It has been about 12 years since Edward S. Lampert acquired Sears and merged it with Kmart to create Sears Holdings (SHLD). Despite numerous spin-offs, asset sales and store closings, which have provided positive returns to shareholders, Sears Holdings today remains unable to stem the slide in its sales and net operating losses. In fact, SHLD’s financial performance has worsened considerably over the past few years.
The consensus view among security analysts and retail consultants is that SHLD will sooner or later file for bankruptcy. It is hard to argue against that view. Although Sears may still have sufficient assets which can be sold to fund ongoing operating losses for a time, the company will be forced into bankruptcy eventually and possibly soon, unless it is able to engineer a relative quick and dramatic turnaround.
Despite the lack of progress in stemming the sea of red ink, there have been positive developments at Sears since Mr. Lampert has taken the helm. First, Mr. Lampert has used the company’s considerable asset base to give it time to scale down its operations outside of bankruptcy. It has worked with mall owners and other landlords, most notably through its Seritage (SRG) spin-off, to repurpose many of its retail stores, bringing in new retailers to reduce Sears’ footprint within its existing locations. In this way, it has earned the mall owners’ goodwill, especially considering the alternative of a messy bankruptcy in which a lot of real estate might have been dumped on them all at once.
Similarly, SHLD has cut a deal with the Pension Benefit Guaranty Corp. to guarantee its pension plan legal obligations, even in the event of a bankruptcy filing. As part of this agreement, it has made payments to reduce its net liability and granted the PBGC a security interest in certain collateral to support its remaining obligations.
At the same time, Mr. Lampert, through ESL Investments and other investment affiliates, has held on to his spin-off stakes, provided significant debt financing for SHLD over the years and periodically increased his equity position in the company. He is therefore in a strong position to steer SHLD through a bankruptcy proceeding, if necessary, which should ensure its survival.
In this post, I will review SHLD’s recent performance and current financial position, provide an admittedly simplistic assessment of the current state of its stores and merchandising efforts and offer some perspective on how a SHLD bankruptcy might unfold.
Recent Financial Performance
For the 26 weeks (i.e. six months) ended July 26, 2017, SHLD’s merchandise sales and services declined 21.7% vs. the prior year to $8.7 billion. That follows an average 15.7% annualized decline in merchandise sales over the two fiscal years ended January 28, 2017. About half of the decline in 2016 and so far in 2017 was due to store closings and 40% was due a drop in comparable store sales. Comparable store sales fell 7.4% in 2016 and by a staggering 11.7% in the first half of 2017.
The steep drop in sales has kept SHLD in a loss-making position. Its adjusted EBITDA (as defined by SHLD) has been consistently negative: ($808 million) in 2016 and ($289 million) in the 2017 first half. Full year 2016 adjusted EBITDA was roughly consistent with the immediately preceding years, while interim 2017 adjusted EBITDA improved over 2016’s ($372 million).
The company uses adjusted EBITDA to measure the profitability of its remaining stores. By that measure, there was some improvement in the 2017 first half.
However, adjusted EBITDA excludes certain “unusual” costs – such as store closing and pension expense – which ought to be included to get a more complete picture of SHLD’s profitability. Store closing costs remain significant and there is no evidence that store closings are near an end.
Similarly, benefit plan contributions have averaged $300 million or so, increasing each year. Here too, the company has provided no indication of when they will begin to decline; but SHLD has begun to offload some of its pension obligations by purchasing a group annuity contract from Metropolitan Life Insurance Company and plans to do more going forward.
Investors should therefore take into account all potential uses of cash, even those that might be considered temporary, in order to get a more complete picture of SHLD’s current performance. Using the more complete measures, SHLD is still burning through a significant amount of cash.
SHLD’s EBITDA before these excluded items was ($1.85 billion) in fiscal 2016, a much wider loss than in the two preceding years, and ($755 million) in the 2017 first half, also worse than the ($565 million) reported in 2016.
By another measure, SHLD used $1.6 billion of cash in operating activities on average from fiscal 2014 to fiscal 2016 and its use of cash for operating activities increased to $1.1 billion in the 2017 first half from $0.6 billion in 2016.
As a result, SHLD will have to continue to raise cash from asset sales at least in the short- to medium-term, to finance its ongoing operating losses, additional store closures and elevated pension costs, if it wants to avoid bankruptcy court.
A quick look at SHLD’s profit margins highlights the problem: In fiscal 2016, SHLD reported gross margin of 21.2% and an SG&A expense ratio of 27.6%, which equates to a cash operating margin of ‑5.4%. By comparison, Wal-Mart’s gross margin was 25% and its SG&A expense ratio was 21%; Target had a 30% gross margin and 19% SG&A expense ratio and even struggling J.C. Penney has a 35% gross margin and 28% SG&A costs. Even after reducing its domestic store base by nearly 60% over the past five years, SHLD is still structurally unprofitable.
Part of the difficulty of achieving adequately positive operating margins may be due to the increasing complexity of SHLD’s operations. The company still maintains close operating relationships with most of the spin-offs. For example, it sells merchandise to Sears Home and Outlet Stores (SHOS), rents space and provides support services to Lands’ End (LE), pays rent to Seritage (SRG) on stores that were previously owned and works with SRG to repurpose stores. Sears Canada also sources much of its merchandise from the same suppliers as SHLD. As a result of these ongoing relationships, both SHLD and the spin-offs have had to develop record-keeping systems to keep their operations separate.
So Why is it So Tough for Sears and Kmart to Compete Successfully?
Although I am not an expert on evaluating retail business models, I have gained some insights from walking around Sears and Kmart stores.
During my recent visit to the stores – Kmart stores in Jersey City, NJ and Colonia, NJ and a Sears store at the Woodbridge (NJ) Mall – I found the stores to be clean and generally well-organized. The Kmart stores would clearly have benefited from a face-lift (i.e. painting, new flooring, new lighting and new shelving), but frankly I do not think that the older interiors really matter much to existing and potential shoppers. In both cases, I believe the Sears and Kmart stores that I visited would be viewed as top tier in most countries around the world, especially in developing countries. The merchandise and prices are what draw shoppers to the stores. I was pleased to see that Sears has launched a new apparel line called Simply Styled, which offers solid quality, classically styled clothing at affordable prices.
SHLD’s biggest problem, therefore, is that it faces formidable competition: retailers with market positions that are well established in the minds of consumers – Wal-Mart is the nation’s premier discounter; Target is a little more upscale, but still offers good value; Kohl’s is a good value choice in everyday apparel; Macy’s and Nordstrom’s are the go-to places for upscale merchandise.
The U.S. has been over-stored for quite some time. Over the years, specialty retailers have whittled away at the market positions of giant department stores, like Sears, especially in categories like apparel. The growing popularity of online shopping has put additional pressure on retailers with physical locations.
The growth and development of online shopping has also reduced in-store inventory requirements. Shoppers can now order online and have their purchases delivered or pick them up in store. As a result, there is less need for retailers to carry at each store low turnover items, which can be ordered online.
With the erosion in its sales base, many of Sears’ mall anchor stores are now cavernous. In recent years, Sears has scaled down the number of SKUs that it carries at each store and filled the space with larger items (e.g. lots of mattresses).
Its new model works for those shoppers who plan ahead and research their purchases online before deciding upon the specific make and model of the products that they want to buy. However, that model often does not work for the buyer who only has a general idea of what he/she wants to buy and prefers to buy it on the spot. For example, if I go shopping at a Sears or Kmart store for a particular item, like an oscillating tool or even men’s athletic shorts, I am more likely today to see a more limited selection than I would find at Kohl’s or Wal-Mart or Home Depot. That limited selection may be OK, if I have made up my mind on buying a Craftsman tool, but many shoppers may prefer to see a wider range of brands at different price points in store before making their decision. Given the more limited selection at Sears, I thought perhaps that Sears might benefit from having computer terminals in store available for shoppers to see a more extensive range of merchandise (with potential assistance from qualified sales personnel).
On the other hand, the Jersey City Kmart had a good selection of apparel at very low prices, with signs highlighting the pricing and discounts. So why was the store so empty? I believe that Kmart (and Sears) are no longer top of mind with customers. With greater awareness of the value offered at Kmart, I believe that more customers would shop there; but today when they want to buy apparel, customers are more likely to think of Wal-Mart or Target or Kohl’s. It is also the case, however, that those who are shopping for items in other product categories are likely to find a better assortment and better pricing at Wal-Mart or Target. As a result, Kmart is shopped by a smaller but loyal customer base that is dwindling over time and also by the few new customers who have managed to find the value that it offers on their own.
The problems at Sears are somewhat related. Sears does benefit from loyal followings for Kenmore appliances and Craftsman tools; but except for a more extensive selection of competitive offerings in appliances, its in-store offerings in all other product categories are limited. Of course, Sears knows which products sell best and consequently, need to be well stocked; but customers also look for products that have lower selling volumes, so Sears is at a disadvantage against retailers that offer a wider selection across more product categories (like tools for Home Depot). I might go to Sears to buy a Craftsman socket set and Dockers khakis; but if I am looking for a circular saw (and unsure about the brand or price point) and a pair of khakis, I would probably prefer to go to a power center with a Home Depot and a Kohls.
SHLD has sought to bridge this growing gap in its in-store offering by developing its online presence. Shop Your Way, its free, member-based social platform, was designed to earn customer loyalty by offering discounts and rewards on an extensive selection of merchandise which members could then either pick-up in store or have delivered directly to their homes. In my opinion, however, it has failed to achieve its objectives because it has not offered a clear and compelling value proposition. More recently, Shop Your Way has adopted a kitchen sink strategy where it offers its members discounts or rewards on everything, including branded merchandise not otherwise carried at Sears or Kmart stores; magazine subscriptions; services, such as hotels.com and Best Western; and even merchandise from other retailers, such as Old Navy, Ulta Beauty and Petco. Instead, I think that Shop Your Way should focus more on targeted promotions to its members to entice them to lift their spending, make sure they are aware of seasonal sales events or offer them deals on specially-purchased items, as a way to build their loyalty. Unless Shop Your Way is able to find a niche, it may eventually be folded into the websites of Sears and Kmart.
Earlier this summer, SHLD’s shares got a boost when the company disclosed that it would begin to sell Kenmore appliances through Amazon.com. In my opinion, this probably will not bring in much additional revenue to Sears and it could conceivably reduce Sears’ profitability by giving a cut of the profit to Amazon. On a visit a few years ago to a Sears flagship store in the Burlington (MA) Mall, a salesman told me that customers generally will not buy a large appliance without examining it in person. If so, customers may choose to buy from Amazon only to get a better price. Besides Kenmore appliances, consumers can already buy other Sears merchandise, including a limited selection of Craftsman tools and Joe Boxer apparel, on Amazon.com.
Still, the Amazon announcement was exciting to me because it opens the possibility (probably remote) that Amazon itself might buy or invest in SHLD in order to expand its physical retail presence in non-food, hard and soft goods. Even if it is interested in doing so, however, it probably would be deterred by SHLD’s ongoing operating losses and high debt levels. At the same time, Amazon looks to me to be getting overextended in its business expansion and so probably would not (or should not) consider buying SHLD, unless it is contemplating splitting itself up.
SHLD’s Financial Position
At July 29, 2017, SHLD was carrying roughly $4.0 billion of debt on its balance sheet, $1.7 billion of pension and postretirement benefits and a shareholder deficit (i.e. negative equity) of $3.7 billion. About $750 million of that debt was in the form of publicly-traded debt securities, including the 6 5/8% Senior Secured Notes due October 2018 and the 8% Senior Unsecured Notes due December 2019. The rest is in a series of bank facilities, including revolving credits, term loans and letter of credit facilities. SHLD’s credit facilities are generally secured by liens on SHLD’s inventory, receivables and domestic subsidiaries with availability subject to a borrowing base.
Two secured loan facilities, with about $700 million in total outstandings as of July 29, are secured by 90 of SHLD’s 380 owned stores. Most of the advances under those facilities were provided by entities affiliated with Mr. Lambert and also by Cascade Investments, an investment vehicle of Bill Gates, the former Chairman and CEO of Microsoft.
The 6 5/8% Senior Secured Notes due 2018 and a Second Lien Credit Agreement are secured by a lien on receivables and inventory and guarantee by domestic subsidiaries that is junior (i.e. subordinated) to the domestic credit facility.
Thus, it appears that 290 of the 380 owned stores are unencumbered; but SHLD has also pledged $100 million of real estate to the PBGC to secure its minimum pension obligations to 2019. It is not clear, therefore, just how much of SHLD’s real estate is unencumbered and how much it could receive for pledging its real estate under a new credit facility from an unaffiliated lender. Using the same advance rate as the existing secured loan facilities suggests as much as $2.0 billion, net of the PBGC pledge, but these remaining unencumbered stores are probably less valuable than those already pledged.
At July 29, SHLD reported $407 million of availability under its domestic credit facility and covenants under that facility that would allow a little more than $1.0 billion of additional borrowings under the second lien facility (assuming that SHLD can find a lender). The company also has a commercial paper facility, provided by Mr. Lampert, under which there were no borrowing at quarter’s end.
SHLD has also raised cash in recent years by selling one of its brand names. It recently sold the Craftsman brand to Stanley Black and Decker for $525 million with another $250 million due in three years. (The $250 million receivable has also been pledged to the PBGC to secure its minimum pension obligations through 2019). Under the agreement, SHLD has the right to sell Craftsman in its own stores, sourced from its existing suppliers, in perpetuity and royalty free for 15 years.
Of the remaining brands potentially available for sale, Kenmore is clearly the most valuable; but Kenmore will almost certainly remain a core business of SHLD and so Mr. Lampert is unlikely to pledge it to anyone but himself or his affiliates.
Diehard, SHLD’s automobile battery brand, is almost certainly less valuable than Kenmore and Craftsman and would probably not be sold independent of Sears Auto Centers.
On balance, therefore, I roughly estimate that SHLD probably has at most another $2-$3 billion of assets that could be sold or pledged for cash. However, this would raise the company’s debt service burden further, so without a clear path to profitability, it may be very difficult for SHLD to attract unaffiliated lenders going forward.
Despite SHLD’s high leverage and diminishing debt capacity, its two publicly-traded debt issues are not trading as if bankruptcy is imminent. The 6 5/8% Senior Secured Notes due October 2018 (rated Caa2 by Moody’s and B- by S&P) recently traded at 94.5 to yield 12.2%. The 8% Senior Unsecured Notes due December 2019 (rated Ca/CCC-) recently traded at 87.1 to yield 15.0%. Granted, those yields are extraordinarily high for debt issues with one- and two-year maturities, respectively, and their yield spreads of 1,090 basis points and 1,355 basis points over comparable maturity Treasurys clearly qualifies them as distressed. However, if bankruptcy was imminent, the 6 5/8s would probably be trading around 50-60 and the 8s would be trading well below 50 in the current economic environment.
At this point, I agree with the consensus that bankruptcy is the most likely outcome for SHLD. But Mr. Lampert has large equity stakes in SHLD and all of the spin-offs. ESL Investments and its affiliates currently own 49% of SHLD, 45% of Sears Canada (SRSCQ), which has filed for bankruptcy, 65% of Lands’ End (LE), 57% of Sears Home and Outlet Stores (SHOS) and 8% of the voting shares of Seritage (SRG) but 39% of its operating limited partnership. In addition, by my tally, ESL holds about $1 billion of SHLD’s $4 billion of outstanding debt. Thus, Mr. Lampert is in a very strong position to steer SHLD through bankruptcy, if it happens.
Until then, SHLD’s share price will depend upon the progress (or lack thereof) that it makes in moving toward profitability. Despite the sharp drop in sales over the past several years, SHLD still trades at an exceptionally low ratio of share price-to-sales, only 0.04 by my calculation. Thus, any whiff of profitability could send the shares sharply higher.
At this time, however, it seems more likely that SHLD shares will continue to drift downward from the current price of $7.59. As noted, Mr. Lampert’s strong investment position in SHLD virtually ensures that SHLD can and will survive the bankruptcy process (as long as Mr. Lampert wants it to do so). However, a return to profitability is still the key to SHLD’s long-term viability post-bankruptcy. For now, that still seems a long-way off, but a final recombination of the SHLD and its affiliated companies, with even more downsizing to come, could (or should) allow the company to find that elusive profitable core.
Update: Sears Canada Moves Toward Liquidation (October 11, 2017)
September 18, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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