Franchise Group: In Exclusive Acquisition Talks w/Kohls

Franchise Group (FRG) is one of my largest positions, naturally I feel obligated to post something on the headline grabbing news that FRG is the apparent winner of the auction for struggling retailer Kohl's (KSS).  Kohl's would be a transformative acquisition, FRG is currently a $2.7B enterprise value company and press reports have them paying $8B for KSS ($60/share).  FRG is currently guiding to $450MM in 2022 EBITDA, TIKR has the consensus KSS estimate at $2.1B.  The combination of FRG being smaller than the target, little known outside of certain value/event-driven circles and fears of credit markets tightening seem to have the market doubting this deal gets done (KSS last traded for $45.75).  But I have faith in CEO Brian Kahn, FRG entered my portfolio as a special situation when it was then called Liberty Tax, which went about a complicated merger and tender offer transaction that looked novel and interesting from an outsider perspective.  Here is FRG's most recent investor presentation for what the company looks like today, a lot has changed, including FRG selling the original Liberty Tax to a SPAC (sponsored by NexPoint).  My thesis in the last two years has mostly revolved around "in Kahn we trust", given the news leaks around credit providers being lined up, it appears this deal is getting done.  I've added some KSS as a small speculative merger arbitrage position alongside FRG.

Taking a few steps back, in April, news broke from Reuters that FRG was joining the bidding for struggling retailer Kohl's (KSS), I was a bit surprised but not entirely, Kahn is a creative deal maker and likely looks at many acquisition opportunities that don't fit Franchise Group's stated strategy of "owning and operating franchised and franchisable businesses".  My guess is the "franchise" part is more aspirational than truth, it is a generic name and strategy, they just look for attractive deals.  Kohl's certainly doesn't seem to fit the franchise mold, hard to imagine someone operating a department store as a franchise, but the deal does resemble other recent FRG acquisitions as the non-core assets could be used to finance the transaction.

Last November, FRG entered into a transaction to buy southeastern furniture retailer W.S. Babcock for $580MM.  Subsequently, FRG went on to sell Babcock's credit accounts receivables to B Riley (RILY) for $400MM, the retail real estate for $94MM, and the distribution centers and corporate headquarters to Oak Street Real Estate Capital for $173.5MM.  More than paying for the acquisition with asset sales and still expecting to receive $60MM in proforma LTM EBITDA.  A similar transaction seems to be in store for Kohl's, the department store chain owns their corporate headquarters, almost all of their distribution and e-fulfillment centers, and own 410 of their retail stores outright and another 238 of them owned but on ground leases.

Reports have FRG re-teaming up with Oak Street Real Estate Capital (part of Blue Owl's platform) to provide $6B in financing based on the corporate headquarters and distribution facilities real estate (might also include the retail real estate, so my 6% cap number below might be too low), and $2B (fuzzy, Seeking Alpha number) from Apollo in non-recourse Kohl's level term loan financing, with FRG kicking in the additional $1B via an upsized term loan.  Apollo isn't the ideal lender, but since they're a direct lender and aren't relying on syndicating the loan immediately like a large regulated bank, the financing seems more secure in the current uncertain environment.  It is an interesting structure, FRG is using no equity, financing it all with debt and will fully own a levered equity stub KSS.

Putting together a quick back of the envelope proforma, I come up with the below:

As always, probably a few mistakes above, feel free to point them out, and obviously, this is all excluding the capitalized leases which is real leverage even if it is non-recourse, but even if you did an EBITDAR valuation, the proforma company would be extremely cheap.  But I think it shows the creativity of Kahn and FRG, they're creating a diversified series of levered bets via non-recourse sale leaseback financing.

Other thoughts:

• While not a "bet the company" deal, it is pretty close and certainly risky.  The market doesn't like highly leveraged companies, FRG will likely trade cheaply for a while as they bring down the debt and eventually further diversify away from Kohl's with future deals.  Kohl's is certainly a weak business, it is in the middle ground of not really having an identity, I can't think of anything you must buy at Kohl's that you couldn't get elsewhere. There's a lot of debt here, things could go horribly wrong.
• There is some political pressure to reject the deal, particularly in Kohl's home state of Wisconsin, likely if FRG acquires KSS, long term this is a slow motion liquidation.  FRG often partners with B Riley, the two are intertwined some, B Riley has a retail liquidation business and often invests in these distressed retailers.  Selling to FRG probably cements Kohl's as a declining business and that might face political backlash.
• FRG is heavily into home furnishings (previously mentioned Babcock, they also own American Freight which sells clearance appliances and Buddy's, a rent-to-own retailer), based on the recent Target inventory debacle, people aren't buying home furnishings anymore now that covid is mostly in the rear view mirror.  Cynically, FRG might be doing this deal to distract from issues at the core business.  However, Brian Kahn has sounded sober through the pandemic regarding inventory, supply chain, going forward expectations, he hasn't sounded surprised by the slowdown and thus far hasn't had to drastically change guidance.
• Macellum Capital Management has been engaging in an activist campaign against Kohl's, they lost their proxy fight recently, but have been putting significant pressure on the company to sell themselves.  Kohl's management believed they were worth $70+, but with the recent downturn and disappointing Q1 earnings, bids have come in lower, so it might be an opportunistic time for FRG to swoop in and be the white knight.  FRG also runs a decentralized management structure, so it could be seen as a preferred buyer for management as they could keep their jobs.
• FRG did recently put a $500MM buyback in place (after it was reported they were a KSS bidder), things could get pretty wild if they use the KSS cash flows to buyback shares versus paydown debt given their Debt/EBITDA ratio would likely remain within there target range immediately upon closing of the transaction.
• Brian Kahn has never been shy about buying shares in the open market (did a lot during that initial Liberty Tax/Buddy's transaction, signed big boy letters with anyone that would sell him shares) and his private equity firm, Vintage Capital, owns 25+% of the company.

Disclosure: I own shares of FRG and KSS

Franchise Group: fka Liberty Tax, Franchise Rollup

Franchise Group (FRG) is the result of the odd conglomeration of: 1) Liberty Tax (old TAXA); 2) Buddy's, a franchised chain of rent-to-own electronics and furniture stores; 3) Sears Outlet business; and soon to be 4) Vitamin Shoppe (VSI); that is being orchestrated by Vintage Capital's Brian Kahn who was recently named the CEO of the newly launched platform company.  Andrew Walker posted two excellent write-ups (here and here) on the situation a couple months ago, I won't do it the same justice, but I'll run through my thoughts anyway as I took a position in it.

Liberty Tax is the third largest tax preparer, well behind both H&R Block and Jackson Hewitt, the tax preparer market is a highly fragmented business with a lot of mom and pops.  It is the type of franchise business where you effectively own your job and you outsource the marketing and back-office infrastructure to the franchiser.  Liberty's business model is mostly targeted at lower income taxpayers who are unlikely to purchase TurboTax or do-it-yourself type software, they want someone else to do it quickly for them and assist in getting their refund as fast as possible, it's a decent business that should be relatively stable.  However, in 2018 Liberty Tax's founder and CEO was forced out after a sex scandal was uncovered and his shares where sold to Vintage Capital that July.  The company understandably struggled through this upheaval and EBITDA dropped 17% from 2017 levels to $35MM (9/30 fiscal year end).  Then in November 2018, TAXA received an acquisition proposal for $13 per share from a private equity buyer that ended up going no where.

Concurrently with all that, Vintage Capital was wrapped up in a bizarre failed merger with Rent-a-Center (RCII) which competes in the same rent-to-own market as Vintage's Buddy's chain with Vintage forgetting to execute a routine extension to the merger agreement that allowed Rent-a-Center to break the deal and force Vintage to pay a substantial break up fee.  Presumably Vintage was going to merge Buddy's with Rent-a-Center and continue to pursue a franchise model.  With that deal off, Vintage moved to Liberty Tax where they already had a substantial holding and offered to recapitalize the company and give existing shareholders an option to tender their shares at $12, a substantial premium to where the shares had fallen after the $13 buyer had backed away.  As part of the transaction, Liberty Tax bought Vintage's Buddy's chain of stores and created "Franchise Group" to pursue a rollup strategy of franchised or "franchisable" businesses.

Since the creation of Franchise Group, Vintage isn't wasting time buying additional struggling businesses, since the merger with Buddy's, they've entered into two transactions but while both Liberty Tax and Buddy's are primarily franchised, the next two fall into the franchisable category.  The first announced was with Vitamin Shoppe (VSI), a struggling vitamin and nutrition retailer that is being disrupted by internet shopping.  The second transaction announced, which just recently closed, is with Sears Hometown and Outlet for the Sears Outlet business and the 8 Buddy's stores that SHOS operated.  My guess is overtime these Sears Outlet stores more or less end up looking like or being re-branded to Buddy's stores as they sell similar household durable type items to the lower income segment.

There's a lot going on here, its a complex situation that I'd guess very few people are looking closely at, volume has been minimal and it just today uplisted back to the NASDAQ under the FRG symbol.  I'm sure there are quite a few mistakes with the below, so do your own homework as well, but I tried to come up with a proforma look at what the combined company might look like once the dust settles.

Most of these numbers are pulled from the recently completed tender offer and the VSI proxy statement.  Alongside the closing of the Sears Outlet transaction, they went ahead and franchised 5 stores to "A-Team" for $15MM (they have 120 more stores).  The tender offer closed this week with just under 4 million shares participating at $12.  Throwing it all together on an admittedly back of the envelope fashion, I come up with the proforma company trading at roughly 5x EBITDA.  Franchise businesses trade all over the map, but generally well above 5x -- a rent-to-own comp like RCII for example trades over 7x EBITDA and they are still mostly company operated stores.  It's hard to put an exact value on FRG, but I'm guessing there are a lot of value levers to pull here and if it works out (and the economy doesn't rollover) could be a multi-bagger.

Disclosure: I own shares of FRG