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Three Questions

Three Questions: Is This the End of Sears? 

For much of the 20th century, Sears, Roebuck and Co., with its iconic catalog and thousands of stores, was the biggest retailer in the United States. Several decades of decline, during which the company failed to respond to brick-and-mortar and online competitors, culminated in a bankruptcy filing in October. Yale Insights asked Prof. Stanley Garstka, an expert in bankruptcy and distressed investing, what would remain of the company and its heritage at the end of the process.

A Sears retail store in Lafayette, Louisiana, in 1981. Photo: Library of Congress.

A Sears retail store in Lafayette, Louisiana, in 1981. Photo: Library of Congress.

What is likely to happen to Sears’s employees, shareholders, and other stakeholders?

There are many constituencies with economic interests in a bankruptcy filing. Of course, the stockholders normally will lose everything and the bondholders will normally take the lead in trying to propose a restructuring plan. Most of the employees of Sears have already lost their jobs. Sears had a workforce of about 317,000 employees in 2005 and only about 68,000 at the time of the bankruptcy filing. The good news is that the approximately 90,000 current and former employees who are eligible for pensions will not lose their benefits. In the last several years, Sears has been required to contribute approximately $5 billion to the pension fund. The pension fund is still underfunded by more than a billion dollars but the Pension Benefit Guaranty Corporation has already indicated that it will take over the obligation if necessary.

In the short run, even as Sears remains open during the bankruptcy procedure, customers are not likely to flock to Sears stores to buy big-ticket items during the holiday buying season. Customers will worry about their ability to return merchandise and whether any product warranties will ultimately be honored. For instance, Kenmore-warrantied products are covered by the Sears Protection Company, a separate entity that may or may not survive the restructuring even if other parts of Sears emerge as ongoing entities from a restructuring process. Would you buy someone a Sears gift card this holiday season?

In retail bankruptcy filings, the suppliers of inventory are a very important constituency. Prior to the bankruptcy filing, 200 suppliers already refused to ship to Sears for fear of not being paid what they are owed. To mitigate this, Sears, upon entering bankruptcy, arranged for $300 million of debtor-in-possession financing and may possibly be able to arrange for more. This should encourage some suppliers to continue to ship merchandise to Sears.

“Unless Sears changes its business model in some fundamental ways, it still may not be able to survive. You need customers!”

Successful emergence as a restructured entity is also very dependent on the speed of the bankruptcy process. The debtor in possession (Sears) pays all of the lawyers, finance, and real estate professionals’ fees, depleting the value of it as an entity.

Is the Sears bankruptcy filing likely to be the end of a story or the beginning of a new chapter?

Sears is a 134-year-old company which in many ways was the Amazon or Walmart of its era. Through its catalogs, with the help of the U.S. Postal System, Sears offered to sell you everything from a screwdriver, television, and clothes to a house. Like many of its retail counterparts, it failed to adapt quickly enough to technological shifts in the economy and changing consumer shopping preferences. And like many of its cohort, it has ended up filing for bankruptcy.

Sears had 3,500 stores as late as 2005, but that has dwindled to fewer than 700 stores now and it likely to contract even more during the bankruptcy process. Sears revenue was $59 billion in 1992 and even after combining with Kmart its revenues shrunk to less than $17 billion in 2017. At the time of filing for bankruptcy, Sears listed total assets of $7 billion and $11.3 billion in liabilities. It had more than $5 billion in debt with interest obligations in excess of $440 million per year.

During the past few years, more than 40 retailers of all kinds have filed for bankruptcy; many of then went straight into liquidation but a bunch filed Chapter 11 and were restructured. Rockport was sold out of bankruptcy to a private equity firm; RadioShack reopened as an online retailer; Toys R Us was essentially liquidated but now some of the Toys R Us corporate brand names are beginning to show up again, this time in grocery stores, as some of the creditors are trying to once again monetize some of its iconic brand names.

The choice in bankruptcy is essentially liquidation or restructuring. A restructuring plan must demonstrate more economic value than a straight liquidation in order for the court to approve it. In order for Sears to have any chance of resuscitation, it could never emerge from Chapter 11 and expect to compete with Amazon or Walmart. That is just too expensive of a proposition. Instead Sears would have to come up with a plan for a smaller business that was more nimble, more focused, and better integrated with an online model of commerce.

What seems to be the model for success in much of retailing is what is happening in bookstores. Over the last several years, with the advent of Amazon, many bookstore closed. Some of the larger chains suffered the most. Recently there has been a revival in bookselling, with smaller, local bookstores emerging quite successfully because their collections are tailored to the local market and an array of events which draw readers into store. They have created an experience which is more than just selling a customer a book. Even Barnes and Noble is testing smaller stores, integrated with online activities so you can buy a book online and pick it up at a local store within an hour. This is the concept that Sears must replicate in the context of its own industry if it are to emerge from Chapter 11.

The bottom line seems to be to shed debt, close unprofitable stores, and walk away from negative executory contracts. But unless Sears changes its business model in some fundamental ways, it still may not be able to survive. You need customers!

What distinguishes the Sears bankruptcy filing from the filings of many other retailers over the last 10 years?

The capital structure of Sears is unique in the respect that Edward S. Lampert controls approximately 50% of the stock and 40% of the debt (mostly secured) of Sears. Of course, the value of his equity is essentially zero now, but his debt position should serve him well in the restructuring process. Before the bankruptcy filing, Lampert’s hedge fun, ESL, received more than $200 million per year in interest payments from Sears for loans to Sears to help keep it afloat.

Over the last four years, Sears has sold two iconic brands, Land’s End and Craftsman, to raise money to keep the company operating. In 2015, Sears also sold 235 of its most valuable store properties to Seritage Growth Properties, a real estate investment trust, for $2.7 billion. Lampert is also the chairman and major stockholder of Seritage, which received in excess of $180 million in rent and other fee payments from Sears in 2017. There still are some iconic brands remaining in the company—most notably Kenmore. One can see that Lampert has a large stake in making something viable out of the restructuring.

Given that Lampert is in a control position in the restructuring process because of his debt holdings, that he has extensive inside information about the operational functioning of Sears (he was chairman and CEO prior to the filing), and that his economic incentives are aligned with having a successful restructured entity, he will likely try to do everything possible to have Sears emerge from bankruptcy as a viable entity.

In the likely event that asset sales or business units are auctioned off in the restructuring process, Lampert, with his knowledge of the business and his secured debt holdings, is well positioned to be a stalking horse bidder—the first bidder in any auction, who has input into the rules of the auction (such as minimum bid increments, who qualifies to bid, etc.) and who will recover various fees incurred in the process if he does not emerge as the winning bidder. In addition, if he were to be the winner of any bidding process, as a secured creditor he could use the full par value of his claims when paying for the acquisition.

Of course, there are several impediments. There will likely be fraudulent conveyance law suits by other creditors charging that ESL took valuable assets out of Sears prior to its bankruptcy filing and paid less than fair-market prices for these assets. Also, since leases on closed stores might be more valuable if the store was closed (even if the store was profitable), Lampert might prefer the value in the lease. In addition, the judge will have to approve any sales transactions and any reorganization plan will have to be proven to be of greater economic value than the alternative of just converting to Chapter 7 and doing a straight liquidation of all of the assets.

Department: Three Questions