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December 27, 2011, was a trying day for investors in the Sears Holdings Corporation (NASDAQ:SHLD). After Sears announced it would likely close more than 100 stores after their lack-luster holiday shopping performances, its stock dropped 27.2% to close at a 52-week low of $33.38.

It is in hopes of discovering a brighter side of Sears that we turn our attention to one of its subsidiary holdings. On December 30, 2011, the stock of Orchard Supply Hardware Stores Company will be distributed to Sears Holdings shareholders. Shares of Orchard will begin regular-way trading on the NASDAQ on Tuesday, January 3, 2011, under the ticker OSH. A dark cloud hovers over the Parent company, but is the future of the pending Orchard spin-off any brighter? That is the question we seek to answer in this two-part article. In Part I we will review the key aspects of the transaction, along with an overview of the business operations. In Part II we will hazard an estimate of the intrinsic value of Orchard, so that we may identify whether the post spin-off trading price represents a discount to the fair value of the underlying business.

About Orchard Supply Hardware Stores Corporation

According to its regulatory filings, Orchard “is a specialty retailer primarily focused on the consumer segment of the home improvement market.” The company operates 89 full-service hardware stores in California. Orchard departs from the model of many of its competitors by not targeting homebuilders or large contractors. As Orchard doesn’t stock low-profit wholesale lumber and other materials, it can reserve valuable square footage in its stores for higher-margin goods. [i]

The bad news in this information is that Orchard is almost entirely exposed to both the health of the housing market in California, and the ability of California homeowners to spend on home improvements. The good news is that, despite operating in this particular industry, the company has remained surprisingly profitable in every year since 2006, except for 2008 when it reported a loss of $243.4 million due to a $268.2 million impairment charge. Although conditions in the home improvement and housing markets may always deteriorate further, Orchard’s financial performance under unusually difficult recent circumstances provides reason to be cautiously optimistic of the company’s future outlook.

Potential for Indiscriminate Selling

The following chart highlights the relative impact of Orchard’s business to Sears.

SHLD

OSH

%

Revenue (ttm)

$ 42.75B

648M

iii

1.60%

Gross Profit (ttm)

11.88B

226.4M

iii

1.91%

GM%

26.73%

34.94%

iii

EBITDA (ttm)

939M

29.2M

iii

3.09%

Net Income (ttm)

($ 363M)

7.2M

iii

N/A

It should be immediately apparent that Orchard’s performance represents little more than a rounding error. As such, the minority holders of SHLD stock are unlikely even aware of the presence of Orchard in Sears’ consolidated results of operations, nor of its pending spin-off. Even better, for every 22.141777 shares of SHLD stock held on December 16, 2011, the Sears shareholder will be distributed just one share of OSH common stock, and one share of OSH preferred stock.

This is potentially good news to the prospective investor in Orchard shares because when the current Sears shareholders receive their pro-rata distribution of OSH shares, they are more likely than not to indiscriminately dispose of their newly acquired shares, if only because holding them will be inconvenient. There is reason to expect there to be significant institutional dumping of the shares on the market; due to the regulatory, contractual, and logistical reasons common to spin-offs.

The aggregate effect of this institutional selling may serve to artificially, and temporarily depress the value, and creating an opportunity for timely purchases below. However, as is discussed below, Insiders will hold over 80% of the company’s common stock, so any meaningful impact on the price will likely be the result of their investment decisions. This is of course all just speculation, but it is logical and is all too common when large parent companies spin off the stock of small divisions or subsidiaries.

Potential Acquisition Target

The investor experienced in spin-off situations will note the disproportionate propensity of spin-off companies to be acquired within their first two years of trading as stand-alone operations. In this case, we are less confident that Orchard will be the future target of an acquisition. The company is heavily leveraged relative to industry averages, and its major competitors already have established significant presences in California, with The Home Depot (NYSE:HD), Ace Hardware, and True Value each currently operating between two to three times as many stores as OSH. By contrast, Lowe’s only operates 20% more stores in the State of California than does Orchard. Even if a large, regional hardware company such as Menards desired to gain a significant presence in California via an acquisition, Orchard’s leverage may serve as an effective deterrent to a takeover.

What About the Insiders?

According to the regulatory filings, after the spin-off, Ares Corporate Opportunities Fund, L.P. (“ACOF”) will own 1,194,000 shares (100%) of the Company’s Class C common stock, along with 20% of Orchard’s total voting rights. ESL Investments, Inc. (“ESL”), controlled by billionaire investor Edward S. Lampert, the controlling shareholder of Sears, will own 2,946,613 shares (61%) of the Class A common stock, along with 49% of Orchard’s total voting rights.[ii] Bruce Berkowitz’s Fairholme Capital Management will own an additional 734,841 shares (15.3%) representing 12.2% of the total voting power.

It is important to note that these insiders will receive their shares by virtue of their positions in Orchard’s current parent entity, Sears. There is nothing to say that any or all of these insiders will not immediately, or ultimately, divest themselves of their holdings in Orchard. The filings are fairly silent as to the intent of these insiders with respect to their pending holdings of OSH shares, though it is indicated that they need not, and may not, retain their interests at all.

Orchard has further incentivized management by reserving 1,000,000 Class A shares for equity-based awards. This is not an immaterial amount of stock, and this should be viewed positively.

Leverage

Reference was made to Orchard’s leverage above. Indeed, the company’s heavy debt-load represents the greatest risk to investors considering a position in OSH shares. In its third-quarter financials (for period ending October 31, 2011), Orchard reported long-term debt and capital lease obligations of $320 million, of which nearly $42 million comprises the current portion. This represents a prodigious amount of debt for a company with a cash balance of $15 million, EBITDA of roughly $30 million, and ‘Adjusted EBITDA’ of $69.4 million.[iii] The company correctly regards its non-GAAP measurement of ‘Adjusted EBITDA’ to more accurately represent the amount of cash available for debt-service. [iv]

In addition, the company’s credit rating was downgraded in June, by Standard & Poor’s and Moody’s to “B-“and “B3” respectively. Orchard is also operating uncomfortably close to a key leverage ratio covenant. Note that Management warns that any further deterioration of the business could lead to the breach of this leverage covenant after the third quarter of 2012, but the company is pursuing certain de-leveraging steps, including the recent sale of the Tracy distribution center as well as several prospective store sales, to provide a greater cushion relative to this particular covenant.

Of course, debt is a two-edged sword. As the consequences of breaching debt covenants, or failing to refinance existing loans would be clearly negative, the implications of even a slight appreciation in the underlying assets or financial position could have an out-sized positive impact on the share price.

Summary

In summary, Orchard is reasonably profitable, but excessively leveraged. Its collection of hardware stores operates in a highly competitive and economically challenging environment. The business appears to be sound, however, and whether the stock represents an acceptable value proposition will depend largely on the range in which the shares trade subsequent to the spin-off. We will look next at the financial analysis which may indicate a reasonable trading level for the shares. After all, not all of the best spin-off investment returns are found in the spin-offs with the most attractive businesses. Orchard has some of the key earmarks of a potentially profitable spin-off opportunity, and so it bears looking into more closely.


[i] Form S-1 Registration Statement, p. 1.

[ii] Form S-1 Registration Statement, pp. 5 and 137.

[iii] EBITDA and Adjusted EBITDA are derived from pro-forma amounts for FYE January 29, 2011 as only trailing three months of stand-alone data is currently available. Pro-Forma reflects new terms under the Brands and Appliance Agreements entered into with a subsidiary of SHLD as a part of the spin-off.

[iv] Per Form S-1, p. 61, the Company calculated ‘Adjusted EBITDA’ by removing from EBITDA any gains/loss on asset sales, stock-based compensation, and extraordinary items such as unusual legal settlements.

Continue to Part II >>

Source: Sears Spin-Off: The Hardware Side Of Sears, Part I