Sportsman's Guide (NASDAQ:SGDE), the catalog and Internet provider of outdoor clothing and gear, has announced that it has agreed to be purchased by Redcats USA, a division of the French company PPR. Formerly known as Pinault-Printemps-Redoute, PPR controls the Gucci and Yves Saint Laurent luxury brands, among others. Redcats sells clothing via catalogs, primarily for women, with lines including Chadwick's, La Redoute, and Roaman's. It also markets a line of home textiles, gifts, and decor. An odd candidate, you'd think. Let's dig a bit further to see whether the proposed purchase makes sense.

The preliminary proxy statement has been available for some time, but I was hoping to read the final version before making any comments. However, the company just released a revised preliminary proxy statement, giving additional details on why management and the board favor the merger (page 16). Reasons include higher Sarbanes-Oxley expenses and an increase in larger and better-capitalized competitors, making it more difficult for Sportsman's Guide to continue historical sales and earnings growth or acquisitions of its own. I'd urge all shareholders to read the final proxy statement when it becomes available.

The agreed-upon price of $31 a share was a nearly 15% increase over the pre-announcement close of $27. As often happens when other potential suitors aren't in play, the share price has hovered just below Redcats' purchase price ever since. That price values the company at approximately $227 million, not including outstanding options. While the contract is not yet sealed with wax, management and the board of directors have both signed off.

Cash flow
At the sale price of $31, my back-of-the-napkin calculation shows a priced-in free cash flow growth rate of about 16% for the next five years (using end-of-2005 free cash flow*). However, consistent free cash flow growth has consistently eluded this company. Over the past five years, free cash flow has ranged from $3.8 million to $15.9 million. Depending on the starting year, compounded annual growth has been 2.8% (2000), -4.2% (2001), or 7.8% (2002).

While earnings have actually grown fairly consistently, inconsistent free cash flow has come from how the company managed non-cash working capital (NCWC**) -- receivables, inventory, payables, and the like. The year-to-year change in NCWC had been negative from 2000 through 2003, which generated free cash flow. This means the company freed up cash through improved efficiencies in managing items such as receivables or inventory.

However, beginning in 2003, NCWC itself actually became negative (meaning current liabilities are larger than current assets minus cash). This can be a way to finance growth, as Wal-Mart (NYSE:WMT) and Dell (NASDAQ:DELL) have done. The company uses supplier credit as a source of capital; ratings agencies generally frown upon this practice, viewing it as a source of default risk. During 2004 and 2005, NCWC has been climbing back toward positive territory, but that used up cash, thus reducing free cash flow.

Where's the growth?
Given the above, why would Redcats be willing to pay $31 per share? This implies a relatively high growth rate in free cash flow. Where will that growth come from? Much of the inefficiency in NCWC seems to have already been worked out of the system. Unless Redcats wishes to continue using negative NCWC to fund growth, cash must be spent to make NCWC positive. The only remaining source for free cash flow, then, is to grow earnings quickly, since capital expenditures are already minimal.

Why Redcats?
Redcats is primarily a women's clothing retailer. It does have a catalog for men's clothing aimed at the big-and-tall demographic. Apparently, it desires to expand into outdoor clothing for men and women as well. I don't know whether Redcats will keep the equipment side of the business (gear for hunting, camping, golf, etc.), but to me, this portion seems a poor fit. I wouldn't be surprised if it were discontinued or removed some other way.

I would have thought that a purchase by Cabela's (NYSE:CAB), a provider of hunting, fishing, and other outdoor gear and supplies, would make a much better fit. If Cabela's purchased Sportsman's Guide, it would gain a customer base which buys similar products at different price points. Dick's Sporting Goods (NYSE:DKS) or Gander Mountain (NASDAQ:GMTN) would also seem more likely purchasers for the same reason. However, while not naming sources, Sportsman's Guide says it had been looked at by other companies, but no credible purchase proposals came about. Reasons included its financial performance, insufficient achievable synergies, and concerns about the selling of ammunition.

Management and the board of directors are basically saying that Redcats offered them the best deal. Without it, they say the company would still be able to grow, but at a reduced rate, in a tougher competitive environment, and with fewer acquisition opportunities of its own.

Unless shareholders vote down the proposal -- which isn't likely -- the sale will go through. Still, those buying as late as early this year have seen more than a 30% gain. Not bad at all.

*Free cash flow is defined as net income plus depreciation minus both capital expenditures and the change in non-cash working capital.
**Non-cash working capital is current assets minus both cash and non-interest bearing current liabilities.

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Foolish contributor Jim Mueller does not own shares in any company mentioned, though Sportsman's Guide was a longtime favorite of his. The Motley Fool is investors writing for investors.