Fitch Downgrades Sears Holdings' IDR to 'B'; Outlook Negative

NEW YORK--()--Fitch Ratings has downgraded its long-term Issuer Default Ratings (IDR) on Sears Holdings Corporation (Holdings) and its various subsidiary entities to 'B' from 'B+'. The ratings on various tranches of debt have also been downgraded by a notch. The Rating Outlook is Negative. A full rating list is shown below.

The downgrades reflect continued deterioration in EBITDA on worse than expected top line growth, with a precipitous decline during the first quarter of 2011. As a result, credit metrics continue to be pressured and leverage could increase by an additional turn or more in 2011 from 4.6x in 2010, and be potentially higher in 2012 and 2013 (versus Fitch's prior expectation of leverage remaining under 5.0x). The revised expectations contemplate reduction in EBITDA from a latest 12-month (LTM) level of $1.2 billion. Leverage is also expected to increase due to a need for higher borrowings to fund operations with EBITDA now under $1.5 billion. Liquidity remains adequate given availability under the company's U.S. and Canadian facilities, the ability to add $1.75 billion in secured indebtedness, and, potentially, to pull other levers over the intermediate term. However, the magnitude of decline in profitability and the lack of visibility to turn around operations remain a major concern.

Market Share Losses Continue:

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 first quarter of this year (1Q'11; on an LTM 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.

Using an industry composite based on Fitch's estimate of Sears' sales mix, industry sales were down an estimated 8%-9% over 2006-2010 or a CAGR decline of just over 2%. During this four-year period, Sears' sales were down 21% or a CAGR decline of approximately 6%. The decline in Kmart sales have been even more pronounced relative to its industry peers. Using a composite of general merchandise, food and drugstore sales for Kmart, industry sales are up almost 20% over the last four years or 4.5% CAGR. In contrast, Kmart sales are down 16% or a CAGR decline of 4.5%. Fitch expects both Kmart and Sears will remain share donors as Sears' comparable store sales are expected to be in the negative 3%-5% range in 2011-13, while Kmart's comps are expected to be down in the low single-digit range.

Tremendous Pressure on Operating Profitability:

Weakness in top line has resulted in operating margins that significantly lag its peers. This is in spite of the company undertaking aggressive cost cutting measures between 2006 to 2009 which resulted in a $1.2 billion reduction in domestic selling and administrative expenses. Domestic EBITDA margin has tracked over 600 basis points (bps) lower on average over 2008 to 2010 compared to its largest retail peers in the discount, department and hardline retail categories. Given chronic underinvestment in the stores due to years of cost cutting and low level of capital expenditures and the lack of a well-articulated strategy to stop market share losses, Fitch expects the high differential will likely continue.

Sears' 1Q'11 EBITDA fell to $63 million from $304 million, a decline of 80% year-over-year on weaker than expected comparable store sales across all the reporting segments. Even if EBITDA were to stabilize for the remainder of the year, this would still reduce EBITDA to $1.2 billion in 2011 (assuming Sears can align inventory more appropriately to sales in the second half of this year) versus $1.45 billion in 2010. However, given continued pressure on sales, a decline in gross margin on excessive inventory markdown, and Fitch's assumption of flat SG&A, EBITDA is expected to remain under pressure. It is difficult to define the magnitude of decline given Sears generates 65% of its profit in the fourth quarter along with the many moving parts, but EBITDA could be well under $1 billion for 2011.

With sales pressure expected to continue into 2012 and beyond, the only way for Sears to stabilize or increase EBITDA would be to increase gross margin levels or reduce SG&A expenses. For every 1% decline in top line at Sears Domestic or Kmart from 2010 reported levels, gross margins would have to increase by 30 bps and 25 bps, respectively, to hold gross profit dollars flat. Fitch thinks the ability to further cut expenses without adversely affecting top line is constrained given years of underinvestment.

Liquidity Adequate But Declining:

At the end of 2010 (year ended Jan. 29, 2011), Sears had liquidity of approximately $5 billion. This consisted of $1.39 billion of cash; $3 billion of pro forma availability under its domestic $3.275 billion credit facility (upsized from the $2.4 billion facility in April 2011); and $510 million availability under its CAD$800 million asset backed revolver (ABL) facility due 2015. This availability has to be adjusted for several factors - Fitch estimates that Sears would require (1) a minimum of $400 million-$500 million in cash to run the business; (2) $2 billion-$2.5 billion to fund peak seasonal working capital needs during the holiday season; and (3) cash collateral or letter of credit borrowings under its domestic facility in the amount of $475 million-$500 million for self-insurance programs. As a result, real 'excess' liquidity would be in the range of $1.5 billion to $2.2 billion. This 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 has a cash dominion requirement and needs to maintain a fixed-charge coverage ratio of 1.0x under its domestic credit facility if usage exceeds a certain amount.

Fitch estimates that Sears would need to generate EBITDA of $1.5 billion in 2011 and $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 could be a drain of another $200 million in 2011 assuming year-end inventories are up roughly 3%) and share buybacks. Given EBITDA is expected to be materially lower, the company will need additional borrowings to fund its operations.

Additional sources of liquidity include the current ability to issue $1.75 billion in secured debt as permitted under its credit facility ($1 billion accordion feature to upsize the facility and $750 million in second lien debt) and asset sales. For example, assuming the Canadian business can sustain EBITDA in the $200 million-$225 million range, gross proceeds from the sale of the business could be in the range of $1 billion-$1.4 billion assuming a 5x-6x multiple. Sears could also cut back on inventory, capital expenditures and SG&A, but these would come at the expense of top line unless Sears right sizes the business through large number of store closings.

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. While concepts of Fitch's RR methodology are considered for all companies, explicit recovery ratings are assigned only to those companies with an IDR of 'B+' or below. At the lower IDR levels, Fitch believes there is greater probability of default, so the impact of potential recovery prospects on issue-specific ratings becomes more meaningful and is more explicitly reflected in the ratings dispersion relative to the IDR. Fitch's recovery analysis assumes a liquidation value under a distressed scenario of approximately $9 billion on 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 Corporation (Corp.) are the borrowers, is rated 'BB/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 ranges 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 1.0 times (x); (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 'BB/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 decide to exercise the accordion feature under the credit facility and/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 'B/RR4', indicating average recovery prospects (31%-50%). While the credit facility and second-lien notes are over-collateralized currently and the spillover 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 last 10 years. The SRAC senior notes are guaranteed by Sears, which agrees to maintain SRAC's fixed charge overage 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.

Fitch has taken the following rating actions:

Sears Holdings Corporation (Holdings)

--Long-term IDR downgraded to 'B' from 'B+';

--Secured bank facility downgraded to 'BB/RR1' from 'BB+/RR1';

--Second-lien secured notes downgraded to 'BB/RR1' from 'BB+/RR1'.

Sears, Roebuck and Co. (Sears)

--Long-term IDR downgraded to 'B' from 'B+'.

Sears Roebuck Acceptance Corp. (SRAC)

--Long-term IDR downgraded to 'B' from 'B+';

--Short-term IDR affirmed at 'B';

--Commercial paper affirmed at 'B';

--Senior unsecured notes downgraded to 'B/RR4' from 'B+/RR4'.

Sears DC Corp. (SDC)

--Long-term IDR downgraded to 'B' from 'B+';

--Senior unsecured notes downgraded to 'B/RR4' from 'B+/RR4'.

Kmart Holding Corporation (Kmart)

--Long-term IDR downgraded to 'B' from 'B+'.

In addition, Fitch assigns the following rating:

Kmart Corporation (Kmart Corp)

--Long-term IDR at 'B'.

The Rating Outlook is Negative.

Additional information is available at 'www.fitchratings.com'. The issuer did not participate in the rating process other than through the medium of its public disclosure.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology'(Aug. 16, 2010);

--'Evaluating Corporate Governance'(Dec. 16, 2010);

--'Analysis of U.S. Corporate Pensions' (Dec. 1, 2010);

--'Recovery Ratings and Notching Criteria for Non-financial Corporate Issuers' (May 12, 2011).

Applicable Criteria and Related Research:

Corporate Rating Methodology

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=546646

Evaluating Corporate Governance

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=581405

Analysis of U.S. Corporate Pensions

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=578365

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=628489

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Contacts

Fitch, Inc.
Primary Analyst:
Monica Aggarwal, CFA, +1-212-908-0282
Senior Director
One State Street Plaza
New York, NY 10004
or
Secondary Analyst:
Kristi Broderick, +1-312-368-3140
Senior Director
or
Committee Chairperson:
Jamie Rizzo, CFA,+1-212-908-0548
Senior Director
or
Media Relations
Brian Bertsch, +1-212-908-0549
brian.bertsch@fitchratings.com

Contacts

Fitch, Inc.
Primary Analyst:
Monica Aggarwal, CFA, +1-212-908-0282
Senior Director
One State Street Plaza
New York, NY 10004
or
Secondary Analyst:
Kristi Broderick, +1-312-368-3140
Senior Director
or
Committee Chairperson:
Jamie Rizzo, CFA,+1-212-908-0548
Senior Director
or
Media Relations
Brian Bertsch, +1-212-908-0549
brian.bertsch@fitchratings.com