More Buyouts in the Teen Clothing Space?

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In early March, the already volatile world of youth fashion was rocked by the announcement that City of Industry, Calif.-based teenage clothing retailer Hot Topic (NASDAQ: HOTT) accepted an all-cash buyout offer from privately held asset management firm Sycamore Partners.

The $600 million deal will provide a significant return for long-term Hot Topic shareholders, and result in Hot Topic's demise as a publicly-traded company. It will also represent the culmination of years of uneven share-price performance and tumultuous boardroom dealings at the struggling clothing retailer.

Despite the unified front that the company's management team has presented, the deal remains subject to legal scrutiny from several shareholder groups who are holding out for a better agreement. Assuming that none of these investigations results in a shareholder lawsuit or otherwise scuttles the deal, it could close by the end of the third quarter of 2013.

About Hot Topic and Sycamore Partners

Hot Topic is a clothing and novelty retailer that sells a variety of clothing products and fashion accessories for teenagers and young adults. The company operates about 600 mall-based "Hot Topic" stores in North America, and around 150 "Torrid" stores in the United States. Whereas the "Hot Topic" concept appeals to a wide range of adolescents, "Torrid" is marketed specifically to plus-size females under the age of 21. Hot Topic also operates a handful of "Blackheart" stores that sell jewelery, tattoo accessories, and other novelty items.

The company employs about 2,200 full-time workers and earned $16.3 million on $718.7 million in 2012 gross revenues.

New York-based Sycamore Partners is a boutique private equity firm that specializes in wealth management, small-scale leveraged buyouts and corporate guidance. The company has worked with fashion-forward clothing retailers like Talbots and Mast Global Fashions, as well as smaller finance firms. Although it does not issue detailed financial statements to the public, Sycamore has at least $1 billion under direct management, and it employs several dozen employees.

How the Deal Is Structured

This relatively straightforward deal will be structured as a "one-step" all-cash buyout. Under the terms of the agreement, Sycamore will issue cash payments of exactly $14 per share to each Hot Topic shareholder as of a yet-to-be-determined record date.

Relative to Hot Topic's pre-announcement closing price of $10.75 per share, this represents a premium of about 30.2%. Relative to the company's most recent closing price of $13.85 per share, it offers a premium of 1.1%.

Complications and Legal Issues

The pending deal is not without controversy. In fact, it is the subject of at least two separate legal investigations that have been launched in an effort to determine whether Hot Topic's board observed the proper "shopping" protocols before announcing the deal. Specifically, the Brower Piven investigation alleges that the company abdicated its fiduciary responsibility to its shareholders by accepting a deal that undervalued it by as much as 17 percent.

It should be noted that such investigations are common in the wake of buyout announcements. In addition, the means by which Brower Piven "values" Hot Topic is suspect: It simply notes that a stock analyst had issued a $16.40 price target for the company at some time in the past. Owing to this relatively flimsy rationale, it is unlikely that these legal actions will ultimately delay or scuttle the deal. However, they could lead the company's board to entertain the prospect of higher rival bids that may provide shareholders with an additional arbitrage opportunity.

Competitors: Who Could Be Next?

Although the announcement of this buyout deal has fuelled talk that more teen apparel buyouts might be on the horizon, such speculation might be premature. For starters, this sub-industry is unique in several key ways, and it does not necessarily respond well to consolidation. Since fashion trends are subject to rapid change, it is often not in the best interest of a management team to accept a merger offer or buyout from an outside group.

While companies like Aeropostale (NYSE: ARO) and Abercrombie & Fitch (NYSE: ANF) have lately struggled to stay out in front of changing clothing tastes and posted underwhelming earnings results, this does not necessarily make them prime buyout targets. In the fashion world, it is often more effective for boards of directors to replace the key executives or managers in order to see change.

Aeropostale has experienced flat sales for the past year, while Abercrombie has actually increased sales by 10%.  With the PEG ratio much larger for Aeropostale, investors are apparently expecting more growth out of that retailer than Abercrombie in the next five years.  Investors who hold positions in Hot Topic's peer companies should not necessarily be crossing their fingers for a flurry of buyout activity.

In sum, investors should refrain from drawing broad conclusions from the specific circumstances of the Hot Topic buyout. Within those constraints, this transaction represents an excellent opportunity for arbitrage investors to realize short-term profit.

Those who believe that legal issues will ultimately delay the deal may wish to initiate a short position in Hot Topic or hold out for a higher buyout offer from a third party. Those who believe that this deal will go through as planned should stand ready to buy into Hot Topic on any news-related dips.

Mike Thiessen has no position in any stocks mentioned. The Motley Fool owns shares of Aeropostale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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