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Sears' Bankruptcy: How It Got Here -- and What Happens Next

Jeremy Bowman, The Motley Fool

It was a long time coming for Sears Holdings Corp. (NASDAQ: SHLD). The venerable American retailer, founded back in 1893, filed for Chapter 11 bankruptcy early Monday. The move would allow Sears to restructure in hopes of reemerging from bankruptcy with part of the business still standing.

The news came as a surprise to no one who's been following Sears' long demise because the company has been bleeding cash for years. Ten years of declining comparable sales, and annual losses since 2010, combined to fully erode what was the country's largest retailer just a generation ago.

While there are plenty of scapegoats, Eddie Lampert, who stepped down as CEO but remains chairman and the company's biggest shareholder, seems to deserve much of the blame. Lampert merged the company with Kmart in 2005, rescuing the discount retailer from bankruptcy, but the move turned out to be misguided. The hedge fund manager refused to make needed investments in the two brands, relying instead on financial engineering to extract value from the company through a series of asset sales and sale-leaseback arrangements including the creation of Seritage Growth Properties (NYSE: SRG), which became the landlord of 235 Sears locations in 2015.

Sears largely missed the boat on e-commerce, allowed Home Depot and Lowe's to take its appliance business, and lost ground in apparel to rival department-store chains. Over the last five years, the company's store count has fallen by more than 50% to less than 700 stores. But closing unprofitable stores and selling and spinning off assets, including the Craftsman tool brand and the Lands' End outdoor-apparel brand, have not saved or improved the underlying business.

The exterior of a Sears department store

Image source: Sears Holdings.

After several cash infusions and arrangements with Lampert's own hedge fund, ESL Investments, the company faced a $134 million debt payment on Oct. 15 that it couldn't meet while simultaneously trying to stock up on inventory for the upcoming holiday season. Sears is reportedly in talks with ESL Investments for a $300 million loan for cash that would help see the company through bankruptcy, according to the Wall Street Journal

As part of the bankruptcy filing, the company announced it will close 142 stores by the end of the year, in addition to 46 locations that were already slated to close by next month. It's possible the company will also sell off real estate and other assets -- such as the Kenmore brand, which Lampert had offered to buy for $400 million, and other businesses such as Sears Home Services and Sears Auto Centers.

As of Aug. 4, Sears had $11.3 billion in liabilities compared to just $6.9 billion in assets -- an unsustainable gap for almost any business. Included in the liabilities: current liabilities of $4.3 billion, which are due within a year; $3.5 billion in long-term debt; and $1.2 billion in pension benefits.

Lenders, which include banks like Bank of America, Wells Fargo, and Citibank, will be repaid according to a court decision. Generally, secured lenders will be paid back before unsecured ones. Considering that Sears has several billion dollars more in liabilities than assets, shareholders will very likely be wiped out -- as indicated by the fact that shares had fallen to less than $0.50 before the bankruptcy declaration.

What it means for customers

There's a good chance that your local Sears or KMart store will close, and investors have responded to the news by sending J.C. Penney (NYSE: JCP) shares higher last week, indicating that they believe the struggling department-store chain will benefit from Sears' bankruptcy. While J.C. Penney is likely to gain some customers from Sears' unraveling, liquidation sales at Sears may put pressure on J.C. Penney and other competitors, especially during the crucial holiday season. It's possible that in the near term, J.C. Penney's sales could be challenged.

If you have a gift card for Sears, you should try to use it as soon as possible, as the retailer's obligation to honor such cards enters a gray area after a bankruptcy declaration. Similarly, extended warranties on appliances and similar products are not expected to be honored after the bankruptcy filing. Sears stopped honoring them when it closed its stores in Canada. However, Sears is expected to continue allowing product returns, according to its return policy, as Toys R Us did earlier this year when it filed for bankruptcy.

Sears customers who have outstanding business with the company may wish to resolve it as soon as possible, though the company said its loyalty program will continue. Others may choose to take advantage of liquidation sales while they're available.

Meanwhile, many Sears employees, who numbered 140,000 as of last year, are likely to be out of a job soon. There might be some silver lining on that front, though: As rival retailers ramp up hiring for the holiday season, it could be relatively easy for store-level employees to find at least seasonal jobs at a competitor. With Amazon's promise to raise wages to $15 per hour, they might even find better pay as well.

Whatever happens next, Sears' bankruptcy is likely to be messy. The company has myriad creditors, including its former CEO; billions in liabilities to resolve; uncertainty over whether it can move forward with a smaller footprint. The process will likely take several months and has widespread consequences for mall landlords, competitors, and lenders.

A titan of American business has fallen -- but it's trying to prop itself back up.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Jeremy Bowman owns shares of J.C. Penney. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has the following options: short February 2019 $185 calls on Home Depot and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Home Depot and Lowe's. The Motley Fool has a disclosure policy.