Bloomberg ran an article April 29 speculating that Rue 21 (NYSE:RUE), Abercrombie & Fitch (NYSE:ANF) and Aeropostale (NYSE:ARO) are all possible private equity targets. Analysts believe that given the high number of deals that took place in 2012--38 valued at $5.7 billion--many more will be forthcoming in 2013. Of the three, I'll weigh in about which company is most likely to walk down the aisle into the arms of private equity firms such as Blackstone (NYSE:BX) and Kohlberg Kravis & Roberts (NYSE:KKR).

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

Rue 21
Apax Partners originally invested in Rue21 in 1998 through Saunders Karp & Megrue (SKM), a middle-market buyout specialist that it merged with in 2005. Rue21 then hit a rough patch in 2001, was forced into bankruptcy in February 2002, and emerged from bankruptcy in May 2003. Investing approximately $52 million since 1998, its November 2009 IPO (SKM didn't sell any shares) and subsequent secondary offering in March 2010, brought the private equity firm $180 million in net proceeds and a realized profit of $128 million. Since then it has maintained and added to its 29.3% ownership interest, which is now worth approximately $222.2 million. That's an annualized return of 14.6%. While it's good, it's not the kind of return most private equity firms are looking for.

Bloomberg's article makes reference to the fact that Rue21's lack of debt combined with significant free cash flow could persuade private equity firms to offer as much as a 50% premium on its current stock price of $31.30. At $47 per share, Apax Partners would be looking at an annualized return of $16.5%. Better, but still less than what most private equity firms expect when doing a buyout. Ultimately, I don't see anything in its current or future performance that will motivate other private equity firms to make a bid.

The odds of a buyout: 25%

SEE:How An IPO Is Valued

The teen retailer's financial performance over the past couple of years has been anything but stellar. Hitting a high of $32.24 in April 2010, it's been downhill ever since. Back then its operating margin was 38%. Fast-forward two years and they're down below 25%. Like Rue21, it has no debt and almost $3 per share in cash. Its cash return, which is defined as free cash flow plus interest expense divided into enterprise value, is 8.5%.

If a private equity firm offered a 50% premium on Aeropostale's stock it would mean a transaction value of $1.66 billion. With a standard 30% equity downpayment, it would need $1.16 billion in debt in order to complete the acquisition. With interest rates of 7%, its annual interest expense would be $81 million. Its free cash flow in fiscal 2013 was $72.5 million, which means it either needs to pay less for the company, borrow less, or use some of the $232 million in cash on Aeropostale's balance sheet to cover interest expense overages in the short-term until it can improve its margins. This to me seems to be a much better fit for private equity firms.

The odds of a buyout: 50%

SEE: How To Invest In Private Equity

Abercrombie & Fitch
The once-hot specialty retailer has a margin problem much like Aeropostale. As recently as fiscal 2008, its operating margin was almost 20%, more than double the 8.3% margin it achieved in fiscal 2012. Macquarie analyst Liz Dunn believes Abercrombie is ready to start improving its margins and has set a 12-month target price of $63 per share, 28% higher than its current share price of $49.16. Dunn has stated, "The stock is inexpensive relative to its own historic multiple and that of the group … Expectations are low and the company has significant catalysts to drive future sales and earnings."

While doing a deal for Abercrombie would be the most expensive of the three options mentioned in this article, it currently has the highest cash return at 10.7%, meaning any kind of margin improvement over the next couple of years would enable a buyer to pay down the debt relatively quickly. In addition, regardless of Abercrombie's past sexist ways, its brand is clearly the strongest of this particular trio.

The odds of a buyout: 50%-75%

Bottom Line
At least one of these specialty retailers will be taken private in the remaining eight months of the year. My bet is it will be Abercrombie & Fitch. 

At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.

Related Articles
  1. Investing Basics

    What Is Private Equity?

    This investment vehicle attracts wealthy investors to increase the value of portfolio companies.
  2. Fundamental Analysis

    A Primer On Private Equity

    Private equity investing is becoming more accessible for individual investors; find out how you can get involved.
  3. Mutual Funds & ETFs

    Learn The Lingo Of Private Equity Investing

    Because of the non-public nature of private equity, it can be difficult to the learn the lingo. We break it down here.
  4. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  5. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  6. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  7. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  8. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  9. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  10. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  1. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  2. Who do hedge funds lend money to?

    Many traditional lenders and banks are failing to provide loans. In their absence, hedge funds have begun to fill the gap. ... Read Full Answer >>
  3. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  4. Can mutual funds invest in private equity?

    Mutual funds can invest in private equity indirectly by buying shares of publicly listed private equity companies, such as ... Read Full Answer >>
  5. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
  6. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!