Focus on: Finance

Has the start of a new decade also signaled the start of a “new normal” for the retail industry? Jeffrey C. Bloomberg, principal and office of the chairman at Gordon Brothers Group, Boston, thinks that may well be the case.

“There was enormous trauma in the second half of 2008 and first half of 2009, but by the third and fourth quarters of 2010, I believe we will see a stabilization of [retail] sales, which will set a new baseline,” Bloomberg said.

Predictions for retailers’ top-line growth this year are modest, across the board perhaps a 2% growth rate. However, given the improvements many retailers have made in expense control, inventory reductions and gross margin increases, Bloomberg expects EBITDA (earnings before interest, taxes, depreciation and amortization) “to increase a fair amount in 2010, particularly in the first half versus retail performance in the first half of 2009.”

On another positive note, there are already signs the juggernaut that has kept lenders’ purse strings tightly bound has begun to loosen. Although financial activity was nonexistent in the first half of 2009, a gradual movement toward deal-making began in the latter half of the year.

“There was a fundamental shift toward more financial activity by September,” noted Cheryl Carner, managing director of Capital Source, Boston. “Now it is a more attractive environment for retail; there are lenders in the market ready to deploy capital on an asset basis or a cash-flow basis.”

Jennifer Herber, managing director of Stephens Inc., Little Rock, Ark., shared Carner’s optimism.

“The public finance sources are opening up; even private sources, such as banks that were really conservative through the third quarter of 2009, are starting to lend and provide financing more easily, ” she said.

A flurry of deals were consummated at the end of last year, including a $500 million high-yield public offering announced by Hanesbrands in November, a $100 million common stock offering completed by Saks Inc. in October, and the November launch of Dollar General’s IPO, which netted more than $445 million for the company.

Noting that liquidity for large-cap investors has improved, Bloomberg still cautioned: “The amount of leverage in the market as far as what people are willing to loan in relation to EBITDA has declined materially. In the height of the market, we saw six-plus and 7x leverage to EBITDA. Now, certainly in the retail market, that has declined precipitously and is basically half of where it was—4x leverage for retailers would be pushing the edge of the envelope.”

Gary J. Prager, managing director of GB Merchant Partners, the investment-management affiliate of Gordon Brothers Group, outlined how the scenario will likely play out:

“Retail is the first sector to feel the crunch going into a recession and is the laggard segment coming out of a recession,” he said. “In the current economy, 10% unemployment and its resulting impact on consumer demand have left capital providers leery about the ability of retailers to rebound or dramatically improve performance in the near term. As a result, the mezzanine of unsecured cash-flow lenders in the retail industry has pulled away because EBITDA levels are so low.”

For smaller and mid-size retailers that lack the assets or cash flow to attract lenders—and for retailers that remain financially challenged—it is still a dry market. Flexible financing sources, such as private-equity firms, are viable alternative resources, according to Stephen’s Herber.

“More private-equity firms are making minority investments in retailers that are looking for capital to expand or restructure operations, pay down debt with burdensome covenants, enter new markets or finance a major acquisition without a change of control of the business,” she explained. (A detailed discussion of this perspective is available here).

Companies such as GB Merchant Partners also look beyond what traditional senior lenders evaluate, taking into consideration such value-added attributes as a retailer’s inventory, brand-name recognition and customer loyalty, to drive their continued participation in retail deals.

For instance, in August GB Merchant Partners closed a $50 million loan to Eastern Mountain Sports, and in November GB Merchant Partners participated in a $75 million loan for The Bon-Ton Stores.

By the fourth quarter of 2010 or early 2011, Bloomberg asserts lenders will begin to feel more comfortable on a cash-flow basis in terms of traditional mezzanine lending to retailers—but first the industry has to build confidence in whatever the new normalized levels prove to be.