The Rota Fortunae is a concept of ancient philosophy referring to the capricious nature of destiny. This allegory illustrates somewhat the concept of mean reversion and the improper tendency to extrapolate past trends in the distant future. Sears (NASDAQ:SHLD) reigned during many decades. The corporation is now without a kingdom and on the verge of bankruptcy. In its 2017 annual report, the corporation acknowledged for the first time the fear of investors. Back in 2015, I estimated that Sears will be bankrupt before 2020. I believe that my assumptions were too optimistic.
Our historical operating results indicate substantial doubt exists related to the Company's ability to continue as a going concern. (Source)
I started to be intrigued by Sears when I realize the potential value of its properties. My hope was to find a diamond in the dust despite the disgusting state of its operations. I particularly enjoy the idea of buying repugnant firms to obtain valuable assets at a significant discount or for free. However, I quickly realized that Sears is a disaster waiting to happen. Even after a drop of 96% from its peak, the shares are overvalued.
By comparing the proceeds generated by the sales of assets versus the cash burned by the operations, I realized that Sears entered in a dead spiral many years ago. Without an extraordinary event, the only possible outcome is a bankruptcy in my opinion. However, I was not able to imagine a scenario in which the corporation would return to constant profitability and solvency.
By definition, Sears is a retailer with a network of stores across the United States. It would be reassuring to see the firm generating positive cash flow from its operating activities on a constant basis. Contrariwise, Sears is burning hundreds of millionss every quarter. This insertion is confirmed by the quarterly operating cash flow illustrated below. Because Sears reports its operating cash flow on a cumulative basis, I did basic adjustments to obtain the quarterly figures.
Due to the seasonal nature of the retail industry, the firm generates an important proportion of its total sales during the fourth quarter of the calendar year. It is evidently explainable by the holiday season. During the fourth quarter of 2013, the operating cash flow figure was equal to $563 million. The same metric was equal to $555 million in the fourth quarter of 2014. However, it is interesting to note the rapid and pronounced deterioration of the profitability in the fourth quarter of 2015 and 2016. Sears burned $113 million in the fourth quarter of 2015 and generated a mere $27 million in Q4 2016. The fact of not being profitable in the fourth quarter of the year is a bad presage for the rest of 2017. The fourth quarter assumes the role of a canary in a coal mine in my opinion.
Because of the increasing interest expense, the declining comparable store sales, the deteriorating reputation of the firm and the challenging environment for the classic retailers, Sears will remain under pressure in 2017. To be optimistic, I will assume that the firm will burn $1 billion in 2017.
The interest expense will increase meaningfully in the next few quarters in my opinion. It will be due to the recent jump of bond yields, the increasing credit risk assumed by the creditors and the debt load bigger than ever.
It is important to mention that 61% of the debt load is composed of variable rate debt. The third quarter report indicates that a 100 basis point change in interest rate would affect the annual funding costs by $26 million. The interest expense in the fourth quarter was equal to $115 million versus $105 million in the third quarter. The following chart illustrates the interest rate variable.
Moreover, the creditors will continue to increase their minimum required rate of return in function of the deteriorating fundamentals of the company. It is insightful to note the progression of the weighted average interest rate on the debt portfolio. Back in 2013, the unsecured debt had an average interest rate of 2.6%. It is now equal to 7.9%. In my opinion, it reflects directly the increasing risk of insolvency. A fraction of the average interest rate increase is attributable to the movements of the bond yields since 2013 in my opinion.
The increasing cost of debt reduces meaningfully the advantages of refinancing the existing debt. In a worst case scenario, the impossibility to refinance the current debt has to potential to trigger a default. Moreover, it will be more costly to issue new debt to finance the unprofitable operations. The following comment of the management is particularly interesting.
The domestic credit facility also effectively limits full access to the facility if our fixed charge ratio at the last day of any quarter is less than 1. As of January 28, 2017, our fixed charge ratio was less than 1.
If availability under the domestic revolving credit facility were to fall below 10%, the company would be required to test the fixed charge coverage ratio, and would not comply with the facility, and the lender under the facility could demand immediate payment in full of all amounts outstanding and terminate their obligations under the facility. (Source)
The third variable affecting the interest expense is the amount of debt outstanding. In my mind, it will act in the same way than the two other variables discussed above. Indeed, the debt load doubled since the beginning of 2013. I also added a chart of the pension plan liabilities. It should be considered in addition to the interest baring debt portfolio due to the fact that the pension plan is underfunded.
Bullish investors may argue that the debt maturities are far away and that it will leave enough time for a turnaround. According to the different contractual obligations, this argument is not valid. It is worth noting that the pension plan contributions are already incorporated in the operating cash flow calculation.
The firm will have to disburse around $876 million in repayment of debt in 2017. Overall, Sears will have to repay grossly $3.2 billion in principal before the end of 2019. These disbursement are not included in the burn rate created by the operations calculated above. Based on these assumptions, Sears will have to find at least $6 billion before the end of 2019 to survive.
Trying to survive involves a minimal level of expenditures. Naturally, it comes with a potential degradation of the existing properties. This is illustrated by putting in comparison the depreciation charges versus the capital expenditures. Moreover, there is a substantial difference between surviving and prospering. I have trouble understanding how a minimal level of capital expenditures can create a significant turnaround.
The reorganization plan should be called a gradual liquidation plan. Sadly, the proceeds are burned rapidly by the unprofitable operations. Currently, the inventory represents more than 40% of the total assets. Inventory is certainly more difficult to monetize than real estate properties.
In my opinion, Sears will fill for bankruptcy protection before the end of 2019. However, I believe that the principal of $1.3 billion due in 2018 has the potential to trigger a default. The proceeds generated by the sale of Craftsman should be enough to pay the principal due in 2017. In other words, the probability that Sears will go bankrupt before the end 2019 is approaching 100% in my opinion. 2018 also represents a huge challenge.
Even if the operating income figure becomes positive, the corporation will have to pay annually approximately $330 million in contribution to the pension plan and at least $400 million in interest expense. Indeed, the contributions to the pension plan are not included in the calculation of the operating income. However, it represents a recurrent charge putting constant pressure on the financial flexibility of the firm. The operating losses totaled $2 billion in 2016. Without a doubt, it indicates that the underlying business is in despair.
Over the past years, Sears sold numerous properties and owned stores to respond to its liquidity needs. The proceeds were sufficient to maintain the corporation alive over the past few years. However, the most valuable stores are already sold and the numbers of owned store is dangerously decreasing. Evidently, the maximum number of stores available for sale is the numbers of stores owned. This number is not infinite. Indeed, I would characterize the current strategy as liquidating slowly the corporation and burning the proceeds in unprofitable operations. In my opinion, liquidating entirely the firm few years ago would have generated proceeds largely higher than the current market capitalization.
In 2015, Sears completed a transaction with Seritage Growth Properties (NYSE:SRG) by selling 235 of its most valuable stores. The proceeds were equal to approximately $2.7 billion. According to the 2016 annual reports, only 380 owned stores remain.
To determine the value of the remaining stores, I assumed that they are as valuable as than the ones sold in the Seritage deal. In this case, they should be worth around $4 billion. This is very unlikely to be materialized due to the fact that the majority of the most valuable properties are already sold. The proceeds from the sale of assets will eventually slow. However, the probability that the losses will remain colossal is very high. By projecting proceeds of $4 billion, Sears would still have to find another $2 billion. The remaining brands are certainly not worth that much considering the proceeds of the most valuable brand Craftsman.
The management started the reorganization plan few years ago. Sadly, it is difficult the see any positive impact on the operational front. The operating income continues to reach new lows and the comparable store sales continue to decline severely. The closure of hundreds of store did not affect positively the comparable store sales. In my opinion, a significant improvement in comparable store sales might indicates the end of the hemoragy. Based on the historical figures and the current actions of the management, it is not for now.
Sears will probably continue to sell its owned stores and its brand names. The Kenmore brands is certainly worth few hundreds of millions based on the Craftsman transaction. However, it would only buy time and not solving the real problem. Even with overly optimistic assumptions, the proceeds would not be sufficient to allow Sears to continue as going concern until the end of 2019.
In conclusion, Sears burned almost two times its market capitalization during its fiscal year of 2016. Everything indicates that the death spiral will continue in 2017. It will only end when the firm will fill for bankruptcy protection in my opinion. I would not be surprised to see Sears filing for bankruptcy protection in 2018 but 2019 looks more certain. The probability of bankruptcy is in direct relation with time. Due to the high short interest and the low publicly traded float, put options look like the best vehicle to profit from a failure of Sears.
Disclaimer: This article reflects my opinion only. I am not a financial advisor. Please do your own due diligence and consult your financial advisor before taking any decision. I am not a financial advisor. The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone acts upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.