Retail Buyouts: No More Bargains?
By Robert Berner
A shopping spree is under way in an industry that used to hold little appeal for acquirers: retailing. In the past six months, buyers have snapped up Sears (S ), May Department Stores (MAY ), Mervyn's, and Toys 'R' Us (TOY ), and on Apr. 8 regional discounter ShopKo Stores (SKO ) became the latest to go into the shopping cart. Luxury marketer Neiman Marcus Group (NMG.A ) has put itself on the block, while takeover speculation is powering the stocks of many other retailers, from J.C. Penney (JCP ) to the owner of Saks Fifth Avenue. (SKS ).
"In 33 years in this business, I've never seen so much activity," says Gilbert W. Harrison, chief executive of Financo, a New York City investment bank involved in the Mervyn's and Toys deals.
While Federated Department Stores (FD ) is buying a rival in May, most of the other deals are fueled by leveraged-buyout (LBO) funds looking to repeat the success of investor Edward Lampert. He piled up huge gains acquiring Kmart (KMRT ) and Sears.
Yet as debt levels rise to finance soaring acquisition prices, dealmakers following in Lampert's footsteps could face buyer's remorse. If hefty assumptions about sales and earnings growth, or the underlying value of the acquired retailers' real estate values, prove overly optimistic, returns could total far less than what many are counting on. "More of the deals than not will fail," predicts Peter Siris, a New York City investment manager and former Wall Street retailing analyst.
Buyout firms had shied from retailers since the early 1990s, when a wave of LBOs ended in bankruptcies. But now, flush with more than $100 billion in cash to invest, such funds are scrambling to find fresh ways to earn high yields.
Lampert is the model. His private investment fund took control of Kmart by buying its debt at bargain prices in bankruptcy protection, before taking the discounter public in 2003. Then he turned Kmart into a cash machine, in part by selling some of its real estate at lofty premiums. Next, he used Kmart's cash and soaring share price to buy Sears for $11 billion. Stock in the combined company, Sears Holdings, now trades at $147, a 900% increase from Kmart's offering price.
But Lampert's followers are hardly buying at rock-bottom prices. As more funds eye retailers and takeover speculation mounts, stock prices of potential targets are rising, in some cases well beyond the retailer's fundamental value. In the last six months alone, department-store share prices have risen by 34%, according to an index of major names by Capital IQ. That's well beyond the 4% gain by the benchmark S&P 500-stock index.
Some buyers are paying well above historic multiples. In March, the buyers of Toys 'R' Us, a group made up of private-equity funds Kohlberg Kravis Roberts Group and Bain Capital and real estate investment trust Vornado Realty Trust (VNO ), spent $6.6 billion, or 12.2 times Toys' previous year's cash flow. Retail buyers have historically spent six to eight times cash flow, investment bankers say. Neiman, whose share price has risen 41% in the last six months, is expected to fetch a similar multiple.
And paying such high prices means buyers are at another big disadvantage to Lampert -- they're borrowing heavily to finance purchases. Lampert converted Kmart's long-term debt to equity when he took Kmart public, and Sears jettisoned much of its own debt through asset sales prior to its acquisition. Toys, however, will take on $6 billion in debt as part of the acquisition by KKR, Bain, and Vornado, according to regulatory filings.
REAL ESTATE RESCUE?
That more than doubles its current debt level of $2.3 billion. The company's cash flow as a ratio to interest expense -- or so-called interest coverage ratio -- falls to 1.7, down from 4 prior to the buyout, investment bankers calculate. A spokesman for Bain says the investment group isn't discussing the deal. In LBOs, bankers generally want that ratio to be at least 2 to 2.5, so a company can absorb earnings shortfalls and make needed investments in the business. Taking on too much debt "narrows the margin for error," warns veteran deal-maker Wilbur Ross of WL Ross & Co.
Still, the buyers of Meryvn's, Toys, and Shopko plan to follow other pages of the Lampert playbook. Like him, they're banking on reducing risk via underlying real estate values of the troubled retailers. In a report last year, for example, Deutsche Bank (DB ) valued Toys' real estate as high as $3.7 billion for its 898 U.S. stores.
Theoretically, that gives these retailers the ability to opportunistically sell off stores to pay down debt or get much of their principal back by liquidating the retailer should their efforts to jump-start it fail. Not one of these buyers has publicly detailed such plans, but an investor knowledgeable about the Toys sale negotiations says as many as 300 of its stores could be sold as part of an effort to turn around the chain.
Trouble is, a lot of folks have the same idea -- so retail real estate could flood the market in coming years. In addition to potential sales by Mervyn's, Toys, and Shopko, analysts say Federated could sell up to 100 stores as part of the May merger and that Lampert could shed upward of 200 Sears stores. The upshot is that such sellers may not realize the prices they expect, says Chicago real estate magnate Sam Zell. "It puts the focus on being a strong operator," he adds.
And that's no slam dunk. Mervyn's has been losing business to Kohl's (KSS ) for years and now faces a resurgent J.C. Penney (JCP ). Wal-Mart (WMT ) has clobbered Toys' core business, and same-store sales at its infant business are weakening. Shopko faces increased pressure in its Midwest territory from Wal-Mart and Target (TGT ), which have put all the other publicly traded regional discounters out of business.
Any buyer of Neiman, meanwhile, wouldn't even consider selling the high-flying luxury retailer's real estate. The four private-equity groups looking at acquiring it plan to aggressively expand the 37-store chain in order to justify the high price the winner will pay, say people knowledgeable about the talks. But it's questionable how many more Neiman stores the nation can support. Making matters worse, all acquirers face the headwind of slower consumer spending as rising interest rates and sky-high energy prices slow the economy.
No analysts currently expect the round of bankruptcies that followed the last cycle of leveraged retail buyouts. Still, don't count on many home runs, either.
Berner is a correspondent in BusinessWeek's Chicago bureau