KKR Knows the Value of a Dollar Store
Kohlberg Kravis Roberts & Co. (KKR) is in the dollar store business. The firm, it was announced yesterday, is the new owner of Dollar General after paying $6.9 billion to take the company private.
Dollar General has struggled in recent years as rising energy costs and other financial challenges have hurt the chain’s core low-income consumer base. Last November, Dollar General announced it would slow the pace of new store openings while closing 400 outlets. At the time, the company said it would dedicate more of its capital outlays to remodeling or relocating existing stores. The expectation now is that KKR will increase the pace of store closings.
"Going private gives them a year or two to rebuild their business and invest more aggressively to expand without Wall Street pressure,’ Burt P. Flickinger III, managing director of Strategic Resource Group, told Bloomberg.
KKR has been very busy in attempts to pick up other retail properties. Yesterday, Alliance Boots, the largest drugstore chain in the U.K., said it had rejected an $18.8 billion offer from KKR.
Separately, KKR is reported to be joining a group including Bain Capital in an attempt to buy the Australian retailer Coles Group. KKR has made a number of bids, all rejected, for Coles over the past year.
Discussion Questions: What explains the high degree of interest that private equity firms have had in recent years when it comes to retailers? What is your reaction to this deal and what it will mean for Dollar General and its customers?
By taking the company private, KKR can aggressively make changes without the pressures of Wall Street and shareholder expectations. It also allows KKR to move forward with store closings and realignments on a faster timeline.
KKR has been very successful in taking under-performing retailers and making aggressive changes in cost alignment and appropriate reinvestments in facilities and merchandising.
The interest is driven by a ton of hidden value, that which the Street has been missing along with the leadership at some of these companies. Wall Street has been busy portending the coming downfall of the consumer, while some retail managers fail to innovate fast enough or simply cannot afford to do so. This is a natural fit for KKR, DG is a sleeping giant with huge store scale aimed at consumers seeking value. Seems like a good play.
Retail, in general, when managed by veteran retailers, frustrates Wall Street. Specialty retail is almost impossible to forecast, particularly when fashion or trend adoption are key variables. It seems as if a solid business concept is not enough…high flying chains of today are closing stores and struggling tomorrow. Mainstream retail simply has performed as a mature, uninspired industry would be expected to. Earnings forecasts are scrutinized intensively, and even a single penny variance can cause significant stock volatility.
When a company like KKR takes a retail chain private, the Street has a pretty good handle on the next set of actions, and the probable impact on financials. As a short term, turn around, financial statement improvement play…retailers are easy pickings. Profits can be had, and all the variables traders are looking for can occur. Once all that has been accomplished, and the retailer must now operate with consistency…it’s an entirely new story.
KKR, of course, has a long history of success with acquisitions of mass retailers. They, along with Yucaipa, know when to get in and when to get out. KKR’s recent moves clearly signal the culmination of months of analysis. The major “secret,” if you will, is the management of the tremendous cash flow KKR is purchasing. And make no mistake about it, that’s what they’re purchasing. This is an especially valuable resource in a privately-held company, particularly one that manages vast monetary resources in a variety of currencies.
During this unprecedented retail buy-o-rama, I’ve seen tremendous opportunities emerge for truly qualified vendors and formerly under-appreciated vendor staff members (artists and product development pros). New ownership means fresh ideas, no sacred vendor cows and the pursuit of sorely-needed upgrades in management and buying talent (Toys R Us anyone?)
KKR’s simultaneous pursuit of three $multi-billion retail deals around the globe reveals its point of view, if nothing else. Clearly there’s a ton of cash out there looking for rapid returns, and chain retailers fit the LBO target profile, due to their underlying tangible assets and cash flows. Ironically, the more distressed the retail brand, the more attractive it may seem as a target, since the perception may be that a profit turnaround or other transactional maneuver is possible.
All this is exciting news for the capitalists, since profits are earned on the velocity of money. Shoppers may not see many benefits, however, unless part of the turnaround formula includes store renovations. This is likely to be low on an acquirer’s to do list, since the usual goals following an LBO are to reduce costs and apply cash flows to debt service.
Investors look at the viability of higher returns and reduced capital expenditures. Many companies, especially if they have had the same leadership for a while, have much fat to trim.
In the Dollar General situation, this is an inflation-proof retailer. When times get hard and the consumer needs to trim dollars off their budget, they shop at more bargain stores. The philosophy of putting stores in a saturation of population that has no other place to go for the essentials has worked well for them. Dollar General has a tremendous amount of potential for profits and without Wall Street telling them how to preform, they will do well.
From the perspective of Wall Street, be it Private Equity, Buyout firms or Hedge-funds, the math is simple–the retail sector represents a mature industry that is cost and debt heavy, with more or less predictable cash-flows. Of course solid assets that retailers have, like real estate, help offset the risk factor. “Growth secondary, efficiency primary” seems to be their motto, as evidenced by the fact that Sears stock was one of the best performers in spite of declining revenues, as Eddie Lampert refused to slash prices to increase sales. If costs and debt can be reduced, it will inevitably affect equity prices, as free cash flow, and hence earnings improve.
The interest here reflects a simple equation of determining the value of a retailer from their held assets and real estate, rather than just the growth of their retail sales. This is what made Kmart boom and the other current acquisitions (like SuperValu) in the retail sector look good. KKR is not looking to run the business better, so much as realize a decrease in costs and an increase in attributable value. This can be easily done by closing poor performing (read money-losing) stores and minimizing offerings in their best performing stores to just the products that have both high-velocity and high margins. By taking the company private, the investors have several years to do this before going public again, and increasing the apparent value of the organization. This is a tried and true method in many types of acquisitions, and makes sense in almost any type of retail environment.
Again, part of the trend that sees American companies as financial instruments rather than businesses.
The private-equity market is awash in cash and looking for ways to grow it, fast, away from the prying eyes of the SEC and Wall Street. And as our colleagues have pointed out above, retail has long been as much about real estate as about customers, products and services.
Assuming that the efficiencies they impose on their portfolio companies depresses some segments of the commercial real-estate market for a year or two, I suppose the bet they’re making is that they then come back afterward to pick up the pieces at bargain prices.
Just sayin’.
From Integrated Retailing:
Private-equity firms have tens of billions of dollars in funds to spend on acquiring companies, turning them around, and taking them public again. They are looking for public companies with undervalued multiples, stable and strong cash-flow generation, low debt levels, and opportunities for operational improvement and margin expansion. That spells retail.
Part of what’s happening here is that the public markets are not fully valuating the cash-flow potential of retailers. There is also the fact that the investment community perceives many retailers as capable of much better financial performance, but needing and ready for rigorous management discipline. (We can hear the groans now: “These guys don’t know retail!”)
Among retailers said to be “in play” are Foot Locker, Aeropostale, Ross Stores, Abercrombie & Fitch, Advance Auto Parts, Build-a-Bear Workshop, RadioShack, Circuit City, Hot Topic, Pacific Sunwear, Bombay Company, Mothers Work, Smart & Final, Yankee Candle, Gap, and BJ’s Wholesale Club.
In retail there is always lots of fat to trim, loads of real estate, and cash flow. You don’t have to be good at it to make a profit. Sears/Kmart is a good example. Going private means no shareholders to worry about. Private Equity firms seems to be able to do what the previous management could not; such as close down underperforming stores by the bushel, fire employees and redirect cash into investors pockets. Other times they see that if the right people were in charge, operations and profits could improve.
KKR can make money from the Dollar General acquisition at least 4 ways: (1)flip the ownership at a higher price/earnings ratio when the category gains favor (2) use the depreciation to shelter taxes, without making major new capital investments (3) increase the inventory turn to reduce net investment and (4) merge Dollar General with Family Dollar and Dollar Tree and maybe Big Lots to reduce competition. Any of these 3 strategies is easy to describe, but owning Dollar General is no guarantee of financial success. Billions have been lost by owners of other retail companies. The Sears Holdings’ model for success isn’t easy to execute.