Sears Escapes Distressed Class in Cash Quest: Corporate Finance

Sears Escapes Distressed Class in Cash Quest
Sears is working toward reducing debt and controlling costs after posting a $2.4 billion fourth-quarter loss in January, the largest in at least nine years. Photographer: Brent Lewin/Bloomberg

Sears Holdings Corp.’s bonds returned almost three times the average of its peers this year as the retailer sold assets and bolstered cash balances after debt fell to distressed levels at the end of 2011.

The notes due in 2018 of the company controlled by hedge fund manager Edward Lampert returned 25 percent this year, compared with 9.2 percent for firms ranging from Claire’s Stores Inc. to J.C. Penney Co. in Bank of America Merrill Lynch’s U.S. High Yield Super Retail index. Cash from operations on a 12-month trailing basis rose to the highest level in six quarters.

Sears is working toward reducing debt and controlling costs after posting a $2.4 billion fourth-quarter loss in January, the largest in at least nine years. The Hoffman Estates, Illinois-based retailer had a narrower loss in the second quarter, helped by reduced inventory costs as Chief Executive Officer Lou D’Ambrosio worked to stay in line with demand as sales slip at department stores catering to middle-income Americans.

“A liquidity crunch is not an issue at Sears for the moment,” said Melissa Weiler, a money manager who helps oversee $10 billion at Crescent Capital Group LP, which doesn’t own Sears debt. “For years, consumers have gone to Sears for their appliances and tools, and they certainly have brand recognition for these types of products in particular.”

Distressed Levels

Spreads on Sears’s $987 million of 6.625 percent second-lien notes due October 2018 narrowed to 757.9 basis points, or 7.579 percentage points, more than comparable-maturity Treasuries Aug. 31, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Those spreads widened to 1,068 basis points on Dec. 31. A spread above 1,000 basis points is considered distressed.

“We improved our profitability position as we reduced expenses and expanded margin rate through more effective promotional design,” Chris Brathwaite, a spokesman for the company, said in an e-mail. “We lowered inventory, reduced debt and enhanced our liquidity.”

Standard & Poor’s revised its outlook on Sears’s CCC+ rating to stable from negative on Aug. 17, citing the company’s ability to pursue asset sales in order to improve the amount of cash on its balance sheet relative to uses, analysts Ana Lai and David Kuntz wrote in the note.

Sears, which will be removed from the S&P’s 500 Index after the close today because it has too few available shares, has $81 million of its $5.4 billion in bonds and loans maturing in 2012 and 2013, according to data compiled by Bloomberg. Maturities are “manageable” until its asset-based revolving credit facility matures in 2016 and its second-lien notes come due in 2018, the S&P analysts wrote.

Sears’s CDS

Credit-default swaps tied to Sears Roebuck Acceptance Corp. increased 0.2 percentage point after news of the S&P removal before falling back the same amount to 20.8 percent upfront the next day, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market. That means investors pay $2.08 million initially and $500,000 annually to protect $10 million of Sears’s debt from losses for five years.

The swaps, which typically climb as investor confidence deteriorates, pay the buyer face value if Sears fails to meet its obligations, less the value of the defaulted debt.

Sears’s shares dropped 8 percent on Aug. 30 before closing at $52.75 Aug. 31. The stock is up 66 percent this year after falling 56 percent in 2011.

Implied Rating

The swap prices imply the debt is rated Caa1, the seventh step of speculative grade, according to Moody’s Corp.’s capital markets research group, one level below the company’s actual B3 rating at Moody’s Investors Service, Bloomberg data show. Moody’s downgraded the credit two levels on Jan. 4 and kept a negative outlook, reflecting “persistent negative trends in sales, which continue to significantly underperform peers” as the retailer doesn’t invest enough in its stores and service, according to analysts Scott Tuhy and Kendra Smith.

Sears is spinning out about 1,238 stores to generate cash, potentially raising $346.5 million, the company said in August. The retailer also said it expects to have $100 million outstanding under an asset-backed line of credit, from which it will fund a cash dividend. Sears’s loss in the second-quarter narrowed to $132 million from $146 million a year earlier, helped by reduced inventory costs. Gross margin widened to 26.7 percent of sales in the quarter, from 25.7 percent a year earlier, boosted by lower cost of sales.

Asset Sales

Sears is working to gain shoppers by offering promotions tied to its credit-card and layaway programs, and by adding features such as mobile checkout, Chief Financial Officer Rob Schriesheim said Aug. 16 in a telephone interview.

Executives have said they’d consider more asset sales. While D’Ambrosio told shareholders at the company’s annual meeting in May that selling its Lands’ End clothing brand wouldn’t be difficult, Schriesheim said there is “nothing imminent planned.”

“Sears Holdings’ recent measures to monetize assets and reduce inventory reassured trade creditors and vendors and ensures sufficient liquidity for the near to intermediate term,” Evan Mann, an analyst at debt-research firm Gimme Credit LLC wrote in an Aug. 22 note. “While current liquidity, the ability to monetize assets, and support from Eddie Lampert buys the retailer time, we are skeptical” about its longer term prospects,’’ he wrote.

Bond Prices

Sears was founded as a catalog company in 1893 and went public in 1906. Lampert, who founded his hedge fund ESL Partners in 1989, bought the debt of Kmart Corp. and then swapped it for stock in a bankruptcy reorganization in 2003. At the same time, Lampert’s funds were also building a 15 percent stake in Sears, Roebuck & Co. by purchasing shares on the open market, and Kmart acquired Sears in 2005 to form Sears Holdings Corp.

The company’s 6.625 percent bonds due in October 2018 rose to 90.8 cents on the dollar Aug. 31, from 76 cents on Jan. 3, Trace data show. The notes are less than 1 cent below this year’s high on July 11.

The debt yields 8.6 percent, which is down from 11.9 percent in January. While Sears has been “slower to respond than they needed to be,” if the business model were “to continue to be streamlined, it could be successful,” Crescent Capital’s Weiler said.

“It really comes down to how fast management is willing and able to adapt its strategy,” she said. “Early movers are the ones that take market share, and in retail this is critical since buzz and a store’s aura play such a key role in consumer behavior.”

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