CREDIT CRUNCH

CHRISTINA VEIDERS

Without access to ready capital, most retailers are dead in today's turbulent waters of food retailing.

Unfortunately, over the last decade, the sea has been littered with flotsam resulting from bankruptcies, liquidations or simply too much leverage placed on once-viable food banners.

This year alone, Winn-Dixie bought most of bankrupt Jitney Jungle stores; Grand Union completed the liquidation of its stores; Big V Supermarkets, under Chapter 11, was brought into litigation with its cooperative wholesaler Wakefern; and Furr's Supermarkets, which filed Chapter 11, is subsequently being acquired by Fleming.

Such headlines are expected to continue. The pattern is all too familiar and it has given banking institutions around the country cause for concern.

Add to this the rapid consolidation in both the food and financial market sectors, which is putting strains on access to capital financing. In addition, the growth of supercenters over the last decade, which has dramatically altered the competitive landscape, has also given banks pause in their lending policies to food retailers. Lenders wonder if food retailers can survive against such a strong format.

As a consequence, retailers seeking growth capital could be asking themselves "where's the money?" when they go to the banks this year.

Independents, in particular, may find themselves caught adrift when it comes time to finance remodels, new stores, acquisitions or capital improvements. Wholesalers, as a consequence, may feel pressured to come up with growth capital for their retail customers to maintain their own volume and market share.

"It's created the perfect storm," said David Schoeder, principal, The Food Partners, Washington, in a presentation at the FMI Convention earlier this year.

Consolidation Wave

Over the last decade a number of bank consolidations created large multiregional banks -- J.P. Morgan Chase, Bank of America, First Union and FleetBoston, among others. The force of global competition and the importance of achieving economies of scale in the financial sector have continued to fuel such mergers and acquisitions in the banking community well into this year.

According to Julie Hossack, managing director, Harris Bank, Chicago, a well-respected food sector bank, lenders participating in 10 or more loans (commercial loans in general) have dropped from 110 in 1999 to 45 in the first quarter of this year, down from 49 in 2,000. What does it mean? For the thousands of companies in the retail food industry, there is just a handful of active lenders, she said.

Lenders have also dropped off on the syndication side, where a group of banks get together to fund a large loan for one borrower. Over the last 12 months there were 118 banks that participated in at least two syndicated loans, down from 122 in 2000 and 166 in 1999, Hossack noted.

"Simply put, banks are finding loans to be inefficient ways to invest their capital," said Hossack. Instead, some banks have shifted their interest away from granting commercial loans to e-driven revenue sources, portfolio management techniques and investment banking models.

"Absolutely, we've seen that pressure," said Matt Hildreth, senior vice president, finance, Fleming Cos., Lewisville, Texas. "Through consolidation of banks and a much stronger view on returns on the institution's balance sheet, spreads have widened significantly. The pro-rata market -- meaning [loans] under a revolver -- has shrunk significantly," he said.

Rising defaults have only exacerbated the situation. The Federal Deposit Insurance Corp. released a first-quarter report last month showing the rate of commercial and industrial loans 90 days or more past due rose 1.8% during the first quarter, a seven-year high. In the same period, banks wrote off a total of $7 billion in bad loans, up 38% from the prior year's first quarter. Commercial and industrial loans accounted for more than half (54.8%) of that amount.

This prompted Federal Reserve Chairman Alan Greenspan to urge banks not to overreact and cut off credit to qualified borrowers. "Such policies are demonstrably not in the best interests of banks' shareholders or the economy," he said during a Senate Banking Committee hearing in June.

Historical Perspective

George Triebenbacher, manager director, GMAC Business Credit Group, New York, put things in perspective for the food sector by recalling the period in the mid-'80s and into the '90s. Then, numerous "financial buyers" were attracted to the food industry because of "their ability to buy companies with other people's money." High-yield investors provided leverage based upon their belief that the cash flows of food retailing were not cyclical. "They also believed that by rolling up regional chains you could significantly grow cash flows by eliminating redundant expenses," he said.

The early players in this game were successful due to lower purchase price multiples. However, competition for quality companies soon heated up, and with it so did the purchase price multiples, said Triebenbacher.

Hildreth said credit spreads have widened dramatically since 1997. As an example, Hildreth, who comes from the investment banking side of J.P. Morgan, said in 1997 a term loan might have been priced at LIBOR (the international rate that banks borrow from other banks), plus 125. Today, that same loan may be at LIBOR, plus 300.

"Buyers failed to realize it was becoming increasingly more difficult to retain market share, let alone grow it," said Triebenbacher, who was involved in many leveraged grocery deals. "There was a tremendous increase in the need for promotional and capital spending in order to retain market positions vs. unleveraged competitors."

As the market competition heated up, some retailers suddenly found themselves over-leveraged when put under pricing and promotional pressures from their competitors. Many retailers were now going to banks for transactions that fell into three different categories -- prepackaged bankruptcies, financial restructuring and distressed sale or liquidation.

In the prepackaged bankruptcy, retailers like Grand Union under its first bankruptcy filing, Pathmark, Penn Traffic and Bruno's all re-emerged with significantly less debt after high-yield debt was converted to equity and leases were canceled on unprofitable stores.

Under financial restructurings, companies like Purity Supreme and Kash N' Karry required additional equity/junior investment to see them through.

In the cases of Grand Union's third bankruptcy filing, Jitney Jungle, Peter J. Schmidt, Schwegmans, Farm Fresh and Victory Supermarkets all found no investors left to "cram down" money to free up cash flow. The companies were subject to distressed sales or liquidation.

"The grocery sector has been impacted specifically by gigantic failures, and the people that have taken it on the chin for the most part have been high-yield lenders," Triebenbacher told SN.

Supercenter Impact

Commercial lenders have also been watching the growth of supercenters, and how they are altering the food retailing landscape. This year Wal-Mart's 800-plus supercenters rose to take the No. 1 slot on SN's Top 75 food retailers' list with a total volume of $57.2 billion. This achievement comes just 13 years after Wal-Mart built its first supercenter. Others expanding their supercenters include Super Kmart, Super Target and Meijer.

"The increase in supercenters causes me nightmares," said Schoeder, who believes it has also caused much consternation among other lenders.

"It doesn't matter whether the supercenter is coming to town or not. The assumption is that they're going to be there.

"Today, Wal-Mart doesn't look at competition in the marketplace. They put in 10 supercenters, add 500,000 square feet of retail space and they do it in a 24-month period. That radically alters the competitive position of the market overnight. They are irrational competitors," said Schoeder. He said food retailers have to make it clear to lenders why they will be a survivor under the siege of a supercenter competitor.

"Supercenters are a huge threat," noted Hossack. Lenders are very wary about supercenter competition, particularly if they are lending to an independent who doesn't have the borrowing capacity to make additional capital expenditures against the main competitor."

Layered on top of all these scenarios is the sluggish state of the U.S. economy. On the one hand, its impact is viewed as bolstering the tight loan market. But the Federal Reserve's lowering of interest rates has helped stabilize the escalating cost of money these days.

Where Independents Stand

While the credit crunch is occurring across the broad spectrum of food retailing, independents may be particularly hard hit since they aren't as well capitalized as the big players. The National Grocers Association, Reston, Va., lists access to competitive growth capital as essential for an independent's future growth.

"We have been concerned with the top five companies and their increasing level of concentration," said Tom Zaucha, president and chief executive officer, NGA. "So much of this is driven by the Wal-Mart phenomena. We call it the 'rush to bigdom.' But that doesn't preclude community-based companies and regional-based companies from growing and maintaining their viability and competitiveness. To do that, however, you do need capital."

Several years ago the NGA formed an alliance with the National Cooperative Bank, Washington, to provide financial services to independent food retailers and wholesalers. NCB, formed by an act of Congress 25 years ago to expand cooperative business in the United States, has since gone private. It is still dedicated to serving the needs of cooperative business, but the bank views the independents in the food sector as a growth opportunity.

"I do feel credit is getting more tight, but we are still seeing competition for the loans," said John Goldthwait, vice president, NCB. "There are people out there willing to lend and we are one of them."

NCB generally lends to smaller independents -- those operating three to five stores. Many of the loans NCB grants are for remodels. The bank's loan origination totaled over $50 million last year.

Wholesaler Sources

The wholesale community has long been a source of financing for independents. Nash Finch, Minneapolis, makes clear it is first and foremost a supplier of goods. Its role as a lender is not to make money lending money, but to grow its business through strategic interests with its retail partners, said Ron Marshall, president and chief executive officer of the Minneapolis-based wholesaler.

"The concept of capital formation for independent retailers is a key strategic initiative to allow us to grow our business," Marshall said, during the FMI presentation. "In order for that to happen, it truly has to be a win-win situation. We gain volume. The retailer increases his profitability and liquidity in a network. It creates a long-term strategic partnership between retailer and wholesaler."

One program is a Low Interest Development Opportunity loan where Nash Finch subsidizes low interest rates for those carrying one of the Nash Finch banners -- IGA, Food Pride or Nash Finch.

Nash Finch has over $90 million in loans, leases and loan guarantees on its books, said Marsh. It is not a source of profit for the company. Going forward, Marsh said a "sound credit policy is a sound credit policy regardless of the institution or the sort of business one is in. This is about growing the business and building new stores in consolidating markets where the strongest retailer can prosper."

Most lenders don't expect the current state of the credit markets to turn around anytime soon. Some say it will take between three and five years before banks can absorb the ramifications of their own mergers and credit problems, and the food retail markets will settle down. "We need stability and continuity to improve access and pricing," said Schoeder.

For the short term, most expect developments to slow in the food sector, especially on the merger and acquisition end. With "financial buyers" out of the game, the "synergistic buyers" (other retail food companies) remain under the control of FTC issues, said Triebenbacher. "The whole merger game is slowing down because of these couple of issues. But it will continue nonetheless because it's a lot easier to acquire the retailer with dominant market share than it is to open green field locations and try to get market share over a longer period."

As for those left on the retailing playing field, most believe the strong will survive. "The Krogers, Albertson'ses, Safeways, they will always be key competitors. At the bottom end, independents who are civically inclined and have a loyal following of shoppers that don't mind paying more for extra service will always be around," said Hildreth.

"It is more challenging," Goldthwait admits. "Independents have to work to remain more competitive. That means remodeling the stores when appropriate, growing when appropriate and really understanding what the customer wants in tailoring their offering. They can't afford to do business as usual. They have to remain dynamic and change with the industry," he commented.

But when capital markets do finally loosen up, Hossack cautions the independents. "They need to be careful how they allocate their capital and choose their capital projects. They have to make sure they don't get themselves to the point where they are too leveraged to reinvest in their stores."