Don’t Discount Quebec…

Interventionists beware - how savvy firms can make a Quebec acquisition
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“As soon as you start intervening in the fluidity of the market there is a discount, there is a general chill in the province.” – Adrien Pouliot, President of Montreal investment firm Draco Capital.

On the heels of Lowe’s failed C $1.8B bid to acquire Quebec-based home improvement retailer Rona, potential investors cannot help but wonder whether a tense political environment and proposed changes to legal frameworks are threatening La Belle Province’s investment climate. Quebec’s business leaders are increasingly concerned that the Lowe’s-Rona debacle has heightened the province’s reputation as a difficult place to conduct business, while rhetoric from politicians on both sides of the aisle has only exacerbated the problem.

Opposed on the grounds that the acquisition would threaten Quebec economically, socially, and culturally, Lowe’s bid was challenged by an organization with a well-documented history of attempting to thwart foreign acquisition bids – the Caisse de dépôt et placement du Québec (Caisse). The Caisse, Canada’s second largest pension fund, is subject to significant political influence and operates under a dual mandate: seek high returns, and contribute to Quebec’s economic develoment. As a pension fund manager, the Caisse is willing to prioritize the politics of keeping companies headquartered in Quebec over maximizing return – it seems to have no qualms about intervening in the public markets to make this happen.

Even though Lowe’s bid of $14.50 featured a 37% premium over Rona’s $10.61 share price, shareholders did not have the opportunity to vote on the acquisition proposal. Many analysts did not believe the claim that Rona represented a “strategic provincial asset” and argued strongly against propping up a chronically under-performing company in the name of cultural sovereignty. Lowe’s eventually withdrew its bid after facing strong pressure from Rona’s Board of Directors, the Caisse, and the Quebec government to do so.

Does Intervention Lead to a Discount?

Pouliot’s sentiment has been echoed by others in the financial community who are fearful that Quebec’s history of market intervention will dissuade firms from pursuing acquisitions of Quebec business- es, thereby limiting shareholders’ ability to profit from tendering their shares in a takeover bid. The Dominion Bond Rating Service, Canada’s leading ratings agency, has echoed concern about recent events in Quebec, noting that any increased interventionist man- date for the Caisse will hurt Quebec firms in the capital markets.

The Parti Quebecois’ election promise to enact laws allowing a board of directors to reject an acquisition bid without conducting a shareholder vote has garnered criticism, as it could have the effect of entrenching bad management and a board that does not prioritize maximizing shareholders’ returns. Business leaders are like- wise concerned about whether the government’s plan to earmark $10B of the Caisse’s existing assets towards a “strategic investment fund” to protect homegrown companies from acquisition, will deter investors from the province and suppress stock prices. Though the tone in Quebec has softened since the election, concerns remain that the province does not provide a safe investment environment.

An analysis of share price movement following acquisition bid announcements for Quebec companies relative to their English Canadian counterparts suggests that investors are generally less optimistic about takeovers in the province. Given that the Quebec discount is relatively small, it is near impossible to quantifiably separate the discount from market noise. However, pessimism on behalf of investors can be used to indicate the market does place a discount on Quebec firms. After deals are announced, the spread between the market price and the acquirer’s offered price gives an indication of the probability that investors place on the transaction’s successful consummation. Owing to the government’s history of unpredictable intervention, this spread tends to be higher for Quebec-based acquisition targets than their out of province peers when the risk profile of these transactions is otherwise comparable.

The “Quebec discount” is not an entirely new phenomenon. The Parti Quebecois’ first election victory in 1976 and the 1995 referendum on Quebec sovereignty both created a sense of instability, leading to reduced common stock valuation and massive capital outflows. The current situation is not as dire as in 1976 or 1995, but valid concerns remain that the unpredictability of government intervention in the capital markets deters firms from putting money into Quebec.

Taking Advantage of The Discount

Making a play for a Quebec company is a viable option if a strategic fit exists and the acquirer believes it will be able to capitalize on the discount while avoiding the challenges associated with purchasing a Quebec firm. Despite its apparent problems, Quebec remains an attractive market, especially in thebretail space. Quebec has a disproportionally high number of retailers who are successful across Canada, with brands like Alimentation Couche-Tard (Mac’s), Metro, Dollarama, and ALDO leading the way. If a foreign retailer is able to establish itself in the province there would likely be few additional barriers to expansion across Canada. The Quebec discount could therefore prove valuable for a firm pursuing an acquisition to strengthen its position in the province or gain a foothold in the Canadian marketplace. If the political waters of Quebec are navigated effectively, an acquisition can be made at an attractive price.

American retailers, in particular, could benefit from capitalizing on the discount. The wave of American retailers recently entering Canada includes Target, Nordstrom, Marshall’s, and Bloomingdale’s, and there are no indications this influx will slow. Driven by a strong Canadian dollar, a saturated American market, and great- er growth in Canada, many American companies have pursued acquisition strategies when expanding north. Acquiring a Quebec company instead of an English Canadian firm also means that there will be fewer bidders driving up an already discounted price.

The major factor limiting American retailers’ Canadian growth to date has been a lack of prime retail space, as vacancies in major malls and shopping centers are at historic lows. Consequently, American companies like Lowe’s and Target have attempted to acquire Canadian firms for their real estate rather than grow organically. Acquiring an underpriced Quebec-based retailer with a national presence would make strategic sense for a US firm with expansionary goals, especially considering that sales per square foot at Canada’s top shopping centers are 88% greater than in the United States. Moreover, the long-term outlook for Canada’s re- tail sector is significantly better than what is forecasted stateside. The time to make a play is now. Political and economic instability has made Quebec’s firms available on the cheap and the race for American retailers to acquire prime retail space is heating up.

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Finding the Right Target

There are two additional criteria (beyond strategic fit) for finding the right target: it must exhibit characteristics that imply a large discount and it cannot be so vital to Quebec that an acquisition is likely to evoke intervention.

The Quebec discount is greatest within the retail sector, as the Quebec government and the Caisse have shown a greater tendency to intervene when a consumer-facing brand with a large labor force is involved. Firms should identify a retailer with national reach, as a firm concentrated mostly in Quebec elicits a greater sense of provincial pride. Buying a firm based in Quebec with lo- cations nationwide provides the dual benefit of capitalizing on the discount and getting immediate access to the entire Canadian market. When searching for a bargain Quebec firm, it can be a benefit if the Caisse has holdings in the company, as this increases the discount’s size by scaring off other potential suitors. Although the Caisse ownership does increase the likelihood an acquisition will be blocked, an effective bidding strategy can reduce this risk.

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It is important that the target firm does not have an exten- sive supplier network in Quebec, as the Caisse has traditionally contested bids that threaten local suppliers. This was a major objection in Lowe’s failed bid, and in 1998 the Caisse stipulated Loblaw promise to maintain the same level of annual spending from Quebec-based suppliers as its target, Provigo, did. Choosing to pursue a Quebec retailer with a large scale provincial supplier network, such as Le Chateau, should be avoided in favor of a firm with a smaller supplier network.

Seeing that politicians can use a foreign company’s takeover bid to rally popular support for the protection of provincial interests, an acquisition should not be pursued during provincial election season. Information regarding the bid and acquirer’s long-term vision should be widely available in French as an important demonstration of cultural sensitivity. These are two costly mistakes that tainted Lowe’s bid amongst the Quebec public, their government, and the Caisse. Failing to communicate to the public in French indicates a lack of regard for Quebec’s culture and heritage. This is a deal breaker.

An acquirer should search for a young target whose lack of history diminishes its cultural significance to Quebec- ers. Pursuing a company such as Jean Coutu, a prominent pharmacy with historical ties to Quebec and locations province-wide, could risk drawing the ire of patriotic Franco- phones, and by extension, their government and the Caisse.

To improve its reputation in the province, the acquirer should only proceed if they receive support from the target’s board. The acquirer should also agree to maintain a Quebec headquarters of the Canadian division, a Canadian listing and a bilingual president of the Canadian division. As well, funds should be ear- marked for community investments to highlight the acquirer’s commitment to Quebec’s development. The provincial government and the Caisse are powerful foes; however, understanding Quebec’s cultural hurdles, and strategically selecting targets that do not provoke public outcry will help avoid their opposition.

Does anyone fit the acquisition criteria?

With these considerations in mind, Reitmans presents an appealing acquisition target. Between its own branded stores and a portfolio of other brands in the women’s and plus-size segments, the company operates a total of 940 locations occupying prime retail space in every province. The Caisse has historically held a significant stake in Reitmans and recent filings suggest the fund currently owns 7% of its outstanding shares. In addition, Reitmans lacks a comprehensive supplier network in Quebec and the brand is not closely tied to provincial identity.

Among Reitmans’ shareholders, there would likely be strong sup- port for a takeover bid. The dividend has remained unchanged since 2010 and the company’s stock has been trading its 52-week low, well below its intrinsic value, due to mismanagement. The Caisse’s involvement may scare off some potential suitors, but a savvy foreign retailer could obtain large gains basing its Canadian entrance strategy on a Reitmans acquisition and subsequent rebranding.

Value is often found where others refuse to look. Recent developments have scared investors away from Quebec, producing both a valuable buying opportunity and a gateway for an American retailer to use Quebec to gain access to the whole Canadian market. Lessons learned from the failure of companies like Lowe’s can be used as the foundation of an effective bidding strategy for a Quebec-based firm. American retailers take note – it is time to do some bargain hunting in Quebec.

Update:

On January 3rd, 2013, the National Post’s Financial Post cited “Don’t Discount Quebec…” in the article “Winter’s late start in East hurts Reitmans and HBC same-store sales” Read Full Article


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