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Private equity to blame for REDgroup collapse

We had a lot of ink and hot air expended this morning on the collapse of the REDgroup, which owns the book chains, Borders, Angus and Robertson (in Australia) and Whitcoulls in New Zealand.

There was much hand wringing about how tough it is, consumer caution, internet book purchases, electronic readers, the value of the Australian dollar, and very little delving into the various databases of the respective newspapers to try and piece together an informed report on why this collapse happened.

In fact a prescient report by a business journalist late last July told us why REDgroup’s days were numbered and added up to more than just the market, the Internet and the Australian dollar.

The real owners, Pacific Equity Partners group, (or the PEP group) has managed to keep a low profile. It has owned REDgroup since 2004, but you wouldn’t know that from this morning’s reports.

But for an explanation of the collapse, go back to a piece written in The Sydney Morning Herald’s Inside column by former insider, David Symons (now gone from journalism). He wrote last July:

What a difference six months makes. At the start of the year REDGroup Retail, owner of the Borders and Angus & Robertson book chains, figured prominently in the suite of retail floats pencilled in for 2010.

Investors dodged a bullet when float talk went quiet as markets softened. The private equity-backed REDGroup is now at risk of drowning under its $175 million debt burden as profits evaporate.

After recording pre-tax profit of $19.5 million for the six months to February, the company has confessed to the New Zealand stock exchange that it is on track to deliver EBITDA of just $25 million for the year to August 2010.

While it’s unusual for a private-equity business to air its dirty laundry (and there are believed to be several other investments in the sector that are close to the brink), disclosure was needed on this one as some of REDGroup’s debt is owned by retail investors in New Zealand.

Yesterday’s earnings guidance will send shivers down the spine of anyone invested in discretionary retail businesses. It’s unlikely that consumers have singled out the bookstore for cutbacks when assessing how to manage a stretched household budget. Worryingly, it’s now clear that REDgroup has struggled to earn even a single dollar of profit in recent months, while breaches of two bank covenants are expected. It seems that poor trading in Australia (rather than New Zealand) is to blame, with the past three months the worst yet.

It’s going to take quite a turnaround before Pacific Equity Partners, which has owned REDGroup since 2004, can achieve a dignified exit.”

Symons got it right: in many respects, REDgroup has been a collapse waiting to happen. That it came a day after the unconnected Borders group in the US failed, was probably co-incidental. The US collapse didn’t cause the local business to fail, but there was a familiar theme: too much debt, a botched Internet and expansion strategy and four CEOs in four years. In other words, poor management, just as there was at REDgroup and Pacific Equity.

Since last July, REDgroup has cut out all the DVD and CD sections in the Borders stores in Australia and written down stock by $30 million, which in turn produced a loss of $43 million for the year to August 2010 as sales fell 10% to around $500 million.

But the key is the reported debt figure of $175 million, which would’ve been costing the group $17 million or more a year. That debt would have been growing as a proportion of sales. But with sales falling, cashflow every month was falling to the point where there was little available to pay that debt because suppliers and staff had to be paid, as did the taxman and landlords like Westfield.

But don’t tell the private equity mobs and their mates in the advice and media sectors that that’s the reality for any business bought by PE. High debt means death if you are in a business that is trying to survive in the current economic conditions.

While weak demand, the internet and greedy publishers contributed to the collapse, the debt burden was the killer, or, to put it another way, the private equity model of buying companies and loading them up with debt was found to be be completely inappropriate to a company facing tough market conditions.

There is a comparison to be made here with the listed women’s fashion retailer, Specialty Fashion group. It just reported lower sales and profits for the December half year as it battled weak consumer demand and intense discounting, and the impact of the strong Australian dollar, which produced more losses than gains.

But Specialty Fashion made clear that it was in a solid financial position. No debt, $16 million in cash and access to various lines of credit totalling $100 million. That’s in a company with annual sales of $550 million and net profits running at an annual rate of just under $30 million.

In other words, a business similar in size to REDgroup in terms of sales, but in an industry far more competitive than books and subject to great changes in demand (fashion whims). And the big difference between the two — no debt and cash in hand at Specialty Fashion. It has a far better chance of surviving the current bout of consumer caution.

And there’s a further knock on impact — Westfield Retail, just separated from Westfield Group, will be a major loser if many of the Borders, A&R and Whitcoulls stores are closed because they are located in many of Westfield’s centres, especially its flagship Bondi Junction centre in Sydney’s east where Borders occupies a big space and the smaller Angus and Robertson has an outlet on the ground floor.

But don’t weep for Westfield, their rents would probably rank just behind the cost of the debt in the list of problem liabilities for REDgroup.

4
  • 1
    michael r james
    Posted Friday, 18 February 2011 at 3:24 pm | Permalink

    What you haven’t explained is what happens with a full bankruptcy? What if someone (who knows how to run bookstores) buys it out to keep running the shops. Of course the purchase price would have to be sustainable and would have to be debt free. Who loses money here —  — I am hoping it is REDGroup and PEP (since this has happened before they were able to have their IPO and offload the toxic bundle to idiot institutional investors in the way Myer was) or have they been able to structure REDGroup so banks or someone else cops the loss?

  • 2
    Posted Friday, 18 February 2011 at 4:30 pm | Permalink

    Thanx for this informative piece.

    Surely the losers will be (1) any equity invested by the owners (2) lenders if their debt wasn’t secured by a mortgage or other charge over the business (3) lenders which secured their debt with a floating charge over the business (4) any lender which secured its debt with a guarantee from a parent company or other related entity with substantial assets, etc.

  • 3
    michael r james
    Posted Sunday, 20 February 2011 at 2:52 am | Permalink

    Gavin, excuse my naivety on those kind of things.
    I read today that $100M of the REDgroup’s debt is to PEP so I can only hope that PEP suffers an actual hit to its bottom line. For once the balloon burst before they could offload it in an IPO to the usual suspects/suckers and recover their dosh (I’ll bet a lot of which is not real debt but pimped up management fees etc.).

  • 4
    Posted Sunday, 20 February 2011 at 9:19 am | Permalink

    I’m no insolvency specialist, but I imagine that it depends on how Pacific Equity Partners’ investment was structured. You will recall that Macquarie Bank is a family of companies which channels investors’ funds into specific projects, while the holding company doesn’t invest its own capital but takes a management fee. Pacific Equity Partners may also be structured to protect the holding company’s capital from the failure of any of its projects.

    But even if that is the case, the investors would be the first to lose their capital and from what you say at least Pacific Equity Partners’ investors have suffered a substantial financial loss. This will damage PEP’s reputation amongst investors considerably and will reduce its capacity to raise funds in the future for new projects or even to increase the capitalisation of existing projects.

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