Kmart’s Bankruptcy: Valuation of Distressed Securities

1. Kmart’s Bankruptcy: Valuation of Distressed Securities

2. Recall: Factors leading to bankruptcy • Competition: primarily with Wal-Mart (“Always Low Prices” vs. "BlueLight Always“) • Liquidity: Cash shortage accompanies by a large inventory build-up. • Reducing spending on the newspaper circulars and advertizing. • Mismanagement by the so-called “frat boys” (Conaway and his team). • Kmart was slow to invest in sophisticated computerized inventorymanagement systems (unlike Wal-Mart and Target). • Over the years, Kmart failed to keep its stores looking fresh and inviting, driving away customers. • High cost of surety bonds and the need for immediate cash as collateral exacerbated an already bad cash situation. • The final straw leading to the bankruptcy filing was a decision by the Fleming Companies (a major food distributor and grocery wholesaler) on Jan 21, 2001 to halt shipments to Kmart after the company failed to make its weekly payment.

3. Valuations in bankruptcy 3 • How big is the pie to be allocated to the various claimants? (recall: absolute priority rule) • Form of recovery (cash, debt, new equity) • Plan of Reorganization includes two types of valuations: • value of assets if liquidated and paid out to claimants. • value of reorganized entity and new claims (e.g. used to have debt, now have equity) immediately after emerging from bankruptcy.

4. Estimating Reorganization Value • Lots of experts fighting over the right value. • Variation in valuation expertise of bankruptcy judges. • In making these estimates, what are the incentives of: • senior debtholders? • junior debtholders? • management?

7. Other Issues in bankruptcy valuation • How to assess risk? • How to assess theoretical liquidation values? • Challenging task of forecasting future performance for such firms: Loss of customers, credibility with suppliers, loss of key employees, ability to serve new capital structure, how to find comp firms, availability of cash for CapX, R&D, advertising, where is the firm in its business cycle? • Include non-typical assets in the valuation (e.g., company plane, art work, excess facilities, NOLs)

8. Bankruptcy Liquidation Analysis • Objective: convince creditors that it would be in their “best interests” to approve the plan and allow the firm to emerge, rather than forcing it to sell all its assets and distribute the proceeds. • Or, does the POR “…provide to each member of each impaired class of claims a recovery that has a value at least equal to the value of the distribution each member would receive if the Debtors were liquidated under Chapter 7…” ? • Because of management incentives, it’s crucial to evaluate the liquidation analysis before accepting a proposed settlement! (for example, assess the reasonability of the liquidation value assigned to fixed assets and real estate properties.)

9. IV.a: Liquidation Analysis(appendix C) IV.a: Given your knowledge of Kmart and the retail industry, what factors would you consider in order to evaluate the reasonability of the Estimated Recovery Rates?

10. Appdx F: Calculation of net estimated proceeds available for allocation 10

11. Note 2: Liquidation value of Accounts Receivable Reasonable?

12. Note 3: Liquidation value of Inventory

13. Note 5: Liquidation value of Net P&E 13

14. Liquidation Analysis Summary Value of Kmart assets in liquidation: $4.1-$4.9B (out of ~ $10.8 B assets). Results in a recovery rate of 40%-48% to the various claimant classes (based on value of debt at time of filling of $10.2 B, in 4/20th balance sheet). Largest amounts relate to inventory (reasonable) and Net PP&E (too low?). Value of real estate assets (note 5) was reduced by 50% + recovery rate of 3%-5% for other fixed assets. But, many of Kmart’s real estate assets are in prime locations!

15. Liquidation Analysis Summary (cont.) • Unaudited estimates prepared by AlixPartners LLC (management representations); they do not evaluate playability of management assumptions! • In the actual reorganization, • secured claims received 100% in cash. • unsecured creditors received estimated 45% in cash and stock. • subordinated debentures received estimated 14.4% in stock. • trade vendors received 9.7% in stock. • preferred, common equity, etc got 0.

16. Estimating Kmart’s Reorganization Value • Kmart hired Miller Buckfire Lewis and Dresdner Kleinwort Wasserstein to do enterprise valuation analysis. • Estimated values as of 4/30/2003 (appdx): • Entity Value (enterprise value): $2,250M to $3,000M. • Equity value: $753M to 1,503M ($8.74-$17.43 per share). • What kid of valuation methods did they use? • comparable company analysis • discounted cash flow analysis

17. IV.b: Comparable Public Company Analysis Q: One of the bankruptcy valuation methodologies described in the Appendix is the “Comparable Public Company Analysis.” Based on the information in this appendix approximate the range of Kmart’s reorganized value as of April 30, 2003 by using the Comparable Public Company methodology.

18. Comparable Public Company Analysis Appendix H: What kind of Comps did you construct?

19. Some Possible Comps

20. Enterprise Value / EBITDA • Enterprise value (per Kmart)= - Market value of Kmart’s NOA. - PV of the FCF to all investors (as seen by market). • EBITDA: • Amount of “cash” to return to equity and debtholders. • Poor man’s cash flows (what about CapX, change in WC?) • But loved by the laymen…

21. IV.c: Discounted Cash Flow Analysis Q: Based on the information in appendix G as well as the financial projections provided as part of the reorganization plan (Appendix C) approximate the range of Kmart’s reorganized value as of April 30, 2003 using the Discounted Cash Flow Analysis method (P=$8.74-$17.43). What did you do…?

22. DCF Analysis (1) Kmart provides 4 years of financial statement forecasts with supporting reasons. Plug into the Excel valuation file. Assumes Cost of Equity of 22.5%; Cost of debt 10% (implied WACC = 15.84%). Constant /average margins, turnovers, leverage after year 5. Terminal growth rate in sales = 5% Results in entity value of $2,628M and equity value of $1,004 M or $11.64/shr. See eVal model (eVal3 KMART DCF 5 yr.xls). Reasonable? What kind of sensitivity analysis would you perform?

23. DCF Analysis (2)

24. IV.d: Summary of Valuation Based on the information in the case and your analysis in Part IV of the case, do you believe that the Fresh Start Accounting equity value provided by Kmart while in Chapter 11 bankruptcy is understated or overstated? Given that Kmart’s management has discretion in the determination of Fresh Start values, what does it suggest about Kmart management’s biases and objectives during and after reorganization?

25. Assessment of the Fresh Start Values • The fresh start equity value reported in the reorganization plan is $1.249 B and the stock price on the emergence date (May 2, 2003) was $15 resulting, in a market value of about $1.345 B. • The fresh start equity value reported in the first 10Q subsequent to the emergence from bankruptcy (filed on June 16, 2003) is $1.712 B. Kmart’s stock price on that day was $22.5 implying a market value of $2.018 B. • What are management’s incentives in the Fresh Start Reporting Process? • Undervalue the Assets? • Overvalue the Assets?

26. V: Post-bankruptcy performance Q: Subsequent to its emergence from bankruptcy, Kmart’s stock price (traded as Kmart Holding Corp: KMRT) had soared from $15 to $25 in a month period, and to $65 (or a market cap of $5.8B) a year after the bankruptcy. Given this stellar post-bankruptcy stock performance, why was the bankruptcy valuation so grossly understated? What explains this amazing turnaround? Did one group of bankruptcy claimants gained wealth at the expense of other groups?

27. Follow the changing value… Was reorganization value over- or undervalued? Management incentives? • May 2, 2003: • fresh start equity value in POR is $1.249 B • stock price on emergence date was $15 resulting in a market value of about $1.345 B. • June 16, 2003: • fresh start equity value in first 10Q subsequent to the emergence from bankruptcy is $1.712 B • Stock price was $22.5 implying market value of $2.018 B. • January 2004: market value = $5800M ($67/shr)

28. Post-bankruptcy performance • Performance was better than projected during bankruptcy. • Kmart closed stores that were nearest to Walmart and operated at a loss and hiked up prices at stores operating furthest from Walmart. • Kmart’s value in bankruptcy appeared artificially depressed due to their write off of most of the value of their PP&E. • The strong negotiating power held by Eddie Lampert and his constant pressure to expedite the proceeding, left little time for other classes to scrutinize and challenge the valuation. • Given this performance, it is clear that the bankruptcy resulted in a transfer of wealth from senior lenders (who settled for cash) and pre-petition shareholders to the unsecured holders. - As noted in Berkowitz (2006, http://www.thehedgefundjournal.com/): “The appreciation in the reorganized equity provided the unsecured note holders with an effective recovery of 24% over three months, 47% over 12 months and 93% over 18 months – a far cry from the 40% cash recovery that the structurally senior pre-petition lenders received.”

29. Summary • A famous bankruptcy case. • Illustrates the challenges companies face and some of the legal solutions to overcome financial difficulties. • An example for vulture investor in bankruptcy.

30. …and where are they now? 30