Duane Reade: An LBO On The Critical List

Its three-year debt binge turned the drug chain from gem to junk

Back when the leveraged-buyout boom was warming up three years ago, shareholders of Duane Reade Inc., the 249-store pharmacy chain based in New York, were complaining that private equity firm Oak Hill Capital Partners got too sweet a deal when it paid $750 million to buy the company.

Now it looks as if Oak Hill is turning out to be the loser, by as much as $240 million. Duane Reade has hemorrhaged cash from virtually the day the transaction closed in July, 2004. Oak Hill replaced the CEO after just 17 months. And the chain has seen its credit rating downgraded four times by Standard & Poor's (MHP ). It now stands at CCC, a level so deep into junk territory that it puts 1 in 4 odds on Duane Reade defaulting within a year. A spokesman for Oak Hill declined to comment.

Whether or not the deal winds up a bust, it warns of trouble to come for other recent LBOs, mostly because of its timing. Corporate bond investors call the pattern "seasoning." As deals reach three years of age or so, it becomes clear whether the companies will be able to generate enough cash to service all the debt they took on to go private. According to Thomson Financial (TOC ), the current wave of LBOs started three years ago this quarter, when private equity firms announced 177 buyouts worth $18 billion. The volume has continued to build since: In the recent quarter ended in September, 313 deals were struck worth $80 billion.

Duane Reade's experience shows how quickly companies can find themselves in trouble after taking on lots of debt. The once-thriving retailer is slumping in nearly every way. Analysts say shoppers consider its 130-odd Manhattan stores convenient, yet cluttered and crowded, places they go to but don't like. And the stores are no longer known for the discounts that attracted people a decade ago. "They lost their core customer," says Diane Shand, an S&P credit analyst.

Behind the scenes, Duane Reade has blundered. It has fought costly battles with labor unions, made poor merchandise choices, failed to deter rampant pilfering, and made no headway in expanding in the suburbs, where customers prefer CVS Corp. (CVS ), an investment-grade company with 25 times Duane Reade's $1.6 billion in revenues.

Outside forces are battering Duane Reade, too. Profit margins on drugs are plunging as mail-order benefits managers proliferate. Minimum-wage hikes in New York have raised labor costs. And the explosion of digital cameras has lured away film-processing customers.

All this would be easier to deal with if Oak Hill had not nearly doubled the company's borrowings, to $500 million, to finance the buyout. Duane Reade needs to offer good product selection but has cut inventory to save cash. Its dire financial straits, say analysts, are forcing the chain to consider trading its best locations for cheaper ones. Relationships with suppliers hinge on how long a $225 million line of bank credit will last; the company has already used $170 million.

BURNING CASH Oak Hill has tried to save its investment. In November, 2005, it installed new Chief Executive Richard W. Dreiling, who is spiffing up stores, overhauling merchandise, tackling theft, and closing or fixing weak outlets. In conference calls with bond investors, he has said the company is on the road to recovery. "These guys are doing the right things," says a credit analyst at a Wall Street brokerage who asked not to be named.

But the same analyst doubts the fixes are enough. About two-thirds of the expected savings from the campaign have been realized, company officials said in a conference call Nov. 9. They're still burning $20 million in cash a year because of $53 million in interest charges. S&P says its next rating move may well be downward.

Bond investors believe Oak Hill wants to sell before industry pressures worsen. But it's doubtful the partners could get enough money to do more than cover the debt, if that, analysts say. Duane Reade is starting to look like a zombie: dead, but walking among the living. Other LBOs may soon follow in its footsteps.

By David Henry

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