Description

Burlington Coat Factory bonds are trading as if there is an imminent risk of bankruptcy despite significant liquidity availability and stellar retail performance.  While the trading performance is in line with the performance of the other retail LBO’s, I believe this is truly a case of the baby being thrown out with the bathwater.  Burlington Coat Factory has grown revenue and EBITDA this year vs the 30-50% declines by the other retail LBO’s.  One can “create the company” at a valuation of approximately 4x EBITDA, almost ½ of the valuation Bain paid in 2006.. 

Business:

Burlington Coat Factory is a leading off price retailer with 427 stores.  It’s traditionally known for outerwear; hence peak sales occur in the winter quarters, and it may be the one retailer in the world where a warm winter is not just a convenient excuse for poor sales performance.  The company buys inventory directly from the manufacturer as well as participating in opportunistic buys of excess inventory.  The store footprint is predominantly in the Northeast, with the average store size about twice that of their peers (more in line with a traditional dept store vs TJ Max or Ross store sizes).  Their low overhead and light sales staff allows them to keep costs down while offering savings to customers, despite the larger stores and lower sales productivity. 

The company was taken private by Bain Capital in early 2006 for $2.2 billion.  Bain purchased the company with 450 mm of equity and has since taken out about $1 mm/quarter in mgmt fees.  Prior to the LBO, Burlington Coat Factory was an ill-covered public company controlled by the Milstein family.  Monroe Milstein, the patriarch of the family, started the retail chain in the seventies and slowly grew it over three decades.  His conservative style resulted in a company with only 427 stores while rivals such as TJ Max have over 2500 stores today. The company focused on locking in solid real estate at extremely low rents ~ as a result the average rent/sq ft is around $5/sq ft; extremely low by any standards. At the time of the sale, Monroe Milstein and his two sons were still involved in the day to day running of the chain.  However, under Bain’s control, a more professional management team has been hired.

At the time of purchase, Bain paid 7.2x trialing EBITDA for the company, believing that they would be able to grow the store footprint over the next couple of years.  With only 427 stores, the company is relatively under-penetrated vs. their peers.  And the current stores are significantly cash flow positive as maintenance capex is minimal.  Also, the company’s distribution and inventory systems were archaic, allowing for significant low hanging fruit along the gross margin side.  The low hanging fruit has allowed the company to improve gross margins despite declining comps in the past year.

Thesis:

Unlike most leveraged retailers, Burlington Coat Factory actually has maintenance covenants written into its credit agreement.  The total Debt/EBITDA covenant is reduced from 6.2x currently to 5.75x in March.  Current Debt/LTM EBITDA is 5.6x, which leaves little room for error in the upcoming year.  Given the current consumer environment, it’s likely BCF will break through its covenants in the upcoming year.  Given the failure of recent retail bankruptcies to avoid liquidation, this leads to concern with regards to the recovery value of the bonds if BCF is not an ongoing business.  While not impossible, there are several reasons why liquidation is unlikely:

1)       Private Equity option to cure: written into the credit agreement is the option to cure by adding in an equity contribution that would be added to EBITDA for the purposes of the covenant calculation.  Assuming a 20% drop in EBITDA for the upcoming fiscal year, this would mean a contribution of $50 mm by the PE guys to keep the value of their equity stake alive.  Given the performance of the company has been solid, and the ability to generate cash and pay down debt, seems likely that the PE guys would contribute some equity in the event that bank negotiations are not successful.

2)       On a reasonable multiple and current EBITDA, the bonds are fully covered under the current capital structure.  Therefore, given the difficulty of current DIP financing, it would make more sense for the bank group to renegotiate the covenants than to force the company into an expensive and damaging bankruptcy process. 

3)       Sales and earnings performance for the company have been solid.  This is not a Linen’s or a Circuit City whose overall strategy is flawed.  Given it is just a capital structure problem, it is most profitable for all involved to restructure the company rather than liquidate the assets.  In this case, the bonds become the fulcrum security and a bondholder is now owning the company @ 4x a growing EBITDA.

Without bankruptcy, you are getting a cash return of 35% in the next year and a yield to maturity of 50%.  The risk/reward is extremely attractive given the high likelihood of a full recovery.

Numbers:

Capital Structure

(1)     Assuming market price of 56%, but this is not actually quoted

(2)     LTM EBITDA of $282 mm as of Sept 1, 2008

Liquidity: The Company has $277 mm of availability under the ABL as of 9/1/08.  This is the peak borrowing quarter for the year as the company accepts its winter and holiday inventory at this time.  The company also had $100 mm in cash at the end of the quarter, giving it $377 mm of liquidity.  By the end of the year, availability should be about $500 mm, which is more than enough for a company that has breakeven cash flows while growing its store base by almost 10% in the past year.

Catalyst