These Two “Special Situations” Have Huge Upside

While the markets remain in a state of turmoil and prices continue to fall, corporate activists have been picking up their pace. Two developing situations are now worth the attention of patient but aggressive investors…

Because the potential returns are getting quite big. Here’s what I’m seeing…

First, there is the ongoing saga of Kohl’s Corp. (KSS). I am stunned that the board of this company has not been replaced in its entirety, and each of the directors sued personally for negligence. The department store turned down takeover bids as high as $68 back in May when the stock was trading in the mid-50s.

The board felt that the department store chain was worth more than that price.

They were wrong.

Kohl’s missed earnings expectations in the second quarter and dramatically reduced its expectations for the full year.

As soon as the report hit the wires, the rout was on: the stock now trades for less than $30.

Activist investors are piling on, demanding that the board be replaced and the chairman of the board be fired. A proxy fight is shaping up, and I am hard-pressed to see how the board wins the day.

Jonathan Duskin, the head of the activist firm Marcellum Advisors, recently sent a letter to the beleaguered depart store chain’s shareholders. He was not nice about demanding the ouster of the entire board. Instead, the letter highlighted the failed sales process at much higher prices, executive departures, and the downgrading of Kohl’s debt to junk status. Furthermore, the activist called the wounds at Kohl’s self-inflicted due to execution issues on the part of the board.

There is little doubt in my mind that Kohl’s is worth a lot more than its current share price. Of course, there will be headwinds from a weakening economy and margin pressure due to inflation, but the stock price should be well above current levels.

The biggest obstacle will be the board’s willingness to fight the needed changes.

The stock is trading at just eight times forward earnings expectations and 82% of tangible book value.

Management has shown itself capable and willing when it comes to destroying shareholder value, so I would stay small and move slowly with Kohl’s, using weakness in the market to accumulate a position. The profit potential here is too big to ignore.

More experienced investors might want to use cash-secured puts or long-dated out-of-the-money calls to bet on the stock’s recovery.

Farmer Bros. Co. (FARM) is another ongoing saga that has attracted the attention of activists. The history of the coffee roaster is full of drama, including family disputes, ill-fated M&A activity, and what was, at the time, a very unpopular move from California to Texas.

Then the pandemic came, and Farmer Brothers was hit hard. Its biggest customers were hotels, restaurants, and casinos, and sales dropped dramatically. The problem is that business has not recovered as strongly as hoped as the economy began to reopen.

Revenues are still well below pre-pandemic levels, and expenses are rising. Debt levels have increased by more than 20% year over year. Cash on hand is down to less than $10 million. Farmer Brothers is losing money, and none of the analysts following the company expect it to turn a profit in 2023, either.

There has been some insider buying by the CEO, CFO, and chief supply chain officer, but there is no convincing evidence the business is improving.

Now, activist investor KCP Partners has accumulated a stake of more than 6% in the company and is pushing for board seats. Farmer Brothers’ board has not issued a response, but I doubt the company will give in too quickly.

If KCP does get board seats, I expect it to push for the sale of the company.

A sale should get a much higher valuation than the current stock price. The new facilities in the Dallas area are running at half capacity, so there is plenty of room for expansion of management can get the core business back on track.

A buyer whose business is already back to pre-pandemic levels could immediately double the facility’s output.

Again, I don’t think you need to back up the truck for this stock, but a small position could lead to outsized gains. Either management gets the business turned around and starts paying down debt, or activists will force a fight to unlock the obvious shareholder value present in this company’s assets and potential.

— Tim Melvin

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Source: Investors Alley