Pair Trade: Retail Ventures Inc and DSW Inc

Hi, I was over at a value investing blog - Barel Kasan and saw that he posted this pair trade. I dug more into it. I thought it'd be an interesting opportunity for us to analyze an arbitrage play.

Investment Thesis
As of May 2, 2009, Retail Ventures (RVI) owns Class B Common Shares of DSW representing approximately 62.9% of DSW’s outstanding common shares and approximately 93.1% of the combined voting power of such shares. DSW currently trades at $12.91 with a market cap of 565.64M (as of market close Aug 10). Therefore RVI's stake should be worth 355.79M.

RVI is currently trading at $3.38 (as of market close Aug 10). RVI's market cap is $165.39M. RVI's book value as of May 2nd, 2009 was $363.1M. The thesis is that there is an arbitrage opportunity since RVI should not trade below its DSW stake. The difference is quite significant and the thinking is that we could take advantage of it.

RVI is basically a holding company. It doesn't have any operating segments. Its main asset is the 62.9% of DSW common shares that it owns, the $103.3M in cash, $10.3M in restricted cash and $81.4M in short-term investments.

RVI does have $128.1M in long-term obligations and $100.4M in Other non-current liabilities. The $128.1M consists entirely of Premium Income Exchangeable Securities (PIES). PIES are a structured product. The total principal amount of PIES is $143.75M. The PIES bear a coupon at an annual rate of 6.625% of the principal amount and mature on Sept 15th, 2011. Except to the extent RVI exercises its cash settlement option, the PIES are mandatorily exchangeable on the maturity date, into Class A common shares of DSW, no par value per share, which are issuable upon exchange of DSW Class B common shares, no par value per share, beneficially owned by RVI. On the maturity date, each holder of the PIES will receive a number of DSW Class A common Shares per $50.00 principal amount of PIES equal to the "exchange ratio" or if RVI elects, the cash equivalent thereof or a combination of cash and DSW Class A Common Shares.

The exchange ratio is equal to the number of DSW Class A Common Shares determined as follows:
(i) if the applicable market value of DSW Class A Common Shares equals or exceeds $34.95, the exchange ratio will be 1.4306 shares;

(ii) if the applicable market value of DSW Class A Common Shares is less than $34.95 but greater than $27.41, the exchange ratio will be between 1.4306 and 1.8242 shares; and

(iii) if the applicable market value of DSW Class A Common Shares is less than or equal to $27.41, the exchange ratio will be 1.8242 shares, subject to adjustment as provided in the PIES.

The maximum aggregate number of DSW Class A Common Shares deliverable upon exchange of the PIES is 5,244,575 DSW Class A Common Shares, subject to adjustment as provided in the PIES.

DSW is a leading U.S. specialty branded footwear retailer. It was wholly owned by RVI. DSW had its initial public offering on July 5, 2005. DSW operates 303 shoe stores in 38 US states as of May 2, 2009. DSW offers a wide selection of better-brand dress, casual and athletic footwear for women and men, as well as accessories. DSW also operates 365 leased shoe departments for four other retailers and sell shoes and accessories through dsw.com.

At first glance, this looks like a straight forward arbitrage play. 2 companies, 1 owns a large chunk of the other but is selling at a large discount to its stake. This time round the PIES structured product messes around with the play.

The reason is simple. The debt can be paid back in DSW shares (ie there is a convertible feature). This lessens the value of RIV's stake in DSW and changes the valuation of RIV's stake in DSW. So the effect of the PIES is to put in doubt the actual value of RVI's 62.9% stake in DSW. We know it's less 'coz RVI might elect to pay the principal amount of debt ($143.75M in DSW shares). In fact, if RVI paid back in DSW shares right now, it'll probably only have to pay out the maximum amount of shares (5.244M shares) which is only worth $67.7M right now. The more shares RVI pays out to the PIES holders, the less the difference in the value of the arbitrage. This means you take off $67.7M from the value of RVI's stake, this leaves RVI's holdings in DSW at $288.09M. It also means that the difference in RVI's value and its DSW stake decreases by $67.7M as well ($122.7M left in the arbitrage amount).

Then you need to account for the conversion feature of the PIES, 'coz that's worth something. Right now, it approximately stands at $76.05M (I treat it as a deep in the money option, so it's just the difference between the principal amount of debt and the value of the shares paid out). That leaves $46.65M in the arbitrage amount.

Having said all the above, $46.65M is only 28% of RVI's market cap. I don't think there's a sufficient margin of safety to do this trade.