Smart Money Envisions Profit in Store for the ‘90s

Why is the smart money buying into bankrupt department stores?

Because major retailers and shrewd investors believe the long recession in consumer spending will end this year--most pointedly in California, where other chains are eyeing Macy’s and Bullock’s stores and financier Sam Zell brought Carter Hawley Hale out of bankruptcy over a year ago.

And there are larger meanings. The current bidding for retail properties represents a return to sound finance after the delusions of the 1980s that landed major chains in bankruptcy. Also the department store business today offers an object lesson for all on how money, brains and hard work create opportunity where there appears to be none.

Federated Department Stores, which itself emerged from reorganization under Chapter 11 bankruptcy in 1992, last week bought half of the debt of R.H. Macy & Co., which filed for Chapter 11 protection from creditors in 1992.

Federated, which still owns Bloomingdale’s, Rich’s, Lazarus and other stores, wants a strong voice in the reorganization of Macy’s, mainly to get its California properties--Macy’s stores in San Francisco and Northern California and Bullock’s stores in the Southland.

There could be a bidding contest. Dillard Department Stores and other chains are also eager to acquire a presence in California, the nation’s largest retail market by far. They see the state coming out of economic doldrums late this year, so they’d like to invest now. The smart money acts a little ahead of the obvious.

Even so, Federated is a relative late-comer. Zell, the Chicago investor who has built a $750-million fortune by taking risks on distressed properties, bought into Carter Hawley Hale in 1992. The company is California’s largest department store chain, with more than 70 Broadway, Emporium and Weinstock’s stores.

Zell, a flamboyant 52-year-old who rides motorcycles for relaxation, was backed by corporate and public employee pension funds in assuming $200 million of Carter Hawley Hale’s debt and adding $50 million in fresh investment. For that his Zell/Chilmark fund gained 75% ownership of the company, which he has now reduced to 52% by selling public stock to raise money for modernizing stores.

But Zell’s investment--he has $25 million of his own money in the Zell/Chilmark fund--is no quick-buck exercise. He faces a risky five years of hard work, by top merchandisers who have been brought in to Carter Hawley Hale, before Zell/Chilmark sees the beginning of apayoff.

The contrast with the ‘80s, a decade praised by some as pro business but which dealt mainly in trickery, is sharp. Many of the nation’s premier retail chains, Carter Hawley, Allied Stores, Federated, Macy’s and others were involved in leveraged buyout deals in which massive borrowings were used to buy up the public stock. The theory was that retailers could run just as well on debt because customers would always spend and cash would always flow to make interest payments. It was an extraordinary delusion.

When customers stopped spending, the chains fell into bankruptcy. Fortunately, valuable franchises did not have to board up their display windows. The bankruptcy laws are suited to retail companies, explains Marc Beilinson of Pachulski, Stang, Ziehl & Young, a Los Angeles law firm specializing in bankruptcy. A firm in Chapter 11 can close stores without having to pay off 20-year leases in full. It can make a deal with bankers who know that forcing liquidation would only get them loan repayments of 25 cents on the dollar, and it can make deals with merchandise suppliers who have a stake in the stores staying open.

Now most of the chains have come through reorganization, with lower debts and a much greater focus on the need for investment and hard work.

At Carter Hawley Hale, new Chairman David Dworkin, 49, a merchant with a track record of success here and abroad, will spend $300 million over five years to remodel stores. Dworkin also is reaching out to California’s widely diverse population with merchandise and programs geared to Latinos, Asian Americans and many other ethnic groups.

But rebuilding the business is not going to be easy. California’s recession--deeper even than Zell foresaw--has held back Carter Hawley Hale’s recovery. The company failed to meet lenders’ targets for pretax profits and had to sell convertible bonds in December. Now it must issue 11.8 million shares to back up the bonds, and that could reduce Zell/Chilmark’s ownership and potential payoff.

Still, if Dworkin and his staff succeed, Zell and his investors will reap a handsome reward. Thomas Friedberg, an analyst at Genesis Merchant Group--a San Francisco investment bank owned partly by Zell and Chicago’s Pritzker family--estimates conservatively that Carter Hawley could be earning $1.25 a share by the end of 1997. That could mean an appreciation in Carter Hawley stock that would give Zell/Chilmark an 18.8% compounded return on its investment.

That would only be the beginning of the rewards for taking substantial risk over an extended period to restore a valuable business franchise. The Carter Hawley investment, it should be noted, is being made when the picture in retailing is uncertain and the outlook for California--by most conventional analyses--is bleak. But that’s when the smart money invests.

And that’s all the more reason why the enthusiasm of other retailers for Macy’s stores is so interesting. It reflects a gut feel by business professionals that California will come back strong and soon, that Americans are ready to spend again in big stores and that today’s merchants can offer customers value and service. In short, the smart money is saying that the ‘90s truly may be a pro-business decade.