Creditors Could Push The Brakes On Retailers

Online Holiday Shopping

Direct-to-consumer online sales have accelerated bankruptcy risk for some retailers, particularly ones that have been slow to shut down underperforming brick and mortar locations. Retail suppliers and other stakeholders have been closely monitoring this tepid operating environment over the last few years, but it seems that trouble is developing. Sears Holdings (NASDAQ: SHLD) and Claire’s Stores are two names that CreditRiskMonitor’s proprietary FRISK® score has highlighted to watch closely through what is considered the most important retail period of the year, the holiday season.  

One of the key components of the FRISK® score is the crowd-sourced, aggregate usage data of CreditRiskMonitor subscribers. These financial risk professionals make decisions for more than 35% of the Fortune 1000 and over 1,000 other large corporations internationally.  Trade credit represents the third largest source of debt financing in the corporate world.  So, how risk managers interpret a business’s financial health ultimately impacts the availability of working capital. This crowd-sourced data cannot be found anywhere else and adds accuracy to the FRISK® ranking that goes well beyond simply looking at financial reports and payment histories.

The troubled ones

In the last few years, U.S. retail sales have grown between 2% and 3% annually, however online sales have absorbed most of that growth. The competition has been vicious and the direct-to-consumer framework remains one of the leading disruptive challenges in the marketplace. For a clearer picture of the most troubled names, we screened for companies with publicly-traded securities in the retail space with the worst FRISK® scores (1 or 2, on the FRISK® score’s 10 point scale). Practically speaking, this is a group of companies that could very well run into a financially distressing event in the near term:

Exhibit 1: Retail Basket FRISK(R) Scores

Stepping back from the individual names here and looking at this list as a group shows an even more troubling picture. For the ten companies shown above, the average probability of bankruptcy has increased nearly 10-fold since the 2007 to 2009 downturn. As the FRISK® Stress Index graph shows below, the financial risks this group faces today is enormous relative to what it experienced during the Great Recession:

Exhibit 2: Retail Basket FRISK(R) Stress Index

A retailer’s risk of bankruptcy is important given that all counterparties are constantly making decisions on whether to do business with them and on what terms. For instance, a supplier may be faced with a tough decision of determining whether to supply inventory and extend credit to a struggling department store. For a real time case, we can briefly contrast the two renowned brand names of JC Penney (NYSE: JCP) and Kmart. While both possess fairly weak financial profiles, there is a clear distinction between the two. Notice that we did not include JC Penney in the list above as it holds a FRISK® score of 3. This rating is far from healthy, but it’s certainly much better than Sears’ rating of 1 (Sears is the parent of Kmart). That difference represents a huge separation for implicit risk, where JC Penney yields a modest 3% probability of bankruptcy and Sears pushes into the range of 30%!

Supplier concerns emerge

Jakks Pacific (NASDAQ: JAKK), the fifth largest toy manufacturer in the industry, recently made just such a tough call, stating that it had suspended shipments to a large retailer, which was identified to The Wall Street Journal as Kmart by unnamed sources within the company. Clearly this was a very difficult choice, but more importantly, it suggests that the supply chain audience has a deepening concern about Kmart’s ability to pay its suppliers. That being said, let’s dig into what may have led to that decision using the tools available to CreditRiskMonitor subscribers.

We’ve already noted that Sears Holdings has a FRISK® score of 1. Many who are already closely following Sears know that management has kept the business afloat through aggressive debt financing and real estate sale/leaseback transactions. Except now, the longevity of this strategy is being seriously questioned, so let’s review the company’s balance sheet:

Exhibit 3: Sears Holdings’ Balance Sheet

As of the second quarter, the company held $276 million in cash and $390 million in trade receivables which can be appraised very close to face value. The roughly $4.7 billion worth of inventory however, simple retail merchandise, could very well sell for cents on the dollar during liquidation. If we conservatively hold current liabilities constant and assume that inventory isn’t worth what is listed on the balance sheet, the business could easily run a working capital deficit.

It’s also worth noting that short term debt increased from $446 million to $714 million. This is something that we look for that may signal increasing near-term distress. The jump is typically due to a debt conversion, which either can develop naturally, simply due to maturity, or from a covenant trigger – which is a much more concerning event. Given that the company is reporting steeper losses, increasing from $802 million to $1.9 billion over the last twelve months, it’s probably safest to view this short-term debt change with a skeptical eye. In short, using CreditRiskMonitor’s database tools, you can see why Jakks Pacific might be reluctant to expose itself to a segment of Sears Holdings.  

Another hairy situation

Claire’s Stores is another example worth diving into. In 2013 the retailer’s gross margins declined from 47% to 45%, swinging a modestly profitable business into a very unstable one. The company’s public debt has been rated below investment grade by the major credit rating agencies for many years. But how much risk is there right now?

You can see from the above table that Claire’s has a FRISK® score of 1, again the worst possible rating. Notably, in the latest quarter Claire’s Z”-score, a measure of financial health, declined from -2.2 to -3.2. However this downward shift resulted from management securing a revolving line of credit. As of October 4th, Standard & Poor’s upgraded the retailer’s corporate credit rating from SD to CC with the following rationale:

“Approximately $179 million of new term loans that were used to cancel roughly $575 million of notes and extend the debt maturities. The transaction is estimated to save the company $24 million in annual cash interest savings.”

 

The associated debt exchange is certainly helpful but not enough to materially alter the company’s long term high risk profile, in our opinion. Currently approximately 78% of total assets are related to goodwill and intangibles and the debt-to-asset ratio is still exceedingly high. As shown below, CreditRiskMonitor’s Liquidity Ratio dashboard view indicates that Claire’s working capital position has rapidly declined: 

Exhibit 4: Claire’s Liquidity Profile

It’s also worth highlighting that the retailer’s senior debt securities run at interest rates of 7-10% per annum. We can presume that if the business were to fall into distress, those subordinate to the debt structure would potentially take a haircut or be wiped out.

Retail overview

This holiday season will prove to be pivotal for many retailers navigating today’s tough environment and some companies may have reached the point of no return. Jakks Pacific is just one example of a business that cut ties with a retailer to, in its view, preserve its own credit portfolio. Claire’s is another difficult case worth watching closely. In fact, the nine businesses mentioned above all have different stories, but each follows a similar theme: rising financial risks heading into the most important sales period of the year. Financial counterparties should keep a close eye on all of them.

For those interested in a retail-related bankruptcy: read our postmortem case study on Hancock Fabrics

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The FRISK® score is calculated by a proprietary model that measures the degree of financial distress for a public company. The model has been back-tested over the last decade to predict 96% of public company bankruptcies. The failure score is enhanced by our subscriber base through crowd sourced behavioral data patterns. Provided below is the scoring chart that displays the statistical probability of bankruptcy within the next twelve months for each score category:

FRISK® Stress Index is a model that provides the average probability of failure for a group of companies (e.g. by industry, portfolio, or country) over the next 12 months. The level of risk is measured through a scale of 0 to 50, with 50 being the most risky.

About CreditRiskMonitor

CreditRiskMonitor is a financial news and analysis service designed to help professionals stay ahead of public company risk quickly, accurately and cost-effectively. More than 35% of the Fortune 1000, plus thousands more worldwide, rely on our commercial credit reporting and predictive risk analytics for assessing the financial stability of over 58,000 global public companies.

At the core of CreditRiskMonitor’s service is its 96% accurate FRISK® score, which is formulated to predict public company bankruptcy risk. One of four key components calculated in the FRISK® score is crowdsourced subscriber activity. This unique system tracks subscribers' patterns of research activity, capturing and aggregating the real-time concerns of what are essentially the key gatekeepers of corporate credit. Other features of CreditRiskMonitor’s service include timely news alerts, the Altman Z” score, agency ratings, financial ratios and trends. CreditRiskMonitor’s network of trade contributors provides more than $135 billion in trade data on their counterparties every month, giving them visibility into their biggest dollar risks.