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Retail Downgrades On The Upswing

<CS:BOLD>NEW YORK -- Kmart Corp.'s fall from grace and into Chapter 11 could be documented as easily from its debt downgrades as from the erosion of its stock price.<BR><BR>The blue-lit retailer's spectacular downward spiral may be an extreme case,...

NEW YORK — Kmart Corp.’s fall from grace and into Chapter 11 could be documented as easily from its debt downgrades as from the erosion of its stock price.

The blue-lit retailer’s spectacular downward spiral may be an extreme case, but it’s by no means the only retail drama being played out through credit downgrades in the post-Enron era. As Kmart Corp.’s fortunes fell, so did its corporate debt rating — seen in successive downgrades from the three primary agencies that track credit worthiness, Moody’s Investors Service, Standard & Poor’s and Fitch.

Dillard’s is now being watched closely following the commencement of a Moody’s review on Jan. 14 (see related story).

Moody’s, for one, put Kmart’s debt on review for possible downgrade on Nov. 6 when its senior unsecured debt was rated at Baa3, the lowest level of investment grade. A little over two months later, on Jan. 22, when Kmart filed for Chapter 11, the discounter’s debt stood at Ca. A series of five downgrades totaled 10 degrees on Moody’s 21-level rating scale.

Kmart’s stock began the year at $4.74 a share and closed at 92 cents on Monday.

In recent weeks, Moody’s also pulled down Saks Inc.’s debt rating two notches to B1 with a stable outlook; reduced Gap Inc.’s debt to Baa3, the lowest level of prime ratings, continuing its review for possible downgrade, and put May Department Stores’ long-term debt, rated at A1, on review for possible downgrade. Dillard’s Inc. is also under the review-for-possible-downgrade microscope with its debt currently one notch below investment grade.

Downgrades, however, represent only incremental moves on the agency’s rating scale. A downgrade of one notch for both May Co. and Gap, for instance, would still leave the firms debt five slots away from each other with the former considerably higher.

While issues currently under review for downgrade are in greater peril of being reduced, other issues on which Moody’s currently has a negative outlook include Limited Inc., Federated Department Stores, Nordstrom Inc., J.C. Penney Co., Sears, Roebuck & Co., J. Crew and ShopKo Stores Inc.

“In general our retail downgrades have exceeded upgrades,” reflecting two years of declining credit quality, said Moody’s retail analyst Marie Menendez. “Our outlook for retailers for the near-term continues to be negative.” Still, she noted, “About one-third of reviews for downgrade and one-quarter of reviews for upgrade have resulted in the ratings being confirmed at existing levels.”

It behooves companies to avoid credit downgrades since they increase borrowing rates and tend to deflate stock prices. Some mutual fund managers are obligated to dump large blocks of a company’s stock if it has been downgraded, particularly if it moves from a prime to a sub-prime, or junk, rating.

“Apparel is going to be highly sensitive,” in terms of credit quality, said Menendez. Ratings are under pressure from sales and profits that have declined during the recession and the ongoing effects of Sept. 11. Also, sated consumers’ bloated closets, a hangover from the buying spree which defined the second half of the Nineties, materialized, a reminder that many apparel retailers had “stopped acting like they were a cyclical business,” she noted.

“The apparel cycle is about three years. For apparel, this was a five-year cycle and for the economy as a whole this was a 10-year cycle. An awful lot of retailers were getting bigger without getting more productive,” said Menendez.

Many new units operated by large retailers “haven’t had a chance to grow to maturity” in the current climate, she pointed out. These immature stores, depending on how they were financed and how much inventory is needed to support them, can increase borrowings and affect a retailer’s credit quality negatively.

Retailers were also so busy growing, many neglected to save cash during the upside of the cycle to help them weather the downside, falling victim, in part, to the “irrational exuberance” which inflated the tech arena particularly.

In the midst of an unprecedented economic run, firms didn’t know when the down cycle would come and, in some ways, were forced to run with the bulls or get stampeded. Menendez noted that stores applied the brakes at the risk of losing available market share.

In her recent downgrade of Gap, Moody’s analyst Elaine Francolino noted, “All three concepts — Gap, Banana Republic, and Old Navy — continue to experience negative comparable-store sales and lower profitability following a period of rapid store expansion and changes in the competitive landscape.” The San Francisco-based specialty pioneer in the past few years has also been consumed with ho-hum fashions, a move away from and then back to basics and herky-jerky shifts in advertising.

Saks Inc. may also have bitten off more than it could comfortably chew at the end of the last century. Francolino noted the firm’s expansion, most notably the acquisitions of Saks Fifth Avenue and Carson Pirie Scott in 1998, “may have stretched the consolidated company’s lean infrastructure.”

Michelle Barishaw, retail analyst at Fitch, which rates a handful of department stores and discounters that carry apparel, said she wasn’t expecting “a lot of ratings actions in the first half of this year” or any improvement for the next 12 months. “Companies can hope for stability and maintaining where they are,” she noted. Overall, “department stores are going to continue to be challenged by discounters.”

Bond-rating agencies have also been feeling pressure to act more quickly on ratings after they were generally slow to move on the disintegration of Enron.

However, a statement from Moody’s Christopher Mahoney, chairman of the firm’s credit policy committee, noted, “any increase in the frequency or extent of recent rating adjustments is a result of changes in Moody’s opinions in the context of a more volatile credit environment, rather than a shift in our fundamental approach to the rating process.”

Moody’s is in the process of finding out exactly how Wall Street wants it to operate and may adjust aspects of its rating methodology according to the financial community’s needs. Rating agencies, though, have had the magnifying glass of review turned on them by lawmakers and Wall Street alike. This scrutiny could make debt downgrades a swifter and more likely occurrence.

RETAILERS ON REVIEW

Retailers whose debt is under review or has been reviewed this year by Moody’s Investors Service:

Charming Shoppes (review commenced Jan. 28).

Dillard’s (review commenced Jan. 14).

Gap Inc. (review ongoing, some ratings lowered Jan. 14).

The May Department Stores Co. (review commenced Jan. 7).

Saks Inc. (review concluded Jan. 8, some ratings lowered).