7-Eleven (NYSE:SE) stockholders received some interesting news early this month when parent Seven-Eleven Japan offered to pay $32.50 in cash for each share it does not already own. Even though that represented a 15% premium at the time, the stock has soared well past the offering price. Today, a special committee from 7-Eleven's board of directors recommended that shareholders reject the offer, and so do we.
Faulty logic
Seven-Eleven Japan (SEJ), directly and through wholly owned subsidiary IYG Holding Co., owns 72.7% of 7-Eleven. If it can buy enough shares to reach 90% ownership, it would be able to effect a short-form merger and forcibly buy out the rest of the company.
In tendering its offer, the parent said it believes 7-Eleven needs to increase its investment in existing infrastructure to "compete effectively in the increasingly competitive convenience store and retail industry over the long term." While SEJ management believes 7-Eleven can adequately fund this through cash flow, it thinks this will result in lower growth and profitability in the short term. Finally, SEJ views its buyout offer as a way for 7-Eleven shareholders to avoid such a short-term scenario.
Let us be blunt: We're not buying SEJ's story.
First of all, 7-Eleven's management has not given any indication that it needs any substantial increase beyond its planned investments in merchandising, store renovation, distribution and logistics systems, and information systems -- all items identified by SEJ. In fact, during the July conference call, 7-Eleven Chief Financial Officer Edward Moneypenny specifically mentioned that the company's future plans would not require significant spending increases.
Even if 7-Eleven needed to increase its investments, as long-term shareholders we're more than willing to endure a little short-term pain for future gain -- and we certainly don't see the need for a total buyout that causes us to forgo all future returns to get it done.
At any rate, we view SEJ's assertions as an attempt to unduly influence shareholders to accept its $32.50 offer. Which leads us to reason No. 2 ...
Fair value
Even though SEJ's offer was 15% above 7-Eleven's price, the shares immediately jumped higher than the offering price and have settled at around $35.60, or about 10% above SEJ's price. This tells us the market feels the deal will not go through under the original terms, possibly because of outside interest in 7-Eleven. Indeed, Canada's Alimentation Couche-Tard -- which operates nearly 5,000 stores, including those under the Circle K brand -- is actively extending its U.S. presence and is reportedly "very interested" in buying 7-Eleven if it were for sale.
However, given the nearly 73% ownership by SEJ, we consider it unlikely that a competitor has any chance of buying 7-Eleven. Smaller companies like Casey's General Stores (NASDAQ:CASY) and The Pantry (NASDAQ:PTRY) don't have the means, and oil giants that operate convenience stores, such as ExxonMobil (NYSE:XOM) and Royal Dutch Petroleum (NYSE:RD), have expressed no interest.
The most likely reason the market is pricing the stock 10% above the asking price is simply one of valuation; Mr. Market is not expecting SEJ to receive enough shares at $32.50 to get it anywhere near the magic 90% ownership level. And, in fact, the market appears to be right: SEJ says no one had accepted its offer through Sept. 19.
In advising shareholders to reject SEJ's offer, the 7-Eleven special committee said it took into account several factors, including its belief that the offer undervalues the stock. It also said discussions are now underway with SEJ regarding an increase in the offering price.
Bottom line
7-Eleven has done very well for us as a recommendation in both Stocks 2004 and Motley Fool Stock Advisor. We are strong believers in CEO Jim Keyes and the rest of his management team. They have guided the business expertly through the launch of the so-called Retailer Initiative and the model-market program. Both have provided a lift to same-store sales, and we expect that to continue as the programs eventually roll out to every store in the country.
Although it should be quite obvious, we therefore advise shareholders to not tender their shares to SEJ for $32.50. Anyone wishing to eliminate uncertainty at this point by selling should do so in the open market and earn roughly 10% more.
But this stock will remain a recommendation in Stock Advisor. Combine management's expertise with a top-notch brand, and you can see why we'd be disappointed to sell even at today's price. We may see some volatility as the SEJ scenario plays out, including a dip in the price if negotiations for a higher offer are not successful. Even if the price drops back to previous levels and SEJ ceases its buyout attempts, however, we'd be more than happy to share in the long-term success of 7-Eleven.
David Gardner recommended 7-Eleven in the June 2005 issue of Stock Advisor. You can peek at the entire roster of the more than 70 picks with a 30-day free trial to the newsletter. Click here for more information.
Fool co-founder David Gardner owns no shares of the companies mentioned in this article. Fool analyst Rex Moore owns shares of 7-Eleven. Read more about the Fool's disclosure policy here.
