Orchard Supply Taken Out To The Woodshed- Will Sears Holdings Reap What It Sowed?

Eighteen months after it was spun off from Sears Holdings(SHLD), Orchard Supply Hardware(OSH) announced that it had filed for Chapter 11 bankruptcy protection and had reached an agreement for Lowe’s Companies (LOW) to acquire most of its assets.  We had been bullish on Orchard at the time of the spin. We were wrong. In its press release the company lays the groundwork for blaming former parent Sears:

Orchard previously has dedicated considerable effort to addressing the substantial overleveraging that originated in 2006, when it was still owned by Sears. Since the spin-out in late-2011, the Company has reduced its debt and has made significant progress against its strategic initiatives to project a consistent and compelling brand identity, drive sales through merchandising and marketing initiatives, improve operational efficiency, and better align resources and talent, and has increased year-over-year same-store sales as a result. Still, the Company anticipated it would not be able to make scheduled payments when the first tranche of its debt matures in December of 2013 and accordingly reviewed a range of alternatives to establish a sustainable capital structure, which would allow it to more effectively run its business and execute on its repositioning and growth strategy. Management and the Board of Directors determined that a sale of Orchard through a Chapter 11 process was the best possible outcome for the Company and its stakeholders.

We believe this telegraphs a strategy of trying to recover additional funds from Sears based on a claim that the company was insolvent at the time of the separation. We have written about similar claims made regarding Verizon’s spin of Idearc and Peabody Coal’s spinoff of Patriot Coal. One might also question the actions of Sears Holdings CEO Edward Lampert, who has been selling all the way down. While there may be some merit to this, ultimately, this company failed to execute. Despite an inability to deliver same-store sales growth and earnings, the company invested heavily in an expensive store-remodeling plan and continued to open new locations. CEO Mark Baker was certainly singing a different tune in a January 2012 interview.

There is likely to be no recovery for either common shareholders or holders of the strange preferred that was issued as part of the spin. Let this be a lesson – highly leveraged spins must execute perfectly or all will be lost.

Disclosure: Unfortunately, the author still has a few shares of OSH and OSHSP

8 thoughts on “Orchard Supply Taken Out To The Woodshed- Will Sears Holdings Reap What It Sowed?

  1. Patrick Connery

    I couldn’t put the buy order in at the time as I was fully invested, but my analysis led me to an similar conclusion originally – we can learn from these mistakes.
    I don’t fully understand the LOW’s stalking-horse deal; interesting that the common is rallying on the news but the preferred is continued to sell-off. Can anyone shed some light on this?

  2. Stephen

    Question – I’ve read in various places that the only benefit of the preferred OSHSP shares is that they’re paid $4 in any liquidation. I must misunderstand this, because Chapter 11 “reorganization” often winds up in liquidation, but I don’t see anyone buying OSHSP shares right now, however, even at 70 cents. Can you clarify what the OSHSP/lisquidation relationship is?

  3. anon

    Go to page 79 of the 10K (see next paragraph). Preferred gets 4.16 AFTER the debt is satisfied. With that said, I am baffled that the Common did much better than the Preferred today. Thought the Preferred will probably go belly up (as will the common), there is a potential $4.16 payout before the Common gets the first penny.

    In the event of any liquidation, dissolution or winding up of the Company, whether voluntary or involuntary, before any payment or distribution of the Company’s assets (whether capital or surplus) shall be made to or set apart for the holders of Common Stock, but after any payments or distributions are made on, or set apart for, any of the Company’s indebtedness and to holders of any stock then outstanding that ranks senior to the Preferred Stock, holders of the Preferred Stock shall be entitled to receive an amount per share equal to the Preferred Stock Per Share Liquidation Preference of $4.16 per preferred share, or approximately $20.0 million as of February 2, 2013, but shall not be entitled to any further payment or other participation in any distribution of the assets of Orchard.

  4. Patrick Connery

    Thanks anon – from what I understand LOW’s bid 205MM of cash won’t come close to settling all of the liabilities; still baffling that the common is being bought at all. Maybe speculating on a competing offer?

  5. anon

    I think the bid as is…leaves Preferreds and Commom belly-up.
    OSH will be able to liquidate 31 stores and keep the proceeds. These are obviously the less desirable stores….their leases are probably of minimal value. I just see them 30 to a 100 million short on paying off the Preferred. And the Preferred get 20 million before the common sees a penny.
    Obviously, the lack of precision on my estimate tells you I don’t have a handle on the details (still looking for the schedules the 8K refers too).

  6. Anon2

    The 30 lease rejection claims probably add a minimum of $10m into the GUCs bucket, so I agree with you that you need AT LEAST a 25% bump in the offer value to get a dime of recovery for the Preferreds.

    Problem is that I don’t see anybody else stepping up. HD tried and failed before with small formats. Ace/True Value have different floorspace requirements. Private Equity maybe, but they’re at a big bidding disadvantage vis a vis Lowe’s given synergies. And we know from the Court docs that OSH tried shopping around for private capital before and no one raised their hands, granted that was under a more harrowing capital structure.

    I have a feeling that if there was going to be somebody else, there would have been rumors by now.

  7. anon

    The preferred traded as low at 18 cents today…. indicating 20 to1 odds against a 20 million recovery. Unbelievably the Common traded at about 1.75 for most of the day.
    Almost the perfect pair trade (short the common / long the preferred).
    But I just don’t know anything about the real estate dynamics / hardware store nuances to take much of a position here. But 20:1 odds…. I think I may take a flyer if it get that low tomorrow.

  8. Anon2

    Btw, someone asked about potential recourse to Sears — the levered recap of OSH happened in 2006, which is well past the 2yr statute of limitations on fraudulent conveyance, so that is off the table.

    People also have gotten it into their heads that Lampert “saved” SHLD shareholders by spinning off OSH. This is wrong. The OSH debt was never recourse to SHLD, so even if the spin never occurred, SHLD would have been similarly unaffected.

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