With the economy on a rebound, U.S. retailers have finally picked themselves up off the floor. The combination of economic uncertainty, Wal-Mart’s increasingly looming shadow and consumer retrenchment all conspired to make the past couple years difficult for retail. For LBO shops intent on bargain hunting, deals could certainly be found. Today, though, with consumer spending on the rise and job growth slowly climbing higher, buyout shops with a taste for retail may have to expand their search for investments beyond the discount bin.
In the past couple of years, investments in such names as Musicland, White Hen Pantry and Spencer Gifts capitalized on the weakness seen in retail and exploited the discounts that were being awarded to the space. The purchase of Musicland, for example, did not require any cash commitment from Sun Capital Partners, the Florida-based buyout shop that completed the deal with only the assumption Musicland’s existing liabilities.
Now, though, with consumer sentiment on the rise, retailers are finally starting to regain their feet. The latest retail sales numbers, released in April, demonstrated a 1.8% spike in March, which capped off the sixth straight month in which those figures have grown.
For retailers looking to put themselves on the block, now is as good a time to do so as any. One investment banker at a retail boutique says, “There’s been a lot of interest and a lot of activity in this sector recently. Depending on the specific situation, we’ve seen multiples expanding from 4.5x to 6x EBITDA to probably 5x to 7x, and in some cases as high as 8x to 9x EBITDA. People have been extremely aggressive.”
If April is any indication, the sector could represent one of the hot spots of 2004. In the last month, Kohlberg Kravis Roberts & Co. and co-investors Change Capital Partners and AlpInvest Partners agreed to acquire Dutch retailer Vendex in a $1.66 billion acquisition. Also in April, Crescent Capital Investments worked out a deal to take Loehmanns private for $177 million and Trimaran Capital Partners grabbed Urban Brands in a roughly $20 million transaction. Other deals in the space that deserve note are Leonard Green & Partners’ $1.2 billion anticipated acquisition of Hollywood Video, Oak Hill Capital Management’s proposed buyout of Duane Reade, Advent International’s purchase of Dufry Group and Hancock Park Capital’s carveout of FAO Schwartz’ Right Start subsidiary.
There are also a number of popular retail names currently up for sale that, according to most with an eye on the sector, should attract private equity interest. Target’s Marshall Fields and Mervyns department store subsidiaries, Spiegel’s Eddie Bauer franchise, Ahold NV’s Bi-Lo and Bruno supermarket chains, and select Winn Dixie locations are just a few of the names out there generating private equity buzz. Overseas, WH Smith plc, the struggling British bookseller, has drawn buyout interest as well.
The appeal of retail from private equity’s perspective stems from the prospective returns available if everything clicks. Dean Kehler, co-founder and managing director of Trimaran Capital Partners, notes, “The beauty is if you get the right formula, you’ll achieve growth from two ends: from each individual store and from the expansion in the number of stores. When you put the two together, the earnings stream can grow pretty rapidly.”
And there are enough trophy deals out there in the retail space to back this sentiment, including KKR’s Shoppers Drug Mart buyout and Bain Capital’s Staples investment, and most recently Clayton Dubilier & Rice’s sale of Kinko’s to FedEx and Leonard Green’s floatation of PetCo Animal Supplies.
With that said, though, investing in retail can be tricky, and the potential potholes have motivated a number of sponsors to steer clear from the sector. “Historically, there’s been a limited number of private equity firms that consistently invest in retail,” Bear Stearns Merchant Banking Senior Managing Director Douglas Korn says. “It’s a relatively specialized field, where sector specific knowledge provides an important competitive advantage but, conversely, the absence of such knowledge can lead to painful results.”
Korn characterizes retail as among the most “Darwinian” of the different sectors, noting, “There’s always somebody trying to come along and deliver goods in a more efficient manner and at a better price.” He adds, “If you’re the incumbent being targeted by a newcomer with a superior model, you can destroy a lot of value.”
According to Korn, “Retail is characterized by very high fixed costs, so if your sales decline, your earnings evaporate quickly and there isn’t a lot of room for error. Because there’s such a high degree of operating leverage, these investments can be very lucrative on the way up, but conversely, they can be brutal to investors on the way down.”
Case in point, Bain Capital saw its investment in Kay-Bee Toy Stores desiccate last year after the company sank into bankruptcy amid competition from the big box retailers, or more specifically Wal Mart, which ate into the toy seller’s profits. FAO Schwartz succumbed to the same fate, while Toys R Us has experienced well documented struggles as well. And it’s not just the toys market being bombarded. From bible resellers and music stores to grocers and department stores, the juggernaut that is Wal Mart has offered up enough sacrifices to the retail gods to placate even the most appetent deity.
“That’s among the first things you generally look at in this sector – What does Wal Mart mean for the investment,” Korn says. “Just about every retailer is in competition with Wal Mart to some degree. The question you have to ask yourself is, Do you have a business model that can be expected to effectively compete? You either have to serve a different consumer, provide a more in depth product offering, or have a service content or features that Wal Mart couldn’t be expected to replicate.”
Looking beyond the competitive factors, another hurdle inherent in retail is the seasonality of the business. Christmas and Hanukah are the obvious holidays with the obvious influence, but in retail, investors need to count on other red-letter days such as the back-to-school or tax-return seasons.
Also, since online retail sputtered after its much-hyped emergence at the end of the decade, retailers still need to find a place to call home. For buyout shops, that means they still need to pore over piles of lease obligations as part of their due diligence.
Michael Kalb, a principal at Sun Capital, notes that when you consider the lease obligations, the seasonality of the business and the working capital needs of retailers, the complexities of doing a deal in the space can prove daunting. “You can have a retailer with 50 different stores and 50 different leases. The seasonality can also be extreme with losses for three quarters of the year and just one quarter where you’ve got to make all that back. You need to understand the working capital needs, and anticipate how much inventory a store requires. Plus, you need to know all of the external factors affecting a business. And all of this has an impact on the investment.”
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Buyout investors are generally picky when it comes to retail, and not every name on the block, no matter how strong a brand, will necessarily attract private equity interest. Just ask Blockbuster, which got looks from curious LBO shops when it was shopped by Viacom late last year, but ultimately sat untouched. Tower Records, another strong brand that has found its market suddenly incommodious, generated virtually no buzz among buyout shops.
“We look for retailers with either a really strong brand name and a leading market position or a company that offers a differentiated product,” Kalb says. “Some retailers have no reason to exist, and you want to stay far away from those companies.”
Grocers, for example are increasingly getting squeezed out of their market by low-cost providers such as Costco and Wal Mart, and video rental stores have seen their market gouged by new digital technology and mail-order options like Netflix that have cropped up. Department stores, meanwhile, have had to compete with the growing number of specialty retailers on the high end and the big-box stores on the low end. Consumers, as retailers know, are a fickle beast, and as Kmart helped demonstrate, in this sector, if you’re not part of the solution, you could have a problem on your hands.