Questions About ESL’s Debt Reduction Proposal for Sears

On Sept. 23, in a 13D filing with the Securities and Exchange Commission, ESL Investments attached a proposal that it had made to Sears Holding (SHLD) that would reduce SHLD’s total outstanding debt by 78% through a combination of asset sales, proposed real estate transactions and conversion of debt into equity.  ESL has hired a financial advisor, legal counsel and public relations firm to assist in formulating and implementing the proposal.  SHLD has not yet endorsed the proposal, but since Edward S. Lampert, the founder, chairman and CEO of ESL Investments, is SHLD’s largest shareholder with a 75% ownership stake and also its Chairman and CEO, it is hard to imagine that the company will disagree.

In its slide presentation, ESL offered a timetable that involves: (1) engaging with the Sears Special Committee and Related Party Transaction Committee of the Board of Directors to obtain their recommendations; (2) gaining the approval of the entire Board of Directors; (3) signing asset sale agreements with ESL and/or its affiliates or partners for Sears Home Services (SHIP) and the Kenmore appliance brand; (4) commencing an exchange offer with unsecured bondholders; (5) having a consortium that includes SHLD enter into a commitment to execute the real estate portfolio transaction and (6) soliciting a shareholder vote, if necessary, to approve the exchange offers and sales transactions.

ESL said that SHLD must take these actions to ensure that the company will retain sufficient financial flexibility (i.e. “the runway”) to continue its transformation.  If completed, its proposal would reduce SHLD’s outstanding debt from $5.59 billion to $1.24 billion and its near-term maturities (through 2020) from $5.24 billion to $0.90 billion.  It would also provide $1.2 billion of additional liquidity over the next two years and reduce annual cash interest expense from $412 million in 2017 to $88 million.

The proposal has three parts:

  1. Asset sales. The proposal anticipates the sale of assets including SHIP and Kenmore appliance brand.  In a letter the Special Committee of the Board of Directors dated August 14, Mr. Lampert offered to buy SHIP for $70-$80 million and Kenmore for $400 million.  The Kenmore transaction is contingent upon ESL obtaining equity financing, for which it is highly confident.  Sears Home Services includes appliance repair and warranty services, home improvement services and parts sales (known as Parts Direct).  The Sept. 23 slide presentation does not indicate what other assets may be sold to achieve the $1.75 billion target.  All asset sale proceeds would be earmarked for debt reduction.
  2. Proposed real estate transaction. The company would list for sale its encumbered real estate portfolio for a period of 12 months.  Proceeds would be used to repay existing secured debt, paying down in order of priority debt owed to third-party lenders, first-out lenders (e.g. Cascade) and ESL.  ESL would lead or participate in a newly-formed consortium (of existing secured lenders) that would agree to buy any remaining real estate that is not sold within the 12-month period in exchange for its outstanding loans.  During the 12-month marketing period, the consortium lenders would receive interest payments in kind (and not in cash).  ESL anticipates that SHLD will reduce $1.47 billion of debt from the proposed real estate transaction.
  3. Proposed liability management transaction. Eligible holders of the ESL 2nd Lien (PIK) loans and 2nd Lien (PIK) notes would convert their debt into one of two new mandatorily convertible secured debt issues that would pay either no interest or interest in kind.  The debt would be automatically converted into equity at the earlier of 1) SHLD’s share price reaching $4 or 2) their respective maturity dates in 2021 and 2022.Holders of unsecured PIK notes would receive the mandatorily convertible zero coupon debt at par; while holders of unsecured cash pay notes would also have the option of receiving 25 cents in cash for every $1.00 of par value (which would cost an estimated $100 million to be paid by ESL).

    ESL has agreed to take the less attractive zero coupon mandatorily convertible notes in proportion to the participation of unaffiliated investors and also to the extent that the holders of cash pay unsecured notes opt to receive the cash payment.

    In total, the proposed liability management transaction would reduce debt outstanding by an estimated $1.12 billion (presumably through the mandatory conversion feature).

There are potential time constraints that may affect the success of the proposal.  ESL said that SHLD must act fast because of upcoming Debt Maturity Reserve payments due on October 1 and the maturity of $134 million of 6 5/8% Second Lien Notes on October 15.  While SHLD’s Board of Directors is probably ready to act quickly on the proposal, it is hard to imagine that the company will be able to complete the proposed liability management transaction by the October debt payment deadlines, even if done privately.

Although the proposal (as presented in the presentation slides attached to the 13D filing) does not call specifically for delaying these upcoming debt payments, it does seem to imply that SHLD may wait to make these payments until after the liability management transaction is completed (in which case, the debt issues would be in default).  That is perhaps why the 6 5/8s fell in price from around 93 to a low of 84.25 earlier this week before bouncing back to close the week at 88.60.  The proposal also does not indicate what minimum level of participation from unaffiliated debtholders ESL is willing to accept and still move forward with the transaction.

In my mind, the liability management transaction is unusual in several respects:  First, it was proposed by an investor and not the company.  Normally, a company determines whether it needs to restructure its debt.  However, Mr. Lampert, by virtue of his position as CEO and his large investment in both the debt and equity of SHLD, is not a typical investor.  (I estimate that in addition to the 75% equity stake, ESL and its affiliates held $1.2 billion of SHLD’s debt as of December 31, 2017.)

It is fair to say that without ESL’s financial maneuvers, SHLD would have been forced into bankruptcy long ago.  With his significant involvement and investment, Mr. Lampert has earned the right, both legally and ethically, to determine the fate of this enterprise.  Still, unaffiliated investors and creditors should recognize that Mr. Lampert as the proponent of the transaction is acting in his own interest and not looking after the interests of all shareholders, as the company is required to do.  Although they might be able to improve upon some of the terms of the liability management transaction, creditors should also understand that practically speaking, they are just along for the ride. 

Although Mr. Lampert’s proposal outlines the sources and uses of debt repayment and exchange offer, it does not shed any light on how the company intends to restore profitability.  Sears EBITDA, as I define it [1], has become increasingly negative for the past five fiscal years.  Last year, its EBITDA was ‑$1.46 billion, worse than fiscal negative 2016’s negative $1.26 billion. [2]   For the first six months of fiscal 2018 and for the fiscal 2018 second quarter, SHLD’s EBITDA continued to be increasingly negative.

While the company did report a sharp slowing in the rate of decline in comparable store sales in the 2018 second quarter from -11.5% to -3.9%, that cannot be called a trend unless comp sales continue to improve for at least a couple more quarters.  More importantly, there has been no improvement in either the company’s gross margin or operating margin as it has continued to shed sales.  Thus, there has not yet been any clear indication that SHLD is shrinking to profitable core.

Although Mr. Lampert’s proposal will give the company more “runway,” there is no evidence that this will be sufficient to bring it to profitability.  Indeed, the magnitude of the losses in recent years which are continuing so far in fiscal 2018, suggests that the reduction in debt will only buy SHLD another year or two, at which point it will likely face a more significant restructuring or bankruptcy.

Although it talks about $1.2 billion of additional liquidity, the proposal does not describe the full impact of the asset sales, real estate sales and debt reduction on the company’s future (or pro forma) performance.  It does not indicate, for example, how much profitability SHLD will lose from the sale of SHIP nor does it provide the expected financial impact of the sale of the Kenmore brand.  (Presumably, SHLD will pay royalties or have to purchase Kenmore appliances at a higher cost.)

The proposal also does not assess the impact of the store sales on the company’s future profitability.  Are these all vacant stores that are being sold?  (Not likely.)  If some of the stores are operating, will SHLD lease them back and continue to operate them?  What will SHLD’s store base look like after the real estate sales are completed?  What will be the impact on its profitability?

Hopefully, Mr. Lampert will communicate to unaffiliated creditors and shareholders what the SHLD “airplane” will look like as it begins to reach the end of the extended “runway,” so that they will be able to make a better assessment of whether the airplane will be capable of lifting off.

September 28, 2018

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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[1]  I define EBITDA as operating income before depreciation & amortization, impairment charges, the loss or gain on asset sales, amortization of the deferred gain on Seritage plus the implied interest portion of lease expense.  The company’s definition of adjusted EBITDA is similar, except that it excludes restructuring charges and pension costs and does not add back the implied interest on leases.

[2]  While the company’s EBITDA (before adjustments) shows a trend similar to mine, its adjusted EBITDA has become less negative over the past two years, improving from ‑$836 million in 2015 to ‑$808 million in 2016 and then to ‑$506 million in 2017.  SHLD’s definition of adjusted EBITDA excludes restructuring costs and pension expense.  In my view, these are large expenses that should not be ignored in an analysis of the company’s historical results.  Restructuring expenses, while often temporary in nature, have been ongoing at SHLD for more than a decade and will continue in the future.  Although pension expense can be considered non-operating, it too has been a significant expense for SHLD over many years.  While it is almost certain that future annual pension expense will not be as high as the $656 million recorded in 2017, pension expense will probably continue at a high level going forward, owing to the $1.5 billion shortfall in the funded status of SHLD’s benefit plans.

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