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Sears’ Turnaround Strategy Pits Shareholders Vs. Bondholders; CEO Lampert is Both

As Sears Holdings Corp struggles to revitalize a limping business empire, CEO Eddie Lampert’s turnaround strategy threatens to pit shareholders against bondholders.

As Sears continues to sell of valuable retail assets to cut costs and raise cash, the proceeds get distributed to shareholders by way of a mix of various financial instruments. In the last twenty-seven months, the retailer has disbursed $2.3 billion to its shareholders in total, dicing up Land’s End, Sears Hometown & Outlet Stores and part of Sears Canada. It still might sell off the what remains of Sears Canada and is considering doing the same with its auto-repair centers.

The problem is that the cash boon for shareholders, many argue, only comes at the expense of the value available to bondholders. Lesya Paisley, a portfolio manager at Aberdeen Asset Management PLC, said, “Bondholders should be very worried about what Eddie is doing. Eddie is talking about fixing the company, but in reality he is engaging in financial engineering.” Mary Gilbert, an analyst at Imperial Capital LLC, concurred, “Sears is getting rid of all the good stuff and leaving bondholders with the underperforming assets.”

Sears has been raising capital by selling off its realty, often choosing the best performing stores because they command higher purchase prices. Unable to reinvigorate languishing sales, Sears has relied upon the value of its realty as a centerpiece of its turnaround strategy. In 2012, Sears earned more than $47 million in revenue from multiple leasing arrangements. Since 2011, Sears had leased major commercial space to other marquee retailers: Whole Foods, Forever 21, Bay Club and Northgate Gonzalez Markets and Dick’s Sporting Goods  have all moved into space operated and formerly occupied by Sears.

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Some industry experts have speculated that Eddie Lampert was originally attracted to Sears precisely because of the value of its real estate. One of Sears’ investors, Baker Street Capital, issued a report recently that the retailer’s 350 remaining locations were collectively worth $7.3 billion. Consider that Sears’ total market capitalization is approximately $600 million. Since 2010, Sears has closed more than 300 stores. In 2013, Sears raised nearly $1 billion from real estate sales. In 2012, the retailer’s realty proceeds reached $618 million.

However, since so much of Sears’ value is a function of its real estate holdings, some bondholders worry that the company is shedding its physical collateral, rendering it vulnerable should there every be a bankruptcy proceeding that required significant liquidation. Should that circumstance arise, bondholder claims would get de-prioritized, since secure and un-secured lenders would likely get first crack at what remained of the company. And Sears’ collateral has certainly been diminished by its turnaround strategy: over the last two years, its overall collateral has plummeted $1.2 billion and the spin off of Land’s End surely shrink its available collateral even further.

Some bondholders are less concerned since not all asset spinoffs necessarily take a bite of out existing collateral. Christopher Kocinski, an analyst with Nueberger Berman Group LLC, said, “Sears needs cash, and if they raise money by spinning off assets that don’t materially dilute the collateral, that is not something we view negatively.”

Adding to that sentiment, Sears spokesperson Chris Brathwaite said, “Our primary focus is on creating long-term sustainable value and increasing the return on assets….We are continuously evaluating our asset structure and whether specific assets and/or businesses are better managed within the current Sears Holdings asset configuration or outside it.”

Eddie Lampert’s own personal fortune is deeply entangled with that of Sears’ since he simultaneously a major shareholder and bondholder. His hedge fund, ESL Investments Inc., own a hefty 48 percent of Sears as well as $95 billion of the company’s unsecured bonds and $3 million of its unsecured notes.

Despite Lampert’s financial involvement in Sears, there are some signs that he has carefully begin to withdraw his position. ESL is slowing down its supply of commercial paper–or short-term debt typically assumed to cover the cost of daily operations–to Sears. Sears owes ESL $285 million in IOUs. Some financial analysts interpret ESL’s reluctance to continue the steady stream of dollars to Sears as an indication that Lampert is insulating himself against personal losses by diminishing his exposure to Sears’ troubles. “If he has billions of dollars of his own net worth tied up in Sears, and if he’s reducing the exposure, that’s not necessarily a good thing,” said Matt McGinley, managing director at International Strategy & Investment Group.

Sears has suffered from debilitating liquidity problems, especially in the last year. Just recently, Sears secured a term loan of $1 billion in order to refinance already existing debt. The loan replaces Sears’ existing $3.275 billion asset-based credit line. A spokesperson from the ailing retailer said that the loan will be secured by the same collateral already in place. Lampert personally owns 25,120,220 shares of the retail giant, about 23 percent of the company. Lampert also personally owns $169 million of Sears’ commercial paper debt.

Sears’ free cash-flow has been negative in each of the last four consecutive years, with a staggering outflow of $1.44 billion. If Sears doesn’t locate additional financing soon, it will likely burn through its available cash reserves in the next nine months or so. McGinley said, “Their liquidity picture overall has not improved over the course of the past several years, and it hasn’t improved because the core operations of Sears are an absolute disaster.” For the investors who still use the investment thesis that Eddie Lampert is a smart guy, well, Eddie Lampert is a smart guy, and guess what, he’s reducing his exposure to Sears.” Sears maintains approximately $3.8 billion in outstanding bond and loans in total.

Sears’ fourth-quarter results did little to further inspire investor optimism. The net loss for the fourth-quarter which ended February 1 contracted to $3.37 per share from $4.61 per share, or $358 million. Revenue for the quarter slipped 14 percent to $10.6 billion.

Sears Holdings’ comparable store sales dipped 6.4% for the quarter to date in the U.S. and 4.4% in Canada. Comparable sales for Sears stores in the U.S. are down 9.2% in the nine weeks that ended January 6, and down 5.7% for Kmart. ShopperTrak reported that U.S. retail sales for the industry at large have risen 2.7% for the same period.For the fiscal year, Sears expects a loss as large as $914 million, potentially amounting to $8.61 per share. This is considerably worse than the loss of $6.20 per share most analysts have been predicting.

Sears secured bonds were trading around 92 cents on the dollar as of April 4. Wary of a possible default, investors have been buying up costly insurance for unsecured bonds to the tune of $1 million per year for every $10 million of  debt.