody's, S&P, Google Finance, IMF

Yes, based off my calculation the stock's probability weighted fair value is $0.80 a 34% premium to the current share price. I'm aware of the limitations of this approach and I do not recommend investing more than 1-2% of your assets in this stock. Once I have time to digest the capabilities of the new management and gain a deeper understanding of the firm, I will publish comprehensive assessment of the firm and its financial prospects.

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Disclosure: I am/we are long BONT.

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.

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