The recently signed a letter of intent (LOI) of CCA Industries (ticker: CAW) to sell the firm for $12/share undervalues the common shares relative to the Class A shares held by management. The involvement of an aggressive hedge fund suggests that ultimately shareholders of the Common stock may get more than the current offer price.
Shareholders of cosmetics mass marketer CCA ought to be happy: since trading as low as $0.36/share (split-adjusted) in December 2000, shares have rallied to $13.80 before settling at the current level of $11.60. Since June 2005, management has been trying to sell the firm as Chairman Ira Berman and CEO David Edell, both 75, are looking to retire and cash out.
What has shareholders worked up on the deal is how insiders are cutting themselves a better deal than what outsiders get. CCA has a dual class share structure of the type vilified by corporate governance activists. Outside shareholders hold Common stock, whereas Berman and Edell both hold Class A stock. Both Common and Class A stock are identical but for one detail: Common shareholders get to elect four board members, and Class A shareholders another three. The effect is that Berman and Edell, whose Class A shares represent less than 14% of the outstanding shares, get to elect almost half the board.
Recall that common and class A shares are supposed to be identical. Nevertheless, Berman and Edell will receive $14.50 for their class A shares in the merger, whereas everyone else will receive only $12. Class A shares have previously traded at a discount to market prices: in February 2006, Berman and Edell each sold 100,000 shares back to CCA Industries at a 3% discount to market value. Their timing was fortuitous, as it occurred only four days after a positive press release after which the stock rallied – only to fall again after their sales. Two other former directors sold their Common Stock in a private transaction to CCA in May 2006 at a 2% discount. Despite these repeated discounts, the board agreed a few months later to cash out Berman and Edell’s Class A stock at a 30% premium to the market. The buyback did not happen, but with the current buyout proposal, Berman and Edell will still realize a 20% premium.
A premium is difficult to justify. Class A shares are not traded publicly and can only be sold through a private placement. Effectively, these shares are restricted stock, and restricted stock trades at a discount to free trading shares. For large and liquid companies, discounts of 10% are typical; for small caps like CCA, 20% discounts and more are the norm. At a 20% discount, Class A shares would be worth only $9.60 rather than $14.50.
The buyout is still in the stage of a letter of intent, so that the opinion of CCA’s financial adviser has not yet been filed and it is not known on what basis the two share classes are valued so differently. A look at other companies with dual class share structures does not support a premium valuation. One recent merger that comes to mind is the purchase of McData by backdating-challenged Brocade Communications (BRCD). McData had two classes of shares that differed only in voting rights, yet both classes were valued equally in the merger and each share from each class was converted to 0.75 shares of Brocade.
One shareholder is not willing to go along with the deal. Costa Brava Partnership III LP, an activist hedge fund, has filed its opposition to the differential treatment and requests the right to inspect books and records. Costa Brava Partnership has a knack for unusual capital structures like that of CAW, and its manager, Seth Hamot, is known to play hardball to obtain fair value. In 2005, Costa Brava sued not only defense technology firm Telos Corp. over the treatment of its Cumulative Exchangeable Redeemable Preferred Stock in its financial statements, but in an extremely unusual move also Telos’ auditor Goodman & Co. The suit remains pending.
For now, holders of CAW can hold out for Costa Brava’s activism to play out and wait for an increase in the merger payment. In the worst case, if the deal were to be called off, the downside for shareholders is limited in a stock with roughly $2.50/share in cash, a 2.4% dividend yield and close to a dollar per share in earnings, and Berman and Edell will quickly search for another buyer so that they can finally retire.
A final word on the buyer: Dubilier & Company is a private equity firm started by Michael Dubilier, son of one of the founders of private equity powerhouse Clayton, Dubilier & Rice. The younger Dublier invests in anything private, from early stage venture capital to leveraged buyouts. And he certainly prefers to hedge his bets. After supporting Al Gore and the DNC during the 2000 presidential campaign, he put his money on Bush/Cheney in the last election. If this donation history is any guidance, we suspect that Dubilier will eventually cave in when confronted by a bully like Costa Brava.
Disclosure: The author manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of CCA Industries.