Description

We believe ASNA is interesting at this price in light of the announced acquisition of ANN. We think this acquisition will create significant value for ASNA shareholders for a number of reasons including (1) the acquisition of 2 strong brands (Ann Taylor and Loft) at a good valuation (4.9x LTM EBITDA including expected synergies) which will be mostly financed by cheap debt, (2) the diversification it provides for ASNA – it doesn’t have to rely on Justice as much as it did before and (3) the powerful delevering that will take place over the next few years as the debt is paid down.

Elke528 posted a write up on ASNA in November 2014 where he provided a good overview of the business. At the time, my view was that the stock was interesting if Justice could get back closer to its historical level of profitability. I believe that at today’s price and in light of the ANN’s acquisition, very few things need to go right for the stock to do very well and the story doesn’t depend as much on a Justice recovery.

Bigger picture, by buying shares in ASNA, we are partnering with an owner operator (David Jaffe whose family owns around 20% of the company) with a good track record of capital allocation at an inflection point in the company’s history because:

1.      The company is in the process of completing a significant capex program to create a shared service platform. Starting in 2016 (fiscal year starts in August so we are almost there), capex will come down significantly and the company is expected to start generating significant free cash flow. Capex was $478 million in 2014, is $350 in 2015 and was expected to come down to around $250 million going forward (this $250 million number is prior to the ANN acquisition so the number will go up to include capex related to ANN). This decrease in CAPEX is about to unleash a lot of free cash flow. This cash flow will be used to pay down the debt that is being used to buy ANN.  The timing is perfect.

2.      Expense savings related to this new platform, other investments, and the 2012 Charming Shoppes’ acquisition are starting to flow through the P&L. The company expects $95 million of savings through 2016 with $60 million to come through in 2015 and 2016 (we have assumed an additional $45 million to come on top of the LTM numbers since we are already through the first half of 2015 – the company has said they would generate $30 million in savings in 2015 and another $30 million in 2016).  

3.      The acquisition of ANN which we will discuss in more details below.

4.      The optimization of the company’s balance sheet – ASNA will have around $1.8 billion of (cheap) debt after the ANN purchase. Over the next few years, ASNA will use all its FCF to delever, increasing the equity value along the way (assuming the enterprise value doesn’t go down!).

5.      The company has built a platform infrastructure that will allow it to be the best buyer of assets in the future. There are not a lot of other strategic buyers in this space. In the future ASNA will mostly compete with private equity but given the level of synergies (as evidenced by the $150 million of synergies for ANN), ASNA has de facto become the best buyer in the industry. They just have to pay a little bit more than PE firms and can pick up assets cheaply (after synergies). Over time, we believe that this will be reflected in an increasing multiple for the company.

Transaction overview

On Monday May 18, ASNA announced the purchase of ANN for around $2 billion. ANN shareholders will receive $37.34 in cash and 0.68 ASNA shares for each ANN share. This represents a purchase price of 7.7x LTM EBITDA excluding synergies and 4.9x LTM EBITDA including synergies.

The combination creates a company with $7.3 billion in LTM sales, $670 million of combined LTM EBITDA but most importantly $821 million in pro forma LTM EBITDA that includes $150 million in estimated annual run rate synergies. Having followed ASNA and its CEO David Jaffe for a while, we believe these synergies are conservative and will be achieved over a 3 year time frame.

How does ANN fit with ASNA?

Since its purchase of Charming Shoppes in 2012, ASNA has spent hundreds of millions of dollar to create a strong shared-service platform. The idea is for ASNA to be a holding company where the brands focus on the marketing and merchandising side of the business while the shared service functions take care of sourcing, IT, and all non-customer-facing back office activities. The beauty of the model is that ASNA can buy a concept like ANN and create significant synergies by plugging the brands into its platform.

Capital Allocation

We expect the company to delever rapidly as it did after the purchase of Charming Shoppes. Jaffe’s track record of capital allocation is good. Maurices and Justice were good acquisitions. Charming Shoppes is still a question mark (they haven’t turned around Lane Bryant yet). Based on the purchase price and the strong brands, we believe that ANN will prove to be a smart bet. The company also bought back close to $150 million of its own shares during the 2010-2012 period at attractive prices.  

Valuation

Pro-forma of the acquisition, ASNA will have around 193 million shares outstanding for a market cap around $2.9 billion. Net debt will be around $1.7 billion for an enterprise value of $4.6 billion. Pro-forma LTM EBITDA was $821 million (including the $150 million in synergies). Add to that the $45 million in expense savings the company is expected to realize by the end of 2016 and we get to a pro forma normalized LTM EBITDA of $865 million. The current EBITDA run rate is a little bit lower because 2015 EBITDA expectations at Justice and Lane Bryant are lower than LTM. Let’s assume that 2018 EBITDA is around $850 million (which would assume very little improvements for Lane Bryant, Justice or the other brands). We expect capex around $300 million, interest of $60 million ($1.2 billion at 5% - $600 million of debt repayment in 2016 and 2017 during the next 2 years) and taxes around $115 million for a FCF of around $375 million. The company would be pretty unlevered by then with leverage slightly above 1x EBITDA. Assuming a 7.5% free cash flow yield, the market cap would be almost $5 billion versus the current $2.9 billion or an upside of almost 80%. We expect the market to start focusing on 2018 numbers in around 2.5 years.

During the analyst day, the company highlighted the profit potential if ASNA can improve Justice, Lane Bryant and Dress Barn. The additional EBITDA could be close to $200 million which would be additional benefit on top of our numbers but we don’t need that for the investment to work very well. If 2018 EBITDA was $950 million instead ($100 million improvement), we have FCF at $440 million and a market cap close to $6 billion for a 110% upside.

On the downside, if EBITDA were to go down to $600 million, the company would still generate $200 million in FCF and at a 7.5% FCF yield, the downside would be around 5%.

Justice

A few words on Justice. I would recommend interested readers to take a look at the Company’s analyst day. The company explains its plan for the brand. The highlights are:

1.      Still a very strong brand with mom and especially with the girl.

2.      The challenge has been too much inventory which slows down turns which forces you to take more aggressive promotions to clear the goods and depress margins.

3.      As a result, the company is shrinking inventory, reducing promotion cadence, and reducing the amount of fashion goods.  

Based on my experience in retail, the plan makes sense. They will certainly have to tweak things along the way but they are clearly attacking the issues heads on. We may not get back to the peak level of Justice profitability but I expect improvements compared to the 2015 level of profitability.

Catalysts

1.      Deal closing during the second half of 2015

2.      Company providing updated guidance for their free cash flow targets including ANN

3.      Debt pay down

Catalyst

1.      Deal closing during the second half of 2015

2.      Company providing updated guidance for their free cash flow targets including ANN

3.      Debt pay down