Fitch: Sears' Short-Term Loan from ESL Highlights Liquidity Woes

Sears Holdings Corporation's (Sears) secured short-term loan is a temporary and short-term fix to a much larger need for liquidity infusion, given significant cash burn in the business, according to Fitch Ratings.

On Sept. 15, Sears secured a $400 million secured short-term loan from entities affiliated with controlling shareholder ESL Investments, Inc. The loan, which is being funded in September, is scheduled to mature on Dec. 31, 2014, which indicates how tight liquidity is going into the holiday season with the need for additional capital to fund inventory build-up.

Mr. Edward S. Lampert, Sears' CEO and chairman of the board, is also the sole stockholder, CEO and director of ESL. The loan is guaranteed by Sears and is secured by a first-priority lien on 25 real properties owned by Sears. Fitch notes that ESL had provided unsecured commercial paper funding (within the $500 million limit) to Sears, but has pulled back on that since year-end 2013, with no CP holdings by ESL at the end of the second quarter.

As long as there is no event of default, the maturity date can be extended to Feb. 28, 2015, at the discretion of the company upon the payment of an extension fee equal to 0.5% of the principal amount. The loan will have an annual base interest rate of 5%. Sears is required to pay an upfront fee of 1.75% of the full principal amount.

Last week, Fitch downgraded Sears' long-term Issuer Default Ratings to 'CC' from 'CCC', reflecting the magnitude of Sears' decline in profitability and lack of visibility to turn operations around, leading to heightened liquidity concerns. EBITDA is expected to be negative $1 billion in 2014 (with LTM EBITDA through Aug. 2, 2014 at negative $860 million) and potentially worse in 2015, after turning negative $337 million in 2013.

Fitch expects top-line contraction of around 9%-10% in 2014 due to estimated domestic comparable store sales of negative 1%-negative 2%, loss of Lands' End business (4.3% of 2013 consolidated sales), and ongoing store closings. Gross margins are expected to contract another 200 bps to 22%, on top of the 220 bps contraction in 2013. Fitch does not expect any catalysts in the business that will stem the rate of decline.

Sears needs to generate a minimum EBITDA of $1 billion annually between 2014 through 2016 to service cash interest expense, capex and pension plan contributions. Given Fitch's projections for EBITDA to be negative $1 billion or worse, cash burn (prior to any working capital benefit) is expected to be around $2 billion or higher annually. In addition, Sears needs an estimated $600 million-$700 million in liquidity to fund seasonal holiday working capital needs.

Given the significant cash burn in the business, Sears injected $2 billion in liquidity in 2012 and $2.5 billion in 2013 through cuts in inventory buys, asset sales, real estate transactions and the issuance of a $1 billion, five-year, first-lien secured loan in October 2013. Through first-half 2014, Sears has generated $665 million in proceeds, including a $500 million exit dividend from the separation of Lands' End and another $164 million from real estate transactions.

The company's remaining potential sources of liquidity include a sale of Sears Canada, the issuance of additional second-lien debt, a further reduction in working capital, and the issuance of real estate-backed debt. Sears' 51% interest in Sears Canada is valued at approximately $765 million (based on market cap as of Aug. 31). Fitch notes that EBITDA at Sears Canada has declined significantly as well, with LTM EBITDA loss of $39 million on revenues of $3.5 billion. The company is also evaluating options to separate its Sears Auto Center business.

Sears could also issue $760 million in second-lien debt as permissible under the company's credit facility, though it is subject to borrowing base requirements. Given the significant reduction in inventory over the past three years, the ability to issue this debt has been constrained over the past three quarters. Fitch expects that the ability to issue this debt even at holiday peak inventory levels (with domestic inventory expected to be at $6.7 billion-$6.9 billion) could be limited as Sears will need to increase borrowings under the revolver to fund the holiday merchandise, unless it generates adequate proceeds through asset sales first.

Fitch expects working capital to be a $400 to $500 million source of funds this year between ongoing reduction in inventory due to the contraction in its core businesses, store closings and the spinoff of Lands' End.

Finally, Sears could issue real estate-backed debt on unencumbered property. At year-end 2013, Sears owned 367 full-line Sears stores, 183 Kmart discount units and 12 Kmart supercenters, all of which were unencumbered (before adjusting for the 25 properties now being used to secure the $400 million term loan). Sears could seek to do a real estate-backed transaction that could potentially be in the range of $2.0 billion-$2.5 billion using a similar approach to valuing the real estate that was used by J.C. Penney to raise a $2.25 billion term loan in May 2013. However, the significant deterioration in Sears' business and the lack of visibility on a turnaround could limit this option. This does not contemplate a series of small real estate transactions that could also involve landlords assuming some of Kmart's and Sears' leases in highly productive malls.

Given the high rate of cash burn in the business, should Sears even be able to execute on a number of these fronts and generate $4.0 billion-$6 billion in proceeds, these actions would take them through 2016. As a result, Fitch expects that the risk of restructuring will be high over the next 12-24 months.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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