ESL response to The Globe and Mail article

Re: “What sank Sears Canada? The inside story of its downfall”, The Globe and Mail (published 20 October 2017)

The article by The Globe and Mail on the history of Sears Canada and its ultimate failure ignores significant facts about the operating management and governance of Sears Canada and the impact that changes in the retail environment have had on all retailers. While reporting on what prior CEOs said about their intentions, the article does not critically evaluate the results of their strategies nor state what those strategies were.

Prior to publication, ESL Investments, the largest shareholder in Sears Canada, responded directly to questions by the author and provided important context, but very little of our response was considered in the article. For those readers interested in ESL’s perspective on the context and facts behind the failure of Sears Canada, we offer the following:

ESL ownership in Sears Canada

Sears Holdings became the owner of Sears Canada shares when it was formed in 2005 upon the merger of Sears and Kmart. At that time, Sears Holdings owned approximately 51% of Sears Canada.

Over time, Sears Holdings increased its ownership of Sears Canada to over 90%. In 2012, Sears Holdings distributed some of its ownership in Sears Canada to all Sears Holdings shareholders, including ESL, while retaining a majority stake of approximately 52%.

In 2014, Sears Holdings decided to put its ownership in Sears Canada up for sale, and conducted a sales process, which would have required a buyer to make an offer to all shareholders on the same terms offered to Sears Holdings. Why sell the Company at that point? Because several management teams had attempted to turn around and transform Sears Canada over many years, but the changing retail environment and the specific strategies pursued had not driven meaningful operational improvements and performance. Sears Holdings believed that another owner and another management team might pursue different strategies that would prove more successful than those in the past. The Company deserved that chance.

Despite a robust sales effort, there were no bids made for Sears Canada, which was testimony to what other retailers and investors believed were the chances of transforming the Company when they actually had to risk their own capital. Subsequent to the failed sales process, Sears Holdings decided to divest a substantial amount of its ownership through a rights offering to all of its shareholders. That rights offering was fully subscribed in October 2014, with ESL and other large Sears Holdings shareholders participating, for a total purchase price of approximately C$400 million.

Sears Canada’s performance

While Sears Canada performed well in the first four years following the merger (doubling earnings before unusual items and taxes from C$193 million in 2004 to C$383 million in 2008), the financial crisis and subsequent recession created significant challenges for the Company. The Company’s performance continued to decline in recent years, exacerbated by the implementation of its “Sears 2.0” strategy in 2016 and 2017.

The premise of this new strategy was to invest more aggressively in sales growth – particularly through technology and lower prices – with the objective of emerging as a more competitive, successful retailer. ESL raised concerns about this strategy with management. In particular, ESL noted that it would be risky and unwise for the Company to pursue additional borrowings on onerous terms to fund a new, untested strategy. Despite this advice, management decided to proceed with these actions and the Company’s operating losses and cash drain rapidly worsened. The opportunity for shareholders to publicly express displeasure with the strategy at the 2017 annual meeting was denied when the annual meeting was postponed/cancelled.

ESL was not informed in advance that Sears Canada intended to seek protection under a CCAA filing, and was extremely unhappy with that decision. Following the CCAA filing, ESL’s decision not to participate in a going concern bid by the former CEO of the Company was based on both the improbability of a going concern bid being accepted and the lack of confidence in the go-forward strategy, which did not represent a change from the approach that resulted in the Company’s insolvency.

ESL believes that the liquidation of Sears Canada was not a foregone conclusion and that a less risky strategy, while not without its own difficulties, could have avoided the unfortunate conclusion. The losses suffered by ESL and other shareholders were certainly significant, but so too were the job losses and other costs borne by the various constituents of Sears Canada.

ESL’s relationship with Sears Canada

ESL has always tried to be a constructive shareholder and support the success of Sears Canada, while recognizing that the Company should seek to maximize the value of its assets and not bet them on untested, risky strategies.

In 2006, Sears Holdings unsuccessfully attempted to consolidate Sears Canada to generate significant operating synergies. Since then, several CEOs were responsible for the day to day management of the Company.  Each CEO and leadership team had an opportunity to pursue strategies that they believed would improve the performance of the Company, subject to the oversight of the Board of Directors, elected by the shareholders. Sears Holdings and ESL occasionally expressed opinions to Sears Canada management, but were not involved in the day to day management of the Company.

There are often disagreements in strategy or tactics among investors, boards and senior management teams, especially during times of rapid change and deteriorating performance. One example is that ESL felt management should have closed more of its unprofitable stores sooner and reduced the Company’s overall operating risk. Another example is that ESL disagreed with the aggressive and risky strategy to stimulate sales growth known as “Sears 2.0”.  ESL believed that strategy was highly risky and unlikely to succeed, but was surprised by the rapid decline in the operating performance and cash flow of the Company.

It’s always easy to second guess a Company when it’s performance doesn’t match expectations, but our feedback was always constructive, focused on improving the competitiveness of the business, to the benefit of customers, associates and shareholders.

Sears Canada’s capital allocation strategy

In late 2005, Sears Canada sold its credit card business for approximately C$2 billion to JP Morgan, a very attractive valuation, and consistent with most retailers no longer operating their own credit card business directly. The capital and risk required to manage a credit card business makes it preferable to allow large financial institutions to own the business.

After the financial crisis in 2008, Sears Canada’s performance declined. In 2013, Sears Canada agreed to sell several significant real estate properties– again at attractive valuations, and much greater than could be justified by the underlying retail operating performance.

These transactions provided significant capital to Sears Canada that was available for investment at the discretion of management and the Board – the property sale proceeds gave the Company additional resources and a chance to be successful.

Importantly, between 2005 and 2015, the Company reduced its outstanding debt to negligible levels and returned excess capital to shareholders, while maintaining a meaningful amount of cash in the business:
• In 2006 the Company returned C$2 billion to shareholders using the proceed of the credit card business sale; however, between 2004 and 2008 Sears Canada also reduced its debt from C$756 million to C$365 million.
• Similarly, in 2010, Sears Canada paid shareholders a dividend of C$3.50 per share, while further reducing debt to C$129 million.
• At the end of the 2011 fiscal year, the Company maintained a cash position of C$400 million. Subsequently, the Company paid dividends of C$1 and C$5 per share in 2012 and 2013, respectively, partly from the proceeds of its property sales. Still, at the end of the 2013 fiscal year, total debt had been further reduced to C$36.0 million and cash had increased to C$514 million.

Finally, the Company continued to invest in its operations as it made these dividend payments.  Public companies typically distribute cash to shareholders through dividends and share repurchases, especially when there is cash available significantly in excess of the company’s operating needs and its ability to deploy that cash in the business at attractive returns. In the case of Sears Canada, due to the concentrated ownership of its shares, the repurchase of shares would not have been productive. Therefore, the payout of a dividend to all shareholders pro rata was the fairest method of accomplishing this objective.

The Globe and Mail’s coverage

While we are not asking to be spared from informed observations about our position on key issues related to the performance of Sears Canada, it is unfortunate when incomplete and selective information is used to comment on ESL’s relationship with the Company over the years.

Furthermore, when comparing the coverage of The Globe and Mail on similar actions taken by Sears Canada and other retailers, there is startling contrast in the assessment of these events. For example, Sears Canada’s decision to exit four stores and sell its leases was described as the Company “abandoning” these locations, while the liquidation of  Zellers and its approximately 200 stores by Hudson’s Bay Company was described by the same reporter as “reaping a big gain”: