How Sears Canada’s Bankruptcy Impacts Sears Holdings Corp … – Seeking Alpha

Sears Canada Inc. (NASDAQ:SRSC) filed for bankruptcy on June 22 in Canada under the Companies' Creditors Arrangement Act (CCAA). While this has only a minor direct impact on Sears Holdings Corp. (NASDAQ:SHLD), the indirect impact is significant. If Eddie Lampert is willing to throw in the towel on his equity investment in SRSC, it could indicate that he is not willing to pour more of his cash into propping up SHLD. In addition, vendors who were already nervous about dealing with Sears may stop shipping goods for the critical Back to School and Fall shopping season. In my opinion, SRSC's bankruptcy filing is just a dress rehearsal for a Chapter 11 filing by SHLD in July.

Canadian Bankruptcy Laws

Sears Canada filed under the CCAA instead of the Bankruptcy and Insolvency Act (BIA), which would have resulted in complete liquidation. There are two critical points in the CCAA that differ from Chapter 11 bankruptcy in the U.S. A monitor, in this case FTI Consulting, is appointed by the court, who has oversight authority but does not control day-to-day operations. The first critical point is that the monitor has supervision over the sale of assets, and not Eddie Lampert. The second point is that the monitor is required to report to the Superintendent of Bankruptcy when they feel creditors would be better off if the case was switched to BIA, which would mean total liquidation.

A June 22 Pre-Filing Report prepared by FTI Consulting contains a large amount of useful information. According to the report, SRSC had cash outflows of C$30-100 million per month over the last 5 months, and in May was burning C$20 million a week. The company only had C$139 million on June 19. Without new sources for cash, it was forced to file.

Its current plan entails: closing 59 stores and laying off 2,900 employees; getting a C$300 million DIP revolving loan at LIBOR+4.5% and a $150 USD equivalent term loan at LIBOR+11% which mature on December 20, 2017; trying to get the authority to suspend certain pension and retiree benefit payments; creating a C$9.2 million key employee retention plan.

A key item mentioned in the report was that the company would try to get "interest in a range of potential transactions involving all or part of the assets or businesses of Sears Canada Group". It is critical to remember that this will be done "under the supervision of the monitor", and not by Lampert.

Below are the cash flow and operational projections until September 16. According to FTI Consulting's forecast, SRSC will only have a negative C$25.7 million operating cash outflow during the 13-week period. It is only closing 59 stores, and it would seem unrealistic to expect that the current burn rate of cash would improve so significantly.

Cash Flow Forecast Until September 16, 2017

13-Week Operating Forecast

Impact on Sears Holdings Corp.

To many SHLD shareholders this information about SRSC may be interesting, but they feel it has little impact on SHLD because SHLD only owns 12% of SRSC and a loss of a few million dollars will not kill SHLD. Correct, but the indirect impact will most likely have a very significant negative impact on SHLD shareholders.

Prior to the filing, SRSC was able to arrange for about C$109 million in financing, but it needed C$175 million. Lampert did not step up and loan the company the other C$68 million. Does this indicate he will no longer be ready to step up and loan SHLD when other financing sources are not? Lampert also owns about 45% of SRSC, and there is a very real possibility that he will get no recovery.

Unlike Chapter 11 bankruptcy in the U.S., where the company/management still has almost complete control of the bankrupt company, in Canada the monitor has a major voice in the bankruptcy process. One can only speculate to conclude that Lampert has finally decided an in-court process is the better way to deal with operations that burn cash, especially since in Chapter 11 he is able wipe out unsecured creditors, shareholders, and certain pension liabilities, while using his and Bruce Berkowitz's secured debt as means to own a large portion of a "new" Sears Holdings.

Some investors are taking the opposite opinion on the SRSC filing. They assert that not proposing to liquidate, but instead to continue operating and selling just some stores, demonstrates Lampert's willingness to pursue his turnaround plans. This could explain the pop in SHLD shares on the day SRSC filed. The reality is that the above extremely low cash burn projections are unrealistic. The company was burning C$20 million per week, but now, all of sudden, this is forecast to improve. This is just another example of Lampert's unrealistic retail expectations. FTI Consulting, as monitor, decides if the operations continue or if the company liquidates going forward, and not Lampert. FTI was retained by Sears Canada last November as consultant, and its reputation as Licensed Insolvency Trustee now as appointed court monitor would dictate its need to be prudent in supervising the cash flow, and it would be quick to inform the Superintendent of Bankruptcy that a liquidation of assets is necessary to protect creditors instead of continuing to operate.

Vendors are the Achilles' Heel for SHLD. The SRSC bankruptcy filing tore this tendon. There is a very real possibility that vendors will now be even less likely to deal with SHLD after SRSC filed for protection. I would assume that many vendors supply both companies, and now they are not getting paid for goods they delivered to SRSC that were not paid for prior to June 22, because the CCAA prohibits the payment for any goods or services provided before the filing date. The unpaid vendors now need to file a claim and may get less than the full amount. Those goods delivered after the bankruptcy filing will, however, be paid (This is the same as under Chapter 11 in the U.S.)

Why would vendors deliver goods now and risk getting only partial payment under the Chapter 11 claims procedure? Why not wait until after SHLD files for Chapter 11 and get paid the full amount as a priority claim under Chapter 11. After SHLD files for Chapter 11, many vendors will be eager to do business with the company again because they know they will be paid in full.

Other Recent News

Sears is closing 20 more stores. Some view this as a positive move to reduce negative cash flow. Others view it as a negative because there are fewer stores trying to support the same amount of debt. Barron's posted an article with an interesting title: "Fraudulent Conveyance Rules May Pave Way for Sears Bankruptcy in July". An article I wrote about Sears in April had the same idea.

Conclusion

Eddie Lampert's unwillingness to lend SRSC cash as the "lender of last resort" and the bankruptcy filing of SRSC could signal that he finally realizes SHLD also needs court protection to stop the cash bleeding. At least in the U.S. under Chapter 11, he does not have to cede power to a court-appointed monitor, which will mostly likely not be easy for his ego to accept. While the current plan is for the Canadian operations to continue with a modest reduction in number of stores, continued cash flow issues could force SRSC into a formal liquidation.

Sears's real problem in the near future is vendors, and this filing has made that problem acute. The reality is that the best way to deal with these issues is to file for Chapter 11 bankruptcy in early July, so that vendors will deliver the needed Back to School and Fall merchandise. I still expect to see a Chapter 11 filing, and therefore, rate all SHLD securities a Sell.

Disclosure: I am/we are short SHLD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am naked SHLD call options.

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How Sears Canada's Bankruptcy Impacts Sears Holdings Corp ... - Seeking Alpha