Is More Consolidation Coming to the Consumer and Retail Industry?

By Asit Sharma Markets Fool.com

Reports are surfacing that Abercrombie & Fitch(NYSE: ANF)is in ongoing talks with multiple entities for an acquisition, and that Kraft Heinz(NASDAQ: KHC) is looking to roll another major consumer goods company into its portfolio.

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In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Fool.com contributor Asit Sharma take a look at these potential deals -- find out who is looking to buy out the teen-focused apparel brand, and why the leadership behind Kraft Heinz is so eager to pursue another multi-billion dollar acquisition.

A full transcript follows the video.

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This video was recorded on May 30, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and it's Tuesday, May 30th.I hope everyone enjoyed their holiday weekend. If youhaven't heard yesterday's special "Behind the Curtain" episode of Industry Focus,check it out to learn more about the team andwhat it's like in the studio. For today'sdiscussion of potential merger and acquisitionactivity in the consumer and retail world,I've recruited senior Fool.comcontributor Asit Sharmato join the show. Hey, Asit,thanks for calling in. How was your weekend, man?

Asit Sharma: It waswonderful, veryrelaxing, a long four days,the highlight of which, I beat mymiddle child 15 year old inone-on-one basketball. Chalk one up for Father Time. How about you?

Shen: Very nice.I was talking to Austin before the show. We gotrained out a few times. I was up in New York. Didyou guys have to deal with that at allin North Carolina?

Sharma: No. We gota little bit of cloud cover here and there. It wasjust a gorgeous weekend. So, we escaped some serious rain. It was very pretty.

Shen: Alright.I'm glad you had a good weekend and wereable to show your sonthat you still have what it takes in the court.

Sharma: I still got it, thanks.

Shen: Kicking off ourdiscussion for today, we have recent reports thatAmerican Eagle Outfitters(NYSE: AEO) is considering a potentialacquisition of its apparel rival,Abercrombie & Fitch. These are both apparel brandsfocused on teenage and young adult consumers, with storeslargely located in mallsall across the country. So,retail weakness and headwindshave been in the headlines quite often and discussed on the show. Wehave a series of bankruptcies from other mall-based chainshit the news recently, including Wet Seal,Aeropostale,American Apparel and BCBG. And with theCoach-Kate Spadedeal announced a few weeks ago, we'realso seeing some consolidationin the apparel space, as well. So, Asit,there are a lot of moving pieces andpotential suitors right now who arepursuing this deal, andI would like to cover this one at a time. Tostart things off, can you giveus a quick rundown of what has been going on inAbercrombie? The stockenjoyed a $7 billion market cap adecade ago, and has sincedeclined to about a tenth of that size. Annual revenue peaked at $4.5 billion. That is down to $3.3 billionlast year. What happened?

Sharma: Oneof the things that you and I talked aboutin regards to retail companies ishaving a market that's strong enough topull your product through.Retailers who are focused on the teen segment work with fickle fashion gods. Goingback to the weekend briefly,I went with my family and saw the Pirates of the Caribbean. Thegods of the sea are fearsome, there'scurse after curse, and you have trouble,sitting in the theater, unraveling which curse isdirected at whom and how do they break it? But they'renothing compared to the fashion gods,especially where teens are concerned. Thefashion gods are brutal. Thiscompany has been in an industry in which itenjoyed a long surge of interest in mall-based traffic, and teenspropelled that for years. Asyou and I discussed many times,online has shifted the retail landscape. Mall traffic has disappeared, andAbercrombie & Fitch, along with many of its retail brethren, is locked into long-termoperating leases andpurchase commitments for material andleases that are based in malls,which are quite expensive,not very lucrative if you're trying to break them. It'sstuck in this fixed cost position with that smallertraffic base.

On top of that, thecompany hashad to try to move with the fashion trends, andit's been out-hustled by the fashion-forwardfast fashion houses likeZara, which have alower economic footprint, a lighter capital footprint, change theirfashions much more quickly. So it's reallya victim of a couple of these larger forces. Operationally, thecompany has done a decent job. It wasalways somewhat profitable. Thatprofit margin has now declined to near flat. Butit's in a fairly liquid position. Anda little bit later, we'llget into the differences between liquidity andsolvency, which is speaking toAbercrombie & Fitch's long-term future. Basically, we'relooking at entrenched trends thatthis company is trying to battle againstwith not a bright outlook looking forward.

Shen: Thanks, Asit,that's a really greatrundown of what the company has been facing.I think, as you mentioned, it's really important to note thatAbercrombie & Fitch is not alone in this. We'vementioned some of the other chainsthat have declared bankruptcy or closed their doors. These are headwinds that a lot of these mall-based stores are facing.Abercrombie, for four years running,the revenue has declinedabout 6% to 9% each year.I'd like to run down a list of differentthings thatmanagementhas tried to do to facedeclining traffic to its stores, butalso the changing trends.

It hasrecently announced thatit will be closing dozens of its stores, about 60 of its U.S.locations. In 2014, they tried to rebrand,going from the big logos on its clothes, seeing that now,places like Zara andH&M, thesefast fashion houses,they give you less branding and logos on their clothesso that you can design your own style, thatseems to be what's popular with their customers. So, rebranding itself a few years ago,changing the look of its fashion. They'retrying to market to older shoppers,moving away a little bit from their coreteenage base. And they've also recently oustedMike Jeffries, who was the former CEO whokind of put Abercrombie & Fitch on the map,taking over the brand in the early 90s whenit was part of The Limited conglomerate. They've also implemented other changes to itsexecutive team and the board of directors. One thingI will note in terms of bright spots for the company, it's not all bad,in that they have their Hollister business,which is actually, at this point, a bigger part ofrevenue than the namesake Abercrombie& Fitch brand is. Butthat has at least managed to maintain flat same-store sales. So,you can see, even in this situation, flat is better than the double-digit same-stores sales declines that they've seen with the Abercrombie brand. They also recently announced a wholesale partnership with Asian e-commerce retailerZalora, to sell its merchandise, which I thought was an interesting way for the company to expand its international reach.

Next up I want to establish a little bit of a timeline for what we know so far regarding the buyout process, and the negotiations that are going on between Abercrombie & Fitch and thepotential buyers. On May 9th,the company confirmed that it has employed an investment bank to helpnavigate buyout talks withmultiple interested parties. The following day, someinitial reports indicated that at least two of theinterested buyers forAbercrombie& Fitch wereAmerican Eagle andExpress(NYSE: EXPR). In the meantime,Abercrombie shares initially jumpedover 12% on the news,before gradually losing those gainsuntil an update made headlines last week. Last week,May 24th, there was news fromAmerican Eagle, which not only wasstill interested in a deal, but itmay be presenting a joint offer withCerberus Capital, which is a private equity fundknown for its interest in these distressed businesses. I think it would be fair to say Abercrombie is part of that category.

So, thenamed suitors we have so farpotentially negotiating this deal includeExpress, American Eagle, andCerberus, and there are likely other entities as well. Express -- just abreakdown of who some of these potential suitors are -- is actually a smaller business than Abercrombie. Ithas a market cap of just over $600 million,Abercrombie is about $850 million. Therevenue in Express'most recent fiscal year was $2.2 billion.Abercrombie's wascloser to about $3.3 billion. So, ifthe companies were to agree to a deal,it would be more so a merger of equals, with acombination of probably cash and stock-basedconsideration. But,if I were a gambling man,I would have to put my chips onAmerican Eagleand Cerberus rather than this deal,just because I think they have the more substantial resources,and also the aesthetic and branding fit that'smore complementary between the two brands. Asit,if you're an American Eagle shareholderand you see this news, how are youthinking about this acquisition andevaluating it?

Sharma: I think you're pleased. If you're an American Eagle shareholder, then you, too, haveseen the ravages of the retail industry in recent years,especially if you've held the stock for quite a while. But, looking atAmerican Eagle's balance sheet, thecompany has around $225 millionworth of cash. It'sliquid. What does liquidity mean? Liquidity means that you haveenough current assets on hand tocover your short-term obligations. It'salso solvent,meaning that American Eagle doesn't have a lot of debt. However, because that profit margin has declined in recent years, I think last year's netprofit margin was just over 5%, thecompany isn't really throwing off enough cash flow to cover its own operations, grow its business, and then take over anAbercrombie & Fitch. So,you must be pleased that this very deep-pocketed private equity firm,Cerberus Capital, is stepping in. Without that,it's going to be a tough deal for American Eagle.

Lookingat the market capitalization, Vince,you mentioned that Abercrombie'smarket cap is down to about $850 million. That lookssort of doable if you only look at the market cap. But American Eagle needsthis private investor because there's more tothe price tag of Abercrombie than meets the eye.Abercrombie has about $2.2 billionworth of long-term commitments. These are those operating store leases that I spoke about, and alsomaterials purchased obligations for their inventory. That's a pretty big balance that you have to add on to the market cap,because whoever buys this company is on the hook for thoseobligations. When you look at total value,enterprise value, it's over about $3 billion,somewhere between $3 billion to $4 billion,once you consider some type of premium for the shares. Hooking up with a very well-resourcedprivate equity group will help American Eaglenot just acquire the company, buthave the resources to realize the synergies that you mentioned,the fact that the product lines aresimilar, much more complementary than an Express and anAbercrombie. So,I think you have to be feeling pretty good ifyou are an American Eagle shareholder. But still, thislarger question looms --once you can buy into .these two companies, the same problem still exists. Theyhave to find a way to reinvent themselves as a merged-up entity. What are your thoughts, Vince, on how these two companies potentially can combine and make something better out of these two parts?

Shen: I've been thinking about some of the synergies,always a buzzword behinda deal like this,in terms of what these companies can realize. Definitely,the obvious benefits that jump to mind forany deal of this nature, whereyou have that larger scale, whichgives the combined company strongernegotiating power, be it with itssuppliers and its vendors. You have the opportunityto mergeproduction facilities andcorporate functions like finance and marketing, etc. to reduce costs. Also, this ideakind of reminds me of the Coach and Kate Spade's,operating in a similar space but ultimately diversifying the business with more than one established brand inthe portfolio. Here, you would addHollister and Abercrombie & Fitch to that portfolio for American Eagle. They also have theirTodd Snyder and Tailgate stores,very small parts of their business but they'reclearly trying to branch out and diversify the different storefronts that they have. Italso seems to me like Abercrombie has been a bit more of asignificant international presence thatcan be leveraged for American Eagle further abroad, not only with thatZaloradeal that I mentioned earlier, butfor a sales revenue breakdown,Abercrombie & Fitch international business was about 36% of total revenue,whereas American Eagle, what I could find, it's about15% of their company operated stores are international locations, somost likely a smallerfootprint. And for Cerberus to be looking at it, from their end, you get two well-known brands that,arguably, this is their business that they can help return to favor with consumers with,potentially, the right rebranding, cost cuts forprofitability, andas you mentioned in terms of those deep pockets,Cerberus has about $50 billion or so inassets under management, giving it thepocketbook it needs to really pursue this deal.

But, all in all,in terms of final thoughts for this,considering the bleak outlook that we'vementioned for Abercrombie & Fitch in terms of some of its comparable sales and trends and the headwinds that it faces, I think that even at some of the current depressed trading levels,a lot of investors have to wonder whether the ultimate buyer isgetting that good of a deal, whether it's Express or American Eagle or someone else. I think it'sunderstandable that the market has been a little skeptical.American Eagle's stock has been pushed down with these deal rumors.I think a lot of people would also be skeptical to buyinto a business that seems increasingly out of touch asyou have some of those fast fashion housesstealing market share, and as mallscontinue to lose foot traffic. Do you take a more bullish viewin terms of the overall benefits that thesetwo companies have together? Or do you think youalso have a similarly more skeptical viewin terms of whether or not this will actually pan out well forboth of the entities involved?

Sharma: Vince, I have a slight sliver of optimism when I think about this deal.I'm skeptical about the industry.I'm skeptical about the market demand and these high fixed costs that both companies face,if we look at the deal beingAbercrombie merging up with American Eagle backed by Cerberus. But, this private equity group is well-resourced,but contrary to what might appear on the surface, the company Cerberus is looking at a number of deals, andthey have a great track record of extracting value for shareholders. Theydon't base the deal coming into it andhelping out American Eagle on some projectednumbers that the two companies can create together. They look at the dealaccording to their owninternal rate of return, and they usually don'tproceed with these types of dealsuntil they think that, with thisaction plan, we'll work with management, we think we can hit ourinternal targets and get our value out in the deal. So, it's sort of astrong vote of confidence. That's whyI have a slight bit of optimism. They'renot going to pull their money into thismerger and watch it sit. They will be a very active partner to make surethat value does get extracted, which will benefit current shareholders of both firms. I still think it's going to be an uphill climb, but I have a little bit of thisoptimistic feeling thatvalue will be created.

Shen: Thank you, Asit, forbringing this up, in terms of the internal rate of return that all these private equity funds and firms will have before they look to invest in any deal like this. It'simportant to note that and,the idea that the vote of confidence that it provides. Mylast point before we move on to our next potential M&A deal is with American Eagle, for their business overall, something to highlight is that while their comps haven't suffered quite as much as Abercrombie & Fitch, and they're also seeing maybe 1% or single-digit declines in their comps during certain periods, but a big point of growth for them is theirAerieoffshoot brand. It will beinteresting to watch, if this deal goes through,how they can combine some of their more stable and high-growth brands and business with the struggles that we've seen from the portfolio brands atAbercrombie & Fitch. But, making sure we have enough time to cover our next topic.

We know thatAbercrombie is fielding acquisition offers. Ournext company,Kraft Heinz,which is the $110 billion food and beverage company,actually appears to be shopping. Back in February, the company put up a massive$143 billion offer to combine with the Europe-basedUnileverinwhat would have been one of the biggest deals in history. That would putmajor staples like Heinz Ketchup,Kraft Mac & Cheese, Jell-O,Breyers Ice Cream,Lipton tea, and Axe Body Spray allunder the same roof. The $50 per share offerpresented a 17% premium for Unilever,but the company soundly rejected the deal. Andeven if the two companies were able to agree on terms, theregulatory scrutiny would have beenpretty intense due to their size and theiroverlapping geographic areas and businesses. But since February,after the Unilever deal fell through,Kraft Heinz have been planning its next move. Asit,before we talk about another deal thatcould be in the works, could you give us a little bit ofbackground on who runs the show atKraft Heinz, andwhy they seem so eager to close another acquisition?

Sharma: Sure.Kraft Heinz isreally aggressivelymanaged and invested in by3G Capital. This is a Brazilian investment firm which has its roots,decades ago, in three Brazilian partners,of whichJorge Lemann isprobably the most visible and well-known. Theseinvestors started with small conglomeratesback in Brazil. Listenerswill be very familiar withAnheuser-Busch Inbev. Thecompany Inbev was a Brazilian beer company, and through a series of mergers, it's become the largest beer brewer in the world. As our listeners know, thecompany acquired SABMiller at the end of last year, and now there'snothing left for Anheuser-Busch to do in terms ofacquisition, except maybe lookoutside of the beer industry. This is a good example of how 3G Capitaloperates. They love to build firms up through mergers, and have acertain playbook that they implement. This playbook is usually isolating a company which is not very well-managed with justmediocre margins. They'llacquire that company and then cut costs dramatically. They did that byreducing headcount, reworkingthe supply chain, byimplementing something called zero-based budgeting,which means that every year,instead of looking at last year's budget,you create it from scratch to seewhat your costs really are, andexecute accordingly.

So, they increased the value of the company, but they're reallynot that concerned aboutgrowing revenues.To me, that's actually a harder thing to do in the business world. It's one thing to find a company that'sdoesn't operate quite as smoothly as it should andoptimize it. But to actually increase sales is a harder task. So, what many investors have noted about 3G Capitalis theirtendency, after they optimize the cost side of a company,to go in and make another acquisition. It's been a very goodvehicle for investment return. Anotherprominent one of their initiatives was the acquisition of the oldBurger Kingbrand,taking that from a private companyback to a public company, merging that withTim Hortons, andslowly trying to take over the quick-service side of the food industry. That,in a nutshell, is how 3G Capital operates. They and longtime partner andfinancier Warren Buffett love to do deals together. 3G provides theoperational aspects and some of the capital, andUncle Warren lends billions of dollars usually in preferred stock. And it's been a very successful formula. So,here we have Kraft Heinz, which wascreated by these partners. They are now trying to figure out, we'veoptimizedKraft Heinz. What else can we acquire? This is where theirlatest target,Colgate-Palmolive(NYSE: CL), comes into the picture

Shen: Rumors of another 3G-backed dealhave been floating around sincelate last year, when the company began raising funding, about $10 billion worth for a consumer goods company,according to people who were close to the matter. You mentionedColgate-Palmolive as the newpotential candidate. The company, though,at least in relation to Kraft Heinz, has nofood or beverage business that would mesh with Kraft,on top of its well-known toothpaste and personal care products,unless you count the dog and cat food business. So,why do you think Colgate-Palmolive is now in thecrosshairs for 3G?

Sharma: This is not just a greatquestion for the podcast, Vince. This is a greatphilosophical question. Why on Earth would this company turn itsattention to a totally different industry within consumer goods? I think thephilosophical answer is that at some point, thisparticular business model that 3G employs, if you cannot improve revenue, you have to look somewhere,and I think they're out of options. There are only so many giant foodconglomerates that are similar toKraft Heinz that you can purchase.Mondelez International, which is,ironically, the old Kraft company, keepscoming up in conversation. That's a merger whichmay or may not occur in the future. There just aren'ta lot of companies in the multi-billion market cap range that would make it worth their while. So, theyhave to look outside of their currentwheelhouse.Colgate is an interesting option. Youcan't get deal synergies fromcomplementary products,but you can diversify your revenue. So that's oneoptimistic way to look at this -- they'rebroadening out their product face andinsulating themselves against possible future declines in theircondiment and packaged foods business.

Shen: OK,that makes sense to me. I figured thediversifying aspect of it would be a key part of whyColgate-Palmolive is attractive. Another part that comes through is,they were recently rejected in that huge deal offer toUnilever,whereas with Colgate-Palmolive,they have a management team that seems quitehappy to consider a sale of its company.I have a note here from CEOIan Cook, who'sreported to have stated his interest inselling the company at about $100 a share. That's amore than 30% premium to current trading levels. Ultimately,with a lot of the bigger names like you mentioned in these sectors, these hugeportfolio companies are often dealing withstagnant or declining revenue.3G Capital actually isn't the only company that'slooking at Colgate-Palmolive, since there arereports that the company is considering a big move like selling itself.Unilever andJohnson & Johnsonhave also been named aspotential suitors. To close us out, anyfinal takeaways from you, Asit,in terms of the way that 3G Capitaloperates, but also what the deal might look like withKraft Heinz and Colgate-Palmolive? Obviously,details right now are scarce. Alot of this is actually just breaking this morning andin the past day. Any final thoughts or takeaways?

Sharma: My final thoughts are, this company,Kraft Heinz, has extremely deep pockets,and they have financing on the side with Warren Buffett whenever they want it. So,they could pay the premium, andpay the $100 that Colgate-Palmolive wants. Onenot very fun aspect of the deal forKraft Heinz is that they would like to findcompanies that have a much lower operating margin than they do andoptimize that. Unilever would have been a great deal,becauseUnilever's operating margins are only around 14%, whereasKraft Heinz'soperating margin is about 23.5%. Looking atColgate-Palmolive, their operating margin is already 25.5%, so there'snot a lot of great work there to doin terms of the cost-cutting we talked about. However, final thought, andI've said this on the show many times, butI'm going to keep repeating it because it's a bit of a hard concept, when you are an acquiring company, you want to look for a target which has a lowerenterprise value to EBITDA value to yours. That meansthe total value of the company divided by its earnings. If thatmultiple is lower than yours, there's somevalue creation that can happen afterwards. In this case,Kraft Heinzhas a current EV to EBITDA value of just over 19.Colgate's EV to EBITDA is about 16.5. So,there's something in therefor this very sharp management team atKraft Heinz to work with. Likeyou said, they have the funds, wevery well may see this deal go through, and thisconglomerate only grow bigger in the near future.

Shen: Thanks a lot, Asit. Bothof these deals, forAbercrombieand Kraft Heinz, aredeveloping. As we get more details, orif something gets locked down and finalized, we willhappily revisit andprovide some moreinput in terms of what the final valuation came out to,and things along those lines.

But, thanks, Fools, for listening. You canreach out to us and the rest of the Industry Focus crew via Twitter @MFIndustryFocus, or send any questions to industryfocus@fool.com. Don't forget to check out podcasts.fool.com to hear our other shows. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anythingbased solely on what you hear during the program. Fool on!

Asit Sharma has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Anheuser-Busch InBev NV, Johnson & Johnson, and Twitter. The Motley Fool recommends Unilever. The Motley Fool has a disclosure policy.