COST OF BORROWING MAY IMPACT M&A ACTIVITY
The divide between poorly performing food retailers and those that are in strong financial position will only increase as borrowing becomes more expensive, according to analysts.
The Federal Reserve has kept interest rates near zero for several years, but is now considering increases that would likely translate into higher interest rates paid by retailers borrowing from banks or issuing new debt.
For companies with steady cash flow and good credit ratings, however, banks will continue to issue loans at favorable rates, analysts say. These companies will still be able to grow their businesses at relatively low cost, while those that are struggling will find it increasingly difficult to fund their ongoing operations, much less their growth.
Those conditions could also accelerate the pace of consolidation in the industry, as smaller, struggling food retailers look for better-capitalized retailers to buy them out.
“We have been talking about consolidation for 15 years, but I think we are finally at a point where consolidation is going to increase meaningfully, because if you are a small player, you cannot survive,” says Karen Short, a New York-based managing director at Deutsche Bank Securities. “You can't survive in a world of rising interest rates. You can't survive as it relates to your ability to grow. You can't survive in a land of rising wages, and the pressures will continue to accelerate.
“If you are strong operator and you are a buyer, your interest rates are probably not going to rise significantly, and if they do, they are not going to impact your [earning statement] meaningfully,” she says. “But if you know you need to sell, your bargaining chips are not that meaningful, because the buyers are dwindling.”
KROGER: 'BUYER OF CHOICE'
One recent example of a strong player buying out a weaker, financially challenged operator is Kroger Co.'s pending acquisition of Roundy's for about $800 million.
In this transaction, the high-performing Kroger will absorb the weaker Roundy's and spare that company from potentially going the way of companies like Haggen, Fresh & Easy and A&P, all of which filed bankruptcy this year.
Shortly after the transaction was announced, Moody's said it was reviewing for a possible upgrade of Roundy's corporate family debt rating of B3, a speculative score indicating high risk.
“The review for upgrade is based upon Moody's view that, should the acquisition by Kroger be consummated, Roundy's will become part of an enterprise with a stronger overall credit profile, and hence a potentially higher rating than if Roundy's remains a stand-alone company,” Moody's said in announcing its review.
Kroger, meanwhile, boasts a Moody's credit rating of Baa2-stable, indicating a moderate credit risk.
“Roundy's and Kroger is a very clear example of a 'have' and 'have-not' situation,” says Andrew Wolf, an analyst at BB&T Capital Markets.
“If you are a mediocre company in the supermarket industry, you are either going to go bankrupt, or it is time to sell, and you are going to try to sell while there is still some value to be had,” he says. “I still see it as a buyers' market.”
Kroger said it will fund the Roundy's acquisition with debt, and it plans to refinance Roundy's debt.
“A lot of their synergies will come from taking high-yield debt and switching it for investment-grade debt,” Wolf says.
Roundy's debt includes $445 million in term loans due in 2021 and $200 million of 10.5-percent second-lien notes due in 2020, according to Fitch Ratings.
Fitch said it does not expect Kroger's financial leverage to increase materially as a result of the acquisition. Kroger's net debt-to-EBITDA ratio is projected to remain within management's targeted range of 2.0 to 2.2, Fitch said.
The ratings agency said it views the transaction as neutral to Kroger's credit ratings.
For a company the size of Kroger, picking up the extra $646 million in Roundy's debt was “not a deal-breaker,” Short says. “Either way you look at it, it will be significantly accretive from an interest rate and interest expense perspective, irrespective of what happens to interest rates.”
WEATHERING A RATE RISE
Chuck Cerankosky, an analyst with Northcoast Research, Cleveland, agrees that companies in a strong financial position will be minimally affected by potential rising interest rates.
“We have companies that can access commercial paper and will probably pay 50 basis points, while other ones with more leveraged balance sheets and earnings challenges might be paying 8 percent, so it really is company-specific,” he says.
He notes that Kroger will likely be able to fund out the debt from the Roundy's acquisition at fixed rates “when they see fit.”
“They will be studying the interest rate curve and the debt market as they work toward the close of that acquisition,” Cerankosky says. “But they are a perfect example of a company that can access the commercial paper market, whereas as a company like Albertsons has a much higher marginal cost of borrowing.”
He adds that he believes the potential for rising interest rates will be “a relatively minor factor.”
“The markets have been anticipating this for some time, and for a long time have been looking at the quality of the underlying credit,” he says. “The prospect of the Fed raising interest rates is likely to have little impact on a company's borrowing costs, because the debt markets already are accounting for that.”
Even in an environment of low interest rates, Supervalu—before divesting its Albertsons holdings to Cerberus—had debt that was in excess of 8 percent, Cerankosky points out.
“It was hardly benefitting from a low interest rate,” he says. “It was reflecting Supervalu's poor retail performance at that time.”
“I think we are finally at a point where consolidation is going to increase meaningfully, because if you are a small player, you cannot survive.”
Since that time, Cerankosky notes, Supervalu has shed assets and improved its balance sheet, “and its interest costs have improved accordingly.”
Among the retailers struggling with debt is Fairway Group Holdings, the high-volume New York-based supermarket chain that was forced to ratchet back its aggressive growth pace after some of its newer stores did not perform up to expectations amid increasing competition from the likes of Whole Foods Market.
In November, credit-ratings agency Standard & Poor's cut Fairway's corporate credit rating to CCC-plus, from B-minus, indicating that the debt is vulnerable to nonpayment.
Fairway had secured a $275 million credit agreement with a $40 million revolver in February 2013 and amended it in May of that year, before its operating performance began deteriorating.
COST OF ACQUISITIONS
As the cost of borrowing goes up, it will affect the amount that buyers are willing to pay for supermarket companies that are seeking to sell some or all of their operations, Wolf notes.
“If you are paying more for the capital, then you have to pay less for the asset,” he says.
This could affect private-equity buyers in particular, who tend to finance acquisitions by issuing debt.
“I think the real question is for private equity,” says Short of Deutsche Bank Securities.
For companies seeking buyers, higher interest rates could make them less attractive because of the increasing cost of borrowing.
“It definitely changes the economics,” Short says. “It is obviously known that The Fresh Market is exploring strategic alternatives, so if you are a private equity company, and you are looking at The Fresh Market, you definitely have to consider the fact that there is the potential for a rising interest rate environment.”
The potential for rising interest rates could mean there will be a flurry of acquisition activity in anticipation of the risk of higher borrowing costs, Short says. For companies in play that do not find a buyer before interest rates rise, “it may make those up-in-the-air transactions less doable,” she says.
Among the other transactions pending that could be affected by rising costs of borrowing is Supervalu's reported pursuit of buyers for its Save-A-Lot limited-assortment banner. Supervalu had said in July that it planned to spin off Save-A-Lot as a separate, publicly traded entity, but in late November, a Reuters report indicated that the company had received “several” offers from private equity firms.
While Short notes that the potential for increased costs of borrowing needs to be contemplated and incorporated into any acquisition decisions, higher costs of borrowing won't necessarily affect whether or not the deals actually get done—it's more a matter of the terms of these deals.
“Nothing would change the trajectory of any decisions that are being made, unless you are a private-equity company and you are looking at transactions that you want to fund with debt,” she says. “Those would be the ones that are most at risk.”
Short notes that as companies seek to divest assets, the number of available bidders is also limited by geography. In the Northeast, for example, Kroger is unlikely to make a bid for any assets that become available through consolidation.
In most geographic areas, there are a limited number of strong strategic buyers capable of bidding for available banners or locations.
“You don't really have a feeding frenzy of bidders for assets,” says Short. “So I think the environment is set up for the strong to continue to get stronger, and to be selective in what they bid for.”