Consensus Advisors: Eat Dog Eat
Through a special arrangement, presented here for discussion is a summary of a current article from Consensus Advisors, a boutique investment and advisory firm specializing in the retail industry.
Each Fourth of July, a select group of world class competitors gather at the corner of Surf and Stillwell Avenues on Coney Island for an epic nationally-televised battle: The Nathan’s Famous Fourth of July International Hot Dog Eating Contest. After fasting for a couple of weeks, these “gurgitators” come to the table anxious to devour wieners at a remarkable rate.
In a somewhat similar fashion, after a two-year self-imposed “fast,” investors have aggressively returned to the retail sector. The resurgence of interest has been driven by the return of deal-hungry private equity to the sector. Private equity firms, which had been very deliberate in its pursuit of buyout opportunities in the years following the financial crisis, are beginning to reassert themselves.
Two of the largest private equity players that led the buyout frenzy from 2005 to 2007 are now driving the resurgence. Leonard Green, which devoured, among others, Neiman Marcus, The Container Store, Petco and Sports Authority prior to the financial crisis, have purchased four household names — J. Crew, Jo-Ann Fabrics, 99 Cents Only Stores and BJ’s — in the past 12 months. Bain, which between 2005 and 2007 consumed entities such as Toy “R” Us, Guitar Center and Burlington Coat — and also participated in the buyout of Michaels — stepped up in late 2010 with the purchase of Gymboree.
One of the key investor attractions is that retailers have historically carried relatively low levels of debt. The net debt level in retailers has decreased even more in recent years, as retailers have stockpiled cash in lieu of store openings. The relatively low debt levels and high cash balances allow for the acquiring firm to layer on significant levels of debt to finance the acquisition, as opposed to more expensive and risky equity.
Private equity has patiently waited out the financial crisis but are anxious to aggressively get back in the game.
However, the retailers’ relatively high cash balances are also turning many into investors themselves. With the risk/reward relationship of opening new stores still skewed toward risk, retailers are looking for other ways to put their money to work. By pursuing M&A transactions, retailers are able to achieve cost-savings and synergies only available to strategic investors.
So, as more private equity pursue the next tier of retail deals, it is likely that they will compete against some of the larger retailers in the bidding war. As hot dog eating champion Joey Chestnut has demonstrated, it’s exciting to step up to a full plate with a true hunger and a desire to succeed.
Discussion Questions
Discussion Questions: What conditions for buyers and sellers make for a successful retail merger? What lessons should retailers have learned from past periods of heightened M&A activity?
This topic is way too deep to summarize in one short comment. However, what I have found over the years is that investors into the retail markets often anticipate faster and bigger results than what might be realistic at any given time, given the “real world” competitive circumstances day to day, product by product, category by category. The best investments are those for retailers that have carved out a true point of differentiation.
The rules have not changed, but the deals have. Retailer values on purchase multiples have declined. They are more selective in what they will buy, having made some mistakes in the past. They want companies that have been in existence for a while, not start-ups or one-store wonders. Last but not least, they want a plan on what needs to be done. Unless they feel confident on the plan going forward, they will not do the deal.
M&A gets mixed reviews from retail CIOs. Some applaud a perception of greater stability, while others complain about meddling from new owners that don’t understand retail. In any case, CIOs who are experienced in dealing with VCs tend to get calls from CIOs at takeover targets, asking for advice.
Historically, M&A activity has produced between a 55% and 85% failure rate. Horizontal M&A has performed at the higher level of failure. Retail M&A has largely been horizontal.
Horizontal M&A is driven by mature markets, saturated markets and intense competition. That is retail. What happens following a merger in this environment is that the marketplace remains mature, saturated and competitive.
In any M&A the players must look for a sustainable competitive advantage. In today’s brick and mortar marketplace, that would be very hard to find in these types of deals. Sustainable competitive advantage is not putting two chains together, closing underperforming stores and carrying on business as usual.
Retail is one of those M&A market places that if you don’t know what you are doing, don’t jump in the water.
The best merger is when each party brings something to the table that the other is lacking. For instance, there may be a company with great ability to drive sales but unable to drive profitability. Matching the great marketer with a company with great systems, structure, and cost controls makes for a potentially great marriage. The caveat, of course, is that the leadership of the company (somebody has to be in charge), is intellectually and emotionally flexible enough to take skills from both sides and mix them together effectively.
Also, if the combination provides highly improved leverage upstream (think the TJX acquisition of Marshalls), the results can be very powerful.
There are not too many of these stories. More typically, two weak companies merge to form a much larger weak company (Sears and Kmart anyone?).
Taking a slightly different tack in responding to this topic, investors and acquisitory retailers are warily eying the debt ceiling battle currently being waged on Capitol Hill, and the possible downgrading of America’s credit rating. These historic M&A entities have been preserving liquidity and protecting their balance sheets in the face of unpredictable financial conditions. As expressed in the topic, they are instead choosing to layer on debt when making deals. This practice, however, can only be made less appealing by a downgraded credit rating.
“Success,” it seems, is a relative term, as there will always be people–lawyers, accountants, and the ever popular “consultants”–who will clean-up (in many senses of that term) after even the worst of unions. But if by success we mean something useful comes about, then the key factor is that each party bring something useful to the wedding: perhaps it’s simply size–i.e. economies of scale are realized that allow for a better competitive position–or maybe it’s something more creative (strong logistics meets strong marketing). That, at least, is the case with the “M” in M&A; the “A,” by contrast, is a takeover: success is dependent upon that which was taken over having some hidden–but realizable–value locked up in its assets.
To create a likely successful merger the cultures of the two parties must be compatible and both parties must compliment the other’s established advantages … such as a profitable traditional farm operation expanding its offerings by merging with an efficient and more contemporary organic farm. Otherwise, it’s a roll of the dice when a company needing to be rescued merges with a company believing it can float a sinking boat.
Lessons learned from the past: Corporate egos can’t make a silk purse out of an unattractive sow’s ears.
I’d prefer to frame the question from the shopper’s perspective: Do retail mergers make for more successful shopping trips? Better merchandise, ambiance, convenience, service, price?
If the answer is yes on most of those attributes, then a retail merger is probably creating value.
If the deal is sold on the basis of “improved operating efficiencies” or “economies of scale” or “real estate portfolio” then it’s time to get skeptical.
With rare exception, retail consolidation profits only the deal makers. In the grocery sector, the top 20 chains controlled 39% of sales in 1992; by 2009 they dominated 64%. But industry net profits have hovered at just over 1% in the same time span. In 2010, FMI says the industry net was 0.98%.
Retailing is a very personal business when it’s done well. The bigger the entity becomes, the greater the distance (physical and psychic) between HQ and the shopper. Few professional investors truly grasp this crucial factor while they are tallying square footage and employee headcounts.
Retail M&A has typically been driven by one of two considerations. A firm may acquire one or more retailers and drive efficiencies in a number of operational areas to generate ROI. Or the acquiring firm may be seeking to gain control of desirable real estate, with an eye toward consolidating under a single banner. In either case, it’s an attempt to get larger and capture greater share in a mature environment.
I don’t see anything that would change these drivers in a renewal of retail M&A activity.
Rarely is there a true merger among retailers. It is far more typically an acquisition of one by the other, at the very least in terms of management. One always assumes the controlling role.
I think the biggest mistake is that corporate ego rules the integration plan. Far too often a retailer changes the banner on stores that have local following, when the financial benefits of that name change rarely materialize.
I’d really like to see more “customer due diligence”. It is often the customer asset that is eroded in the run up to being sold or merged as this critical asset of a business is traded for a better financial shape that can be more easily viewed. By then, customers may have gone elsewhere.
Understanding the customer dynamics will also help clarify the potential fit or overlap. It would be great to hear some businesses asking for this view before they get too far down the M&A path.