Kmart Inc.

and Builders Square Case

1. What happens if Kmart's managers decide NOT to accept the Leonard Green offer?

If Kmarts managers decide not to accept the offer they become limited in their options:

● They can continue to wait for a better bid, but they have struggled to get any one interested in their company as it is. If they decide to turn down Green, but end up not securing another buyer, they would be forced to return to Green who could offer a much lower bid because Kmart would now be left out of options.

● It was also projected that Builders Square only had enough cash and working capital to continue its operations for one more year without any other changes. So their other option is to try and restructure themselves again so that they can continue operations and at least make enough money to pay off their leases. We believe this method would be very hard to pull off, since Builders Square has been trying to do this for the last couple years with no success. Although they have tried to fix themselves already, they can’t, which is why they are looking for bidders.

● In dire circumstances, Kmart could just liquidate all of Builders Square assets and use them to pay off debt. Then they could sublease out their empty buildings and use the rent revenue to continue to pay their contracted leases.

2. If Kmart's managers were to accept the Leonard Green offer, what would they receive as compensation? What would they give up?

● In the merger, Kmarts managers would receive $10 million in cash and warrants that if exercised could give Kmart up to 30% ownership in the new firm.

we think that combining two failing companies will just create one bigger failing company. how do you think the newly-formed Builders Square/Hechinger firm will perform? What problems will it solve (if any)? What problems remain (if any)? ● We believe that the newly formed Builders Square/Hechinger firm will still struggle competing with Home Depot and Lowes. Overall. Kmart will receive 30% ownership through warrants. The new firm should be able to increase their profit margin by decreasing costs. Should Kmart's managers care about the fate of the new Builders Square/Hechinger? What happens to Kmart if Builders Square/Hech performs well? Performs poorly? Managers need to care about the fate of the new company. who have most of the market share. and they will be contingently liable for 147 of their leases. according to Exhibit 12. However. if Leonard Green’s plan doesn’t work. If the new company does well. 3. Kmart would also have to forfeit $10. but then would receive 25 of the buildings back so that they could use them for other purposes (renting to others. possibly by receiving discounts for buying in bulk. Another issue that still remains is that the new firm is not using clustering in their location strategy.● Kmart would turn over 162 of its stores to LGP as well as its Builders Square headquarters. ● Advantages that come with the merger are that it will be a larger company with more potential for economies of scale. 4. This is something that Home Depot and Lowes both utilize in order to maximize profits and that the newly formed Builders Square/Hechinger will lack. but Kmart would remain liable if the new company were to fail. As part of the merger deal. putting in new Kmart stores). LGP would also assume Kmart’s $2 billion in long-term lease obligations. Kmart can exercise their warrant and become part owners in a new successful company. Kmart may even consider buying it back after 5 years. Assuming that Kmart moves forward with Leonard Green proposal. is that over 50% of its stores will be directly competing with Home Depot. ● The problems that this new company will face. .7 million payment in kind to the new LGP holding company. If the newly merged company does well enough.

both Builder’s Square and Hechinger have been trying for years to turn their company's around themselves. and they have experienced managers and professionals working on it. ● Another thing to consider is the likely hood of these projections. It doesn’t seem very believable that LGP could take two struggling companies and with his limited experience. If Green fails. only 6% of Home Depot’s sales come from building materials and related products compared to the combined 3. ● According to exhibit 1 the Home Improvement market has been growing at a steady pace of about 3. A lot of this growth steams from the do it yourself consumer market which is the primary target for the Builders Square and Hechinger Co. Kmart will be required to pay off the long term leases on 147 of their old buildings. the Combined Projections for Proposed Builders Square . If the newly merged company fails. As a result of Kmart guaranteeing its subsidiaries leases.Hechinger Merger. he has no experience with Home Improvement/DIY stores.Kmart remains liable for the leases that it had guaranteed for Builders Square. Although LGP has had some success in turnaround in the retail industry. merger. Kmart would be in a much worse position to pay off the debt then if they had just ran a nonprofitable Builders Square. turn them into highly successful companies that can compete with top dogs in the industry. . In addition. 5.5% for the past 5 years.4% for Builder’s Square and Hechinger Co. Their profits do struggle in the beginning due to an increasing amount of revenues lost to competitors along with their high count of closing stores. Green estimates that by 2001 the merged firm will have paid off nearly 60% of their accumulated debt and the EBITDA after savings less capital expenditures and cash interest will have more than tripled as the new Hechinger and Builders Square combo finds their place in the market. Leonard Green has put together some projections on the Builders Square/Hech combo. Assess those projections in light of your industry analysis. the value of this merger depends not only on the cash received. As seen in exhibit 10. but also the credit worthiness and skill of the buyer. After year 3 the effects of competitor openings and store closings levels off with only a 1% change simulating what appears to be the end of the acquisition struggles. Green projects an increased gross profit margin as well as EBITDA assuming a 2% growth rate for the combined firm. Home Depot and Lowes. Although Home Depot and Lowe's dominate the bulk of the home improvement market.

but if it were to fail. Will LGP really be able to turn around two failing companies or will he just turn them into one larger failing company.98 |8. they would be responsible for paying the entire value of the leases at $849 million. The proportionate range we calculated takes into account the likely hood of either situation. ● In valuing the investment. Kmart could receive up to $108 million from exercises warrants. This range is the proportionate value that Kmart can expect to receive from the merger. How can Kmart's managers evaluate whether Leonard Green's offer is a fair one? What are the major uncertainties in your analysis? What are the most important assumptions that you must make? ● In order to evaluate the LGP offer. They have the chance to unload all their assets and liabilities and receive a possible return on them later down the road.803 |$819 |$35 . We assumed that with LGP’s success. so we used their P/CF multiples to determine what the merged company’s value would be in Year 5. the new company could be operating similar to Home Depot. If the merger were to succeed.6.62 |0.37 |$1. | | |Price/Cash Flow Multiple | |Merged Comparative CF | |Home Depot |Lowes |Payless |18. we gave LGP only a 20% chance of actually being able to turn the company around and meet its projected cash flows. Kmart would most likely exercise their warrants during Year 5. ● We assumed that at best. ● The range that we came up with was -$561million to -$667 million (see exhibit below). we approached the sale as an investment for Kmart. when the merged company’s cash flows are $95 million. The major uncertainties that we face are the proposed projections for the merged Builder’s Square and Hechinger. and at worst similar to Payless. We then took 30% of that value to determine the value that Kmart would get if they exercised their warrants at that time. While they have an 80% chance of failing and returning the lease obligations to Builder’s Square.

what would you propose? We decided that it would be best to not take the $10 million cash from LGP.8 | |-$849 |-$849 |-$849 |-$679 |-$679 |-$679 | |-$630 | | |-$677 |-$561 |-$620 |-$667 7.2 | |0. In order to remain conservative we . After this liquidation. would you proceed with the Leonard Green buyout? If not.8 |$108 |$541 |$246 |$11 |$49 |$2 | |0. they will still be responsible for 25 years worth of leases on many of their former buildings. so in order for Kmart to to remove some more of this liability.8 | |0. We calculated the remaining liability on Builders Square books as $570. As CEO of Kmart.| |Chance of Success | |Company CF in 5th Year | | |0.5 million.2 | |$1.2 | |0. they can sublease their old buildings and use the rent revenue to pay off the remaining leases. but rather just have Kmart liquidate the assets of Builders Square and use them to pay off the leases.803 |$819 |$35 |Value of Exercised Warrants in 5th Year | |Total Effect of Success | | |Chance of Failure | |Leases Due | |Total Effect of Failure | | |Total Value | |'+ initial cash | | |-$571 | |0.

that was similar to Payless Cashways. We also feel that we are projecting very conservative numbers and the Builders Square liquidation value could significantly increase depending on the number of buildings they can find subleasers for. assuming that Kmart may only get 75% of the value that we calculated. Overall we believe that the safest option for Kmart which will minimize their losses is to liquidate the assets of Builders Square and use the proceeds to pay off their obligations. We discount this lease rate even further. the total value of the liquidation to Kmart would be a loss of $496 million. . Kmart could sublease their buildings at a CF/Sq Ft ratio. This worst case scenario is much more appealing then the $800 million loss that could occur with the sale to LGP. Using the value that Kmart could receive from the subleases. and then again by 50% to simulate that they may only be able to find subleasers for 50% of their properties.decided that in a worst case scenario. and the value that they can get from those subleases.

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