Sears: Death by Debt

Sears: Death by Debt Minutemen Equity Fund Hannah Kim, Joshua Owczarski, Sam Jezard Isenberg School of Management University of Massachusetts, Amherst Submitted February 20, 2015 Table of Contents Company Overview .............................................................................................................................................. 3 Competition ............................................................................................................................................................. 3 Debt ............................................................................................................................................................................ 4 Financials ................................................................................................................................................................. 6 REIT Conversion ................................................................................................................................................. 10 Sears’ Turnaround potential? ........................................................................................................................ 11 Conclusion............................................................................................................................................................. 13 References ............................................................................................................................................................ 13 2 Company Overview Sears Holding Corporation is a multi-billion dollar retailer with a 125 year history operating across the United States. Presently with a market cap of approximately $4 billion, the company operates 1,980 stores in the United States through Kmart and Sears, and 449 full-line stores in Canada. The Company reports in three segments, Sears Domestic, Sears Canada, and Kmart. In Canada, the Company operates as a majority stakeholder with 51% ownership. Proprietary brands include Kenmore, Craftsman, and Diehard. Sears Domestic primarily focuses on commercial sales, specialty stores, and home services while Canada focuses primarily on the sale of apparel. As of February 1, 2014, the Company operated 1,152 Kmart stores across the United States, Guam, Puerto Rico, and the U.S. Virgin Islands. Kmart brands sells products in many merchandise categories including apparel, consumables, and electronics. Notable apparel brands include Joe Boxer and Jaclyn Smith. Presently, over 800 Kmart stores operate in-store pharmacies. Competition Sears Holdings Corporation faces increasing pressure from other retailers that compete in the same space. Since the company sells products in a variety of categories, there are many competitors who are taking away market share. Competitors include Lowe’s, Home Depot, Walmart, and Target have business models that are more efficient and profitable compared to Sears. 3 Debt The main reason Sears will be bankrupt within five years is due to its current amount of debt. In its most recent quarter, Sears had an astronomical $4.9 billion in debt, versus only $126 million in total shareholders’ equity. This equates to a very disturbing debt/equity ratio of 39.21 for the most recent quarter, nothing even close to a desirable number. With a current ratio of 0.9, Sears would be unable to cover its current debt in the upcoming year without more financing. Around $3 billion in debt is due in October 2018, with another $625 million due in 2019. While these bonds are all trading around 93 cents on the dollar, debt extended out to 2027 and 2028 is trading around 60 cents to the dollar, signs that Wall Street does not believe that Sears will be around by that time. The Company’s debt, presently rated as junk by both Moody’s and Fitch has been downgraded 20 times since 2005. Moody’s rating on Sears is currently Caa1, while S&P rates the Company CCC+. Bloomberg analysis of the debt characterizes the Company as level 4 High Yield with a default risk of 2.40%- 4.0%. To compare, this figure stood at 0.50% in 2010. This percentage reflects financial health and operating conditions. DEFAULT PROBABILITY HY1 0.52% - 0.88% HY2 0.88% - 1.50% HY3 1.50% - 2.40% HY4 2.40% - 4.00% HY5 4.00% - 6.00% HY6 6.00% - 10.00% Table 1. Bloomberg rankings of default probability. Bloomberg While Sears is able to maintain a gross margin of around 25%, their hefty selling, general, and administrative expenses of around $10 billion a year have thus far ensured they 4 sustain a heavy operating loss and a negative EBIT. These operating expenses primarily include severances and expenses attributable to store closings. These expenses have been a weight on the Company’s back as they try to compete in an increasingly crowded space. In the latest fiscal year, Sears’ operating loss totaled $927 million and EBIT totaled $718 million. Of the Sears outstanding debt, $400 million is a secured short-term loan agreement with entities affiliated with ESL investments, Mr. Edward Lampert’s personal hedge fund. Mr. Lampert and ESL investments also held an aggregate of $205 million in secured notes due 2018. The debt issued by CEO Lambert’s hedge fund, while a lifeline to the company, are secured by over two dozen properties that should the company declare bankruptcy, be forfeited to ESL Investments. A majority of the debt held by ESL is asset-backed, which relates to the one positive item Sears has on its balance sheet: its stores. In 2014, Sears sold two full line stores for $64 million in cash, resulting in a gain of $42 million. So, while Sears continues to post lower and lower earnings, its one true defense against bankruptcy is and will be the sale of its property. However, as Sears is forced to issue more debt to cover its losses, it will eventually run out of brands to spin off and buildings to sell. According to Bloomberg, it now costs more to insure against a default for a year than for five years, a sign that Wall Street traders are betting on bankruptcy. If Sears does indeed sell and leaseback 300 stores as part of its turnaround efforts, it gives it less leverage when it comes time to issue more debt in order to pay the bills, and it effectively eliminates the cushion provided by owning those stores. Further sale of property would only further hurt their already steeply declining revenues. 5 Financials As has been plainly pointed out in the aforementioned sections, the financial situation of Sears Holding Corporation is disastrous. To say that S is bleeding cash and racking up exceptionally high levels of debt is naïve at best. The financial situation at Sears is more akin to a sliced artery, haphazardly patched with duct tape and super glue. The core business segments of Sears’ companies, namely retail sales of consumer goods and services, has not been profitable for 4 years, and only marginally profitable prior to that. The only successful part of their newly formulated business strategy has been the fire sale of real estate and long-standing exclusive brand names such as Land’s End, which are only considered successful when compared to total liquidation. As the company stands today, the only real value lies in its massive real estate portfolio, nascent online “Shop Your Way” retail service, and the in-house brands Diehard batteries, Craftsman tools, and Kenmore appliances, all shells of their former selves, much like their parent company. Sears is a dying company when viewed in plain text, but the hard, publicly available financial data spells the writing on the wall for the one-time king of American consumer retail. Sears’ financial distress can be seen as soon as one takes even a cursory glance at their income statement. Using their Q3 2014 10-Q and 2013 10-K statements, numerous glaring trends are laid out in black and white. Overall revenue has fallen 9.75% in the 39 weeks ended November 1, 2014 when compared to revenue over the same period in 2013. Total costs and expenses have fallen 7.24% over the same period, reflecting a failure to reduce costs adequately in a smaller economy of scale. Sears’ failed to turn a profit during the 39 weeks ended November 2, 2013, posting a $1.007B net loss, and accelerated this hemorrhaging of cash to an eye- watering $1.523B net loss over the same period in 2014. 6 Free Cash Flow Conversion 2007 2008 2009 2010 2011 2012 2013 2014 EBITDA $ 3,618 $ 2,597 $ 1,283 $ 1,639 $ 1,306 $ (648) $ (8) $ (195) Taxes $ 933 $ 550 $ 85 $ 123 $ 27 $ 1,369 $ 44 $ 144 Capital Expenditures $ (508) $ (870) $ (497) $ (361) $ (426) $ (432) $ (379) $ (329) Change in Working Capital $ 498 $ (2,115) $ (336) $ (252) $ 265 $ (1,885) $ (181) $ (77) Free Cash Flow $ 1,679 $ 3,292 $ 1,037 $ 1,407 $ 588 $ (564) $ (250) $ (591) Table 2. Free cash flow conversion from 2007 to 2014. Bloomberg Loss per diluted common share rose from $9.49/share to $14.33/share over the same period, including an increase in shares outstanding of a meager .2M shares. It should be noted that 48% of shares outstanding are owned or affiliated with the CEO Edward “Eddie” S. Lampert and/or his hedge fund, ESL Investments. The balance sheet of Sears paints an equally grim picture. A quick look at their current assets shows a fast decline – 27.89% from Q3 2013 to Q3 2014. Mercifully, their current liabilities have dropped 13.09% over the same period, but this is not the full story. A deeper look shows that short-term debt has increased 19.70% over the same period, showing an increased reliance on short-term, high yield credit. Long-term debt

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