More Distress, But Fewer Deals

Despite the Sluggish Economy, we reported 10 catalog-related deals in terms of mergers and acquisitions during the second quarter. But that’s half the number of deals that went down in the same quarter of 2008.

Some familiar names were present among these deals, including J. Jill, Spiegel Brands, FAO Schwarz, Toys ‘R’ Us and Golden Gate Capital. “There were transactions executed at opposite ends of the deal spectrum,” says David Solomon, co-CEO of New York-based investment firm Lazard Middle Market, which tracks transactions for Multichannel Merchant. “Some high-flier Internet acquisitions and, on the other end, underperforming companies sold in distress or bankruptcy.”

Has activity picked up at all?

“The overall M&A market is decidedly slower than the heady days of 2006 and 2007, particularly so for consumer direct marketers,” Solomon says. “The drop in consumer and business spending has stressed the mainstream catalog and multichannel world.”

And that affects M&A. “On the buy-side, strategic buyers are generally less likely to take risks as they, too, are reeling from shrinking sales and profits,” Solomon says.

Meanwhile, financial buyers have plenty of equity to spend, “but they are dealing with struggling portfolio companies themselves and are frustrated by the limited availability and high cost of debt — which is a critical factor in a leveraged buyout.”

What about the sell-side?

“Companies that in better times might consider selling are reluctant to start down the road when their sales and profits are in a trough that they believe is temporary,” Solomon adds. “This is further compounded by anecdotes that multiples are down.”

Even if a seller is willing to accept these realities, actually agreeing on valuation is much tougher in a recession, Solomon says. “If a seller’s financial performance is dropping, a buyer will discount the price because of the uncertainty around earnings, increasing the gap between seller and buyer,” he adds. “It’s not surprising, then, that deal volume is down” or that many transactions involve distressed companies that are being forced to sell — often at deeply discounted valuations.

Traditional retailers will likely continue to struggle

The severity of retail distress is caused by “a combination of high debt levels with the more inflexible cost structure of traditional and multichannel retailers,” Solomon says.

Stores have fixed rent and personnel costs, while catalogs struggle with higher costs of circulation, resulting in financial stress when sales decline. Plus, there have been a large number of total retail liquidations, which is shrinking the store base and accelerating the surprisingly rapid channel shift toward Internet retailing occurring in the U.S., he says.

Meanwhile, Solomon says Internet retailers generally continue to grow and post strong earnings through the recession. Web merchants are in a perfect position “to fill the vacuum left by shrinking store and multichannel retailers,” he adds.

But there are bright spots

Companies that have performed well through the recession and have opted to sell are achieving strong valuations, he says. “M&A deal value for Internet retailers was $3.3 billion in the first half of 2009, up 17% over first half 2008.”

Furthermore, lenders are cautiously re-entering cash-flow lending, and sellers of strong performing companies are taking their companies to market. “Caution remains regarding a soft back-to-school season and the upcoming holiday season,” he says. “Earnings stability will be necessary to allow a return to normalcy in the M&A markets.”