TQI capital focuses has always been long term- term investing but once in awhile, if there is a good opportunity arises in the short term, I will be open to the ideas. I would say Mr. Buffett has the same thoughts as well. Let winds back to 1988 letter by Mr. Buffett on his thoughts on merger arbitrage:
“In past reports we have told you that our insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents,” Buffett wrote in his 1988 letter to Berkshire Hathaway shareholders.
“We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long-term investments.”
So, how does Buffett thinks when it comes to such arbitrage. Buffett says investors must be able to answer four questions. From the 1988 letter:
“To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire — a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?”
Let’s dive right in!!!
Company: Capri Holdings Limited
Ticker: CRPI, listed in US
Industry: Fashion, luxury
Investment thesis
On 10 August 2023, Tapestry (owner of Coach, Kate Spade, and Stuart Weitzman) announced that it is going to acquire Capri Holdings Limited, a global fashion luxury group consisting of Versace, Jimmy Choo, and Michael Kors. Capri Holdings shareholders will receive $57.00 per share in cash for a total enterprise value of approximately $8.5 billion with a breakup fee of $240mil (paid by Capri).
This announcement doesn't seem to surprise a lot of people as Capri group has been performing poorly and it has been trading at an attractive valuation for years. One of the most well known investors-Greenlight capital (David Eihorn) has invested and exited the position upon the announcement.
However, sentiment changed when FTC sent a 2nd request to Tapestry and Capri for more information on their planned $8.5bil deal on 06.11.2023 and the spread between the acquired price and its current price widened. Currently, the spread is about 16% and if the M&A closes, the opportunity to make 16% in an estimated <1 year period seems to be quite attractive. (higher than treasury rate)
The downside risk will be if the deal collapses either due to block by FTC or Tapestry pulls out from the deals as a result of a prolonged period (could be due to recession risk). The potential downside will be around 25% to 40% based on the pre acquisition trading price range - $30 ~ $35 in the short term. This report will be assessing the likelihood of the deals getting done by looking at both the acquirer and target as well as FTC consideration.
Assessment
Acquirer
Tapestry started off as a monobrand- Coach before it followed the path of LVMH/Kering group to be a luxury conglomerate by acquiring both Kate Spade (2017) and Stuart Weitzman (2015). Its core business remains stable and generates a decent margin (OPM 22%). As for its acquisition, it doesn't seem to be successful given the performance of the 2 acquired companies. (Both sales and margin barely grow and worst still shrink in terms of margin under the Tapestry group)
Sources: Extracted from 10ks
Although past performance does not represent future outcome, their track record does suggest poor capital allocation. Given that this is the biggest acquisition by far (about 85% of Tapestry market capitalization upon the announcement), it will be really tough for Tapestry to manage it since they have no experience in managing a very large organisation (expected 33k employees), possible culture clash (used to compete with each other), possible loss of key management (very likely),etc.
As for financing, Tapestry will be using bridging facilities of around $8bil raised from Bank of America N.A. and Morgan Stanley Senior Funding, Inc. However, there are some changes in their financing and on 15/11/2023, Bloomberg reported that Tapestry issued $4.5bil of debt signalling that Tapestry is committed to closing the deals. (at a coupon ranging from 7-7.8% but subject to redeem at 101% if the deals failed)
There is no doubt that the market doesn't like the deal (Tapestry experienced a 16% drop in market capitalisation YTD) as it is highly leveraged. Raising debt in a relatively high interest rate environment as compared to the past certainly increases the credit risk. (if assuming $8bil of debt at 7% interest rate, interest burden will easily be $560 mil annually)
If the acquisition becomes successful, the projected OCF will be around $1.6bil vs net debt of $9bil or 3.75x net debt/OCF. Tapestry will halt its share repurchase but not dividend (doesn't make sense to keep dividend) in order to pay off its debt if the deal goes through.
Target
Capri follows the similar strategy as per the Tapestry group where it started with a single brand - Michael Kors and then expanded by acquiring both Jimmy Choo in 2017 and Versace 2018 to compete with the industry leaders.
There is no secret that under Capri group, Michael Kors, its core business was shrinking due to a series of missteps such as discounting its product frequently. They are in need to revamp its brand image and the management made 2 expensive acquisitions as stated below to premiumise their brands.
Sources: Extracted from 10ks
The acquisition certainly did not meet the company's ambitious goal (Jimmy Choo to $1bil and Versace at $2bil sales) but its growth and profitability has been decent. Although there is a slow down in growth in the recent year, the brands remain strong and it takes time to reach the expected Roic. (Versace family is still vested with the company)
As for the management/CEO, he is highly incentivised to close the deals due to the exit package offered to him. The long time CEO/Chairman John Idol stands to land a golden parachute (estimated $40mil) if the deals go through.
FTC
Lastly, after looking at both acquirer and target, FTC will serve as the final roadblock for the merger to happen. According to the FTC website, the vast majority of deals reviewed by the FTC and the Department of Justice are allowed to proceed after the first, preliminary review. However, FTC surprises the market when it requests for a second review.
This seems counterintuitive as the purpose of FTC is to prevent anticompetitive mergers or acquisitions. Luxury industry is fragmented in the first place and even with the combined entity, its market share will only be around 5.1% as per GlobalData PLC.
Secondly, it is hard for the FTC to argue that the consumers will get hurt due to the lack of competition. This is because of the nature of the luxury industry. Consumers want high prices for the goods they buy as it will reflect greatly on their status.
Perhaps, FTC could be coming from different points (ie: Minimum Price policy) to block the merger as per Antitrust consultant Darrell Prescott. To quote him:
“In an effort to better control their brands and images, many fashion and luxury goods makers wish to implement price controls to restrict the prices at which retailers may sell their products. These controls often take the form of a suggested retail price policy or a required minimum price policy. The law on these restrictions has evolved significantly over time and become more permissive.
However, because the law in this area is still relatively unsettled, companies do expose themselves to the risk of antitrust liability when they implement such programs, especially in certain states in the U.S., or at the federal level if the resale pricing policy is part of a horizontal price restraint among competitors.”
As of now, the above is merely speculation as there are no clues on what is triggering the second review. My best guess is that FTC has no solid point to block the acquisition and FTC shouldn’t be the biggest concern for the deals. Even if there are concerns, I believe Tapestry will yield by addressing the concern such as selling part of the business to close the deals.
I am more concerned about the drags and Tapestry financial positions to secure sufficient funds to close the deal or some scandals on Capri group blow up right before the deal gets done.
Valuation on Capri (The target)
I am going to value it based on the sum of parts method, (current market capitalization is around $5.6bil). Let assume that Jimmy Choo and Versace are able to retain their valuation from acquisitions despite its increasing profitability to be conservative (valuing at $3.3bil), MK alone is only valued at $2.3bil.
With a revenue of almost $4bil and operating income of $0.7bil (for MK division only after minusing corporate cost), the valuation does seem to be quite attractive even assuming declining revenue and profitability growth. (Q22023 results are really poor and the company experienced low double digit negative growth.) There seems to be sufficient margin of safety even if the deals failed to go through.
Conclusion
Tapestry has a poor track record in doing acquisitions and I am not optimistic that the post merger company will perform great. However, I do think that the acquisition is likely to go through given that FTC has minimal cases to argue against the deals. (based on the case where Tiffany is being acquired by LVMH that is arguably more dominant than any luxury companies)
Besides, even if the deal didn't go through, Capri valuation does seem to offer sufficient margin of safety as stated above. Capri does have some other alternatives like spinning off its brands or continuing to buy back its stocks in the future. Best if Kering group (owner of YSL and Gucci) offers to purchase some of its gems (like Jimmy choo or versace) from their hand when the macro environment stabilises and return the proceeds to shareholders.
Of course, things could continue to go south (if the acquisitions failed) given how unpredictable the current CEO can be (ie: screwing up its succession planning) or continue poor decisions and minority shareholders have little control. (holding poor company with little prospect to recover)
This is a bet that I am willing to take given the odds of success are high for a relatively short period of time. (deadline will be August 2024 or 9 months from now) It is all about risk vs rewards.
Disclaimer: I have position in the company and receive no fees for writing the post. I am not affiliated or have any role with the company. This post is just for educational purpose and it is not an advice to buy or sell the stocks. Invest at your own discretion.
Resources
Antitrust Issues in the Luxury and Fashion Industry by Darrell Prescott
Surprise Second Request Threatening Tapestry's Acquisition Of Capri by Bram De Haas