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.
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
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.
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
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.
For more sporting Foolishness:
- Sportsman's Guide in the Crosshairs
- Foolish Forecast: Sportsman's Guide Shifting
- Sportsman's Guide Shapes Up