Description

Investors in Retail Ventures, Inc. are paying a discounted price for pending IPO DSW Inc. and getting free call options on Value City Department Stores and Filene’s Basement. This investment combines several of my favorite themes: a bad retailer masking the performance of a good retailer, a signaling transaction artfully designed to enrich insiders in which minority shareholders can indirectly participate and initiating bulge bracket research coverage.

Jay Schottenstein, through privately-owned Schottenstein Stores Corporation, and Cerberus each have ‘money-good’ $50 million term loans to Retail Ventures, Inc. (RVI) due June 2006 bearing interest in cash at 15%. The only reason savvy controlling and insider shareholders give up 15% coupons that they could probably extend indefinitely is because they expect even more from the alternative. The 15% loans will be paid down on or about June 6, 2005, when RVI carves out a portion of its DSW Inc. subsidiary (DSW) in an IPO managed by Lehman Brothers. Schottenstein Stores and Cerberus will then have their RVI warrants amended to include the right to purchase RVI’s DSW stock at the IPO price (see below).

I believe DSW alone is worth at least $15 per RVI share (33% higher than the current price). Investors would then have a free call option on RVI’s two other subsidiaries—Value City Department Stores and Filene’s Basement—with the striking price equal to the outstanding debt. RVI’s under-valuation relative to DSW may become increasingly apparent as investors begin to focus on DSW when the road show begins later this month. With float limited to 14.7 million shares, the ‘value gap’ could begin to close quickly.

DSW. DSW (Designer Shoe Warehouse) operated 172 stores at January’s end, averaging slightly less than 25,000 gross square feet and 21,250 selling square feet (85%). DSW states in the prospectus that the concept could support 400 stores with no change in unit economics. The plan is to open approximately 30 stores annually for the foreseeable future at a cost of $1.7 million per store before vendor financing of approximately $300 thousand. A DSW store offers 30,000 pairs of shoes in 2,000 styles at an average price of approximately $40 (Payless’ average price, by my calculation and as a point of comparison, is $14.25). Women’s shoes range from Keds to Prada (designer shoes reach $380 per pair at the Union Square, NY store). The stores are carpeted and well lit and 43-inch shelving displays make the store easy to navigate and stock, with sample shoes sitting above a stack of boxes in a run of sizes that basically represent the store’s inventory. Shopping is self-service; associates are mainly limited to the cash wrap and re-stocking. Inventory is replenished weekly, and pricing is low every day to encourage frequent visits by shoppers who like the ‘thrill of the hunt’ and want to find something each visit. DSW’s loyalty program, which provides $25 off for every $250 spent within a six-month period, has 5.5 million active members (defined as purchase within the last two years). Particularly striking is that these ‘loyalty shoppers’ comprise 60% of sales with their average ticket 19% greater than average. This implies that the majority of sales are to shoppers buying 5-6 pairs of shoes in six months. There is something more here than a typical shoe store experience. These customers are collectors.

By January 2006, DSW should have 202 stores and sales of approximately $1.1 billion. DSW’s operating margins began to improve dramatically in 2004, reaching 6.3% for the 39 weeks ended October 30, 2004 after several years around 2.5%-3.5% (since spring is a bigger selling season than Christmas for DSW, full-year operating margins should be below 6.3%). Management attributes the improvement to a strong spring selling season leading to higher initial mark-ups and lower markdowns. Store maturation may also have contributed together with a diminishing relative contribution from leased departments, which DSW operates for Stein Mart (153), Gordman’s (48) and Filene’s Basement (22).

Filene’s Basement and Value City Department Stores. The Basement (26 stores) and Value City (116 stores) may generate sales of approximately $375 million and $1.3 billion in 2005 (January 31, 2006). Basement’s original Boston store offered top tier/couture fashion at dramatic markdowns with weekly progressive markdowns. The concept did not transfer well into new locations, however, and merchandise assortments and store experience began to resemble a poorly run T.J. Maxx. The company was acquired by RVI in 2000 and now offers every day low pricing. The stores I have visited recently were designed for a more pleasant shopping experience (reminiscent of Stein Mart). Expansion in margins will not be dramatic. The Basement has already been ‘turned around,’ and I am assuming 1% operating margins.

Value City offers more promise. Heywood Wilansky, who was the Basement’s President & CEO from 2003-2004, was also President & CEO of Bon-Ton, a successful turnaround, from 1995-2000. Value City stores average 87,000 gross square feet (about the same as Bon-Ton) and offer off-price merchandise acquired in buy-outs that are offered at 20-70% discounts. The result is a too-large, low-end JC Penney. Value City’s operating issues are real; Wilansky has quite a job ahead of him. Nevertheless, with $1.3 billion in sales, if Value City were able to achieve Bon-Ton’s 3-4% operating margins, it would make a meaningful difference.

Other. Jay Schottenstein is well known in retailing; the Schottensteins are among America’s wealthiest families, and their name (together with Value City’s) adorns the Ohio State basketball arena. Jay is Chairman of American Eagle Outfitters, Inc., a poor-man’s Abercrombie & Fitch, with $1.9 billion in sales that has had great success. Jay understands liquidations as well as anyone in retailing, and Schottenstein Stores competes with Gordon Brothers and Kimco. The Schottenstein reputation also extends to related party transactions (see below).

The company’s web site at dswshoe.com has a virtual store tour that is helpful.

Potential comparables are Payless ShoeSource, Inc. and Brown Shoe Company, Inc. Growth in square footage at DSW, however, is significantly greater. I estimate that DSW will trade at 15x 2005 earnings versus 16.5x for Payless and 12x for Brown Shoe.

Sum-of-the-parts. For simplicity sake, I consider the valuation before the IPO. I estimate DSW will achieve sales, operating profit and net income of $1.1 billion, $66 million and $38 million, respectively, in 2005. A valuation representing $15 per RVI share would imply multiples of 15x earnings, 0.6x sales and just over 9x operating profit. Value City and Filene’s Basement, if worth just 0.2x sales, would cover the $345 million of net debt at RVI. If Value City and the Basement were to achieve operating margins of 2% and 1%, respectively, it would add more than $1 of value to RVI.

Risks. A cancellation or delay of the IPO may cause RVI shares to decline significantly.

Related party transactions are extensive (see RVI’s 10-K and DSW’s S-1 filings). I believe, however, that this situation has something in common with the incentives surrounding a spin-off—sometimes it is the very act of a controlling shareholder or management team appropriating shareholder value that highlights the opportunity and catalyzes the investment.

In connection with the offering, Schottenstein Stores and Cerberus will each have 1.5 million RVI warrants with a $4.50 striking price amended to include the right to acquire DSW shares from RVI at the IPO price. These warrants were issued in connection with the $100 million term loan. A separate $75 million convertible term loan made by Schottenstein Stores and Cerberus will become non-convertible. To make the lenders whole (and then some), RVI will issue warrants that either convert into RVI stock at $4.50 or RVI’s DSW stock at the IPO price. Schottenstein Stores and Cerberus, in other words, have their hands in both of your pockets. The silver lining is that they are motivated to execute the IPO and make DSW successful.

DSW will continue to be subject to cross-corporate guarantees with RVI, Value City and Filene’s Basement. Value City, in particular, could experience deteriorating operating results.

Disclaimer:

I own RVI stock. I may buy or sell additional shares without notification. You should conduct your own due diligence before buying any shares.

Catalyst

The DSW IPO should take place on or about June 6th. Lehman and CIBC should initiate coverage. As with any carve-out, interesting arbitrage opportunities may arise. Any improvement in Value City’s operating results could also benefit shareholders.