Investment Dealers' Digest

Yucaipa's Pathmark PIPE Dream

Thanks to a $150 million PIPE (private investment in public equity), Ron Burkle is back in the grocery store business.

The Los Angeles billionaire, who made notable investments in such supermarket operations as Food4Less and Fred Meyer before those companies were bought by the Kroger Co., has bellied up to the salad bar again. Burkle announced on March 24 that the Yucaipa Cos., a private equity fund of which he is the managing partner, has taken a $150 million equity stake in Pathmark Stores Inc., giving Yucaipa a 40% stake in the company.

Pathmark, a regional supermarket chain with 143 stores in New York, New Jersey and Pennsylvania, boasts either first or second market share in eight of the nine major metropolitan regions in which it does business. But despite its enviable market position and prime real estate, Pathmark's profits have been lagging of late, and the infusion of new capital, along with the presence of strategic investor Yucaipa, appears to be "exactly what they needed," says Karen Short, an analyst at Fulcrum Global Partners in New York. "I think it was great," she adds of Yucaipa's arrival.

What makes the deal most interesting to many on Wall Street is the way it was structured. To make its investment, Yucaipa opted to use a PIPE creating 20 million new shares of common stock at $7.50 a share, above the $7.53 at which Pathmark shares were trading last week at press time. Assuming shareholder approval for a deal that has already gotten the green light from Pathmark's board, Yucaipa will take five of eleven board seats, making it "a large, vocal shareholder," in the words of Fulcrum Global's Short.

In addition, the deal gives Yucaipa stock rights in the form of 10.06 million warrants exercisable at $8.50 per share. If certain conditions are met, another 15 million of the 10-year warrants are exercisable at $15 a share. If all goes according to plan, says Yucaipa partner Michael Duckworth, Yucaipa could eventually own 59% of the company.

"What we've tried to do here is to say that we have a lot of confidence in what we can do for the company," says Duckworth. "Our thesis is that Pathmark is a tremendous asset with great per-store volume," he went on, "but it's been overlevered for almost 20 years now since Merrill Lynch Capital Partners led a buyout in the 1980s. So, essentially we'll be paying down debt and injecting capital into the company."

"So, for our shareholders, they're not getting a straight buyout," he adds. "They'll share in the gains fully until they've essentially had triple the stock price." At that point, Duckworth says, the takeover firm will "ask for a promotion" as it exercises its warrants.

Duckworth says that had Yucaipa opted for a straight leveraged buyout, the change in ownership would have meant paying down high-coupon junk bonds and replacing them with still-more expensive debt. The PIPE leaves the existing debt in place. "That's the magic of staying under 49%," he says.

Using PIPEs in this way is no longer novel, as it has been going on at least since the late 1990s, industry experts say. But the fact remains that a deal such as the Pathmark one would not have been possible without the existence of PIPEs, according to Brian Overstreet, president of Sagient Research, the parent company of PlacementTracker, an online service that follows the PIPE industry.

Using the PIPE, Overstreet says, "allows them to take control of the equity with a small amount of money, on a relative scale, and get the debt down and grow the stock price. Because Pathmark is a public company, the private equity investor can get more immediate gratification than had it taken the grocer private. When the new owners get up in the morning and punch the ticker, they can see their gains.

"The PIPE gives them flexibility for acquisition," Overstreet adds. "And it leaves the door open to raise more equity in the future."

The PIPE also made it possible for Yucaipa to take an outsized equity position without purchasing previously issued stock, which would have been a much more drawn-out process. And since a PIPE requires approval from both a company's board and shareholders, notes finance professor David Brophy at the University of Michigan, the deal is transparent. "It's an open kimono," he says.

(One aspect of the deal that was not mentioned in the press release but emerged from press reports following the announcement is that Pathmark will be paying Yucaipa $3.3 million in consulting fees over the next five years.)

Meanwhile, for Pathmark to achieve a turnaround-and for Yucaipa to activate its warrants and win 59% control of the company-Pathmark will have to overcome numerous hurdles.

On April 13, Pathmark posted a loss of $262.3 million, or $8.73 a share, for the fourth quarter. That compared with net earnings of $9.6 million, or $.32 a share, a year earlier. Excluding a slew of one-time accounting charges, Pathmark said it would have earned $2.5 million, or $.08 a share.

Although the company is already well-managed, analysts say, it is laboring under long-term debt of some $600 million and faces competition from high-end food stores like Whole Foods Market Inc. as well as from such discount sellers as Dollar Tree Stores Inc. and Wal-Mart Stores Inc. for goods such as paper towels and packaged products.

"The problem with Pathmark," says Short, "is that there isn't just one thing they can do to fix things. You don't just go from $149.9 million Ebitda (earnings before interest taxes depreciation and amoritization) to $200 million overnight. And they face things like rising health care and labor problems, high inflation, a competitive environment and weather problems.

"So this investment has bought them time," she adds. "And it has bought them an investor who's involved day-to-day in strategic direction of the company."

Another New York research analyst, Ivan Feinseth at Matrix USA, is more skeptical that a turnaround is in the offing.

"The stock is pretty much trading at fair value," he says. "Yucaipa had a good track record and they're getting good real estate and a good management team. But if you were going to buy something in the supermarket sector, this would not be it." Feinseth notes that the company's cost of capital is 5.1% while it's return on capital is only 3.7%.

In past supermarket deals, Yucaipa's exit strategy has been to spruce up a franchise and sell it at a premium to bigger players in the business: one past holding, Dominicks Fine Foods Inc., is now owned by Safeway, and Ralphs Grocery Co., another former Yucaipa company, was shopped to Kroger, which also owns former Yucaipa holdings Food4Less and Fred Meyer. "There are a lot of retailers for whom this would be a strategic fit," notes Short, citing Albertson's Inc. and Ahold USA Inc.

However, those companies have their hands full just now, she says, noting that Albertson's recently acquired Shaw's Supermarkets Inc. And Ahold was already blocked by the Federal Trade Commission from buying Pathmark in 1999 because of antitrust concerns.

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