LBO Firms Shop For Diamonds In Retail’s Rough –

Mention retail to the average stock or bond investor and you’ll probably get a sigh or a groan. The industry started 2002 facing the challenge of a down economy, and by the end of the year its prospects didn’t look any better: Retail sales were lackluster during the holiday season, and the U.S. Department of Commerce last month said retail sales rose a modest 3.4% in 2002, down from a 3.7% gain in 2001.

But talk to a buyout pro about retail and you’ll get a variety of responses, some of them even bordering on optimistic. Dealmakers say that while retail is clearly going through a rough time, that adversity has helped close the gap between buyer and seller expectations, and opportunities do exist.

“I think there has been a lot of uncertainty, with a mismatch between seller expectations and what private equity investors could realistically pay,” said David Landau, a general partner with Apax Partners. “This uncertainty is causing each side to meet in the middle, and if nothing exogenous occurs, we should see a continuation of this trend.”

Last year was certainly no boom for retail buyouts. Just $2 billion of last year’s $44 billion of deals were for retail companies. However, that handful of deals included some big-name companies-most notably, Bear Stearns’ $153.5 million purchase of Lerner New York/New York, and Apax Partners’ $375 million investment and partnership in the Phillips-Van Heusen buyout of Calvin Klein. Those deals fall in the “soft line” segment of retail.

Most buyout pros said they like specialty retail, which is aimed at specific segments of the population. “We saw the largest percentages gained in niche markets, especially in the soft lines, and that trend should continue,” said a Chicago-based retail analyst.

“Most LBO firms are invested in specialty retail, as opposed to the other categories,” said Bill Barnum, a co-founder of the Los Angeles-based Brentwood Associates. “That is where the growth is.”

In November, Brentwood acquired Zumiez Inc., a specialty retailer that sells skateboard-style clothing and equipment to teens. In 1998, the retailer had 33 stores in operation, but a boom in sales led to an additional 70 stores in more than a dozen states by the time Brentwood moved in. According to Thomas Davin, an operating partner at Brentwood, Zumiez earns 25% more per square foot than the industry’s standard range of $300 to $350 per square foot.

Indeed, “hard line” specialty retail-defined as a retail store selling hard products, which include electronics and home furnishings, as opposed to a soft line product, which is composed mainly of fabric – has also seen some activity, including the $275 million IPO of Petco Animal Supplies Inc. by Leonard Green & Partners and Texas Pacific Group, and Bear Stearns’ $300 million acquisition of The Vitamin Shoppe from FdG Associates.

David Oddi, a partner with Saunders, Karp & Megreu noted recent sales increases at hard-line retailers like Organized Living, IKEA and Bed, Bath & Beyond. “The hard lines saw a spike in sales during the first half of 2002,” he said. “I think 2003 will be a repeat [regarding trends] of 2002.”

Conversely, buyout pros are avoiding mass channel distribution and department store buyouts, which could hurt Kmart’s chances of being purchased by a financial buyer (see sidebar, next page).

Low Prices, Sound Management

Whatever the segment, buyout shops are being highly selective about their retail investments. One trait that they universally look for is consumer affordability. “We look for [retail companies] that sell their products at a reasonable price,” said John Howard, a senior managing director with Bear’s Merchant Banking Group.

That helps to explain Bear’s interest in Lerner, whose business model is to sell affordable apparel to women.

Clearly, the price of the acquisition played a major factor as well. “We bought Lerner’s because it was offered at the right price, which gives management an opportunity to re-vitalize the company,” said Howard.

Sound management is equally important, playing a role in Bear’s $300 million purchase of Vitamin Shoppe. During seller FdG’s five-year involvement, revenue quadrupled from $65 million in 1996 to $270 million in 2002.”When we purchased The Vitamin Shoppe, we invested in a concept, the management team and their ability to manage that concept,” said Bear’s Howard.

Management made a big difference to Apax, too. “We were not looking to get into the designer apparel business when we were approached by Phillips-Van Heusen to work with them to acquire Calvin Klein,” said Landau. “But I’ve known Bruce Klafky (CEO and chairman of PVH) he and his team are outstanding operators, and they have a proven platform for acquiring and integrating brands.”

Bad Times Expose Good Companies

Not only are sellers more willing in a down economy, but a tough market makes it easier for buyers to see who’s worth going after. “Market uncertainty over the previous 18 months helps to define the best of breed,” said Howard Romanow, a principal with FdG. “In tough times, [buyout shops] can see who has the differentiated models that will lead to success and act accordingly.”

Indeed, even the most retail-crazy buyout pro won’t pull the trigger unless the company’s report card shows all A’s. “Strong consumer propositions, strong management and a solid market position are all factors,” added Apax’s Landau. “But good’ is not good enough retail companies must be great in all three categories.”

Problem is, even for the best retailers, financing an acquisition is no small task. Lending terms are restrictive across all industries, but the retail industry is no favorite of debt providers. “There are fewer and fewer lenders that have an interest in retail,” said Romanow. Bear’s Howard added, “It is difficult to get financing for retailing deals, and therefore, volume is reduced.”

Market pros say one potential target for buyout shops is FAO Inc., owners of FAO Schwartz. The downturn began when the toy store filed for Chapter 11 bankruptcy protection on Jan. 13, after a year-long struggle since The Right Start Inc. bought FAO in January 2002 for approximately $55 million. The Right Start also purchased Zainy Brainy, an educational toy company, in 2001 for $100 million.

“The [FAO] merger was capital intensive, and it is very difficult to integrate three distinct concepts,” said an analyst at a New York-based bank. “But the kiss of death was the weak holiday season following the longshoreman’s strike.” Retail sales increased just 1.4% in December over the previous month, and that jump was due mostly to increased car sales, according to the Commerce Department report.

“FAO hired an investment banker to raise funds, and they plan to re-emerge from Chapter 11 protection this summer,” the analyst continued. “The merger puts the companies’ worth at about $600 million, but it will probably take about $100 million in cash for an LBO firm to do this deal.”

What To Expect in 2003

Analysts and buyouts pros alike are singing the same song: 2003 is shaping up as a mirror image to 2002.

“There is a general concern over the pace of retail spending by consumers,” said a retail analyst. “Retailers are looking for the next big thing, the next hot trend. We are maintaining a conservative outlook for the first quarter [of 2003], but look for it to worsen thereafter.”

Yet there are a number of LBO firms who expect to take advantage of the sluggish retail market. “Other buyout shops not comfortable [investing] in retail only get involved when the market is hot – but that’s not us,” said Apax’s Landau. “Now is the exact time to invest, because the uncertainty in the market is the key to more realistic pricing.”

But all of that could change depending on the conflict with Iraq and its impact on the economy. “In general, everyone is waiting for a resolution in Iraq if there is a fast resolution, business will improve drastically and quickly,” said Bear’s Howard. “During times of uncertainty, people hesitate, [whether they are] lenders, buyers or consumers.”