I recommend investors buy Matalans (MTNLN) 9.

625% Sr Notes due

3/31/2017 at $93.50 for a yield to maturity of 11.80%. I believe
Matalan can appreciate to 98.625 in a year, giving investors an IRR of
16.80%. Matalans bonds should appreciate as the company benefits
from lower cotton prices, better inventory management and an
increased focus on its ladieswear segment. Matalan benefits from an
all bond capital structure and has no maturities until April 2016. In
addition, the business has low capex requirements and Matalan has
generated positive free cash flow every year since 1998, with the
exception of 2003. Lease adjusted leverage is high at 6.6x (5.9x net),
but I project Matalan will use its free cash flow to delever and end 2013
with leverage of 5.9x (5.2x net). For investors that are more risk
averse, the Matalan 8.875% Sr Secured Notes due 4/9/2016 at $99.25
provide a good opportunity. The yield to maturity is less than 10% at
9.31%, however, I believe investors can earn an IRR of 13.30%, over
the next year. Leverage on a lease adjusted basis is 5.4x and you
benefit from being higher up in the capital structure.
Matalan is a value clothing retailer with the UKs largest portfolio of out
of town stores. The company currently operates over 200 stores that
average ~30,000 sq ft. The company has a 10.1% share of the GBP
9.5 billion UK value clothing market as of 2009. According to Matalans
OM, the market has grown from GBP 3.4 billion in 1999 to 9.5 billion in
2009 and an expected level of 11.8 billion in 2014. The company
operates at 3 price points; its opening price point of Good, which is in
line with supermarkets, while the companys Better and Best
products are priced at a discount to high street retailers. Good
products represent about 40-45% of Matalans product assortment,
Better 30-35%, and Best 20-25%. Matalan offers a wide
assortment of products in five main departments: ladieswear,
menswear, kidswear, footwear & essentials, and homeware.
Approximately 29% of revenues are from ladieswear, 22% from
menswear, 18% from kidswear, 17% from footwear & essentials, and
14% from houseware.
Matalan was founded in 1985 by John Hargreaves. The company was
taken public in 1998. In 2006, John Hargreaves took Matalan private
again, paying GBP 817 million or 8.9x EBITDA. In 2010, Matalan was
put up for sale and John Hargreaves reportedly turned down a GBP 1.3
billion offer or 7.9x EBITDA. During its time as a private company,
Matalan refreshed all its stores, rolled out the store within a store
format, and strengthened its buying and merchandising teams.
According to a presentation at a Goldman Sachs conference last year,
the company said it benefits from having a wealthy and liquid owner
who would likely come to the companys aid should it ever find that it
needed it.

Matalans core customer is a 30+ year old female who visits Matalan
regularly to buy products for herself, her family, and her home and is
from the lower middle class or skilled or unskilled working class. The
company has a high conversion rate and believes that 60% of its
customers who visited a store within the past year made a purchase.
In addition, through its Matalan Card, the company maintains a
database of 11 million active customers or 1 in 3 UK households.
Matalan actually has two different cards. One, a Black card, represents
approximately 1 million holders who have an average basket size of
GBP 25 and shop more frequently. Its other card, the Red card is rolled
out to the remaining 10 million customers. Based on the cards, the
company has segmented its account base into different segments that
it can tailor its direct marketing toward.
In 2011 Matalan was hit with the perfect storm and EBITDA fell from
GBP 154 million in 2010 to GBP 91 million in 2011. First off, cotton
prices rose in 2010 from around $0.80/lb to almost $2.20/lb, putting
pressure on Matalans gross margins. Cotton represents about 20-25%
of Matalans cost of goods sold.
Source: Bloomberg

Matalan has long lead times and so higher cotton prices did not begin
to affect Matalans gross margins until about nine months later. Gross
margins dropped an average of 590 bps YoY in 2011 and dropped by as
much as 810 bps in Q3 11. The UK also suffered from difficult weather
in 2011. April and May were warm, while June, July, and August were
unseasonably cool, followed by an Indian Summer in September and
October. Because Matalan has such long lead times and because until
recently the company had to take its whole order size (so if it order
more product than met demand, it was forced to heavily mark down to
clear excess merchandise), the company found itself with way too
much winter stock. To clear excess inventory and make way for next
seasons products, Matalan had to resort to large markdowns.
2011 was also not good from the UK consumers standpoint either. The
average consumer faced lower disposable income, higher cotton
prices, higher petrol prices and as a result saw its purchasing power
squeezed. The UK value market is very competitive and as a result,
Matalan faced a very promotional competitive environment, putting
further pressures on gross margins. Finally, some of Matalans
problems were self-inflicted. The company bought too much stock,
Matalan had product issues with its core ladieswear division, and it also

got its promotions wrong. Matalan put its products on sale in the
Spring, after their competitors, contributing to a fall in traffic.
The overall value clothing and housewares segments are very
competitive and the level of promotion is very high. In the value
clothing market, Matalan competes against the supermarkets such as
ASDA and Tesco in the Good product category and other value
retailers such as Primark in the Better and Best categories.
Matalans OM says that Primark has 19.2% share of the value market,
followed by ASDA with 16.7%, New Look with 10.7%, TK Maxx with
10.3%, Tesco with 10.2% and Matalan with 10.1%
Matalan is unique in that it locates itself in out-of-town retail parks to
keep its rents low. About 65% of its store base is located in retail
parks, 30% in standalone stores and 5% in shopping centers or city
centers.
Matalan operates in a fiercely competitive environment as the amount
of space devoted to the value concept has seen a substantial increase.
The top 6 value clothing retailers accounted for approximately 72% of
the total retail UK value market in 2009 (up from 74.1% in 2006). The
market leader is Primark and Matalan has been losing share to Primark
over the past few years. The UK housewares market is fragmented
(top 25 players have approximately 65% of the market), but it is
starting to consolidate. The market generated GBP 11 billion in sales
in 2010. The leading three companies are Argos (5% market share),
John Lewis (5%), and Duneln (5%). Matalan is a small player, ranking
18th with a 2% market share.
The UK consumer is very challenged. Consumer incomes have only
now started to flatten out after years of decline. The ASDA income
tracker measures discretionary spending for the average household
and is now about 12% below its 2010 peak.
The UK unemployment rate is high at 7.8%, while discretionary
spending is being pinched with stagnating incomes and a CPI level of
2.7% (above the BOEs target of 2.5%). The current economic
environment is hurting consumer confidence, with levels not seen
since the depths of the Great Recession.
Finally, high petrol prices have reduced the number of trips consumers
make for out-of-town shopping.
Opportunities

Matalans unsecured bonds should be able to trade up to $98.625 for

several reasons. Margins should start to improve as management is
focused on driving margin improvement from better buying through
total control of quantity, design, and quality. Management also plans
to expand existing brands while growing new ones. Finally, cotton
prices have receded and this should help to drive increase in margins.
However, the biggest swing factor is likely to be markdowns.
Matalan benefits from a benign maturity schedule with nothing due
until April 2016 when its GBP 250 million senior secured bond and
undrawn GBP 30 million undrawn revolver comes due.
Matalan benefits from strong liquidity with GBP 118 million of cash and
17 million of revolver availability
Strong free cash flow. Matalan has generated positive free cash flow in
every year except for 2003. For 2012, I expect free cash flow of GBP
23 million and 27 million in 2013. Matalan benefits from low capex
requirements following its ambitious store roll out over the past 5
years. Given low capex requirements, Matalan requires EBITDA of only
GBP 65 million to be free cash flow neutral (20 million capex and 45
million in interest expense).
Comps trade on average at approximately 8.2x LTM EBITDA (Marks &
Spencer- 7.3x, Next- 8.6x, Debenhams- 6.8x and Mothercare- 9.9x)
giving Matalan a good equity cushion that builds as company
generates free cash flow. I feel that a multiple of 6x is more
appropriate for Matalan and while this is a lower equity cushion, it still
provides a decent equity cushion nonetheless.
Selective store expansion. Management sees the opportunity for 100
additional stores in the UK and Ireland
Online- Online grew 100% last year to GBP 25 million and is expected
to grow another 100% in 2013. Matalan launched its functional online
website in 2008. As management works to grow Matalans online
business, it is focused on value/proposition instead of prices/sales.
According to management, online has a greater average basket size
than Matalans average store. Features include next day delivery for
orders placed before 5pm, free standard deliveries on orders over GBP
50 million and free store refunds if items are defective or returned
within 7 days. While Matalan does not currently offer a click and
collect product, competitor New Look has recently introduced this and
it is only a matter of time before Matalan does so also.

Given Matalans leverage, investors are compensated for the risks

compared with other UK/European retailers. However, as Matalans
margins start to stabilize and grow, the gap should narrow. In addition,
given the companys liquidity and free cash flow generation, should the
credit markets continue to rally, investors will look to companys such
as Matalan in a grab for yield, helping to push up prices. Investors who
buy Matalans 9.625% Sr Notes due 2017 at $93.50 can expect to earn
an IRR of 16.8% over the next year as Matalans bonds appreciate to
$98.625

Exhibits
Summary Financial Projections (full model available upon request)

Relative Value