Weighing Recent Bankruptcy Warning Signs for Sears Holdings
We read recently that Warren Buffett knew that Sears was going to fail ten years ago.
In 2005, Mr. Buffett reportedly said: "Eddie is a smart guy, but putting Kmart and Sears together is a tough hand … Turning around a retailer that has been slipping for a long time would be very difficult."
Maybe that’s why Mr. Buffett’s net worth has increased by over $2 Billion dollars since Election Day. There’s only one Oracle of Omaha!
Fact is, no bankruptcy should come as a surprise – there are always warning signs. Let’s review the most recent red flags for Sears Holdings.
Recent Red Flags: Financial Results, Company News
- In the last days of December, Eddie Lampert, hedge fund owner and leading shareholder, announced that Sears has obtained a Secured Standby Letter of Credit of $200 MM “to fund operations”, with the option to expand that to $500 MM from Mr. Lampert’s own hedge fund, “with the consent of the lenders.” In addition, the WSJ reported this week that another $500MM loan was obtained, secured by mortgages on properties from affiliates of Mr. Lamperts hedge fund. (Source: Wolf Richter/Wolf Street, Wall Street Journal).
- In the latest financial report, Q3 2016 revenue fell by 13% to $5 billion, and YTD sales declined by 9.9% vs. the comparable year ago period. Other results: Gross margin declined; operating losses grew; working capital decreased; cash burn from operations continues at a significant clip; shrinking assets continue to fund operations. (Source: CreditRiskMonitor)
- Sears has roughly $2.8 billion in junk bonds and term loans coming due in the next few years. In the last quarter, Fitch's affirmed their 'CC' rating but warned of “significant default risk”, S&P expressed liquidity concerns, and Moody's downgraded their debt. (Source: Wolf Richter/Wolf Street, CreditRiskMonitor)
- This week, Sears announced plans to sell the Craftsman brand to StanleyBlack&Decker. It has sold brands including Lands’ End and Hometown & Outlet Stores, as well as big parts of its real estate holdings, and continues to search for a buyer for Kenmore, DieHard, and Sears Home Services business.
- Sears announced store closings and management departures in December, as well as additional sale-leaseback deals via Seritage Growth Properties. (Source: Wolf Richter/Wolf Street, CreditRiskMonitor).
Bankruptcy Risk Rating: the FRISK® score
The FRISK® score model didn't predict bankruptcy 10 years ago, as Mr. Buffett did, but the FRISK® financial risk score for Sears Holdings has been a ‘1’ for several years. On a 10-point scale, a “1” signals the very highest likelihood of bankruptcy.
The FRISK® score is a predictive bankruptcy risk model that predicts public company bankruptcy within 12 months, with over 96% accuracy. It incorporates market data, agency ratings, financial metrics, crowd-sourced click data from credit managers, and many other factors. Learn more here.
The ‘Bankruptcy Checklist’: More Warning Signs
In advance of an updated in-depth pre-bankruptcy analysis, we thought it would instructive to put our short-form “bankruptcy checklist’ to the test.
Let’s review the list of red flags, to determine – based on the latest data - how far along the path to bankruptcy Sears really is. (Get the checklist of public company bankruptcy warning signs, here.)
FINANCIAL STATEMENTS AND SEC FILINGS
- Declining sales trend, coupled with recurring losses: YES
- Unfavorable performance ratios such as declining operating margins for successive quarters: YES
- Sharp decline in cash flow from operating activities; negative cash flows dropping deeper in the red, severe drop in cash balances: YES
- Persistently negative working capital and other liquidity measures: YES
- Rapidly declining or negative stockholders’ equity: YES
- Adverse current and/or quick ratios; A majority of financial ratios comparing unfavorably to industry benchmarks and peers: YES
- Inability to generate positive rates of return on equity or assets: YES
- Warning signs revealed on the MD & A or SEC filings: YES
(such as: on going concerns about ability to operate, reduced borrowing capacity under existing credit facilities, few financing options, constrained liquidity, issuance of second or third lien debt, reliance on the credit facility for the company's long-term liquidity, lower ability to negotiate asset sales, restructurings, and management changes).
MARKET SIGNS AND FINANCIAL RISK SCORE
- Debt agency rating downgrades: YES
Fitch’s – Affirmed ‘CC’ rating (November)
S&P -- CCC+ rating affirmed, but revised assessment of Sears' liquidity to less than adequate from adequate (December)
Moody’s: Downgraded from SGL-2 to SGL-3 (September)
- Missed interest payments on debt: NO
- Restructuring advisors consulted to reorganize capital: NO
- Refinancing and restructuring of debt: YES
- Off-balance sheet arrangements for increased liquidity: YES
- Asset sales, or a sharp decline in total assets: YES
- Spending cuts and reduced business activity in response to restricted liquidity: YES
- Equity issuances as the company explores other financing options: NO
- A sharp drop in stock market capitalization over the course of a year, adjusted for dividends: YES
- Listing Exchange Notice warning of non-compliance, due to average price per share minimum; late SEC filings or other violations: NO
- A FRISK® score deep in the red zone, signalling higher bankruptcy risk: YES
Expert Commentary and Opinion: Closer to Bankruptcy
In his recent excellent analysis on Wolf Street, Wolf Richter observes:
- Sears is scrambling for financing right after the holiday selling season – a concern, at a time of year when retailers should be swimming in cash and profits.
- Their recent Letter of Credit is not from a bank, but from affiliates of Lambert’s hedge fund, ESL Investments. i.e., no one outside of Lambert is still willing to lend to Sears.
- The aforementioned LOC may calm Sears’ suppliers in the near term, to keep them shipping product -- but according to “sources familiar with the matter”, suppliers were “requesting cash in advance before they agree to ship or are opting instead to avoid shipments altogether.”
- According to the last quarter’s financials, Sears had $258 MM in cash as of October 29 and $174 MM available to borrow via its revolving credit line. (Prior to recent asset sales). They will need an estimated $1.5 Billion to get through 2017, according to Moody's.
Business Credit Risk: Summary
When Sears fails, it won’t surprise those who have been watching the retailer’s sharp decline in recent years.
- There is no mistaking the recent signals. 15 of the 19 checklist categories indicate that Sears is showing many of the warning signs of bankruptcy.
- A round up of experts (summarized above) offer a more sophisticated financial analysis, looking at cash burn and refinancing needs. Recent asset sales have extended the runway -- but the inevitable outcome is the same.
- Observed ”facts on the ground” support this view. The consumer appears to have moved on to other retail options … sadly confirmed by recent holiday reports of a lack of inventory and extremely poor retail conditions.
With regard to timing:
The question on everyone’s lips for some time now: when will Sears finally file for bankruptcy? Mr. Richter’s view is that Mr. Lampert and Sears’ Management may wait until it is maximally advantageous to file for bankruptcy, estimated to be not before July 2017, for reasons related to debt and sales-leaseback timing and management incentives. Read more here. While the latest asset sales may extend this timing, the underlaying retail operation isn't sustainable.
Bottom line: It’s always better to reduce the risk of loss by protecting your company pre-bankruptcy, than to deal with a claim in bankruptcy. If Sears is your financial counterparty, tighten credit terms to the extent you can contractually do so.
Thank you to these sources, for their excellent analysis and commentary, quoted above:
Wolf Street: “Is the 2nd Half of 2016 When Sears Finally Kicks the Bucket?”
Money Morning: “How Warren Buffett Knew Sears Was Going to Fail"
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