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.
Sears spokesman Chris Brathwaite declined to comment on the deal beyond the details included in the press release, except to say that this possibility "had been anticipated or contemplated when the deal was announced." After the deal closed, Moody's Investors Service gave Orchard Supply a B1 credit rating, a deeply speculative grade. Moody's rating "considers the leveraged nature of Orchard's expected balance sheet," along with competitive threats posed by Lowe's ( LOW) and Home Depot ( HD), the ratings outfit said in a press release. Orchard Supply currently operates 84 hardware stores in California, and its financials are not available to the public. Sears, which has a speculative-grade debt rating by all the major ratings agencies, reported more than $4 billion in debt outstanding at the end of its second quarter. Marty Fridson, the publisher of Leverage World, said it looks like the deal became partly "seller financing," which leaves Sears on the hook should the junk bond market further deteriorate or if something went wrong with Orchard Supply Hardware. "That certainly wouldn't be their first choice," Fridson said. "I'm sure they would have rather had the cash and moved on, rather than having the potential of being dragged back into it in the event of a failure down the road." In its release, Sears said the use of a note for part of the dividend was always on the table "to ensure that Orchard Supply Hardware would not be dependent on conditions in the high-yield debt market." Orchard Supply expects to refinance the note when "market conditions improve and provide it with an appropriate financing rate." Will that happen? It might or might not. "There have been big capital outflows from the high-yield debt sector with the flattening of the yield curve, and it hasn't been the best time for raising money there lately," Fridson said. "A number of deals have been postponed or canceled. That doesn't mean this is an exceptionally poor deal among others that have been out there, but it's just been a tougher environment lately."
If things go as planned for Orchard Supply, the transaction could be a good deal for Sears, particularly stockholders already benefiting from the $225 million dividend. "This deal didn't go as planned, but underwriting a part of it isn't a big deal for a big company like Sears," said Charles O'Shea, a senior analyst with Moody's. "But it does show how complicated these deals can get. We still haven't seen any real estate transactions yet." In the absence of those, investors are left with two slightly wounded discount chains where markdowns were said to be rampant over the Thanksgiving holiday. Whether there's more markdowns coming for the stock remains to be seen.