Retail's next M&A targets

An overcapacity of stores is shrinking retail sales, and fueling acquisition activity and private equity buyouts.

By Parija B. Kavilanz, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) -- America's bloated retail landscape is about to shrink some more.

Over the past two years, the U.S. retail industry, burdened by too many stores and slowing sales and profit growth, has seen a frenzy of M&A activity as well as billion dollar leveraged buyouts by cash-rich private equity firms.

And analysts say that it's not over yet.

On Monday, low-price chain Dollar General (Charts) announced it had agreed to be acquired by private equity firm Kohlberg Kravis Roberts & Co. L.P. in a deal valued at $7.3 billion, including debt.

Also recently, private equity consortiums have snapped up Michael's Stores for $6 billion in June, acquired PetCo in July for $1.8 billion, and purchased Yankee Candle for $1.6 billion in October.

Industry experts expect a rush of more deals in the coming months, and they warn that no retailer is immune from becoming a potential target.

Bigger doesn't mean better

That's in part because there are just too many stores. According to the International Council of Shopping Centers (ICSC), there are nearly 50,000 shopping centers in the United States.

That's more than 20 square feet of retail space for every American shopper, said Kevin Regan, senior managing director with FTI Consulting, which advises clients on corporate finance and restructuring.

"It's far more selling space than in any other country. The closest is Canada, with 13 square feet per per shopper," he said.

But as long as Wall Street craves profits and consumers keep shopping, retailers will continue to push growth, even if each new store erodes sales and profitability at their older stores.

Case in point: Wal-Mart.

Wal-Mart, (Charts) the world's largest retailer, already operates close to 4,000 Wal-Mart supercenters, discount stores, neighborhood markets and Sam's Club warehouse stores in the United States. In 2007, it plans to open as many as 330 new stores.

At the same time, there's clear evidence that as Wal-Mart pushes growth, its new stores are eating into sales at existing stores. Indeed, Wal-Mart's sales at stores open at least a year have slowed considerably, to grow between 1 and 3 percent on average over the last three years, down from more than 5 percent historically.

Meanwhile, consumer spending has held up, thanks to a stable jobs market and income growth. In fact, according to a "2007 Global Powers of Retailing" report from Deloitte Touche Tohmatsu, consumers spent a whopping $3.01 trillion last year at the top 250 global retailers, up 6 percent from 2005.

FTI Consulting's Regan said he's confident that there will be more buyouts ahead, citing recent store closing announcements. Last month, for instance, Gap Inc. said (Charts) it will shutter all 19 of its Forth & Towne stores that cater to older women.

"This suggests that a struggling retailer may be positioning itself to be attractive to buyers," he said.

Deals ahead

In 2006, LBOs accounted for 31 percent of all U.S. merger and acquisition volume, according to Citibank. And private equity and hedge funds are especially interested in retail opportunities, given the success they've had with Toys R Us and Mervyns.

Experts say retailers are attractive targets because they generally tend to be cash flow positive, with little debt on the balance sheet, and own their real estate.

In recent months, buyout speculation has swirled around Gap, Home Depot (Charts), BJs Wholesale Club and Borders.

Citigroup analyst Kimberly Greenberger picked struggling Goth and music-inspired clothing chain Hot Topic (Charts) as an attractive LBO candidate.

"It has relatively inexpensive valuation and low debt levels," she wrote in a wrote to clients last month.

In the same note, Citigroup analyst Bill Sims wrote that Build-A-Bear (Charts) was his pick for a takeover. "In addition to its attractive valuation, Build-A-Bear has no long-term debt and generates stable cash flow," Sims said.

"We expect Build-A-Bear's free cash flow per share to increase steadily over the next three years to $53 million in 2008 from $36 million in 2006," he said. "However, Build-A-Bear's recent bout of negative [comparable] growth likely makes private equity a bit nervous."

Love Goel, CEO of Growth Ventures, an investment firm focused on retailers, said he's confident that both the size and volume of private equity deals in retail will pick up.

"Retailing is a $4 trillion industry. There's lots of potential to mine for companies," he said.

The ongoing shakeout, he predicts, will also benefit consumers. "Private equity firms succeed if they can improve retailers' sales and profitability. So at the end of the day, the deals only work if retailers are able to win over consumers and not just Wall Street," Goel said.

-- Analysts quoted in this story do not personally own shares of the retailers mentioned in this story and their firms do not have an investment banking relationship with those companies.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.