Quan finished these notes on June 6th, 2014. At that time, one share of PetSmart was going for about $58 a share. PetSmart recently agreed to be bought out for $83 a share in cash. So these notes are entirely unactionable. But I thought some blog readers might enjoy seeing the kinds of notes Quan prepares as part of the newsletter process. And lots of you may have read articles about the PetSmart leveraged buyout and wondered about the industry, the company, its future, the price being paid here, etc. These notes – the PDF is 105 pages – give more detail on the company than press reports do.
We always have some notes that Quan has prepared but have never been used in a Singular Diligence issue. This happens for a couple reasons. One, when Quan and I discuss the notes we may come to the conclusion we were wrong about the company and the stock in our initial assessment – it’s not actually appropriate for the newsletter because of risks to the company or because the price is higher than we first thought. Two, the price of the stock can go up between the time Quan writes the notes and the time we would publish an issue.
That’s what happened in the case of PetSmart. PetSmart was going to be featured in an issue of The Avid Hog – the predecessor to Singular Diligence – during the summer. But, activist investors pushed for the company to put itself up for sale. PetSmart’s board announced they were reviewing strategic alternatives – and so the stock price rose.
The stock price went on to rise a lot more from that point, because the price ultimately paid in the LBO was higher than what traders originally speculated after the announcement.
Whether or not PetSmart was a good speculative bet at that point – it turns out it was – it was no longer a good investment to present to subscribers. The same can be said now about the leveraged buyout. The calculus for an LBO is different than it is for Quan and I deciding on a passive stake in a publicly traded buy and hold investment. PetSmart was a good buy and hold investment at $58 a share. It was not a good one at the $70 and up prices that the stock traded at after the market knew the company was for sale. The LBO might be a good deal at $83 a share for the buyers. But we wouldn’t recommend buying PetSmart at $83 a share.
As you can see in the “Value” section of the notes, we valued PetSmart at 13 times normal EBIT. That works out to something like 9.7 times EBITDA. I want to be clear – we were not suggesting anyone should pay 9 to 10 times EBITDA for the stock – we were saying that at a price of 9 to 10 times EBITDA the future returns in PetSmart for investors would be similar to the returns they could get in the market as a whole. In fact, the quote from the notes would be “At 13 times EBIT, investors can get an adequate return in PetSmart”.
We generally want a stock to be trading at about two-thirds of our appraisal price to recommend it. So, even if we thought PetSmart was worth $90 a share – we’d want to recommend it when it traded at something like $60 a share.
As a result, both of these statements are true:
After PetSmart announced it was reviewing strategic alternatives, the stock was too expensive to present in our newsletter
The buyers of PetSmart who are now paying $83 a share in cash may not be overpaying