The acceleration of growth in online apparel sales should be carefully considered when performing financial due diligence of an apparel target. Goldman Sachs estimates that by 2020 $50B of apparel sales will migrate online (from the current $300B over all channels in apparel), which is equivalent to the combined apparel and accessories sales for Macy’s Inc., Nordstrom Inc., and Kohl’s Corp in all channels. Driving the shift online is Amazon, the 7th largest apparel retailer in the US and the largest online retailer by a wide margin. As a result, Goldman Sachs notes, more brands will be forced to sell directly to Amazon.com, largely because they need to migrate where consumer traffic is. Additionally, mobile display, distribution infrastructure, and free shipping will continue to make it less expensive and faster for consumers to shop online. Given this retail landscape, there are several items that can impact the purchase price that a potential buyer or seller should consider during the financial due diligence of an apparel company.
During due diligence, it is important to understand how the shift to an online sales channel can alter the dynamics of a retailer’s sales. For example, brands will benefit to varying degrees by selling direct to consumers. Omni-channel gives brands such as Nike Inc., Ralph Lauren Corp., Hanesbrands, Carters Inc., and Columbia Sportswear Company the opportunity to sell direct to consumers and capture the downstream retailer margin and potentially reduce selling expenses. From a due diligence perspective, M&A clients need to be aware that excess inventories of these same brands at brick and mortar stores may increase, causing some retailers to dump excess inventory online. This process may keep brick and mortar margins high as retailers maintain pricing in the store and drive online sales up as volume increases. However, the dumping will likely drive overall ecommerce margins down as retailers drop online prices of any excess inventory, which is likely an unsustainable business model. Understanding changes in retail sales that result from a shift in the sales channels can result in significant run rate quality of earnings adjustments. M&A clients will need to consider how each sales channel has grown or shrunk, the resulting impact on margins, changes to revenue recognition (and any resulting lag), and evaluate what will be representative of the business going forward.
The shift to omni-channel can also impact areas of the business such as sourcing and distribution. In particular, retailers may see these costs increase or decrease to meet ecommerce trends and customer demands. These additional demands from building the online channel may result in additional quality of earnings or working capital adjustments. For example, a cost change may result from accommodating customers’ demands for just-in-time delivery, which will in turn impact inventory and potentially require both a quality of earnings and working capital adjustment. Cost changes may also be associated with an increase in the number of need distribution centers or an upgrade in distribution center efficiency or technology.
There are several ways a company can account for returns, allowances, and discounts. Such revenue adjustments can lead to material changes in M&A purchase prices in the retail industry. It is important to ensure that the adjustments to revenue are properly accounted for and are representative of the business; otherwise revenue adjustments may result in quality of earnings adjustments during due diligence. A number of circumstances can lead to significant quality of earnings adjustments. If there have been changes in accounting policies in recent history or a major shift to online sales, a run rate quality of earnings adjustment may be necessary. Certain one-time events such as additional discounting from an anniversary sale or a temporary change in the competitive landscape may result in quality of earnings adjustments to accurately reflect the business’ performance going forward. It is also helpful to understand the terms of the retailer’s agreements with wholesalers when considering quality of earnings adjustments, including those related to chargeback rates and agreement termination.
The growth of Amazon has forced most apparel players to carefully consider their own online strategy. While some apparel players sell directly to consumers, others may choose to partner with Amazon or other online companies, even though this may limit longer term online margins. However apparel players address ecommerce, it is important to fully understand the impact their decisions will have on due diligence when considering a merger, acquisition, or divestiture.
If you have any questions regarding the due diligence of a potential acquisition or divestiture, you can reach out to us at HSteinmetz@friedmanllp.com and BCraske@friedmanllp.com or to your Friedman advisor.