MOVIE STAR, INC. (MSI - $1.48)

 

This is a buy recommendation for Movie Star, Inc. (MSI).  After many months of negotiations and the appointment of a special committee at both companies, MSI today announced a reverse merger with privately held Frederick’s of Hollywood (FOH), the lingerie and intimate apparel retailer based in Los Angeles.  The merger will create significant synergies and cost savings for the combined firm, resulting in increased margins and considerable growth potential.  Before the announcement of the merger, we had valued MSI stock as high as $2.70 per share, based on recently improved performance and projections.  Despite the immediate spike in price (up 17% on the news), MSI, and the new public company, post-merger, appears significantly undervalued. 

 

While a lot more data about the combined company, including the real level of EPS accretion or dilution from the purchase of FOH, will be forthcoming when the SEC documents are filed, we believe this period of “information uncertainty” provides a buying opportunity.

 

MSI is a designer, manufacturer, importer and distributor of women’s intimate apparel (lingerie, pajamas, nightgowns, and other related items), and sells its products in specialty stores, department stores, national and regional chains, as well as through direct mail catalogs.  MSI’s presence is primarily in large chain stores; in FY 2006, 25 percent of its sales came from Wal-Mart stores alone.  The Company had a strong year in FY 2003, but saw a steady erosion of sales—and profitability—from FY ‘04 through FY ’06, although a good portion of the problems were attributable to one-time events.  The stock fell from a high of $2.61 per share in October 2003 to a low of $0.50 in January 2006.  Despite past losses, MSI appears to have righted its ship in the latter half of 2006 (beginning of FY ‘07), and has now doubled since November on stronger earnings and the merger announcement.

 

Fredericks of Hollywood, MSI’s merger partner, sells its famous lingerie and intimate apparel through its approximately 130 retail outlets, and through its popular catalog and online stone.  FOH had $139 million in revenues for its fiscal year ended July 29, 2006.  It emerged from bankruptcy protection in 2003, and one of its owners, Michael Tokarz, is a former KKR partner and is also the largest shareholder of MSI with a 22.4 percent stake. 

 

MSI’s financials before the merger announcement provide strong support that MSI shares are still trading very cheaply.  In the first quarter of FY 2007, MSI improved net sales to $18,690,000, a 37.1 percent increase over the same period last year, in which sales were $13,637,000.  MSI was also able to increase gross margin to 31.2 percent, up 4 percent from last year’s first quarter mark of 27.2 percent.  The combined effect resulted in net income of $366,000 ($0.02 per diluted share) for the first quarter, compared to a net loss of $371,000 for the same period last year.  The real first quarter net was significantly impacted by a large increase in SG&A expense, which rose $811,000 over Q1 ‘06.  Most of this increased expense comes from $540,000 in professional fees directly related to the merger. 

 

Discounting this expense, pro-forma net income for the quarter would have been $690,000 (adding back the $540,000 expense, net of 40% taxes).  MSI Q1 sales on an annualized basis (historically the firm’s sales have been stable quarter-to-quarter) are $75 million.  If they can achieve the same margins for the entire year—there is no reason to expect otherwise—this amounts to net earnings of $2,760,000, or about $0.18 per share.  Given this net, at the current price, P/E is very low at 7.38.  A more proper multiple is between 15x to 20x; at the low end, this puts the share price at $2.70, and $3.60 at the high end. 

 

On a price-to-sales metric, MSI has $4.74 in sales per share ($75 million in sales, 15.8 million shares).  In the Value Line Small Cap apparel metric, similar companies average a valuation of roughly .5x sales.  This would value MSI at $2.37 per share, not quite as high as the P/E valuation, but still representing an 82 percent increase over the current price.  As a further boon, MSI has over $9 million in NOLs.  Net of 40 percent taxes, this provides over $5.4 million in sheltered income. 

 

The timing of the merger is indicative of how undervalued MSI is.  TTG Apparel, LLC owns 22.4 percent of MSI’s outstanding shares.  TTG is owned wholly by Michael Tokarz.  Tokarz, in turn, jointly owns FOH with hedge fund Fursa Alternative Strategies LLC.  We believe management’s goal, in this instance, was to execute this merger as cheaply as possible.  Accordingly the timing of this merger should come as no surprise; MSI was not going to stay so cheap for very long.  We think there is a strong possibility that between now and closing MSI pays somewhat less for FOH.

 

Current MSI shareholders are also being offered the exclusive, non-transferable rights (backstopped by the FOH shareholders) to buy up to $20 million of newly issued MSI stock to fund the expansion of the FOH retail footprint. 

 

Even with the spike in MSI shares, the combined company should trade considerably higher.  FOH had revenue of $139 million in FY06, ending in July.  MSI is projected to have revenues of $75 million for FY07.  FOH’s stores, designs, and personnel are expected to drive top line growth, while MSI’s well-developed sourcing capabilities are expected to help increase gross margins and improve operational efficiencies. Assuming the synergy created by the merger can boost sales by at least 5 percent, combined sales for FY07, on a prorated basis, should be no less than $225 million.  Likewise, savings in SG&A costs and elimination of other operational redundancy should increase margins.  If the company can raise current net margins of nearly 4 percent to 5 percent, net income for the combined company would be in the $11 to $12 million range. 

 

As part of the merger FOH will receive 23.7 million shares, putting the total of outstanding shares at 39.5 million.  At $1.50 per share, the market capitalization will be approximately $60 million, or a little more than 25 percent of sales.  This, however, does not factor in the $20 million offering to current MSI shareholders.  Should the shareholders not fully exercise this right, TTG, Tokarz, and Fursa will cover any shortfall via a backstop, bringing the eventual market cap, at $1.50 per share, to approximately $80 million, or just over 30 percent of sales.

 

With net income of $11 to $12 million, this market capitalization represents only a 7.1x P/E multiple, extremely low compared to others in the industry.  If the new company was valued at a 15x multiple, still on the low side, the stock would more than double.  This may even be conservative.  Not only should the two companies become more efficient, but the lines will compliment each other very well, with FOH securing the top end, and MSI securing the lower end for fuller market coverage.  Better still, through this merger, both sides will be able to refinance their debt on more favorable terms, allowing them to expand.  FOH alone plans to build 50 new stores over the next 36 months, and will continue to expand its online and catalog businesses.  With the proposed expansion, synergistic growth, and reduced cost structure, the combined company could easily grow to sales in excess of $300 million in three years, with net margins of better than 5 percent.  The share price would climb to keep pace. 

 

Last, but not least, it is possible that the deal offered MSI improves as current shareholders get more information and possibly determine that MSI sold itself too cheaply. 

 

 

Catalysts:

- Significantly undervalued; strong current earnings

- Trading at only 7x projected combined earnings

- Merger will provide synergy and cost savings

- Improved bid from FOH

- $5.4 million in sheltered future income