Is the Economy Improving?

WSJ Headline Economic Activity Gauge Update

The objective of our blog is to summarize how what is going on in the economy impacts middle-market companies based upon information from the media and government, what I learn talking with owners of middle-market companies, with middle-market focused private equity firms, subordinated debt and other lenders as well as with other advisors to middle-market companies.

Since our last entry (March 23, 2009) when we asked, “When will the economy turn around?” and introduced our WSJ Headline Economic Activity Gauge, I have been struggling to come up with an update that would be positive or encouraging. We are reading comments like, “unemployment is rising less rapidly” or “retail sales have stopped getting worse” and also “economic indicators should begin to rise from depressed levels to merely weak levels” or “the recovery will feel more like a recession” – none of which are particularly encouraging. A recent piece by BNP Paribas summarized the current situation well saying, “Most of the hard data is quite mixed: the most compelling insight is that the declines are moderating…Even if most sectors have stopped declining [or more accurately are falling less rapidly] the economy will probably remain in recession for many more months and then recover quite slowly.”

From what I am hearing, it seems that residential real estate may not yet have hit bottom, retail sales are still falling with the prospect of many more retail storefronts closing – as many as 300,000 more!, commercial mortgage defaults are just beginning, and credit card defaults and delinquencies are rising. Adding to the fears of increasing problems for retailers, of unemployment and of commercial mortgage defaults, the May 22 WSJ reported that for the 12 month period ended March 31, “the U.S. shopping malls collectively posted a 6.5% decline in tenants’ same store sales”. The article continued, “This time around, because of the dramatic changes in consumer spending practices, we’re very likely to see more malls in the death spiral than we’ve ever seen before,” and the article summarizes, “The [shopping mall] industry’s woes are worsening...For towns and cities that are home to dying malls, the fallout can be devastating. Malls hire hundreds of workers and are significant contributors to the local tax base” - all pointing to continued increasing economic problems particularly in unemployment, which some are saying may get as high as 13% and when taking into consideration the underemployed may exceed 15%.

In terms of merger and acquisition activity in the middle-market, according to D.A. Davidson’s Q1 2009 issue of The Dealmaker, “Middle-market M&A transactions have declined significantly over the past three quarters… Deal volume and the number of transactions are down 76.3% and 70.9% respectively over Q4 2007 peak activity”. And addressing valuations for those transactions, the D.A. Davidson report continues, “Middle-market M&A multiples declined to 5.0x EBITDA in 2009 - down 37.5% over Q3 2007 peak valuations”.

Since we introduced the WSJ Headline Economic Activity Gauge with the Friday, March 20 Edition, we have categorized the headlines of each Friday’s Edition through May 22 for a total of ten. Here is the summary:

Date-----------Positive-------Neutral--------Negative-----Total Headlines
March 20 ------6/19% -------3/10% ---------22/71% ---------31
March 27 -----12/32% -------3/8% ----------23/61% ---------38
April 3 --------10/23% -------2/7% ----------15/56% ----------27
April 10 --------7/23% -------5/16% ---------19/61% ----------31
April 17 -------15/42% -------0/0% ----------21/58% ---------36
April 24 --------8/27% -------6/20% ---------16/53% --------30
May 1 ----------7/21% -------3/9% ----------23/70% ----------33
May 8 ----------7/17% -------9/22% ---------25/61% ---------41
May 15 ---------7/16% ------11/24% ---------27/60% ---------45
May 22 --------15/31% -------7/14% ---------27/55% ---------49

So, what do we take from all this and what is the impact for middle-market companies? At least from this gauge, negative headlines still far outnumber positive ones which would indicate that we still have a ways to go before there are signs of a turnaround, unless the "positives" from May 22 are the beginning of a trend. Taking all this into consideration, I don’t think middle-market company valuations will get back even to today’s levels for 3-4 years. As a result, except in situations where a company must sell for one reason or another, as this weak economy persists, we are recommending that our clients consider recapitalizing the business as an alternative to a sale at this time.

With the dearth of opportunities to acquire good companies at valuations agreeable to buyers and sellers, private equity and subordinated debt funds still have literally billions of dollars to invest in middle-market companies to help them grow, to facilitate acquisitions, to buy out a partner or to recapitalize the company. A recapitalization enables the business owners to take some money “off the table” – to diversify personal assets, to have a strong financial partner to help get the company though what may be a long and difficult time and possibly to facilitate acquisitions of weaker competitors so that the company can be larger and stronger as the economy does turn around. We think a recapitalization is well worth consideration. In the mean time, hunker down and stay tuned…