Recently, analyst firm Jefferies listed several retail stocks as top leverage buyout, or LBO, candidates. Basically, the analysts think the stocks have gotten so cheap that private equity will take them private via borrowing debt to restructure and hopefully create value.
Jefferies thinks that Aeropostale (NASDAQOTH:AROPQ), American Eagle Outfitters (NYSE:AEO), and Body Central provide interesting values with high internal rate of return, or IRR, and limited debt. The only problem is that the teen retail segment has become highly competitive, with numerous players that can easily compete online with cloud software tools and social media advertising.
The first perplexing data point is a disconnect between declining and even negative earnings and the listed IRRs of 25% or more. An investor who buys Aeropostale has no reason to expect a decent return even if a new project can generate a 25% rate of return. The point is that the company as a whole is losing money. Naturally beaten-down stocks with potential catalysts can be attractive and Jefferies does provide ample history of 11 recent LBOs in the specialty retail sector.
This specialty retailer focused on 14-to-17-year-old customers had a very successful decade during the 2000s. The stock surged to a high of more than $30 in 2010 from lows below $3 at the start of the decade. Aeropostale hasn't seen much success in the last three years. It operates 975 namesake stores and an additional 145 stores for younger kids called P.S. from Aeropostale.
At a market value of only $750 million and with a revenue base of nearly $2.2 billion, the stock appears ripe for a restructuring. In addition, Aeropostale has roughly $100 million in cash and no debt, which makes it attractive to private equity that could leverage up the balance sheet. The biggest risk to investors is the large decline in revenue due to a 15% reduction in comparable sales during the second quarter of 2013. The company continues to list a challenging teen retail environment with weak traffic trends as a major problem.
American Eagle Outfitters
Like Aeropostale, American Eagle was a hugely successful retailer in the early 2000s. The stock peaked back in early 2007. American Eagle operates more than 1,000 stores. The concept focuses primarily on 15-to-25-year-old men and women under the namesake brand. American Eagle also operates Aerie stand-alone stores that focus on intimates and personal-care products for girls.
With a market value of $2.7 billion, the stock will require a rather large private equity buyer. The stock is also extremely profitable, which probably means limited turnaround capabilities for private equity firms. It does face a challenging retail environment with weak comp sales pushing total sales negative for the second quarter of 2013. With $400 million in cash and no debt, private equity might be interested in leveraging up the balance sheet in this low-interest-rate environment.
With its market cap plunging below $100 million, this specialty retailer of young women's apparel and accessories in the U.S. appears prime for going private. The company operates 289 stores in only 28 states and operates in a highly competitive market with Forever 21 and several other online-only retailers such as Nasty Gal.
With a revenue base of $300 million, Body Central appears ripe for a private-equity turnaround. As disappointing as results have been over the last couple of years, the company actually earned $0.75 per share in 2012. It has $39 million in cash and no debt, but the cash level is getting low considering the expected losses for 2013 and no guarantee of a return to profit in 2014.
The biggest concern for investors who want to follow Jefferies into these potential LBO targets is that the IRRs are apparently based on historical data that is no longer accurate or viable going forward. The teen retail and young women's retail sectors remain as challenged as ever. There's no indication that the market is becoming less competitive due to the growing impact of Internet-only retailers and limited reduction of competition from the primary mall retailers.
Strong balance sheets could indeed generate big buyout gains for existing investors, but long-term investors will incur too much risk trying to pick the winners in the group, while the losers could quickly pull down a portfolio. Investors are better off staying away from speculating on buyouts.
Fool contributor Mark Holder has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.