LBOs motivating lean, mean retail machines

Drug Store News, Oct 9, 1989 by James Frederick

LBOs motivating lean, mean retail machines

Part II in a series on leveraged buyouts in the chain drug and supermarket industries.

The junk bond market is in a state of turmoil. Respected economists and business writers are beginning to question the whole concept of leveraged buyouts and the debt financing that makes them possible. Even junk bond king Michael Milken called in The Wall Street Journal for a return to equity-based financing in American business. With the default of highly leveraged Campeau Corp. and other firms, the word on Wall Street is that the era of highly leveraged takeovers and insider-led buyouts may be nearing an end.

True or not, the problems of Campeau, Revco D.S., Dart Drug Stores and other highly leveraged companies at least underscore one important conclusion: There's nothing like a good takeover scare or a serious debt crisis to turn a dormant drug or food chain back into a lean, mean, fighting machine.

The changes can be painful for both companies and individual employees who find themselves out of work. But the pressures induced by an LBO or a defensive restructuring have spurred many post-LBO chains to new levels of performance and have challenged managers and employees to do the best job they've ever done.

Consider Jack Eckerd Corp. Four years ago Eckerd faced a hostile takeover attempt by The Dart Group on top of a sustained run of declining earnings and losses, a breakdown in morale and serious problems with both its market image and its strategic direction. Today, some three-and-a-half years after its managers took the company private in a defensive, $1.2 billion LBO, Eckerd is flexing its newfound muscles and bursting with vitality. The chain is the epitome of a trim and well-focused market force.

For that matter, consider Safeway Stores, or Kroger Co., or Hook-SupeRx Inc., or Revco D.S. No one, including the managers of those chains, would argue that their companies aren't better-run, more in touch with their markets -- albeit smaller -- than they were before taking on huge debt loads to go private. Faced with massive debt pressures and the need for immediate and sustainable cash flows, those companies have trimmed down, cut costs, revamped their marketing and merchandising strategies and focused hard on their customers to boost revenues.

Safeway

Safeway is a good example. As in most LBOs, the company paid dearly for its buyout three years ago. To pay down its crushing, $5.7 billion debt, the highly leveraged supermarket chain was forced to abandon all but its most important markets, cut store count and capital spending in half and cut warehouse inventory by $75 million. The result, however, was a rapid reduction in Safeway's debt, from $5.7 billion to $3.1 billion in two years.

Freed from the shackles of public ownership, Safeway's managers also took immediate and bold steps to build the core business. They flew in the face of conventional LBO wisdom by cutting, not raising, store prices to become more competitive. They added to store service levels, and gradually boosted capital spending back up. They decentralized decision-making to put store groups in touch with their own markets, unleashing what chairman Peter Magowan called "a whole new flood of entrepreneurial spirit, of creativity in problem-solving and in goal-setting."

The result, according to Magowan: Safeway's operating profit is now almost as high on a $14 billion sales base as it was on a pre-LBO base of $20 billion. Its return on assets has gone from 13.5 percent to 20.3 percent. All divisions are "highly profitable." And the chain now ranks No. 1 or No. 2 in all its markets.

"I believe the LBO process itself caused us to transform the company into a truly excellent one," said Magowan at a business school symposium last May. "The discipline of paying down the enormous debt we owed forced us to set high hurdle rates for performance and new capital spending.

"The knowledge that you would be sold off if you did not perform was a powerful stimulus," Magowan added. "And finally, the transformation of our operators from being managers to being co-owners of the business may have been the most powerful stimulus of all."

Safeway's chairman concludes: "I don't think we could ever have done what we did without going through the LBO."

"Safeway is an LBO that's really worked," said Sutro & Co. analyst Jonathan Ziegler. "Their cash flow is enough to pay down debt and fund operations, and I wouldn't be surprised if they even begin to make a few acquisitions. They've done a lot of things right and made few missteps."

Safeway's experience also points up another truth, according to Prudential-Bache research analyst Kimberly Walin. "The concept of a nationwide chain just doesn't work," she said. "You have to compete locally."

Eckerd

Meanwhile, the debt pressures of LBOs have spurred other retailers to higher performance levels, as well. Eckerd, for instance, has focused hard on market image, store renovation, remerchandising, store technology, pricing, advertising and other core concerns since going private. Thus, it has been able to generate enough cash flow to reduce its original debt by more than half, to under $450 million, and maintain the capital needed to keep those improvement programs going.