Big Prices Could Spell Big Problems For Retail Deals

By Mark Cecil and Jeremy Harrell

Not in question is that prices have gotten much higher. From 2000 to 2007, average purchase-price-to-EBITDA multiples for retail LBOs in the United States nearly doubled, rising from 6.3x to almost 11.5x, according to Standard & Poor’s Leveraged Commentary and Data.

Lindsey Alley, a managing director in the consumer and retail group of investment bank Houlihan Lokey Howard & Zukin, said that the multiples paid for retailers in the last few years have simply gotten “too high.” The need to service the loans used to pay those lofty prices could siphon off cash that retailers need to put to work to freshen up brands for fickle consumers, she said. “I’ve yet to see a big retail transaction that can support those kinds of multiples, unless there’s underlying savings I’m not aware of,” Alley said of the 12x to 14x multiples she’s seen being paid to acquire specialty retailers.

Indeed, debt multiples for U.S. retail deals followed right along with the skyrocketing prices. The amount of senior debt piled on to LBO’ed retail companies rose from an average of 3.0x EBITDA in 2000 to 4.9x EBITDA in 2007, while overall debt loads increased from 4.2x EBITDA to 6.2x EBITDA over the same period, according to S&P Leveraged Commentary and Data.

Granted, the loans taken out to finance these deals came with historically low interest rates, and with favorable covenants (if there were any). Moreover, retail chains often have valuable real estate holdings to support inexpensive, asset-backed loans. John M. Baumer, a partner at consumer-focused LBO shop Leonard Green & Partners in Los Angeles, which has recently snapped up household names such as Petco (for the second time) and home-storage company The Container Store, went so far as to say that recent deals were often done with “bulletproof capital structures.” With covenant-lite loans imposing few restrictions, Baumer said, “there’s no immediate risk these deals will blow up.”

Maybe not. But over the long haul friendly loan terms can’t save retailers from defaulting on their payments. Rising gas prices and a housing slump that has dried up the market for home-equity loans—an important source of consumer cash—could well spell trouble for cash flow in coming months.

Big Spenders

Needing to move mountains of money, many generalist firms joined sector specialists over the last few years in a retail-company shopping spree. It marked a big change for many firms because retailers, with their unsteady cash flows, had not previously been considered good buyout candidates.

In fact, U.S.-based buyout firms in 2000 completed just 15 retail deals, and those with disclosed valuations totaled $318 million, according to Thomson Financial, publisher of Buyouts. By 2005, the number of deals had more than doubled to 39 deals, while the disclosed deal value spiked to more than $2 billion. Through Sept. 18, the industry had already far surpassed its full-year 2006 disclosed value total—$16 billion vs. $6 billion—and was on pace to complete rougly as many deals, although the pace will certainly slow in the last quarter of 2007.

Notable deals in the last two years include the $7.6 billion purchase in 2005 of Toys ‘R’ Us by Kohlberg Kravis Roberts & Co. and Bain Capital; the $5.6 billion buyout of craft chain Michaels Stores by Bain Capital and The Blackstone Group; and KKR’s $7.3 billion LBO earlier this year of thrift outlet Dollar General. All three of those deals were consummated for more than 11x EBITDA, and none is giving off signals of imminent or long-term danger.

The same can’t be said for Linens Holding Co., the parent of retailer Linens ‘N Things. Apollo Management bought the home-furnishings chain for $1.3 billion in 2005, paying a relatively modest 7.3x EBITDA. However, successively weak quarters and stiff competition from rival Bed Bath & Beyond have exacted a heavy toll on Linens Holding. In February, its high-yield bonds traded above par, according to pricing information from the NASD. By July, they were trading as low as 59 cents on the dollar; by September, they were back up to 70 cents, a level still considered “distressed” by most analysts. Apollo could not be reached for comment.

Anthony Chukumba, a senior research analyst at FTN Midwest Securities Corp. and an expert on the retail sector, said that while Linens ‘N Things comes with its own set of baggage—such as intense competition from lower margin competitors like Target Corp.—the company’s difficulties showcase the risk of rising leverage multiples. If consumer spending heads south, or a brand suffers in the marketplace, LBO firms have little flexibility to contend with the difficulty.

To be sure, covenant-lite loans do give retailers greater margin for error than might otherwise be the case, said Chris Farrell, managing director and head of specialty retail banking for UBS AG. But the lack of covenants means that LBO firms run the risk of missing out on the warning signs that come with meeting loan benchmarks.

“The fear is that covenant-lite deals, designed to provide breathing room and flexibility, may in fact mask serious problems that when finally uncovered are too late to rectify,” said Farrell. “We could see a fair number of restructurings.”

Return Of The Strategics

Lofty prices probably won’t be much of an issue in the coming months. Turbulence in the credit market suggests that large-scale retail deals are off the table until at least 2008. “I think it’s a relatively slow period over the next few months,” Leonard Green’s Baumer said of retail deal-making. “There are real questions about whether consumer spending is tapped out.”

One benefit of a slowdown would be the opportunity to spend more time preparing retailers for any downturn. Buyout shops will also have the opportunity to take advantage of the M&A market as sellers, although they are naturally unlikely to command the same multiples they paid just months earlier.

Macy’s lost nearly a quarter of its market cap between July 4th and Labor Day once it became clear that a $17 billion buyout was not viable. Grocery store chain Kroger lost 5 percent during the same period, while electronics retailer Best Buy fell 6 percent. Buyers are paying a turn or less for retailers in today’s market, while still-active sponsors are expected to put more equity into deals or take minority stakes, like the recent investment Goode Partners made in women’s apparel retailer Intermix.

Deals will get done, said Jamie O’Hara, managing director of TSG Consumer Partners in San Francisco. “There’s still a tremendous amount of capital out there that’s been raised,” he said. “It’s got to go to work, so people are going to be buying businesses.” Moreover, strategic acquirers remain on the prowl, emboldened by the disappearance of cheap debt that has been the buyout industry’s main weapon against them.

“The pendulum has swung back to strategics, and we can expect them to take advantage of the current environment,” since they can leverage their balance sheets and offer stock and cash to effect mergers, UBS’s Farrell said,

Another deal-environment-shifting change is also under way in the retail sector, one that would be exacerbated if the economy indeed heads south, according to Farrell. The double-digit profit growth rates that the big-box retailers produced in the last decade have cooled off into the single-digits. If consumer spending slows, the pressure will build for these retailers to show results, and that will likely push them toward consolidation to wring greater profits from operations, Farrell said.

Whether sponsors are immediately willing to participate in any consolidation, either as buyers or sellers, remains to be seen. Farrell notes that in some cases, sponsors behave like “quasi-strategics” given the retailers they already own. A good bet is that they’ll find a way to take part by writing larger equity checks.