(c) 2008 Investment Dealers' Digest and SourceMedia, Inc. All Rights Reserved.
November 10, 2008
An admittedly nervous manager of the cosmetics counter at New York's Century 21 department store has noticed the slowdown. A window shopper in front of that store says he's cutting his holiday-spending budget by 30%. And while shoppers from Italy to Mexico to Canada are out in force on a crisp November night, most said they are spending less.
They all have their reasons to be cautious--a dramatically slowing economy, concerns about jobs and bloated credit card debt, among other things--but it all adds up to the same thing: a bleak outlook for the retail sector just as the most important time of the year rolls around.
Meanwhile, a few miles away along Route 3 in New Jersey, a well-traveled road between the state and New York City, stands a Linens 'n Things store perched high above the traffic. A bit further is electronics retailer Circuit City, followed soon after by crafts retailer Michaels Stores.
The first is facing liquidation, the second may be heading towards a similar fate having announced the closing of some 150 stores and massive layoffs, and all three have had a massive amount of debt piled on their balance sheets, leverage that was acquired when credit was cheap and there was no shortage of liquidity.
"Folks are generally factoring in the holidays in valuations, and if you look at current trading levels, there is a built-in expectation that it will be an absolute disaster," says Steven Tricarico, managing director of investment bank Jefferies & Co.'s consumer and retail investment banking group. He focuses on retail and apparel, and joined the firm from Wachovia 10 months ago.
Market research company NPD Group recently conducted a holiday spending survey, which revealed 26% of consumers will spend less this year versus last. And according to research conducted by BDO Seidman, US retailers are bracing for a 2.8% decline in total sales this holiday season, based on a survey of 100 chief marketing officers at top retail stores. By many accounts, those estimates are conservative.
"The consumer must go through the de-leveraging process, similar to financial institutions," says Dan Binder, an equity analyst also with Jefferies. "Never in our lifetime have we seen both go through a de-leveraging process of this magnitude the way they are now. That's a pretty powerful force and it will destroy a lot of wealth and spending power."
The squeeze being put on consumer credit is powerful indeed, according to the Fed's most recent loan survey unveiled last week. And Binder notes that there is a direct correlation between banks' willingness to lend and retail sales growth. Unfortunately for the retail space, until the debt cycles begin to reverse course, significant growth in retail sales will not be seen.
Retail on the rocks
The slow going in retail sales is being mimicked by the M&A activity in the sector. US retail M&A underwriting has plummeted by 69% year to date versus the year-ago period, to about $15 billion from $48.5 billion, according to Thomson Reuters.
On a global scale, things are no better, with total industry M&A underwriting at $48.3 billion year to date, versus $143.2 billion in the year-ago period. And, with many bankers advising their clients to adopt a wait-and-see approach until after the holidays, the remainder of this year is not expected to fill that gap.
"Retail apparel companies are holding their breath until after the holidays before determining the next steps," says James Grayer, a partner with law firm Kramer Levin Naftalis and Frankel. "Retail apparel deals on my desk are moving very slowly. They're in the form of ideas and term sheets. Things are just going along at a much slower clip than they were prior to the current credit crisis."
Troubled retailers like Linens n' Things and Mervyn's, both the product of leveraged buyout deals of several years ago, have been forced to throw in the towel, left with no recourse in an airtight lending environment and insecure suppliers.
Circuit City ran into some similar resistance, and now the fate of that company lies in the balance. "Vendors may be starting to change terms on them," says Tricarico. "If that is the case, Circuit City may need enhanced liquidity to fund its business through the holidays." And, they may have to pay more upfront for merchandise as opposed to the typical payment window of 45-to-90 days.
The electronics retailer retained investment bank Rothschild to advise on its restructuring, a process through which the company hopes to avoid a bankruptcy filing by focusing instead on shrinking its business.
"You're already seeing bankruptcies, and in some cases they're turning into liquidations," says Jefferies' Binder. "Financing is tight, and in some cases the businesses are so bad they're not worth saving."
No one knows for sure when the debt markets are going to open up again, but deal activity is likely to remain constrained until it does. Only companies with the highest of debt ratings have access to the credit market, and the prevalence of such names is weakening.
One source close to the retail space suggested that rating agencies are over-compensating with a rash of downgrades in response to having fielded some of the blame for "not minding the store," as one source close to the industry put it, which led to the credit crisis. For example, Standard & Poor's recently placed the debt of Liz Claiborne, including its BB+ corporate credit rating, on CreditWatch with negative implications. Liz Claiborne does not have excessive leverage, sources say, with about $898 million of debt as of mid-summer.
"I don't think it's damaging," says Grayer, who has advised the company in the past. "It's a hard time for all companies in the retail space."
The company, which operates brands such as Juicy Couture, Kate Spade and Lucky Brand Jeans, went through a strategic review process last year amid a changing of the guard when William McComb took over as chief executive.
The opportunity
Of course, the investment banking community is amenable to making adjustments during a period that will go down as one of the most trying ever for both Corporate America and the consumer. Bankruptcy and restructuring are areas in which many firms are bulking up (see related story).
Some, like Jefferies and Peter J. Solomon Co., consider themselves well-positioned in the restructuring arena, while others may have a tougher time gaining a foothold. "There has always been a group of really good bankers who have focused in the distressed space," says Richard Chesley, a partner in the restructuring practice at Paul Hastings. "Lazard. Rothschild. The Blackstone Group. Houlihan Lokey. Perella Weinberg Partners. These are all established firms in this space, who have not only extensive experience in this arena, but extensive relationships which are critical in this practice."
Ken Berliner, president of Peter J. Solomon, says his firm is scouting large and mid-sized LBOs that have unfolded over the past several years for opportunity. "I think activity is going to increase substantially in the restructuring arena," says Berliner. "We should see activity across a wide range of sub-categories, ranging from apparel to the specialty retailer into more main line retail, and to a lesser extent department stores and the mass channel."
There's no shortage of places for Berliner to look. Some of the LBOs in recent years include Michaels Stores, taken private by Bain Capital Partners and Blackstone, Guitar Center by Bain Capital Partners, Goody's Family Clothing by Prentice Capital Management and GMM Capital (Goody's emerged from bankruptcy in late October), and accessory and costume jewelry retailer Claire's Stores, which was acquired by Apollo Management.
Many of them face possible store closings or liquidations because of what's occurring in the economy and the amount of leverage put on these firms. "It's having an impact on their earnings and ability to service their debt in connection with the LBO," says Kevin Stephens, senior vice president in Houlihan Lokey's consumer products group. "You may begin to see some rationalization of the stores there, as well." Some could wind up selling or closing stores, or sub-letting to the extent their leases allow.
"Larger retailers like Linens and Mervyn's were often times the anchors to an entire store base that was in the shopping center these stores were located. When they close, it has an impact on overall foot traffic throughout the center," says Stephens.
Richard Steinman, an investment banker with Greenhill & Co., formerly led the retail investment-banking group at Morgan Stanley. While there, he advised Sears in its merger with Kmart. Steinman, who joined Greenhill about 18 months ago as managing director, says many of the larger LBOs done during that period were designed in such a way that they are not likely to falter.
"The most recent LBO deals are covenant lite, which means they don't have especially restrictive covenants," he says, "And many have the ability to PIK [payment in kind] their debt. Until they literally run out of cash, many of these companies won't run into problems."
In many larger LBO deals, private equity firms were putting on as much as seven-to-eight times Ebitda in leverage, and in some instances the only reasons those companies are still around is because they were purchased in a covenant-lite environment.
"The lack of covenants is a major reason highly-levered concepts like Michaels and Claire's Stores have not had to undertake difficult restructurings," says Jefferies' Tricarico. But if these companies need to go out and get capital tomorrow to, for instance, satisfy stricter supplier terms, they may be forced to liquidate, he said.
Investment bankers are also spending an increasing amount of time on advisory work, given that many of their clients that trade in the public markets are facing valuations that are off unprecedented amounts, in some cases by as much as 80% from peak levels. "We're telling our clients to stay focused on their balance sheets and cash flow statements," says Berliner. Houlihan's Stephens says the firm is seeing a lot more activity in special situations. "Companies are coming to us and saying 'we're in violation of one of our debt covenants or we are likely going to be in default of our credit agreement soon. How can you help?'"
Lastly, Berliner is advising his clients that now is not the time to change their DNA. "Stay true to your business," he says. Don't try and be something that you're not."
Show me the deal flow
The M&A train, meanwhile, has not come to a complete halt, and bankers are turning their attention to where the deals are getting done. This is a passageway to advisory work and restructuring advice, one that leads to non-core asset sales on the cheap and all-cash transactions.
Peter J. Solomon recently advised privately held Athleta in its all-cash sale to the Gap, a transaction valued at about $150 million, sources say. Athleta makes women's performance apparel such as yoga pants and other comfort clothing.
The deal is indicative of those that are getting signed on Wall Street because it didn't require the debt markets. "It's a super high-growth company," says Tricarico. "The Gap has plenty of cash and they wrote a check. For them, it's the next growth avenue."
Action sports company Quiksilver could have been similarly positioned but instead is facing reorganization. The company, which at one point in time was debt-free, took on nearly a billion dollars in leverage as a result of its Rossignol acquisition in 2005, which it acquired for $350 million. A couple of weeks ago Quiksilver sold it for about $50 million. "The Rossignol business struggled post-acquisition," says Tricarico. "Quiksilver wound up putting additional leverage on its balance sheet."
Quiksilver retained Morgan Stanley to advise on its strategic alternatives, which sources say include a possible sale. "I think if you're on the board you consider all options," says Tricarico, who expects a likely buyer would be Nike or another strategic acquirer. Jefferies is in talks with a combination of private equity firms and "logical strategic buyers" that might be interested in the company.
The Pied Piper?
The private equity community played a vital role in several mega LBO deals that unfolded in the retail industry over the past several years. Capital during that period was inexpensive and many of the highly levered deals did not require that much equity. That tide, of course, has since changed.
"Private equity funds that historically put up 30% or 40% of a purchase price now have to put up 50% or more," says David Ansel, an attorney with Loeb & Loeb, who focuses on middle-market private equity deals.
As a result, Ansel says private equity firms have been more open to doing club deals, or to make an investment where they may not necessarily be in control.
Circle Peak Capital, a private equity firm, made a minority investment in luxury papers company Mrs. John L. Strong in September. While the firm would not disclose the value of the investment, it's the only holding of seven in which Circle Peak does not own a majority stake. Circle Peak founder, R. Adam Smith, projects continued strength in high-end products that he says command loyal followings due to the unique nature of their brands.
Smith's firm is currently considering other investments into luxury and specialty-product companies. The reason, he says, is because such brands continue to outperform the broader markets and also command higher margins than many mass-luxury brands.
"For these products, their clients are repeat clients, meaning they return to the brands and products they're comfortable with," says Smith. "They purchase with a certain amount of frequency and where a price point is accessible."
Of course, this does not hold true for all of luxury retail, including apparel. "For luxury goods, part of the appeal is a 'feel-good' factor," says Dana Telsey, founder of Telsey Advisory Group. "Uncertainty makes that 'feel-good' factor less positive and it makes the higher end softer than it has been before."
Private equity firm LNK Partners is also seeking a place to put capital to work, and has avoided taking on exorbitant amounts of debt, which excluded it from some of the recent larger LBO deals in retail. However, that approach places the company at an advantage.
"We are thoughtful and creative with our deal structure, and always very careful about striking the right balance of risk versus return," says Paige Daly, a managing director with LNK Partners. "Our kind of deal is about partnership--one where we have the ability to add value, and provide insight and differentiated access in a way that propels the business."
Private equity firm Marwit Capital Partners, meanwhile, recently announced that one of its holdings, Orange, Calif.-based Boot Barn Holding Corp., a value-oriented western footwear and apparel retailer, acquired 22 stores in the Southwest from BTWW Retail. Boot Barn will re-brand all of the stores, which currently operate under the Western Warehouse brand, under its own umbrella. Marwit would not disclose the value of those transactions except to say they were all-cash acquisitions. "Boot Barn was just being opportunistic," said a company spokesperson.
Last week, BTWW Retail filed for Chapter 11.
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2008 Investment Dealers' Digest and SourceMedia, Inc. All Rights Reserved.
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