UNY & FamilyMart: Scale & Synergy Means Own the "Love Call" UnderDog?

• After a news report March 6 suggesting it was the case, on March 10, 2015, Family Mart (8028 JP) and UNY (8270 JP) announced they had commenced discussions of Management Integration with a Basic Agreement (regarding Name, Management, HQ and merger ratio according to this Japanese source) to be announced in August 2015. Both companies' management and the official releases say discussions will be done “in the spirit of treating both companies as equals.” 
• The schedule from here is a long drawn-out process. Basic Plan announcement is August this year. Full details are due between end-2015 and April 2016 followed by AGMs in May and deal completion September 2016. Before any of that we have the announcement of both companies current year results and next year forecasts in the second week of April 2015 (Apr8-10). Neither company is expected to have improved results.

There is a question of WHY because the two parties, while both retailers, are not alike.

• FamilyMart is a $4bn market cap asset-light CVS franchise model with a 'high' PBR and a clear pattern of promoting organic growth on an asset-light branded strategy. It wants to be the "True Number 1 Convenience Store in the World." 
• UNY Holdings is a $1.3bn holding-company hodgepodge with negative revenue growth over the past 5yrs, trading at a PBR well below 1 (with commensurately low ROE and ROA). The HoldCo contains two CVS chain brands under single management - Circle K and Sunkus,  a group of regional supermarket/superstore chains with $7+bn in annual revenues, Japan's number one kimono retailer, a couple of other clothing/sundry chains catering to the regional/elderly customer, and a few other side businesses which generate 10-15% of OP in any given year, including a credit card business with 3+mm members.
• Importantly, the form of the announced transaction is complex (and for those interested in the accounting, there could be some fireworks (or the deal structure might be tweaked). Being so complex it gives a hint as to what the real aim is here.If this were really just about the CVS business, there was a far easier transaction to do. 
• Related to that, one must consider Itochu and FamilyMart. They have publiclyundertaken to discuss potential marriage of equals with a company which is decidedly not their style historically. Or so it would seem. FamilyMart's behind-the-scenes approach had been industry gossip for a year, and the above-linked Toyo Keizai article (a decent one if you read Japanese) talks on p1 about "FamilyMart's Love Call" (nota bene: nothing to do with Ornette Coleman) which UNY had heretofore rebuffed. FamilyMart/Itochu are not doing this to buy UNY 10-20% cheap. This is strategic and involves the next decade or three of retail evolution. Japan Inc doesn't day-trade Japan Inc. There is a strategic imperative here, and when the larger, 'nimbler' one is merging with a smaller and 'slower-moving' business by choice, or "Love Call", it makes sense to figure out why.

And there is a question of MERGER RATIO.

Answering the WHY may help with the understanding of "in the spirit of equals" and what that means to the merger ratio. 

• Looked at one  way, the high-margin monoline business model of the larger FamilyMart would be 'polluted' by the lower-margin CVS business of Circle K Sunkus, and even more by the low-margin and low-growth 'destination-type' large-scale retail store platform of UNY. 
• Looked at another way, this merger would allow FamilyMart and Circle K Sunkus to approximately gain the scale of  Seven Eleven Japan in terms of 'ubiquity of presence' in the CVS space, use that scale to re-brand and increase effectiveness of promotions, create dramatic synergies in SG&A, logistics, likely COGS, and use that newfound scale to introduce Private Brand products and proprietary services to rival those of Seven-Eleven (financial, online, products from the GMS business, locally-differentiated product, etc). It would also allow Itochu and FamilyMart a leg into a larger retail space in a changing retail environment in Japan. This changing retail model is something every retailer is hard at work on, and the nature of that changing model is part and parcel of every major CVS chain, and most major large-scale format retailer, including very specifically FamilyMart's and UNY's individually stated strategies (in the Annual Reports), Seven Eleven, Lawson, 7&i, Aeon, etc. So far, neither FamilyMart nor UNY have been able to execute this well on their own. This deal provides a jump-start to their ambitions. 

CONCLUSIONS:

• A deal between UNY and FamilyMart is not a like-for-like transaction so to understand relative fair value, digging is required.
• Any way you slice it, UNY looks rich on a Last-12 Months earnings basis, but cheap on an asset basis, and relatively cheap to FamilyMart on an cash-flow basis, more so on a multi-year basis. 
• There are risks in a merger ratio bet any time you see the words "in the spirit of equals" because you never know if that is the underdog throwing its shareholders and legacy under the bus to protect its employees' jobs. When Seven Eleven and Ito Yokado merged, Seven Eleven shareholders were distinctly favoured because of the growth trajectory of Seven Eleven and because of IY's lower margins and lower ROE.
• After digging, and some simple observations, I don't find this deal to be quite the same for FamilyMart shareholders as the 7&i deal was for Seven Eleven shareholders.
  • Seven Eleven brought world-class process to the table. FamilyMart has substantially less marginal expertise (FM among CVS is decidedly middle-of-the-road while UNY GMS among GMS is actually better than average), and despite a large store count, FamilyMart has not created nearly the per-store OP that Seven Eleven enjoys, and indeed FM's margins and OP/store lags those of Lawson.
  • This deal is not just a CVS merger. The potential merits to FamilyMart and Itochu from joining with the long-tail merchandise of UNY Holdings, are in the logistics, expertise in selling to an elderly population (which UNY has in spades), and the manifold benefits of single Private Brand sales across the platform (as 7&i does, especially with the Seven Premium and Seven Gold brands) should lead to improved OP margins per store and OP margins across superstores and developing mini-stores.
  • SevenEleven OP as a percentage of the 7&i retail OP (i.e. not counting SevenBank) OP is 85+%. In a FamilyMart/UNY combination, over the last 5 years the average is about 4:3, and some of UNY's 'weakness' is in higher depreciation. On a operating cashflow basis it is about 51:49.
• I find the upside to merger ratio to be between 'somewhat', and dramatically in favor of UNY.
• However, the BIG RISK is that we get a Seven Eleven-ItoYokado type merger ratio, which means UNY throwing its shareholders under the bus. Is that possible? Certainly. TIJ after all. UNY has a half-dozen analysts covering it. FamilyMart has three times more. The perception of FamilyMart vs UNY is that FamilyMart is far more worth the effort - it's far bigger after all. Or is it....  ...despite UNY's significantly higher net debt, UNY's equity base is larger than FamilyMart's. Put another way.... with both at the same PBR, UNY is the bigger market cap. And the equity value of UNY's float is higher than FamilyMart's. 
• If you make a bet on the merger ratio and you are in the 'somewhat' camp, I would suggest waiting until after the earnings and next FY forecast announcements of the two companies in the second week of April (Apr8-10). If in the 'somewhat' camp, that obviously leaves you 'short gamma' to moves till then and on announcement. If in the 'dramatically' camp, you can wait.  
• This deal is not a 'must-do' deal for either FamilyMart or UNY. This leaves non-negligible 'strategic risk' both before the merger ratio announcement and afterwards. I would likely exit a pair-position once the merger ratio is announced.