Gap and Home Depot prime candidates as recapitalization pitches from investment bankers to retailers increase - analysis17 January 2007

Recapitalization discussions in the apparel and retail sectors are accelerating along with the evaluation of other options, an industry banker said.
Recapitalization is one of the top-five ideas being presented in meetings with retail and apparel clients, said the banker. Gap and Home Depot, along with a number of other major retailers, are being pitched recapitalization ideas, said the banker.
Shareholders are telling these companies to “keep up what you are doing but do it more aggressively,” added the banker, referring to share buybacks and dividends.
Recapitalization discussions are occurring because the debt markets, whether bond or leveraged loans, are very vibrant, said Joseph Stein, Managing Director at Peter J Solomon Company. Investment bankers are presenting recapitalization ideas because these companies are overcapitalized and the market is willing to finance them, Stein added.
Retail companies need to better optimize their capital structure, the banker noted. Management at the largest apparel and retail operators are coming to the realization that their businesses possess more and more characteristics of the consumer products industry — absolute slower growth, more mature markets, less cyclical businesses and underleveraged balance sheets, explained the banker. Therefore, companies need to more actively manage their balance sheets to maximize returns for shareholders, he added.
The record number of buybacks and dividend increases are examples that management attitudes in this sector are changing, the banker noted. Apparel and retailer operators are now attempting to catch up to consumer companies in their approach to managing their balance sheets, he added.
Home Depot, within the last 45 days, repurchased USD 4bn of stock after issuing USD 3bn of new debt, said the banker. Home Depot management believes it is underleveraged so it took on some additional debt to partially finance its share repurchase, he explained. Stein added that this could be a first step in process which could lead to larger debt offerings in the future. The Home Depot debt offering and share repurchase was certainly not overly aggressive, he added.
“Limited Brands is a great example” of management understanding the changing dynamics of the industry, said the banker. In 2004, Limited paid a special dividend, did a tender offer for its stock and was willing to have its credit rating drop to complete a sizable recapitalization, he explained.
Home Depot took a credit ratings hit on its debt issuance to buy back stock, but had “full knowledge” of the downgrade prior to the offering since it discussed the debt offering with credit rating agencies prior to the offering, said Stein. S&P dropped Home Depot’s credit rating to A+ from AA.
Currently, companies are taking a balanced approached to evaluating the amount they are willing to borrow to complete a recapitalization, noted Stein. Management is evaluating re-investing in their businesses, making strategic acquisitions and recapitalizing their balance sheet, he added. Companies are remaining conservative to date, he claimed.
Both bankers noted there has been a lot activity in the mid-cap area with Michaels Stores, Burlington Coat Factory, Neiman Marcus and OSI Restaurant Partners (Outback Steakhouse) either being taken private or exploring the option. However, recently, the focus has shifted to larger cap companies like Gap and Home Depot. Activity will continue because the capital markets are supporting these transactions, said Stein. Historically, there have been times when the market did not have the resources to fund these recaps, he added.
On 8 January, this news service reported that Gap, the listed San Francisco-based apparel retailer, had been presented various strategic ideas by Goldman Sachs as early as June 2006.
This news follows increased shareholder activism at Home Depot in late 2005 and the resignation of Bob Nardelli on 2 January.
Both Gap and Home Depot are prodigious generators of free cash flow, have conservative capital structures but have suffered from poor same-store sales performance during the past year.
Shareholder activism has been accelerating as these stocks have underperformed the market.

by Ed Mullane

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