By  on July 14, 2006

NEW YORK — Shares of Jones Apparel Group dropped 5.7 percent Thursday after Merrill Lynch downgraded the stock, citing "diminished prospects of a sale and the related likelihood of weaker fundamentals."

Sources said if a deal does happen, it would likely be with Bain Capital, which has emerged as the top, if only, contender because two other potential buyers are believed to have dropped out. Shares of Jones were down $1.77 to close at $29.49 Thursday in New York Stock Exchange trading. More than two million shares traded hands, compared with an average trading volume of 796,827 shares.

Bain has been involved as a potential bidder for the $5 billion Jones Apparel Group since the early stages of the sale process. However, there is no guarantee that a deal with Bain can be worked out. Some investment bankers familiar with the Jones prospectus — as well as private equity sources — said there was an equal likelihood that a deal with Bain would fall apart.

Sources cited as key issues the margin pressures for the moderate brands sold at the department store level, as well as a tightening of overall market conditions in terms of the ability to finance mergers and acquisitions. Many private equity shops with money to spend, feeling pressure to get deals done while they can, are eyeing other targets.

According to sources in the investment community, New York-based Thomas H. Lee Capital, the new firm started by Thomas H. Lee, the founder of the Boston-based legendary buyout firm Thomas H. Lee Partners, is said to be in pursuit of the bridal group being sold by Federated Department Stores Inc., which includes David's Bridal. Cerberus Capital Management, which had dropped out of early bids for Jones, is said to be eyeing Mother's Work, which is described as a "recession-proof" business.

In addition, the prospectus on Eddie Bauer is due out within the week. VF Corp. is said to be setting its sights on Bauer. And Perry Ellis International — in conjunction with two private equity firms, Icahn Management and possibly Cerberus — is believed to be the other contender for Bauer. However, men's wear firm Joseph A. Banks may be planning a play for the outdoor lifestyle firm, investment sources said.Jones in May received three second-round bids averaging $32 per share, which was $1 to $2 lower than the share's trading average at the time. Since then the stock has hovered in the $31 to $32 range. Investors, however, interpreted the Merrill Lynch report as concluding that the Jones auction process is at a stalemate.

Merrill Lynch analyst Virginia Genereux wrote in a research note that there is major uncertainty about the value of Jones' apparel brands, such as Gloria Vanderbilt and Norton McNaughton, "given their recent deterioration and the uncertain outlook for 'undifferentiated' third-party wholesalers in the traditional department store channel."

She downgraded the stock to sell from neutral.

Market and financial sources said the moderate business has been underperforming in the department store channel this year. Sources close to the company said Jones has been shutting some of its offices, as well. Overseas offices in China and Hong Kong are said either to have closed or to be in the process of closing.

The art department in Bristol, Pa., which produces the look books that are shown to buyers, has been shuttered, said a source familiar with the company and its Bristol operation. The entire unit is expected to be closed by May 2007, the source said, adding that there is already a "For Sale" sign outside the Bristol headquarters.

Jones, through the help of an outside consultant, has been reevaluating its operations since 2004. A Jones spokeswoman declined comment.

Although cost-cutting will most likely help the company and boost its valuation, another problem may be harder for the apparel giant to resolve. Sources close to the New York and Bristol operations said many of the company's employees are discontent, partly because the sale process has dragged on, but also because company executives are reportedly not providing any information or updates on how the talks have been proceeding.

One source in New York said some employees are seeking jobs elsewhere rather than run the risk of losing their positions in a merger. The source close to the Bristol operation said some workers, such as senior patternmakers, are looking to take early retirement rather than face an uncertain future.

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