Inventory Central to Retail M&A Due Diligence – Part I

M&A activity in the retail sector looks to be heating up in the second half of 2011. The Street reports that there are up to 28 possible retail deals in 2011, which include both potential and closed deals. The largest deals include the following:
Potential Purchaser Proposed Target Proposed Purchase Price Current Deal Status
Leonard Green and CVS Capital BJ’s Wholesale $2.8 billion Expected to close Sept. 2011
VF Corp. Timberland $2.2 billion Deal Closed
PPR Volcom $607.5 million Deal Closed
Leonard Green and TPG Capital J. Crew $3 billion Deal Closed
Walgreen $429 million Deal Closed
Schiffer-Gold Family and Leonard Green 99 Cents Only Stores $1.34 billion Currently accepting bids
Liberty Media Barnes and Noble $1 billion Bid dropped; Instead, Liberty invested $204 million in B&N

The key to an M&A deal in the retail sector is inventory. As the largest asset on a retailer’s balance sheet, inventory must be thoroughly scrutinized by prospective buyers. Understanding inventory issues is paramount when pursuing an acquisition of a retailer. A buyer must be informed and knowledgeable on the supply and demand of the product being purchased, as well as the macroeconomic environment affecting the target’s business. This post will address issues a buyer should address when purchasing the inventory of a retailer. Subsequent blog posts will address M&A due diligence procedures to minimize inventory risks and issues involved in purchasing the inventory of a bankrupt retailer.

A buyer must ask: What is the inventory that I am buying? In other words, is the inventory salable and what is its true value? Although deal specific information is hard to come by, many M&A transactions end up in dispute as a result of inventory-related issues.  These disputes can lead to litigation, which is a distracting and costly process. Post-closing inventory adjustments can result from various issues, including: the target’s alleged misrepresentation of inventory; the identification of excess, obsolete or damaged inventory; or as a result of a contract stipulation requiring the purchased inventory to turn a certain number of times over a specified period.

As companies pursue acquisitions in the retail sector, they face various risks associated with the existing inventory of the target. Buyers should perform in-depth due diligence on the target’s inventory in order to gain a complete understanding of that inventory and its value. Performing a thorough due diligence prior to completing a transaction will decrease the risk of unknowingly purchasing slow moving, obsolete and/or damaged inventory (i.e. inventory that is not salable at full value), and assist the buyer in gaining an understanding of any shrink-related inventory issues, including the controls in place to prevent shrink.

Other risks associated with the purchased inventory relate to the new owner making changes to the inventory product mix and the newly acquired company’s existing business model post-closing. For example, if a buyer changes the make-up of the target’s product mix, it faces the risk of encountering challenges in selling the existing inventory on-hand, further exacerbating potential inventory issues.

Stay tuned for next month’s second installment of this blog on due diligence procedures in analyzing inventory.

Have you encountered any issues with inventory in an M&A deal?