A bit over one year ago, I tested Sears (SHLD) for its insolvency risk using the Altman Z-Score. Back then, the result was 2.30, which for the model I used already put Sears at risk but not in the highest-risk category.
Today, I'll revise my calculations using the most recent data, to see how things evolved.
As a refresher, the Altman Z-Score is defined by Wikipedia like this:
The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company.
The Z-score is a linear combination of four or five common business ratios, weighted by coefficients. The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by industry and approximate size (assets).
The Z-score has 5 inputs:
- T1 = Working Capital / Total Assets.
- T2 = Retained Earnings / Total Assets.
- T3 = Earnings Before Interest and Taxes / Total Assets.
- T4 = Market Value of Equity / Book Value of Total Liabilities.
- T5 = Sales / Total Assets.
The inputs show above then come together using the following formula:
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5
Calculation for Sears
- Current assets: $9451 million.
- Current liabilities: $8835 million.
- Total assets: $19396 million.
- Retained earnings: $606 million.
- EBIT: - $1062 million (this includes the removal of $330+$8 million in impairment charges)
- Market capitalization: $5426 million.
- Total liabilities: $16475 million.
- Revenues: $39036 million.
Using this data we get the following parcels:
- 1.2 * T1 = 0.038
- 1.4 * T2 = 0.044
- 3.3 * T3 = - 0.181
- 0.6 * T4 = 0.198
- 0.999 * T5 = 2.011
This gives us an Altman Z-score of 2.11.
Interpretation and Conclusion
The Altman Z-score is interpreted according to the following ranges (Source: Creditworthy.com):
3.0 or more,
Most likely safe based on the financial data. Of course, mismanagement, fraud, economic downturns, and other factors may cause an unexpected reversal.
2.7 to 3.0,
Probably safe to predict survival, but this is a portion of the gray area and is below the threshold of relative safety.
1.8 to 2.7
Likely to be bankrupt within two years. This is the lower portion of the gray area and dramatic action may be required to effect survival.
Highly likely headed for bankruptcy. Rarely would a firm be expected to recover from a financial condition generating this or lower scores.
Sears' Altman Z-Score went down a bit, from 2.30 to 2.11, belying its continued, though slow, decline. Sears' score greatly benefits from the size of its revenues versus its total assets, a ratio which actually increased since I last analyzed it. This was the result of revenues falling slower than total assets.
All the other parcels continue to get worse, thus giving credence to the initial analysis. It's also noteworthy that Sears had $618 million in cash and $1.1 billion in short-term borrowings at the end of 2012, and it's now down to $481 million in cash and up to $1.83 billion in short-term borrowings at the end of Q1 2013, so cash is down and short-term borrowings are piling up.
Although Eddie Lampert, Sears' CEO and famous hedge-fund manager - he controls around 55% of Sears' stock directly and indirectly - has been creative in finding funding sources, the end still seems to be drawing nearer as time goes by. Examples of his funding creativity would include starving the stores for capex, reducing inventory, selling performing stores for top money as well as spinning off several subsidiaries.
At this point, a turnaround seems unlikely. Sears is now producing negative cash-flow and would need some kind of operational turnaround not to burn money continuously. Even EBITDA is turning negative and that's before capex. Some of the measures which allowed Sears to live this far, like the reduced capex, reduced inventory and the selling of (some) profitable stores are bound to make the turnaround even harder.
Regarding the Z-score, it should soon step into the highest-risk category, highlighting how the insolvency risk is becoming shorter-term.