Return of the Retail Roll-Up

by: Clumsy Rick, CFA

Given strong corporate balance sheets, low retailer valuations and rising costs, I believe we could see more strategic retailer acquisitions in 2011. Hardline sectors which have historically seen more acquisitions could see more activity, but the outlook is particularly compelling for apparel retailers. This could be a relevant theme to consider in 2011, in conjunction with company-specific fundamental analysis.

In the past, I have been critical of strategic acquisitions of retailers by other retailers in many retail sub-sectors, as synergies are often low. Also, consolidating management and operations reduces the autonomy of the acquired company, which can ruin creativity and the business model. However, I think the current environment is more compelling than usual. Consider:

  • Large Cash Hoards: Many retailers are financially strong -- perhaps too strong. Many are sitting on considerable piles of cash, earning almost no interest, and with little or no debt. While they could pay out one-time dividends or buy back more stock (and some certainly will), a compelling acquisition could offer a much higher return.
  • Retail Valuations Are Quite Cheap: There are many retailers trading at or under 4.5x-5.5x Trailing Twelve Month (TTM) Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). I will suggest valuations at this level are inexpensive relative to historical averages, especially if the TTM represents a low point. Private equity investors would seem to agree based on recent deal multiples (Gymboree (NASDAQ:GYMB) at 6.8x EBITDA, Jo-Ann Stores (NYSE:JAS) at 7.8x EBITDA and J. Crew Group (JCG) at 8.6x EBITDA) -- and these are financial, not strategic, buyers that arguably have cost or other synergy benefits.
  • Interest Rates and Corporate Yield Spreads Remain Low: With many potential acquirers also having low valuations, all-cash deals using cash on hand and debt can make more financial sense.
  • Consolidation Benefits Growing: The traditional benefits for retail roll-ups remain intact, including better non-merchandise buying, stronger positioning with landlords and some corporate consolidation. IT consolidation is perhaps more important, given the large investments that companies are making in enterprise and merchandising systems for more sophisticated labor, pricing, merchandise flow and marketing models. A robust IT system can be a competitive advantage in retail today. Rising cost pressures in merchandise sourcing also suggest greater retail consolidation benefits.

Some retail sub-sectors have had traditional consolidators (such as O'Reilly Automotive (NASDAQ:ORLY), Monro Muffler Brake (NASDAQ:MNRO), and AutoNation (NYSE:AN)) or moderate consolidation over time (like Dick's Sporting Goods (NYSE:DKS), Staples (NASDAQ:SPLS), and Best Buy (NYSE:BBY)). Given the current environment, it would seem reasonable to see further activity in these hardline retail sub-sectors. However, I think the bigger opportunity is in apparel retailing, as all the factors listed above seem to be even more keen in this space. Rising cost pressures, including commodity (i.e., cotton), transportation and labor, are hitting hardest here. Also, investments in IT systems are coming at a fast pace that could leave some smaller players at a disadvantage.

Potential Acquirers
Essentially, any retailer with a strong balance sheet and proven management team could be a potential acquirer. Below is a list of a few companies that come to mind:

  1. Ascena Retail: The former Dress Barn has made no secret that acquisitions will be a part of its growth strategy. It has a good track record with its Tween Brands acquisition and a solid approach that leaves the acquired business and management team largely intact.
  2. Urban Outfitters (NASDAQ:URBN): With several successful divisions and an extremely talented management team, Urban was recently reported in the press as being interested in making a competing bid for JCG. Whether that goes through or not, URBN could be a player in future deals.
  3. Sears (NASDAQ:SHLD): Eddie Lambert's company has been involved in deals before and was also reportedly interested in bidding for JCG. With a recovering economy and recently reported stronger earnings, SHLD could be in the hunt again.
  4. The Limited (LTD): Another extremely talented management team with a sophisticated operation. The Limited could make lemonade out of many retail lemons and either keep them or spin them off years later, with a great return to shareholders.
  5. The Gap (NYSE:GPS): Gap has the capacity and infrastructure to fold in a successful growth retailer in an accretive transaction. Its size could provide large synergies to an acquired company.

Target Companies
A key part of the deal equation is whether managements and boards want to sell, which is usually hard to tell from the outside. Also, different acquirers would be interested in different targets, so the players need to align to make a deal happen. Beyond the fit for the acquirer, some key characteristics that make a target attractive include a low valuation, a strong brand, store growth potential, high margins or the potential for higher margins and international growth potential.

Below are few public companies that I think meet some of these characteristics and could fit a niche of an acquirer:

  1. Ann Taylor (NYSE:ANN), 5.5x TTM EBITDA: Strong balance sheet, cash flow and brand. Potential for significantly higher margins and international expansion.
  2. Hot Topic (NASDAQ:HOTT), 5x TTM EBITDA: Strong balance sheet. Unique business model. Potential for significantly higher margins. Small company that could benefit from economies of scale.
  3. Aeropostale (NYSE:ARO), 4.2x TTM EBITDA: Strong balance sheet, margins and cash flow. Potential for domestic growth (PS from Aero chain) and international expansion.
  4. Destination Maternity (NASDAQ:DEST), 5.4x TTM EBITDA: Good cash flow with potential for higher margins. Dominate niche with potential international growth.
  5. Coldwater Creek (NASDAQ:CWTR), 5.5x TTM EBITDA: Strong brand. Fair balance sheet and cash flow, but large potential for turnaround and margin growth. Small company that could benefit from economies of scale.

This list is in no particular order and is not meant to be complete, especially as it does not consider any private companies either. Rather, I'd view the whole retail roll-up idea as an interesting investment theme for further fundamental research on both potential acquirers and targets.

Disclosure: I am long BBY.