Capri Holdings Limited

Special situation: Merge arbitrage

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Jan 11, 2024

Tapestry Inc. announced the acquisition of Capri Holdings Limited for $57 per share, the price today stands at $50, which represents an arbitrage situation with a potential of 14%.

Coach, Kate Spade, and Stuart Weitzman are Tapestry’s fashion and accessory brands. The firm’s products are sold through about 1,400 company-operated stores, wholesale channels, and e-commerce in North America, Europe, Asia, and elsewhere. Coach is best known for affordable luxury leather products. Kate Spade is known for colorful patterns and graphics. Women’s handbags and accessories produced 69% of Tapestry's sales in fiscal 2023. Stuart Weitzman generates nearly all its revenue from women’s footwear.

Michael Kors, Versace, and Jimmy Choo are the brands of Capri Holdings, a marketer, distributor, and retailer of upscale accessories and apparel. Michael Kors, Capri’s largest brand, offers handbags, footwear, and apparel through more than 800 company-owned stores, wholesale, and e-commerce. Versace (acquired in 2018) is known for its ready-to-wear luxury fashion, while Jimmy Choo (acquired in 2017) is best known for women’s luxury footwear.

Key points in the investment thesis

Capri Holdings shareholders have approved the purchase by Tapestry and accept the $57 per share that will be paid in the transaction.

Tapestry has completed its acquisition financing process after closing a bond issue transaction worth $7.5 billion.

The regulator Federal Trade Commission (FTC) will give the green light to the merger since there is a low risk that the combination of both companies will create a monopoly or there will be some regulatory problem.

China's antitrust regulator approved the planned purchase.

The acquisition process should close in the first quarter of 2024.

Acquisition

In August 2023, Tapestry Inc. announced that they have reached a definitive agreement under which Tapestry will acquire Capri Holdings. Under the terms of the transaction, Capri Holdings shareholders will receive $57 per share in cash for a total enterprise value of about $8.5 billion. After hearing this news, the price of Capri Holdings went from trading above $35 to $52 in a few hours.

The goal of this acquisition is for the combined company to generate more than $12 billion in annual sales, with a presence in more than 75 countries. The combination of Coach, Kate Spade and Stuart Weitzman along with Versace, Jimmy Choo and Michael Kors creates a powerful new global luxury house.

The total enterprise value of the transaction will be approximately $8.5 billion, which represents a 9x adjusted EBITDA multiple in the latest TTM, or 7x including expected synergies. The payment of $57 per share places the valuation made by Tapestry at the fair value of Capri Holdings.

Valuation and investment thesis

In the pure style of Joel Greenblatt, the thesis explores a special situation of arbitrage in an acquisition.The valuation is set; the investment potential is to receive $57 per share, and the risk is based on scenarios which the operation falls through.

Most milestones for completing the acquisition have been achieved since the announcement of the agreement in August 2023. Firstly in October, Capri Holdings shareholders approved Tapestry’s acquisition proposal, as mentioned earlier, at $57, close to the company’s fair value. Subsequently, in November, Tapestry announced the closure of the operation’s financing with the issuance of $4.5 billion and €1.5 billion in senior unsecured bonds. Along with the existing $1.4 billion in term loans, Tapestry's excess cash, and the anticipated future cash flow, the company has fully funded the $7.5 billion in debt financing planned and is well positioned to close the deal.

During the same month, the merger approval process by the regulator, the Federal Trade Commission (FTC), began. The FTC commission requested additional information about the acquisition from both companies to thoroughly analyze the potential regulatory implications. In this regard, it seems unlikely that the FTC will oppose this operation, as there is no risk of forming a monopoly, and the luxury sector is lightly regulated.

In January, antitrust approval was granted by the Chinese regulator, another step in successfully concluding the operation, expected to be completed during the first quarter of 2024.

It is noteworthy that, with most milestones achieved for closing the operation, there persists a spread of around 12-14% during the thesis publication. This could suggest uncertainty in the market, both in terms of timelines and the definitive conclusion. Given the current yield of the one-year American bond, around 5%, we believe that the additional risk premium in the operation does not signal additional doubts in the market.

It is notable that a renowned bond manager like Bill Gross, at this market juncture, finds the Capri arbitrage operation more interesting than bond investment, as he recently mentioned in a tweet.

Risks and uncertainty

FTC could delay or block the agreement for detrimental effects on competition.

The Federal Trade Commission (FTC) in the United States can block mergers or acquisitions if it believes they may have anticompetitive effects detrimental to competition. Some notable cases of FTC blocks include:

Staples and Office Depot (2016): The FTC blocked the proposed merger between Staples and Office Depot, two of the largest office supply retailers. The main concern was that the merger would eliminate effective competition in the market, potentially leading to price increases for business consumers.
Sysco and US Foods (2015): Reason: The FTC prevented the merger between Sysco and US Foods, two major food distributors and service providers. The concern was that the merger would significantly reduce competition in the national food distribution market.
AT&T and T-Mobile (2011): Reason: The proposed merger between AT&T and T-Mobile was blocked by the FTC and the Department of Justice. The agencies argued that the merger would substantially reduce competition in the mobile phone service market, leading to higher prices and fewer options for consumers.
Whole Foods and Wild Oats (2007): Reason: The FTC blocked the acquisition of Wild Oats by Whole Foods, stating that the merger would reduce competition in the organic and natural foods market. There were concerns that the merger would result in higher prices for consumers.

Our assessment of this risk is: The Federal Trade Commission (FTC) is unlikely to block a merger between luxury brand companies for two reasons:

Firstly, the luxury goods market is often characterized by a multitude of brands catering to distinct consumer segments, and the merger is not expected to create a monopoly or significantly reduce competition.

Secondly, the FTC typically focuses on mergers that may harm consumer welfare by leading to higher prices or reduced choices. In the luxury segment, where pricing strategies are often driven by exclusivity and brand image, such concerns may be less pronounced.

There are no precedents of blocks in similar brands, and the potential deployment is also unlikely if the two parts of the agreement provide information in an agile and transparent way. This situation can be hedged using put options.

Tapestry could back out of the agreement following the due diligence.

During the acquisition process and information request, aspects may be uncovered or events may unfold that could lead to the renegotiation or cancellation of the agreement. In such a scenario, Capri Holdings' stock could revert to levels seen before the announcement of the tender offer.

At this stage of the process, the probability is low. On November 27, Tapestry issued bonds to finance the operation, and Capri's shareholders have also approved the tender offer. This situation can be hedged using put options.

Conclusion

Arbitrage situations can entail significant risk, as the upside is limited, but the downside in the event the deal does not close can be substantial. In this acquisition, after analyzing various statements from the companies and monitoring the acquisition process's progress, it appears that the deal is quite firm. The market is acknowledging this by recovering to the $50 range.

If the transaction is finalized during the first quarter of 2024, and as of this thesis date, the annualized return on investment would be close to 60%. If the closing extends up to six months, it would result in an annualized return of 26%

For all these reasons, we believe that the operation will close successfully, and the market provides an opportunity to take advantage of this special situation.

DISCLAIMER: All the information provided in this document is purely informative and does not constitute a buying recommendation (according to Spanish Law Article 63 of Law 24/1988, of July 28, on the Stock Market Regulator, and Article 5.1 of Royal Decree 217/2008, of February 15). DuckPond Value Research & Investment Notes are not responsible for the use of this information. Before investing in a real account, it is necessary to have the appropriate training or delegate the task to a duly authorized professional.