RILY - Risk Outweighs Reward With Franchise Group

2023-08-10 14:34:33 ET

Summary

• Franchise Group is set to be acquired in a management buyout, with holders of common stock receiving $30 per share.
• The current offer represents a minimal spread above the most recent closing price, with a potential downside of over 23% if the takeover falls through.
• The deal's financier, B. Riley Financial, has come under scrutiny from short-sellers, raising concerns about the acquisition not currently reflected in the stock price.

Brief

Franchise Group (FRG), the parent company behind names such as Pet Supplies Plus, Wag N’ Wash, American Freight and The Vitamin Shoppe, is set to be acquired in the second half of 2023 in a management buyout led by the current CEO that will see holders of FRG's common stock receive $30 per share. Investors holding Franchise Group's common stock should realise any profits they have made to date, and potential investors looking to make a quick buck on the merger should look for opportunities elsewhere in my view. This stock represents greater risk than reward at current levels due the miniscule spread, the reputation of the deal's financier, and the options market implied downside.

Minimal Spread

On the 10th of May this year, FRG announced that it had entered into a definitive agreement and plan of merger with members of the company's senior management team led by Brian Kahn, the Company’s Chief Executive Officer, in a deal backed by a financial consortium that includes B. Riley Financial and Irradiant Partners. The deal would see FRG's management acquire approximately 64% of FRG's outstanding common stock that the management team does not already own. The deal offers existing shareholders $30 per share of common stock, a 31% premium to the pre-announcement stock price, and values FRG at $2.6 billion, including the Company’s net debt and outstanding preferred stock.

The current offer for Franchise Group's common stock of $30 per share is a little over 1% above the most recent closing price of $29.68. The potential downside however seems far greater. As stated in the company's announcement of the deal, the $30 cash offer represents a 31.9% to the stock's unaffected share price of approximately $22.74. Should the takeover fall through for any reason, and assuming that the stock would return to this pre-announcement level, investors could realise a market loss of over 23%. The risk-reward ratio alone is enough to keep me away from this stock, but let's dig a little deeper.

Shaky Financial Backing

Although this is a management-led buyout it is backed by B. Riley Financial to the tune of $250 million and recently, B. Riley has come under scrutiny from short-sellers. Wolfpack Research has described B. Riley as " a bottom-feeder investment bank crumbling before our eyes... a lender of last resort for the dregs of the public market " with " skeletons in the closet ". The allegations against B. Riley include but are not limited to: a deteriorating loan portfolio in excess of $500M; governance and conflicts of interest regarding related-party Applied Digital; equity investment losses well in excess of $400 million; accounting inaccuracies; over-leverage; and reliance on external financing. As recently as July of this year, B. Riley raised $115 million from the issuance of common stock, and since 2018 has raised $2 billion in debt financing - all while reporting minimal profits and paying generous dividends!

Any issues that arise at B. Riley could have negative implications for the FRG acquisition and hurt current investors.

Options Market Implied Odds

With FRG stock trading at a miniscule 1% spread between spot and deal price, the equity market is essentially saying this deal will almost certainly close - and soon considering that 6-month treasuries are currently paying investors just shy of 5.5% on an annualised basis. At this stage, it is unlikely that a greater bid will come through. The acquisition offer announced on May 10th included a 30-day 'Go Shop' Provision which allowed the company to search for superior proposals of which zero have been received.

The options market is likewise pricing this deal as a near certainty. The $25 strike puts on FRG Stock expiring in November last traded at $0.15. Assuming that FRG stock will return to its pre-announcement price of $22.74 in the event of the deal failing, the simple implied probability of the deal not closing is just 6.6%. We can transfer this implied probability onto the stock and come up with the expected value of a long only investment.

The stock currently trades at $29.68. In the event that the deal is completed, and no superior offer comes through, we know our shares will be exchanged for $30 each, generating a negligible profit of $0.32 per share. If the deal fails, we can assume the share price will fall to the pre-announcement price of $22.74, generating a hefty loss of $6.94 per share. Plug these numbers into an expected value calculation and we get the following:

Expected Value = (Expected Loss * Probability of Loss) + (Expected Profit x Probability of Profit)

Expected Value = (-$6.94 x 6.6%) + ($0.32 x 93.4%)

Expected Value = $-0.16 per share

As calculated, the expected value of this trade is actually negative.

Summary

The risk associated with buying Franchise Group's common stock seems far greater than the reward and investors should stay clear. The stock is priced on par with short-term US treasury bills, but does not fully reflect the risks associated with the deal's financier, B. Riley Financial. Investors with pre-existing holdings in this stock should realise any profits they have made to date and move on to the next opportunity. Speculators dabbling on the deal spread should realise the potential profits to be made are miniscule and are far outweighed by the huge potential losses. The market is full of great opportunities, there is no need to gamble on this one.

For further details see: