On Monday, it was hard to miss those eye-popping numbers for the Dollar General
The announcement excited the market (as large deals tend to do), driving Dollar General's stock to a close of $21.07, up more than 25% from Friday. It also spawned a slew of articles, mostly about whether the deal is a bargain, how this year is shaping up compared with mergers and acquisitions activity in previous years, and who might be the next target.
What I didn't see, and what I believe Motley Fool readers deserve, is a well-reasoned discussion of why certain retail companies are handing themselves over to the less-than-tender embrace of private equity firms in deals like this, and why this is good for the companies and their investors.
It's the economy, stupid!
One is tempted to paraphrase that famous line from a presidential campaign back in the mid '90s to explain private equity deals like this one -- "It's the money, stupid!" Now that's partially correct, because KKR clearly believes it can extract value from Dollar General that isn't priced into the stock now. But I think there's a more profound reason for this type of deal that is better described as ...
It's the market, stupid!
Why? Because the market can't see beyond the next quarter's earnings forecast. Once a retail company gets to a certain size, it becomes easier to lose its way. The pressure to grow sales means building new stores at an ever- increasing pace. The pressure to grow earnings leaves an ever-diminishing margin for error. Once a retailer gets in a hole, particularly with real estate and inventory problems, it can be very expensive and time-consuming to dig its way out. The market simply doesn't have the patience to wait. Voila ... enter the private equity firm.
Dissecting Dollar General
The company has been in business since 1955, operating out of modestly sized storefronts to sell merchandise (largely consumables) at rock-bottom prices to customers with modest incomes. It has grown to more than 8,000 stores with more than $8 billion in annual sales, with more than half that growth coming in the past seven years. It's a highly recognizable brand, operating in a large and growing market, with a loyal customer base. Same-store sales have been slowing in recent years, at just about 2% for fiscal 2005 and the first nine months of 2006, but are still positive.
So what went wrong? The most recent 10-Q filed with the SEC in October tells the story. In Dollar General's third quarter of fiscal 2006, it recorded a net loss of $5 million, yielding earnings of $88 million for nine months compared with $205 million the prior year. The culprits for this large decline in earnings are real estate and inventory.
On the real estate side, the company took about $15 million of writedowns in the third quarter for impairment of assets, with an estimated $58 million more to come in fiscal 2007. Dollar General acknowledged the need to close 400 stores (about 5% of the total), and cut the new store growth rate about in half for 2007 and 2008 until there's a more effective real estate strategy. Not good for investors who have an expected future growth rate built into the stock price.
The inventory side is much more troubling. Not only did the company take a third-quarter writedown of $63 million as a below-cost inventory adjustment, but it explained that it had around $300 million of inventory (at cost) that needed to be liquidated, which would result in significantly higher markdowns in the fourth quarter and throughout fiscal 2007 (emphasis added). More specifically, Dollar General said it expects higher than usual inventory markdowns to depress gross profit levels to about 27% for 2007. Compare this with 29% plus gross margins back in 2004 and 2005.
The inventory problem resulted from "packaway" strategies, i.e., the company has been taking merchandise that doesn't sell and packing it away in the hopes of selling it sometime in the future. It realized this isn't working; the stuff isn't selling. It's clogging up its stores and distribution network, and limiting its ability to buy new stuff that will sell. The old stuff represents about 18% of Dollar General's total inventory. It will take the rest of this year, and a good deal of next year, to get rid of it. On total sales next year of about $9 billion, it will cost about $150 million to $200 million of gross profit to sell the old stuff. Management also anticipates higher store labor, advertising, and other costs to clean up the problem. If you think I'm being unduly harsh, go back and read Dollar General's 10-Q from Nov. 3, 2006, pages 26 through 29.
Inventory problems revisited
This isn't an unusual situation for a retailer. Consider the deal a year ago in which Apollo Management took Linens 'n Things private. That deal closed during the first quarter of 2006. For the second quarter, Linens 'n Things reported adjusted EBITDA of negative $14.6 million compared with positive $16.6 million in the year-before quarter, a significant decline. The company said, "We also used this time frame to clear nonproductive merchandise, which while resulting in increased markdowns, did create open to buy dollars and helped to improve store operations." There's basically the same problem at Dollar General: not taking enough markdowns to clear old inventory, resulting in too much old stuff taking up space on shelves that should be filled with new stuff. Linens 'n Things no longer has public equity, but its debt is public, so you can find quarterly financial releases detailing this problem on its website.
The silver lining
Now before you say to yourself, "What a mess, I'm getting out of my retail stocks, pronto," consider that dark clouds can often have silver linings. I see two of these notable missteps by highly recognizable retail companies.
The first silver lining I put in the "Hooray for the board" category. The boards recognized that there was a significant problem. The board's responsibility is to protect the interest of shareholders. Dollar General's and Linens 'n Things' stocks were noticeably underperforming. Clearly, it was going to take a while to fix the problems, and board members couldn't expect the share prices to recover anytime soon. What better way to protect shareholder interests than to find a private equity firm that was willing to give the holders an immediate premium to the stock price? That's the way it's supposed to work. I find it particularly appealing that the boards of both companies were willing to give up their seats for the good of the shareholders.
The second silver lining goes back to the short-term focus of the market, because it is going to take a while for these two companies to fix their inventory and merchandising problems. By going private, they get out of the quarterly spotlight and get some breathing space. Both companies have strong brands built up over many years. I, for one, would like to see those brands emerge as stronger, more efficient companies. The private equity route gives them that chance. And if KKR and Apollo make a bunch of money in the process for their shareholders, I say they've earned it.
What companies might be next? I'm cautious about this type of speculation. Why buy a lagging company when there are great ones to choose instead? That said, the financial press has said there are rumors that BJ's
To read more about private equity buyouts, see:
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Fool contributor Timothy M. Otte surveys the retail scene from Dallas. He has been known to snap up some bargains from time to time (both inventory and investments), but he doesn't own stock in any of the companies mentioned in this article. The Motley Fool has a disclosure policy.
