SEARS – THE NEXT ZERO BY 2020 THE OPEN UNIVERSITY OF HONG KONG TONG CHO YI JOEL WAN FUNG STEPHEN WONG SUN WING SIMON FEBRUARY 20, 2015
SEARS – THE NEXT ZERO BY 2020
THE OPEN UNIVERSITY OF HONG KONG
TONG CHO YI JOEL
WAN FUNG STEPHEN
WONG SUN WING SIMON
FEBRUARY 20, 2015
1
Table of Contents
Introduction .................................................................................................................... 2
Ways to survive ............................................................................................................... 4
1.1 Transformation to brick-and-click retailing helps Sears? ................................ 4
1.2 Transformation to member-centric retailing helps Sears? ............................... 5
1.3 Can Sears survive in brick-and-mortar retailing industry? .............................. 6
1.4 Can we trust Sears corporate leaders in bringing the company to survive? .... 7
1.5 Can Sears bring in the right management talents? ......................................... 10
Financial Analysis ........................................................................................................ 11
2.1 Liquidity ......................................................................................................... 12
2.2 Profitability .................................................................................................... 14
2.3 Long-term Solvency....................................................................................... 16
Why Sears will not be acquired by others? .................................................................. 18
Conclusion ................................................................................................................... 20
Appendix ...................................................................................................................... 24
2
Introduction
Sears Holdings, one of the largest department stores retailers in the past, is now facing
a potential bankruptcy. A growing number of reports and commentaries in the past
discussed the possibility for Sears to be filed for Chapter 11. However, Sears seems
immortal and has been surviving until now, which has disappointed a number of
financial analysts. Can Sears keep running until 2020 and after?
In our report, we will explore the possible ways for a traditional retailer to survive in
the new and ever-changing business environment, and then point out the infeasibility
of those ways for Sears by studying its company strategies and organizational
structure. A brief financial analysis also provided to show the solvency problem of the
firm. Lastly, a study on Sears’ financing policy will be used to illustrate the reason
why Sears will become zero value in 5 years.
3
The following Graph 1.1 summaries the framework for our analysis:
Graph 1.1: Analysis framework for Sears
It is evident that the retail industry is shrinking slowly and online shopping has been
on the rise. Sears, following other retailers of similar scales, has put a great deal of
effort on transformation its business model. So far, no brick-and-mortar retailers seem
to do well in their online business and Sears is no exception. The financial condition
of Sears also makes it infeasible to further develop a viable new online business. The
financial performance of the firm is so poor and not appealing to investors, so the
chance of being taken over has become terribly slim. Bankruptcy, we believe, is the
final destiny to the firm.
4
Ways to survive
1.1 Transformation to brick-and-click retailing helps Sears?
E-commerce has been growing quickly. According to the findings from Statista,
e-commerce sales in U.S. has an upward trend from 2000 to 2013 (Figure 1) and it
will continue in future (Figure 2). The rapid development of e-commerce has eaten
traditional retail market and many retailers are considering switching to e-commerce
to survive. Sears has a strategy of shifting its massive brick-and-mortar presence to
e-commerce since 1999.
Argument
It is not easy for companies to turn store-based into brick-and-click retailing
successfully. According to research from Internet Retailer, no brick-and-mortar
retailer, including Staples, Wal-Mart and Sears, has substantial growth in online sales
after their transformation. Only Amazon, the traditional e-commerce company, has
rapid growth in online sales. (Figure 3)
The reason why traditional retailers fail to compete in the cyber frontier is that
e-giants like Amazon has strong brand loyalty in the e-commence area. They create
customer value, from reliable and stable site to user-friendly interface, which
5
traditional retailers are hard to complete. Besides, Amazon has a strong e-commence
network and links itself to Yahoo!, Excite and AOL.com and patent on ‘one-click’
shipping procedure. As a result, traditional retailers like Sears faces difficulty in
gaining on-line retail market share. The dominating market share in internet retailing
captured by Amazon support our argument (Figure 4).
1.2 Transformation to member-centric retailing helps Sears?
Sears is losing its reputation, according to Nielsen 15th annual public opinion survey
in 2014 (Figure 5 and 6). Customer-centric, which detects the customers need and
uses the resources according, is one of the successful factors of Amazon’s good
reputations according to the survey. If Sears can develop a differentiated
member-centric approach, it may survive. Therefore, Sears is moving away from
product-centric to a member-centric business model, which focuses on providing
benefits to members.
Argument
To achieve customer oriented strategy, Sears has launched Shop Your Way loyalty
program to develop a member-driven social commerce platform across web and
mobile channels. However, the characteristics of Shop Your Way program fail to
6
differentiate itself from others loyalty program such as Target’s RED card and Macy's
Star Rewards.
According to Sears’ FY2013 fourth-quarter report, the firm has its twenty-eighth
consecutive quarter decline in sales, even though it attempted a turnaround by its Shop
Your Way loyalty program in 2009. This shows that the loyalty program cannot turn
the company around.
Member-centric retailing emphasizes building long-term relationship with shoppers.
However, Sears had low credibility that it alleged in selling the private information of
the credit card customers to third party vendors such as Memberworks, Cendent and
Encore Marketing for profit (Bovay et al. v. Sears, Roebuck & Co). The incident
caused a reduction in the number of loyal customers and undermined Sears’
competitiveness.
1.3 Can Sears survive in brick-and-mortar retailing industry?
Sears can no longer grow in brick-and-mortar retailing industry following to the
general declining trend in retail business. Store-based retailers are facing challenges
from e-retailing. According to ShopperTrak, foot traffic in stores has declined from
7
2010 to 2013 (Figure 7). Based on Euromonitor International statistics, companies in
brick-and-mortar retailing industry have no significant growth. Some retailers like
Sears has a drop in retailing shares from 2009 to 2013 (Figure 8).
1.4 Can we trust Sears corporate leaders in bringing the
company to survive?
Sears faces problems in the transformation to brick-and-click retailing. If the company
can develop a viable new business, the company may survive. However, the overall
corporate leaders, from the Board of Directors to the senior management, have so far
shown no leadership in bringing the right change, which we believe is one of the
factors leading the company to bankruptcy.
Graph 1.2 : Organization Chart of Sears Holding
8
1.4.1 Potential Conflict of Interest
From the Board of Directors, the dual status of Edward S. Lampert enables him to
operate Sears for his own interest rather than the long-term benefit of the company
(Graph 1.2). Being the major shareholder and the main source of funding of Sears,
Edward S. Lampert, who acts as the Chairman of the Board of the Directors and the
CEO of Sears, is also the founder and CEO of ESL Investment.
In the latest $400 million borrowing, the estimate value of the secured asset for such
borrowing is much more than $400 million. In other words, this is unlikely to be an
arm-length transaction, and Mr. Lampert is expected to gain a lot if Sears defaults on
repayment. Besides, starting from last year, Edward S. Lampert changed the form of
his loan to the company, from unsecured to secure. This change may imply loss of
confidence of Lampert in the Company.
1.4.2 Change for Worse
For the senior management, the co-operate leaders of Sears are short-sighted, which
limits the profitability of the company. The competitive advantage of Sears depends
on the value creation of exclusive brand and valuable real estate. However, the
management makes the wrong decision that allows the products of profitable and
9
exclusive brands like Kenmore and Craftsman sold in other retail stores, which has
weakened the competitiveness of Sears.
Besides, Sears sold most of its beneficial company real estate including the valuable
stores in Cupertino, California which cost$102.5 million and left very few other assets
to sell. Sears lost its strong pillars to generate the cash flow in the long term.
Sears management lacks the vision for the future development. The declining
operation performance can be regarded as the indicator for the above analysis.
1.4.3 High Turnover of Senior Management
The rapid replacement of key senior executives makes Sears face the difficulty in
setting goals and strategic direction, which affects the consistency of strategy and
creation of the long term planning. For Instance, Imran Jooma, who acted as the
Executive Vice President in charge of online, marketing, pricing and financial services
from 2011, left the company in February 2015.Employees need to modify themselves
for the new organizational behaviors, which may lead to the negative impact on the
employee morale and the performance.
To conclude, the incapacity of the corporate leaders and the frequency change in key
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management personnel limits the company to develop a viable new business.
1.5 Can Sears bring in the right management talents?
Evidence has shown that it is difficult for Sears to attract talented business leaders in
order to change.
According to the annual report, Sears faces the decline of employees in both the
United States territories and Sears Canada (Figure 9). The number had dropped 22%
from 2010 to 2014. The annual report also reveals that most of the executive officers
were appointed within the last 5 years. This reflects that the turnover rate of staff has
been relatively high.
Sears faces the serious debt problem and it is difficult for the company to offer
attractive packages for talented business leaders to join.
On the other hand, the new talented business leaders find themselves difficult to
develop their career as the continuous shrinkage of store network and the integration
of the online operations.
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In short, the declining reputation of Sears greatly reduces its appeal to potential talents.
This causes the vicious cycle.
Financial Analysis
In this part, we will use financial statements’ figures to assess the probability of
bankruptcy for Sears. Trend analysis will be used for future performance prediction
and industry average data will be used to evaluate the performance of Sears in the
industry.
To achieve a more comprehensive conclusion, we will focus on 3 aspects:
(1) Liquidity : to assess company’s ability to repay current debt
(2) Profitability : to assess the ability in generating profits
(3) Long-Term Solvency : to assess the future financial burden of the company
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2.1 Liquidity
Current ratio: A dynamic drop about 30% from 1.3 in FY2010 to 0.96 in 3rd
quarter
2014 (Figure 10), which is much lower than 1.24 industry average. The decrease is
due to the huge increase in short-term debt, from USD$869 million in FY2010 to
USD$2,171 million in latest quarter(Figure 11), 140% on average for each year,
resulting in an upward trend in borrowing but a downward trend in cash, from
USD$1,689 million in FY2010 to USD$326 million in latest quarter (Figure 11). One
possible reason for the inverse relationship is the continuous yearly loss, and the
company seems to fail in generating cash-flow from operating activities so the
company initiates cash flow from investing or financing activities, such as the
$USD994 million from short-term borrowing and $USD996 million from disposal of
PPE in FY2013. It implies that the current assets of the company are insufficient to
cover current liabilities, and Sears needs to borrow to finance its operation. That
create huge pressure to the firm in handling debt repayment and Sear may choose to
default its debt in the end.
Quick Ratio: It decreases from 0.24 in FY2010 to 0.1 in 3th
quarter 2014 (Figure 10),
and the performance is below the industry average of 0.9. The decrease due to the
cash burn under decreasing losses, and the divergence between quick ratio and current
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ratio may be the result of the high stock level which is 85% of all current assets. Such
poor quick ratio put Sears’s liquidity in a very dangerous position.
Stock turnover rate: With 85% of the current assets as inventory, the company has a
lower stock turnover ratio of 3.38, which is lower than the 9.32 industry average. It
indicates the lower efficiency to turn inventory into more liquid assets such as account
receivables or cash, and this further lower the liquidity position.
Receivables and Payables Period: During the recent years, both receivables and
payables remind stable at around 60 days and 35 days respectively. However, a
company with receivable period longer than its payable period implies an inefficient
credit policy. When the rate of cash paid faster than that of those received, the
liquidity level is worsened.
The above ratios analysis show problems in company’s liquidity, which is a
detrimental factor lead to bankruptcy.
Cash flow: The company suffered from a huge decrease in free cash flow, from
USD$1,146 million in FY2010 to negative USD$1,709 million FY2013 (Figure 12).
14
The downward trend is mainly due to the increasing operation losses, from USD$297
million in FY2009 to negative USD$1,116 million in FY2013. The poor operating
efficiency pushes the company to sell its assets and raise debts to generate enough
cash for its daily operation, such as the large cash inflow from disposal of assets of
$USD995 million and long-term borrowing of $USD994 million in FY2013 (Figure
13).
To conclude, we are pessimistic about the liquidity of Sears and expect the ability in
repayment of debt is much lower than the acceptable level, increasing the risk of
bankruptcy.
2.2 Profitability
Revenue growth: There is a decreasing trend for the revenue (Figure 14), from
$USD44,043 million in FY2010 to $USD36,188 million in FY2013, negative 3.6%
per year on average. This result shows that the transformation of Sears is not
successful, and the decrease in revenue may continue if there is no turnaround
strategy to improve the situation.
The gross profit margin deceases from 27.7% in FY2011 to 24.2% in FY2013, which
15
match with the decreasing trend of the industry and indicate that the market is
shrinking. In the annual report, the company further states the decrease is also due to
theextra discount for customer under the new customer-oriented program. Thus, under
this new strategy, a lower gross profit margin is expected since the revenue per good
decreases, unless the company has a greater cost control.
The negative net profit margin is increasing from -2.33% in FY2012 of total revenue
to -5.6% in the travelling twelve months ended Feb 2015. When comparing with the
industry average of 4.71%, the performance of Sears is much worse than its
competitors. Moreover, the selling and administrative cost is still at around 27-28% of
sales. This is unfavorable since Sears has tried to lower these costs by shutting down
stores and labor cut, and it seems the cost control is not as effective as expected.
Moreover, Sears has declared dividend of $USD 476 million in the FY2013 even the
company was making since FY2011. This may shows that the management is not
acting at the interest of Sears.
The downward trend of revenue and profit shows that the new strategies of Sears are
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not as successful as expected. There is also a doubt that whether the business can be
sustained.
2.3 Long-term Solvency
The unusual gearing ratio of 41.17 of the latest quarter indicates the company highly
relies on debt financing. There will then be problems of large interest payment and
debt repayment. This problem is also reflected on the negative interest coverage of
-9.19 in the travelling twelve months.
In FY2009, total assets value was $USD 24,808 million while the total liabilities
amount to $USD15,712 million, with assets to liabilities ratio of 1:58 to 1. However,
as the company keeps selling the PPE, the assets value records a decreasing trend and
declines by about 26% to $USD18,261 million in FY2013, while the total liabilities
increases to $USD16,522 million, resulting in a ratio of 1.11 to 1. With the lower asset
to liabilities ratio, the assets may not cover the liabilities in future, especially when
there are impairment for intangible assets and the continuous disposal of PPE.
Price to book ratio: The ratio in FY2013 is 33.2, showing that the valuation is much
higher than the book value of the company. This situation is unusual especially for a
17
retailing company recorded losses in the recent years. That reflects Sears is much
expensive than its retail peers such as Wal-Mart and Costco.
The above financial analysis shows that Sear is facing a serious problem in current
debt repayment. This problem cannot be easily solved since there is a trend of
decreasing profit margin and revenue, which indicates the company cannot generate
profit. More importantly, the over-dependence on debt financing creates a huge
amount of future repayment of debt, which will negatively affect the liquidity.
Therefore, if the profitability cannot be improved as predicted in the opening section,
the chance of Sear’s bankruptcy will increase,
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Why Sears will not be acquired by others?
In fact, even for some companies which did not operate well, they still avoided
bankruptcy because of acquisition. However, we do not expect it will take place in
Sears due to several reasons.
Firstly, the company keeps making loss starting from 2012, and this loss is expected
to be long-lasting due to the trend and the business environment. For a company that
cannot bring profit, acquisition seldom takes place since the acquirers always look for
an expected positive return from the action.
Secondly, there is not much valuable intangible asset left in Sears. Some acquisitions
may still take place even if the acquiree was making a loss, since there are valuable
assets remaining which can bring competitive advantages. For example, Motorola’s
patents helped finalize the acquisition from Lenovo. However, in Sears, the main
intangible asset came from the Kmart’s acquisition, which was impaired in the recent
years, and there are not many unique intangible assets, which can bring benefits to the
acquirer, in Sears.
Thirdly, the gearing ratio is extremely high. For acquisition to take place, the
19
company should not bear much debt. Otherwise, the other interested companies may
not take the step since there are high risks to take a huge amount of debts.
Can new financing be obtained?
Companies which keep making loss may still stay alive by borrowing money to
finance and last for several more years. However, for Sears, we do not expect this
situation since there is a doubt whether it can obtain sufficient funding to finance the
debt repayment and operation, due to the over-dependence on the shareholders and the
low creditability, and, more importantly, a substantial amount of repayment in 2018.
In order to achieve the $1 billion additional capital target for 2014, the company had
to borrow $400 million from the major shareholder, ESL Investment, while another
$665 million comes from the spin-off the business and selling of assets. On the other
hand, the credit rating of the company has been downgraded from CC to CCC in
2014.
Moreover, a huge amount of long-term debt has been issued during the year, resulting
in a future repayment of above $2 billion due 2018, which is just 3 years away from
now. There is then a hard situation for Sears to pass in 2018.
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To conclude, the above facts show that there is problem on credibility for the company.
Along with the analysis showing the declining profitability and liquidity, Sears may
be unable to repay the short-term debt, especially a huge amount of $USD2.2 billion
in 2018.
Conclusion
Bankruptcy is the only fate for Sear and it is very likely to take place no later than
2020.
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24
Appendix
Figure 1
Figure 2
25
Figure 3
Figure 4
26
Figure 5
Figure 6
Nielsen released their 15th annual public opinion survey on the reputations of the 60
most visible companies, and the retailer topping the list -- or, rather, populating the
bottom ranks. Sears was even lower than its retail rival, tumbling from 46th
in 2013 to
53rd
in 2014. (Report not available)
27
Figure 7
Figure 8
28
Figure 9 : Sears Holding number of employee (2009 – 2013)
Figure 10 : Sears Holding liquidity trend (2010 to 3Q 2014)
290000 280000
264000 246000
226000
32000 32000 29000 28000 23000
0
50000
100000
150000
200000
250000
300000
350000
FY2009 FY2010 FY2011 FY2012 FY2013
Number of Employee
US Canada
1.34
1.11 1.1 1.09
0.9
0.24 0.16 0.15
0.19 0.1
1.24
0.96
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
2010 2011 2012 2013 3Q of2014
Liquidity
Current Ratio
Quick Ratio
Industry Current Ratio
Industry Quick Ratio
Linear (Current Ratio)
Linear (Quick Ratio)
29
Figure 11: Sears Holding current assets and liabilities trend (2010 to 3Q2014)
Figure 12 : Sears Holding free cash flow (2010 to 3Q2014)
325 360
1175 1177 1332
2096
1689
1375
747 609
1028
326
0
500
1000
1500
2000
2500
2010 2011 2012 2013 2014 3Q of2014
Current Assets and Liabilities
Short-term debt
Cash
Linear (Short-term debt)
Linear (Cash)
-2000
-1500
-1000
-500
0
500
1000
1500
2000
2010 2011 2012 2013 3Q of 2014
Free Cash Flow
Free Cash Flow Operating cash flow
Capital expenditure Linear (Free Cash Flow )
Linear (Operating cash flow) Linear (Capital expenditure)
30
Figure 13: Sears Holding cash flow components (2010 to 2014)
Figure 14: Sears Holding revenue trend (2010 to 2014)
-4000
-3000
-2000
-1000
0
1000
2000
2010 2011 2012 2013 2014
Cash Flow Components
Net income Cash flow from PPE Long-term debt issued Cash dividends
44043 43326
41567
39854
36188
30000
32000
34000
36000
38000
40000
42000
44000
46000
2010 2011 2012 2013 2014
Revenue