Wednesday, June 8, 2011

Value Merger

Liquidation World (LQW) has been discussed in many value circles over the last few years as a potential value investment. Having traded below book value for the better part of four years, shareholders must have been delighted when news came out last week that the company has agreed to be taken over. But the shares plunged on the news, as the take-out price was lower than the stock's market value! How can value investors protect themselves from falling into such value traps?

There were a number of warning signs at Liquidation World which should have kept investors away. First, the company has not been profitable for a number of years. This can still be okay if there is ample cash to survive, but there wasn't. Not only was the company in debt, but it owed a ton in operating lease obligations.

Operating leases act like debt, as they are cash commitments that must be paid. Ignore them at your own peril! Furthermore, just as a debt-laden company can't afford to shrink (as the fixed debt payments then need to be serviced by smaller revenue amounts), a company with operating leases is forced to stay at locations even if the locations are burning cash. Incredibly, Liquidation World has more stores open now than it did in 2001, which was the company's most profitable year in the last decade; it has lost money in most years since then. Management was either unwilling or unable to shrink, which is what a retailer should do (to close unprofitable stores and free up capital and resources) when it can't make ends meet.

There does appear to be a smart value participant in all this, however, as the buyer (Big Lots, BIG) appears to be getting a good deal. Instead of having to grow slowly and organically, or pay a premium price for an acquisition, Big Lots is paying a pittance because Liquidation World is otherwise on the brink of bankruptcy. The cost for Big Lots is only about $400,000 per store, including every store's existing inventory, customer goodwill, and staff.

Big Lots is now free to make the changes it wants to make the Liquidation World stores as profitable as those of Big Lots. With an ROE 20% and a P/E of just 11 with no balance sheet debt, Big Lots may be worthy of consideration as a value play in itself.

Disclosure: None


Anonymous said...

Saj, do you know what's up with GDC? The stock traded as low as $3.37. Please let us know if you do find out.

Anonymous said...

Re anon(1:26),

Offer expired.

Hester said...

I own BIG. I bought recently after they tanked when their mission to sell themselves failed.

The deal is definitely good for BIG. They are very smart capital allocators.

If BIG makes on the new Liquidation stores what they make on their current Big lots stores, they'll only increase EBIT 6-7%, so it's not hugely important to BIG, but this deal really does showcase their capital allocation skills.

Sorin said...

Hi Saj,

What do you think about A.C. Moore Arts and Crafts (ACMR) ? Ever looked at it ?


Saj Karsan said...

Hi Sorin,

I have not. I'll post here if I have any thoughts on it.

Saj Karsan said...

Hi Sorin,

The situation is a bit risky for me. I'm worried about them running out of cash before they can right the ship.