Merrill Lynch sees cap structure trade in Saks convertible, stock, CDS returning up to 20.5%

By Ronda Fears

Nashville, April 19 - The prospect of Saks Inc. splitting its upscale and more modest department stores has already pushed the stock up by around 25% on speculation, and while the 2% convertibles have taken a beating due to the situation, Merrill Lynch analysts said in a report Tuesday that certain hedge strategies could boost total returns to as much as 20.5%.

Of three alternatives - selling the department store group while retaining Saks Fifth Avenue, selling the entire company, or doing nothing and continue with status quo - the Merrill analysts believe doing nothing is the least likely even though there are powerful forces within the company and among stockholders both for and against a sale.

The Merrill analysts believe that the sale of the department store group could drive Saks stock to between $22 and $25, and if the whole company is sold, the stock could go for as high as $29.

On Tuesday, Saks shares closed up 34 cents, or 1.9%, at $18.20.

Straight 7.5% bonds vulnerable

Saks' 7.5% senior unsecured notes have only modest covenants to protect bondholders and do not have special protection in the event of a highly leveraged transaction, the analysts pointed out. Importantly, they add, the bond covenants state that merger and consolidation could, but not necessarily would, provide bondholders some protection if Saks were to split up.

Total return for the 7.5% bond was estimated by the analysts at 12.5% with Saks shares at $13, dropping to around 2.5% if the stock rose to $29. Moreover, the Saks spreads reflect the prevailing uncertainty about the outcome, the analysts said, with Saks five-year CDS at 350/375 basis points over Libor versus 370/395 bps for Neiman Marcus Group, 510/540 for Toys "R" Us and 220/240 for JC Penney.

"SKS is trading on top of NMG, a company that has announced its intention to explore ways to enhance shareholder value, including a possible sale of the company," said Merrill bond analyst Richard Edelman. "The tighter trading levels of JC Penney indicate the bond market's current perception of a lower likelihood of an adverse outcome for Penney bondholders than for those at Saks."

Long convertible, short stock, sell CDS

Thus, Yaw Debrah, head of Merrill's U.S. convertible research team, said buying the Saks convertible, while shorting equity on a light delta hedge, provides long equity exposure that would be of benefit if the stock does continue to rise.

This strategy produces average returns of about 13.8% for stock prices between $13 and $25 on a one-year horizon, he said. Specifically suggested is going long the 2% convertible, shorting 3.2 shares of stock and writing a five-year CDS, receiving annual premium of 350 bps on $50 notional for every $100 of convertible principal.

The convertible is trading around 104.

If the company does nothing, he said, the five-year spreads on the company's bonds could improve to about 230 bps over Libor, whereas if the company is taken out via an LBO, spreads could widen out to 500 bps in line with Toys "R" Us.

Should nothing ever transpire, Debrah said the drop in value of the convertible, as the stock drops following the removal of takeover speculation, should be compensated for by an increase in the value of the short credit protection assuming spreads narrow and the convertible regaining lost premium as the specter of a cash takeover recedes.

Selling the CDS increases the income derived from the position, at a cost of a capital loss if spreads on the company widen from current levels. This is possible in the case of a cash LBO, or if there is an event such as an intensification of the accounting enquiry, causing both the stock and bonds to drop simultaneously.

The main risk to this strategy, he said, is that credit spreads on the bonds widen alongside a drop in the stock. If spreads were to widen to 400 bps, as opposed to tightening to 230 bps, at a stock price $13, it would reduce the total return to about 4%. If an LBO takes place for less than $22 per share, then total return estimates for stock prices below $22 and above $19.65 could be halved.

Long convertible, sell CDS

By buying the convertible and writing CDS on the company's credit, an investor gains long equity exposure and increased yield. However, Debrah pointed out that there is less downside protection than the first hedge strategy, in the event of a simultaneous drop in stock and widening of credit spreads.

This strategy produces average returns of about 15.6% for stock prices between $13 and $25 on a one-year horizon. Specifically suggested is going long the 2% convertible and writing five-year CDS, receiving annual premium of 350 bps on $300 notional for every $100 of convertible bond principal.

The main risks to this strategy are the same as above. But if spreads widen to 400 bps instead of tightening to 230 bps at a stock price $13, it would cause total return to turn negative by about 10%.

Long stock, sell CDS

This hedged strategy is for investors who believe that it will take longer than six months for the company's strategy to be realized, Debrah said, which would allow sufficient income to be accumulated from the short CDS position. It could achieve returns superior to that of the long convertible/short CDS position, he added, assuming that sufficient income is received from writing the CDS.

The strategy produces average returns of about 20.5% for stock prices between $13 and $25, assuming that it takes at least 6 months for the company's strategy to be realized. Specifically suggested is going long 3 shares of stock and writing five-year CDS, receiving annual premium of 350 bps on $300 notional.

Buying the stock provides capital gains if a sale scenario is realized, Debrah said, while writing the CDS provides income and downside protection if the company does nothing, the stock falls, but bond spreads improve.

The main risks to this strategy are the event of credit spreads increasing with no movement in the stock or a negative move in the stock, or if the company achieves a sale of the department store group in a shorter period of time that does not allow sufficient income to be accrued to produce a positive outcome.

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