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A Brickload of debt, but few synergies to be seen

Leon's Furniture Ltd. may be famous for its Don't Pay a Cent sales event, but for a home furnishings retailer that has its fortunes tied to a softening economy, it has been a rather big spender of late. The market should be cautious about the wisdom and timing of its biggest outlay yet – the acquisition of its much larger rival The Brick Ltd. for $700-million.

Leon's has been aggressively opening stores – six last year (bringing it to 76 in total) with another five planned for this year and each of the next three years. It recently launched a buyback of up to 3.5 million shares. It has also been steadily increasing dividends, which, given its stalled earnings growth, are eating up an increasing portion of profit. Dividends accounted for a 36-per-cent share of net income in 2010, rising to 64.2 per cent last year, and that ratio will likely be higher this year.

Despite the store openings, second-quarter revenue fell by 0.8 per cent to $208-million from a year earlier. The company could struggle to equal last year's revenue and profit of $683-million and $56.7-million, respectively – both well below levels in 2008.

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This would not be troubling to a debt-free company that has more than $180-million in cash, bonds and equities, but Leon's is giving all that up, dipping into new credit facilities of up to $500-million to pay for The Brick, a chain with 230 stores and plans of its own to expand.

One would expect a long list of compelling reasons for the deal, but they are strangely undercut by Leon's plans.

Leon's points to unspecified savings from greater purchasing power, combined distribution and elimination of one set of public company filings. But Leon's is keeping The Brick business intact, along with its head office and CEO, thus forgoing many potential synergies.

The two chains will remain highly competitive – with others as well as each other, particularly in Ontario, Quebec and the Maritimes, where they have many overlapping stores. As a result, they will be unable to let up on marketing costs. "The dual branded strategy to me at this point is not obvious," GMP Securities analyst Martin Landry said. Neither are the value of the synergies or impact on earnings, which Leon's wasn't sharing Monday.

Until the deal was announced Sunday, Leon's looked like a decent defensive retail play given the uncertain economy. Now it's using up its cash, levering up and limiting the synergies a takeover could bring.

Most puzzling of all is that Leon's isn't even making a counterintuitive bet on the economy. Management's outlook in its second-quarter report stated that consumer spending will remain soft and that growing profits will be a challenge, but its "strong financial position" and experience adjusting to market conditions would allow it to adapt. If the economy continues to go south, Leon's may come to regret giving up its strengths at a time when other companies are clinging to theirs.

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