Description

Bluestem Group Investment Thesis (BGRP)

Opportunity

Bluestem Group (BGRP) is an extremely cheap, underfollowed $1bn+ market cap company, with an asset light and highly FCF generative business model that has demonstrated explosive topline and EBITDA growth.

The primary reason for the opportunity is technical in nature. Bluestem is a post reorg former NOL shell story which is OTC listed but primarily trades through distressed desks. Importantly however, management has been explicit about its plans for a proper listing in the next 6-18 months which should help catapult the stock higher.

At the current price of $6.30, investors create the Company at a trailing EV/EBITDA-Maintenance Capex and levered FCF yield of 6.6x and 14.4% respectively. On Pro Forma 2015E Run Rate numbers, the metrics are even more compelling at 5.8x and 18% respectively. At the midpoint of our illustrative valuation (see below), we think the stock is worth 77% above the current stock price.

Background

Legacy Company: Until last week, Bluestem went by the name Capmark and traded under the ticker CPMK. As many investors are aware, Capmark, a GMAC spinoff, was a classic carnage story from the financial crisis: a multi-billion dollar Commercial Real Estate lender which filed for bankruptcy in October 2009 and emerged in September 2011. The company emerged from bankruptcy having equitized debtholders, some legacy assets in runoff and a $1bn+ NOL. After winding down the vast majority of its legacy assets and paying down debt, the company was not much more than an NOL shell.

Centerbridge Involvement: In March of 2014, Centerbridge entered into an agreement with Capmark whereby it would invest $5mm in convertible preferred stock and received 5 year warrants to purchase from the company 43mm shares at a strike of $4.01. The warrants were only exercisable in conjunction with an acquisition, with the warrant proceeds expected to help fund the equity component of an M&A deal. Finally, Centerbridge committed to a ‘put’ option whereby the company could sell up to $100mm in aggregate principal amount of seven year subordinated floating rate PIK notes (L+700), whose proceeds would also be used for acquisition purposes.

Bluestem Brands: With Centerbridge’s involvement, the company began looking for M&A targets. In September of 2014 Capmark announced the acquisition of Bluestem Brands from Bain Capital Ventures and Battery Ventures for $590mm. Bluestem is a leading multi-brand online retailer selling a broad selection of branded and private label retail products to low and middle income consumers.

Orchard Brands: With a few hundred million of cash and monetizeable legacy assets, CPMK further utilized its ample dry powder on May 27, 2015 with the announcement of its acquisition of Orchard Brands for $410mm from American Capital Ltd. Orchard is a leading multi-channel direct marketer serving both women and men in the Baby Boomer and Senior demographics (age 50+). The company expects to close on the transaction in July.

Name Change: Just last week, Capmark (CPMK) announced that it had changed its corporate name to Bluestem Group, with a new ticker symbol of BGRP.

Putting it all together: An investment in BGRP provides shareholders with the opportunity to invest in 1) Bluestem brands, 2) Orchard Brands, 3) Holdco assets which include: (a) $108mm in Net Real Estate to be monetized in the near term (as per management), (b) a $1bn+ NOL and (c) a meaningful net cash position.

Bluestem Brands

Business Overview: Bluestem, with its 63 year old catalog, was essentially e-retail before there was e-retail. The lion share of company sales comes from its Fingerhut brand, a $1bn revenue catalog and online retailer established in 1948, and for a period of time, owned by Federated Department Stores. The driving force of Bluestem’s consumer value proposition is its credit offering, underpinned by a proprietary credit underwriting system with prudent risk management controls. The company targets low to middle income customers who are underserved by traditional credit providers (think Credit Cards). Through Bluestem, customers have the ability to purchase on credit from the company’s more than 280,000 SKUs of merchandise while deferring payment from the time of purchase. Consistent monthly payments enable Bluestem customers to improve their FICO scores. This stands in stark contrast with purchases made using Credit Card credit where payment deferrals would hurt that same customer’s FICO score. Importantly, despite its sub-prime consumer exposure, the company demonstrated strong financial performance through the recession and subsequent recovery.

A retailer selling to low income customers on credit might remind investors of Conn’s, but the similarities end there: Conn’s is brick and mortar based whereas Bluestem is catalog and online (minimal capex and high FCF conversion). Conn’s sells 2,900 branded products and has a limited offering focused on Furniture & Mattresses, Home Appliances and Consumer Electronics. If you visit the Fingerhut website, on the other hand, you might think that you mistakenly stumbled upon target.com. The company offers its customers nearly everything ranging from shoes, fitness equipment, furniture, toys, kitchen appliances, strollers, gaming consoles, tents, Apple products… and that’s just from the home page. The most striking difference between Conn’s and Bluestem, however, lies in their credit books. Conn’s is in the process of a very public attempt to sell its credit portfolio which should help de-risk the business. Bluestem has already successfully done this through its arrangement with Santander Consumer USA (SCUSA). Piper Jaffray’s March 3, 2015 report on Conn’s entitled “Credit Stability Remains On-track; Selling Portfolio Provides Add'l Value” provides insight into how the analyst community views this type of arrangement:

“This type of transaction would appear to create additional value by minimizing credit

risk, increasing ROIC, drive a net cash infusion into the business, and potentially allow

for EBITDA (or EPS) multiple expansion.”

SCUSA Arrangement: On September 19, 2013, Bluestem announced that it entered into a seven year agreement with SCUSA for the vast majority of its credit portfolio. Under the terms of the agreement, SCUSA acquired the bulk of Bluestem’s receivables. On a go forward basis, Bluestem retains control of underwriting potential customers with SCUSA obligated to purchase all newly originated revolving receivables at par (100%) through a contractual agreement which extends through April 2022. In handing over its credit book Bluestem accomplished two things: 1) enhanced liquidity which can help fuel growth through mitigating working capital related cash needs, 2) de-risk of the business: receivables are now off of the balance sheet and the credit exposure has been passed to SCUSA. To be clear, Bluestem must continue to prudently underwrite as the arrangement is subject to covenants (i.e. Bluestem cannot “bet the house” on SCUSA’s account) and it is in Bluestem’s interest to underwrite well so that SCUSA is incentivized to continue the relationship post-expiry. The direct risk though at the end of the day lies with SCUSA. Bluestem continues to service the portfolio and, under a Risk Adjusted Margin (RAM) formula, Bluestem shares in some of the upside. Notably though, the pound of flesh extracted in exchange for the right to sell receivables to SCUSA is a meaningful shift in the credit book from being a net source of cash (income) to a net use of cash (expense). For context, 2013 EBITDA went from $144mm pre SCUSA to $66mm on a PF for SCUSA basis (Q414 Bluestem Earnings release). To further bolster access to liquidity, in June of 2015 the company announced on its Q1 earnings call that it is negotiating with SCUSA to amend the terms of its arrangement. Under the proposed amendment, Bluestem would be allowed to utilize an additional liquidity provider, thereby enhancing the company’s position by removing its dependence on a single financial institution.

Financial Snapshot: A summary of Bluestem financials, PF for the SCUSA deal (i.e. as if the arrangement had been in place for all periods) shows a rapidly growing and highly Free Cash Flow generative business.

Orchard Brands

Business Overview: Orchard Brands is a leading multi-channel direct marketer serving both women and men in the Baby Boomer and Senior demographics (age 50+) which generated $1bn in TTM revenue. The company operates a portfolio of 13 brands offering a diverse apparel assortment which it markets through various channels including: more than 500 million catalogs and mailers annually; free standing inserts, magazines, package inserts, and mini-catalogs; 13 internet sites on one common platform with a universal cart; and 30 retail and outlet stores. Orchard Brands maintains a database of 5.3 million unique customers and 8.0 million gross customers purchasing as of LTM Q115.

Transaction Merits: We think the Orchard Brands portfolio is a great fit for Bluestem. At their core, both businesses have large legacy catalog components with robust and growing e-retail platforms. The transaction will result in both cost and revenue synergies. On the cost synergy side, management has guided to a minimum of $10-20mm in savings which include G&A redundancies and marketing optimization. As per management, however the G&A synergies pale in comparison to the revenue synergy opportunity. The potential revenue synergies can be divided into two basic buckets: 1) increase in higher margin apparel offerings to the Bluestem customer base, 2) application of Bluestem credit underwriting to the Orchard customer which includes both expanding credit options to existing customers as well as utilizing Bluestem’s sophisticated underwriting process to offer credit to those customers that have been rejected for credit at Orchard. For certainty, we want to emphasize that Orchard currently has zero credit risk as the credit referenced is simply a private label credit card offering underwritten and provided by Alliance Data Services (ADS), akin to a Banana Republic or Bloomingdales card.

Financial Snapshot: A summary of Orchard financials reveals a business which, like Bluestem, is highly Free Cash Flow generative.

Valuation

Consolidated Financials: On a Pro Forma basis, here is what the combined Bluestem and Orchard financials look like.

Enterprise Value Build Up: On a fully diluted basis for outstanding Centerbridge warrants, management options and giving credit for $108mm in Net Commercial Real Estate assets which should be monetized in the coming months, with cash and debt pro forma as of 3/31/15 for the Orchard Brands acquisition and finally attributing $150mm in value to the NOL for EV purposes, here is what the Enterprise Value looks like:

Implied Valuation: On an LTM and 2015E run rate basis, an investment in BGRP creates the company at an extremely attractive valuation across all metrics. For context Conn’s trades at 10.9x and 13.2x 2015E EBITDA and EBIT respectively. We think for many of the reasons outlined above that BGRP is a higher quality business model than Conn’s. In truth, we think there really is no good comp for BGRP and think it is not inconceivable to make the argument that BGRP should be bucketed not with brick and mortar businesses like Conn’s but rather fast growing, capex light e-commerce businesses which command even higher multiples.

Target Valuation: We think the proper way to value this business is NOT on EBITDA as many retail investors are wont to do. The business is extremely asset light and in short, the retail EBITDA that it generates is much more valuable than that of other retailers with materially higher maintenance capex needs and correspondingly lower Free Cash Flow conversion. In light of this, EBIT, or in this instance EBITDA less Maintenance Capex, provides a much better metric on which to value this business. Based on a range of EV/EBITDA-Maintenance Capex multiples, we think the stock could be worth between $8.85 and $13.47, implying upside potential of 40% to 114%.

Appendix A: Diluted Share Count Calculation

Catalyst

1. Closing on Orchard Brands transaction anticipated in July 2015.

2. Continued earnings expansion.

3. Gradual change in the shareholder base: over the last 6 months, there has been a gradual shift in the shareholder base from predominantly legacy distressed debt funds which owned the company either through or post-bankruptcy as a liquidation play to special situation debt and equity funds interested in owning the ongoing Bluestem and now Orchard businesses. Over time, and especially in conjunction with catalyst #4 below (Uplisting), we expect the BGRP shares to migrate into the hands of vanilla equity investors which will lead to a more proper valuation of the company.

4. *Uplisting* In our view, the most important catalyst is a pending uplisting of the stock. While the company maintains an OTC listing, management has been explicit in its plans to uplist the stock onto NYSE or NASDAQ and become a normal SEC filer within the next 6-18 months.