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Balancing Tangible, Intangible Asset Values in Chapter 11 Retail Restructurings

Nov 30, 2018

 This article first appeared in The Journal of Corporate Renewal

 By Alexander McKeown, Director, Hilco Merchant Resources and Benjamin Kaplan, Associate, Hilco Streambank

It should come as no surprise to turnaround professionals or even casual readers that the retail industry is in a state of transition. However, contrary to the popular refrain, this transition does not signal that brick-and-mortar retail is dead, nor is it in the midst of an apocalypse.

The retail industry is evolving to respond to changes in consumer expectations of brick-and-mortar stores within omnichannel platforms. Customers now demand that retailers merge digital and physical experience rather than merely offer products for purchase. The ability to buy products online and pick them up in a store (BOPIS) is a simple example of what this merge can look like. However, the investment required to accommodate this shift is affected by debt-heavy balance sheets and increasing borrowing costs as interest rates rise.

As a result, retailers that are unwilling or unable to adapt may find themselves in a restructuring or sale scenario, often in bankruptcy. They must effectively execute store closing sales to achieve the near-term recovery goal of maximizing inventory value and exiting poor real estate, while considering the potential effects those decisions may have on preserving brand value over the long term for the go-forward enterprise.

Debt Maturities on the Rise

Retail in 2018 will be remembered for Toys R Us, once a darling of the industry, going out of business. While a variety of factors contributed to its demise, principal among them was the company’s debt stemming from a $6.6 billion leveraged buyout in 2006. Despite being profitable, the company could not afford to continue making its $400 million interest payments, and was forced to file for Chapter 11 protection and ultimately shutter the business.

The refrain regarding excessive debt, heard often during the 2008 financial crisis, is rearing its head again. According to Fitch Ratings, between 2019 and 2025 debt maturities on high-yield borrowings will average $5 billion per year, compared to a relatively modest $1.9 billion maturing in 2018. Likewise, Moody’s forecasts $15 billion of retail debt maturities between 2018 and 2020, with $5.9 billion of that occurring in 2019 alone. As interest rates rise or credit markets tighten, retailers will find it more difficult to refinance or issue new debt, leaving those with maturing debt no choice but to file for bankruptcy.

As retailers face the prospect of a Chapter 11 filing, developing a cohesive plan to conduct store closing sales—often a necessary part of a retail restructuring due to lease costs—and preserve brand value become paramount. With the number of retailers filing for Chapter 11 poised to rise over the next several years, understanding the steps that will help retailers manage the pressures of maturing debt and navigate a Chapter 11 restructuring to a successful end is more relevant than ever.

Managing Store Closings

As a retailer generates a smaller portion of its revenues and profits from its store base, it will try to close underperforming stores to suit demand. This can be done in the ordinary course as part of a regular evaluation of a healthy retailer’s real estate portfolio or in the case of a distressed retailer, under the protections provided by Chapter 11. Often, however, completing a restructuring or M&A transaction will require a Chapter 11 filing to shed unprofitable leases and also provide a platform to maximize the value of any excess inventory.

Specifically, when it comes to retail Chapter 11 restructurings in which a debtor plans to sell a portion of its business as a going concern, store closing sales must be managed with an eye toward maintaining brand value, as decisions made during the store closing process can meaningfully impact that value.

Two considerations must be addressed: how to maximize the value of its excess inventory in closing stores, and how to prevent erosion of the brand in a going concern sale or restructuring. Importantly, the value of a retailer’s inventory in a store closing liquidation will play a major role in the success of a restructuring, as stakeholders will evaluate this short and predictable outcome against the potential long-term enterprise value of the business.

The most successful efforts harmonize recoveries in the short term on real estate; inventory; furniture, fixtures & equipment (FF&E); and other tangible assets with long-term intellectual property and brand value retention. Ultimately, in a Chapter 11 restructuring a retailer must find a way to establish and maintain a consistent customer experience and carefully craft sale messaging if a balance is to be achieved.

Maximizing Inventory Recovery

Inventory value is maximized when it is sold through the retail store base directly to the end consumer. In the context of a Chapter 11 retail restructuring, the company and its advisors identify underperforming store locations through which inventory and FF&E can be sold and slate them to close. Identifying the right real estate to exit is essential and can bring value in the short and long term. In addition to relieving the burden of operating unprofitable stores, ensuring that a retailer’s remaining stores are in desirable malls or areas with low vacancy rates can have a meaningful impact on brand value.

Once locations to be closed are identified, retailers should determine the capacity for how much, if any, additional inventory can be sold through the stores during the specified sale term. If there is additional capacity, other excess or unwanted inventory located in ongoing stores or distribution centers can be identified to be sold through the closing locations.

As store closing sales commence, consumers are notified through sign walkers, store signage, press releases, and the company’s traditional channels of communication, including email and social media. It is critical that messaging, which will have a direct impact on inventory recovery, does not infringe the customer experience or the perception of the business as a going concern.

An effective liquidation sale’s messaging communicates a sense of urgency, value, and finality to the consumer. Generally, this can be achieved using a “store closing” theme and emphasizing that only some locations are closing and that the company as a whole will continue to operate. Delivery of that message should be consistent across the retailer’s website, email communications, and social media posts.

In addition to sale signage, operational considerations that minimize disrupting the customer experience reinforce that the company will continue to operate despite closing select stores in the short term. Loyalty programs and gift cards should remain in place for the duration of the sale. Likewise, there should be recourse for customers who have purchased product online but wish to return it during the store closing sale. Halting legacy programs or customer deposit orders—which is a particularly sensitive issue in closings of furniture-related stores—only erodes consumer confidence that the company will continue to operate.

Finally, in-store customer transition programs should be used to make customers aware of other stores nearby and the ability to shop online, and should incentivize them to avail themselves of those options. Store closing events also often attract a retailer’s “aspirational” shoppers—customers who could not otherwise afford to shop at the retailer but for the out of the ordinary discounts being offered. A properly run sale that promotes a consistent customer experience is an effective way to attract and catalog an expanded customer base.


 

When executed well, the retail experience remains consistent, and value can be retained regardless of the underlying operational struggles.

 


Preserving Intellectual Property Value

For retail brands, there is a wide and volatile range of possible values for intangible assets, depending on whether they are marketed on a fair market, orderly liquidation, or forced liquidation basis. That volatility can quickly erode brand value when intangible assets are poorly managed in store closing sales or at other times. Decisions made during the store closing process can have lasting effects that are only measurable after the restructuring period has concluded.

A retailer that ignores brand value in its approach to store closing events will likely experience erosion of that value, which manifests either as a blemished image from the customer’s perspective or lower-than-expected values when it attempts a restructuring or Section 363 sale of its remaining business. The best way to combat this potential erosion is to ensure that brand assets are accounted for and maintained through the entire process, and to prioritize preserving the customer experience and meeting customer expectations. Successful execution of this endeavor becomes even more challenging during a financial and operational restructuring.As a simple hypothetical example, Amazon Prime members receive free two-day shipping as part of their membership. This simple perk offers both convenience and value, and has become an integral promise of the Amazon Prime brand. If the company were to suddenly eliminate this membership benefit, then consumers would feel a deep sense of betrayal and lose both financial and sentimental incentives to continue their relationship with the brand. Imagine that a retailer undergoing a restructuring also gives its customers free shipping and is losing meaningful margin with every sale. The challenge of maintaining a positive brand experience under such pressure and the microscope of Chapter 11 is intense.

Minimizing Brand Erosion

Avoiding disruption in a retailer’s operations is key to executing the restructuring plan. A brand’s intellectual property (IP) assets, such as trademarks, patents, and internet domains, are typically invisible to the untrained eye, but if identified and accounted for early on, the brand IP will not be stripped of value during the transition through a restructuring.

By cataloging the owned trademarks, patents, and domains, along with key information such as expiration dates and fields of use, retailers can quickly identify any risk of losing valuable trade names, technologies, or e-commerce platforms. This is especially true during a store closing sale and the associated tumult of a Chapter 11 restructuring, given that this task is often completed by outside counsel who may not be integrally involved in the bankruptcy filing.

Another aspect of the customer experience that can be overlooked is the use of communication channels, specifically social media and email. In the digital age, effective communication must include some digital elements. As noted earlier, it is in a retailer’s best interests to use messaging that does not overlook customer perception of the business as a going concern. Compromising the customer’s perception of the brand weakens the retailer-customer relationship for a go-forward operation, subsequently reducing the value of the brand.

It is essential for a retailer to maintain its traditional customer touchpoints to maintain a sense of continuity and longevity through the consumer’s eyes. Effective communication can include setting up a link on the website to answer frequently asked questions (FAQs) that customers may have about product returns, outstanding gift cards, loyalty programs, or the nearest operating locations. When executed well, the retail experience remains consistent, and value can be retained regardless of the underlying operational struggles.

An example of maintaining continuity and longevity is the way in which customer programs are managed during store closings. Loyalty program members and customers with gift cards have either earned their rewards through repeated and loyal spending habits or received them as gifts for special occasions. Failing to continue these programs diminishes consumers’ confidence in the brand. The promise offered by the brand is broken, and the relationship between the customer and retailer is damaged, which is detrimental to brand IP value.

If the customer is lost early in the process due to a lack of brand continuity, the prospects for a successful restructuring diminish. Too often, retailers are seeking going concern buyers for the business or the brand after critical infrastructure and programs have been compromised, resulting in a substantial decrease in value.

Recent Successes

The challenge of balancing brand and inventory values has been evident in a number of transactions over the past few years, including Aeropostale, Gymboree, Payless, and The Limited. In each case, store closing sales were held to right-size the lease portfolio, and the company emerged from Chapter 11 as a viable going concern business.

Another retailer, Target, announced in 2015 that it would exit the Canadian market and close more than 130 underperforming stores. Given the scale of the closings and the fact that Target is a multinational brand, the news was not only covered extensively in the United States but was also carried internationally. Target recognized that its Canadian brick-and-mortar operations had not succeeded, so it shed underperforming assets and refocused on the United States, where it is investing $7 billion in stores and its website, and on other markets. As evidenced by its strong performance in the U.S. and elsewhere since then, the brand benefited from a well-run sale that mitigated negative press and allowed Target to continue to meet customer expectations elsewhere.

Vestis Retail Group, too, benefited from rationalizing its Sports Chalet, Bob’s, and Eastern Mountain Sports holdings, which were ultimately purchased by Sports Direct. Taking advantage of Chapter 11 protections was essential to Vestis shedding many of the underperforming stores under the Sports Chalet banner and addressing underperforming Bob’s and EMS locations to form a leaner operation. Today, both Bob’s and Eastern Mountain Sports continue to operate with little lasting detrimental impact to their brands, despite closing stores.

Most recently, the Brookstone case perfectly exemplified a retailer that conducted store closing sales while retaining significant brand value. The company decided to immediately commence store closing sales at all of its mall-based locations when it filed Chapter 11 in August, while maintaining its airport store locations and its e-commerce and wholesale businesses.  Concurrently, the company explored an M&A transaction for its remaining assets.

The strategy worked. Multiple financial buyers expressed intense interest in the company’s intellectual property, ultimately resulting in a bidding war. After entering into an agreement to market its intellectual property backed by a $56.35 million stalking horse bid, the final result was a far more robust $72.2 million sale to Bluestar Alliance and Apex Digital. The Brookstone case exemplifies how much value a retailer’s IP can generate, even after an aggressive store closing sale.

Bringing It All Together

Brick-and-mortar retailers that are unable to adapt their businesses to changing consumer preferences and are saddled with debt they are unable to service are likely to be faced with a restructuring scenario. They should consider the balance between tangible asset value and the more volatile brand value to yield the best possible outcome. By understanding how to maintain a consistent customer experience and brand identity, even during store closing sales, a retailer can significantly increase the likelihood of a successful outcome, achieving maximized inventory recovery along with strong brand value retention.