The Deal: Sears Has Time on Its Side

NEW YORK (The Deal) -- In a twist of fate over the past year or two, department store operator Sears Holdings (SHLD) may have more time to turn itself around than troubled rival J.C. Penney (JCP).

That might not have been what industry watchers would have predicted when Apple's ( AAPL) retail head Ron Johnson sauntered into the Plano, Texas-based retailer in late 2011, bringing a Sillicon Valley approach to shake up the dowdy department store chain.

That swashbuckling, and an inattentiveness to J.C. Penney's core customers, cost Johnson his job in short order.

And the drama continues at J.C. Penney as Johnson's original backer, hedge fund manager Bill Ackman, had a very public spat with the board he sat on which he left in a huff.

Which might go to show: hedge fund managers shouldn't run retailers. Because that has been somewhat the case over at Hoffman Estate, Ill.-based Sears where CEO Eddie Lampert still controls about 62% of the company.

Yet Sears could be in a better position to make it through a revamp than J.C. Penney for a number of reasons.

In Sears' favor is a real estate portfolio it has yet to fully monetize, which could be borrowed against to help fund operations, according to according to Moody's Investors Service analyst Scott Tuhy. By Tuhy's count, Sears' real estate holdings, as measured by store count, are comparable to its competitor's so it should be able to raise at least another $2.5 billion as J.C. Penney has done already.

Sears also owns Land's End, which it acquired for $1.9 billion in cash in 2002. From the most recent figure available, in January 2012, the division was valued at $1.25 billion, or about 7.5 times Ebitda, according to Mary Ross Gilbert, a managing director at Imperial Capital. But considering recent multiples for retail consumer brands stretching into the double digits, that number could be higher, perhaps around $1.5 billion at about 9 times Ebitda.

Sears has also earmarked $215 million in real estate to be sold in the future, adding yet more cash to its balance sheet, with $45 million anticipated in the next six weeks and another $170 million remaining.

One obvious asset that Sears is less likely to sell is its iconic brand names such as Kenmore, Craftsman and DieHard, which are owned by KCD IP. That's mostly because of a complicated financing structure in which KCD IP issued $1.8 billion in asset-backed securities, which are held by Sears Reinsurance, in support of Sears' insurance programs. KCD IP collects royalties from the brand names it owns to service the debt, which is also backed by the rights to those names. So cash generated from a sale of those assets would have to first be applied to paying down that debt, before it could be used for any other purposes.

Sears also has that 51% stake in Sears Canada, which has a market capitalization of C$1.23 billion ($1.17 billion) and is worth nearly C$630 million.

And there is a $1 billion accordion feature linked to its revolving credit facility that Sears could use, in addition to nearly $1.1 billion undrawn on available domestic credit facilities, according to Moody's Aug. 22 report.

And, for its fiscal year 2013 second quarter ending Aug. 3, Sears domestically reported $383 million in cash and cash equivalents, according to its earnings results released Thursday.

That all adds up to about $7 billion if fully realized to fund operations.

Still, Sears is inarguably in decline. Its adjusted Ebitda for the first half of fiscal 2013 entered negative territory of $63 million. And all-important retail comparable store sales domestically were down by 0.8% for the seond quarter, while Kmart's comparable store sales were down 2.1%, year-over-year. Sear's Canada comparable store sales declined 2.5%

Sears, during its 2013 fiscal year, sunk $267 million into paying interest expense and $378 million in capital expenditures, while this year it expects to spend $352 million to pay for unfunded pension obligations.

That totals to between $900 million and $1 billion shelled out by the company on an annual basis, and with negative Ebitda thus far this year, means that amount roughly represents the company's cash burn in fiscal 2013.

The second half of the year will likely prove more profitable than the first, but estimated Ebitda for the year according to analysts' estimates provided by Bloomberg is still expected to be negative $8.9 million for fiscal 2013, which means that Sears will burn through up to $1 billion in cash.

Also weighing on Sears is total unfunded pension obligations, which according to its second-quarter report, total nearly $2.1 billion. Although that amount could decrease if interest rates go up, Tuhy added.

That would give Sears roughly a four-to-five-year window to right itself.

And even more important, according to the Moody's report: "The company's debt maturity profile is benign with no meaningful debt maturities until the 2018 maturity of the company's $1.25 billion of second lien notes."

For J.C. Penney the situation is more dire, as the only assets it has left to monetize in order to fund operations are its Liz Claiborne and Monet brands, which it acquired for $268 million from Liz Claiborne Inc., now known as Fifth & Pacific Cos., in 2011.

J.C. Penney said it expects to end this year with nearly $1.5 billion in liquidity.

In July, Moody's calculated that J.C. Penney would go through $1.4 billion by the year's end. However, the retailer reported it had dropped more than $700 million in its second quarter -- as its earnings beat analyst's expectations to the downside. With that kind of pessimisstic report, J.C. Penney could surpass Moody's estimates and go through $2 billion by the end of the year.

And with comparable store sales sinking another 11.9%, according to the company's second-quarter earnings Tuesday, rescue from the turnaround trumpeted by Johnson and Ackman almost two years ago still seems far off. Though it should be noted, in J.C. Penney's favor, that this was an improvement over larger declines in recent past quarters: 21.7% for the same period a year ago and over 25% for all of fiscal 2012.

That could be cold comfort for the retailer, however. Unless its cash burn is significantly slowed -- soon -- its future as a going concern is very much in doubt.

Ackman, in a letter to investors in his hedge fund Pershing Square Capital Management LP, didn't mince words, characterizing J.C. Penney as a "failure." His fund still holds a 17.7% stake and he agreed to a blackout period precluding him from selling shares right away.

But Thursday, J.C. Penney felt compelled to pass a poison pill to protect it from future activist investors and a possible takeover, now that it is at its most vulnerable.

-- Written by Richard Collings

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