What's That Smell At Duane Reade?

The trouble with value stocks is that the value sometimes gets away. That may soon happen at Duane Reade, New York City's dominant drugstore chain. Along with the city, Duane Reade suffered through the fierce bear market in stocks and, worse, September 11: Its most lucrative store had been a World Trade Center fixture. Such extraordinary woes, plus the costs of an ambitious expansion, have been weighing on the stock.

Then, two days before Christmas, a surprise arrived. Duane Reade announced it had agreed to be bought out by Oak Hill Capital Partners, a private-equity firm founded by Texas billionaire Robert Bass. That day, the stock rose 12%, to 17 a share, the price Oak Hill is offering public shareholders. "We are confident that this agreement delivers excellent value," said Duane Reade CEO Anthony Cuti. Yet some big investors beg to differ. One, Copper Arch Capital, a New York firm with 7.8% of Duane Reade, may start a proxy fight to kill the deal. A letter from Copper Arch Chairman Scott Sipprelle to Duane Reade's outside directors puts the company's minimum value at $27.75 a share -- some $260 million more than the bid.

THIS WOULD BE OF MERE passing interest on the side- walks of New York, and of nil interest beyond the metropolis, if not for the expectation among some investors that reforms are leveling Wall Street's playing field. In this case, several big investors are crying "tilt." As Roger King of King Investment Advisors, holder of nearly 1.3 million Duane Reade shares, told me: "Something about this just doesn't pass the smell test."

Founded in 1960 as one store in lower Manhattan, the chain by 1997 counted 67 outlets. Then controlled by Donaldson, Lufkin & Jenrette, it went public in 1998 at 16.50 a share. The stock was a hit right off, opening on the NYSE at 22. With this and a 2001 sale of stock at 34.50, DLJ (by then a part of Credit Suisse First Boston (CSR )) profited handsomely on its investment, having paid $8.33 a share.

The heroes were a pair of DLJ managing directors, Andrew Nathanson and David Jaffe. After Duane Reade went public, both also sat on its board, where Jaffe still serves as chairman of the compensation committee. Nathanson left the board after a couple of years. He is now managing partner of Oak Hill Capital. Yes, this is the same Oak Hill that is offering $17 a share to buy Duane Reade. Neither Nathanson nor Jaffe, now a managing director of private-equity firm Centre Partners Management, returned my phone calls.

A proxy statement with details of how the deal came together is due any day. One plain explanation is that Duane Reade still faces such risks that it drew no better bid than Oak Hill's. But longtime investors are dubious. They note that prospects for the chain's 241 stores are brightening in step with those of Wall Street and the metropolitan economy. Foot traffic is rising in lower Manhattan, with the recent reopening of a subway stop at Ground Zero a particular boost. They also complain that Cuti is set to keep his job and share in Duane Reade's revival as an investor, while they will be frozen out. "Duane Greed" is what one investor now calls the company.

A value-investing firm with over 10% of Duane Reade is Westport Asset Management. It has held its stake since 1998. Chief Investment Officer Andy Knuth sees Duane Reade very simply. "If a private equity group thinks it's worth $17 [a share] now, then they must think it's worth more later," he told me. And with Cuti keeping an equity stake, he adds: "I bet there will be an initial public offering of the company within three years." No reformer has yet changed this Wall Street rule: Value investing is good; value investing from the inside can't be beat.

By Robert Barker

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