Troubled Chains' Rocky Road

Market watchers see more restructurings for retail's laggards as cheap credit fades away.
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Updated from 10:48 a.m. EDT

There are always a few stragglers in the retail business depending on which way the winds of fashion blow. But nowadays, with economists forecasting a slowdown in consumer spending, those chains with continuously sinking sales could be nearing a crossroads.

For years now, cheap credit, along with all the capital flowing into private equity coffers, has kept many retailers afloat. Those companies bleeding market share to the competition have stayed alive by borrowing money, or else deep-pocketed buyers have come calling, looking to buy assets on the cheap.

Now, observers in the debt market are expecting credit to dry up, and investment banks are quietly beefing up their restructuring teams in anticipation of a rash of defaults and bankruptcies that could break out as a result.

"Even those investment banks catering to the retail or direct-marketing industry that haven't had restructuring teams are considering building out their business in that area," says Karen DelPrete, a managing partner with Gilbert Tweed Associates, an executive search firm. "There's a pervasive anticipation out there that there will be a need for restructuring in those areas in the future."

Last month, Standard & Poor's Global Potential Fallen Angel survey showed that more companies had speculative-grade credit ratings than at any time since 2003. Meanwhile, credit guru Edward Altman, a professor at New York University, predicts that "the benign credit cycle will end soon, perhaps as early as the fourth quarter of 2006 or the first quarter of 2007."

For its part, Morgan Stanley has recently hired a number of restructuring specialists.

"We've been expanding our restructuring staff because we're anticipating a deterioration in credit quality and a rise in default," says Marie Ali, a spokeswoman for Morgan Stanley. "It's not specific to retail."

But another high-level source at a major investment bank says there are three or four middle-market apparel retailers who will soon need to negotiate changes in their credit agreements based on "operational difficulties" and cash shortages.

"That sort of activity could be viewed as a leading indicator of the difficulties to come in that industry," says the source, who requested anonymity.

Howard Davidowitz, chairman of retail consulting and investment banking firm Davidowitz & Associates, says the retail sector could be the first place to feel the pain when the credit cycle finally turns.

"Most people in this business know that the consumer is slowing down, and struggling companies can't keep borrowing money to sustain themselves forever," says Davidowitz. "There will be stores closing all over the place. Everybody in the investment banking business knows it, and they're very quietly staffing up to capitalize on it. Once the cycle turns, then the money to be made is in the restructuring business."

Same Troubles, Different Options

Hot Topic


is one of the retailers that has seen same-store sales spiral downward, though its unclear what effect that's had on its overall financial health. The company's teen customer base has rebelled against its goth stylings, leaving it to record declining same-store sales in every month except one since March of last year.

Hot Topic's July comparable-store sales fell 7.2%, while second-quarter same-store sales dropped 5.5%. Based on the disappointing results, the company warned investors late last month that it now expects to post a loss of 2 cents to 3 cents a share for the second quarter. Analysts were expecting break-even results.

"You increase your risk in direct proportion to the extent you define yourself as extreme fashion in this business," says Davidowitz. "If you go on the edge, you have a tremendous upside, but your downside is huge because if the slightest thing goes off the track, you are done."

Things went way off track for

Sharper Image


after it bet its future on air purifiers and massage chairs that quickly went out of style. It posted a 23% same-store sales decline for July, continuing a long string of dismal results.

Other retailers get hurt when they trailblaze a product line, only to find the competition catching up quickly.

Pier 1 Imports

(PIR) - Get Report

docked itself on the retail map by selling wicker furniture and other distinctive home furnishings at low prices. But when


(TGT) - Get Report

began mimicking its products, its sales dropped off a cliff.

Earlier this year, Pier 1 issued a fresh bond offering, prompting Standard & Poor's to lower its credit rating to junk status. The company said the financing would allow it to execute on a product makeover plan it rolled out in February, but its sales have yet to recover. In July, the company's same-store sales dropped 14.9%.

"If you're management or sitting on the board of directors at one of these retail companies, and you have the opportunity to be refinanced rather than be replaced, what are you going to do? Obviously, you're going to refinance," says Michael Appel, a restructuring specialist with Quest Turnaround Advisors. "The problem with that is that all you're really doing is buying time. But that can't go on forever."


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, the specialty apparel empire that owns the Banana Republic and Old Navy chains, as well as its namesake stores, is the largest retailer with ongoing sales problems. It has posted negative same-store sales, a key retail metric gauging sales at stores open for at least a year, for every month so far this year and in each of the last 37 months except five. Shares of Gap have lost almost a quarter of their value over the last two years as a result of the sales tailspin.

Gap has pledged to improve results in the back half of the year. But even if a long-awaited turnaround fails to materialize, the company isn't a good candidate for major financial woes, given its improved balance sheet, its profitability and the large amounts of cash it generates.

"Gap is a marketing and operational crisis -- not a financial crisis," says Davidowitz. "This company has the kind of critical mass that certain private equity buyers might be very interested in, but the brand will have to go through a major transformation to survive."

Gap's competitor,

Limited Brands


, is also feeling the pain of obsolescence at its Limited and Express apparel chains. But the company's other businesses, such as its Victoria's Secret chain, are faring well, and the company has a history of spinning off assets. So, it's expected to look for ways to rid itself of its apparel stores.

If successful, investors who stick it out with Limited and other troubled retailers could be rewarded.

"The downside here is clear, but you have to bear in mind that the upside in these situations is also tremendous," says Davidowitz. "Can these stocks rocket up if they execute a turnaround? Yes, they can. But the odds are against it."