The phrase "transformational acquisition" gets tossed around a lot, but the deal Leon's Furniture Ltd. is about to complete qualifies. In swallowing Brick Ltd. next week, Leon's is taking out a chief competitor twice its size.
And yet the enthusiasm that drove Leon's shares to a 52-week high of $14.75 in late January has dissipated; now, at about $12.50 apiece, they're only modestly above the levels of last fall, before the company announced the deal. Leon's is now getting little, if any, credit for The Brick.
And that, unfortunately, could be entirely appropriate. Leon's may be, more than virtually any other retail name, a play on the Canadian consumer and the country's near-term economic outlook. And those macro worries should overshadow the benefits Leon's can conjure from its new, bulked-up status.
First, let's understand some of the bull case, because there are those who believe the company is deeply undervalued.
Michael Krestell of research firm M Partners believes Leon's will close 10 overlapping stores, boost gross margins through its new buying power and make modest reductions in its selling expenses. Couple this with an estimate of 2.5-per-cent sales growth from new and existing locations, and he figures the newly combined company can post just less than $200-million in EBITDA, or earnings before interest, taxes, depreciation and amortization. After making adjustments for all the real estate Leon's owns, and the debt it is taking on to make the deal, and Mr. Krestell suggests Leon's shares could push $19 apiece.
Are those synergies attainable? Leon's says it will continue to operate The Brick as a separate nameplate with its own management, which prompts critics to suggest much of the cost-savings potential is dampened.
It should be noted, though, that The Brick has typically had gross margins – revenue minus the cost of the furniture sold – a couple of percentage points higher than Leon's.
Where the Brick becomes less profitable than Leon's is through its proportionally higher "selling, general and administrative" costs, not to mention its high-priced interest payments.
If Leon's picks up economies of scale in its buying power, and then manages to run The Brick like it runs itself, it can achieve all of Mr. Krestell's projected synergies and more.
Paul Gardner, a portfolio manager at Avenue Investment Management in Toronto, says Leon's is one of two stocks his firm has held since its start in 2002 (Toronto-Dominion Bank is the other). He notes a debt-free balance sheet and healthy cash position made it easy for Leon's to take the plunge, and even after spending $700-million on The Brick, the company will still have a below-average 25-per-cent debt-to-capital ratio.
Leon's earned 67 cents a share in 2012; Mr. Gardner figures it will be 80 cents a share in 2013 and more like $1.30 in 2014. That means, he says, Leon's is trading at about 10 times its potential earnings, compared to a typical multiple of 15 and a price to earnings ratio of 20 at its peak. And it currently has a 3-per-cent dividend yield, to boot.
Here, however, is the rub: Both bulls assume Canada's economy will remain sufficiently robust to drive consumers – arguably, already tapped-out – to continue to spend.
Mr. Gardner's confidence is premised on 2-per-cent growth in Canada's GDP, housing prices that are flat to down no more than 5 per cent and what he calls "decent" job growth. He believes a continuing wave of suburban immigrants will make up a key part of Leon's customer base.
And, to return to Mr. Krestell: His analysis relies on 2.5-per-cent sales growth at Leon's, which actually reported a 2.7-per-cent sales decline in 2012. The company referred to it as "another challenging year" that "reflected a continuation of weak consumer confidence and a decrease in housing starts."
Investors who are optimistic that we are in a brief rough patch should then find Leon's shares compelling.
But those more worried about Canada's economy should conclude both Leon's furniture and its shares will be on deep discount for some time.
Leon's Furniture Ltd. (LNF)
David Milstead