An Urge to Merge in Retail
A series of huge acquisitions has rocked the retail landscape in recent months, and the sector is ripe for more. But rather than a wedding march for this game of musical chairs, the tune sounds more like taps.
"I don't think all this reflects a pickup in the retailing business," said Hugh Johnson, chief investment strategist with First Albany. "Retail sales have been fairly strong for two years now. This is primarily an attempt by companies to figure out a way to compete with
Wal-Mart
(WMT) - Get Report
."
"Retailers are finally coming to grips with the fact that their universe is undergoing massive transformation and a massive change in the way it operates," said Kurt Barnard, the president of Barnard's Retail Consulting Group. "Unless they're willing to fall in line, they will simply fall out."
Squeezed by competitive pressures from giant competitors that use their scale to achieve a low-cost business model, blockbuster deals like
Kmart's
(KMRT)
$11 billion acquisition of
Sears
(S) - Get Report
and
Federated's
(FD)
$11 billion acquisition of
May Department Stores
(MAY)
seem to be motivated by the belief that the only way to fight back is by getting bigger.
"They feel that by becoming bigger, they can put pressure on their vendors and suppliers to reduce costs," Johnson said.
Big retailers that dominate their space, like Wal-Mart,
Target
(TGT) - Get Report
,
Best Buy
(BBY) - Get Report
,
Home Depot
(HD) - Get Report
and
Costco
(COST) - Get Report
, have shown little appetite for retail acquisitions.
The lion's share of negotiating is taking place at older retailers that have been mowed over by the discount phenomenon. Shares of
Toys R Us
(TOY)
rose more than 2% last Thursday on reports that Cerberus, a hedge fund, has joined with
Goldman Sachs
(GS) - Get Report
and
Kimco Realty
(KIM) - Get Report
to bid about $5 billion for the company. The toy chain announced last year that it would consider selling off its toy business, having been routed by Wal-Mart's encroachment into the space. But while the company wants to focus on the lucrative Babies R Us operations, the new bidders reportedly want the whole business.
Circuit City
(CC) - Get Report
, having taken a back seat to Best Buy in consumer electronics for years, rejected an unsolicited $17-a-share buyout offer last week from Highfields Capital Management, a Boston-based hedge fund. The firm had proposed taking the company private, where it could focus on rejuvenating its business outside the glare of the public markets. Circuit City's rejection marks the second time in two years it has refused a buyout offer from private investors. The company said it would not consider other bids, but future missteps will give rise to renewed buyout talk.
Elsewhere in electronics, regional chains like
Tweeter
(TWTR) - Get Report
have been named by observers as potential buyout candidates.
Rex Stores
(RSC)
has garnered attention with its low earnings multiple and attractive real estate portfolio. Also,
Sharper Image
(SHRP)
has surfaced in speculation about a chain looking to expand, like
RadioShack
(RSH)
, although some observers say the company's founder would be unlikely to sell.
Analysts point to the grocery business as a fertile ground for more buyouts, since Wal-Mart and Target have entered the fray. Regional grocery chains, like
Krogers
(KR) - Get Report
,
Safeway
(SWY)
,
Albertson's
(ABS)
and countless private chains could feel inclined to band together in an attempt to cut costs.
Also, the department store business could see further consolidation in the wake of the Federated/May deal. With discounters, specialty retailers and luxury chains continuing to steal market share from these more traditional store models, regional chains like
Dillard's
(DDS) - Get Report
could be on the prowl for a quick way to get bigger.
But before investors buy into the bigger-is-better thesis, they might consider that some of the best performances logged by retailers in recent years came from companies that have actually gotten smaller.
Shares of
Aeropostale
(ARO)
, a teen clothing chain spun off from Federated in 2002, added over 60% in 2004 and nearly 160% in 2003.
Abercrombie & Fitch
(ANF) - Get Report
, another teen clothing chain, saw its stock climb 93% in 2004 and 21% in 2003. It broke from the shackles of its corporate parent,
Limited Brands
(LTD)
, in the late 1990s.
Similar trails were blazed by numerous specialty retailers, like
Too
(TOO) - Get Report
,
Coach
(COH)
and
New York & Co.
(NWY)
.
"These companies were doing lousy with the same management teams under their corporate parents," said Peter Siris, hedge fund manager with Guerilla Capital. "They spun off, and all of a sudden, they started setting the world on fire. It's not clear that mergers work right now, but it's real clear that spinoffs work."
Along with mergers and buyouts, talk of more spinoffs in retail is swirling on Wall Street as well. Howard Davidowitz, chairman of a New York-based retail consultancy called Davidowitz & Associates, speculated that Limited Brands would soon be shedding the remainder of its apparel business, leaving it with only its Victoria's Secret and Bath & Body Works chains, where it derives about 70% of its sales.
In the last eight years, Limited has spun off or sold a dozen companies, including Lerner, Lane Bryant, Abercrombie & Fitch, Gaylan's and Limited Too. Meanwhile, its namesake apparel chain, Limited, and its Express store chain have been weighing on profits and shedding underperforming stores.
"The Limited is being dragged down by their apparel business tremendously, and they've shown a propensity for spinning off underperforming businesses," Davidowitz said. "My speculation is that they'll get out of the apparel business completely."
Elsewhere, Pacific Growth Equities analyst Andy Graves speculated that the Marshall Field's chain could be spun off from Federated amid its impending merger with May. May outbid Federated for the chain in 2004, when it was auctioned off by Target. The move was later second-guessed after Gene Kahn, May's former chairman and chief executive, resigned in January.
Shares of
Sak's
(SKS)
have also moved recently on speculation that the company could sell or spin off its middle-market department store division in order to concentrate on its Saks Fifth Avenue unit, which targets the luxury market.
"For most retailers these days, the road to growth at this point is all about targeting very specific consumer demand and building value propositions around that demand as opposed to trying to be all things to all people," said Wendy Farina, a principal with Kurt Salmon Associates.