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Bloomberg: Scott Rostan on “Saks at Priciest Means KKR Mulls Neiman Merger: Real M&A”

KKR & Co. (KKR), the buyout firm weighing an investment in Saks Inc., may need to get creative to extract more value from what’s already the most expensive U.S. department-store stock.

Saks, which is exploring options including a sale, surged this week to the highest level since 2008 after Bloomberg News reported that KKR is considering an investment in the $2.3 billion luxury retailer and may seek a merger with closely held rival Neiman Marcus Inc., which is studying a sale. The gain left New York-based Saks at a higher price relative to earnings and free cash flow than any of its U.S. peers, according to data compiled by Bloomberg.

 While financial investors typically seek to take companies private, Citigroup Inc. said a leveraged buyout of Saks may yield a return of just 9.5 percent, less than half the goal private-equity firms usually target. Instead, KKR may view a tie-up of Saks and Neiman Marcus as a way to generate higher returns, with Frost Investment Advisors LLC seeing a merger offering the opportunity to close overlapping stores and increase purchasing power.

Saks’s rich valuation, at a time when U.S. stocks are at a record high, means “private-equity firms are going to have to look for opportunities that may not have been on their typical formula list,” said Scott Rostan, founder of New York-based Training The Street, which teaches new hires at investment banks how to structure mergers and acquisitions. “The traditional bread-and-butter leveraged buyout is not going to be that easy. They’re going to have to be more creative. With Neiman, you’ve got a willing participant. KKR may see a combination of Saks (SKS) and Neiman as a more formidable competitor down the road.”

Weighing Options

Saks hired Goldman Sachs Group Inc. to explore strategic alternatives, including a sale, two people with knowledge of the matter said this week. Dallas-based Neiman Marcus is also on the block, with private-equity owners TPG Capital and Warburg Pincus LLC exploring a sale or public offering of the luxury chain, people familiar with the matter said this month. The firms acquired Neiman Marcus in 2005 for about $5.1 billion.

KKR is weighing an investment in Saks, people with knowledge of the matter said this week, though it wasn’t immediately clear whether the buyout firm had approached the retailer. It may seek a merger with Neiman Marcus, the people said.

Representatives for Saks, KKR, TPG and Warburg declined to comment.

Saks Surge

Saks shares rose May 22 to a more than five-year high of $15.50. It closed yesterday at $15.49, leaving it with a price-earnings ratio of 35, the highest among U.S. department stores that have market capitalizations larger than $1 billion, data compiled by Bloomberg show. Saks’s free cash flow multiple of 49 also tops the group, which had a median multiple of 19 yesterday, the data show.

Today, Saks shares fell 0.6 percent to $15.40 at 10:08 a.m. New York time.

The stock’s recent gains diminish the potential return a buyer such as KKR would earn in an LBO of Saks, Deborah Weinswig, a New York-based analyst at Citigroup, wrote in a note to clients yesterday.

Weinswig estimates that a buyout price of $20 a share — 46 percent higher than Saks’s level before reports surfaced that it was weighing a sale — would earn an internal rate of return of 9.5 percent. Financial buyers usually look for targets than can provide an IRR of at least 20 percent, she said.

‘Quite Expensive’

“Saks is quite expensive,” Paul Swinand, a Chicago-based analyst at Morningstar Inc., said in a phone interview. “With the price appreciation, it’d be hard to justify the multiples. You’d have to take on out-of-range leverage levels and lower rates of return, and you start pushing all these models to justify the takeover price.”

Merging Saks with Neiman Marcus instead would create an upscale department-store chain with more than $7 billion in annual sales, second only to Nordstrom Inc., data compiled by Bloomberg show.

A merger also offers cost-cutting opportunities that could bolster value and profitability, said Nikhill Patel, an analyst at San Antonio-based Frost, which oversees about $9 billion and according to data compiled by Bloomberg, held Neiman Marcus bonds and Saks stock as of March 31.

“It’s a great potential merger,” Patel said in a phone interview. “Some of the advantages that we like in the combination include savings from combining the buying teams, the bargaining power and also the ability to leverage best practices among the two companies.”

Margin Improvement

Patel estimated that after a tie-up of Saks and Neiman Marcus, about $80 million in costs could be eliminated.

That could help improve Saks’s margins, which have lagged behind peers including Neiman Marcus, said Maria Mendelsberg, a Denver-based fund manager at Cambiar Investors LLC, which oversees about $8 billion including Saks shares.

Saks’s profit margin of 2 percent in the latest fiscal year compares with 3.2 percent at Neiman Marcus and 6.1 percent for Nordstrom, according to data compiled by Bloomberg.

KKR or another buyout firm may be able to earn a high enough return from taking Saks private if it sells and leases back some of the company’s real estate, according to Matt Lockridge, a Dallas-based money manager and consumer stocks analyst at Westwood Holdings Group Inc., which oversees $15 billion and owns Saks shares.

Saks Appeal

Lockridge said estimates for the value of the real estate, including the flagship store on Fifth Avenue in New York, are as high as $1.8 billion, more than three-quarters of Saks’s market capitalization.

“Either a merger with Neiman or a buyout of Saks would work, but Saks on a standalone basis would be an interesting long-term investment,” Lockridge said in a phone interview. He said a takeover offer should be more than $20 a share.

Still, while low interest rates in the U.S. benefit private-equity firms borrowing funds for deals, targets have gotten more expensive. The Standard & Poor’s 500 Index touched its highest price-earnings valuation this week in more than three years as the index reached a new high, data compiled by Bloomberg show.

Given the high prices, financial buyers on the prowl may seek alternatives to traditional buyouts. With a substantial KKR investment as opposed to an LBO offer, Saks and the private-equity firm could team up to acquire the retailer’s larger rival Neiman Marcus, Rostan of Training The Street said.

“Saks probably wouldn’t have the financial heft to buy Neiman Marcus,” he said. “A substantial investment from KKR could be a way of getting it to work.”