Retail: Factors Spurring M&A Action

by: Tony Rochel

With the holiday spending season behind us, we have seen which retailers are surviving and which are thriving. Also, with holiday spending up 5% there is evidence that the economy is picking up steam and consumer confidence is on the rise. Further, the apparel segment of the industry is still highly fragmented and stock prices are still slightly undervalued across the board. These conditions are enticing for potential buyers and will fuel M&A activity. Whether an acquisitive brand is seeking synergistic gains or wants to enter a different demographic or geographic area, there are plenty of opportunities. After conducting a basic stock screen I have come up with six companies to look at and review.

Who Are the Buyers?

There are two types of M&A transactions: strategic and financial. Strategic buyers will be looking to grow revenue and cut costs. Revenue growth can be attained by expanding geographically (internationally) or more likely into a different demographic. Another growth area for retail apparel is internet sales, a retailer light in this area may look to acquire a complementary retailer with higher direct to consumer sales. A perfect example of this type of strategic purchase is Sears (NASDAQ:SHLD) and J Crew (JCG). Although most people think of Sears as an outdated department store that sells high quality tools, it may be making a transition into branded retail apparel. It acquired Lands End in 2002 and has identified that J Crew would make a good compliment to it by expanding its demographic reach. This may be a model for other branded retailers looking to broaden their demographic coverage.

On the other hand, financial buyers will be looking for strong cash generation and steady dependable growth – but not too much of it. Due to the financial crisis many retailers have been retiring debt and decreasing fixed costs. As sales growth makes a comeback, many of these companies will experience significant bottom line growth and the financial buyers will be there ready to pounce. According to Prequin, a private equity research group, private equity firms were sitting on $437B in December and that number has been somewhat steady over the past two years. For many firms, it is getting to the point where they must put this money to work or face giving it back to investors; this will likely heat up the buyout game.

The Usual Suspects

In either case, strong brands will be a good investment. When I created my screen, I came up with names that pretty much everybody has heard of. J Crew made the list but is already a candidate so I will look at Abercrombie (NYSE:ANF), Aeropostale (NYSE:ARO), American Eagle (NYSE:AEO), American Apparel (APP), Gap (NYSE:GPS) and Urban Outfitters (NASDAQ:URBN).

Abercrombie is overpriced to be a viable candidate for acquisition but may work for a buyer looking for a project. ANF has two segments that account for the majority of its sales, Hollister with 43% and Abercrombie with 44%. With a healthy gross margin, it is evident that its customers are willing to pay for their products; however ANF is performing poorly as an investment while looking at ROA and ROE. Also, ANF had direct to consumer sales of 8.5% in FY2009 which was 6% lower than FY 2008. Direct to consumer segment is attractive because of the high margins, but it will likely never be large portion of income because of the nature of retail apparel. However, a target of above 8.5% of sales is certainly attainable. If ANF or a buyer is willing to do some work on its operations, ANF could certainly stand to be a strong candidate. However, as it stands, I would not purchase this stock with the intent of making a gain on an acquisition.

American Eagle is in a similar position that Abercrombie is in albeit with a lower gross margin and higher net margin indicating more efficient operations. They cover some of the same demographic groups as Abercrombie. Also, nearly 12% of its sales are direct to consumer, a segment that has seen significant growth since 2005 and is continuing to grow. American Eagle is priced slightly below my price target of $16, which does not make it a candidate for a financial acquisition but it may be attractive for a strategic acquisition. For instance, American Eagle would be a good compliment to a brand like J Crew. They do not have overlapping demographics and American Eagle is a strong brand with steady sales growth. I place American Eagle on the list of potential mergers for 2011, it is nearly impossible to calculate a target price for a merger when the other party is not known since the synergistic cost savings and growth factors are not known, for that reason I have not listed a target price for a merger.

American Apparel is a great company. However it is on the rocks right now amidst a slew of corporate problems. American Apparel is unique in that its clothing is made in the USA and yet they have high gross margins, the problem lies in their executive team. Caught employing 1500 illegal workers in 2009, a class action lawsuit in summer ’10 and in December APP was accused of withholding crucial information from its auditor. Their product is superior and their customers have loyalty, but an American Apparel is not a likely candidate for a strategic M&A move. There may be some interest from an activist investor or a PE group willing to shake things up. All things said, APP is on hold for me but I am watching it very closely.

Urban Outfitters is a diversified retail apparel company. With two popular brands under its belt and e-commerce representing over 15% of its sales, it is able to reach across several demographic groups. Its diversified strategy is successful and its success is evidenced by its strong gross margin and its strong bottom line. Set that aside, URBM has seen excellent revenue growth, earnings growth and same stores growth over the past five years - Urban Outfitters is on the right track. It has the highest bottom line margin of all of the ones I have listed but it is not cheap by any measure of the word. In some way, this is evidenced by its interest in J Crew, however J Crew does not offer much in the form of strategic initiatives. I am in the camp that believes that URBN is merely attempting to glean something from J Crew by analyzing their inner workings. In all, the good is that Urban Outfitters has strong growth, good management, a strong brand and more growth opportunities. The bad is that this is already reflected in its price and that its projected growth will consume significant capital. Urban Outfitters opened around 40 stores in 2010 and is would like to continue to grow. One of its biggest constraints will be the availability of cash for capital expenditures and working capital. I ran an LBO model on it but because of its high share price and growth track, it is not a great candidate for a financial acquisition. In all, Urban Outfitters is not likely a good candidate for a strategic or financial acquisition but it may be acquisitive itself.

Aeropostale seems to have fallen out of favor amongst its customers. It still boasts high earnings which translate to high ROA and ROE but its revenue growth is on a downward trend and it had to have newsworthy promotional sales over the holidays to turn its inventory. Also, after capitalizing leases, its ROIC is about average for the industry. ARO is in a transitional period, it was hot a couple years ago but has lost momentum. Without intervention its now healthy margin will continue to slowly shrink as will its stock price. ARO is well suited for a strategic acquisition from within the industry by a group like Urban Outfitters and if its stock price continues to decline it may be a good candidate for a financial buyer. In either case, the acquirer must have the expertise and experience to enliven the brand and bring it back.

Big Bet

I say big bet because it has the largest market cap of the companies I analyzed. At almost $13B in market capitalization, Gap is the largest that I analyzed. It’s stock has dropped just under 10% in recent days after it reported a decrease in December sales when analysts were expecting an increase. Decreasing sales is nothing new for Gap, which has been experiencing issues with growth over the past three years and its stock price reflects this. The majority of Gap’s sales is divided between Old Navy, Gap, and Banana Republic, representing 40%, 41% and 17% of its sales, respectively. With these three brands Gap covers a wide demographic range. If the economy and consumer confidence does not rebound, the low price point is covered at Old Navy. If consumers see increased disposable income, it has Banana Republic to poised to reap the benefits. Gap has only 8% of its sales as direct to consumer but has identified opportunities in Canada and abroad and will seek to expand this segment in the future. Over the past f years Gap has been at work on its operational side and increased it’s gross margin by over 5%. However it needs to spend some time working on its merchandising, with its operations in order it may be time to switch quarterbacks and get a CEO more familiar with the fashion industry. Gap is not likely a candidate for strategic M&A, however I ran an LBO model on it and if Gap can post modest increases in sales next year and onward, it would be a very strong candidate for a private equity buyout (LBO max target price $30/share).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.