Fredrick’s of Hollywood and Movie Start Inc.: Reverse Merger Mania

by: Michael Goode December 26, 2007 | about stocks: FOH    
Michael Goode

Michael Goode

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It is merger time! My favorite micro-cap reverse merger is going to happen in just one month. Movie Star Inc. (MSI) [$1.63 0.00%, market cap: $25.6M] will buy the larger, private Fredrick’s of Hollywood. I previously wrote about this transaction back in August when MSI’s stock price was around $2.20 per share. It currently trades at $1.60.

After everything is done, the combined company will have no net debt (or net cash), $215 million in annual sales, and 55.75 diluted shares outstanding (including conversion of preferred stock). Given the current price of $1.60, the implied diluted market cap is $89 million. There is a rights offering in mid-January that will raise $20 million. This offering is priced at $1.76 (only shareholders as of late November can participate). At that price, the implied diluted market cap of MSI/Fredrick’s is $98 million.

Given the combined company’s proforma price to sales ratio of .41, it seems a bit cheap. For comparison, Limited (LTD) [$19.04 0.00%, market cap: $7.621B] is priced at .65. However, considering that $64 million (30%) of the combined company’s sales will come from the low-margin manufacturing / distribution business of MSI, the company seems to be price about right (subtracting out the sales of MSI, the P/S ratio rises to .6).

In terms of earnings, I come up with estimated proforma earnings for the year ended last June for the combined company of $2.8 million. I do not include the preferred stock dividend because I assume conversion to common stock (this will not happen, but I must avoid double counting the cost of that preferred stock and I count it as diluted common stock). I also take out all direct merger-related costs, and do not include interest expense (most of the debt will be paid off, and there will be $20 million in cash on the balance sheet when the merger goes through).

This gives a proforma P/E of 32. However, it is likely that there will be some significant cost savings of the merger. Assuming that SG&A is cut by just 5% (a modest assumption), I come up with proforma earnings of $5.5 million and a proforma P/E of 16.2. This is a reasonable multiple, especially considering the growth the company should see.

Here are the drivers of growth in sales:

  • 50 anticipated new Fredrick’s stores over the next three years will increase the number of stores by 38%.
  • Organic growth in same store sales and online/catalog sales will be about 8% per year as old stores are remodeled, Fredrick’s brand regains some cachet, and concentration of stores increases as the store total increases. Fredrick’s only averages about $400 in annual sales per square foot. This should increase to at least $500. For comparison, Victoria’s Secret averages somewhere between $600 and $700 per square foot.

    • Furthermore, costs should decrease:

  • Cost of goods should decrease as the company’s greater size increases its bargaining power with suppliers and as Fredrick’s sources more of its product from MSI.
  • SG&A as a percentage of sales should decrease due to cost cuts and an increased number of stores, and greater sales per store.

    • MSI/Fredrick’s still remains a risky play. That being said, Fredrick’s has a well-known brand, and it is available on the cheap to the public markets for the first time in about a decade.

    Disclosure: I am long MSI, and am also a customer of Fredrick’s.

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    This article has 2 comments:

    •  
      Dec 27 10:43 AM
      Sounds like you have been speaking with the deal's bankers too much. Why would you recommend investors to purchase common of the acquiring shell when the post-deal company will be majority owned by a preferred? Your light-hearted caveat emptor on this issue

      "I do not include the preferred stock dividend because I assume conversion to common stock (this will not happen, but I must avoid double counting the cost of that preferred stock and I count it as diluted common stock)."

      Seems naive at best.

      What exactly is the dividend rate? What is the preference? Is there a reason why you don't mention that Frederick's has had some serious problems in the past (Chap. 11) and why it isn't considering it's own IPO?

      Did you factor increased public company costs in your analysis? Sarbox, accounting, legal, reporting, etc.? It seems like the 5% g&a savigns you reference can be quickly sopped up here.

      A 32 P/E, even pro-forma'd for a 16 p/e when speciality retailers are currently trading at 7x trailing EBITDA (SHOO, KCP, CHRS, etc.) seems really expensive.

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    •  
      Jan 29 03:15 PM
      You bring up good questions. I think I mentioned in my previous article on MSI/Fredrick's that Fredrick's had been in bankruptcy. Anyway, all the troubles with bankruptcy were due to over-leveraging.

      In my pro-forma I necessarily included the public costs, because I did combine the two companies, and the costs of Sarbox et al. should not increase substantially just because the company is now larger.

      As to the valuation, you are looking a lot smarter than I am what with the continued troubles in retailing.
      Reply | Link to Comment
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