Description

 Summary:

Recent market turmoil has created an attractive merger arbitrage opportunity in the shares of BJ's Wholesale Club.  This $51.25 take-private has a good chance to close on Sept. 9^th, but could stretch to Sept. 29^th.  The $1.00 spread is a good ROR on its face and you pay nothing for the ~3% scenario that Wal-Mart returns with the $55 - $60 indication of interest it made in April during BJ's auction process.  Most importantly, an unusual confluence of positive factors make this deal 98%+ likely to close and in the remote scenario of deal break, stressed downside is likely limited to ~25%.

BJ Overview

BJ operates ~190 club warehouses concentrated in the Eastern part of the US.  Households and small businesses pay $50 annual membership fee in order to shop for bulk food / merchandise at BJ.

The business has a history of maintaining membership renewal rates, even after membership fee increases.  In Jan. 2011, BJ raised membership rates from $45 to $50 (pure margin), yet  is continuing to comp positively in traffic, ticket, SSS.  Naturally, EPS has exceeded guidance in light of these trends.

Happy to go into more details on the biz in the thread if anyone interested - but those recent BJ trends and LG's actions speak louder than my words:

History (boring but important)

In an unusual move, Leonard Green purchased 9.5% of BJ in May/June 2010 in the public market at prices ranging from $37.60 - $39.75.  Paid $132mm in total price/premium (some purchases done via bespoke in-the-money calls).  Putting money to work buying stock in public markets when a PE firm lacks control and/or board representation requires a lot of conviction in both the business and the purchase price.  Although purchasing stock gives a cost-advantage in any subsequent sale process (LG can roll the 9.5% stake it bought cheaply into the 35-40% required equity), there is no guarantee the company will pursue a sale.  PE firms to date have been unwilling to make Carl Icahn-like hostile bids.

LG rattled its saber and worked behind the scenes to warm up reluctant BJ management to the prospect of a sale, and BJ announced it will explore strategic alternatives in Feb. 2011.

This dynamic reverses the classic adverse selection problem of LBOs... instead of a board trying to sell at rich valuations to a buyer that might end up with future buyer's remorse and walk from the deal, we have a buyer willing to risk 27% of the eventual equity required to purchase the company (9.5% of shares out / 35% equity check) on the hope that BJ would pursue a sale.  Since PE firms rarely buy stock in the market, we are rarely treated to this dynamic.

The deal is too big for Leonard Green to fund the entire $640mm equity check, so it partnered 50/50 with CVC.  Each firm is contributing $320mm.

Wal-mart optionality

Background of the proxy states Company A submitted $55 - $60 indication of interest in April 2011.  Company A is Wal-mart (Sam's Club).  In lieu of signing an NDA, the parties shared info with a third party legal firm and had econometric consultants review local market overlaps.  Wal-mart indicated it wasn't willing to agree to divest significant numbers of stores to secure antitrust approval, so BJ did not include Wal-mart in the bidding process.  Perhaps WMT just wanted a peek at the books, perhaps not.  BJ geography is complementary with Sam's Club, so there is logic to the combination.  BJ shareholder vote is set for 09/09, so WMT must make a move before then.  BJ just reported earnings (strong) on 08/17, so now is the time for WMT to make a move.  I assign 3% probability.

Merger Agreement

The deal is not conditioned on financing, and LG has $2.6B of committed financing (including ABL).  Committed financing means banks have promised to fund bridge loans to the buyer in order to close the deal in the event the banks can't syndicate a separate financing within certain rate caps negotiated in the commitment.  I.E. if capital markets completely close, the banks end up hanging these loans on their balance sheet (as in '08).

Changes in the economy, markets, etc. do not allow the banks to walk from the financing, nor LG to walk from the deal.

However, LG can pay a termination fee to walk at any time for any reason, which lets them willfully breach the contract.. for a price.  This fee is set at $175mm, or 27% of the $640mm of equity committed to the deal - a big barrier to walking!

Timing

Merger agreement gives the buyers a "marketing period" of 15 business days in order to place financing after all conditions to close are met.  The final condition to close is shareholder approval on Sept. 9^th. 

Given the state of credit markets and depending on the rate caps in the commitment letters (not disclosed), the buyers may decide to just draw on the bridge right away to close the deal and come up with permanent financing down the road.  There is precedent for closing without waiting for the marketing period - both when financing is syndicated early (good market) and when buyers know financing can't be placed at acceptable terms (bad market).

I think 55% deal closes on Sept 9, 45% close on Sep 29^th.

Downside

Before Leonard Green filed 13-D in the name back in June 2010, BJ was $37.01.  Moves in comparable companies that play to the consumer's value mentality.

COST :  +38.4%, DG:  +17.0%, DLTR:  +62.5%, WMT +9.6%, FDO:  +25.1%

Assume BJ fell back to the $37.01 from which it came, and there is 26% down without reducing downside for the strength of comps, the strength in BJ's business after raising membership rates, cost saves executed in Jan. of this year, higher guidance, etc.  It would be trading at ~5.2x EBITDA and ~13x earnings   I feel very comfortable underwriting that downside.

Expected Value

1% probability of $37

3%  probability of $55

96% probability of $51.25

EV = $51.22

Catalyst