Sears Distressed as Investors Reject Closings: Corporate Finance

Jan. 3 (Bloomberg) — Sears Holdings Corp.’s bonds have crossed into distressed territory as its plan to close as many as 120 locations may fail to stem more than four years of declining sales and prevent it from using up cash as profitability wanes.

The extra yield investors demand to hold Sears’ debt instead of Treasuries has breached the 10 percentage-point level traders consider as distressed, double the spread at the end of 2010. Credit-default swaps on its finance unit are at about the highest level since 2008, as Fitch Ratings cut Sears’ rating and Standard Poor’s gave the retailer a “negative” outlook.

The Hoffman Estates, Illinois-based company, which sells goods from cosmetics to washing machines at Sears and Kmart stores, is struggling to create a plan to restore profitability. Shares of the largest U.S department-store chain fell 31 percent last week after Chief Executive Officer Edward Lampert announced the cost-cutting plan Dec. 27.

“The way the business is being run now is not sustainable,” Bonnie Baha, the head of the global developed credit group at DoubleLine Capital LP, which oversees $21 billion, said in a telephone interview from Los Angeles. Sears has put itself “in a precarious position, especially absent a focused business plan, about what sort of a retail operation they want to be,” she said.

Falling Bonds

The retailer’s $987.4 million of 6.625 percent notes due October 2018 fell as low as 74 cents on the dollar on Dec. 27, the least since they were issued in exchange for other debt in August, according to Trace, the bond price reporting system of the Financial Industry Regulatory Authority. The debt yielded 11.8 percent on Dec. 28.

Sears had $4.55 billion of outstanding borrowings on Oct. 29, according to a regulatory filing. That included $2 billion of notes and debentures and $1.65 billion of secured borrowings.

Kimberly Freely, a Sears spokeswoman, didn’t immediately respond to a voicemail message seeking comment on the movement in the company’s bond.

Spreads on Sears widened to 10.68 percentage points on Dec. 31 from 5.02 percentage points at the end of 2010, according to Bank of America Merrill Lynch index data. That compares with 7.27 percentage points for B rated debt, up from 5.46 percentage points.

Default Odds

Investors now consider Sears’s credit to be virtually on par with that of novelty retailer Spencer Spirit Holdings Inc., which had a spread of 10.65 percentage points, the data show.

Credit-default swaps on the retailer, which rise as investor confidence deteriorates, climbed almost 17 percentage points to 31.8 percent upfront in December, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. That’s in addition to 5 percent a year, meaning it would cost $3.18 million initially and $500,000 annually to protect $10 million of Sears’s debt.

Those levels imply the market perceives a 77 percent chance Sears will default within five years, based on a 40 percent recovery expectation, according to a standard pricing model maintained by CMA. That’s up from 47 percent odds at the end of October. The contracts pay face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

“The Sears brand has been so damaged by mismanagement that they may have alienated a whole generation of shoppers,” said Craig Johnson, president of consulting firm Customer Growth Partners in New Canaan, Connecticut. “Their value is deteriorating by the month. They need new ownership and a new strategy.”

Cash Flow

Adjusted fourth-quarter cash flow will be less than half 2010′s $933 million, with same-store sales falling 5.2 percent in the eight weeks ended Dec. 25, Sears said in a Dec. 27 statement. Department-store sector sales overall climbed 4 percent in November and December, according to an estimate from the International Council of Shopping Centers, a New York-based trade group.