Handbag maker Coach Inc’s US$2.4bn purchase of designer and smaller luxury handbag and accessories maker Kate Spade & Co, backed by up to US$2.1bn in bank loans, shows that US retailers are opening their purses to buy rivals to boost profits, bankers and analysts said.

More mergers and acquisitions designed to bolster competitiveness would drive up retail M&A lending, after a 66% drop in 2016 to US$18bn from US$53bn in 2015 as the sector continues to face stiff challenges from online retailers.

“As more retailers feel pressured to grow revenue and profitability in a very challenging retail environment, equity markets remain robust and access to capital remains fairly cheap, M&A activity will continue and even accelerate,” said Mickey Chadha, senior credit officer at Moody’s Investors Service.

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Coach, which has investment-grade ratings of Baa2 by Moody’s, BBB by Fitch and BBB- by S&P, was put on alert for a possible downgrade by Moody’s and Fitch, based on the added debt it is taking on for the purchase.

Kate Spade’s non-investment grade credit ratings of Ba3 by Moody's and BB- by S&P could be revised upward after the acquisition on an improved financial risk profile.

Two days after the announcement of Coach’s acquisition of Kate Spade, clothing retailer Abercrombie & Fitch Co said it is in preliminary talks with several companies interested in a tie-up.

“Reasons (for retail mergers) could range from product and geographic diversification to adding online capabilities – for example PetSmart and Chewy or Wal-Mart and Jet.com – to cost savings to simply taking out a competitor,” Chadha said.

PetSmart Inc, operator of more than 1,500 pet stores, agreed to buy online pet retailer Chewy Inc in April, and Wal-Mart Stores Inc purchased e-commerce company Jet.com last August to boost their online business.

Coach secured a commitment from Bank of America Merrill Lynch for up to US$2.1bn under a 364-day senior unsecured bridge term loan facility to finance its Kate Spade buy. Coach has US$4.5bn of global revenue, according to Moody’s.

Coach plans to put permanent funding in place via an US$800m six-month loan and a US$300m three-year loan as well as US$1bn of senior unsecured notes before the merger closes, which is expected in the third quarter.

WALKING DOWN THE AISLES

Mergers driven by cost savings make sense even for retailers without immediate financial pressures, amid declining traffic to brick and mortar stores, and heavy sales promotions as well as weak teen spending on apparel, according to Moody’s.

Competition in the sector has pulled median secondary bids for US retail loans lower since the start of the year to 99.1 on May 11 from 99.9 on January 4, according to Thomson Reuters LPC data, and could erode further if bankruptcies accelerate, several bankers said.

“Payless (ShoeSource) filed for bankruptcy protection in April, J Crew’s term loan is trading in the 60s, and there’s a lot of concern about mid-level retail stores that are in the malls in particular,” a senior banker said.

Retail companies looking to bolster e-commerce and overcome difficult store locations and other issues make strategic corporate marriages increasingly likely, and could encourage more investment-grade retailers to snap up junk-rated rivals following Coach and Kate Spade’s example, according to the banker.

“We’ll see a lot of M&A if there is value in the franchise, if the name carries panache and interest by customers,” he said. “Kate Spade is one of those.”

Investors are, however, braced for further bad news from the retail sector, particularly from apparel retailers in coming months.

“I don’t think that we’ve really seen the volatility that we could if the retail sector was to start to experience a decline, and I think that’s what is going to happen in the sector sometime this year,” one investor said.