By and  on July 30, 2007

Has retailing's leveraged buyout craze come to a grinding halt?

In the past few months, retailers from Macy's Inc. to Tiffany have faced ongoing speculation that they are takeover targets — distorting share prices and distracting operations. But industry watchers say that private equity firms now face slimmer pickings and increased risk in the retail sector as the market fumbles with tighter credit markets and consumer spending concerns.

As a result, analysts see a shift of private funds away from buyouts, which often resulted in hefty premiums of up to 35 percent over a stock's price, toward more strategic deals, including everything from spin-offs and licensing agreements to buying brands piecemeal.

Recent activity appears to bear out that scenario. On Thursday, VF Corp. made a $775 million purchase of Seven For All Mankind and $110 million deal for Lucy Activewear. On Friday, Brown Shoe Co. Inc. acquired an undisclosed stake in Edelman Shoe Inc., which markets the Sam Edelman footwear brand to Macy's, Neiman Marcus, Nordstrom and the Victoria's Secret catalogue, among others. Under the agreement's terms, Edelman's Sam Edelman and Libby Edelman will maintain a majority interest in the company, while Brown Shoe acquired an option to buy the remaining interest in the future.

Meanwhile, Deb Shops announced Friday that Lee Equity Partners LLC acquired all outstanding shares for $27.25 a share or roughly $395 million. Deb Shops said Lee Equity will finance the acquisition through cash and new committed credit facilities. The same day, American Capital Strategies Ltd. and UBS Securities LLC, with Golden Gate Capital as the equity sponsor, announced a $710 million cash infusion for Appleseed's Brands, a private label apparel brand for men and women ages 55 and older.

An informal WWD poll of industry analysts identified a dozen retailers and vendors that would be attractive targets for private equity money based on strong, free cash flow, including Macy's Inc., Nordstrom Inc., Gap Inc. and J.C. Penney, which had free cash flows of $2.38 billion, $878 million, $678 million and $483 million, respectively. Two firms, Gottchalks and Quiksilver, made the list based on availability and potential to generate cash, which is important because private equity firms need cash generation to pay off any incurred debt from a deal or just for investment purposes.Roy Ophir, a partner and senior analyst at Brownstone Asset Management, a New York-based hedge fund that specializes in high-yield corporate debt and distressed securities, said debt is used by private equity firms to increase their return on investment, much like mortgages are used by individuals to increase the affordability of real estate purchases.

"Without the debt necessary to finance these large LBOs, private equity cannot afford to pay as much for those," Ophir said.

He pointed to several factors that led to a repricing of risk across the credit and equity markets. In mid-June, Bear Stearns announced the "impending failure" of an internal hedge fund that speculates on mortgage-backed securities. Several weeks later, bond investors rejected several large debt issuances.

Ophir also pointed to Thursday, when debt financing for two large LBOs were either postponed or canceled, including Kohlberg, Kravis & Roberts' $22 billion LBO of Alliance Boots, the U.K. health and beauty retailer. Media reports last week said the private equity firm postponed selling more than $10 billion in debt until conditions in the credit markets improve.

And Ophir noted that "the Macy's LBO is very unlikely in this environment," referring to speculation that KKR made a takeout bid for the department store chain at $24 billion.

Even if private equity is able to finance deals, others are pointing to the retail sector's scant attractive offerings.

"We're starting to run out of publicly traded companies," said A.G. Edwards analyst Robert Buchanan, who cited Macy's, J.C. Penney, Nordstrom, Dillard's and Kohl's as attractive companies.

Buchanan said the benefits behind taking retailers private makes sense, as private operations would allow established companies with limited opportunity for additional physical growth to focus on expanding operations outside of Wall Street's parameters of expectations.

But Buchanan pointed to limited realities beyond the ideals — noting a dwindling list of retail companies that have the fundamentals to spark private equity interest.

"Private equity looks for two things: established cash flows and real estate — they are not interested in turnarounds," Buchanan explained. "What these guys are interested in is fat operating margins over years and the cash that goes with it."Goldsmith Harris analyst Gary Giblen said retailers are increasingly valued by the market at potential buyout prices, instead of on a company's operations and fundamentals.

"That's why the sector has done so well," said Giblen, who said Hartmarx, Saks Inc., Nordstrom and Dillard's could be good target candidates. "If you're doing great, or if you're doing poorly, companies are valued on a buyout basis — so it doesn't matter what you do."

And Brean Murray Carat analyst Eric Beder, who called the LBO boom "overhyped" for the retail sector, said buyout valuations are difficult to ascertain, as companies do not have to disclose the value of hidden assets, such as real estate, via the Securities and Exchange Commission.

"Hidden assets can only be discovered when you buy the company and do due diligence," Beder said. "Real estate has material value, but at the same time, for investors, it's almost impossible to get a handle on."

Beder said most specialty retailers do not have hidden assets as they lease the space in which stores are operated.

"I think most retailers that are left are not LBO-ready. They have great cash flow, but how secure it is is not clear," Beder said. "There's a lot of hype about retail LBOs — but at the end of the day, they're not getting done."


Acquisition Targets?
(Companies Cited as Possible Targets, Ranked by Free Cash Flow)
COMPANY (ticker)
FREE CASH FLOW
1. Macy's Inc. (M)
$2.38 billion
2. Nordstrom Inc. (JWN)
$877.9 million
3. Gap Inc. (GPS)
$678 million
4. J.C. Penny Co. Inc. (JPC)
$483 million
5. Tiffany & Co. (TIF)
$51.2 million
6. Dillard's Inc. (DDS)
$39.9 million
7. True Religion Apparel Inc. (TRLG)
$29.2 million
8. Hartmarx (HMX)
$25.5 million
9. Zumiez Inc. (ZUMZ)
$18.9 million
10. Bon-Ton Stores Inc.(BONT)
$16.7 million
11. Gottschalks Inc. (GOT)
-$25.9 million
12. Quicksilver (ZQK)
-$48.8 million

Private Equity's Top Players
(Ranked By Capital Raised Over Past Five Years)
COMPANY
CAPITAL RAISED
RETAIL HOLDINGS
1. Carlyle Group
$32.5 billion
Oriental Trading Co., Pacific China Holdings Ltd., Philosophy Inc., Mattress Giant
2. Kohlberg Kravis & Roberts
$31.1 billion
A.T.U. Auto-Teile-Unger Holding GmbH, Maxeda, Sealy Corp., Dollar General
3. Goldman Sachs Principal Investment Area
$31 billion
4. Blackstone Group
$28.36 billion
Gold Toe Investment Corp. and Moretz Inc.
5. Texas Pacific Group
$23.5 billion
J. Crew, Ducati Motor Holding SpA, Neiman Marcus Group Inc. Bally
6. Permira
$21.5 billion
Valentino Fashio Group SpA
7. Apax Partners
$18.9 billion
Tommy Hilfiger Corp., Spyder Active Sports
8. Bani Capital
$17.3 billion
Burlington Coat Factory
9. Providence Equity Partners
$16.4 billion
10. CVC Capital Partners
$15.7 billion
Debenhams, Revlon Inc.
11. Cinven
$15.1 billion
12. Apollo Managment
$13.9 billion
Linens-N-Things, Claire's Stores Inc.

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