Waiting in Lampert's Orchard

While investors wait for Sears (SHLD) to revive its retail operations, a recent deal to spin out part of its Orchard Supply hardware chain shows that the cash-raising plank of Ed Lampert's turnaround platform is also given to tremors.

Sears' stock has lost 25% since the beginning of August amid a series of disappointing sales and earnings reports. The stretch has been the first major test of loyalty to Lampert, the hedge fund guru who brought Kmart out of bankruptcy and bought Sears a year ago.

Last week, reflecting Lampert's efforts to monetize noncore assets, Sears announced that it closed on a $58.7 million investment from Ares Management LLC, a private equity firm, in the retailer's Orchard Supply Hardware subsidiary. Ares bought 19.9% of the garden supply company and a three-year option to acquire another 30.2% stake for $126.8 million.

News that the deal had closed was contained in a press release issued the night before Thanksgiving, and elicited no reaction from Wall Street, which first learned of the sale in October. In anticipation of a turkey dinner, however, some Sears followers might not have noticed a modification to the transaction's initial terms. Specifically, Orchard Supply didn't raise the $405 million it had planned to get from the high-yield debt market.

According to the October press release, Orchard was going to use the $405 million to pay a dividend of about $450 million to Sears when the Ares investment closed. As drawn up by Sears' innovative finance department, the transaction is something like a leveraged buyout of Orchard, or more precisely, a "recapitalization" in which Sears -- which paid $415 million for the chain in 1996 -- is able to harvest cash from a nine-year-old investment and still retain majority ownership of the chain.

One problem: Last week's press release made mention of only $250 million in debt financing for Orchard, consisting of a $130 million revolving credit facility and a $120 million loan backed by commercial mortgages. As a result, Sears got $225.5 million in cash from the deal, along with a $230 million note from Orchard bearing interest at 10% to 12.5%. In essence, Sears loaned Orchard Supply half the money it planned to receive, insisting on junklike interest rates for its trouble.