South Africa’s largest apparel retailer, Edcon, could face a cash crunch unless it can restructure the huge R25-billion debt taken out by its private-equity owner, US-based Bain Capital, in the next two years.
Reports by analysts say that Edcon has a strong cash flow, but the hefty amount it must repay on that debt is soaking up its profits.
Edcon’s plight is a cautionary tale of how a private equity deal — in which the company’s own profits end up paying the debts incurred to buy it — can go awry.
The 80-year-old group, which owns 1 430 stores trading under the brands Edgars, Jet, Boardmans and CNA, was bought out by Bain in 2007 in South Africa’s largest private-equity deal and delisted from the JSE.
Since then, Edcon has struggled to balance the need to invest in new stores with the imperative to pay interest on debt taken out by Bain.
In the three months to June, Edcon’s R838-million in net financing costs vastly exceeded its R679-million in earnings before interest, taxes and other deductions. Last year, Edcon managed to cut its total debt to R19,5-billion by selling its debtors book to Absa, but the debt has again crept up to R22,6-billion, partly due to the rand’s fall against the dollar.
Its debt burden meant Edcon largely missed out on the last retail boom as its rivals took market share. While recent signs of a turnaround are promising — profits edged up and cash sales increased — any cash it makes is soaked up by the interest payments to overseas funders.
This came to a head as two recently released reports questioned how long Edcon could keep going without “restructuring” its debt.
Brokerage Morgan Stanley, in a report titled The Capital Structure is Unsustainable, advised investors to take a short position on the bonds raised by the owners and listed on the Irish Stock Exchange.
Morgan Stanley says Edcon has enough cash to keep going for a year-and-a-half, based on its current rate of burning money, “but it will need to address the capital structure well in advance of that. Edcon is burning cash, and it is a matter of when, not if, this company needs to restructure”.
After the report, Edcon bonds on the Irish Stock Exchange plummeted. At one point they were trading at less than half their face value. The yield on Edcon’s E425-million (R6-billion) bond, which is meant to be repaid in 2019, climbed 23% last month, reflecting investors’ concern over a possible default -before calming marginally in recent days.
Merrill Lynch says that, while Edcon “has a realistic chance of avoiding a default in spite of continuing macroeconomic pressures”, this could “probably only be achieved through raising new equity by early 2016”.
Weak credit sales were the main reason for profit growth having been so poor for the past nine months, it says. “Aside from the weak credit sales, the performance of the business has actually been rather good, which is encouraging, given challenging market conditions.”
A note from RMB Global Markets Research says Edcon’s ability to trade its way out of its highly indebted position in the next two years is questionable. Even though “the hope of a potential [new listing] kept bondholders relatively calm until now”, hopes of this were fading as Edcon had not mooted it.
“In the absence of an equity capital infusion by private-equity shareholders, it is difficult to see how Edcon can reduce its R24,8-billion gross debt without resorting to debt restructuring. The question is not if it will happen, but when.”
Retail expert Syd Vianello, who has long predicted a cash crunch at the group, says Edcon was likely to face a squeeze only in two years’ time. “They have to up their game to generate more sales [and] more operating profit to service the debt.
“If the economy doesn’t turn and carries on as lacklustre as it has for the next two years, and they don’t produce an improved performance, they will run out of cash in two years’ time, and there will be no more assets to sell to raise cash,” he says.
Edcon’s fate darkened last month when ratings agency Standard & Poor’s (S&P) cut its rating from B-to CCC+. It says: “Edcon is burdened by substantial debt, and we view its capital structure as unsustainable.”
But S&P says it was not expected to default on bond repayments within the next 12 months at least.
An Edcon spokesman admitts that the rating downgrade reflected “Edcon’s heavy dependence on the SA economy and its concentration in clothing and footwear merchandise”. But he says these factors were offset by its leading market position, brand diversity and strategic improvements.
It is unlikely that an initial public offering will happen soon as Edcon CEO Jurgen Schreiber told Bloomberg that Bain would not plan a listing until it reported at least three quarters of profitability.
Operationally, the group is doing better than it has for years: it has cut jobs, refurbished stores and added new merchandise. In the June quarter, like-for-like sales rose 2,8% at Edgars and 2,2 % in its discount division. But credit sales fell 3,3% and 3,2% as Absa is stricter on granting credit.
Vianello says the fall in value of the bonds needn’t worry Edcon now. “If it extends to the point where creditors and suppliers become jittery, that becomes a problem,” he says.
Pictured is Edcon CEO Jurgen Schreiber.
* This article was first published in Sunday Times: Business Times