Rona's stock shows takeover hope lives

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Rona Inc.'s stock may have lost its takeover fever, but the stock price is still clinging to hope that the company will be bought out, analysts say.

"We estimate that the market is incorporating an approximate 20-per-cent likelihood of a Rona acquisition," said National Bank Financial analyst Vishal Shreedhar in a research report.

After U.S.-based competitor Lowe's Cos. withdrew its $14.50-a-share takeover proposal Monday, Rona's shares fell 12 per cent. Three of the eight Bay Street analysts actively following Rona reduced their 12-month target price on the stock, shaving almost $1 off the Street's average target price, to just under $13.

But despite the lowered outlook and deep drop in share value, analysts said the stock price is still pricing in a takeover premium. Indeed, many of the analysts see a reduced but still significant possibility that Rona will eventually strike a deal with Lowe's or some other suitor.

Mr. Shreedhar's own price target is $13 a share – which he has based on a 30-per-cent chance that Rona will be bought out "in the range of $15 to $19 a share." His previous target of $14 a share was based on a 50-per-cent probability of such a deal.

He indicated that reducing the probability to zero would knock roughly another $1 off the share price.

Before Lowe's interest in acquiring Rona first came to public light last spring, Rona's stock was wallowing below $10 – reflecting the company's weak financial performance in recent years as well as its tepid growth prospects. Its price-to-earnings valuation was below 10 times, based on forward 12-month consensus earnings forecasts.

The lingering hope of a takeover deal should keep Rona from reverting to these levels, said analyst Mark Petrie of CIBC World Markets. "Though we do not believe a takeout by Lowe's is likely, it is possible that a non-strategic acquirer could emerge," he said in a report. "As such, it is possible that some form of takeout premium will be embedded in the stock for some time period."

At its current price, Rona's stock is trading at about 11.5 times the earnings that analysts expect it to generate over the next 12 months. In contrast, S&P 500's home-improvement retail sub-index – composed of Lowe's and Home Depot Inc. – fetches nearly 18 times forward earnings.

Analysts said Rona's financial results have trailed expectations this year, but there are signs that the company is starting to move in the right direction.

Management is making progress on implementing a new strategic plan that includes reducing the firm's reliance on big-box stores, as well as financial initiatives aimed at cleaning up its capital structure and improving its return on capital. Same-store sales edged up 1 per cent in the second quarter compared with a year earlier, ending seven straight quarters of declines.

"If Rona is able to execute on its plans and deliver substantial improvement in its operating performance, shares will trade on a fundamental valuation much close to that of the U.S. [home improvement retailers]," Mr. Petrie wrote. However, he added, "We do not see major strides on the immediate horizon."

Analysts don't expect Rona's management initiatives to start showing significant benefits in its financial results until next year. In the nearer term, they expressed concern that Canada's softening housing market could put a strain on sales.

Still, one analyst – Keith Howlett of Desjardins Securities – remains convinced that Lowe's hasn't given up on buying Rona – and that its return with a new offer will drive the share price again, possibly before the end of this year. "Our view remains that Lowe's wants to conclude a transaction with Rona before Rona closes, or shrinks in size, 23 big-box stores located outside Quebec," he wrote in a note to clients Monday, in which he reiterated his "buy" rating and $16.50 target price.

"Lowe's will either now proceed with a hostile bid within three months, or intensify its competitive actions in the marketplace to facilitate more productive negotiations in two or three years."