Sector Spotlight: Loan issuance backing retail M&A roars back

Leveraged loan issuance funding buyout and M&A deals to the long-challenged U.S. retail sector has surged to a six-year high, coming a close second only to the record-setting pace of 2015. The $14.2 billion of loans backing such deal-making to retailers already exceeds the past four years combined, highlighting just how much the market has opened to consumer-related industries as lenders — flush with cash and seeking yield — survey a broader spectrum of credits to back.

According to LCD, the $14.2 billion of U.S institutional loans backing retail M&A is just $1.4 billion behind the comparable period of 2015 and $3.15 billion shy of the full-year record.

This rise in deal financing pushed the retail share of M&A and LBO loan issuance to 5.5%, a six-year high.

Adding high-yield debt to the financing totals, volume across institutional loans and bonds backing retail M&A-related activity is just $1.5 billion shy of the $22.46 billion record set in 2015.

The retail revival, however, follows a long and tumultuous ride for the industry. A significant share of the loan debt that had been issued by retailers for M&A-related activity in the record-setting 2015 had fallen into distressed territory long before the COVID-19 pandemic took hold. Moreover, nearly two-thirds of issuers ultimately engaged either in a restructuring or distressed exchange, engineered a highly contentious balance sheet maneuver, or filed for Chapter 11.

In more recent times, foot traffic remains a significant challenge for the brick-and-mortar stores, while supply chain disruptions and inflation could continue to hit sales and eat into profits.

Before taking stock of this new vintage of deals, for this analysis, LCD will drill down to the retail sector performance as measured by the S&P/LSTA Leveraged Loan Index.

Returns

Since the 2015 record year for retail M&A loan issuance, the sector has underperformed the broader loan index in four out of the six annual readings, including in 2021 thus far. During the so-called "retail apocalypse" of 2017, when defaults from the sector began to spike, retail loans lost 1.72% in contrast to the broader index, which returned 4.12%.

Retail is now a relatively smaller component of the index, at 3.16% as of September, meaning it could be more susceptible to outsized moves at the sector level. At the end of 2015, the sector made up 5.39% of all index loans. By comparison, healthcare credits account for 9.76% of the index, while electronics (LCD's proxy for technology) comprise 15.49%.

Pricing

The below chart paints clearly the bifurcation in the pricing of retail loans to the broader index. In late 2017, the differential between retail, excluding food and drug, and the broader index widened to over a thousand basis points.

The next big hit came, unsurprisingly, with the pandemic lockdowns. Per LCD's data, the differential between retail and the broader sector ballooned even further, to over 1,400 basis points in May 2020 during the market recovery that followed the near-indiscriminate selloff in March 2020, as investors looked to reward the more COVID-19 resilient sectors.

Distress and defaults

The retail sector has also endured a higher share of defaults. In the five-year period ending Sept. 30, the lagging 12-month default rate (by amount) of the retail sector averaged 6.69%, versus 1.97% in the broader index. The retail default cycle peak of 14.64%, reached in April, is more than 10 full percentage points higher than the 4.17% loan default cycle peak of September 2020 for the overall index.

As a forerunner to default activity, retail has also maintained an outsized ratio of distressed loans. In the five-year period through Sept. 30, the sector-level distress ratio for retail averaged 13.2%, versus 3.6% in for the leveraged loan index. The pandemic peak, at 52.5%, compares to 24.3% in the broader index at the March 2020 month-end reading.

Speaking of defaults, recoveries on retail loans — again, excluding food and drug — are relatively weak, according to S&P Global's LossStats database.

Historically, recoveries on all debt backing retail have averaged 54.9%, versus 59.2% for all sectors. For term loans, retail has recovered 69.6% historically, versus 72.8% across all sectors.

And now?

For the 2021 crop of retail M&A and LBO loans, deals are clearing at higher leverage multiples, and ratings quality has deteriorated. Both trends, though, are in line with the broader market. Loan sizes, however, are smaller on average, and the nature of companies coming to market suggests credit selection is tilted toward less discretionary, or more pandemic-resilient, businesses.

Starting with leverage: In 2015, M&A and LBO deals backing retailers carried leverage of 4.24x on average; in 2021, total leverage averages 4.89x.

Meanwhile, the average size of institutional term loans backing M&A-related activity in 2021 is $590 million, versus $814 million in 2015.

Looking at credit ratings, 55% of the 2021 institutional deals by volume backing M&A-related retail deals are rated B by S&P Global Ratings at the corporate level, and 36% carry a B-minus rating. Only 6% carry BB ratings.

In 2015, the retail M&A ratings quality mix was higher, with 41% rated B+ and 33% rated BB. Less than 10% were rated B or B-.

Across all institutional M&A-related loans in 2021, 35% are rated B, 33% are rated B- and 8% are rated B+. Just over 22% carry BB+, BB or BB-minus corporate credit ratings at S&P Global Ratings. In 2015, 37% of M&A-related institutional loans were rated BB+, BB or BB-minus. Only 4% were rated B-minus in 2015, versus 33% today.

Retail wave?

Digging deeper to individual credit stories of the 2021 crop of deals, the single-B businesses are either less consumer-discretionary by nature — such as retail gas stations, tire recycling services and pet supply stores — or are more insulated from COVID-19 impacts, such as those that focus on outdoor pursuits, home décor and interior design, medical and school uniform apparel, educational products, and photo printing.

S&P Global Ratings credit analyst Daniel O'Loughlin noted that the Germany-based sandal maker Birkenstock brand, for example, benefits from relatively lower fashion-led volatility.

"We believe the footwear industry will remain supported by positive industry factors, such as casualization, premiumization, sustainability and wellness trends. ... [W]e expect a more challenging environment for formal shoes, while sport and casual shoes could enjoy some long-term benefits also supported by the shift to working from home," O'Loughlin writes.

Brick-and-mortar retailer The Michaels Companies Inc., meanwhile, has experienced "strong demand and a double-digit increase in comparable sales as consumers sought different forms of at-home entertainment," according to S&P Global Ratings analyst Pasha Azadmard.

As for pricing, despite higher leverage levels and lower ratings, today's M&A-related retail deals offer less compensation, with an average yield-to-maturity of 5.04% at issuance, versus 6.09% in 2015.

Into the unknown

While the rebound in retail M&A is encouraging, labor and supply chain problems and COVID-19 variants create additional uncertainty for the industry, as reflected in September's U.S. Consumer Confidence Index.

The key indicator into purchasing attitudes among U.S. consumers fell to a seven-month low at 109.3 in September, from 115.2 in August, the third straight monthly decline, according to The Conference Board survey.

The research firm cited the spread of the delta variant, deepening concerns about the state of the economy and short-term growth prospects, as well inflation concerns in dampening optimism.

Consumer confidence is still high by historical levels, but the Index has now fallen 19.6 points from the recent peak of 128.9 reached in June, per the Conference Board. The recent declines suggest consumers have grown more cautious and are likely to curtail spending going forward, according to the research group.

Away from sentiment indicators, consumers spent at a much faster pace than expected in September, though Americans focused more on buying tangible goods than experiences as the delta variant continued to influence where money was being spent.

Sales at retail stores, restaurants and online sellers rose a seasonally adjusted 0.7% in September from the previous month, the U.S. Commerce Department said Oct. 15.

Breaking this down, sales at restaurants and bars were virtually flat from the previous month, while online sales rose at a far bigger clip in absolute terms than clothing stores.

Meanwhile, inflationary pressures, supply chain constraints, and the potential reversal of recent consumer activity could dampen the recent momentum.

Throughout much of the past decade, retail companies have focused on reducing inventories through strategies like just-in-time sourcing, and supply chain disruptions could impact the bottom line more acutely as a result.

According to Panjiva, a global trade data company and business line of S&P Global Market Intelligence, fourth-quarter imports are on pace to beat the record-setting levels of 2020, and if companies did not adapt their purchasing strategies in the third quarter, they may face heavy delays at congested ports.

These high-demand conditions are likely to lead to inflation, and executive mentions of that topic in third-quarter earnings calls increased 74% year over year, according to Panjiva.

See "Q4'21 Outlook: The logistics of seasonal cheer" and "September shows slower import growth; holiday trends emerge" for further coverage.

Indeed, it is indisputable that inflation has arrived, at least for now, with the 12-month change in the consumer price index coming in higher than 5% every month since May.

Looking ahead, per LCD's quarterly survey of buy-side, sell-side and advisory professionals, a higher share, or 12%, now see U.S. headline inflation exceeding 4% one year from now, up from 6% of professionals expecting to see a 4% inflation figure in the second-quarter reading.

Only 4% of respondents expect inflation to be 1.9% or lower.

Put another way, 96% believe inflation will be at or above the Fed's policy target of a 2% average, and arguably, not transitory.

In closing, with smaller cushions to absorb cost increases and the impact on profits, speculative-grade retailers are more at risk from inflation and supply-chain disruptions.

U.S. households are flush with cash, to the tune of $2.5 trillion on aggregate, but as S&P Global's U.S. Chief Economist Beth Ann Bovino points out, supply disruptions could limit their ability to spend.

Ultimately, the upswing in M&A from the retail sector is notable, but there is a clear focus on credit selection tilted to less consumer-discretionary companies and to COVID-19 resilient companies among the speculative-rated issuers.