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.