Jefferies Has Found Three Stocks That Are Top Leveraged Buyout Candidates

24/7 Wall St.

Over the past year and a half, Wall Street has seen increased leveraged buyout (LBO) activity within the specialty retail space. The most recent takeout announcement back in May was for Rue 21. Incidentally, that may not work out so well, as Rue21 has had horrible same-store sales since the deal was announced.

That deal notwithstanding, the Jefferies team believes the group remains on the radar for future LBOs, given the companies' significant cash balances, little to no debt with the exception of their leases, and business models with consistent cash generation. In a new report they use LBO analysis as an equity valuation tool to analyze the 23 specialty retailers in their coverage universe. They have boiled down the candidates to three that look like they could go the leveraged buyout route. They also highlight three additional stocks that screen extremely high in their analysis.

Aeropostale Inc. (ARO) posts a staggering 31% internal rate of return (IRR). This is one of the top metrics that a leverage buyout firm will look for. This compares with an average IRR for specialty retailers of 16%. The company is a specialty retailer of casual apparel and accessories with principal target markets of 14- to 17-year-old women and men. It operates 975 stores in the United States and Canada. The company also has a smaller brand -- 145 stores -- for younger kids, P.S. from Aeropostale, that serves four to 12 year olds.

Aeropostale posted an operating loss of $43.8 million, compared to a tiny profit in 2012's second quarter. Cost of sales jumped from 75% to 82%, and selling, general and administrative (SG&A) expense increased as a percentage of sales from 25.2% to 27.5%. This stock ranks at the top of the Jefferies list. It jumped last week when private equity firm Sycamore Partners disclosed buying an 8% share in the company. Sycamore said it bought 6.25 million shares of Aeropostale at a cost of $54 million because the stock is “an attractive investment.” It also said in a regulatory filing that It plans to talk to the company’s management, its board and other stockholders and may consider various actions. The Thomson/First Call price target for the stock is posted at $10, with a high target of $19. The stock closed Thursday at $9.59.

American Eagle Outfitters Inc. (AEO) has an eye-popping 25% IRR. The company operates as an apparel and accessories retailer in the United States and Canada. The company's retail stores offer denims, sweaters, fleece, outerwear, graphic T-shirts, footwear and accessories for 15- to 25-year-old men and women under the American Eagle Outfitters brand name, as well as intimates and personal care products for girls under the Aerie brand name. As of February 2, 2013, the company operated 893 American Eagle Outfitters stores and 151 Aerie stand-alone stores, as well as 49 franchised stores in 13 countries. American Eagle common shares currently trade at a 37% discount to its conservatively estimated private market value, which represents significant upside of 55%. The consensus price target for the stock is $16, and the high target is posted at $20. The stock closed Thursday at $14.24.

Body Central Corp. (BODY) also comes in with an off-the-charts IRR of 26%. The company reported a dreadful second quarter, which hammered the share price. Body Central operates as a specialty retailer of young women's apparel and accessories in the South, Mid-Atlantic and Midwest regions of the United States. It operates stores under the Body Central and Body Shop banners, as well as a direct business comprising its Body Central catalog and e-commerce website at bodycentral.com. The company's stores sell tops, dresses, bottoms, jewelry, accessories and shoes, primarily under its Body Central and Lipstick labels. The lower the share price goes, the more attractive the stock becomes. The consensus price target is $11, with the high target at $12. The stock closed Thursday at $6.43.

Jefferies also highlighted three other names in its report that also ranked extremely high when run through its metrics screen. Abercrombie & Fitch Co. (ANF), Francesca’s Holding Corp. (FRAN) and Vera Bradley Inc. (VRA) could all draw the attention of private equity firms looking for a specialty retail play.

Since 2010, 11 retail LBOs have taken place, including such high-profile names as J. Crew, Hot Topic and Cole Hann. It is pretty clear that private equity firms see a ton of unlocked value in the right retail names. The Jefferies top three certainly make sense on the basis of what is attractive from a takeover standpoint. For investors who wish to take a shot, even if a deal does not happen, the stocks are attractively priced and may offer upside either way.

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