Trends in Asset Values 2016

Article

Date february 2016

Featured in The Secured Lender

Predicting the future is not for the faint of heart.  Back in 2013, we published our take on trends in asset values for the coming year in The Secured Lender.  We’re at it again for 2016.  We’ll take a look at trends in the commercial & industrial, retail and brand markets and then translate those trends into recommendations for Asset Based Lenders.  We first review our predictions from 2014. How did those projections measure up?  Then, looking forward, we discuss the critical forces at work that will impact current and future asset valuations and liquidations.

Commercial & Industrial 

The commodities landscape has shifted dramatically over the past two years, illustrating just how quickly the value of assets correlated to the commodities markets can plummet.  Back in 2013 we projected that some softness in commodity prices would bode well for manufacturing and distribution segments. We also projected instability in the price of crude oil despite the stability of the market at the time, which has come to pass in a much more significant way than anyone could have imagined. While at the time we expected tempered liquidation activity due to more disciplined inventory management practices, commodity volatility has overwhelmed that in key industries such as mining and oil & gas extraction. We anticipated distribution channels would shift toward a one-step direct-to-retail model, which has and will continue to occur.  We also predicted severe distress in coal-related industries, which similarly has come to pass.

Commodities Weakness
Over just the past year we have witnessed continued weakness in the global commodities markets, due in large part to slower growth in China.  Into the coming year, Chinese economic woes will continue to be a drag on demand for commodities including steel, coal, oil and precious metals, which are all worldwide markets. As the breakneck growth in construction and infrastructure slows in China, it is easy to see why there is little relief in sight for most commodities. Unfortunately, until China regains momentum in its growth, the commodities glut will persist and the impacts continue globally.

Steel and Metals
Global steel production is one example of the challenges facing global commodities. With domestic demand in China dropping nearly 4% in 2015, producers have been forced to export—flooding global markets with cheap Chinese steel.  In the United States, some plants are sitting idle as capacity utilization has dropped to just 69 percent, according to the American Iron and Steel Institute. Additives in the steelmaking process such as molybdenum and metallurgical coal have followed suit. For producers of these commodities, their dependence on robust steel production means that their values are closely correlated to the price of steel. Consequently, as steel prices plummeted, the price of molybdenum halved.  This adverse climate is likely to persist at least in the near term.

Energy
The WTI oil-price index has fallen over 50% off its 2014 peak.  Energy services companies have had to shed assets at low prices to raise cash, and many producers can barely generate enough cash flow to service their debt. As a result, credit rating agencies are expecting default rates to increase significantly heading into 2016 as energy companies’ hedges cannot protect them in the long term. Our assessment is that the worst is yet to come for many oil and gas firms. 

The coal industry has fared no better. Under pressure from environmental regulations and collapsing demand, prices have declined over 20%. Lenders in the coal space have seen a great deal of distress from coal producers as large debt loads and weak prices have led many companies to seek bankruptcy protection.

While falling oil and gas prices have hurt the energy industry by and large, it has been good news for many other industries, such as plastics.  With steady demand from the automotive and packaging sectors and record low resin prices driven by the shale gas boom, this industry is in perhaps its most competitive position in decades.  Petrochemical companies are also, on the whole, benefitting from low cost feedstocks spurred by the shale boom.  As of mid-November, the Henry Hub spot price of natural gas was hovering around $2.00/MMBtu.

Lenders to commodity producers have been kicking the can down the road and in the coming months will be forced to make difficult decisions about whether and how long this can continue. Collateral values have failed to recover and lenders will now be forced to reevaluate their ABL portfolios in the context of a prolonged downturn in asset values in commodity sectors. We expect many operators may be approaching the point of bankruptcy in 2016. Even many of the larger producers that were expected to be able to “ride out the storm” are beginning to face distress.

Unfortunately, the persistent weakness in the commodities markets and economic softness throughout Europe and the rest of the world offer no indications of a near-term turnaround. Furthermore, China’s devaluation of its currency has served the interests of its own exporters, but will continue to have a detrimental effect on producers and manufacturers in the United States. 

Trends
• Most companies that rely on commodity sales for revenue will face growing distress and continue to suffer in the short and medium-term
• Chinese economic growth will continue to be the primary factor affecting price swings in the commodity markets.
• Shifts towards direct-to-retail distribution and just-in-time manufacturing models will continue to present challenges for wholesale distributors. The scope of this shift is inclusive of most sectors and we will likely witness remaining distress in this area.
• Lenders will find it harder in the coming months to kick the can down the road as asset values fail to rebound and some may be forced to foreclose in an unfavorable environment.


Retail

Back in 2013, we made several predictions for the retail economy in the U.S. and Canada. We stated that consumer sentiment would dictate recoveries and in fact they did. Over the past two years, retail liquidation values have held up in aggregate, with strengthening in some subsectors. As expected, home improvement retail performed well as the residential real estate market grew. Fast fashion has put stress on conventional specialty apparel retailers, particularly in the youth and women’s sectors. Omni-channel correctly emerged as a defining criteria for health, performance and longevity. This trend has been paired with a movement towards right-sizing of the real estate footprint, however many retailer efforts have fallen short. We also correctly stated that social media would become a driving force in retail liquidations. In our experience over recent years it has become a primary tool for marketing store closing projects.
One area where our prediction fell short was with respect to headwinds for retailers of hard media (books, music, video, games) and electronics.  Many have been able to remain more vibrant than predicted, but we still maintain these retailers will eventually succumb to the movement from hard media to digital media distributed over the internet.
As we stand on the threshold of 2016, conditions for the consumer are better than back in 2013 with lower energy prices, lower unemployment and a stronger housing market.  While consumer spending and confidence have increased moderately from 2013, consumer spending increases have disappointed.  While the macroeconomic environment is more stable, the changing dynamics of retailing are reaching a tipping point.  

Shifts in Foot Traffic & the Impact of Omni-channel
Shopping habits are changing.  E-commerce sales currently represent approximately 10% of total retail sales and are projected to increase to 17% by the end of 2020.  Diving deeper, it is apparent that more consumers are ultimately making their apparel purchases online with one caveat – it must be all about them.  Subscription sites such as birchbox.com, barkbox.com, stitchfix.com, bonobos.com and, of course, warbyparker.com have gotten it right by making the e-commerce shopping experience even easier and more personal than ever.  Over 60% of U.S. consumers today make an online purchase at least once a month.  Amazon continues to lead with Prime membership and ever-shortening delivery times.  At the current rate of growth, half of all U.S. households will be Prime members by 2020.  
 
Where once retailers chose between brick-and-mortar and Omni-channel strategies, all are now somewhere along the omni-channel to opti-channel spectrum. We believe that, ultimately, the omni-channel approach—all channels seamlessly accessible to all customers—will give way to opti-channel strategies— optimized channels for segmented customers—as retailers are forced to review multichannel investments using conventional ROI metrics.
 
Traditional Malls on the Decline
Mall traffic is down by half since 2010 and retailers are looking to optimize footprints. Some areas have been hurt harder than others as the traditional mall increasingly becomes outmoded. As predicted back in 2013, real estate asset values have bifurcated, gaining strength in costal cites such as Boston, New York, San Francisco and Washington DC, and stagnating, or most likely declining, most everywhere else. Numerous centers are under redevelopment, especially those with Big Box vacancies that need to be reconfigured to achieve tenancy. Retailers continue to try to reinvent themselves via changes in their store configurations, sizes, store counts and logistics. As we head into 2016 this trend towards declining physical store performance will likely persist. We are also starting to see signs that even “A” rated properties and the once hot Outlet Centers are wrestling with re-tenancy and turnover.  
 
As retailers struggle to keep pace with these changes, those that adapt will flourish and those that don’t will fail. Retailers are focusing on the in-and-around-store experience to attract consumers otherwise engaged in shopping virtually.  More experienced-based lifestyle shopping centers that offer entertainment, gourmet dining, retail boutiques and premium outlets are popping up to replace the traditional mall.  In fact, most enclosed mall landlords have removed the “people counter” devices from their properties because of the staggering decline in foot traffic.  Further, it is projected that approximately 15% of U.S. enclosed malls will be converted to non-retail space or fail entirely within the next 10 years.  This shift has amplified the importance of optimizing store locations. 
 
Specialty Apparel: Over the past year, we have seen quite a few retailers who were not able to maneuver quickly enough and fell behind the curve.  Women’s specialty apparel retailers like Delia*s, DEB Shops, Body Central, Love Culture, Cache, and Coldwater Creek have all fallen victim of the shift toward e-commerce and away from the enclosed mall.  We expect this sector to continue to struggle unless retailers adjust their strategies in light of these trends.
 
Sporting Goods: Sporting Goods Retailers are facing increased pressure as branded apparel vendors like The North Face, Patagonia, Under Armour, and Nike continue to grow their brick-and-mortar presence and have developed their web platforms to include outlet sections.  This has resulted in continued margin compression for traditional sporting goods retailers like City Sports, who filed for bankruptcy protection in early October. Another contributing factor was this year’s uncommonly warm fall season which caused many customers to refrain from their usual warm weather purchases.

Trends
• E-commerce will continue to threaten physical store sales. Retailers that embrace the shift and optimize operations will flourish.
• Mall occupancy rates will continue to struggle and poorly-performing properties will face reuse or demise while strong performing properties will experience near term stability.
• Specialty retail and general sporting goods stores will continue to experience stress as they work to meets the needs of fickle consumers and a changing retail environment.


Brands

A Maturing M&A Market for Brands
As we predicted back in 2013, the involvement of brand licensing companies as major players in the brand M&A space has continued to grow and support strong brand valuations. These firms own brand assets and generate all or the vast majority of their revenues from royalties. Since the time of that prior analysis, one new entrant has joined the three established participants and a variety of smaller participants that together represent a significant number of brand acquisitions over the last 18 months. Some are backed by private equity, others by the public markets, and a few by private capital.  Combined, they bring a greater degree of liquidity into this asset class.   Likewise, as this particular segment of the market continues to mature, a more proven valuation standard based on market comps is beginning to form.   This explains the parallel increase of lending against brands as the main (or sole) source of collateral and growing advance rates against these intellectual property assets.

Looking forward, market conditions and the various attributes that determine a brand’s value (e.g.: retail vs. wholesale, distribution channels, competitive environment, margins, geographical reach, etc.) will continue to drive brand values, in addition to the overall increased universe of prospective buyers for these assets. As we have said many times before, brand valuation is as much art as it is science. As we move into 2016, the recent scrutiny of Iconix’s accounting practices has cast a small but noticeable shadow on the organic growth potential of these brand portfolios.  It remains to be seen whether this will lead to a more cautious approach by the investors fueling the pace of brand acquisitions.    


Trends
• A growing pool of capital chasing a diminishing number of brand opportunities will continue to push valuation multiples upward
• While the major participants will continue to focus on larger ticket purchases, smaller brands may not benefit from this ascending trend.  This will create value opportunity for acquirers, but greater valuation risks for ABLs financing these brands
• A reassessment by major retailers of longstanding brand relationships is likely to shake up the market for DTR (direct-to-retail) opportunities and engender the adoption of more house brands
• A greater number of non-distressed brands are likely to explore licensing on a larger scale, even for core products 


What this all means for asset-based lenders

As we move into 2016 we’ll likely experience an uptick in distress in key sectors—commodity-based industrial sectors, as well as specialty apparel and sporting goods retail. The impact of e-commerce and Chinese economic growth cannot be understated and we’ll reconcile with these forces throughout 2016. The coming year will almost certainly be characterized by uneasiness about general economic stability worldwide and a more cautionary environment for investors.  

Asset-based lenders will also continue to adjust to changes brought about by new leverage rules.  Banks are still going through the process of classifying loans in accordance with the new guidance, deciding whether to renew certain capital commitments, or suggest that some companies seek other financing.  In turn, higher risk-rated assets are finding a new home with non-traditional financing partners.

As the Federal Reserve raises the federal borrowing rate, we anticipate many cash flow loans tripping covenants. The higher cost of interest will cause some loans to transition back to asset-based loans or transition to increasing use of mezzanine lending. This is expected to create growth conditions for asset-based lenders.

The best safeguard against the threats facing the industries highlighted above and portfolio companies operating within them is information. As we enter the New Year, the obstacles may be different, or heightened, or even the same. But in each case, as always, knowledge is power and prevention is worth twice the cure.