DBRS Comments on Sears Canada Q1 Results – No Impact on Ratings

DBRS notes that Sears Canada Inc. (Sears Canada or the Company) has reported a significant decline in its Q1 F2009 performance, with sales and operating net earnings declining by 11% and 60% respectively compared with Q1 F2008. While the decline in performance is material, DBRS’s ratings on Sears Canada, including its Issuer Rating of BB, are unaffected at this time given the relatively small contribution of Q1 results to full-year earnings. However, DBRS believes that a failure to improve on Q1 performance through F2009 could ultimately result in pressure on the Company’s ratings.

For the quarter ended May 2, 2009, Sears reported operating net earnings of $16.8 million on sales of $1.12 billion, compared with operating net earnings and sales of $42.5 million and $1.25 billion respectively for Q1 F2008. An increasingly difficult operating environment resulted in weaker than expected sales performance across most channels and categories and a same store sales decline of 10.4% for the quarter (compared to a 6.2% decline in Q4 and 1.6% for full-year F2008). The drop in sales could not be offset by ongoing gains from cost reduction initiatives, resulting in the Company’s adjusted operating margins dropping to 2.05% for the quarter from 4.96% in Q1 F2008.

Sears Canada’s ratings have historically been driven primarily by the potential impact of struggling majority shareholder, Sears Holdings Corporation (Sears Holdings) on Sears Canada and not necessarily by Sears Canada’s own performance or credit metrics. More specifically, the ratings reflect: 1) the influence of Sears Holdings on the day-to-day decision-making and operation of Sears Canada (i.e., cost-cutting and reduced capital investment); and 2) the possibility that Sears Holdings could remove significant cash flow and/or capital from Sears Canada.

That said, DBRS does not believe there is necessarily a direct relationship between the ratings of the two companies and therefore the trends on Sears Canada have been left Stable despite continued deterioration at Sears Holdings. The Stable trend reflects the fact that Sears Canada has been performing relatively well in recent years; for the 52 weeks ended January 31, 2009, Sears Canada reported operating EBITDA (before unusual items) of $517.0 million on sales of $5.733 billion, compared with operating EBITDA and sales of $521.6 million and $5.845 billion, respectively for the comparable prior period. DBRS is therefore concerned that the decline in performance noted in Q1 could continue through F2009, resulting in materially weaker performance and a credit risk profile that is less resistant to the ongoing decline of Sears Holdings, which could ultimately place pressure on Sears Canada’s ratings.

Despite the potential for weaker operating performance, DBRS believes the Company’s Medium-Term Note (MTN) holders would still realize a 90% to 100% recovery on a going concern basis and thus the RR1 recovery rating would likely remain unchanged. DBRS’s view is based on: 1) the Company’s brand and licence values; 2) its real estate portfolio; 3) its relatively low debt levels; 4) its short bond maturities (May and September 2010); and 5) the Company’s large cash balances ($745 million at May 2, 2009 – excluding restricted amounts). We note however, a potential downgrade of the Company’s Issuer Rating would also result in a corresponding downgrade of the MTN rating (currently rated BBB), even if DBRS’s recovery value estimation is unchanged.

DBRS acknowledges that Q1 results are not indicative of a trend and the Company has the opportunity to improve its top-line and margin performance during the remainder of the year through improvements in marketing and merchandising, as well as further cost reductions. DBRS notes however, that a material improvement in performance will be challenging as it will require stabilization of the overall retail environment. Should Sears Canada’s performance recover as the year progresses, the Stable trend will likely remain. However, should DBRS note continued weakness in revenue and general operating performance over the next quarter or two leading up to the all-important holiday season, the trends could be revised to Negative. DBRS will continue to monitor the declining performance and management strategy at Sears Holdings for potential impact on Sears Canada’s ratings.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Merchandisers, which can be found on the DBRS website under Methodologies.

This is a Corporate Rating.