Imagine a firm that sells mattresses in the U.S. – in fact, this firm is the largest U.S. mattress retailer with over 3,500 store locations. The firm has been expanding its store count at a breakneck pace, growing its number of locations at an average annual rate of over 35% since 2013, and doubling its store count over the last two years alone. This has been achieved through acquisitions, as well as store openings, with the company opening 310 stores in fiscal 2015.
This is an impressive rate of store growth for a firm in a mature industry, where mattress demand is driven by the replacement cycle. Curiously, there are an estimated 9,200 mattress stores in the U.S., compared to roughly 12,700 Starbucks locations across America. How can an industry where consumers purchase a mattress roughly every ten years have even a remotely similar number of store locations to Starbucks, where coffees are purchased every day?
The company is Mattress Firm Holding Corp. (Nasdaq: MFRM), and upon further analysis, MFRM had many characteristics of a good short. The business had accumulated a significant level of debt from its aggressive acquisition strategy, was facing greater competition from online retailers, and had acquired a number of substandard store locations that needed to be exited (one example was the five Mattress Firm and Mattress Firm-owned stores within one mile of one another in Indiana). Furthermore, to justify the current share price, MFRM would have had to have grown revenues at 8% for the rest of time, as well as achieved significant margin expansion. This appeared highly optimistic, given MFRM had already reached approximately 25% market share and was running out of large acquisitions to continue its inorganic growth strategy.
However, out of nowhere a little-known South African retailer called Steinhoff International announced a takeover offer for MFRM. A standard takeover premium – the amount by which the offer price surpasses the prevailing market price before the deal – usually ranges between 20% and 30%. Steinhoff offered an astronomical 115% deal premium!
Every short-seller dreads the moment when a company they have shorted announces that they are going to be acquired. As companies are typically acquired at a premium to the pre-announcement share price, the takeover target can rally hard on the day the deal is announced. This can be a frustrating short term hit to the performance of any fund that shorts stocks.
In a world of ultra-low interest rates, the availability of cheap money to finance deals has contributed to a flurry of deal-making activity. Alarmingly, 80% of developed market sovereign bonds are yielding less than 1%, and this environment of easy money has heightened the risk of a takeover for any short position. In other words, companies are able to dramatically lower their borrowing costs to make a deal stack up financially. More insidiously, some companies have succumbed to using acquisitions funded with cheap debt to engineer growth, and are willing to acquire companies at valuations that simply make no sense, all in order to continue the illusion of growth.
For the record, Montaka was not short MFRM. Even with the clarity of hindsight, we struggle to understand the rationale of the deal and the exorbitant deal premium offered. This begs the question: what can be done to protect investor capital on the short side, in light of this takeover risk?
We acknowledge the risk that certain short positions in the Montaka portfolio could potentially be taken over, and limit the size of our short positions accordingly. At the end of the second quarter of 2015, the average short position size was just 1.3%, limiting the harm from any takeovers that could occur. Furthermore, the Montaka team pressure-tests every single short position in the portfolio for takeover risk, trying to find reasons why a short might be a likely takeover candidate. This might involve an assessment of the attractiveness of the company’s assets to various strategic buyers, the presence of a majority shareholder that could take the company private, as well as the degree to which an excessive valuation might make the stock less appealing to would-be acquirers.
A case in point for our analysis of takeover risk causing us to forgo a short opportunity is WhiteWave Foods (NYSE: WWAV). WWAV is a U.S. business that produces dairy and dairy alternatives, such as soy milk, flavored creamers, yogurt, and a range of other products. The firm had embarked on a debt-fueled roll-up of smaller food companies; its stretched balance sheet led us to believe that it had limited funding capacity for future large-scale acquisitions.
However, WWAV had demonstrated strong organic growth (8% organic constant currency revenue growth in 1Q16) and owned a range of dairy-alternative brands that would have been attractive to a larger food company looking to diversify away from traditional dairy categories. Although the valuation already baked in much of the future growth – revenues needed to grow at 10% forever and margins had to dramatically expand to justify the $45/sh valuation – we chose to shelve the WWAV short idea due to our assessment of an unpalatable level of takeover risk.
Just one day after we had ruled out WWAV as a short, Danone announced that it was acquiring WhiteWave for $56.25 per share in cash. Despite not knowing exactly who might have acquired WWAV or when a bid would have occurred, we gained comfort in knowing that our process had successfully protected the capital of our investors in this instance. As much as we seek to avoid shorting companies that have a material chance of being acquired, there are times when an unanticipated takeover offer will emerge. However, after having stress-tested the Montaka short portfolio, we remain of the view that any takeover risk for our shorts is mitigated by our sensible approach to position-sizing.