S&P: Private equity-backed retailers in trouble

As the US retail sector struggles after a bleak holiday season, three private equity-backed retail companies are at risk of defaulting on their debt.

Loehmann’s Holdings, backed by Istithmar World, Oak Hill Capital Partners-owned Duane Reade and Oriental Trading Company, a Carlyle portfolio company, are all rated as a default risk in Standard & Poor’s latest retail industry report card.

This year will be another tough one for retail companies, especially those that were acquired in leveraged buyouts, S&P said.

“The 2009 outlook for US retail ratings indicates another year of heavy downward pressure,” S&P said. “One characteristic of [retail] is that 78 percent of the issuers that we rate are below investment grade. Many of these are the result of LBOs in prior years.

“With the economy in recession and consumers in turmoil due to sharp declines in discretionary incomes and rising unemployment, we see “stay-away-from-stores” behavior continuing well into 2009,” the agency added. “Our rating outlooks indicate that 37 percent of retail ratings are in jeopardy, while only 7 percent have upgrade prospects. We also note that 29 percent of the 150 ratings are considered to be close to default.” 

Several private equity-backed retailers fell into bankruptcy in 2008, including Apollo Global Management-backed Linens ‘n Things, a houseware retailer, and Sun Capital-backed department store Mervyns. 

Loehmann’s, an apparel chain, will continue to show weak performance in the near-term, the report said. “Liquidity remains weak, as the company continues to fund operating losses with additional debt”, the report said. Istithmar bought Loehmann’s in 2006 from venture firm Arcapital for $300 million.

Duane Reade’s cash protection measures are “very weak”, S&P said, and liquidity is limited. “Competition could pressure operating performance and stall a turnaround. Given its concentration in the New York metropolitan area, a downturn in the region’s economy could hurt operating performance”, the ratings agency said.

Still, the pharmacy operator has had several quarters of improved sales and profits trends, the agency said. Oak Hill purchased Duane Reade in 2004 for $750 million.

Duane Reade said it has been achieving steady sales, margins, working capital management and EBITDA performances since its turnaround efforts began in 2005. Also, the company has no debt maturities before the second half of 2010, $70 million of borrowings available and the “strong support of Oak Hill Capital Partners …who, along with its co-investors, have approximately $280 million of equity and capital invested in the business”.

Oriental Trading, which Carlyle bought in 2006 for about $1 billion, is a maker of party supplies, novelties, toys and children’s arts and crafts. The company’s weak operating trends continued through the second quarter of 2008, revenues decreased by 4.2 percent and operating margin narrowed to 13.7 percent from 14.9 percent in 2007. The company’s leverage increased to 8.5 times from 7.6 times.

The company is in danger of violating its leverage covenant, which becomes more restrictive starting at the end of 2008, S&P said. 

Carlyle did not return calls for comment. Istithmar could not be reached by press time.