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 (collectively, Sears) to 'CC' from 'CCC'. A full list of rating actions follows at the end of this release.
KEY RATING DRIVERS
EBITDA Materially Negative: The magnitude of Sears' decline in profitability and lack of visibility to turn operations around remains a significant concern. EBITDA for Sears Holdings Corporation (Sears or Holdings) is expected to be negative $1 billion in 2014 (with LTM EBITDA through Aug. 2, 2014 at negative $860 million) and potentially worse in 2015, after turning negative $337 million in 2013.
Fitch expects top-line contraction of around 9% to 10% in 2014 due to estimated domestic comparable store sales (comps) of negative 1%-negative 2%, loss of Lands' End business (4.3% of 2013 consolidated sales), and ongoing store closings. Gross margins are expected to contract another 200 bps to 22%, on top of the 220 bps contraction in 2013. Fitch does not expect any catalysts in the business that will stem the rate of decline.
Cash Burn Significant Concern: Sears needs to generate a minimum EBITDA of $1 billion annually between 2014 through 2016 to service cash interest expense, capex, and pension plan contributions. Given Fitch's projections for EBITDA to be negative $1 billion or worse, cash burn (prior to any working capital benefit) is expected to be around $2 billion or higher annually. In addition, Sears needs an estimated $600 million to $700 million in liquidity to fund seasonal holiday working capital needs.
Funding Options May Not Be Enough to Support Operations Beyond 2016: Given the significant cash burn in the business, Sears injected $2 billion in liquidity in 2012 and $2.5 billion in 2013 through cuts in inventory buys, asset sales, real estate transactions and the issuance of a $1 billion five-year first lien secured loan in October 2013.
Through the first half of 2014, Sears has generated $665 million in proceeds, including a $500M exit dividend from the separation of Lands' End and another $164 million from real estate transactions. Below is a summary of potential sources of liquidity:
--Asset sales: Sears announced in mid-May that it is exploring strategic alternatives for its 51% interest in Sears Canada (with its stake valued at approximately $765 million based on market cap as of August end), including a potential sale of Sears Holdings' interest or Sears Canada as a whole. Fitch notes that EBITDA at Sears Canada has declined significantly as well, with LTM EBITDA loss of $39 million on revenues of $3.5 billion. The company is also evaluating options to separate its Sears Auto Center business.
--Second lien notes: The ability to issue $760 million in second lien debt as permissible under the company's credit facility is subject to borrowing base requirements. Given the significant reduction in inventory over the past three years, the ability to issue this debt has been constrained over the past three quarters. Fitch expects that the ability to issue this debt even at holiday peak inventory levels (with domestic inventory expected to be at $6.7 billion to $6.9 billion) could be limited as Sears will need to increase borrowings under the revolver to fund the holiday merchandise, unless it generates adequate proceeds through asset sales first.
--Working Capital: Fitch expects working capital to be a $400 to $500 million source of funds this year between ongoing reduction in inventory due to the contraction in its core businesses, store closings and the spinoff of Lands' End.
--Real estate backed debt on unencumbered property: Sears owned 367 Sears full line stores, 183 Kmart discount units and 12 Kmart supercenters at the end of 2013 which were unencumbered. Sears could seek to do a real-estate backed transaction that could potentially be in the range of $2.0-$2.5 billion using a similar approach to valuing the real estate that was used by J.C. Penney to raise a $2.25 billion term loan in May 2013. However, the significant deterioration in Sears business and the lack of visibility on a turnaround could limit this option. This does not contemplate a series of small real estate transactions that could also involve landlords assuming some of Kmart's and Sears' leases in highly productive malls.
Should Sears even be able to execute on a number of these fronts and generate $4.0 to $6 billion in proceeds, given the high rate of cash burn in the business, these actions would take them through 2016. As a result, Fitch expects that the risk of restructuring is high over the next 24 months.
Recovery Considerations for Issue-Specific Ratings:
In accordance with Fitch's Recovery Rating (RR) methodology, Fitch has assigned RRs based on the company's 'CC' IDR. Fitch's recovery analysis assumes a liquidation value under a distressed scenario of approximately $6.5 billion (low seasonal inventory) to $7.5 billion (close to peak seasonal inventory assumed in 3Q'14) on domestic inventory, receivables, and property, plant, and equipment.
The $3.275 billion domestic senior secured credit facility, under which Sears Roebuck Acceptance Corp. (SRAC) and Kmart are the borrowers, is rated 'CCC+/RR1', indicating outstanding (90%-100%) recovery prospects in a distressed scenario. Holdings provides a downstream guarantee to both SRAC and Kmart borrowings, and there are cross-guarantees between SRAC and Kmart. The facility is also guaranteed by direct and indirect wholly owned domestic subsidiaries of Holdings, which own assets that collateralize the facility.
The facility is secured primarily by domestic inventory, which is expected to range from an estimated $5.3 billion in January 2015 to an estimated $6.9 billion around peak levels in November 2014, and pharmacy and credit card receivables, which are estimated to be $0.3 billion-$0.4 billion. The credit agreement imposes various requirements, including (but not limited to) the following provisions: if availability under the credit facility is beneath a certain threshold, the fixed-charge ratio as of the last day of any fiscal quarter should not be less than 1.0x; a cash dominion requirement if excess availability on the revolver falls below designated levels; and limitations on its ability to make restricted payments, including dividends and share repurchases.
The $1 billion first lien senior secured term loan due June 2018 is also rated 'CCC+/RR1', as it is secured by a first lien on the same collateral and guaranteed by the same subsidiaries of the company that guarantee the revolving facility. Under the guarantee and collateral agreement, the revolving lenders will have priority of payment from the collateral over the $1 billion first lien-term loan lenders. The term loan that was formerly listed under Sears Holding Corporation is now listed under Kmart Corp and SRAC as they are the co-borrowers while Holdings is the obligor.
The $1.24 billion second lien notes due October 2018 at Holdings, which have a second-lien on the same collateral package as the credit facility and $1 billion term loan, are rated 'CCC/RR2', indicating superior recovery prospects (71%-90%). This reflects Fitch's expectation for the continued decline in the collateral that secures the first lien and second lien debt due to the shrinking business and asset sales, as well as the potential for an additional $760 million in second lien debt.
The notes contain provisions that require Holdings to maintain minimum asset coverage for total secured debt (failing which Holdings has to offer to buy notes sufficient to cure the deficiency at 101%) that could provide downside protection. If the borrowing base is less than the principal amount of Holding's consolidated debt that is secured by liens on the collateral that also secures the notes as of the last day of any two consecutive quarters (collateral coverage event), Holdings must offer to purchase an amount of notes sufficient to cure the collateral coverage shortfall at 101% of their principal amount, plus accrued and unpaid interest. Fitch also notes that the second lien notes have an unsecured claim on the company's unencumbered real estate assets, given that the notes are guaranteed by substantially all the domestic subsidiaries that guarantee the credit facility.
The senior unsecured notes at SRAC are rated 'CC/RR4', indicating average recovery prospects (31%-50%). The recovery on these notes are derived from the valuation on the company's unencumbered real estate assets held at Sears, Roebuck and Co, which provides a downstream guarantee of SRAC's senior notes and also agrees to maintain SRAC's fixed-charge coverage at a minimum of 1.1x. However, should a substantial portion or all of the owned real estate be used to raise additional secured debt, it could adversely impact the ratings on the unsecured notes. Recovery to the senior unsecured notes also takes into account potential sizable claims under operating lease obligations and the company's underfunded pension plan.
Rating Sensitivities
Negative Rating Action: A negative rating action could result from a significant decline in liquidity if Sears in unable to inject the needed liquidity to fund ongoing operations.
Positive Rating Action: A positive rating action could result from a sustained improvement in comps and EBITDA to a level where the company is covering its fixed obligations. This is not anticipated at this time.
Fitch has taken the following rating actions:
Sears Holdings Corporation (Holdings)
--Long-term IDR downgraded to 'CC' from 'CCC';
--$1.24 billion second-lien secured notes downgraded to 'CCC/RR2' from 'B-/RR2'.
Sears, Roebuck and Co. (Sears)
--Long-term IDR downgraded to 'CC' from 'CCC'.
Sears Roebuck Acceptance Corp. (SRAC)
--Long-term IDR downgraded to 'CC' from 'CCC'';
--Short-term IDR affirmed at 'C';
--Commercial paper affirmed at 'C';
--$3.275 billion secured bank facility downgraded to 'CCC+/RR1' from 'B/RR1' (as co-borrower);
--$1 billion first lien term loan downgraded to 'CCC+/RR1' from 'B/RR1' (as co-borrower);
--Senior unsecured notes downgraded to 'CC/RR4' from 'CCC/RR4'.
Kmart Holding Corporation (Kmart)
--Long-term IDR downgraded to 'CC' from 'CCC'.
Kmart Corporation (Kmart Corp)
--Long-term IDR downgraded to 'CC' from 'CCC'';
--$3.275 billion secured bank facility downgraded to 'CCC+/RR1' from 'B/RR1' (as co-borrower);
--$1 billion first lien term loan downgraded to 'CCC+/RR1' from 'B/RR1' (as co-borrower).
Fitch has withdrawn its long-term IDR on Sears DC Corp.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (May 28, 2014);
--'Recovery Ratings and Notching Criteria for Nonfinancial Corporate Issuers' (Nov. 20, 2013).
Applicable Criteria and Related Research:
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393
Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=721836
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=868934
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