Sears: Death by Debt

Transcription

1 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

2 Table of Contents Company Overview... 3 Competition... 3 Debt... 4 Financials... 6 REIT Conversion Sears Turnaround potential? Conclusion References

3 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

4 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 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 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 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 This percentage reflects financial health and operating conditions. DEFAULT PROBABILITY HY1 0.52% % HY2 0.88% % HY3 1.50% % HY4 2.40% % HY5 4.00% % HY6 6.00% % 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

5 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 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

6 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 Q Q and 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 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 eyewatering $1.523B net loss over the same period in

7 Free Cash Flow Conversion 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 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 Q to Q 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 is not being serviced as quickly as it should at Sears. The vast majority of Sears long-term debt obligations are due in 2018/2019 and was recently re-graded as Caa3 with a Negative outlook by Moody s. Sears debt is junk, and must carry a high interest rate going forward, which the company stands unable to service. LT debt has decreased $93M or 3.24%, an amount tripled by their increased short-term debt (+$325M, %.) Sears Holding is becoming ever increasingly reliant on short-term debt, and stands to fail to meet their long-term debt obligations in the next 5 years. A shareholder could look past one year of weakened performance if the company was in a deflationary environment or undergoing a massive restructuring, but Sears is undergoing neither and has not been for 5 years. In fact, Sears has been on a downward spiral since 2006, 7

8 with the Company s identity left to rot since the 1990 s. This is somewhat consistent with the overall trend of retail sales in department stores, shown below, but Sears trajectory has underperformed the retail sector quite impressively % US Department Stores: Sales as % of General Merchandise, Apparel & accessories ( ) % U.S. Department Store Sales as % of GAFO Chart 1. Department Store Sales as a percentage of total Industry Sales. Bloomberg Part of this downfall is Sears slip in overall market share of the retail sector from 2006 level of 27% (market leader) to just 19% in This has been caused by, among other factors, a disorganized company direction, lack of innovation in-store, poor brand recognition, and above all, a change from brick-and-mortar retail sales to online sales. Other retailers such as Target, Walmart, Kohl s, and Macy s have successfully implemented online retailing to help lure customers back from internet retail giants like Amazon and ebay, but Sears has been unable to do the same with their Shop Your Way online retail site. Sears and Kmart have equity in brands that they wholly own, namely Diehard, Craftsman, and Kenmore, that they have not licensed to be sold outside of their store, which may very well be stagnating sales of these brands as well. Overall market share decline is outlined in the following pie charts. 8

9 Market Share FY 2006 Market Share FY 2013 Other 16% Other 21% JC Penney Co Inc 16% Nordstrom Inc 7% Kohl's Corp 12% Macy's Inc 22% Sears 27% JC Penney Co Inc 10% Nordstrom Inc 10% Kohl's Corp 16% Macy's Inc 24% Sears 19% Charts 2 and 3. Change in Industry Market Share from 2006 to Bloomberg Total revenue from 2006 has fallen every single year from $53.012B to $36.188B in 2013 a 31.73% decline. Sears has not turned a profit since Same store sales have been declining at a rate between 3-10% since Short term debt has ballooned from $95M in 2006 to $1.32B in 2013 an incredible increase of 1289%. Net income and EPS have tanked since 2007 from healthy levels to negative levels, shown in the following graph: EPS to Net Interest Margin (5.00) (10.00) Adjusted EPS Net Income Margin % Linear (Adjusted EPS) Chart 4. Sears Holding Corporation Profitability from 2007 Present. Bloomberg Further insight into the current financial state of Sears is not necessary to determine that the company is doomed. Unless the company can radically reduce costs through elimination of 9

10 non-key assets, recast their brand as a better alternative to internet and brick-and-mortar retailers, and find a way to restructure and refinance 100% of their short and long term debt, the company will be forced to liquidate their assets to satisfy their creditors in the next five years. The only alternative is to constantly issue new debt, because their equity is for all intents and purposes, worthless. The company has not turned a profit in 4 years, they pay no dividends although they are structured as a REIT, their costs are increasing, and their revenues are set to further fall. No business can stand to function without breaking even, and there seems to be no light at the end of the tunnel for this once iconic American retailer. Chapter 7 bankruptcy will be the ultimate fate of Sears by REIT Conversion Sears has been in financial trouble for quite some time with a net loss every year since Instead of focusing most of its energy on re-evaluating the business model, management s reaction to the poor state of its financials has been to engineer creative financial solutions to manipulate the numbers and stave off the inevitable: bankruptcy. Sears only valuable assets in this market are its real estate properties. In November 2014, Sears introduced a plan to form a new real estate investment trust by selling anywhere from 200 to 300 stores to the REIT and leasing the stores back to Sears. This strategic move is meant to protect the value of the real estate properties in case of bankruptcy. Putting some properties into a REIT is also a move meant to appease shareholders who have been disappointed with Sears performance over the past few years. 10

11 Properties Kmart Sears Domestic Sears Canada Owned Leased Independently Owned and operated Chart 5. Sears Holding Corporation Properties Structure. Bloomberg Selling and leasing back real estate properties is usually a strategy that is employed when a company wants to extract the value, namely capital, from real estate properties in order to direct that cash flow to profitable areas of the business. Sears does not have profitable areas of business. This last-ditch attempt at salvaging the business may buy the company time but it will not reinvigorate the dying retailer. Sears management is responsible for not just selling its stores to a REIT, but also financial manipulation. The Sears CEO, Eddie Lampert, has been turning Sears major subsidiaries into non-guarantor entities, which means that most creditors cannot touch the assets that are in these specific subsidiaries. Sears had 4 main non-guarantor entities, with REMIC, KCD IP, Sears Reinsurance, and SRe Holding. Sears Turnaround potential? Sears has a phenomenal management team with a proven track record. CEO Eddie Lampert also serves as the CEO of ESL investments, a hedge fund that owns 49% of Sears 11

12 common stock. With ESL being so heavily invested in Sears, it is clear that Lampert has bought in to bringing the retailer back to life. However, even with his attempts to capitalize on Sears real estate holdings and lease them back to Sears and other retailers, unless the Company is able to generate more revenue, we are only delaying the inevitable. Sears last turned a profit in 2010, and EBIT has been sloping downward ever since that time. There is the possibility that Sears attempt to grow its online marketplace will indeed be successful. As Sears looks to cut back on its number of brick and mortar stores and decrease inventory, it may in fact be able to cut the costs that have been weighing it down and producing negative financial results. It was number five amongst online retailers in 2013 in terms of sales. A leaner, more efficient Sears may be in store for the future. Having said that, in-store sale still account for more than 90% of revenue, and Sears high e-commerce sales are more of a testament to the size of the company and its historical brand image rather than its future potential. It is estimated that in 2012 Sears online sales of $1.2 billion accounted for just 3% of its total sales. Even if e-commerce sales grew at 20% a year, it would be another 15 years before the $18 billion mark was reached, and that wouldn t even constitute half of total sales. By that time, Sears will be fully drowned in debt and out of buildings to sell. Despite the high amount of revenue earned in-store, Lampert continues to show that he would rather focus on Sears online presence versus improve on its brick and mortar stores. This is even when traditional online retailers like Amazon are looking to create physical locations for customers to shop. In 2012, Sears spent only $1.51 per square foot on its Sears stores and $1.04 on its Kmart brand stores, paltry in comparison to companies such as Home Depot and Macy s, which spent $5.56 and $6.25 per square foot respectively (Bloomberg.com). It has also been 12

13 reported by Walter Loeb from Bloomberg.com that Sears traditional seven-year maintenance cycle has been ignored in the vast majority of their stores (Loeb, Bloomberg.com). Conclusion It is coming to a point where Sears 129-year history is working against the Company. During the prosperous days, the Company was the go to store for everything from power tools to entertainment. In the modern day where consumers can compare dozens of prices from their living room and stores are increasingly specialized, it is becoming increasingly difficult to compete. We believe that if not for CEO Eddie Lampert and ESL Investments, the Company would have already run out of cash and began bankruptcy proceedings. A primary reason for ESL s continued support of Sears does not revolve around the Company s operations but on the land. While we see value in the land over the next 5 years, we do not see Sears making past References 1. Natarajan, Sridhar. "Traders Are Betting Sears Will Be the Next Big Retailer to Fail." Bloomberg.com. February 19, < 19/sears-turnaround-seen-failing-by-traders-in-credit-swaps-market> 2. Loeb, Walter. "Sears Will Drown In Debt As Savvy Consumers Shop Elsewhere." Forbes. September 18, < 3. All data cited in this report was retrieved from the Bloomberg Terminal. 13