Friday, October 07, 2005

This Too Will End Badly

Bain's Fault or Bad Luck That KB Toys Failed?

That was the headline above an excellent Wall Street Journal article earlier this week, asking whether it was fair-play for private-equity firms to extract cash in the form of special dividends, funded by debt, out of companies whose business models don’t stand a chance of making it when their capital structure is loaded with that very same debt used to pay off the private-equity guys.

The article explained:

Bain Capital, a private-equity firm, took control of KB Toys in 2000 by putting up just $18 million. It financed much of the rest of the $302 million purchase price by loading up the company with debt.

KB Toys, as anybody who accidentally went into one of their stores remembers, was a mall-based retailer that had the misfortune of selling pretty much the same toys you could buy at Wal-Mart, only cheaper.

Debt-wise, the toy business is tough to manage, being highly seasonal—hence cash flows are not steady throughout the year, and if you miss the Christmas season, you die. In other words, it’s not the kind of business you want to leverage up.

Which is exactly what Bain Capital did.

It all worked out well for Bain Capital, which in April 2002 collected a $121 million dividend -- a tenfold return on its investment in just 16 months, according to a court filing made by an unhappy holder of KB Toys debt.

KB Toys…couldn't recover with so much debt on its hands. Its financial troubles worsened, and the company filed for Chapter 11 bankruptcy protection in January 2004.

So why rehash a days-old WSJ story?

Actually, I’m not rehashing an old story: I am previewing a story that I expect will appear in the Journal one fine day, perhaps a year or two from now—but maybe sooner.

The story that will be told is about how Orchard Supply Hardware Stores, an 84 store, California-only hardware chain acquired by Sears in 1996 (giving Sears a full nine years to screw it up), was loaded with debt, KB Toys-like, in order to pay a big fat dividend, Bain Capital-like, to the parent company at the behest of the controlling shareholder of that parent company.

To whit, Eddie Lampert.

If you’ve never been in an Orchard Hardware store, think of Orchard as the Sears or K-Mart of the hardware business, but operating solely in California.

During its public existence the company never quite managed the transition to the Home Depot-era of home centers, and was languishing when Sears came along in 1996 and paid about a quarter-billion in cash for it.

Thus, for the last nine years, Sears has been managing Orchard Supply about as effectively as it has been managing itself...which is to say pretty badly.

For some time, word has been that Orchard was on the block, and today we read that Eddie Lampert’s Sears Holdings is extracting a $450 million dividend from Orchard Hardware—funded by $405 million of debt and a $58.7 million investment in Orchard by Ares Management LLC, an LBO group out of Los Angeles.

The Sears Holdings press release reads, in part:

David B. Kaplan, Senior Partner of Ares Management, said “We are delighted to partner with Sears and the management team of Orchard Supply in this transaction which provides the business with both capital and sponsorship. We all share the collective vision that Orchard Supply is an exciting retail concept with strong growth prospects…”

As far as I can tell, the “capital” that “this transaction provides the business” is in reality all of $13.7 million, as follows:

$405 million New Orchard Debt + $58.7 Ares “Investment” - $450 million Dividend to Sears Holdings = $13.7 million of new “capital” for the aging Orchard store base.

That is hardly enough “capital” to give the all stores a fresh coat of paint, let alone make them competitive with Home Depot and Lowes.

If there are any people left in the Sears PR operation after Eddie’s house-cleaning, they could save themselves some time by preparing the future press release on the sad dénouement of Orchard Supply transaction, by which Sears Holdings loaded a pile of debt onto an aging retailer with a deteriorating market position simply because it could.

And the Wall Street Journal might want to keep that Bain Capital/KB Toys article handy, as a reference for past deals-gone-bad.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.


hedged said...

Seems like a pretty good deal for SHLD shareholders, i.e. the people ESL works for. Take out a big hunk of cash, lower risk, and retain some upside if Ares can turn around the business.

Seems like using LBO tactics internally (nonrecourse financing, maximal leveraging) is a shareholder optimal idea. If ESL really wants to salvage his Orchard Supply equity if things go wrong, he can negotiate a capital infusion from the parent (assuming, of course, that SHLD doesn't lose access to capital simultaneously with a downturn at Orchard).

AA said...

If capital markets are generally efficient, why is such a thing possible in the first place?
Very strange...

tahoe kid said...

OSH once had potential as the "Anti-Home Depot." Many of the OSH stores are sited close to Home Depot and offered a reasonable alternative to the chaos one often finds at Home Depot. That is unless you find crowded aisles, long register lines and little or no sales help attractive. OSH offers smaller stores with good sales staff roaming the store who actually ask you if you need help and short register lines. So what could go wrong? Sears bought them. They stocked OSH with Craftsman tools (not a bad idea)and Kenmore appliances (REALLY bad idea) but they never figured out their competitive advantage. When I need some help I go to OSH. When I know what I want, don't mind the chaos and want better prices I go to Home Depot. The issue with Sears is the bulls are focused on the financial aspect of the merger. They are ignoring the fundamental aspect of the business.

whydibuy said...

This stuff is the same technique Carl Icahn has used repeatedly. I believe he forced Kerr-McGee to load up on debt to pay him off with a special dividend.

Slash said...

Orchard Supply Hardware can not survive no matter how much capital you put into it. I live close to three OSH (as they are called here).

The ratio of cars in a OSH parking lot vs. Home Depot is about 1:15 on any weekday or evening, on weekends it gets worse. Home Depot has cleaned up while OSH has languished, stores look old from both out side and inside, merchandise is more expensive, less choices and help is hard to find. But they have opened up another OSH near by, for what?

I wrote about how Eddie is making the same the mistake Carly made when she bought Compaq. The only difference is Carly couldn't do LBOs on Compaq- I guess Compaq IP wasn't leverageable. My thesis was that all Eddie can do is extract "value" out of Kmart by selling real estate and as you point out doing fancy financings, you can't save a dead horse by tying it to another dead horse. Eddie is smart financier and is very well paid for that, he is no Sam Walton.

Jeff Matthews said...

"hedged": this is absolutely a 'pretty good deal' for SHLD, and it is no doubt 'shareholder optimal.'

Unfortunately, it is not 'employee optimal' because, as always, the employees will get nailed by this deal, when it all falls apart.

"aa": capital markets are generally 'efficient' but they can also--and regularly do--suffer from temporary insanity.

So long as there is a buyer of Orchard Hardware Triple-ZZZ debt or whatever it ends up being rated, the deal will get done.

"tahoe kid" makes the point: it's all about prior mismanagement of the business.

Which is too bad, because prior management never suffers like the employees will suffer.

"whydibuy" is correct: Icahn has forced more than one company to "Do the Wrong Thing".

And "slash" is even more correct: you could probably not turn Orchard around if you had Buffett behind you.

BelowTheCrowd said...

Hardly a new thing in the LBO business. I worked for a small company that was purchased by Golden Gate Capital -- an offshoot of Bain, run mostly by ex-Bain Capital folks. Same deal.

They bought the company at a good price because the original owner had tax issues and needed cash. They then saddled it with debt, used much of the debt to pay themselves a variety of fees -- a huge "transaction fee," ongoing "consulting fees" and all sorts of other fees for auditing, helping the company hire new management to supplement the already bloated management structure, etc.

In the meantime, the company -- which had been neglected under the original owner's management -- was unable to grow because cash was unavaible for investment in critical infrastructure and operations, or even to hire and retain qualified personnel. The management -- mostly the original owner's cronies -- never got shaken up. Why go through all that trouble? Golden Gate extracted most of the purchase price just by running up debt and charging the company all the outrageous fees.

This past year they sold out, taking advantage of a current craze for companies in that particular niche. To make the company more attractive, they fired many critical long-time employees (but strangely, none of the management cronies). The new owners bought a minefield which I suspect they still don't fully understand, with the expectation of taking it public in a couple of years. When the reality sinks in, that one could turn out to be a lawsuit as well.

But that's the reality of the LBO business. Anybody who sells to an LBO firm is probably signing up to have their business destroyed under a mountain of debt.

Like many things, this kind of deal works when the perception of risk/reward in lending gets screwed up. In a few years time we'll find banks writing off the ZZZ- debt that they never should have taken on in the first place. Just as they did after the last LBO craze. There will be more than one lawsuit and more than one major financial implosion before it's all over.

Then the bankers will all stop making the ridiculous loans that allow this stuff to happen, and even the junk bond investors will start getting picky about what bonds they will and won't touch. And someday in the future a new generation of bankers will come along that doesn't know the risks...


BelowTheCrowd said...

As to OSH:

I have one near me. It could be a very nice alternative to a Home Depot. For one thing, it's smaller and thus is located a lot closer in to my residential area. In addition, it tends to focus on stuff you need as a homeowner, not stuff that contractors buy. Third, there's a lot of "home/garden" type stuff that HD doesn't stock. I believe there is a niche for that stuff.

Sadly, their execution stinks. Owenership by Sears has not helped any. In my current area, they abandoned a store that had been in existence for a long time (which now is occupied by a Ross) in favor of a new location with similar square footage but an almost useless parking lot that is so small it would never be allowed under current zoning.

In short, a horrific shopping experience in most ways. The only place that's worse is the local Sears.


Aaron Koral said...

Jeff - quick question: how can medium sized companies protect themselves and their employees against these "raider style" LBO tatics? Don't get me wrong, I'm all for shareholder value, but can't there be any "compassion" (for lack of a better word) for the employees these deals seem destined to hurt? Keep up the great work, and thanks!

BelowTheCrowd said...

More often than not, these transactions involve privately held companies, and more often than not the owners need to sell for one reason or another (often for estate planning).

If the owner is concerned about the ongoing business he can be careful about who he sells to and how. Often that's not high on their priority list when the sale is made.

In normal times, the control on such things is the lenders' unwillingness to make loans that will cripple or bankrupt the business. But when money is easy and returns are hard to find, inexperienced bankers or bond buyers often allow bad deals to get through. It happened in the 80s, and it's been happenning again recently.

Make no mistake about what's happenning though. It's a money transfer from careless lenders to smart dealmakers. And many of those careless stupid lenders are going to be asking you and me, along with the court system to bail them out when their bad loans fail.


Jeff Matthews said...

Aaron: the best way any company can stop the raiders from looting a good business is to do what Google did--keep control via voting shares.

Google got slammed in the press for this, which was ironic given that most public newspaper chains come with Class A/B ownership structures to protect the so-called integrity of the press from filthy hands.

(Google's motive was not, however, to fend off corporate was fend off Microsoft from trying something with its cash.)

The second way, of course, is to run the business so well the market makes it too expensive for the raiders to loot.

The third way is to take the company private or never go public at all.

Otherwise, any company in this environment--with so much private equity money chasing deals--is vulnurable.

Aaron Koral said...

To Jeff & btc:

Thank you both for your intelligent insights. I greatly appreciate it.

suze q said...


It is hard to believe that this sort of deal is seen as a positive one for Lampert and his crew. To me it speaks volumes as to what type of man we are dealing with.

Why is it that the Wall Street Journal doesn't expose this deal for what it is??? Complete manipulation of finances for the benefit of the Officers of a company. Why would the SEC allow this to be legal???

Meme chose said...

It is not widely known that Bain was taught how to do this by its founder Bill Bain 20 years ago, when he leveraged up Bain & Company to finance his retirement package (they were forced to do a serious reorg a couple of years later).