2017 was a perfect storm for "brick and mortar" retailers who officially lost the war with Amazon, and no less than 30 retail chains filed for bankruptcy in a year in which the CEO of Urban Outfitters said the "retail bubble has now burst"...
... bringing the total number of Chapter 11 cases since mid-2015 to 50, accounting for over $20 billion in liabilities.
So is the worst over for retail, or is the sector just now approaching the eye of the hurricane?
According to the latest Moody's research report on the retail sector, the rating agency now forecasts at least six retail & apparel issuers defaulting over the next 12 months, with most of these occurring in the first half of the year.
While the good news is that the industry default rate is expected to peak at 12.43% this March, Moody's cautions that the still-high default forecast for the remainder of 2018 points to more pain before this lower ratings rung in retail stabilizes. Recent defaulters include Tops Markets, which filed for Chapter 11 on February 21, which followed Bon-Ton's filing on February 4. Charlotte Russe and Charming Charlie both defaulted in December, and Claire's has hired restructuring advisors.
Meanwhile, the Toys “R” Us bankruptcy in September its overnight Chapter 7 liquidation has only added to pressures by accentuating potential pressures between vendors and the more stressed retailers, even as it left some 33,000 employees without a job.
The problem is that it only gets worse from there, and the rating agency expects upcoming maturities for distressed issuers will spike in 2019. Defaults are growing as many struggle with high leverage and challenged operating performance. These challenges are compounded by the biggest risk - mounting maturities - which spike in 2019. Overall, issuers in the Caa1 and lower group face $14.9 billion in public and private maturities due 2018 through 2020 as shown in Exhibit 1. The lion's share of these maturities (Exhibit 2) is attributable to just five issuers:
Additionally, while the credit markets have remained open to refinancings, those with more challenged credit profiles and operating performance problems will face growing challenges in tapping the markets, especially in an environment where monetary policy is tightening.
Meanwhile, spooked by the Toys "R" Us fiasco, many others will face the risk of vendors pulling the supply plug in the wake of Toys “R” Us bankruptcy, which was triggered when certain vendors cut the company off. As companies move down the rating scale, the vendor portion of the liquidity profile can become strained as concerns over the strength of the company are magnified. Tighter repayment terms, including the dreaded “cash on delivery” (COD), can have an even more serious impact on liquidity than a looming debt maturity. Without vendors, companies don’t get merchandise, and without merchandise, there are no sales.
So in addition to the above 5, who else is on the list?
Many of the names on Moody's distressed list, and those that have filed for bankruptcy in the past 12 months, are, or rather were, sponsor-owned. It will hardly surprise anyone that many distressed retailers are highly leveraged following sponsor-led LBOs. High leverage has proved problematic for the retail industry due to the industry's inherent cyclicality and operating income challenges post-recession. Such pressures have been vastly aggravated the past 10 years with the rapid rise of online competition, which has severely squeezed profit margins across the board.
The debt loads assumed by many smaller retailers have created an untenable competitive reality: they are financially ill-equipped to deal with the changing retail landscape. They also lack sufficient resources to build out online capability, keep stores fresh, and fend off pricing threats from larger competitors. The successful retail LBO stories, such as Dollar General Corp. (Baa2 stable) and BJS Wholesale Club Inc. (B3 stable), have typically been those that haven't needed to compete online.
The exhibit below lays out the quantitative characteristics of the 20 distressed issuers in Moody's Caa/Ca universe. Putting these metrics into perspective the debt/EBITDA Caa ”range” is 6-8x, with the EBIT/interest “range” 0.5-1x. Debt/EBITDA above 8x results in a Ca score, as does EBIT/interest below 0.5x.
And before we present the full list of upcoming maturities over the next 3 years, virtually none of which will be made, here is Moody's brief discussion on whether the retail situation is improving.
Buoyed by favorable macroeconomic conditions, as well as the potential favorable impact from the US Corporate Tax Law change implemented by Washington in late 2017, we believe retail is improving. However, we continue to believe that a “have/ have nots” phenomenon is accelerating, with the effect akin to a teeter-totter. As the larger, better capitalized retailers continue to grow and prosper, the smaller, highly-leveraged retailers are struggling harder to compete and survive.
There are four key pillars that retailers need to have in place to remain healthy, similar to the stability that the four legs provide for a chair: capital structure, liquidity, capital spending, and competitive position. As we progress down the ratings/credit quality scale, these four “legs” tend to get more distorted in relative “length” to each other. For example, a retailer with high leverage will potentially have problems in all four of these categories, which we explain as follows:
- Capital structure: When leverage remains stubbornly high and operating performance fails to keep pace, the capital structure is significantly weakened over time. Ultimately, the burden of too much debt always wins. A leveraged capital structure has deleterious effects for liquidity, capital investment, and competitive positioning.
- Liquidity: This is the oil that keeps the engine running. An unfriendly or onerous debt maturity schedule makes it difficult to keep the oil flowing, and as we saw with Toys “R” Us, can create enough vendor concern to cause a bankruptcy due to a trade squeeze.
- Capital spending/investment: Without money to invest, stores get tired and therefore become unattractive to shoppers. Websites lose their ability to keep up with competitors and become unattractive to visitors. Supply chains slow down, negatively impacting inventory efficiency.
- Competitive position: Competing with larger, better capitalized retailers is challenging in a static environment. Today’s retail is as volatile as ever driven by the secular shift to e-commerce, making competition the most acute it has ever been. And, in the midst of this, Walmart and Amazon are fighting the battle of the century over market share, using price as a key weapon. Virtually every other retailer runs the risk of being collateral damage in this battle, making flexibility critical, which is an asset most lower rated retailers do not own.
That was Moody's being diplomatic. The real answer, as shown in the table below which lists the full schedule of upcoming debt maturities by retail issuer, is that unfortunately no, for most retailers except a handful of very prominent online names, the situation is not only not improving, but it's never been worse.