Finish Line Unlikely To Walk Away From Genesco Purchase


Genesco logoGenesco’s (ticker: GCO) poor second quarter results triggered a panicked reaction from Finish Line (ticker: FINL), which is “evaluating its options regarding” the merger of the two firms. Predictably, in the current jittery market, nervous investors sold off the stock temporarily to a record spread of almost 25% below the purchase price. A detailed analysis of the situation shows that Finish Line stands little chance of either getting out of the agreement or re-negotiating a lower price as long as Genesco’s management remains committed to seeking the highest price.

Finish Line emerged as the winner of a bidding war with Foot Locker over Genesco, trumping Foot Locker’s highest bid by $3.50. Unfortunately, Genesco shareholders’ lucky streak ran out last week when the company reported a loss of $0.13/share after 13 cents per share of merger-related expenses. So the business just about broke even. We estimate that same store sales across its four brands declined by 4.5% on average (Genesco gave separate figures for each business line). Hal Pennington, Chairman and CEO of GenescoHal Pennington, CEO and Chairman, attributed the results to a

combination of a later start to ‘back-to-school,’ later sales tax holidays in Texas and Florida, and a generally challenging retail environment, especially in footwear. While back-to-school season is still in progress, we are encouraged by the improving trend in sales for the third quarter to date.”

Footwear has gone through a difficult quarter generally, and several other retailers have suffered from declining same-store sales and the tax holiday problem. The table shows the underwhelming results for the most recent quarter of some of the other major shoe retailers:

Company (ticker) Same store sales Quarter ending
Payless Shoe Source(PSS) -1.4% August 4
DSW (DSW) +5.9% July 29
Shoe Carnival (SCVL) -7.1% August 4
Footstar (FTAR) -7.9% June 30
Nine West (JNY) -8.0% (across all brands) July 7
Famous Footwear (BWS) +3.6% August 4
Foot Locker (FL) -7.3% August 4
Kenneth Cole (KCP) -1% June 30
Timberland (TBL) -6.2% June 30
Timberland (TBL) +1.8% August 4
Finish Line (FINL) -3.9% June 2

Shoe Carnival also identified the change of tax holidays in Texas and Florida from July to August as a source of its problems. Overall, it is clear that Genesco’s troubles are far from company specific and are not excessive in comparison to its competitors. Even Finish Line reported a steep drop in same store sales in its most recent quarter. The picture for earnings is similar to that of same store sales.

The across the board drop in same store sales was hardly a surprise to anybody, with Genesco itself guiding analysts to assume no comp gains for the year, and some analysts forecasting lower numbers. For example, Jill Caruthers of Johnson Rice & Co had predicted a 0.9% drop in Q2 same store comps. Moreover, the slowdown was not limited to footwear but also affected other apparel retailers. Some examples: Ann Taylor (ANN) -5.0%, bebe (BEBE) -6.3%, The Gap (GAP) -7.0%, Limited Brands (LTD) -3%. The market was not surprised when Genesco announced its results before the market opened on August 30, and the stock traded practically unchanged from the previous day’s close until Finish Line published its press release at 11:21 a.m.

It is surprising that despite its own poor performance, Finish Line implied with its press release that it may invoke the Material Adverse Change (MAC) clause of the merger agreement. Such clauses are standard in merger agreements and allow buyers to back out of a merger if sudden and unforeseen events occur. The most famous example is probably the end of the merger negotiations between Dynegy and Enron, when Dynegy invoked a material adverse change clause after the full extent of Enron’s problems had come to light.

Other buyers have been less successful in getting out of merger agreements. When Tyson Foods tried to cancel the purchase of IBP, the Delaware courts argued in a landmark decision that a MAC clause

is best read as a backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner,”

and forced Tyson to buy IBP.

Walking away from the merger agreement will be extremely difficult for Finish Line, and a bad quarter for Genesco is just not enough. Even more so because the merger agreement specifically excludes an industry-wide downturn or an economy-wide recession from the definition of a material adverse event:

[…]no event, circumstance, change or effect resulting from or arising out of any of the following shall constitute, a Company Material Adverse Effect:[…] changes in the national or world economy or financial markets as a whole or changes in general economic conditions that affect the industries in which the Company and the Company Subsidiaries conduct their business, so long as such changes or conditions do not adversely affect the Company and the Company Subsidiaries, taken as a whole, in a materially disproportionate manner relative to other similarly situated participants in the industries or markets in which they operate.”

Concerns that Finish Line’s financing could evaporate due to Genesco’s poor results are also overblown. Its debt commitment letter from UBS contains an almost verbatim copy of the Material Adverse Event clause in the merger agreement:

none of the following shall constitute […] a Material Adverse Effect: […] changes in the national or world economy or financial markets as a whole or changes in general economic conditions that affect the industries in which the Acquired Business and its subsidiaries conduct their business, so long as such changes or conditions do not adversely affect the Acquired Business and its subsidiaries, taken as a whole, in a materially disproportionate manner relative to other similarly situated participants in the industries or markets in which they operate.”

Moreover, there is reason for optimism for Genesco’s current quarter. Management suggested in its conference call that the effects of the tax holidays have been reversed in the last few weeks. Early reports of the tax holiday weekend from other sources also indicate that it was a success. If this is indeed the case, then Finish Line’s panic reaction soon will be replaced by a renewed commitment to the merger.

Finish Line logoNevertheless, there remains a risk that Finish Line will seek to renegotiate the price. The risk for shareholders is not so much that Finish Line can make a valid case in court, but that Genesco’s management will be less than steadfast in defending the current $54.50 price. Most key executives have options that are deep in the money, in addition to fixed golden parachutes and restricted stock. As a result, a drop in the merger consideration will impact their personal payoff considerably less than the reduction in shareholders’ payout:

Per share price of GCO % change in shareholders’ payout

54.50
0.00%

50.00
(8.26)%

46.33
(15.00)%

Hal N. Pennington (age 69), Chairman and Chief Executive Officer % change in Pennington’s payout

$21,864,769

0.00%

$20,475,830

(6.35)%

$19,005,493

(13.08)%

James S. Gulmi (age 61), Chief Financial Officer % change in Gulmi’s payout

$6,764,592

0.00%

$6,233,214

(7.86)%

$5,695,958

(15.80)%

Robert J. Dennis (age 53), President and Chief Operating Officer % change in Dennis’s payout

$7,531,629

0.00%

$7,090,467

(5.86)%

$6,530,173

(13.30)%

Jonathan D. Caplan (age 53), Senior Vice President % change in Dennis’s payout

$5,996,550

0.00%

$5,621,610

(6.25)%

$5,230,057

(12.78)%

James C. Estepa (age 55), Senior Vice President % change in Dennis’s payout

$5,977,619

0.00%

$5,767,275

(3.52)%

$5,419,297

(9.34)%

Calculation based on 10-K and proxy statement. Includes options, restricted shares and golden parachutes

Of the executives listed in the table, only Dennis is guaranteed to remain with Genesco after the merger and has already signed a new employment agreement. Most other executives will probably retire. Finish Line does not need two CFOs or two Chairmen, although we would not be surprised to see them hang around as part-time consultants. Most have reached retirement age and are probably more interested in heading off to the golf course than fighting a battle over the icing on the cake, so they may well consent to a lower price. A similar argument can be made against this: if they were to accept a lower price, they would spend the next few years defending themselves against inevitable shareholder litigation, especially because Foot Locker logoFoot Locker is still lurking in the background as a potential backup buyer. Its highest bid was $51, and the mere presence of another potential acquirer will limit Finish Line’s room for seeking price concessions. The most likely outcome of any renegotiation is a face saving total value of $54.50 with a $45-50 cash component and the balance consisting of FINL stock. Genesco’s management would be well advised to insist on a floor to ensure that the certain erosion of FINL’s stock price resulting from inevitable arbitrage shorting of FINL will not destroy the value received by GCO’s current shareholders. In addition, GCO shareholders should be allowed to elect whether they want cash or FINL stock. Such a compromise will allow both sides to declare victory.

Even though we think Finish Line has no real argument for getting out of the merger agreement, or even making a case for a lower price, it is far from certain that Genesco’s management will be firm. The biggest risk faced by shareholders is that Genesco’s management seeks to accommodate an aggressive Finish Line and accept a lower price. We hope that Pennington will hold firm before retiring to the golf course and does not wish to leave a legacy as an easy pushover.

The author manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of GCO.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: