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Moody’s: Retail Distress Reaching Recession Level

News of store closures has almost become the new normal. 100 doors here. 68 doors there. Plus, the bankruptcy of the week.

But Moody’s Investor Services says there’s nothing normal about it—unless your point of reference is the 2008-09 recession. Because that’s the last time the percent of retailers and apparel companies in distress rose this high.

“Moody’s-rated US retailers rated Caa or Ca today make up just over 13% of our total rated retail portfolio, which is the highest level since the Great Recession, when this group comprised 16% of the portfolio,” said Moody’s Vice President Charlie O’Shea. “And the increase comes at the same time as the broader universe of Caa rated companies is likewise growing.”

And the worst part is this number is poised to go higher considering the amount of retailers carrying tons of debt, a result, Moody’s says, of a period of prolonged low interest rates. “During such cycles, sponsor activity typically heats up, fueled by strong investor appetite for yield, with cheap money serving as a ‘dinner bell’ for feasting on target companies,” the report says. “During such cycles, sponsor activity typically heats up and investors chase yield.”

The company lists Claire’s, J.Crew, Tops and Rue 21 among chains that have high levels of debt to fund acquisitions.

And, every debt comes due. Moody’s says the 19 companies on the lowest tier have a combined debt of $5 billion. Forty percent of which is due by the close of 2018, with a spike in 2019.

During earnings call after earnings call, retail executives have lamented the challenging retail environment and the promotional atmosphere. Well, if Moody’s is correct, it’s only going to get worse. The company says when retailers are hurting the most, they reach for quick fixes, which too often come in the form of deep discounts. That in turn has a negative effect on the whole industry—as we’ve seen. And if they ultimately have to liquidate, that only drives overall prices further south.

Of companies in this tier, there’s more potential for defaults as well because they typically have fewer options for funding maturities than healthy companies do.

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To spot the companies with the most precarious potential for tumbling to Caa/Ca level, Moody’s says you only need to look at five metrics: stressed liquidity, weak quantitative credit profiles, challenged competitive positions, sponsor ownership and erratic management structure.

Chief among these factors is liquidity. Lack of liquidity when debt matures can alone create a default, no matter the retailer’s health otherwise. For this reason, Moody’s advises companies to refinance before the situation becomes dire.

Weak quantitative profiles mean the retailer has little financial flexibility, which could prove untenable.

Sponsor ownership or leveraged buyout transactions are prime candidates for Caa ratings, Moody’s says. “These deals almost always start with high leverage because the return calculus for the sponsors creates incentives for minimizing equity and maximizing debt,” report says. “Therefore, these companies are frequently challenged from the start, with weak credit metrics.”

The next one, a challenged competitive position, is one too many retailers today can relate to. This threat essentially means the sand has run out from under the company’s feet, as is the case for those who have allowed their innovation to lag, the fashion quotient to flag or—in the case of secular change–their foot traffic to sag in favor of online competitors. By example, Moody’s sites the sinking of Hanjin as having created a current that pulled some stores under.

Risk could also start at the top, as is the case when there’s a shuffle in the C-suite. Erratic management is all it would take to suck an already unstable company under. Succession plans like those at Walmart and Costco helped these high-rated retailers maintain their footing—and their ratings. However, executive changes typically have ripple effects throughout the organization. No matter how smoothly it goes, ratings might be at risk depending on what the master plan of the new CEO turns out to be.