By Gerald Hirschberg On Nov. 17, Standard & Poor's Ratings Services said that its ratings on Sears, Roebuck and Co. (S), including the 'BBB' corporate credit rating, remain on CreditWatch with negative implications, where they were initially placed Oct. 21.
This CreditWatch update follows the announcement that Sears has agreed to merge with unrated Kmart Holding Corp. (KMRT) in a transaction valued at over $11 billion. It is likely that ratings for Sears and the new holding company parent, Sears Holdings Corp., will be in the 'BB' category upon completion of the merger, which is scheduled for the end of March, 2005.
The combined company will include the approximate 870 Sears full-line stores, 1,500 Kmart discount stores, and about 1,100 Sears specialty stores. With combined revenue of about $55 billion, Sears Holdings will be the third-largest retailer in the U.S., behind Wal-Mart Stores (WMT) and Home Depot (HD).
Despite the resulting company's much greater size, and synergies that are estimated by management of about $500 million per year after the third year, both retailers lag their peers in terms of store productivity and profitability. Sears continues to be challenged by competitors such as J.C. Penney (JCP) and Kohl's (KSS), while Kmart faces Wal-Mart in numerous markets. To be successful, Standard & Poor's believes that management will need to make the Sears and Kmart stores more relevant to consumers in terms of convenience, merchandising, and value.
Although we see the merger as an opportunity for Sears to accelerate its "off-the-mall" strategy by converting existing Kmart stores into Sears Grand stores, this strategy is still in its infancy and has yet to demonstrate success. While Kmart has greatly improved its profitability by reducing both costs and promotional sales, sales continue to decline. Selling some Sears proprietary brands may help differentiate the company's offerings, but it will still face substantial challenges competing with Wal-Mart and Target (TGT).
Business risk for the combined entity will limit consideration for an investment-grade rating. Financing for the acquisition is expected to utilize existing cash at both companies. Sears Holdings should be able to utilize asset sales, tax benefits, and a lower or eliminated dividend to enhance cash flow, which will help offset restructuring costs. Standard & Poor's will monitor developments, and meet with management to discuss the company's future financial and business policies prior to resolving the CreditWatch listing. Hirschberg is a credit analyst for Standard & Poor's Ratings Services