Monday, September 30, 2013

Rue21: A Deal to Rue

Yield hungry investors have swarmed syndicated leveraged loans this year. It seemed that they were throwing caution to the wind. Anything and everything seemed possible. Then came Rue21-one of the biggest high profile deals to flop in a while. Rue is a rapidly growing value orientated teen apparel fashion retailer. It has added 500 stores over the past years, and is scheduled to reach 1000 stores by year end.

In May, Apax, a UK private equity firm, offered to buy Rue for $1.1B Acquisition with a $62 Mln breakup fee. An affiliated Apax entity already owned 30% of Rue. The offer represented $42 per share- a 23% premium to market, 1.2X sales and 9.2X EBITDA. Comparable multiples were 0.5X sales and 8.4X EBITDA. The premium represented Rue’s rapid growth potential.

Apax would contribute $280 Mln in equity with the balance financed by debt representing a FD/EBITDA multiple over 6X. The debt included a JPMChase, BofA and Goldman $530 Mln syndicated loan. The loan was richly priced at L+ 475 with a 1% LIBOR floor.  During the syndication, Rue announced disappointing sales and earnings due to a “challenging retail environment”. Same store sales fell 9.5% thru 3Q and by 12.8% in September. The syndication struggled, and the agents offered 20-25% discounts without success.  See Syndication.

Some observations:
1)  Aggressive leverage for a rapidly growing firm is always a challenge. Add in fashion retail and the margin for error is razor thin.
2)  The purchase price was rich leading to the need for increased leverage. It only made sense assuming Rue’s growth would continue.
3)  Unexpected performance issues during the syndication are always possible. Nonetheless, I wonder how unexpected this really was. First, simple extrapolation, which appears to be the case here, is dangerous when constructing projections for growth firms. A modest downside case would indicate how problematic the debt service would be if a slowdown occurred.
4)  Basic earnings quality analysis also suggested concern. Earnings are an opinion while cash is a fact. Despite Rue’s growing sales and net income since 2009, their free cash flow peaked in 2011, and fell in FYs 2011 and 2012.  Growth related, rapid CAPEX and inventory increases were part of the problem. This coupled with a performance decline suggests a) Rue must curtail its growth and b) Rue will have difficult time repaying its debt. Loan investors undoubtedly saw this, and declined to participate despite the original rich price and even with the substantial discount -  they would not bite.

Diminished growth means the purchase price and capitalization rationales are no longer valid. Apax should consider renegotiating the deal or walking away after paying the breakup fee. The banks would be happy. Rue’s current shareholders, of course, would be upset, but would still be $62 Mln richer. Discretion is sometimes the better part of valor.


PS - Just over two months until Acquisition Finance in Amsterdam (see side note or click here)

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