Sears: Why the troubled chain's vendors are worried

Shoppers at a Sears store
Scott Mlyn | CNBC
Shoppers at a Sears store

Sears Holdings deepening financial troubles have forced insurers and banks to raise the cost of guaranteeing payment to vendors, rattling the retailer's supply chain as the company heads into the key holiday season.

The move by these financial intermediaries—in an opaque but vital quarter of the retail business where makers of goods ranging from apparel to TVs seek to insure they get paid—comes in the wake of unusual steps Sears has taken to raise cash for operations. In the past three weeks, the retailer twice has turned to its billionaire CEO Eddie Lampert's hedge fund for a cash infusionfirst as the anchor on a $400 million loan and then again Thursday as a buyer for most of its stake in the ailing Sears Canada. Sears aims to raise $380 million with that deal.

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Sears spokesman Chris Brathwaite said the company is on track to raise $1.45 billion this year, a sign of its "financial flexibility" and capacity to meet its obligations. He said the company has the financial resources to work directly with vendors and that there has not been a significant impact on its supplier relationships following the events of the past few weeks.

Cash flow concerns

Suppliers, however, have become increasingly concerned about the company's financial strength. The retailer, which oversees some 2,300 Sears and Kmart stores, has lost about $6 billion since 2012 and its margins are far below the industry average.

To protect themselves from the risk of non-payment, suppliers sometimes will buy insurance on their receivables. In more extreme cases, they purchase a derivatives contract, called a put option, that pays out if the company defaults. With concerns about Sears' cash flow on the rise, insurers have sharply reduced coverage. And put options have become so costly they no longer make economic sense for some suppliers.

Large underwriters of credit insurancevendors' conventional first line of defense against nonpaymentessentially have stopped offering coverage on Sears for new clients, insurance brokers said. Euler Hermes Group, one of the top underwriters, told clients this week that it was canceling coverage for new shipments, said a person informed of the new policy. Euler Hermes declined to confirm those cancellations, but said it was closely monitoring the situation.

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A senior executive at Atradius, another large underwriter, said Sears' recent fundraising had not eased his concerns about the business.

"We have contracted our cover to where we are comfortable for the moment but we will continue to monitor the situation because everyone knows it is not a comfortable one," said David Huey, president of the insurer's U.S. operations.

In the market for put options, the price of a so-called "accounts receivable put" was quoted by an underwriter at 295 basis points on Sept 26. That is up some 50 percent since the $400 million loan from Lampert's hedge fund was announced on Sept. 15, a person familiar with recent market pricing said.

The Lampert loan worried investors in part because it was secured by 25 properties, whereas previous short-term funding from Lampert had been unsecured.

The put price quoted Sept. 26 means a vendor would be paying 35 percent of the value of shipped goods on an annualized basis merely for payment protection. By comparison, a put on receivables owed by rival chain JC Penney was priced under 100 basis points.

Fewer Options

The put option has "sky-rocketed into the uneconomical range," said Marc Wagman, managing director of Aequus Trade Credit, whose clients include Sears vendors. "Sears suppliers in this case have few options."

Wagman said some of his clients are reconsidering whether they can afford the risk of selling to Sears.

Brathwaite, the Sears spokesman, said he believed put prices and other insurance reflect "perception rather than reality" and that providers of these financial products can use "false information to their advantage."

This is not the first time vendors have faced a spike in the cost of put options on Sears. The price jumped above 300 basis points in early 2012, an underwriting source said, amid worries about Sears' deteriorating earnings performance.

Lampert at the time took measures interpreted as a sign he was worried about the supply chain. His hedge fund bought a stake in receivable put option agreements from an undisclosed financial institution.

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Sears referred questions about the 2012 option purchase, and whether similar action might be taken again, to Lampert's fund, ESL Investments. ESL did not respond to a request for comment.

To be sure, there are no outward signs of vendors cutting ties with Sears as insurance and other hedges dry up. An executive whose firm supplies small ticket plastic items to Sears said he is continuing to do business now without financial protection. "Getting any kind of insurance has been difficult for months now," the executive said.

Adds another supplier: In the short term, "we'll take some risk to support them" with or without credit insurance. The long term: The vendor may have no choice but to hold back shipments. "As of today, it's o.k.," he added.

If Sears has a poor holiday quarter there is a risk suppliers will start reducing exposure in 2015, insurance brokers and analysts said.

Suppliers long have turned to factoring companies, which purchase invoices at a discounted price and profit if they receive payment from the retailer. But factors, too, according to sources, have scaled back on coverage to Sears' vendors. CIT Group, the largest factoring company, declined to comment.

"Eventually their suppliers are going to say, 'If I can't get it factored, if I can't get it credit insured, then I'm going to stop selling product,"' said Donald Harkey, a senior executive at insurance broker Arthur J. Gallagher & Co.

Sears said that less than 3 percent of its gross inventory involved factoring companies. "It's a very, very small percentage of our overall business," Brathwaite said.

Looking ahead

Still, Sears stock has rebounded about 10 percent since news of the stake sale in Sears Canada on Thursday. But Wagman of Aequus Trade said that he was concerned that the capital infusion would not be enough to ease vendors' concerns.

With vendors on edge, performance in the upcoming fourth quarter, to be announced in February, could prove critical, some analysts said. Sears lost $358 million in the last holiday season quarter and hasn't turned a profit during the industry's key selling season since 2011.

"This year I think they are good," said Evan Mann, a senior analyst at debt research firm Gimme Credit, referring to the possibility of vendors reducing exposure to Sears in 2014. "But if they have a really bad Christmas and liquidity looks bad at the end of the year, next year could be problematic."