July/August 2011

Post-‘Crash’ Effects on Inventory Recovery Values: Where Are Values Today?

Lender activity has returned, as has the customers’ leverage in negotiating in this competitive lending environment. However, when it comes to monitoring their portfolios, lenders need to remain diligent to ensure that appraisals are being completed in a timely manner based on the level of risk and in such a way that accurately reflect current recovery values in the marketplace.

The market crash of 2008 and resulting cycle of impacts for retail and consumer product companies has cycled through and brought us to today’s reality, with most fears alleviated but not without critical areas for lenders to monitor portfolio risk.

Most retail and consumer products companies were forced into a reactionary mode after the 2008 market crash. After several years of relatively consistent growth, many companies had moved away from certain basic inventory management disciplines, including identifying and eliminating underperforming items and managing expenses. All of this occurred as their efforts to grow and gain market share resulted in bloated inventory levels and “over-stored” markets.

Over the course of 2009 and 2010, most companies effectively managed to reduce inventory levels significantly by managing their supply chain more efficiently, right-sizing inventory levels and tailoring inventory mix to meet the demand of their customers. Many companies have also rationalized every possible line item operating expense, including the effectiveness of headcount levels for reductions in payroll and, in many cases, working diligently with landlords for rent concessions, particularly in markets where vacancy rates have been above average. For those that reacted quickly, collateral value was preserved, in most cases, by mid-2010.

In 2011, we have seen a more “normalized” environment. In fact, Q1/11 showed moderate growth in sales coming out of the holidays. Now that inventory has been rationalized, underperforming items eliminated for the most part and consumer spending improved, albeit not to pre-2008 levels, companies are operating at the highest level of efficiency in several years, although they still face many challenges in today’s environment.

Late in 2010 and thus far in 2011, retail and consumer companies have faced significant expense increases, particularly in fuel and cotton costs, which likely may be impossible to pass on to the customer completely and have begun to impact gross margins. Continued increases affect inbound freight costs, as well as their distribution costs from port to distribution centers and stores. Furthermore, there has been a shortage in containers available for in-transit shipments, resulting in delayed receipts and, ultimately, lost sales or significant decreases in gross margin. Although weather is always a factor for sales and gross margin, the volatile weather patterns (i.e., floods, tornadoes and snowstorms) have also affected sales during the first half of the year. Companies have also partnered more closely than ever with their suppliers to adjust downward the size of some products to maintain price points and margins on a unit level, while contending with increased raw material and freight costs.

Not all industries have experienced improving sales trends, and consumer confidence varies almost week-to-week, resulting in cautious spending. The marketplace has experienced a “reset;” consumers will not likely return to pre-2008 levels of spending and will continue to demand value, as they deal with stretching dollars to cope with gasoline prices at close to $4.00 per gallon and real estate and stock portfolio values still below pre-2008 levels. Historically high unemployment and underemployment also continue to impact spending activity negatively.

We see continued price increases in low-margin basics, such as food, resulting from increased fuel costs. Grocery retailers are highly competitive, battling for every consumer dollar in their efforts to retain or gain market share, and we expect to see continued consolidation in this sector. Traditional “value” retailers (e.g., Target and Wal-Mart) have experienced soft sales or declines as customers gravitate to the dollar store concepts. In response, dollar stores are expanding their assortments in food and basic items, and operate on a lower cost structure than the industry giants, ultimately gaining market share. Consumer sentiment has decreased across an environment with no growth in real income, and with rising energy and food prices, resulting in only marginal consumer spending increases in April.

Certain industries, such as electronics, music and video, books, jewelry, arts and crafts, and furniture, will continue to face significant challenges, as consumers struggle with reduced discretionary income, and technology changes to the music, video and book industries. Many furniture retailers continue to face weak sales and eroded gross margins given the weakness in the housing market; many of these retailers have taken expanded customer deposits, which can be a danger to an asset-based lender in the event the inventory would need to be liquidated. Dollar stores and off-price retailers will be highly competitive, attempting to take market share from discount mass merchants. Several dollar store concepts have aggressive store opening plans for 2011 in anticipation of their current opportunity in the marketplace.

Within the latter part of 2010 and throughout 2011 year-to-date, we have seen a number of trends with respect to recovery values within consumer and retail inventory valuations. Many companies with which we work have shown year-over-year sales improvement. However, positive sales trends must be considered with caution, as they are being compared, in many cases, to weak 12-month sales; when compared to pre-recession levels, sales trends can often still be negative or flat.

Segments that have weathered the downturn with stable, or even strengthened, recovery values include children’s apparel, medical supplies and footwear. Industries currently yielding recovery values similar to those seen in 2007 include sporting goods and family/men’s apparel. However, a few sectors continue to experience recovery values at historic lows, including jewelry, furniture and many home furnishing categories. It continues to be critical that lenders monitor these inventories regularly and, where possible, include monthly monitoring of SKU-level inventory-to-sales mix analysis, which is one of the best tools available to track a potential erosion of inventory collateral.

Lenders should review their portfolios not only by company, but by industry concentration to identify potential areas of risk. Furthermore, understanding the effect of macroeconomic trends on their portfolio companies at a fairly detailed level is also critical; this includes the effect of increased fuel and cotton costs, how the cost increases are being accounted for, and the likelihood of passing on all or part of the increases to customers. Additionally, lenders should monitor the timing of actual-versus-planned receipts to ensure a company’s flow of goods is not interrupted due to reduced container capacity. Missed timing on seasonal goods or out-of-stock status on key items will result in lost sales or reduced margins.

Lender activity has returned, as has the customers’ leverage in negotiating in this competitive lending environment. However, lenders need to remain diligent in monitoring their portfolios to ensure that appraisals are being completed in a timely manner, based on the level of risk, and accurately reflect current recovery values in the marketplace.

Ed Zimmerlin Jr., senior vice president and inventory group leader, has worked with Hilco Appraisal Services since 2001. During that time, he relocated from Hilco’s Boston office to its corporate headquarters in Chicago to help form Hilco’s industrial inventory appraisal group. Over his time with Hilco, Zimmerlin has worked directly on or supervised over 5,000 inventory appraisals. He also works closely with Hilco’s various liquidation groups, especially when they involve a company for which Hilco has performed the valuation work. Before joining Hilco, Zimmerlin worked with Staples Corporation, Fidelity Capital, and GE Lighting. He holds a Bachelor’s degree in finance & accounting from Babson College in Wellesley, MA, and is an active member of the CFA and TMA. He can be reached at ezimmerlin [at] hilcoappraisal [dot] com.

Laura Brodeur, senior vice president, manages appraisal operations for the Retail and Consumer Products division. She has nearly 20 years of experience in retailing, asset-based lending and inventory valuation. Prior to Hilco, Brodeur was in senior management with several large retail finance organizations. Her experience in the asset-based lending sector, while primarily focused on collateral valuation and risk management, ranged from underwriting loans to managing recovery efforts. As a member of the Hilco Appraisal team, Brodeur brings a “lenders’ perspective” to the planning, production, and reporting of inventory appraisals. Her background also includes inventory valuation and asset disposition experience. Complementary to her appraisal experience, Brodeur also has direct retail experience, having worked in finance for Talbots, a national women’s apparel retailer based in Massachusetts. She is also familiar with operational and financial aspects of multi-channel retailers and vertically integrated consumer products companies. She can be reached at lbrodeur [at] hilcoappraisal [dot] com.