Toughening up in retail

Despite the downturn in consumer confidence, buyout practitioners still see opportunities in the retail arena, especially in niche sectors of the market and in “alternative business channels” such as online shopping. But the easier pickings of the past are gone, and buyout houses will have to work harder to increase value in new retail investments.

“Some of the more obvious opportunities are already gone and, while I think retail will continue to attract interest, it probably won’t be at the same rate as over the past couple of years,” said Tim Lebus, director at Duke Street Capital.

According to Lebus, one of the reasons retail has proved so popular among buyout houses in the last five years is the change in attitude among banks, which have become much more comfortable lending to growing High Street brands with strong franchises.

But he says that the general outlook for retail deals today is less rosy than a couple of years ago. For example, he notes that retailers such as Courts and Allders have gone out of business. “On the other hand, you’ve got success stories like Pets at Home, who seem to be doing very well,” Lebus said.

The pet shop chain was acquired last July by Bridgepoint and reported a 45% earnings increase in May 2005, when it also announced plans to open a further 17 outlets in the coming year.

Guy Weldon, a director at Bridgepoint, says the strategy with Pets at Home can probably be applied to most other retail investments. One of the attractions of the business, he says, was the potential it offered to roll out the brand through more store openings.

Weldon says: “It’s a truism, but you need to be able to expand and to have the right infrastructure to support expansion. For example, we invested in a national distribution centre for Pets at Home, which can support over 200 stores even though we’ve currently only got 160.”

A key part of the strategy has been improving gross margins by, for example, consolidating suppliers and driving down costs. “Like many retailers, we’re also sourcing a lot more product from China and Asia,” says Weldon.

Keeping a close eye on like-for-like sales growth has also been important. “We don’t want the core estate going backwards just because we’re growing revenues through new stores,” says Weldon. “We want the existing portfolio of stores to enjoy the same levels of growth.”

The company also operates in a market in which much of the competition is small and less professional. “The business dominates its category, which means we can take market share from independent shops,” says Weldon.

One important factor in some of the successful retail investments has been financial investors taking advantage of the retailer’s property portfolio, according to Jonathan Pitkanen, a retail analyst at Fitch Ratings.

“Property is one reason retail has been the industry of choice for venture capitalists as it’s given new investors an easy win in terms of extracting value,” he says.

Others argue that the property angle only applies to a limited number of deals.

Guy Weldon at Bridgepoint says property has been an important element in some of the refinancings of the firm’s retail transactions, such as Homebase, but is not a vital element and that in most retail businesses property is leased.

He adds that with many retailers there has been a lot of fat on the supply side that private equity owners have been able to trim.

“An entrepreneur can come in and slash the supply side and generate a lot of cash very quickly,” says Pitkanen, adding that entrepreneurs such as Philip Green have been adept at techniques such as extending payment terms with suppliers so as to reduce costs.

Weldon argues that retail has been particularly attractive to buyout houses not just because of the benign market conditions but also because retail businesses can produce extra value relatively quickly.

Rolling out a proven brand, squeezing costs and improving margins are fairly straightforward, Weldon says. “In retail, you can increase value substantially by pulling the right levers,” he says. “Of course, if you get those things wrong it can quickly work against you and destroy value and there are examples of that.”

The acquisition of Debenhams by Texas Pacific Group (TPG), CVC and Merrill Lynch Private Equity is another example of buyout investors squeezing working capital and the supply chain to deliver value. The buyout houses paid £1.9bn for it in late 2003 and have already taken out £1bn in dividends. Debenhams, which has 107 stores, is planning to open a further 20 in the coming four years.

Pitkanen says that Debenhams, like many other retailers, does not necessarily have to have top line sales growth to deliver increased value. “Sales may be static or even falling. What is important is issues such as squeezing working capital,” he says.

Philippe Costeletos, TPG partner in London, says retail has been one of the firm’s core investment themes. “It’s a cyclical sector with good long-term growth prospects as well as potentially attractive unit economics and roll-out opportunities for proven concepts,” Costeletos says.

He adds that in the UK, department stores have remained a “well-entrenched destination for shoppers”, compared with the decline experienced in the US, and that retail will continue to be an area of focus for TPG, both in the UK and in Continental Europe.

James Stewart, a director at mid-market firm ECI, is also positive on the sector. ECI’s portfolio includes sandwich store chain Benjys and two companies with a strong internet shopping element, and M&M.

Stewart believes internet and mail order retail companies are a particularly good investment and can help investors buck the trend of falling consumer spending. “During Christmas, when sales were down on the High Street, internet shopping was doing well,” he says.

ECI also invested in Tragus, the management buy-in established in 2002 for the Café Rouge and Bella Italia restaurant chains, which was sold in January to Legal & General Ventures.

Stewart sees Tragus as basically a retail company that was undervalued compared with traditional High Street retailers. There is a lot of value to be made from taking an underperforming brand such as Café Rouge and turning it around, he says.

Although there was a successful exit for Tragus, there are uncertainties about how exits for some other retail businesses may be handled in the coming year or two. While there have been some predictions of a recovery in the IPO market in the second half of this year, not everyone is persuaded that there is a substantial demand in the public markets for retail offerings, particularly given the uncertain trading outlook for the sector.

“I’d be surprised if many of the exits were IPOs and it’s more likely there will be consolidation acquisitions by larger groups, or secondary purchases,” says ECI’s Stewart, pointing to the significant increase in secondary buyouts as a proportion of exits since 2000.

Weldon is also uncertain that there is enough demand for flotations, and he questions whether the public markets are prepared to pay the kind of prices that owners can get from trade sales or secondary purchases.

“It’s interesting that clothing retailer Fat Face was looking at both an IPO and a private equity sale, and ended up going to Advent,” Weldon says. On the other hand, he adds, Halfords was turned around by CVC, which then successfully floated it.

“Just as there will be winners and losers on the High Street, the same will apply to IPOs,” Weldon says.

As for future buyout opportunities, there has been speculation over a number of high-profile retailers, including Woolworths, Sainsbury and Somerfield.

Fitch’s Pitkanen argues that big supermarket chains such as Sainsbury might pose problems for potential purchasers because competition issues would make it difficult to sell on to trade buyers. But he sees Somerfield, which has received one bid from a consortium including Apax Partners, as a more interesting opportunity. “Somerfield has convenience stores and private equity players like that because they can sell them on to the supermarkets,” Pitkanen says.

But it is not just what is happening in the retail sector as a whole or even the consumer spending downturn that will affect future buyout opportunities. To some extent, it is the very success of private equity players in the retail sector that could restrict the number and quality of targets in the future.

This is because many of those retailers that have been targeted, or that fear they may be targeted by private equity houses, are busy trying to achieve the same kind of cost-cutting and business efficiencies that the buyout firms have pioneered. This in turn can have the effect of making the company less attractive to buyout houses because there is less scope for extracting value.

“In many cases, private equity players have made the sector more efficient, which means you now have companies like Marks and Spencer adopting similar techniques to try and make themselves less vulnerable to a takeover,” says Pitkanen.