The whiplash from the double take hurt my neck. I really couldn't believe I was reading that Finish Line
The only good thing coming from this development is that Genesco shareholders are getting an offer that is $5.50 higher than the unsolicited bid Foot Locker
Price
Of all the things that don't make sense to me, the price isn't one of them. At $54.50 per share, Finish Line says it will be paying about $1.5 billion in enterprise value for Genesco. That makes the price-to-sales ratio just under 1 and puts the EV/EBITDA ratio at about 8. According to these metrics, at least, the price isn't outrageous.
It was a pretty balance sheet
Over the past few years, financial performance has been a rollercoaster ride. In 2004 and 2005, margins increased and things looked rosy indeed. However, in 2006 and into 2007, margins have been on the decline and growth has been slowing.
Fortunately, the company had a balance sheet without any debt. With growth slowing and the income statement deleveraging, it's a good thing Finish Line didn't have to worry about making those fixed interest payments. That luxury is no longer there and, quite frankly, it's turned a bad situation into a worse one.
Finish Line is making the acquisition in cash. With only $62.9 million on its balance sheet, it's taking on debt to finance the rest. According to management, it expects the "debt to EBITDA ratio to be in the mid-five times area" for the new company. Given the data, I calculate the ratio to be 5.7. That seems very high for a retailer. Let's see what other retailers are this highly levered.
|
Company |
Debt/EBITDA |
EBITDA/Interest |
|---|---|---|
|
Cost Plus |
8.2 |
1.9 |
|
Finish Line* |
5.7 |
2.0 |
|
Pep Boys |
4.8 |
2.3 |
|
Rite Aid |
4.6 |
2.3 |
|
Movie Gallery |
4.6 |
2.0 |
*Author's calculation assuming 8% interest rate on the debt. The company did not disclose the interest rate.
This is not exactly a star-studded lineup. These companies are struggling, and their debt loads are not helping.
That severely levered balance sheet adds way more risk to the equation. FINL is an inconsistent operator. That's not what you want if you have a big ol' slab of debt staring you in the face. We've all heard that higher risk can bring higher reward, but this seems to be simply higher risk.
Oh, well. It was a pretty balance sheet.
A growth story?
In the transcript of the conference call, management commented that "while this transaction is about growth, not cost savings, this scale does provide us with some opportunities for increased efficiencies." I don't think this can really be about growth. But management can't say that in front of a crew of Wall Street analysts. How is management going to sell the idea?
It's funny, but there wasn't much data about growth expectations. Perhaps it's too early. Still, the cost savings have been quantified. I just find that interesting.
Neither of these two retailers is growing very quickly, and I don't expect that to change just because they've joined together. This has to be about scale and cost savings. Perhaps Finish Line can kick-start its growth a little, but the more important thing that needs to be done is to generate operating leverage. That's because margins are going to have to expand to pay the interest and to pay down that debt load.
Strong cash flows?
So far, we've learned that the balance sheet will be weakened, creating extra risk, and that the deal is about growth, although operating efficiencies seem more important. But there is one more gem from the transcript: "We remain confident that our strong free cash flow from operations following the transaction will allow us to reduce our net debt and fully fund our growth initiatives."
Last year, these companies were not big free cash flow generators. Between the two of them, they generated $2 million in free cash flow. Yes, I could make some adjustment for growth and maintenance capital expenditures. And, yes, last year could have been an anomaly, as they have generated more free cash flow in prior years. But you know, it looks like an uphill battle. I don't see that heavy debt load being paid down for quite a while, so those operating improvements had better come quickly.
Conclusion
As I look at the data, all I can ask is: Why? Why would Finish Line pursue this acquisition? How much reward is there for all of the risk it seems to be taking? I don't see it. I wasn't a big fan Finish Line before, and should this acquisition be approved, I would be even less of one.
I think that's why the market is voting with its dollars today and selling off shares. And I wonder what the activist shareholder hoping the company would go private is thinking today.
For more on Finish Line and Genesco, check out:
Retail editor and Inside Value team member David Meier is ranked 8,405 out of 30,613 rated investors in CAPS and does not own shares in any of the companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.
