NEW YORK–(BUSINESS WIRE)–Fitch Ratings has downgraded its long-term Issuer Default Ratings (IDR) on Sears Holdings Corporation (Holdings) and its various subsidiary entities to ‘CCC’ from ‘B’. The ratings on various tranches of debt have also been downgraded by a notch. The Rating Outlook is Negative.
The downgrades reflect the continued deterioration in EBITDA on worse than expected top-line growth, with both Kmart and Sears running negative mid-single-digit comps in the fourth quarter. EBITDA for 2011 is expected to be below $400 million versus $1.5 billion in 2010, based on Sears’ update provided through Dec. 25, 2011. As a result, credit metrics continue to be pressured and leverage is expected to be 8.0 times (x) or more in 2011, up from 4.6x in 2010, versus Fitch’s prior expectation of leverage increasing to the 6.0x-7.0x range.
In addition, there is increasing risk that EBITDA could turn negative in 2012 with top-line contraction in the mid-single-digit range (due to comparable store sales decline and store closings) even if gross margin remains flat with 2011 levels. As a result, Sears will need to fund operations with increased borrowings.
Liquidity is expected to remain adequate to fund 2012 working capital needs given current availability under the company’s U.S. and Canadian facilities. However, Sears may need to access external sources of financing to fund operations in 2013 and beyond, as the magnitude of the decline in profitability and lack of visibility to turn operations around remain a major concern. If Sears is unable to access the capital markets or find other adequate sources of availability, and EBITDA remains at the current rate or lower, there is a heightened risk of restructuring over the next 24 months.
As of Dec. 23, 2011, Sears had $483 million of borrowings under the domestic revolver (vs. no borrowings in prior year), with $2.1 billion of availability under its domestic $3.275 billion credit facility due 2016 and $800 million under its CAD$800 million credit facility due 2015. Fitch expects that total availability at the end of its fiscal year (FY) ending January 2012 could be a bit lower than the $2.9 billion at Dec. 23 as Sears could draw down further to fund Spring inventory (December tends to be close to peak liquidity levels as retailers get flushed with holiday sale proceeds).
Assuming cash balances in the $500 million to $600 million range, about $1.8 billion-$2 billion of availability under its domestic credit facility and $800 million under the Canadian credit facility, Fitch expects Sears will have liquidity of approximately $3.1 billion to $3.4 billion at FY end January 2012. This is almost $1.5 billion to $1.8 billion lower than the $4.9 billion in total liquidity at the end of FY end January 2011. The difference can be explained by the shortfall in EBITDA and the need to fund operations as well as funding required cash contributions to its underfunded pension plans and share buybacks.
Fitch estimates that Sears would require a minimum of $400 million-$500 million in cash to run the business and approximately $1.5 billion to $1.7 billion to fund peak seasonal working capital needs during the 2012 holiday season (assuming lower inventory levels versus 2011 as a result of store closings and tighter inventory buys based on the company’s recent announcements). As a result, real ‘excess’ liquidity adjusted for peak seasonal working capital needs would be in the range of $900 million to $1.5 billion. This does not take into account further shortfall in EBITDA and assumes Sears has full access to both its domestic and Canadian credit facilities. However, covenants may constrict liquidity levels over time if profitability continues to wane; for example, Sears needs to maintain a fixed-charge coverage ratio of 1.0x under its domestic credit facility if usage exceeds a certain amount.
Fitch estimates Sears would need to generate EBITDA of $1.2 billion to $1.3 billion annually in 2012 and 2013 to service cash interest expense ($260 million-$280 million), capex ($400 million), contribution to pension plans ($300 million) and debt maturities. Other uses of cash could be working capital (which is expected to be a drain of $100 million to $150 million in 2011 before any impact from store closings) and share buybacks.
Additional sources of liquidity include the ability to issue $1.75 billion in secured debt as permitted under its credit facility ($1 billion accordion feature to upsize the domestic credit facility and $750 million in second lien debt). However, Sears could have difficulty tapping into this debt given deteriorating operating trends and credit market conditions. Sears could also cut back on inventory (as noted in its recent press release), and further reduce capital expenditures and SG&A, but these would come at the expense of the top line unless Sears right-sizes the business through a large number of store closings.
However, Fitch views the company’s current plan of store closures (100 to 120 Kmart and Sears Full-Line stores which equates to approximately 5% of total square footage) as a modest source of liquidity relative to the significant deficiency in free cash flow.
Market Share Losses = Tremendous Pressure on Operating Profitability:
Domestic Sears and Kmart stores have been underperforming their retail peers on top-line growth for many years and the combined domestic entity has lost over $9.5 billion, or 20% of its 2006 domestic revenue base of $48 billion (the two companies merged in March 2005) through the third quarter of 2011 (on a latest 12-month basis). The top-line weakness reflects competitive pressures, inconsistent merchandising execution and the lack of clarity about the company’s longer term retail strategy, particularly in the face of continuous changes in its top ranks. Sears’ challenge will be to generate longer term sales and earnings growth at both Sears and Kmart in the face of continued market share gains by its largest retail peers within the department store, discount and big-box specialty retail segments.
Sears’ recent earnings pre-announcement points to 2011 EBITDA to come in below $400 million, a significant shortfall from the $1.45 billion generated in 2010 on weaker than expected comparable store sales across all its reporting segments. Fitch expects EBITDA could likely turn negative in 2012 on mid-single-digit top-line contraction (given both comp store declines and store closings) even with modest expense reduction of $100 million to $200 million and gross margins flat to 2011 levels.
Recovery Considerations for Issue-Specific Ratings:
In accordance with Fitch’s Recovery Rating (RR) methodology, Fitch has assigned RRs based on the company’s ‘B’ IDR. Fitch’s recovery analysis assumes a liquidation value under a distressed scenario of approximately $6.7 billion (low seasonal inventory) to $7.7 billion (close to peak seasonal inventory) on inventory, receivables, and property, plant and equipment (PP&E).
The $3.275 billion domestic senior secured credit facility, under which Sears Roebuck Acceptance Corp. (SRAC) and Kmart Corporation (Kmart Corp.) are the borrowers, is rated ‘B+/RR1’, indicating outstanding (90%-100%) recovery prospects in a distressed scenario. Holdings provides a downstream guarantee to both SRAC and Kmart Corp. borrowings and there are cross-guarantees between SRAC and Kmart Corp. The facility is also guaranteed by direct and indirect wholly-owned domestic subsidiaries of Holdings which owns assets that collateralize the facility.
The facility is secured primarily by domestic inventory which has historically ranged from $8 billion to $10 billion around peak levels in November, and pharmacy and credit card receivables which range from $650 million to $700 million. The credit facility has an accordion feature that enables the company to increase the size of the credit facility or add a first-lien term loan tranche in an aggregate amount of up to $1 billion and issue $750 million in second-lien debt. The credit agreement imposes various requirements, including (but not limited to) the following: (1) if availability under the credit facility is beneath a certain threshold, the fixed-charge ratio as of the last day of any fiscal quarter be not less than 1.0x; (2) a cash dominion requirement if excess availability on the revolver falls below designated levels, and (3) limitations on its ability to make restricted payments, including dividends and share repurchases.
The $1.25 billion second lien notes due October 2018 at Holdings are also rated ‘B+/RR1’. The notes have a second lien on all domestic inventory and credit card receivables, essentially representing the same collateral package that backs the $3.275 billion credit facility on a first lien basis. While Fitch has not made a distinction between the first- and second-lien notes at this point given the significant collateral backing the notes and facility, it could do so in the future should Sears be able to exercise the accordion feature under the credit facility, issue additional second-lien notes or the assets serving as collateral decline materially. The notes contain provisions which require Holdings to maintain minimum asset coverage for total secured debt (failing which the company has to offer to buy notes sufficient to cure the deficiency at 101%).
The senior unsecured notes are rated ‘CCC/RR4’, indicating average recovery prospects (31%-50%). While the credit facility and second-lien notes are overcollateralized currently and the spill-over could provide better than average recovery prospects for the unsecured bonds, factors considered in assigning the recovery rates include the potential sizable claims under lease obligations; the company’s underfunded pension plan; the ability to add additional secured indebtedness; and the potential overestimation of recovery value assigned to owned PP&E under a liquidation scenario. The 31%-50% range would be in line with or better than the average recoveries in the retail sector for defaulted unsecured bonds, which have generally been in the 25%-40% range over the past 10 years. The SRAC senior notes are guaranteed by Sears, which agrees to maintain SRAC’s fixed-charge coverage at a minimum of 1.1x. In addition, Sears DC Corp. (SDC) benefits from an agreement by Sears to maintain a minimum fixed-charge coverage at SDC of 1.005x. Sears also agrees to maintain an ownership of and a positive net worth at SDC.