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Some LBO'd Retailers Facing Make Or Break Holiday Season

This year's holiday shopping season will be more critical than ever for some retailers who were leveraged buyout targets and will need to generate more free cash flow in order to help pay down debt on time.

This year's holiday shopping season will be more critical than ever for some retailers who were leveraged buyout targets and will need to generate more free cash flow in order to help pay down debt on time. Among those retail stores, the area that seems to be hit the worst is the specialty retailers, including Linens 'n Things, Brookstone and Burlington Coat Factory, which will all have to look to increase free cash flow, according to Moody's Investors Service.

"What is the same for many of these companies is that current free cash flow levels are weak as compared to the debt load incurred," said Margaret Taylor, v.p. and senior analyst at Moody's. "This makes these companies highly dependent on either top line sales growth or improving cash flow generation from expense cuts or working capital management in order to generate sufficient cash flow to repay their debt."

Taylor explained that in 2004 free cash flow for specialty retailers was 7 1/2%, so most companies, without any improvements, would be able to pay down debt in about 15 years. Between 2005 and 2006 that number has eroded and now free cash flow is 0.2%, year-to-date. "That's as close to 0 as you can get," Taylor said. "That means you need almost a millennium to pay back debt." Average debt to EBITDA was about 6.7 times in 2006, as compared to 6 times in 2004. For strategic transactions, free cash flow to debt was 1.9% in 2005 as compared to 11% in 2004. Thirteen specialty retailers have participated in a strategic transaction in 2006, according to a Moody's report, "U.S. Retail and Apparel Industry Outlook."

This year, across all deals, free cash flow has been low in the space following a strategic transaction. Leveraged buyouts included Michaels Stores, PETCO Animal Supplies and Sally Beauty; strategic transactions included Amscan, BCBG and Rent-A-Center. The ratings agency points to Brookstone, Burlington and Linens 'n Things because all three missed performance expectations in the first quarters after they were bought out.

The LBO of Brookstone by OSIM International, JW Childs Associates and Temasek Holdings closed in the fall of 2005 and the company missed its holiday season performance goals last year, which weakened its credit metrics, Moody's says. So this holiday season is even more important because Taylor said about 80% of Brookstone's earnings come from this time of year. "They can't stand to do poorly on 80% of their earnings again," Taylor said. As one buysider put it, "Everything depends on Christmas."

Apollo Management's LBO of Linens 'n Things was completed in January (CIN, 1/20). The company missed its performance expectations for the first six months of the year, but it has maintained adequate liquidity and the ratings agency noted the company was in "turnaround mode." "We weren't expecting them to have a stellar holiday so they can probably withstand a soft Christmas," Taylor said.

Burlington's LBO by Bain Capital closed in April (3/24) and the company missed earnings for its fourth quarter ending May 31, but did meet its first quarter performance expectations. Taylor said Burlington has a big Easter season so it is able to have a softer Christmas. Free cash flow to debt is about 2%, according to Moody's.

Calls to a Bain spokesman, and Apollo and J.W. Childs officials were not returned. A call to a Philip Roizin, executive v.p. of finance at Brookstone, was referred to a spokesman who did not respond. Barbara Smith, Linens 'n Things treasurer, and Michael Prince, v.p. and chief investment officer at Burlington, also did not return calls. --Kristen Haunss

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