Trends in Asset Values 2014
Date November 2013
Featured in The Secured Lender
Every fall, it’s tradition here at Gordon Brothers Group for the team to gather in our largest conference room. We unlock the glass cabinet in the corner and pull out the softball-sized crystal ball. Like each of the 110 years before, this multi-faceted glass orb is placed in the center of the table under an intense spot light. The executives look into the light and reveal to all prognostications for the coming year. This year we decided to write it all down and publish our insights in The Secured Lender.
Looking ahead to 2014, our team at Gordon Brothers Group sees pockets of emerging opportunity for asset-based lenders (ABLs) with strong due diligence capabilities and the discipline to deploy capital selectively. However, a number of persistent macroeconomic headwinds will continue to constrain broader growth across multiple industry sectors.
In this article, we discuss the critical forces at work in the markets for retail, real estate, commercial & industrial and brand assets in order to help ABLs make sense of current valuation levels and prepare themselves for the impact of emerging industry trends on valuations in the future.
Continued Headwinds for Consumers
Consumer sentiment, according to the Thomson Reuters / University of Michigan consumer sentiment index, has shown steady improvement over the course of 2013, reaching a six-year high of 85.1 in June. The positive trend took a step back in July, however, as the index fell to 80.0 (versus an expected increase to 85.5), reflecting ongoing consumer skepticism regarding the employment market and wariness over rising interest rates.
This general strengthening in consumer sentiment over the course of the year has provided a positive driver for retail inventory valuations. On a comparative basis, asset values have held or even increased slightly in the past few years. At healthy retailers for which we have conducted disposition projects over the course of many years, asset recovery values have increased steadily from the depths of the recession to today. In some cases, sales multipliers are up by as much as 25 percent. Of course, these figures vary widely due to a particular company’s circumstances.
The outlook for consumer spending, however, remains cloudy heading into Q4, creating uncertainty for asset-based lenders assessing new opportunities in the sector. Recent National Retail Federation numbers indicate that the average family will spend 7% less on back-to-school shopping this year, with potential carryover effects for the upcoming holiday season. In addition, unemployment remains stubbornly high, as recently as 7.3% in August.
For ABLs with existing loans in the retail sector, a decline in consumer sentiment is not necessarily a negative development. Our experience has shown that drops in consumer sentiment can have a positive effect on inventory recovery values in liquidation scenarios, as shoppers tend to become more value-conscious and gravitate toward sales and store-closing events.
Overview by Segment
- Home improvement-related retailers have demonstrated resilience in recent years and continue to have a positive outlook as the housing market recovers.
- Apparel companies that have developed ‘fast fashion’ design and manufacturing processes – which enable them to move products from the design phase to the sales floor at a rapid pace – will continue to be well-positioned relative to their peers.
- Retailers of the digital world (books, music, video, games and electronics) will continue to struggle as digital media replaces the physical media and the online channel replaces bricks & mortar.
Evaluating Potential New Borrowers
For ABLs, key indicators to examine during due diligence to ensure a strong collateral base include:
- “Omni-channel” development: With online retail share increasing every year, consumers expect brick-and-mortar retailers to offer a robust online sales presence. Retailers that integrate online (and catalog) operations as a core part of their business will continue to outperform “single-channel” competitors going forward.
- Real estate flexibility: Retailers stuck with inflexible real estate portfolios (box size, lease term, clustering, mall type, etc.) will continue to be challenged as the need for real estate optimization has doubled. Innovative options for retailers may include subletting a portion of their floor space to complementary third parties to create a “store within a store.”
- Social media presence: In our experience, it is much easier for retailers that have a built-out social media presence to achieve strong results in a liquidation scenario, since such retailers are able to market sales or store closing events to customers within a short timeframe without incurring the expenses typically associated with traditional advertising vehicles.
A Tale of Four Cities
Within the last year, the market for real estate has begun to show increasing signs of stratification, with ‘A’ class properties increasing in value while ‘B’ and ‘C’ class properties have flat-lined or even declined. This division between the ‘haves’ and ‘have-nots’ has been even more evident in four cities – New York, Washington, D.C., San Francisco and Boston –while real estate in other cities and suburban areas has lagged.
Overview by Segment
- Residential: Multifamily has taken off, especially in the four major markets above. Demand is very strong and rents have grown to the point that some markets may actually be in the early stages of overheating.
- Retail: While mall vacancy rates have declined somewhat, they continue to remain high at 8.3% in the second quarter of 2013 when compared against the pre-recession vacancy rate of 5.1% in the second quarter of 2005. Strip centers have fared much worse overall at 10.5% as compared to 6.7% respectively during the same periods, according to REIS Inc. A key driver behind these trends has been the increasing aversion of brick-and-mortar retailers to add potentially burdensome real estate obligations in the wake of the financial crisis and the ongoing explosion of the online channel. Today, many of these retailers would prefer to temper expansion overall and instead pay a premium for the perfect property quality and location rather than risk the flexibility of their real estate portfolios simply to expand their footprints. Another area of strength is single tenant net-leased properties, which typically house nationally- or regionally-funded retail businesses that have an established value proposition and remain viable even in the face of online retailers such as Amazon.
- Office: With the exception of certain markets, office real estate remains relatively soft. This weakness is especially prevalent in suburban areas, even in the four major markets mentioned above; in some cases, current office rents in such areas are equal to their levels from 20 to 25 years ago. Corporations are scaling back their real estate footprints, and office space that is not situated in a prime urban location has lost much of its attractiveness.
- Industrial: Stratification in property values is especially pronounced in this segment of the market, as many potential occupants have little appetite for older or outdated facilities. This dynamic is particularly acute in the Rust Belt.
Commercial & Industrial
Key Macroeconomic Drivers: Relative Stability for Now
The slow-but-steady rehabilitation of consumer demand since the financial crisis, combined with long-term declines in prices for key commodities, has produced a generally positive climate for manufacturers. For the first eight months of 2013 commodity prices for copper and corn decreased 13 percent and 28 percent, respectively, according to the Wall Street Journal, supporting a reasonably stable environment for manufacturers and distributors within the sector. Transportation costs, however, including trucking and rail rates, remain at near-record highs in the U.S. These continued increases could pose a threat to domestic manufacturers’ profitability in the medium term. As a result, we continue to remain wary of ongoing fluctuations in crude oil prices.
On the whole, our Commercial & Industrial team has observed a much more disciplined approach to inventory management and balancing in the consumer product space over the past several years. This has resulted in a general reduction in excess finished inventories being offered for sale at distressed pricing levels.
On an industry-specific level, asset-based lenders should be aware that shifting trends in energy production and changes in distribution models are currently creating challenging short- to medium-term conditions for companies in the following areas:
- Distributors: Distributors in several sectors, including electronics, lawn & garden, and pet care, are struggling as an increasing number of large retailers source products directly from manufacturing facilities. This shift in the traditional business model has turned what was formerly a two-step model into a one-step model: direct to retail. This is especially true of electronics distributors in Asian markets.
- Renewable Energy : Results for producers of solar components and players in the ethanol sector are currently very soft. These industries have relied heavily on tax credits and subsidies in hopes of reaching commercial viability, but have not fared well on a stand-alone, free-market basis. Fuel stock prices, meanwhile, are having a significant negative impact on biodiesel and ethanol plants.
- Coal: Historically lower natural gas prices have had a pronounced negative impact on the coal market, where we are seeing a great deal of distress and numerous bankruptcies.
For ABLs needing to monetize collateral rapidly, it is helpful to take an integrated approach to the various assets owned by these companies in order to arrive at an optimal recovery. The sale of certain assets out of sequence can often negatively impact the value of the remaining assets.
For example, selling the best inventory first often makes it difficult to sell less desirable inventory later on. Similarly, the order of approach is crucial: current customers, competitors and strategics should always be contacted first, leaving tier two players such as discounters and distributors for later. For equipment, it’s often important to keep the plant in a “warm” state in order to maintain the value of the equipment.
Fully leveraging all the inventory, machinery and equipment, real estate, accounts receivable and intellectual property as one package and potentially continuing to operate the business to finish processing inventory while maintaining sales operations can deliver far better results than would have been available through a piecemeal approach. Working with a partner that has the ability to fund a purchase of multiple asset categories on a comprehensive basis can enable ABLs to maximize recovery while minimizing the additional cash outlay required.
Brands are Back
The market for brand assets has continued to mature over the last several years, with a stable and consolidated secondary market of brand management companies emerging to support generally higher valuations. Moreover, with competition in the overall lending market steadily increasing since the financial crisis, senior ABLs have resumed lending against brand assets in significant numbers. ABLs are not only deploying more capital today with brands as collateral, but are also accepting more aggressive deal structures, including non-amortizing term loans.
Brand Management Companies Hit their Stride
Brand management companies – specialized buyers that purchase brands then license them to generate a recurring royalty stream – have been active in the distressed and M&A markets for years. Until recently, however, there were few established players in the space, leading to high levels of volatility in valuations and constrained liquidity for sellers.
Over the past five years, brand management companies have become very adept at acquiring brands, finding best-in-class licensees across multiple geographical end-markets and maximizing sales by category while maintaining the integrity of the brand. As a result, the larger companies in the space have grown, strengthening the secondary market for brand assets and giving ABLs greater confidence in brands’ value and stability as collateral.
Over the past 12 months particularly, we have witnessed an increased effort by white-shoe private equity firms to partner with or create new brand management companies. ABLs should keep an eye on these developments as it should continue to support increasing brand values.
Despite, or even because of, the maturing of pure brand management companies, most are still not equipped to purchase brands in distressed processes, especially when other hard assets are included in the process. Thus, ABLs seeking to rapidly recover value from brands should focus on brand players with the ability to purchase all assets. Such was the case in the brand-driven distressed sales of Polaroid, Sharper Image and Coby Electronics,
Trends driving higher valuations in the market for standalone brand assets include:
- Rising numbers of Asian (and particularly Chinese) manufacturers bidding on or licensing brands
- Strong valuations, both in terms of multiple of sales and multiple of EBITDA for hot, strong and growing brands in the traditional M&A market
- Increasing prevalence of global brands, as well as brands emerging from developing markets to challenge more established names
- Ongoing rapid expansion of well-known luxury brands in emerging markets
- Greater prevalence of celebrity-owned, sponsored or associated brands
- Steady growth in the number of exclusive or proprietary brands offered by retailers such as Target, Wal-Mart and others
- Large retail operators engaging selected third-party manufactures to establish “brand shops” or “stores-within-stores,” following on the established trend in high-end appraisal.
Looking forward, we see a continually strengthening macroeconomic environment with the biggest risk being increasing interest rates or an external shock. Either a slower raise in rates or a sudden shock could easily derail and overwhelm the microeconomic trends outlined in this article resulting in more distressed sales of assets.
Each of the five major asset types –inventory, real estate, machinery & equipment, receivables and intellectual property- live on a spectrum of valuation predictability. The standard deviation of each is subject to its underlying attributes. For example, retail inventory is relatively easy to predict value while brands are inherently difficult (thus the different loan-to-value ratios used by ABLs).
Our advice to ABLs: stay abreast of both macroeconomic and microeconomic trends, but more importantly, stay close to your borrowers. While consulting a crystal ball is always fun (and nostalgic for us here at Gordon Brothers Group), the ability to both aggressively underwrite new loans and recover on those gone bad is largely based on a strong understanding of the collateral and strong monitoring processes.