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Retail dealmaking: Surviving and thriving in the middle

by contributors Michael Dart, Todd Hooper and Jay Agarwal, Kurt Salmon | Published August 16, 2012 at 1:10 PM

What happened to the middle? Conventional wisdom says that many of the U.S.'s extremely successful retailers cater to either value-focused or luxury consumers. Recent winners include retailers on both ends of the spectrum -- from the rise of the dollar store to the resurgence of luxury retail. And economists suggest that America is becoming increasingly bifurcated, with consumers being lured toward either discount or high-end brackets.

But what about retailers that can cater to both low- and high-income segments, retailers that find themselves squarely in the middle?

A recent stream of deals -- such as Sycamore Partners LLC's purchase of Talbots Inc., Ascena Retail Group Inc.'s acquisition of Charming Shoppes Inc., Golfsmith International Holdings Inc.'s sale to an investor group and the sale of Cost Plus Inc. to Bed Bath & Beyond Inc. -- has signaled that significant opportunity does in fact lie in the middle. Buyers have been paying robust multiples -- between 9 and 11 times Ebitda in 2011 and year-to-date 2012 -- for some of the middle's best-known brands, including the Cost Plus, Charming Shoppes and Golfsmith deals. But other midtier retailers such as Gap Inc., Ann Inc. and Abercrombie & Fitch Co. are trading at attractive valuations -- between 4 and 6 times Ebitda -- which represent a significant discount compared with premium and value retailers trading between 7 and 11 times Ebitda.

Looking beneath the surface, it's easy to see the reason for the renewed interest in the middle. Just think of the potential -- middle retailers cater to most Americans, and they are well-positioned to benefit as the economy improves and lower- and middle-income consumers start to trade up once again. And some middle retailers, such as Target Corp., attract higher-income consumers as well.

Many middle brands have a great history and significant cachet, and with the right strategies and initiatives applied in the private setting, significant growth potential. Middle retailers can also make smart financial sense. They can often have less fashion risk than some of their lower-end counterparts. As a result, they can add a much-needed dose of stability to a firm's cash flow while providing leverage for other purchases.

So how can the middle become less vanilla? We recommend these three strategies to middle-retail management teams and prospective acquirers:

Rediscover the brand's sweet spot. Many midtier brands have considerable history, but are ripe for repositioning to attract new customers. Let's take Express Inc. as one example. After being acquired by Golden Gate Capital, the new leadership repositioned the brand to become more contemporary and fashion-forward, making the product and the stores cool again. This was complemented by increasing the marketing budget to 4% of sales, or $83.2 million, in 2011 -- well beyond what Express' competitors spend. As a result of these changes, the business has been outperforming the industry in recent quarters -- with 10% same-store-sales growth in 2010 and 6% in 2011.

Face omnichannel head-on. Many middle retailers have been sluggish to adapt to a changing retail environment. But in a private setting, they may have greater freedom to make the types of broad changes necessary to survive in an increasingly omnichannel world -- starting with taking a serious look at their store fleet. We believe that many retailers could benefit from closing 25% to 30% of their worst-performing stores and opening new stores amounting to 10% or 15% of their total in better locations.

Gap is a model of this strategy. While the company saw declines in its core U.S. specialty retail business over the past decade, and recently announced the closure of about 20% of its U.S. full-price fleet, it has built a highly profitable $1.5 billion business in the outlet/off-price channel over the past decade. In addition, Gap's $1.3 billion, high-Ebitda-margin Internet business has grown at double-digit rates since its inception. The company has developed significant capabilities in the omnichannel arena, and has been able to launch new businesses such as Piperlime.com, a leading online-only women's apparel retailer.

Leverage shared service opportunities. Combining two or more similar middle retailers in the same portfolio and implementing a shared services platform between them can provide tremendous cost synergy opportunities and drive favorable post-deal economics.

For example, think of the cost-saving opportunities realized by combining some of the back-end functions of Ascena and Charming Shoppes, or Bed Bath & Beyond and Cost Plus. And Wolverine World Wide Inc.'s purchase of Collective Brands Inc.'s performance and lifestyle group means the popular Sperry Top-Sider, Saucony, Stride Rite and Keds brands will benefit from Wolverine's global distribution strength as well as reduced operational costs.

For private equity firms looking for a clear exit strategy for a middle retailer in their portfolio, consider the consolidation opportunity as a selling point for retailers in the same space.

The sheer size of the middle's potential customer base means it's not going away anytime soon. And as recent deal activity has shown, private investors may be best suited to oversee the types of broad strategic changes necessary to ensure long-term success for many middle retailers. For those investors that haven't yet gotten a piece of the middle, there are numerous brands that remain relevant and are trading at attractive multiples. The middle deserves a closer look.

Michael Dart, Todd Hooper and Jay Agarwal are retail strategists in Kurt Salmon's private equity and strategy practice.

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