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File Pursuant to Rule 424(b)(3)
Registration No. 333-175105

 

PROSPECTUS

Orchard Supply Hardware Stores Corporation

 

 

             Shares of Class A Common Stock, Par Value $0.01 Per Share

             Shares of Series A Preferred Stock, Par Value $0.00001 Per Share

This Prospectus is being furnished to you as a shareholder of Sears Holdings Corporation (“Sears Holdings”) in connection with the planned distribution (the “Distribution” or the “spin-off”) by Sears Holdings to its shareholders of all the shares of Class A Common Stock, par value $0.01 per share (the “Class A Common Stock”), and Series A Preferred Stock, par value $0.00001 per share (the “Preferred Stock”), of Orchard Supply Hardware Stores Corporation (“Orchard”) held by Sears Holdings immediately prior to the spin-off. Immediately prior to the time of the Distribution, Sears Holdings will hold all of Orchard’s outstanding shares of Class A Common Stock and Preferred Stock. At the time of the Distribution, Orchard’s outstanding capital stock will be composed of the following classes of capital stock, each of which is described in greater detail in the “Description of Our Capital Stock” section of this Prospectus:

 

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Class A Common Stock, which is being distributed in the spin-off, will represent approximately 80% of the general voting power of Orchard’s outstanding capital stock, and will entitle holders thereof to one vote per share;

 

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Orchard’s Class B Common Stock, par value $0.01 per share (the “Class B Common Stock”), will represent less than 0.5% of the general voting power of Orchard’s outstanding capital stock, and will entitle holders thereof to one-tenth of one vote per share;

 

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Orchard’s Class C Common Stock, par value $0.01 per share (the “Class C Common Stock”), will represent approximately 20% of the general voting power of Orchard’s outstanding capital stock, and will entitle holders thereof to one vote per share; and

 

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Preferred Stock, which is being distributed in the spin-off, will represent 100% of Orchard’s outstanding nonvoting capital stock.

At the time of the Distribution, Sears Holdings will distribute all of the outstanding shares of Class A Common Stock and Preferred Stock on a pro rata basis to holders of Sears Holdings common stock. Every 22.141777 shares of Sears Holdings common stock outstanding as of the close of business on December 16, 2011, the record date for the spin-off (the “record date”), will entitle the holder thereof to receive one share of Class A Common Stock and one share of Preferred Stock, except that holders of unvested shares of restricted stock of Sears Holdings will receive cash in lieu of shares. The Distribution will be made in book-entry form. Fractional shares of Class A Common Stock or Preferred Stock will not be distributed. Instead, the distribution agent will aggregate fractional shares of the Class A Common Stock and the Preferred Stock into whole shares of each security, sell such whole shares in the open market at prevailing rates and distribute the net cash from proceeds from the sales pro rata to each holder who would otherwise have been entitled to receive fractional shares in the Distribution.

We expect that the spin-off will be tax-free to Sears Holdings shareholders for U.S. federal income tax purposes, except for any cash received in lieu of fractional shares. The Distribution will be effective as of 11:59 p.m., New York City Time on December 30, 2011, which we refer to hereinafter as the “distribution date.” Immediately after the Distribution is completed, we will be a publicly traded company independent from Sears Holdings. From and after the Distribution, certificates representing Sears Holdings common stock will continue to represent Sears Holdings common stock, which at that point will include the remaining businesses of Sears Holdings.

No action will be required of you to receive shares of Class A Common Stock and Preferred Stock, which means that:

 

•

no vote of Sears Holdings shareholders is required in connection with this Distribution and we are not asking you for a proxy and you are requested not to send us a proxy;

 

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you will not be required to pay for the shares of our Class A Common Stock and Preferred Stock that you receive in the Distribution; and

 

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you do not need to surrender or exchange any of your Sears Holdings shares in order to receive shares of our Class A Common Stock and Preferred Stock, or take any other action in connection with the spin-off.

There is currently no trading market for our Class A Common Stock or Preferred Stock. We intend to list our Class A Common Stock on the NASDAQ Capital Market under the symbol “OSH” and to quote our Preferred Stock on the OTCQB, and expect that trading for both will begin the first trading day after the completion of the Distribution. We do not plan to have a “when-issued” market for our Class A Common Stock or Preferred Stock prior to the Distribution.

All share and per share information relating to our capital stock in this prospectus reflects the 6 to 1 stock split, which became effective on December 8, 2011.

In reviewing this Prospectus, you should carefully consider the matters described under “Risk Factors” beginning on page 22 for a discussion of certain factors that should be considered by recipients of our Class A Common Stock and Preferred Stock.

 

 

NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR DETERMINED IF THIS PROSPECTUS IS TRUTHFUL OR COMPLETE. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.

This Prospectus does not constitute an offer to sell or the solicitation of an offer to buy any securities.

 

 

The date of this Prospectus is December 12, 2011.

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TABLE OF CONTENTS

 

Summary			1
Questions and Answers About the Company and the Spin-Off			14
Risk Factors			22
Cautionary Statement Concerning Forward-Looking Statements			45
The Spin-Off			47
Dividend Policy			57
Capitalization			58
Selected Historical Consolidated Financial Data			60
Unaudited Pro Forma Consolidated Financial Data			62
Management’s Discussion and Analysis of Financial Condition and Results of Operations			67
Business			89
Management			97
Compensation of Directors			104
Executive Compensation			105
Security Ownership by Certain Beneficial Owners and Management			126
Certain Relationships and Related Party Transactions			130
Description of Our Capital Stock			137
Shares Eligible for Future Sale			146
Use of Proceeds			148
Determination of Offering Price			149
Legal Matters			150
Experts			151
Where You Can Find More Information			152
Index to Consolidated Financial Statements			F-1
Index to Unaudited Interim Condensed Consolidated Financial Statements			F-25

You should not assume that the information contained in this Prospectus is accurate as of any date other than the date set forth on the cover. Changes to the information contained in this Prospectus may occur after that date, and we undertake no obligation to update the information, except in the normal course of our public disclosure obligations and practices.

 

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QUESTIONS AND ANSWERS ABOUT THE COMPANY AND THE SPIN-OFF

Set forth below are commonly asked questions and answers about the spin-off and the transactions contemplated thereby. You should read the section entitled “The Spin-Off” beginning on page 47 of this Prospectus for a more detailed description of the matters described below.

All references in this Prospectus to “Sears Holdings” refer to Sears Holdings Corporation, a Delaware corporation; all references in this Prospectus to “Orchard,” “the Company,” “we,” “us,” or “our” refer to Orchard Supply Hardware Stores Corporation, a Delaware corporation, and its subsidiaries. Throughout this Prospectus, we refer to Sears Holdings’ common stock, $0.01 par value per share, as Sears Holdings common stock or Sears Holdings shares and the holders thereof as the Sears Holdings shareholders; Orchard class A common stock, $0.01 par value per share, as Class A Common Stock; Orchard class B common stock, $0.01 par value per share, as Class B Common Stock; Orchard class C common stock, $0.01 par value per share, as Class C Common Stock; Orchard Series A Preferred Stock, $0.00001 par value per share, as Preferred Stock; the Class A Common Stock, Class B Common Stock and Class C Common Stock together as the common stock; and the Class A Common Stock, Class B Common Stock, Class C Common Stock and Preferred Stock together as the capital stock.

 

Q:	What is the spin-off?

 

A:

The spin-off is the overall transaction of separating Orchard from Sears Holdings, which will be accomplished through a series of transactions that will result in Sears Holdings shareholders owning all of the capital stock of Orchard that is owned by Sears Holdings immediately prior to the Distribution. Immediately prior to the spin-off, the capital stock owned by Sears Holdings will be composed of all of our outstanding Class A Common Stock and Preferred Stock. At the time of the spin-off, the Class A Common Stock will represent approximately 80% of the general voting power of Orchard’s outstanding capital stock and the outstanding shares of Preferred Stock will represent 100% of Orchard’s outstanding nonvoting capital stock. We will authorize the creation of Class C Common Stock, which will not be distributed in the spin-off and will represent approximately 20% of the general voting power of Orchard’s outstanding capital stock. Class A Common Stock owned by ACOF I LLC (“ACOF”) immediately prior to the spin-off will be exchanged for Class C Common Stock. The spin-off will be effected on the distribution date by the pro rata distribution of our Class A Common Stock and Preferred Stock by Sears Holdings to Sears Holdings shareholders, except that holders of unvested shares of restricted stock of Sears Holdings will receive cash in lieu of shares.

At the time of the spin-off, we will also have issued and outstanding shares of our Class B Common Stock, which will not be distributed in the spin-off. Our outstanding shares of Class B Common Stock are held by certain former employees of Orchard who acquired such shares of Class B Common Stock in connection with past equity investment programs of Orchard. Our Class B Common Stock is also the class of capital stock underlying options granted to certain employees prior to the date of the spin-off. At the time of the spin-off, the Class B Common Stock represents less than 0.5% of the voting power of Orchard. At the time of the spin-off, all of our Class C Common Stock will be held by ACOF, a wholly owned subsidiary of Ares Corporate Opportunities Fund, L.P., an affiliate of Ares Management LLC (“Ares Management”).

 

Q:	What is Orchard?

 

A:

We are a California specialty retailer primarily focused on the consumer segment of the home improvement market. Our stores are designed to appeal to convenience-oriented customers, whose purchase occasions are largely driven by their home repair, maintenance and improvement needs throughout the home, garden and outdoor living areas. As of July 30, 2011, we operated 89 full-service hardware stores in California. We opened four new stores in California within the past three years—one in 2010, two in 2009, and one in 2008. Our stores average approximately 43,600 square feet of enclosed space, plus approximately 8,300 square feet of nursery and garden area. Our stores carry a broad assortment of repair and maintenance, lawn and garden and in-home products.

 

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We were originally formed as a purchasing cooperative by a group of farmers in California’s Santa Clara Valley. We opened for business on March 1, 1931 with a single store in San Jose, California and we were incorporated in Delaware on March 31, 1989. In 1996, we were acquired by Sears Roebuck, which is now a wholly owned subsidiary of Sears Holdings. We conduct substantially all our operations through Orchard Supply Hardware LLC, our direct wholly owned subsidiary. Our principal executive offices are located at 6450 Via Del Oro, San Jose, California 95119 and our telephone number is (408) 281-3500. Our website address is www.osh.com.

Following the Distribution, we will be a publicly traded company independent from Sears Holdings, and Sears Holdings will not retain any ownership interest in us. However, we anticipate that immediately following the Distribution, ESL, which currently owns approximately 61% of Sears Holdings common stock, will own approximately 61% of our outstanding Class A Common Stock, representing approximately 61% of Class A Common Stock voting power and approximately 49% of the general voting power of our outstanding capital stock. Following the spin-off, ESL will also own approximately 61% of our outstanding Preferred Stock, which is our outstanding nonvoting capital stock. As a result of ESL holding more than 50% of our voting power for the election of eight of ten directors immediately after the consummation of the Distribution, we may qualify as a “controlled company” under the Nasdaq Marketplace rules, which would allow us to rely on exemptions from certain corporate governance requirements otherwise applicable to Nasdaq-listed companies. However, we do not currently intend to rely on such exemptions.

In connection with the Distribution, we have entered into or will enter into various agreements with Sears Holdings which, among other things, (i) govern the principal transactions relating to the Distribution and certain aspects of our relationship with Sears Holdings following the spin-off, (ii) establish terms under which Sears Holdings will provide us with certain transition services, (iii) establish terms pursuant to which we may sell certain appliances and related protection agreements supplied to us by Sears Holdings on a consignment basis and (iv) establish terms pursuant to which we may acquire and sell certain Sears Holdings proprietary branded merchandise. These agreements were made or will be made in the context of a parent-subsidiary relationship and were or will be negotiated in the overall context of our separation from Sears Holdings. The terms of these agreements may be more or less favorable than those we could have negotiated with unaffiliated third parties. However, these agreements generally incorporate arm’s length terms and conditions, including market-based pricing and term of duration. For more information regarding the agreements between us and Sears Holdings or Sears Roebuck, as applicable, see “Certain Relationships and Related Party Transactions—Agreements with Sears Holdings” in this Prospectus.

 

Q:	What are the reasons for the spin-off?

 

A:

Sears Holdings’ board of directors has determined that pursuing a disposition of Orchard through a spin-off is in the best interests of Sears Holdings and its shareholders, and that separating Orchard from Sears Holdings would provide, among other things, financial, operational and managerial benefits to both Orchard and Sears Holdings, including but not limited to the following expected benefits:

 

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Strategic Focus and Flexibility. Sears Holdings’ board of directors believes that following the spin-off, Orchard and Sears Holdings will each have more focused businesses and be better able to dedicate resources to pursue appropriate growth opportunities and execute strategic plans best suited to their respective businesses without regard for the other and in a more efficient manner.

 

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Focused Management. The spin-off will allow management of each company to devote its time and attention to the development and implementation of corporate strategies and policies that are based primarily on the specific business characteristics of the respective companies, and to design more tailored compensation structures that better reflect these strategies, policies, and business characteristics. In particular, in the case of Orchard, separate equity-based compensation arrangements should more closely align the interests of management with the interests of shareholders and more directly incentivize the employees of Orchard, which will allow Orchard to more efficiently recruit and retain such employees.

 

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Investor Choice. Sears Holdings’ board of directors believes that the spin-off is expected to increase investor understanding of Orchard and its market position within its industry, while also allowing for a more natural and interested investor base. Separating Orchard from Sears Holdings also allows investors to make independent decisions with respect to each of Sears Holdings and Orchard based on, among other factors, their different business models, strategies and industries. The spin-off will enable Sears Holdings to distribute its holdings of Orchard to its shareholders while allowing it to focus on its remaining business going forward.

 

Q:	Why is the separation of Orchard structured as a spin-off?

 

A:	Sears Holdings believes that a tax-free distribution of our Class A Common Stock and Preferred Stock for U.S. federal income tax purposes is the most efficient way to separate our business from Sears Holdings in a manner that will improve flexibility and benefit both Sears Holdings and us.

 

Q:	What will I receive in the spin-off?

 

A:

As a holder of Sears Holdings common stock, you will receive a distribution of one share of our Class A Common Stock and one share of our Preferred Stock for every 22.141777 shares of Sears Holdings common stock held by you on the record date for the Distribution. Your proportionate ownership interest in Sears Holdings will not change as a result of the Distribution. For a more detailed description, see “The Spin-Off” in this Prospectus.

 

Q:	What is being distributed in the spin-off?

 

A:

Approximately 4,806,000 shares of our Class A Common Stock and 4,806,000 shares of our Preferred Stock will be distributed in the spin-off, based on the number of shares of Sears Holdings common stock outstanding as of the record date. The Class A Common Stock will represent approximately 80% of the general voting power of Orchard’s outstanding capital stock and the outstanding shares of Preferred Stock will represent 100% of Orchard’s outstanding nonvoting capital stock. For more information on the shares being distributed in the spin-off, see “Description of Our Capital Stock” in this Prospectus.

 

Q:	What is the Preferred Stock?

 

A:	Terms of the Preferred Stock include the following:

 

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Liquidation Preference. In the event of any liquidation, dissolution or winding up of Orchard, whether voluntary or involuntary, before any payment or distribution of Orchard’s assets is made to or set apart for the holders of Class A Common Stock, Class B Common Stock or Class C Common Stock, but after any payments or distributions are made on, or set apart for, any of Orchard’s indebtedness and to holders of any stock then outstanding that ranks senior to the Preferred Stock, holders of the Preferred Stock are entitled to receive an amount per share equal to approximately $4.16, but shall not be entitled to any further payment or other participation in any distribution of the assets of Orchard.

 

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Dividends. The terms of the Preferred Stock do not entitle the holders thereof to any dividends, and we do not expect to pay any cash dividends on any shares of our capital stock, including the Preferred Stock. The terms of the Certificate of Designation of the Preferred Stock will provide that dividends and other distributions may not be paid on any shares of our capital stock until all outstanding shares of the Preferred Stock have been redeemed in accordance with the terms of the Certificate of Designation or otherwise repurchased unless such dividend or distribution (i) has been unanimously approved by our board of directors, (ii) relates to a “poison pill” stockholder rights plan or (iii) is a distribution of cash in lieu of fractional shares made in connection with this Distribution.

 

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Repurchase/Redemption. All, but not less than all, of the then-outstanding shares of Preferred Stock may be redeemed at a redemption price per share of Preferred Stock in cash equal to approximately $4.16 upon a date and time, or the happening of an event, determined by the affirmative vote of a

 

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majority of our board of directors and, (i) for so long as ACOF and its permitted transferees hold Class B Common Stock and Class C Common Stock representing at least 15% of our outstanding common stock (calculated without reference to any shares of capital stock issued or issuable after the Distribution), such vote must include the vote of at least one director elected by the holders of the Class B Common Stock and the Class C Common Stock and (ii) for so long as ESL holds more shares of our common stock than ACOF, such vote must include a non-management director elected by the holders of the Class A Common Stock who shall be designated by a majority vote of the directors elected by the holders of the Class A Common Stock. In addition, to the extent not prohibited by law, Orchard may, at any time and from time to time, repurchase in the open market, in privately negotiated transactions or through tender offers or other transactions any amount of the then outstanding shares of Preferred Stock that it desires to repurchase at such sums and on such conditions as shall be negotiated between or among Orchard and one or more holders of Preferred Stock. The terms of the Preferred Stock will provide that no shares of our capital stock, other than our Preferred Stock, may be redeemed, repurchased or otherwise acquired by us until all outstanding shares of the Preferred Stock have been redeemed or otherwise repurchased unless such redemption or repurchase (i) is made in connection with an employee incentive or benefit plan or other compensatory arrangement, (ii) has been unanimously approved by our board of directors, (iii) relates to a “poison pill” stockholder rights plan or (iv) is a distribution of cash in lieu of fractional shares made in connection with this Distribution.

 

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Conversion. The Preferred Stock will not be convertible into shares of Common Stock or any other security of Orchard.

 

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Voting. Except as required by law, the Preferred Stock does not entitle the holders thereof to vote on any matter submitted for shareholder action, and the consent of the holders thereof is not required for the taking of any corporate action, provided that the terms of the Certificate of Designation of the Preferred Stock shall not, by merger, consolidation or otherwise, be amended, waived, altered or repealed without the affirmative vote of the holders of a majority of the voting power of the Preferred Stock, voting as a separate class.

For more information on the Preferred Stock being distributed in the spin-off, see “Description of Our Capital Stock” in this Prospectus.

 

Q:	What is the record date for the Distribution?

 

A:	Record ownership will be determined as of the close of business on December 16, 2011, which we refer to as the record date.

 

Q:	When will the Distribution occur?

 

A:	The distribution date of the spin-off is expected to be December 30, 2011. We expect that it will take the distribution agent up to ten business days after the distribution date to fully distribute the shares of our Class A Common Stock and Preferred Stock to Sears Holdings shareholders.

 

Q:	What do Sears Holdings shareholders need to do to participate in the Distribution?

 

A:

Nothing, but we urge you to read this document carefully. Shareholders who hold Sears Holdings common stock as of the record date will not be required to take any action to receive our Class A Common Stock and Preferred Stock in the Distribution or a cash payment in respect to any fractional shares you are otherwise entitled to as a result of the Distribution. No shareholder approval of the Distribution is required or sought. You will not be required to make any payment, surrender or exchange any of your shares of Sears Holdings common stock or to take any other action to participate in the Distribution. For more information on the treatment of fractional shares see “Q: How will fractional shares be treated in the spin-off” below.

 

Q:	What will happen to the listing of Sears Holdings shares?

 

A:	Nothing. Sears Holdings shares will continue to be traded on the NASDAQ Global Select Market under the symbol “SHLD.”

 

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Q:	Will the spin-off affect the trading price of my Sears Holdings common stock?

 

A:

The trading price of Sears Holdings common stock immediately following the Distribution may be lower than immediately prior to the Distribution because the trading price will no longer reflect the value of the Class A Common Stock and Preferred Stock of Orchard that is being spun-off in the Distribution. Furthermore, until the market has fully analyzed the value of Sears Holdings without Orchard, the price of Sears Holdings common stock may fluctuate.

In addition, it is also anticipated that, as early as two trading days prior to the record date and continuing up to and including the distribution date, there will be two markets in Sears Holdings common stock: a “regular-way” market and an “ex-distribution” market. Sears Holdings common stock that trades on the regular-way market will trade with an entitlement to shares of Orchard Class A Common Stock and Preferred Stock distributed pursuant to the Distribution. Shares that trade on the ex-distribution market will trade without an entitlement to shares of Orchard Class A Common Stock and Preferred Stock distributed pursuant to the Distribution. See “The Spin Off—Trading Prior to the Distribution Date” in this Prospectus for more information.

 

Q:	What if I want to sell my Sears Holdings common stock or my shares of Class A Common Stock and/or Preferred Stock?

 

A:

You should consult with your financial advisors, such as your stockbroker, bank or tax advisor. Neither Sears Holdings nor Orchard makes any recommendations on the purchase, retention or sale of Sears Holdings common stock or the shares of Class A Common Stock and Preferred Stock to be distributed in the spin-off.

If you decide to sell any shares before the Distribution, you should make sure your stockbroker, bank or other nominee understands whether you want to sell your Sears Holdings common stock or the shares of Class A Common Stock and Preferred Stock you will receive in the Distribution. If you sell your Sears Holdings common stock in the “regular-way” market up to and including the distribution date, you will be selling your right to receive shares of Class A Common Stock and Preferred Stock in the Distribution. If you own Sears Holdings common stock at the close of business on the record date and sell those shares on the “ex-distribution” market up to and including the distribution date, you will still receive the shares of Class A Common Stock and Preferred Stock that you would be entitled to receive in respect of the Sears Holdings common stock you owned at the close of business on the record date. See “The Spin-Off—Trading Prior to the Distribution Date” in this Prospectus for more information.

 

Q:	How will Sears Holdings distribute shares of our Class A Common Stock and Preferred Stock?

 

A:

Holders of Sears Holdings common stock on the record date (except for holders of unvested shares of restricted stock of Sears Holdings, who will receive cash in lieu of shares) will receive shares of Class A Common Stock and Preferred Stock in book-entry form. See “The Spin-Off—Manner of Effecting the Spin-Off” in this Prospectus for a more detailed explanation.

 

Q:	How will fractional shares be treated in the spin-off?

 

A:

No fractional shares will be distributed to holders of Sears Holdings common stock in connection with the spin-off. Instead, the distribution agent will aggregate all fractional shares into whole shares and sell the whole shares in the open market at prevailing market prices. The distribution agent will then distribute the aggregate cash proceeds of the sales, net of brokerage fees and other costs, pro rata to each Sears Holdings shareholder who would otherwise have been entitled to receive a fractional share in the Distribution. Accordingly, if you hold fewer than 22.141777 shares of Sears Holdings common stock as of the record date, you will not receive any shares of our Class A Common Stock or Preferred Stock; however, you will receive a cash distribution from our distribution agent representing the proceeds from the sale of the fractional shares to which you are entitled, net of brokerage fees and other costs. See “The Spin-Off—Manner of Effecting the Spin-Off” in this Prospectus for a more detailed explanation. The receipt of cash in

 

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lieu of fractional shares generally will be taxable to the recipient shareholders that are subject to U.S. federal income tax as described in “The Spin-Off—Material U.S. Federal Income Tax Consequences of the Spin-Off.”

 

Q:	What are the U.S. federal income tax consequences of the spin-off?

 

A:

Sears Holdings has received an IRS Ruling substantially to the effect that, for U.S. federal income tax purposes, the Distribution, except for any cash received in lieu of a fractional share of our Class A Common Stock and Preferred Stock, will qualify as tax-free under Section 355 of the Internal Revenue Code of 1986, as amended (the “Code”). The IRS Ruling also provides that certain internal transactions undertaken in anticipation of the Distribution will qualify for favorable treatment under the Code. In addition to obtaining the IRS Ruling, Sears Holdings expects to receive an opinion from the law firm of Simpson Thacher & Bartlett LLP as to the satisfaction of certain requirements necessary for the spin-off to receive tax-free treatment under Section 355 of the Code upon which the Internal Revenue Service will not rule. The receipt by Sears Holdings of the opinion and the continued validity of the IRS Ruling are conditions to effecting the spin-off. The tax consequences of the Distribution are described in more detail below under “The Spin-Off—Material U.S. Federal Income Tax Consequences of the Spin-Off.”

Each Sears Holdings shareholder is urged to consult his, her or its tax advisor as to the specific tax consequences of the Distribution to that shareholder, including the effect of any state, local or non-U.S. tax laws and of changes in applicable tax laws.

 

Q:	Does Orchard intend to pay cash dividends?

 

A:

We do not expect to pay any cash dividends on the Class A Common Stock, Preferred Stock or any other shares of our capital stock for the foreseeable future. The terms of the Certificate of Designation of the Preferred Stock will provide that dividends and other distributions may not be paid on any shares of our capital stock until all outstanding shares of the Preferred Stock have been redeemed or repurchased unless such dividend or distribution (i) has been unanimously approved by our board of directors, (ii) relates to a “poison pill” stockholder rights plan or (iii) is a distribution of cash in lieu of fractional shares made in connection with this Distribution. In addition, the terms of the Preferred Stock do not entitle the holders thereof to any dividends. The loan documents relating to our Senior Secured Credit Facility, our Senior Secured Term Loan and our Real Estate Secured Term Loan also restrict our ability to make distributions with respect to and to repurchase our capital stock and the capital stock of certain of our subsidiaries. The loan documents contain customary exceptions, including the ability to make distributions with additional shares of capital stock and to repurchase stock in accordance with benefit plans for our management and employees.

 

Q:	How will the Class A Common Stock and Preferred Stock trade?

 

A:

Currently, there is no public market for our Class A Common Stock and Preferred Stock. We intend to list our Class A Common Stock on the NASDAQ Capital Market under the symbol “OSH” and to quote our Preferred Stock on the OTCQB, and expect that trading for both will begin the first trading day after the completion of the Distribution. We do not plan to have a “when-issued” market for our Class A Common Stock or Preferred Stock prior to the Distribution. “When-issued” trading in the context of a spin-off refers to a transaction effected on or before the distribution date and made conditionally because the securities of the spun-off entity have not yet been distributed. On the first trading day following the distribution date, we expect that “regular-way” trading will begin. “Regular-way” trading refers to trading after the security has been distributed and typically involves a trade that settles on the third full trading day following the date of the sale transaction. See “The Spin-Off—Trading Prior to the Distribution Date” in this Prospectus for more information. We cannot predict the trading prices for our Class A Common Stock and Preferred Stock or whether an active trading market for either security will develop. See “Risk Factors—Risks Related to Our Class A Common Stock and Preferred Stock and the Distribution” and “Risk Factors—Risks Related to Our Class A Common Stock and Preferred Stock and the Securities Market.”

 

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Q:	What is the OTCQB?

 

A:

We expect that the Preferred Stock will be quoted on the OTCQB. These are quotation services that display real-time quotes, last-sale prices, and volume information in over-the-counter (“OTC”) equity securities. An OTC equity security generally is any equity that is not listed or traded on a national securities exchange such as NASDAQ.

The OTCQB is only a quotation medium, not an issuer listing service, and should not be confused with The NASDAQ Stock Market. Market makers for OTCQB securities generally are required only to match up willing buyers and sellers. Generally, market makers are not required to purchase securities directly from willing sellers or sell securities directly to willing buyers. For this and other reasons, the trading markets for OTC equity securities are generally significantly less liquid than the trading markets for securities listed on a national securities exchange or authorized for quotation on The NASDAQ Stock Market and, therefore, there may be a substantial delay in execution of trades.

 

Q:	Do I have appraisal rights?

 

A:	No. Holders of Sears Holdings common stock are not entitled to appraisal rights in connection with the spin-off.

 

Q:	How will the spin-off affect the Sears Holdings stock fund of the Orchard Supply Hardware Retirement Savings Plan?

 

A:

Orchard employees were previously eligible to participate under the Sears Holdings 401(k) Savings Plan. Effective July 18, 2011, Orchard established the Orchard Supply Hardware Retirement Savings Plan (the “Orchard Savings Plan”). The account balances of our employees, including any shares of Sears Holdings common stock held in the Sears Holdings Stock Fund under the Sears Holdings 401(k) Savings Plan, were transferred by a trust to trust transfer from the Sears Holdings 401(k) Savings Plan to the Orchard Savings Plan on August 4, 2011, and under the Orchard Savings Plan this is a closed fund. Based on the record date for the Distribution, the trust of the Orchard Savings Plan will receive on the distribution date one share of our Class A Common Stock and one share of our Preferred Stock for every 22.141777 shares of Sears Holdings common stock held in the Sears Holdings Stock Fund under the Orchard Savings Plan. The Orchard Savings Plan fiduciary will direct the trustee of the trust of the plan to take steps to liquidate the Orchard shares in an expeditious and prudent manner and then to allocate the proceeds in the same manner as a cash dividend under the Sears Holdings Stock Fund of the plan.

Participants of the Orchard Savings Plan are no longer permitted to make new purchases of Sears Holdings common stock through their plan accounts. As to those shares of the Sears Holdings common stock held by the Orchard Savings Plan at the time of the Distribution, participants may direct that the shares be exchanged for a different investment alternative in accordance with plan terms or may decide to remain invested in the shares until such time as the applicable plan fiduciary decides that the Orchard Savings Plan will no longer permit any investment in Sears Holdings common stock. At that time, the plan will dispose of all remaining Sears Holdings shares held in participant accounts and invest the proceeds in another investment alternative to be determined by the plan fiduciary. (This will not prohibit diversified, collectively managed investment alternatives available under the Orchard Savings Plan from holding Sears Holdings common stock or prohibit Orchard Savings Plan participants using self-directed accounts, if available, from investing these accounts in Sears Holdings common stock).

 

Q:	How will the spin-off affect the Sears Holdings stock funds of the other employees in the company-sponsored savings plan sponsored within the Sears Holdings controlled group of corporations?

 

A:	Current and former Sears Holdings employees hold Sears Holdings stock under the Sears Holdings Stock Fund in an account under the Sears Holdings 401(k) Savings Plan, the Sears Puerto Rico Savings Plan, the

 

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Kmart Retirement Savings Plan for Puerto Rico Employee or the Lands’ End, Inc. Retirement Plan (collectively, the “Savings Plans,” which excludes the Orchard Savings Plan). Based on the record date for the Distribution, the trust of each Savings Plan will receive on the distribution date one share of our Class A Common Stock and one share of our Preferred Stock in the Distribution for every 22.141777 shares of Sears Holdings common stock held in the Sears Holdings Stock Fund under the applicable Savings Plan. The applicable Savings Plan fiduciary for each Savings Plan will direct the applicable trustee or custodian of the trust of such plan to take steps to liquidate the Orchard shares in an expeditious and prudent manner and then to allocate the proceeds in the same manner as a cash dividend under the Sears Holdings Stock Fund of such plan.

 

Q:	Are there risks associated with owning the Class A Common Stock and Preferred Stock?

 

A:

Our business is subject to both general and specific risks and uncertainties relating to our business. Our business is also subject to risks relating to the spin-off. Following the spin-off, we will also be subject to risks relating to being a publicly traded company independent from Sears Holdings. Accordingly, you should read carefully the information set forth in the section entitled “Risk Factors” beginning on page 22 of this Prospectus.

 

Q:	Can Sears Holdings decide to cancel the Distribution or modify its terms even if all conditions to the Distribution have been met?

 

A:

Yes. Although the Distribution is subject to the satisfaction or waiver of certain conditions, Sears Holdings has the right to terminate the Distribution at any time prior to the distribution date (even if all such conditions are satisfied). Also, Sears Holdings may modify or change the terms of the Distribution, including by accelerating or delaying the timing of the consummation of all or part of the Distribution.

 

Q:	Where can I get more information?

 

A:	If you have any questions relating to the mechanics of the Distribution, you should contact the distribution agent at:

Wells Fargo Bank, N.A.

Shareowner Services

161 North Concord Exchange

South St. Paul, MN 55075-1139

Attn: Account Management

Phone: (800) 468-9716

Fax: (651) 450-4078

 

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RISK FACTORS

You should carefully consider the risks described below, together with all of the other information included in this Prospectus, in evaluating the Company and our Class A Common Stock and Preferred Stock. The following risk factors could adversely affect our business, results of operations, financial condition and stock price.

Risks Relating to Our Business

If we fail to offer merchandise and services that our customers want, our revenues may be limited, which would reduce our revenues and profits.

In order for our business to be successful, we must identify, obtain supplies of, and offer to our customers attractive, innovative and high-quality merchandise on a continuous basis. Our products and services must satisfy the desires of our customers, whose preferences may change in the future. If we misjudge either the demand for products and services we sell or our customers’ purchasing habits and tastes, we may be faced with excess inventories of some products and missed opportunities for products and services we chose not to offer. In addition, our revenues may decline or we may be required to sell the merchandise we have obtained at lower prices. This would have a negative effect on our business and results of operations.

The home improvement retail industry is highly competitive and we may be unable to compete effectively.

If we are unable to compete effectively in the highly competitive home improvement retail industry, our business and our results of operations could be materially adversely affected. The home improvement retail industry is highly competitive with few barriers to entry. We compete against a diverse group of retailers, both small and large, including warehouse home centers and local hardware stores. We consider The Home Depot, Lowe’s, Ace Hardware and True Value as our primary competitors. Based on publically available information, we believe that in California each of The Home Depot, Ace Hardware and True Value currently has between two to three times as many stores as we do and that Lowe’s has, by number of stores, over 20% more stores in the state than we do. Some of our competitors are actively engaged in new store expansion. Discount retailers such as Walmart, Target and Kmart, and multi-line retailers such as Sears Roebuck, also compete with us in certain product areas. In addition, our garden centers compete against smaller local nurseries. Online and catalog businesses, which handle similar lines of merchandise, also compete with us. Many of our competitors have a larger number of stores, more products available online, substantially greater financial, distribution and marketing resources, larger market shares and a more widespread, national presence. Such factors may provide our competitors with greater financial resources to expand, grow and allow for stronger relationships and aggressive pricing with vendors and third party suppliers. Furthermore, some of our competitors have been aggressively building new stores in locations with high concentrations of our stores and in locations we have targeted for expansion. We expect that as the home improvement retail industry market grows, new competitors will enter the market and competition from established companies will increase.

In addition to competition from Sears Roebuck’s full-line stores, Sears Holdings also owns, franchises and authorizes dealers to operate specialty retail stores, which have product lines that are similar to ours. Following the spin-off, Sears Holdings will not be restricted from competing with us or from opening new Sears Roebuck, Kmart or specialty stores in our markets or in locations we have targeted for expansion.

Our success depends on our ability to differentiate ourselves from our competitors and remain competitive with respect to shopping convenience, merchandise in-stock availability and customer service. The performance of our competitors, as well as changes in their pricing policies, marketing activities, new store openings and other business strategies, could have a material adverse effect on our business, financial condition and results of operations.

 

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Our business has been and will continue to be affected by worldwide economic conditions and, in particular, California economic conditions; a failure of the economy to sustain its recovery, a renewed decline in consumer-spending levels and other conditions, including inflation, could lead to reduced revenues and gross margins, and negatively impact our liquidity.

Many economic and other factors are outside of our control, including consumer and commercial credit availability, consumer confidence and spending levels, inflation, employment levels, housing sales and remodels, consumer debt levels, fuel costs and other challenges currently affecting the global economy, the full impact of which on our business, results of operations and financial condition cannot be predicted with certainty. The California economy, in particular, has recently been susceptible to slowdowns and recessions. These economic conditions adversely affect the disposable income levels of, and the credit available to, our customers, which could lead to reduced demand for our merchandise. Also affected are our vendors, upon which we depend to provide us with financing on our purchases of inventory and services. Our vendors could seek to change either the availability of vendor credit to us or other terms under which they sell to us, or both, which could negatively impact our liquidity. In addition, the inability of vendors to access liquidity, or the insolvency of vendors, could lead to their failure to deliver inventory or other services. Certain of our vendors also are experiencing increases in the cost of various raw materials, such as copper, steel and resin, which could result in increases in the prices that we pay for merchandise, particularly in our plumbing, industrial and electrical categories.

In addition to credit terms from vendors, our liquidity needs are funded by our operating cash flows and, to the extent necessary, borrowings under our credit agreements. The availability of financing depends on numerous factors, including economic and market conditions, our credit ratings, and lenders’ assessments of our prospects and the prospects of the retail industry in general. The lenders under our credit facilities may not be able to meet their commitments if they experience shortages of capital and liquidity and there can be no assurance that our ability to otherwise access the credit markets will not be adversely affected by changes in the financial markets and the global economy.

Continued high rates of unemployment, depressed home prices, reduced access to credit and the domestic and international political situation also adversely affect consumer confidence. Low consumer confidence and the threat, outbreak, or escalation of terrorism, military conflicts or other hostilities may lead to reduced consumer spending, particularly by our customers on many of the discretionary items we sell that relate to home and garden improvement projects. These factors could cause us to increase inventory markdowns and promotional expenses, thereby reducing our gross margins and operating results.

If we do not successfully manage our inventory levels, our operating results will be adversely affected.

We must maintain sufficient inventory levels to operate our business successfully. However, we also must guard against accumulating excess inventory as we seek to minimize out-of-stock levels across all product categories and to maintain in-stock levels. We obtain a portion of our inventory from vendors located outside the United States. Some of these vendors often require lengthy advance notice of our requirements in order to be able to supply products in the quantities we request. This usually requires us to order merchandise, and enter into purchase orders for the purchase and manufacture of such merchandise, well in advance of the time these products will be offered for sale. As a result, we may experience difficulty in responding to a changing retail environment. If we do not accurately anticipate the future demand for a particular product or the time it will take to obtain new inventory, our inventory levels will not be appropriate and our results of operations may be negatively impacted.

Adverse changes in economic factors specific to the home improvement industry may negatively impact the rate of growth of our revenues and comparable store sales.

Sales of many of our product categories and services are driven by housing turnover and activity level of home and garden improvement projects. The expiration of government stimulus programs specific to the housing sector during the second half of fiscal 2010 may adversely affect the rate of housing turnover. Steep declines over recent years in home prices, the increasing number of households with negative equity, increasing mortgage

 

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delinquency and foreclosure rates, reduction in the availability of mortgage financing, fluctuations in interest rates on variable rate mortgages, fewer housing starts and significantly lower housing turnover have limited and may continue to limit consumers’ discretionary spending and have diminished consumer confidence levels which in turn has adversely affected consumer spending on home and garden improvement projects. The impact of these economic factors specific to the home and garden improvement industry is exacerbated by what is expected to be a gradual and prolonged period of economic recovery with slow employment growth. We believe that these economic conditions were a contributing factor in our year-over-year decline in revenues of $21.7 million, $79.1 million and $73.3 million for fiscal 2010, 2009 and 2008, respectively.

Our revenues may fluctuate for a variety of reasons, which could adversely affect our results of operations.

Our business is sensitive to customers’ spending patterns, which in turn are subject to prevailing economic conditions. Our revenues and results of operations have fluctuated in the past, and we expect them to continue to fluctuate in the future. A variety of other factors affect our revenues and financial performance, including:

 

•

actions by our competitors, including opening of new stores in our existing markets or changes to the way these competitors go to market online;

 

•

seasonal fluctuations due to weather conditions;

 

•

timing and concentration of new store openings and related pre-opening and other start-up costs;

 

•

changes in our merchandise strategy and mix;

 

•

changes in population and other demographics; and

 

•

timing and frequency of our promotional and discounting events.

Accordingly, our results for any one quarter are not necessarily indicative of the results to be expected for any other quarter, and comparable store sales for any particular future period may increase or decrease. For more information on our results of operations, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Prospectus.

Extended cold or wet weather in California, particularly in the spring, can have an adverse effect on our operating results.

The sale of a substantial portion of our merchandise depends upon our customers undertaking repair, maintenance and improvement projects in their home and garden. We believe that our customers are more likely to begin such projects during periods of warm and dry weather. Accordingly, we have historically realized a significant portion of our revenues and earnings for the year in the spring selling season, which includes March, April, May and June. In 2009 and 2010, we generated 29% and 30% of our revenues in the second fiscal quarter, respectively. Wet, windy and/or cold weather conditions can reduce foot traffic in our stores. Extended cold or wet weather conditions in California, particularly during the spring months, can significantly reduce our revenues and have a material adverse effect on our results of operations. For example, we believe unseasonably cold and wet weather in March of 2011 had an adverse impact on sales, particularly of our lawn and garden products. Furthermore, lower than anticipated revenues during the spring selling season may cause us to increase inventory markdowns and promotion expenses, thereby reducing our gross margins and operating results.

If we are unable to obtain suitable replacement financing upon the maturing of our existing financing arrangements, our business and results of operations could be adversely affected.

Our business and results of operations depend substantially on our ability to obtain financing for our operations. We currently have the following secured financing arrangements:

 

•

a Senior Secured Credit Facility with a revolving availability up to $120 million, subject to a borrowing base, $20 million of which expires on December 21, 2011 with the remainder expiring on December 21, 2013;

 

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•

a $200 million Senior Secured Term Loan which matures on December 21, 2013; and

 

•

a $50 million Real Estate Secured Term Loan which matures on December 21, 2013.

Current economic conditions have generally adversely impacted the availability, cost and terms of debt financing. There can be no assurance that we will be able to replace our existing financing upon the maturity of our Senior Secured Credit Facility, Senior Secured Term Loan and Real Estate Secured Term Loan on commercially acceptable terms, or at all. If we are not able to renew or replace our existing financial arrangements when they become due, our costs for borrowings will likely increase and our revenues may decrease, or we could be precluded from continuing our operations at current levels. If we are unable to refinance our Senior Secured Credit Facility, Senior Secured Term Loan and Real Estate Secured Term Loan prior to their respective maturity dates, we cannot guarantee that we will generate enough cash flow from operations or be able to obtain enough capital to repay our outstanding indebtedness on such dates. In such event, we may need to close or sell stores, sell assets, reduce the number and/or frequency of store openings and improvements, issue capital stock or securities convertible into capital stock or issue debt securities to repay our indebtedness. If implemented, these actions could negatively impact our business, operating results or dilute our capital stock.

If we are unable to comply with the terms of our Senior Secured Credit Facility, Senior Secured Term Loan or Real Estate Secured Term Loan, our business and financial condition would be negatively impacted.

As of October 29, 2011, we were in compliance with the financial covenants under our financing arrangements, and we currently believe that we will continue to be in compliance with these covenants through at least the end of the third quarter of fiscal 2012. However, the decline in our operating results for the first three quarters of fiscal 2011, coupled with continued economic weakness in the markets in which we operate, may adversely impact our prospective compliance with the financial covenants under the Senior Secured Term Loan and the Real Estate Secured Term Loan. During the three months ended October 29, 2011 (i) we entered into the Appliances Agreement with a subsidiary of Sears Holdings that we had planned to enter into at the Distribution and (ii) we entered into a sale and lease-back transaction with respect to our distribution center located in Tracy, California. In addition, through our subsidiaries, we expect to sell one of our stores and concurrently enter into a short term lease agreement with respect to the property. We also intend, through our subsidiaries, to sell three other stores to another purchaser and concurrently enter into long-term leases for the properties. These sale-leaseback transactions have been approved by our board of directors but the transactions have not yet closed, and there can be no assurance that they will actually be consummated. We expect the long-term sale-leaseback transaction to generate tenant improvement allowances to help update the stores to enhance the shopping experience for our customers. We intend to use a portion of the net proceeds to pay-down our Senior Secured Term Loan and Real Estate Secured Term Loan, and we also are approaching the lenders under our existing financing arrangements to discuss, among other things, the extension of the maturity date under our Senior Secured Term Loan, improved terms of the financial covenants under our Senior Secured Term Loan and Real Estate Secured Term Loan, and certain technical amendments under each of our Senior Secured Term Loan, Real Estate Secured Term Loan and Senior Secured Credit Facility. For more information regarding our compliance with our financial covenants, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Analysis of Financial Condition” in this Prospectus. Notwithstanding these actions, the Company continues to examine a number of alternatives with respect to future compliance and liquidity, including asset sales and/or sale-leaseback transactions. In addition, if necessary or advisable, we may seek to strengthen our financial position by monetizing additional owned store properties or by seeking to renegotiate our financing arrangements in order to remain in compliance while continuing to follow our current business plan, which includes plans for store expansion. In such case, if such renegotiations were necessary but unsuccessful, we would expect to modify our business plan in a manner that would allow us to remain in compliance. Such a modification could result in slower growth, a delay of new store openings and the potential for a decline in sales. Notwithstanding our expectations, if our operating results were to continue to decline or if market conditions were to worsen, we may be unable to meet our financial covenants, and lenders could demand repayment of the amounts outstanding under our financing agreements. Under such circumstances, no assurances

 

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can be given that our financing arrangements could be renegotiated, or that alternative financing would be available on terms acceptable to us, if at all. In addition, any refinancing could be at higher interest rates and may require us to comply with more onerous covenants which could further restrict our business operations.

We may not have sufficient cash to repay our debt obligations on the occurrence of an event of default resulting from a change in control trigger.

Our Senior Secured Credit Facility, Senior Secured Term Loan and Real Estate Secured Term Loan contain an event of default resulting from a change of control default, which includes the following: (i) certain mergers, consolidations, sales or transfers of all or substantially all of the assets of OSH LLC and OSH LLC’s subsidiaries to persons other than ACOF, ESL and Sears Holdings; (ii) adoption of a plan of liquidation of OSH LLC; (iii) prior to an initial underwritten public offering of common stock of the Company, Sears Holdings, ESL and ACOF ceasing to collectively hold directly or indirectly at least 50% of the total voting power of all shares of our and OSH LLC’s voting capital stock; (iv) following an initial underwritten public offering of common stock of the Company, a person or group, other than Sears Holdings, ESL and ACOF, collectively holding directly or indirectly at least 40% of the total voting power of all shares of our and OSH LLC’s voting capital stock and Sears Holdings, ESL and ACOF collectively holding less than such person or group; and (v) our board of directors not consisting of continuing directors (“Change in Control”).

Immediately following the Distribution:

 

•

Sears Holdings will not own any capital stock of the Company;

 

•

ESL will beneficially own approximately 61% of our outstanding shares of Class A Common Stock and approximately 49% of the general voting power of our capital stock; and

 

•

ACOF will beneficially own 100% of our outstanding shares of Class C Common Stock and approximately 20% of the general voting power of our capital stock.

Neither ESL nor ACOF have agreed to maintain their shareholding in the Company following the Distribution. If, following the Distribution, one or both of ESL and ACOF dispose of all or part of their shareholding in the Company such that their combined total voting power drops below 50%, this may trigger a Change in Control event of default under the Senior Secured Credit Facility, Senior Secured Term Loan and Real Estate Secured Term Loan. An event of default could trigger certain acceleration clauses and cause those and our other obligations to become immediately due and payable and we may not have sufficient cash funds available to repay our debt obligations upon such a Change in Control.

Increases in interest rates could adversely affect our operating results.

An increase in prevailing interest rates could adversely affect our operating results. At January 29, 2011, we had approximately $271.5 million aggregate principal amount of variable interest rate indebtedness under our Senior Secured Credit Facility, Senior Secured Term Loan and Real Estate Secured Term Loan. The variable interest rates applicable to this indebtedness are based on several interest rate indexes that fluctuate on a regular basis, including the London Interbank Offered Rate (“LIBOR”) and the prime rate as publicly announced by certain of our lenders and the U.S. federal funds rate. If interest rates increase, our debt service obligations on this variable rate indebtedness would increase even though the amount borrowed would remain the same, and our net income would decrease. As a protection against rising interest rates, we have entered into an interest rate cap agreement with respect to our Real Estate Secured Term Loan with a notional amount of $25 million, capping LIBOR at 4%. The cap agreement does not eliminate interest rate volatility for the remainder of our variable rate indebtedness. In the future, we may enter into interest rate swaps or additional cap contracts to reduce interest rate volatility. The terms of our cap agreement with respect to our Real Estate Secured Term Loan or such additional agreements as we may enter to reduce interest rate volatility, may be unfavorable to us depending on rate movements and may not completely protect us from increased interest expense in particular situations.

 

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Substantial Leverage—Our substantial leverage may place us at a competitive disadvantage in our industry.

We are substantially leveraged and have significant debt service obligations. At July 30, 2011, our outstanding debt (excluding capital leases) was approximately $254.3 million. Our significant debt and debt service requirements could adversely affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities. For example, our high level of debt presents the following risks:

 

•

we are required to use a substantial portion of our cash flow from operations to pay principal and interest on our debt, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, product development efforts, strategic acquisitions, investments and alliances and other general corporate requirements;

 

•

our interest expense could increase if prevailing interest rates increase, because a substantial portion of our debt bears interest at floating rates;

 

•

our substantial leverage increases our vulnerability to economic downturns and adverse competitive and industry conditions and could place us at a competitive disadvantage compared to those of our competitors that are less leveraged;

 

•

our debt service obligations could limit our flexibility in planning for, or reacting to, changes in our business and our industry and could limit our ability to pursue other business opportunities, borrow more money for operations or capital in the future and implement our business strategies;

 

•

our level of debt may restrict us from raising additional financing on satisfactory terms to fund working capital, capital expenditures, product development efforts, strategic acquisitions, investments and alliances, and other general corporate requirements; and

 

•

covenants in our debt instruments limit our ability to pay dividends or make other restricted payments and investments.

Significant Debt Service Requirements—Servicing our debt requires a significant amount of cash and our ability to generate cash may be affected by factors beyond our control.

We may be unable to generate sufficient cash flow from operations or to obtain future borrowings under our credit facilities or otherwise in an amount sufficient to enable us to pay our debt or to fund our other liquidity needs. Our ability to generate cash is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. If we do not have sufficient liquidity, we may need to refinance or restructure all or a portion of our debt on or before maturity, sell assets, or borrow more money, which we may not be able to do on terms satisfactory to us or at all. In addition, any refinancing could be at higher interest rates and may require us to comply with more onerous covenants which could further restrict our business operations. We cannot assure you that our business will generate sufficient cash flow from operations or that future sources of funding will be available to us in amounts sufficient to enable us to fund our liquidity needs. If we are unable to meet our obligations with respect to our debt, we could be forced to restructure or refinance our debt, seek equity financing or sell assets. A default on any of our debt obligations could trigger certain acceleration clauses and cause those and our other obligations to become immediately due and payable. Upon an acceleration of any of our debt, we may not be able to make payments under our other outstanding debt.

Credit rating downgrades could increase our financing costs and negatively affect our access to capital.

Our credit ratings may affect our cost of financing and our ability to access financing sources. In June 2011, our credit ratings were downgraded by two nationally recognized statistical rating organizations. Rating agencies revise their ratings for the companies that they follow from time to time and our ratings may be revised or withdrawn in their entirety at any time. Any further credit rating downgrade could increase our financing costs and could limit our access to financing sources.

 

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If our stores or distribution center experience catastrophic damage and loss due to natural disasters, our operations would be seriously harmed.

Each of our stores, our store support center and our distribution center are located in California in areas that are susceptible to earthquakes and other natural disasters, such as wildfires, floods and tsunamis. If any of our facilities, and in particular our distribution facility in Tracy, California, were to experience catastrophic damage and loss, it could disrupt our store operations, delay shipments of our merchandise, reduce our revenue and result in large expenses to repair or replace our facilities. The occurrence of any of these natural disasters could have a material adverse impact on our business, results of operations and financial condition.

We currently rely on a single distribution center. The loss or disruption of operations at our centralized distribution center or our failure in the future to expand or add additional distribution facilities could have an adverse effect on our business, operations and operating results.

A majority of our inventory is shipped directly from our suppliers to a single centralized distribution center that we lease in Tracy, California, where the inventory is then received, sorted and shipped to our stores. Our operating results depend on the orderly operation of our receiving and distribution processes, which in turn depend upon on our private fleet of leased tractors, leased and owned trailers, third-party common carriers and our effective management of our distribution facilities. We may not anticipate all the changing demands that our expanding operations will impose on our receiving and distribution system, and events beyond our control, such as disruptions in operations due to fire, earthquakes or other catastrophic events. In addition, shipping problems or labor disagreements may result in delays in the delivery of merchandise to our stores.

If we expand our retail store base, we may need to expand our distribution facilities, therefore we may need to acquire, construct or lease additional distribution facilities in other geographic locations to accommodate a planned expansion. An expansion of our distribution facilities will require significant capital investment, costs and time and could place increased demands on our financial, managerial and operational resources. We may also need to invest in additional information technology to achieve a unified receiving and distribution system.

While we maintain insurance, in the event our distribution center were to be shut down for any reason or if we were to incur higher costs and longer lead times in connection with a disruption at our distribution center, our insurance may not be sufficient, and insurance proceeds may not be timely paid to us.

We rely extensively on computer systems to process transactions, summarize results and manage our business. Disruptions in these systems could harm our ability to run our business.

Given the number of individual transactions we have each year, it is critical that we maintain uninterrupted operation of our computer and communications hardware and software systems. Our systems are subject to damage or interruption from power outages, computer and telecommunications failures, computer viruses, security breaches, including breaches of our transaction processing or other systems that result in the compromise of confidential customer data, catastrophic events such as fires, tornadoes and hurricanes, and usage errors by our employees. If our systems are breached, damaged or cease to function properly, we may have to make a significant investment to fix or replace them, we may suffer interruptions in our operations in the interim, we may face costly litigation, and our reputation with our customers may be harmed. Our ability to maintain sufficient inventory levels in our stores is critical to our success and largely depends upon the efficient and uninterrupted operation of our computer and communications hardware and software systems. Any material interruption in our computer operations may have a material adverse effect on our business or results of operations.

We rely on third parties to provide us with services in connection with the administration of certain aspects of our business.

We have entered into agreements with third-party service providers (both domestic and international) to provide processing and administrative functions over a range of areas, and we may continue to do so in the future. These areas include credit card processing, e-commerce services, payroll following the spin-off and

 

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product returns. Services provided by third parties could be interrupted as a result of many factors, such as acts of God or contract disputes. Any failure by third parties to provide us with these services on a timely basis or within our service level expectations and performance standards could result in a disruption of our business and have an adverse effect on our business and operating results.

We could incur charges due to impairment of intangible and long-lived assets.

As of January 29, 2011 we had intangible asset balances of $145.5 million, which are subject to testing for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Our intangible assets consist of $107.6 million of our trade names and $37.9 million of favorable leasehold rights. Failure to achieve sufficient levels of cash flows could result in impairment charges for our trade names. If the decline in our revenues continues, this could have a material effect on our trade name valuation and could result in an impairment charge. Our long-lived assets, primarily building and fixtures at our stores and favorable leasehold rights, are also subject to testing for impairment. A significant amount of judgment is involved in our impairment assessment. Failure to achieve sufficient levels of cash flow could result in impairment charges for intangible assets or fixed assets, which could have a material adverse effect on our results of operations.

Our failure to retain our senior management team and to continue to attract qualified new personnel could adversely affect our results of operations.

We depend on the talents and continued efforts of our senior management team. We do not maintain key-man life insurance on any of our executives and do not have employment agreements with any of our executives. The loss of one or more of the members of our senior management may disrupt our business and materially adversely affect our results of operations. Furthermore, our ability to manage our further expansion will require us to continue to train, motivate and manage our employees and to attract, motivate and retain additional qualified managerial and store personnel. We believe that having store personnel who are knowledgeable and experienced in home repair matters has been an important factor in our historical success and we believe it will continue to be important to growing our business. Competition for these types of personnel is intense, and we may not be successful in attracting, assimilating and retaining the personnel required to grow and operate our business profitably.

Persons associated with members of our board of directors following the Distribution, whose interests may be different than your interests, will exert substantial influence over us.

A member of our board of directors who is associated with ESL (the “ESL Director”) will, following the Distribution, beneficially own approximately 61% of our outstanding shares of Class A Common Stock and approximately 49% of the general voting power of our capital stock. Persons associated with directors elected by holders of our Class B Common Stock and Class C Common Stock (the “Class B/C Directors”) following the Distribution, will, following the Distribution, beneficially own 100% of our outstanding shares of Class C Common Stock and approximately 20% of the general voting power of our capital stock. Accordingly, such persons, and thus the Class B/C Directors and ESL Director will have substantial influence over many, if not all, actions to be taken or approved by our shareholders, including any transactions involving a change of control. In addition, persons associated with the ESL Director will have substantial influence over the election of our eight directors elected by the holders of Class A Common Stock and persons associated with the Class B/C Directors will have the power to direct the election of our two directors elected by the combined vote of the Class B Common Stock and the Class C Common Stock (the outstanding shares of our Class B Common Stock will, following the Distribution, collectively have less than 0.5% of the voting power of our capital stock).

The interests of such persons associated with the ESL Directors and the Class B/C Directors, which have investments in other companies that may compete with us, including Sears Holdings, may from time to time

 

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diverge from the interests of our other shareholders, particularly with regard to new investment opportunities. In addition, this substantial influence may have the effect of discouraging offers to acquire our Company because the consummation of any such acquisition would likely require the consent of such persons.

We may be subject to product liability claims if people or properties are harmed by the products we sell or the services we offer.

Some of the products we sell may expose us to product liability claims relating to personal injury, death, or property damage caused by such products, and may require us to take actions such as product recalls. We also provide various services, which could also give rise to such claims. Although we maintain liability insurance, we cannot be certain that our coverage will be adequate for liabilities actually incurred or that insurance will continue to be available to us on economically reasonable terms, or at all. Product liability claims can be expensive to defend and can divert the attention of management and other personnel for significant periods, regardless of the ultimate outcome. Claims of this nature, as well product recalls, could also have a negative impact on customer confidence in the products we stock and in our reputation, our business and our operating results.

We may be subject to periodic litigation and other regulatory proceedings. These proceedings may be affected by changes in laws and government regulations or changes in the enforcement thereof.

From time to time, we may be involved in lawsuits and regulatory actions relating to our business or products we sell or have sold. These proceedings may be in jurisdictions with reputations for aggressive applications of laws and procedures against corporate defendants. We are impacted by trends in litigation, including class-action allegations brought under various consumer protection and employment laws, including wage and hour laws. Due to the inherent uncertainties of litigation and regulatory proceedings, we cannot accurately predict the ultimate outcome of any such proceedings. An unfavorable outcome could have a material adverse impact on our business, financial condition and results of operations. In addition, regardless of the outcome of any litigation or regulatory proceedings, these proceedings could result in substantial costs and may require that we devote substantial resources to defend our Company and could affect the future premiums we would be required to pay on our insurance policies. Further, changes in governmental regulations could have adverse effects on our business and subject us to additional regulatory actions.

In the ordinary course of business, we are subject to product liability litigation as a result of the sale of certain products, including products that have included asbestos. On April 1, 2011, a judgment was entered against us in the case of the Save Mart Supermarkets v. Orchard Supply Hardware LLC, in California Superior Court in Fresno, California. Save Mart obtained a $5.1 million verdict on claims of breach of contract and breach of the implied covenant of good faith relating to the termination by Orchard Supply Hardware LLC of a contract for the lease of a store to be built by Save Mart. On August 24, 2011, the Company entered into a settlement agreement with Save Mart to satisfy the $5.1 million judgment, release the Company of all liabilities, and waive all rights of appeals by both parties. The settlement includes three parts: 1) a $0.5 million cash consideration paid to Save Mart, 2) the amendment and extension of an existing lease between Save Mart and the Company for a store unrelated to the one originally in dispute and 3) the lease of a new property to the Company. As of July 30, 2011, we had recorded a $5.1 million accrual for this matter. The Company estimates that this liability will be reduced by approximately $1.0 million to $2.0 million as a result of the settlement. For a description of certain current legal proceedings, see “Business–Legal Proceedings” in this Prospectus.

We intend to open new stores at an increased rate compared to recent years, which could strain our resources and have a material adverse effect on our business and financial performance.

Our future growth depends in part on our ability to successfully open and operate new stores profitably. As of July 30, 2011, we operated 89 full-service hardware stores in California. We opened four new stores in California within the past three years. We plan on opening one new store in 2011 and anticipate opening additional new stores

 

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in 2012. We intend initially to open these new stores within California; however, we may expand into locations outside of California. Expanding our store base will require us to invest significant financial resources and place increased demands on our management, operational and administrative infrastructure. In addition, our planned expansion will require us to increase continually the number of people we employ, as well as to expand and upgrade our management information, inventory tracking and other systems. Successfully opening a new store is a significant operational and administrative challenge. It is possible that we may not foresee all of the problems that could arise during a store opening or realize the expected benefits of opening a particular store. An increased number of stores may also make it more difficult for us to maintain our customer service standards and develop and implement the financial controls and procedures and reporting systems that will be required of us as a public company. If we fail to meet these increased demands and operating complexities, it could have a material adverse effect on our business, financial condition and results of operations.

We are subject to regulations that impact our business and a failure to comply with such regulations could lead to lawsuits or regulatory actions against us.

Operating in California exposes us to a particularly challenging regulatory environment, with aggressive enforcement efforts by private litigators in several areas of law, including, without limitation, environmental laws, consumer protection laws, employment laws, anti-discrimination laws, and wage and hour regulations and laws. This strict regulatory and litigation environment requires the Company to maintain a heightened compliance effort and exposes us to defense costs, possible fines and penalties, and liability to private parties for monetary recoveries and attorneys’ fees, any of which could have an adverse effect on our business and results of operations.

California and federal employment and labor laws govern our relationship with our employees and affect our operating costs. These laws include minimum wage requirements, overtime pay, unemployment tax rates, workers’ compensation rates, citizenship requirements and sales taxes. We are currently, and from time to time in the past have been, the subject of lawsuits by certain of our employees alleging various violations of these regulations, including suits alleging that we wrongfully denied certain of our employees overtime wages or that we unlawfully deducted costs for workers compensation expenses. A determination that we do not comply with these laws or other related laws could harm our profitability or business reputation. Future government-imposed increases in minimum wages, overtime pay, paid leaves of absence or mandated health benefits could also materially and adversely affect us.

From time to time we are subject to claims of employment discrimination, unlawful employment practices and Americans with Disabilities Act claims.

If we do not maintain the security of our customer, associate or company information, we could damage our reputation, incur substantial additional costs and become subject to litigation.

Any significant compromise or breach of customer, associate or company data security either held and maintained by the Company or our third party providers could significantly damage our reputation and result in additional costs, lost sales, fines and lawsuits. The regulatory environment related to information security and privacy is increasingly rigorous, with new and constantly changing requirements applicable to our business, and compliance with those requirements could result in additional costs. There is no guarantee that the procedures that we have implemented to protect against unauthorized access to secured data are adequate to safeguard against all data security breaches. A data security breach could negatively impact our business and our results of operations.

If we are unable to renew or enter into new store leases on competitive terms our revenue or results of operations could be negatively impacted.

As of July 30, 2011, we leased 74 store locations under long-term agreements. If our cost of leasing existing stores increases, we may be unable to maintain our existing store locations as leases expire. Our profitability may decline if we fail to enter into new leases on competitive terms or at all, or we may not be able to locate suitable

 

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alternative stores or additional sites for our new store expansion in a timely manner. Furthermore, a small number of our leases will expire within the next ten years and some do not grant us any rights to renew the lease. A failure to renew or enter into new leases could reduce our revenue and negatively impact our results of operations.

We are required to comply with increasingly stringent federal, state and local environmental laws and regulations, the cost of which is likely to increase and may adversely affect our results of operations, cash flow or financial condition.

Our operations, properties and the products we sell are subject to various federal, state and local environmental laws and regulations. These laws and regulations not only govern our current operations, properties and the products we sell, but also impose potential liability on us for our past operations. We expect environmental laws and regulations to impose increasingly stringent requirements upon our industry and us in the future. Our costs to comply with these laws and regulations may increase as these requirements become more stringent in the future, and these increased costs may adversely affect our results of operations, cash flow or financial condition.

If we fail to timely and effectively obtain shipments of product from our vendors and deliver merchandise to our customers, our operating results will be adversely affected.

We cannot control all of the various factors that might affect our timely and effective procurement of supplies of product from our vendors and delivery of merchandise to our customers. A majority of the products that we purchase, domestically or overseas, must be shipped to our distribution center in Tracy, California. Our utilization of foreign imports also makes us vulnerable to risks associated with products manufactured abroad, including, among other things, risks of damage, destruction or confiscation of products while in transit to our distribution center, work stoppages including as a result of events such as longshoremen strikes, transportation and other delays in shipments including as a result of heightened security screening and inspection processes or other port-of-entry limitations or restrictions in the United States, lack of freight availability and freight cost increases. In addition, if we experience a shortage of a popular item, we may be required to arrange for additional quantities of the item, if available, to be delivered to us through airfreight, which is significantly more expensive than standard shipping by sea. As a result, we may not be able to obtain sufficient freight capacity on a timely basis or at favorable shipping rates and, therefore, we may not be able to timely receive merchandise from our vendors or deliver our products to our customers.

We rely upon proprietary and third-party land-based carriers for merchandise shipments to our facility in Tracy, California and from this facility to our stores. Accordingly, we are subject to the risks, including labor disputes, union organizing activity, inclement weather and increased transportation costs, associated with such carriers’ ability to provide delivery services to meet our inbound and outbound shipping needs. In addition, if the cost of fuel continues to rise or remains at current levels, the cost to deliver merchandise from the distribution center to our stores may rise which could have an adverse impact on our profitability. Failure to procure and deliver merchandise either to us or to our customers in a timely, effective and economically viable manner could damage our reputation and adversely affect our business. In addition, any increase in distribution costs and expenses could adversely affect our future financial performance.

We rely on foreign sources for merchandise, and our business may therefore be negatively affected by the risks associated with international trade.

A portion of our merchandise is purchased from foreign vendors, either directly by us or indirectly by our distributors who, in turn, sell this merchandise to us. We believe that in order to remain competitive we must maintain or increase the portion of merchandise purchased from such vendors. This reliance on foreign vendors results in our facing risks inherent in purchasing from foreign suppliers, including:

 

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economic and political instability in countries where these vendors are located;

 

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increases in shipping costs;

 

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•

transportation delays and interruptions;

 

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adverse fluctuations in currency exchange rates; and

 

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changes in U.S. and foreign laws affecting the importation and taxation of goods, including duties, tariffs and quotas, or changes in the enforcement of those laws.

Any increase in cost to us of merchandise purchased from foreign vendors or restriction on the merchandise made available to us by such vendors could have an adverse effect on our business and operating results.

If our relationships with our vendors were to be impaired, it could have a negative impact on our competitive position and our business and financial performance.

Most of our vendor arrangements are not long-term agreements, and, therefore, our success depends on maintaining good relations with our vendors. Our growth strategy depends to a significant extent on the willingness and ability of our vendors to supply us with sufficient inventory to stock our new stores. If we fail to strengthen our relations with our existing vendors or to enhance the quality of merchandise they supply us, or if we cannot maintain or acquire new vendors of favored brand name merchandise, our ability to obtain a sufficient amount and variety of merchandise at acceptable prices may be limited, which would have a negative impact on our competitive position. In addition, our inability to stock our stores with new and desired merchandise at attractive prices could result in lower revenues and decreased customer interest in our stores, which, in turn, would adversely affect our financial performance. In addition, we may not be able to develop relationships with new vendors, and products from alternative sources, if any, may be of a lesser quality and more expensive than those we currently purchase. During fiscal 2010, branded products acquired under license from Sears Holdings, including Kenmore and Craftsman products, accounted for approximately 6% of total purchases of all inventory from all vendors. Merchandise supplied to stores by our top ten suppliers accounted for approximately 24.4% of our total purchases. The loss of or a reduction in the amount of merchandise made available to us by Sears Holdings or by these other key vendors could have an adverse effect on our business and operating results.

Our ability to obtain commercial insurance at acceptable prices, or at all, may increase our costs and lower our operating results.

We believe that extensive commercial insurance coverage is prudent for risk management. Prior to the Distribution, we obtained our umbrella insurance policy and several other policies through policies obtained by Sears Holdings and we benefited from the lower insurance premiums that Sears Holdings was able to obtain. Upon our spin-off from Sears Holdings, we will no longer be covered under these Sears Holdings policies and we will be required to obtain independent insurance coverage for replacement of these policies. We may be unable to obtain adequate insurance coverage for such replacement policies at reasonable costs or at all and, in any event, anticipate that the cost of our insurance will increase significantly as compared to the amounts we were charged when our insurance was provided under Sears Holdings’ plans. In addition, for certain types or levels of risk, such as risks associated with earthquakes or terrorist attacks, we might determine that we cannot obtain commercial insurance at acceptable prices. Therefore, we might choose to forego or limit our purchase of relevant commercial insurance, choosing instead to self-insure one or more types or levels of risks. If we suffer a substantial loss that is not covered by commercial insurance, the loss and attendant expenses could have a material adverse effect on our operating results. Also, insurance may not be available in the future with the scope of coverage and in amounts of coverage adequate to insure against such risks and disturbances.

Risks Relating to our Relationship with and Separation from Sears Holdings

Following this Distribution, we will continue to depend on Sears Holdings to provide us with many key services for our business and we will be required to develop our own systems quickly and cost-effectively.

Prior to the Distribution, we have been operating as an indirect majority-owned subsidiary of Sears Holdings, and certain key services required by us for the operation of our business are currently provided by

 

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Sears Holdings. We have or will have, prior to the completion of the Distribution, entered into agreements with Sears Holdings or its subsidiaries related to the Distribution including, among others, the Distribution Agreement, Transition Services Agreement, Appliances Agreement and Brands Agreements.

Pursuant to the Transition Services Agreement, a subsidiary of Sears Holdings will provide us with accounting, human resources, certain employee benefits, logistical and supply chain, information technology, environmental and safety program, risk management and insurance and inventory support services. The Transition Services Agreement will continue for a period not to exceed twelve months from the date of the Distribution. We will pay the fees, expenses and taxes incurred by Sears Holdings or its subsidiaries in connection with its provision of the services as set forth in the Transition Services Agreement. The Transition Services Agreement may be terminated (i) by mutual agreement of the parties, (ii) for cause by either party, (iii) for convenience by Orchard upon sixty days’ prior written notice to Sears Holdings or (iv) the sixtieth day following Orchard’s receipt of written notice from Sears Holdings terminating the agreement due to a change in control of Orchard.

We believe it is necessary for Sears Holdings to provide these services to us under the Transition Services Agreement to facilitate the efficient operation of our business as we transition to becoming a publicly traded company independent from Sears Holdings. We will, as a result, initially be dependent on our relationship with Sears Holdings for transitional services following the Distribution. Although Sears Holdings is contractually obligated to provide us with these services until at least the first anniversary of the distribution date, these services may not be provided at the same level as when we were part of Sears Holdings, and we may not be able to obtain the same benefits. When Sears Holdings is no longer obligated to provide these services to us, we may not be able to replace these transitional services on terms and conditions, including costs, as favorable as those we will receive from Sears Holdings. See “Certain Relationships and Related Party Transactions—Agreements with Sears Holdings.”

As a publicly traded company independent from Sears Holdings, we may experience increased costs resulting from a decrease in the purchasing power we currently have as a result of being a subsidiary of Sears Holdings.

Prior to our separation from Sears Holdings, we were able to take advantage of Sears Holdings’ size and purchasing power in procuring services, including insurance, advertising, shipping and receiving, logistics, store maintenance contracts, employee benefit support, credit and debit card interchange fees and other services. As a result of our separation from Sears Holdings, we will be a smaller company than Sears Holdings and we will not have access to financial and other resources comparable to those available to us prior to the Distribution. As a company independent from Sears Holdings, we may be unable to obtain goods, technology and services at prices and on terms as favorable as those available to us prior to the Distribution, which could increase our costs and reduce our profitability.

We may have been able to receive better terms from unaffiliated third parties than the terms we receive in our agreements with Sears Holdings.

The agreements related to our spin-off from Sears Holdings, including the Distribution Agreement, Transition Services Agreement, Appliances Agreement and Brands Agreements have been negotiated or will be negotiated in the context of our separation from Sears Holdings while we are still a majority owned indirect subsidiary of Sears Holdings. Accordingly, these agreements may not reflect terms that would have resulted from arm’s-length negotiations among unaffiliated third parties. The terms of the agreements being negotiated in the context of our spin-off are related to, among other things, the principal actions needed to be taken in connection with the spin-off, indemnification and other obligations among Sears Holdings and us and the nature of the commercial arrangements between us and Sears Holdings following the Distribution. We may have received better terms from third parties because third parties may have competed with each other to obtain the right to enter into certain of these agreements with us. However, these agreements generally incorporate arm’s length

 

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terms and conditions, including market-based pricing and term of duration. See “Certain Relationships and Related Party Transactions–Agreements with Sears Holdings” of this Prospectus for more detail.

Conflicts may arise between Sears Holdings and us in a number of areas relating to our past and ongoing relationships, including:

 

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business opportunities that may be attractive to both Sears Holdings and us;

 

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the nature, quality and pricing of transitional services Sears Holdings has agreed or will agree to provide to us;

 

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labor, tax, employee benefit, indemnification and other matters arising from our separation from Sears Holdings;

 

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major business combinations involving us;

 

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employee retention and recruiting; and

 

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intellectual property matters.

Currently, Sears Roebuck, Kmart stores, and certain specialty retail stores owned by Sears Holdings or that are operated by franchisees and dealers authorized by Sears Holdings have product lines that are similar to ours. Following the Distribution, Sears Holdings will be under no contractual obligation not to compete with us or from opening new Sears Roebuck, Kmart or specialty stores in locations we have targeted for expansion. In addition, our ability to sell merchandise under Sears Holdings’ proprietary brands, such as Craftsman, Easy Living, Kenmore and Weatherbeater, will be subject to the terms of the Appliances Agreement and Brands Agreements. The Appliances Agreement grants Sears Holdings control over the assortment of merchandise available to us and may therefore affect our use of floor space and the type of merchandise available to our customers.

Risks Relating to Our Class A Common Stock and Preferred Stock and the Distribution

Becoming a public company will increase our expenses and administrative burden, in particular to bring our Company into compliance with certain provisions of the Sarbanes Oxley Act of 2002 to which we are not currently subject.

As a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. These increased costs and expenses may arise from various factors, including financial reporting, costs associated with complying with federal securities laws (including compliance with the Sarbanes-Oxley Act of 2002), tax administration, and legal and human resources related functions. In anticipation of becoming a public company, we will need to create or revise the roles and duties of our board committees, adopt additional internal controls and disclosure controls and procedures, retain a transfer agent and adopt an insider trading policy in compliance with our obligations under the securities laws.

In addition, changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, and related regulations implemented by the SEC and NASDAQ are creating uncertainty for public companies, increasing legal and financial compliance costs and making some activities more time consuming. We are currently evaluating and monitoring developments with respect to new and proposed rules and cannot predict or estimate the amount of the additional costs we may incur or the timing of such costs. These laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management’s time and attention from revenue-

 

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generating activities to compliance activities. If our efforts to comply with new laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, regulatory authorities may initiate legal proceedings against us and our business may be harmed. The costs of compliance or our failure to comply with these laws, rules and regulations could adversely affect our reputation, financial condition, results of operations and the price of our Class A Common Stock and Preferred Stock.

We also expect that being a public company subject to these rules and regulations will make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. As a result, it may be more difficult for us to attract and retain qualified executive officers and qualified persons to serve on our board of directors, particularly to serve on our audit committee.

Failure to achieve and maintain effective internal controls in accordance with Section 404 of Sarbanes-Oxley could have a material adverse effect on our business and the market price of our Class A Common Stock and Preferred Stock.

As a public company, we will be required to document and test our internal control over financial reporting in order to satisfy the requirements of Section 404 of Sarbanes-Oxley, which will require annual management assessments of the effectiveness of our internal control over financial reporting and, beginning with our annual report on Form 10-K for the year ending February 2, 2013, a report by our independent registered public accounting firm that addresses the effectiveness of internal control over financial reporting. During the course of our testing, we may identify deficiencies which we may not be able to remediate in time to meet our deadline for compliance with Section 404. Testing and maintaining internal control can divert our management’s attention from other matters that are also important to the operation of our business. We also expect that the imposition of these regulations will increase our legal and financial compliance costs and make some activities more difficult, time consuming and costly. We may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404. If we are unable to conclude that we have effective internal control over financial reporting, then investors could lose confidence in our reported financial information, which would likely have a negative effect on the trading price of our Class A Common Stock and Preferred Stock. In addition, if we do not maintain effective internal controls, we may not be able to accurately report our financial information on a timely basis, which could harm the trading price of our Class A Common Stock and Preferred Stock, impair our ability to raise additional capital, or jeopardize our continued listing on the NASDAQ Capital Market or any other stock exchange on which our Class A Common Stock and Preferred Stock may be listed.

We do not expect to pay dividends for the foreseeable future.

We do not expect to pay cash dividends on our Class A Common Stock or any other shares of our capital stock for the foreseeable future. In addition, the terms of the Preferred Stock do not entitle the holders thereof to any dividends. We currently intend to retain any future earnings for use in the business. Further, our current credit arrangements generally prohibit our paying of cash dividends. As a result, you may not receive any return on an investment in our capital stock in the form of dividends. The terms of the Preferred Stock will provide that dividends and other distributions may not be paid on any shares of our capital stock until all outstanding shares of the Preferred Stock have been redeemed or repurchased unless such dividend or distribution (i) has been unanimously approved by our board of directors, (ii) relates to a “poison pill” stockholder rights plan or (iii) is a distribution of cash in lieu of fractional shares made in connection with this Distribution.

Our Class A Common Stock and Preferred Stock may have a low trading volume and limited liquidity, resulting from a lack of analyst coverage and institutional interest.

Our Class A Common Stock and Preferred Stock may receive limited attention from market analysts. Lack of up-to-date analyst coverage may make it difficult for potential investors to fully understand our operations and

 

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business fundamentals, which may limit our trading volume. In addition, if neither ESL nor ACOF is actively trading our Class A Common Stock, our trading volume may be limited. The Stockholders’ Agreement will provide that during the period beginning on the date of the spin-off and ending on the date that is the earlier of (i) the date that ACOF completes the acquisition of an aggregate number of additional shares of our common stock equal to 15% of the total shares of common stock outstanding as of such date and (ii) the date that is six months from the date on which the distribution agent has completed the electronic issuance of all of the shares of our Class A Common Stock in connection with the spin-off (with such period subject to extension upon certain circumstances detailed in the Stockholders’ Agreement), none of Orchard, ESL, Lampert or Crowley, nor any of their affiliates will (i) acquire, directly or indirectly, any securities of ours or our subsidiaries or (ii) knowingly or intentionally hinder or inhibit ACOF from making any such purchases of our securities, subject to certain restrictions. Such limited liquidity may impede the development of institutional interest in our Class A Common Stock and Preferred Stock, and could limit the value of our Class A Common Stock and Preferred Stock. Additionally, low trading volumes and lack of analyst coverage may limit your ability to resell your stock. Low trading volume may be particularly pronounced in the case of shares of our Preferred Stock because such shares will only be quoted on the OTCQB, where there is generally less liquid trading and less participation by market makers.

Our principal shareholders will have substantial control over us following the Distribution and, among other things, they could delay or prevent a change in corporate control and may have interests different than yours.

As of the Distribution, we will have four classes of capital stock:

 

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Class A Common Stock, which is entitled to one vote per share and which elects eight members of our board of directors;

 

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Class B Common Stock, which is entitled to one-tenth of a vote per share and which, together with our Class C Common Stock, elects two members of our board of directors;

 

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Class C Common Stock, which is entitled to one vote per share and which, together with our Class B Common Stock, elects two members of our board of directors; and

 

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Preferred stock, of which the Preferred Stock is a series and which does not have voting rights.

As of the Distribution, ESL will own approximately 61% of our outstanding Class A Common Stock, representing approximately 61% of Class A Common Stock voting power and approximately 49% of the general voting power of our outstanding capital stock, and will own approximately 61% of our outstanding Preferred Stock, which is our outstanding nonvoting capital stock. As of the Distribution, ACOF, will own 100% of our outstanding Class C Common Stock, representing approximately 99% of the collective voting power of our Class B Common Stock and Class C Common Stock voting together and approximately 20% of the voting power of our outstanding capital stock. Pursuant to our Amended and Restated Certificate of Incorporation that will be in effect at the Distribution, at any time that ACOF owns a number of shares of our Class B Common Stock and Class C Common Stock representing in the aggregate a percentage of our outstanding common stock that is less than 10% but equal to or greater than 5% (calculated without reference to any shares of capital stock issued or issuable after the Distribution), then the Class C Common Stock, voting together with the Class B Common Stock as a single class, shall have the right to elect only one director. If at any time ACOF and its affiliates and permitted transferees owns a number of shares of our Class B Common Stock and Class C Common Stock representing in the aggregate a percentage of our outstanding common stock that is less than 5% (calculated without reference to any shares of capital stock issued or issuable after the Distribution), then there shall no longer be separate classes of directors and all classes of our capital stock entitled to vote for directors would vote together as a single class.

As a result of their respective capital stock ownership, as of the distribution date, ESL and ACOF acting together would have the ability to control the outcome of certain matters on which holders of all classes of our capital stock vote together as a single class, including, among other things, approving mergers or other business combinations and effecting certain amendments to our Amended and Restated Certificate of Incorporation. In

 

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addition, as of the distribution date, ESL will hold a majority of the stock that votes in the election of our directors elected by the Class A Common Stock shareholders and ACOF will have the power to control the election of the two members of our board of directors elected by the Class B Common Stock and Class C Common Stock shareholders (the outstanding shares of our Class B Common Stock will, following the Distribution, collectively have less than 0.5% of the voting power of our capital stock). This concentration of ownership might harm the market price of our Class A Common Stock and Preferred Stock by discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of us. In addition, the interests of ESL and ACOF may differ from or be opposed to the interests of our other shareholders. See “Security Ownership by Certain Beneficial Owners and Management” in this Prospectus for a more detailed description of the beneficial ownership of our capital stock by ESL and ACOF following the Distribution.

In addition, ACOF will have preemptive rights over our issuance of certain debt pursuant to the Stockholders’ Agreement (see “Certain Relationships and Related Party Transactions—Other Related Party Transactions” for a description of our Stockholders’ Agreement). Unless otherwise consented to by ACOF, such preemptive rights require us to notify ACOF of the terms of certain debt that we wish to issue and provide them the opportunity to purchase up to 100% of such debt, depending on the time such event occurs and on other circumstances. Complying with this process could hinder our ability to timely take advantage of favorable market conditions to obtain debt financing on advantageous terms.

Further, the Stockholders’ Agreement will provide Class B/C Directors with consent rights, so long as ACOF, together with its affiliates and transferees, beneficially owns shares of Class B and/or C Common Stock that represent at least 15% of the total voting shares at the time of the Distribution over certain corporate activities, including any change in control, certain changes in the number of directors constituting our board of directors, any redemption of our Series A Preferred Stock , certain changes to our Charter or By-laws, issuances by us of stock (other than in connection with stock plans or similar arrangements), rights offerings and any liquidation of our corporate assets. The Stockholders’ Agreement will also provide for so long as ESL holds more shares of our common stock than ACOF, that a non-management Class A Director designated by a majority vote of our Class A Directors will have a consent right over certain corporate activities, including our issuance of any capital stock (other than in connection with stock plans or similar arrangements) and our engaging in any rights offering. These consent rights may limit our ability to enter into the corporate activities subject to such consent rights.

Our Class A Common Stock and Preferred Stock prices may decline if ESL or ACOF alter their strategy with respect to their ownership of our capital stock.

ESL and ACOF have advised us that they have not reached any decision regarding whether or for how long they will retain their stock ownership in us and what form, if any, the disposition or distribution of their stock in us will take. ESL and ACOF will, in their sole discretion, determine the timing and terms of any transactions with respect to their shares in us, taking into account business and market conditions and other factors that they deem relevant. Neither ESL nor ACOF are subject to any contractual obligation to maintain their ownership position in us, although they may be subject to certain transfer restrictions imposed by securities laws and the Stockholders’ Agreement (as described in “Certain Relationships and Related Party Transactions—Other Related Party Transactions—Stockholders’ Agreement). Consequently, we cannot assure you that either ESL or ACOF will maintain their ownership of our capital stock. Any announcement by ESL or ACOF that they have reached a determination regarding what to do with their shares of our capital stock, or the perception by the investment community that ESL or ACOF has reached such a determination, could have an adverse impact on the price of our Class A Common Stock and Preferred Stock. For further description of transfer restrictions that may apply to our capital stock, see “Description of Our Capital Stock—Shares Eligible for Future Sale” in this Prospectus.

 

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Risks Relating to the Spin-Off

If the Distribution or certain internal transactions undertaken in anticipation of the spin-off are determined to be taxable for U.S. federal income tax purposes, our shareholders could incur significant U.S. federal income tax liabilities.

Sears Holdings has received an IRS Ruling substantially to the effect that, for U.S. federal income tax purposes, the Distribution, except to the extent of any cash received in lieu of fractional shares of our Class A Common Stock and Preferred Stock, will qualify as tax-free under Section 355 of the Code. The IRS Ruling also provides that certain internal transactions undertaken in anticipation of the Distribution will qualify for nonrecognition tax treatment under the Code. The IRS Ruling is binding upon the Internal Revenue Service, but its continued validity is subject to factual representations that we and Sears Holdings made to the Internal Revenue Service concerning certain conditions that are necessary to obtain tax-free treatment under the Code have been satisfied. In addition, the Internal Revenue Service will not rule on whether a distribution satisfies certain requirements necessary to obtain tax-free treatment under Section 355 of the Code. Therefore, in addition to obtaining the IRS Ruling, Sears Holdings expects to receive an opinion from the law firm of Simpson Thacher & Bartlett LLP as to the satisfaction of these required qualifying conditions. An opinion of counsel is not binding on the Internal Revenue Service. Accordingly, the Internal Revenue Service may reach conclusions with respect to the spin-off that are different from the conclusions reached in the opinion. The opinion will be based on certain facts and assumptions, and certain representations and undertakings, which, if incomplete, incorrect or not satisfied, could alter counsel’s conclusions.

If the Distribution ultimately is determined to be taxable, the Distribution could be treated as a taxable dividend or capital gain to you for U.S. federal income tax purposes, and you could incur significant U.S. federal income tax liabilities. In addition, Sears Holdings would recognize a taxable gain to the extent that the fair market value of our Class A Common Stock and Preferred Stock exceeds Sears Holdings’ tax basis in such stock on the date of the Distribution. Sears Holdings would not expect tax on such gain, if any, to be substantial. For additional discussion on the possible tax consequences of the Distribution, see “The Spin-Off—Material U.S. Federal Income Tax Consequences of the Spin-Off” in this Prospectus.

Dispositions or redemptions of our Preferred Stock received in the Distribution may have less favorable tax consequences than dispositions or redemptions of our Class A Common Stock received in the Distribution.

Any Preferred Stock received by a Sears Holdings shareholder in the Distribution will constitute “Section 306 stock” for U.S. federal income tax purposes. As a result, any cash received by a Sears Holdings shareholder in lieu of fractional shares of Preferred Stock generally will be treated as ordinary dividend income.

Furthermore, subsequent dispositions or redemptions of our Preferred Stock generally will also be treated as ordinary dividend income, even if such proceeds would otherwise have resulted in capital gain or do not exceed such shareholder’s basis in our Preferred Stock, unless our Preferred Stock is disposed or redeemed in a transaction that terminates the shareholder’s entire interest in us (including any of our Class A Common Stock and taking into account certain constructive ownership rules).

The rules relating to Section 306 stock are complicated and shareholders are urged to consult their own tax advisors regarding the application of those rules.

We might not be able to engage in desirable strategic transactions and equity issuances following the Distribution because of restrictions relating to U.S. federal income tax requirements for tax-free distributions.

Our ability to engage in significant equity transactions will be limited or restricted after the Distribution in order to preserve for U.S. federal income tax purposes the tax-free nature of the Distribution by Sears Holdings. Even if the Distribution otherwise qualifies for tax-free treatment under Section 355 of the Code, it may be taxable to Sears Holdings if 50% or more, by vote or value, of shares of our Class A Common Stock and

 

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Preferred Stock or Sears Holdings’ common stock are acquired or issued as part of a plan or series of related transactions that includes the Distribution. For this purpose, any acquisitions or issuances of Sears Holdings’ common stock within two years before the Distribution, and any acquisitions or issuances of our Class A Common Stock and Preferred Stock or Sears Holdings’ common stock within two years after the Distribution, generally are presumed to be part of such a plan, although we or Sears Holdings may be able to rebut that presumption. If an acquisition or issuance of shares of our Class A Common Stock and Preferred Stock or Sears Holdings’ common stock triggers the application of Section 355(e) of the Code, Sears Holdings would recognize a taxable gain to the extent the fair market value of our Class A Common Stock and Preferred Stock exceeds Sears Holdings’ tax basis in our Class A Common Stock and Preferred Stock. If the Distribution was subject to Section 355(e) of the Code, we would not expect tax on such gain, if any, to be substantial.

Under the Distribution Agreement, there will be restrictions on our ability to take actions that could cause the Distribution to fail to qualify for favorable treatment under the Code. These restrictions may prevent us from entering into transactions which might be advantageous to us or our shareholders. For a description of the Distribution Agreement, see “Certain Relationships and Related Party Transactions—Agreements with Sears Holdings—Distribution Agreement.”

We may be unable to achieve some or all of the benefits that we expect to achieve from our spin-off from Sears Holdings.

As a publicly traded company independent from Sears Holdings, we believe that our business will benefit from, among other things, allowing us to better focus our financial and operational resources on our specific business, allowing our management to design and implement corporate strategies and policies that are based primarily on the business characteristics and strategic decisions of our business, allowing us to more effectively respond to industry dynamics and allowing the creation of effective incentives for our management and employees that are more closely tied to our business performance. However, we may not be able to achieve some or all of the benefits that we expect to achieve as a company independent from Sears Holdings in the time we expect, if at all.

We may be unable to make, on a timely or cost-effective basis, the changes necessary to operate as a company independent from Sears Holdings, and we may experience increased costs after the spin-off.

In the past three years we have operated largely independently of Sears Holdings’ corporate organization, although Sears Holdings has assisted us by providing certain corporate functions. Following the spin-off, Sears Holdings will have no obligation to provide assistance to us other than the interim services to be provided pursuant to the Transition Services Agreement as described in “Certain Relationships and Related Party Transactions—Agreements with Sears Holdings” of this Prospectus. Because our business has previously operated with the assistance of Sears Holdings, we cannot assure you that we will be able to successfully implement the changes necessary to operate entirely independently or that we will not incur additional costs that could adversely affect our business and operating results.

Our historical consolidated financial information is not necessarily representative of the results we would have achieved as a publicly traded company independent from Sears Holdings and may not be a reliable indicator of our future results.

The historical financial information we have included in this Prospectus may not reflect what our results of operations, financial position and cash flows would have been had we been a publicly traded company independent from Sears Holdings, during the periods presented, or what our results of operations, financial position and cash flows will be in the future when we are independent from Sears Holdings. This is primarily because:

 

•

our historical financial information reflects allocations for certain services and expenses historically provided to us by Sears Holdings that may not reflect the costs we will incur for similar services in the future as a company independent from Sears Holdings; and

 

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•

our historical financial information does not reflect changes that we expect to experience in the future as a result of our spin-off from Sears Holdings, including changes in the cost structure, personnel needs, financing and operations of our business.

Following the spin-off, we also will be responsible for the additional costs associated with being a publicly traded company independent from Sears Holdings, including costs related to corporate governance and public reporting. Accordingly, there can be no assurance that our historical financial information presented herein will be indicative of our future results.

For additional information about our past financial performance and the basis of presentation of our financial statements, see “Selected Historical Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and the notes thereto included elsewhere in this Prospectus.

As a publicly traded company independent from Sears Holdings, we may not enjoy the same benefits that we did as a subsidiary of Sears Holdings.

There is a risk that, by separating from Sears Holdings, we may become more susceptible to market fluctuations and other adverse events than we would have been if we were still a part of the Sears Holdings organizational structure. As part of Sears Holdings, we have been able to enjoy certain benefits from Sears Holdings’ operating diversity, purchasing power, available capital for investments and opportunities to pursue integrated strategies with Sears Holdings’ other businesses. As a publicly traded company independent from Sears Holdings, we will not have similar diversity or integration opportunities and may not have similar purchasing power or access to capital markets.

Risks Relating to Our Class A Common Stock and Preferred Stock and the Securities Market

There currently exists no market for our Class A Common Stock and Preferred Stock. An active trading market may not develop for our Class A Common Stock and Preferred Stock. If our share price fluctuates after the Distribution, you could lose all or a significant part of your investment.

There is currently no public market for our Class A Common Stock and Preferred Stock. We intend to list our Class A Common Stock on the NASDAQ Capital Market under the symbol “OSH” and to quote our Preferred Stock on the OTCQB, and expect that trading for both will begin the first trading day after the completion of the Distribution. We do not plan to have a “when-issued” market for our Class A Common Stock or Preferred Stock prior to the Distribution. There can be no assurance that an active and liquid trading market for our Class A Common Stock and Preferred Stock will develop as a result of the spin-off or be sustained in the future. The lack of an active market may make it more difficult for you to sell our shares and could lead to our share price being depressed or more volatile.

We cannot predict the prices at which our Class A Common Stock and Preferred Stock may trade after the spin-off. The market price of our Class A Common Stock and Preferred Stock may fluctuate widely, depending on many factors, some of which may be beyond our control, including:

 

•

our business profile and market capitalization may not fit the investment objectives of some Sears Holdings shareholders and, as a result, these Sears Holdings shareholders may sell our shares after the Distribution;

 

•

actual or anticipated fluctuations in our operating results due to factors related to our business;

 

•

success or failure of our business strategy;

 

•

actual or anticipated changes in the U.S. and California economies or the retailing environment;

 

•

our quarterly or annual earnings, or those of other companies in our industry;

 

•

our ability to obtain third-party financing as needed;

 

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•

announcements by us or our competitors of significant acquisitions or dispositions;

 

•

the failure of securities analysts to cover our Class A Common Stock and Preferred Stock after the spin-off;

 

•

changes in earnings estimates by securities analysts or our ability to meet those estimates;

 

•

the operating and stock price performance of other comparable companies;

 

•

overall market fluctuations;

 

•

changes in laws and regulations affecting our business;

 

•

actual or anticipated sales or distributions of our capital stock by our officers, directors or certain significant shareholders;

 

•

terrorist acts or wars; and

 

•

general economic conditions and other external factors.

In addition, the stock market in general has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of companies like us. These broad market and industry factors may materially reduce the market price of the Class A Common Stock and Preferred Stock, regardless of our operating performance.

Substantial sales of Class A Common Stock and Preferred Stock may occur in connection with the spin-off, which could cause the price of our Class A Common Stock and Preferred Stock to decline.

Although we have no actual knowledge of any plan or intention on the part of any significant shareholder to sell our capital stock following the spin-off, it is likely that some shareholders, possibly including our significant shareholders, will sell shares of our capital stock if, for reasons such as our business profile or market capitalization as a company independent from Sears, we do not fit their investment objectives. In particular, Sears Holdings is a member of the S&P 500 Index, while we will not be and, accordingly, certain Sears Holdings shareholders may elect or be required to sell our shares following the spin-off due to such shareholders’ own investment guidelines or other reasons.

The Class A Common Stock and Preferred Stock held by ESL and our “affiliates,” the Class B Common Stock and the Class C Common Stock may be sold in the public market only if registered or if the holders thereof qualify for an exemption from registration under Rule 144 under the Securities Act which is summarized under “Description of Our Capital Stock—Shares Eligible for Future Sale.” Individuals who may be considered our affiliates after the spin-off include individuals who control, are controlled by or are under common control with us, as those terms generally are interpreted for federal securities law purposes. These individuals may include some or all of our directors and executive officers. Individuals who are our affiliates will be permitted to sell their shares of Class A Common Stock and Preferred Stock only pursuant to an effective Registration Statement under the Securities Act, or an exemption from the registration requirements of the Securities Act, such as the exemptions afforded by Section 4(1) of the Securities Act or Rule 144 thereunder. As described under “Description of Our Capital Stock—Registration Rights Agreements,” pursuant to the new stockholders agreement we will be entering into with ESL and ACOF, we expect to grant registration rights to ESL and ACOF.

Sales of a substantial number of shares of Class A Common Stock or Preferred Stock could adversely affect the market price of the Class A Common Stock and Preferred Stock and could impair our future ability to raise capital through an offering of our equity securities. In addition, our Class C Common Stock, which immediately following the Distribution will constitute approximately 20% of the voting power of our capital stock, automatically converts to an equal number of shares of Class A Common Stock in the event ACOF transfers such shares to any person or entity that is not affiliated with ACOF or if at any time ACOF owns a number of shares of our Class B Common Stock and Class C Common Stock representing in the aggregate a percentage of our

 

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outstanding common stock that is less than 5% (calculated without reference to any shares of capital stock issued or issuable after the Distribution). As a result, sales of a substantial number of shares of Class C Common Stock by ACOF to an unaffiliated third party could also adversely affect the market price of shares of the Class A Common Stock. Additionally, the Class C Common Stock may be converted into Class A Common Stock on the basis of one share of Class A Common Stock for each share of Class C Common Stock upon the approval of our board of directors and subsequent approval of (i) our shareholders voting as a separate class and (ii) the holders of a majority of the voting power of the Class C Common Stock voting as a separate class.

Your percentage ownership in us will be diluted in the future.

Your percentage ownership in Orchard will be diluted in the future because of additional equity awards that we expect will be granted to our directors, officers and employees in the future. We intend to establish equity incentive plans that will provide for the grant of common stock-based equity awards to our directors, officers and other employees. Further, shares of Class C Common Stock held by ACOF will automatically convert into an equal number of shares of Class A Common Stock in certain circumstances. In addition, we may issue equity in order to raise capital or in connection with future acquisitions and strategic investments, which would dilute your percentage ownership.

Provisions in our Amended and Restated Certificate of Incorporation and Amended and Restated Bylaws and of Delaware law may prevent or delay an acquisition of the Company, which could decrease the trading price of our Class A Common Stock and Preferred Stock.

Our proposed Amended and Restated Certificate of Incorporation and Amended and Restated Bylaws and Delaware law contain provisions that are intended to deter coercive takeover practices and inadequate takeover bids by making such practices or bids unacceptably expensive to the raider and to encourage prospective acquirers to negotiate with our board of directors rather than to attempt a hostile takeover. These provisions include rules regarding how shareholders may present proposals or nominate directors for election at shareholder meetings and the right of our board to issue preferred stock without shareholder approval.

We believe these provisions protect our shareholders from coercive or otherwise unfair takeover tactics by requiring potential acquirers to negotiate with our board and by providing our board with more time to assess any acquisition proposal. However, these provisions apply even if the offer may be considered beneficial by some shareholders and could delay or prevent an acquisition that our board determines is not in the best interests of our company and our shareholders. Accordingly, in the event that our board determines that a potential business combination transaction is not in the best interests of our Company and our shareholders but certain shareholders believe that such a transaction would be beneficial to the Company and its shareholders, such shareholders may elect to sell their shares in the Company and the trading price of our Class A Common Stock and Preferred Stock could decrease.

The combined post-Distribution value of our Class A Common Stock and Preferred Stock may not equal or exceed the pre-Distribution value of Sears Holdings common stock.

After the Distribution, Sears Holdings common stock will continue to be listed and traded on the NASDAQ Global Select Market. We have applied to list our Class A Common Stock on the NASDAQ Capital Market under the symbol “OSH” and quote our Preferred Stock on the OTCQB. We cannot assure you that the combined trading prices of Sears Holdings common stock and our Class A Common Stock and Preferred Stock after the Distribution, as adjusted for any changes in the combined capitalization of these companies, will be equal to or greater than the trading price of Sears Holdings common stock prior to the Distribution. Until the market has fully evaluated the business of Sears Holdings without our business, the price at which Sears Holdings common stock trade may fluctuate. Similarly, until the market has fully evaluated our business, the price at which shares of our Class A Common Stock and Preferred Stock trade may fluctuate significantly.

 

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It is expected that our Preferred Stock will be quoted on the OTCQB rather than listed on a national securities exchange, there may be limited liquidity in our Preferred Stock and the quote of our Preferred Stock may be volatile, all of which could limit your ability to sell your Preferred Shares.

Although our Class A Stock will be listed on the NASDAQ Capital Market, it is expected that our Preferred Stock will be quoted on the OTCQB, and will not be listed on any national securities exchange, which may limit the trading volume of our Preferred Stock. There is a greater chance for market volatility for securities that are quoted on an OTC quotation system as opposed to a national securities exchange. This volatility may be caused by a variety of factors, including the lack of readily available quotations, the absence of consistent administrative supervision of “bid” and “ask” quotations, and generally lower trading volume.

The OTC quotation system is a regulated quotation service that displays real-time quotes, last-sale prices and volume information for shares of stock that are not listed on a national securities exchange. Trades in OTC quotation system securities will be displayed only if the trade is processed by an institution acting as a market maker for those securities. Although there initially will be at least one institution acting as a market maker for our shares, that institution will not be obligated to continue making a market for any specific period of time. Thus, there can be no assurance that any institution will be acting as a market maker for our stock at any time. If there is no market maker for our shares and no trades in those shares are reported, it may be difficult for you to dispose of your Preferred Shares or even to obtain accurate quotations as to the market price of your shares.

Moreover, because the order handling rules adopted by the SEC that apply to shares listed on a national securities exchange do not apply to OTC quotation system shares, no market maker will be required to maintain an orderly market in our shares. Accordingly, an order to sell our shares placed with a market maker may not be processed until a buyer for the shares is readily available, if at all, which may further limit your ability to sell your shares at prevailing market prices.

 

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CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS

Certain statements made in this Prospectus contain forward-looking statements. Forward-looking statements are subject to risks and uncertainties that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements. Forward-looking statements include information concerning our future financial performance, business strategy, plans, goals and objectives.

Statements preceded or followed by, or that otherwise include, the words “believes,” “expects,” “anticipates,” “intends,” “project,” “estimates,” “plans,” “forecast,” “is likely to” and similar expressions or future or conditional verbs such as “will,” “may,” “would,” “should” and “could” are generally forward-looking in nature and not historical facts. Such statements are based upon the current beliefs and expectations of Sears Holdings’ management and are subject to significant risks and uncertainties. Actual results may differ materially from those set forth in the forward-looking statements.

The following factors, among others, could cause our actual results, performance or achievements to differ from those set forth in the forward-looking statements:

 

•

our ability to offer merchandise and services that our customers want, including our proprietary brand products;

 

•

competitive conditions in the home improvement retail industry;

 

•

worldwide and, in particular California, economic conditions and business uncertainty, the availability of consumer and commercial credit, changes in consumer confidence, tastes, preferences and spending, and changes in vendor relationships;

 

•

our ability to successfully manage our inventory levels;

 

•

adverse changes in economic factors specific to the home improvement industry;

 

•

sales fluctuations for a variety of reasons, including changes in our merchandising and promotional strategies;

 

•

extended cold or wet weather in California, particularly during our spring selling season;

 

•

the terms and availability of additional financing or replacement financing upon the maturing of our existing financing arrangements;

 

•

increases in interest rates;

 

•

significant inflation in the U.S. and/or California;

 

•

our ability to comply with the terms of our existing financing arrangements;

 

•

catastrophic damage to our stores or distribution center due to natural disaster;

 

•

our reliance on a single distribution center;

 

•

our extensive reliance on computer systems to process transactions, summarize results and manage our business;

 

•

our reliance on third parties to provide us with services in connection with the administration of certain aspects of our business;

 

•

impairment charges for intangible and long-lived assets;

 

•

our ability to attract, motivate and retain key executives and other associates;

 

•

the influence of certain members of our board of directors and their affiliates who have substantial influence over us;

 

•

the outcome of pending and/or future legal or regulatory proceedings, including product liability claims and environmental claims;

 

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•

our inability to execute our growth strategy;

 

•

our inability to maintain the security of customer, associate or company information;

 

•

our inability to maintain our leases or enter into new leases in a timely manner;

 

•

the impact of complying with increasingly stringent environmental laws and regulations;

 

•

failure to timely and effectively obtain shipments of products from our vendors;

 

•

our reliance on sources outside the U.S. for merchandise;

 

•

our ability to maintain good relationships with our vendors;

 

•

our ability to acquire commercial insurance at acceptable prices;

 

•

our inability to protect or preserve our intellectual property or to defend ourselves against assertions of intellectual property by others;

 

•

the inability of our historical financial statements to be indicative of our future performance;

 

•

our continuing dependence on Sears Holdings subsequent to the spin-off and our inability to quickly and cost-effectively develop independent systems;

 

•

the impact of increased costs due to a decrease in our purchasing power following the spin-off and other losses of benefits associated with being a subsidiary of Sears Holdings;

 

•

our agreements related to the spin-off and our continuing relationship with Sears Holdings were negotiated while we were a majority owned subsidiary of Sears Holdings and we may have received better terms from an unaffiliated third party;

 

•

the impact of increased costs associated with being a public company;

 

•

our inability to maintain effective internal controls as a public company;

 

•

our inability to pay dividends;

 

•

low trading volume of our capital stock due to limited liquidity or a lack of analyst coverage;

 

•

the ability of our principal shareholders to exert substantial control over us or prevent a change of control;

 

•

the impact on our capital stock in the event our principal shareholders alter their strategy with respect to us;

 

•

the costs to shareholders in the event the spin-off is determined to be taxable for U.S. federal income tax purposes;

 

•

our inability to engage in desirable strategic transactions and equity issuances due to restrictions related to the tax-free nature of the Distribution;

 

•

our failure to fully realize expected benefits from the spin-off; and

 

•

difficulty in operating as a publicly traded company independent from Sears Holdings.

Certain of these and other factors are discussed in more detail in “Risk Factors” in this Prospectus. These factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this Prospectus. While we believe that our forecasts and assumptions are reasonable, we caution that actual results may differ materially. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we projected. Consequently, actual events and results may vary significantly from those included in or contemplated or implied by our forward-looking statements. The forward-looking statements included in this Prospectus are made only as of the date of this Prospectus, and we undertake no obligation to publicly update or review any forward-looking statement made by us or on our behalf, whether as a result of new information, future developments, subsequent events or circumstances or otherwise.

 

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THE SPIN-OFF

General

Sears Holdings regularly reviews and evaluates the various businesses that Sears Holdings conducts and the fit that these businesses have within its overall business and growth strategies to help ensure that Sears Holdings’ resources are being put to use in a manner that is in the best interests of Sears Holdings and its shareholders.

Sears Holdings has announced its plan to spin-off Orchard as a publicly traded company independent from Sears Holdings, to be accomplished by means of a pro rata dividend to Sears Holdings’ shareholders.

On December 30, 2011, the distribution date, each Sears Holdings shareholder will receive one share of Class A Common Stock and one share of Preferred Stock for every 22.141777 shares of Sears Holdings common stock held as of the close of business on the record date. Immediately following the Distribution, Sears Holdings’ shareholders will own approximately 80% of the general voting power of Orchard. You will not be required to make any payment, surrender or exchange your common stock of Sears Holdings or take any other action to receive your shares of Orchard Class A Common Stock and Preferred Stock.

Following the Distribution, we will be a publicly traded company independent from Sears Holdings, and Sears Holdings will not retain any ownership interest in us. However, we anticipate that immediately following the Distribution, ESL Investments, Inc. and affiliated entities (“ESL”), which currently owns approximately 61% of Sears Holdings common stock, will own approximately 61% of our outstanding Class A Common Stock, representing approximately 61% of Class A Common Stock voting power and approximately 49% of the general voting power of our outstanding capital stock. Following the spin-off, ESL will also own approximately 61% of our outstanding Preferred Stock, which is our outstanding nonvoting capital stock. As a result of ESL holding more than 50% of our voting power for the election of eight of ten directors immediately after the consummation of the Distribution, we may qualify as a “controlled company” under the Nasdaq Marketplace rules, which would allow us to rely on exemptions from certain corporate governance requirements otherwise applicable to Nasdaq-listed companies. However, we do not currently intend to rely on such exemptions.

The distribution of shares of our Class A Common Stock and Preferred Stock as described in this Prospectus is subject to the satisfaction of certain conditions. For a more detailed description of these conditions, see “—Spin-Off Conditions” below.

Reasons for the Spin-Off

Sears Holdings’ board of directors has determined that pursuing a disposition of Orchard through a spin-off is in the best interests of Sears Holdings and its shareholders, and that separating Orchard from Sears Holdings would provide, among other things, financial, operational and managerial benefits to both Orchard and Sears Holdings, including but not limited to the following expected benefits:

 

•

Strategic Focus and Flexibility. Sears Holdings’ board of directors believes that following the spin-off, Orchard and Sears Holdings will each have more focused businesses and be better able to dedicate resources to pursue appropriate growth opportunities and execute strategic plans best suited to their respective businesses without regard for the other and in a more efficient manner.

 

•

Focused Management. The spin-off will allow management of each company to devote its time and attention to the development and implementation of corporate strategies and policies that are based primarily on the specific business characteristics of the respective companies, and to design more tailored compensation structures that better reflect these strategies, policies, and business characteristics. In particular, in the case of Orchard, separate equity-based compensation arrangements should more closely align the interests of management with the interests of shareholders and more directly incentivize the employees of Orchard, which will allow Orchard to more efficiently recruit and retain such employees.

 

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•

Investor Choice. Sears Holdings’ board of directors believes that the spin-off is expected to increase investor understanding of Orchard and its market position within its industry, while also allowing for a more natural and interested investor base. Separating Orchard from Sears Holdings also allows investors to make independent decisions with respect to each of Sears Holdings and Orchard based on, among other factors, their different business models, strategies and industries. The spin-off will enable Sears Holdings to distribute its holdings of Orchard to its shareholders while allowing it to focus on its remaining segments going forward.

Manner of Effecting the Spin-Off

For every 22.141777 shares of Sears Holdings common stock that you own as of the close of business on December 16, 2011, the record date, you will receive one share of our Class A Common Stock and one share of our Preferred Stock on the distribution date. Fractional shares of Class A Common Stock or Preferred Stock will not be distributed to Sears Holdings’ shareholders. Instead, a distribution agent will aggregate fractional shares into whole shares, sell the whole shares in the open market at prevailing market prices and distribute the aggregate net cash proceeds of the sales pro rata, based on the fractional share such holder would otherwise be entitled to receive, to each holder who otherwise would have been entitled to receive a fractional share in the Distribution. Accordingly, if you hold fewer than 22.141777 shares of Sears Holdings common stock as of the record date, you will not receive any shares of our Class A Common Stock or Preferred Stock; however, you will receive a cash distribution from our distribution agent representing the proceeds from the sale of the fractional share to which you are otherwise entitled, net of brokerage fees and other costs. The distribution agent, in its sole discretion, without any influence by Sears Holdings or us, will determine when, how, through which broker-dealer and at what price to sell the whole shares. Any broker-dealer used by the distribution agent will not be an affiliate of either Sears Holdings or us.

The aggregate net cash proceeds of these sales generally will be taxable for U.S. federal income tax purposes. See “—Material U.S. Federal Income Tax Consequences of the Spin-Off” for an explanation of the tax consequences of the Distribution. If you physically hold certificates for Sears Holdings common stock and are the registered holder, you will receive a check from the distribution agent in an amount equal to your pro rata share of the aggregate net cash proceeds of the sales. We estimate that it will take approximately ten business days from the distribution date for the distribution agent to complete the distributions of the aggregate net cash proceeds. If you hold your Sears Holdings common stock through a bank or brokerage firm, your bank or brokerage firm will receive, on your behalf, your pro rata share of the aggregate net cash proceeds of the sales and will electronically credit your account for your share of such proceeds. Shareholders should consult their bank or broker for further detail.

Sears Holdings will distribute shares of our Class A Common Stock and Preferred Stock on December 30, 2011, the distribution date. Wells Fargo Bank, N.A. will serve as transfer agent and registrar for our Class A Common Stock and Preferred Stock.

If you own Sears Holdings common stock as of the close of business on the record date, the Class A Common Stock and Preferred Stock that you are otherwise entitled to receive in the Distribution will be issued electronically, as of the distribution date, to you or to your bank or brokerage firm on your behalf by way of direct registration in book-entry form. Registration in book-entry form refers to a method of recording share ownership when no physical share certificates are issued to shareholders, as is the case in this Distribution. If you sell Sears Holdings common stock in the “regular-way” market up to and including the distribution date, you will be selling your right to receive shares of our Class A Common Stock and Preferred Stock in the Distribution.

Commencing on or shortly after the distribution date, if you hold physical share certificates that represent your common stock of Sears Holdings and you are the registered holder of the Sears Holdings shares represented by those certificates, the distribution agent will mail to you an account statement that indicates the number of our Class A Common Stock and Preferred Stock that have been registered in book-entry form in your name.

 

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Most Sears Holdings shareholders hold their common stock of Sears Holdings through a bank or brokerage firm. In such cases, the bank or brokerage firm would be said to hold the shares in “street name” and ownership would be recorded on the bank or brokerage firm’s books. If you hold your Sears Holdings common stock through a bank or brokerage firm, your bank or brokerage firm will credit your account for the shares of Class A Common Stock and Preferred Stock that you are entitled to receive in the Distribution. If you have any questions concerning the mechanics of having shares held in “street name,” we encourage you to contact your bank or brokerage firm.

Results of the Spin-Off

After our separation from Sears Holdings, we will be a publicly traded company independent from Sears Holdings. Immediately following the Distribution, we expect to have approximately 15,762 shareholders of record, based on the number of registered holders of Sears Holdings common stock on December 7, 2011 and the number of registered holders of Class B Common Stock and Class C Common Stock that we expect to have immediately following the Distribution. Our outstanding capital stock immediately following the Distribution will consist of approximately 4,806,000 shares of Class A Common Stock, approximately 8,644 shares of Class B Common Stock, approximately 1,194,000 shares of Class C Common Stock and approximately 4,806,000 shares of Preferred Stock (excluding, in each case, the shares to be received by Sears Holdings in respect of Sears Holdings treasury shares that will contributed to us for cancellation immediately following the Distribution). The actual number of shares to be distributed will be determined on the record date and will reflect any issuance of new shares pursuant to Sears Holdings’ equity plans, and any shares repurchased by Sears Holdings under its common share repurchase program, in each case on or prior to the record date. The Distribution will not affect the number of outstanding shares of Sears Holdings common stock or any rights of Sears Holdings’ shareholders.

Before the Distribution, we will enter into the Distribution Agreement and other agreements with Sears Holdings to effect the Distribution and provide a framework for our relationship with Sears Holdings after the Distribution. These agreements will govern the relationship between Sears Holdings and us subsequent to the completion of the spin-off and provide for the principal steps to be taken in connection with the spin-off and other matters. For a detailed description of these agreements, see “Certain Relationships and Related Party Transactions—Agreements with Sears Holdings” in this Prospectus.

Material U.S. Federal Income Tax Consequences of the Spin-Off

The following is a summary of the material U.S. federal income tax consequences to Sears Holdings and to the holders of Sears Holdings common stock in connection with the spin-off. This summary is based on the Code, the Treasury Regulations promulgated thereunder and judicial and administrative interpretations thereof, in each case as in effect and available as of the date of this Prospectus and all of which are subject to change at any time, possibly with retroactive effect. Any such change could affect the tax consequences described below.

This summary is limited to holders of Sears Holdings common stock that are U.S. Holders, as defined immediately below. A “U.S. Holder” is a beneficial owner of Sears Holdings common stock that is, for U.S. federal income tax purposes:

 

•

an individual who is a citizen or a resident of the United States;

 

•

a corporation, or other entity taxable as a corporation for U.S. federal income tax purposes, created or organized under the laws of the United States, any state thereof or the District of Columbia;

 

•

an estate, the income of which is subject to U.S. federal income taxation regardless of its source; or

 

•

a trust, if (i) a court within the United States is able to exercise primary supervision over its administration and one or more United States persons have the authority to control all of its substantial decisions or (ii) in the case of a trust that was treated as a domestic trust under the law in effect before 1997, a valid election is in place under applicable Treasury Regulations.

 

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This summary also does not discuss all tax considerations that may be relevant to shareholders in light of their particular circumstances, nor does it address the consequences to shareholders subject to special treatment under the U.S. federal income tax laws, such as:

 

•

dealers or traders in securities or currencies;

 

•

tax-exempt entities;

 

•

banks, financial institutions or insurance companies;

 

•

persons who acquired Sears Holdings common stock pursuant to the exercise of employee stock options or otherwise as compensation;

 

•

shareholders who own, or are deemed to own, at least 10% or more, by voting power or value, of Sears Holdings equity;

 

•

holders owning Sears Holdings common stock as part of a position in a straddle or as part of a hedging, conversion or other risk reduction transaction for U.S. federal income tax purposes;

 

•

certain former citizens or long-term residents of the United States;

 

•

holders who are subject to the alternative minimum tax; or

 

•

person that owns Sears Holdings common stock through partnerships or other pass-through entities.

This summary does not address the U.S. federal income tax consequences to Sears Holdings shareholders who do not hold Sears Holdings common stock as a capital asset. Moreover, this summary does not address any state, local or non-U.S. tax consequences or any estate, gift or other non-income tax consequences.

If a partnership (or any other entity treated as a partnership for U.S. federal income tax purposes) holds Sears Holdings common stock, the tax treatment of a partner in that partnership will generally depend on the status of the partner and the activities of the partnership. Such a partner or partnership should consult its own tax advisor as to its tax consequences.

YOU SHOULD CONSULT YOUR OWN TAX ADVISOR WITH RESPECT TO THE U.S. FEDERAL, STATE AND LOCAL AND NON-U.S. TAX CONSEQUENCES OF THE DISTRIBUTION. THIS SUMMARY IS NOT INTENDED TO BE, NOR SHOULD IT BE CONSTRUED TO BE, LEGAL OR TAX ADVICE TO ANY PARTICULAR INVESTOR.

Sears Holdings has received an IRS Ruling substantially to the effect that, for U.S. federal income tax purposes, the Distribution will qualify as tax-free under Section 355 of the Code, except for any cash received in lieu of a fractional share of our Class A Common Stock and Preferred Stock. The IRS Ruling also provides that certain internal transactions undertaken in anticipation of the Distribution will qualify for nonrecognition treatment under the Code. The IRS Ruling is binding upon the Internal Revenue Service, but its continued validity is subject to factual representations that we and Sears Holdings made to the Internal Revenue Service concerning certain conditions that are necessary to obtain tax-free treatment under the Code have been satisfied.

In addition to the IRS Ruling, Sears Holdings expects to receive an opinion from the law firm of Simpson Thacher & Bartlett LLP as to the satisfaction of certain requirements necessary for the spin-off to receive tax-free treatment under Section 355 of the Code upon which the Internal Revenue Service will not rule. The opinion will be based on, among other things, current tax law and assumptions and representations made by us and Sears Holdings, which if incorrect in certain material respects, would jeopardize the conclusions reached by Simpson Thacher & Bartlett LLP in its opinion. The opinion of counsel will not be binding on the Internal Revenue Service or the courts. For these reasons and the reasons discussed above in connection with the IRS Ruling, notwithstanding receipt by Sears Holdings of the IRS Ruling and the opinion of counsel, the Internal Revenue Service could assert successfully that the Distribution was taxable.

 

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Subject to the limitations and qualifications described herein, and on the basis of the receipt of the IRS Ruling, the following is the opinion of Simpson Thacher & Bartlett LLP as to the material U.S. federal income tax consequences of the spin-off to U.S. Holders of Sears Holdings common stock:

 

•

subject to the discussion below regarding Section 355(e), no gain or loss will be recognized by Sears Holdings as a result of the Distribution;

 

•

no gain or loss will be recognized by, or be includible in the income of, a holder of Sears Holdings common stock, solely as a result of the receipt of our Class A Common Stock and Preferred Stock in the Distribution, except with respect to any cash received in lieu of fractional shares;

 

•

the aggregate tax basis of the Sears Holdings common stock and shares of our Class A Common Stock and Preferred Stock in the hands of Sears Holdings’ shareholders immediately after the spin-off will be the same as the aggregate tax basis of the Sears Holdings common stock held by the holder immediately before the spin-off, allocated between the common stock of Sears Holdings and shares of our Class A Common Stock and Preferred Stock, including any fractional share interest for which cash is received, in proportion to their relative fair market values on the date of the spin-off;

 

•

the holding period of shares of our Class A Common Stock and Preferred Stock received by Sears Holdings’ shareholders will include the holding period of their Sears Holdings common stock, provided that such Sears Holdings common stock is held as a capital asset on the date of the spin-off; and

 

•

a Sears Holdings shareholder who receives cash in lieu of a fractional share of our Class A Common Stock in the Distribution will be treated as having sold such fractional share for the amount of cash received and generally will recognize capital gain or loss in an amount equal to the difference between the amount of such cash received and such shareholder’s adjusted tax basis in the fractional share. That gain or loss will be long-term capital gain or loss if the shareholder’s holding period for its Sears Holdings common stock exceeds one year.

Sears Holdings’ shareholders that have acquired different blocks of Sears Holdings common stock at different times or at different prices should consult their tax advisors regarding the allocation of their aggregate adjusted basis among, and their holding period of, shares of our Class A Common Stock and Preferred Stock distributed with respect to such blocks of Sears Holdings common stock.

Any Preferred Stock received by a Sears Holdings shareholder in the Distribution will constitute “Section 306 stock” for U.S. federal income tax purposes. As a result, any cash received in lieu of fractional shares of Preferred Stock by a Sears Holdings shareholder generally will be treated as ordinary dividend income. Furthermore, proceeds of a disposition of such Preferred Stock may be treated as ordinary dividend income even if such proceeds would otherwise have resulted in capital gain or do not exceed such shareholder’s basis in our Preferred Stock. Similarly, proceeds on redemption by us of such Preferred Stock generally would also be treated as ordinary dividend income even if the proceeds would not otherwise have been so treated. Any such deemed ordinary dividend income will not be eligible for the dividends received deduction that might otherwise be applicable to corporate U.S. Holders. If a Sears Holdings shareholder disposes of our Preferred Stock in a transaction that terminates such shareholder’s entire interest in us (including any of our Class A Common Stock and taking into account certain constructive ownership rules), the special rules applicable to Section 306 stock will not apply. Subject to applicable limitations, non-corporate U.S. Holders generally will be eligible for reduced rates of taxation as “qualified dividend income” under the Code on any such disposition or redemption, including the amount of any cash received in lieu of fractional shares (in the event such amounts are treated as ordinary dividend income), in taxable years beginning before January 1, 2013. The rules relating to Section 306 stock are complicated and shareholders are urged to consult their own tax advisors regarding the application of those rules.

U.S. Treasury Regulations require certain shareholders that receive stock in a spin-off to attach to their respective U.S. federal income tax returns, for the year in which the spin-off occurs, a detailed statement setting

 

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forth certain information relating to the spin-off. Within a reasonable period of time after the distribution, Sears Holdings expects to make available to its shareholders information pertaining to compliance with this requirement.

If the Distribution were not to qualify as a tax-free spin-off for U.S. federal income tax purposes, each Sears Holdings shareholder that receives shares of our Class A Common Stock and Preferred Stock (which, in such event, would not be treated as “Section 306 stock” as described above) in the Distribution would be treated as receiving a taxable distribution in an amount equal to the fair market value of such shares, which generally would be treated in the following manner:

 

•

first as a taxable dividend to the extent of such shareholder’s pro rata share of Sears Holdings’ current and accumulated earnings and profits;

 

•

then as a non-taxable return of capital to the extent of such shareholder’s tax basis in its Sears Holdings common stock; and

 

•

thereafter as capital gain with respect to any remaining value.

Additionally, each shareholder’s basis in the Class A Common Stock and Preferred Stock would be equal to its fair market value on the date of the Distribution. Furthermore, Sears Holdings would recognize a taxable gain to the extent the fair market value of our Class A Common Stock and Preferred Stock exceeds Sears Holdings’ tax basis in our Class A Common Stock and Preferred Stock prior to the spin-off.

Even if the Distribution otherwise qualifies for tax-free treatment under Section 355 of the Code, it may be taxable to Sears Holdings (but not Sears Holdings’ shareholders) under Section 355(e) if 50% or more, by vote or value, of shares of our Class A Common Stock and Preferred Stock or Sears Holdings’ common stock are acquired or issued as part of a plan or series of related transactions that includes the Distribution. For this purpose, any acquisitions or issuances of Sears Holdings’ common stock within two years before the Distribution, and any acquisitions or issuances of our Class A Common Stock and Preferred Stock or Sears Holdings’ common stock within two years after the Distribution, generally are presumed to be part of such a plan, although we or Sears Holdings may be able to rebut that presumption. Even if these rules were to apply to cause the spin-off to be taxable to Sears Holdings, it would remain tax-free to the Sears Holdings shareholders.

In connection with the Distribution, we and Sears Holdings will enter into the Distribution Agreement, whereby we will agree to be subject to certain restrictions to preserve the tax-free nature of the spin-off. For a description of the Distribution Agreement, see “Certain Relationships and Related Party Transactions—Agreements with Sears Holdings—Distribution Agreement.”

Sears Holdings’ shareholders should consult their own tax advisors as to the specific tax consequences of the spin-off to them, including the application and effect of state, local or non-U.S. tax laws and of changes in applicable tax laws.

Listing and Trading of Class A Common Stock and Preferred Stock

As of the date of this Prospectus, we are a majority-owned subsidiary of Sears Holdings. Accordingly, there is currently no public market for our capital stock. We intend to list our shares of Class A Common Stock on the NASDAQ Capital Market under the symbol “OSH” and quote our shares of Preferred Stock on the OTCQB.

Following the spin-off, Sears Holdings common stock will continue to trade on the NASDAQ Global Select Market under the symbol “SHLD”.

Neither we nor Sears Holdings can assure you as to the trading price of Sears Holdings common stock or our Class A Common Stock and Preferred Stock after the spin-off, or as to whether the combined trading prices

 

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of our Class A Common Stock and Preferred Stock and Sears Holdings common stock after the spin-off will be less than, equal to or greater than the trading prices of Sears Holdings common stock prior to the spin-off. The trading price of our Class A Common Stock and Preferred Stock may fluctuate significantly following the spin-off. See “Risk Factors—Risks Related to Our Class A Common Stock and Preferred Stock and the Distribution” and “Risk Factors—Risks Related to Our Class A Common Stock and Preferred Stock and the Securities Market” in this Prospectus for more detail.

The shares of Class A Common Stock and Preferred Stock distributed to Sears Holdings shareholders will be freely transferable, except for shares received by entities and individuals who are our affiliates. Entities and individuals who may be considered our affiliates after the spin-off include entities and individuals who control, are controlled by or are under common control with us, as those terms generally are interpreted for federal securities law purposes. These entities and individuals may include some or all of our directors and executive officers. Individuals who are our affiliates will be permitted to sell their shares of Class A Common Stock and Preferred Stock only pursuant to an effective Registration Statement under the Securities Act of 1933, as amended (which we refer to in this Prospectus as the Securities Act), or an exemption from the registration requirements of the Securities Act, such as the exemptions afforded by Section 4(1) of the Securities Act or Rule 144 thereunder.

Trading Prior to the Distribution Date

 

We do not plan to have a “when-issued” market for our Class A Common Stock or Preferred Stock prior to the Distribution. However, as early as two trading days prior to the record date and continuing up to and including the distribution date, there will be two markets in Sears Holdings common stock: a “regular-way” market and an “ex-distribution” market. Sears Holdings common stock that trades on the regular-way market will trade with an entitlement to shares of Class A Common Stock and Preferred Stock distributed pursuant to the Distribution. Shares that trade on the ex-distribution market will trade without an entitlement to shares of Class A Common Stock and Preferred Stock distributed pursuant to the Distribution. Therefore, if you sell Sears Holdings common stock in the regular-way market up to and including the distribution date, you will be selling your right to receive shares of Class A Common Stock and Preferred Stock in the Distribution. However, if you own Sears Holdings common stock at the close of business on the record date and sell those shares on the ex-distribution market up to and including the distribution date, you will still receive the shares of Class A Common Stock and Preferred Stock that you would otherwise be entitled to receive pursuant to the Distribution.

Spin-Off Conditions

The spin-off is subject to the satisfaction or waiver by Sears Holdings of the following conditions:

 

•

the Sears Holdings board of directors shall have authorized and approved the Distribution and related transactions and not withdrawn such authorization and approval, and shall have declared the dividend of Class A Common Stock and Preferred Stock to Sears Holdings shareholders;

 

•

each ancillary agreement contemplated by the distribution agreement between Orchard and Sears Holdings (the “Distribution Agreement”) shall have been executed by each party thereto;

 

•

the Securities and Exchange Commission (the “SEC”) shall have declared effective our Registration Statement on Form S-1, of which this Prospectus is a part, under the Securities Act of 1933, as amended (which we refer to in this Prospectus as the Securities Act), and no stop order suspending the effectiveness of the Registration Statement shall be in effect, and no proceedings for such purpose shall be pending before or threatened by the SEC;

 

•

our Class A Common Stock shall have been accepted for listing on the NASDAQ Capital Market or another national securities exchange or quotation system approved by Sears Holdings and our Preferred Stock shall have been accepted for quotation on the OTCQB, subject to official notice of issuance in each case;

 

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•

Sears Holdings shall have received the written opinion of Simpson Thacher & Bartlett LLP as to the satisfaction of certain requirements necessary for the spin-off to receive tax-free treatment under Section 355 of the Code upon which the IRS will not rule;

 

•

the Internal Transactions (as described in “Certain Relationships and Related Party Transactions—Agreements with Sears Holdings—Distribution Agreement” in this Prospectus) shall have been completed;

 

•

no order, injunction or decree issued by any governmental authority of competent jurisdiction or other legal restraint or prohibition preventing consummation of the Distribution shall be in effect, and no other event outside the control of Sears Holdings shall have occurred or failed to occur that prevents the consummation of the Distribution;

 

•

no other events or developments shall have occurred prior to the Distribution that, in the judgment of the board of directors of Sears Holdings, would result in the Distribution having a material adverse effect on Sears Holdings or the shareholders of Sears Holdings;

 

•

Sears Holdings shall have received a certificate signed by our Chief Financial Officer, dated as of the distribution date, certifying that prior to the Distribution we have made capital and other expenditures, and have operated our cash management, accounts payable and receivables collection systems, in the ordinary course consistent with prior practice;

 

•

prior to the distribution date, this Prospectus shall have been made available to the holders of Sears Holdings common stock as of the record date;

 

•

our current directors shall have duly elected the individuals listed as members of our post-Distribution board of directors in this Prospectus, and such individuals shall be the members of our board of directors immediately after the Distribution;

 

•

prior to the Distribution, Sears Holdings shall deliver or cause to be delivered to Orchard resignations, effective as of immediately after the Distribution, of each individual who will be an officer or director of Sears Holdings (other than Sears Canada Inc.) after the Distribution and who is an officer or director of Orchard immediately prior to the Distribution;

 

•

immediately prior to the Distribution, our amended and restated certificate of incorporation (“Amended and Restated Certificate of Incorporation”) and Amended and Restated Bylaws (“Amended and Restated Bylaws”), each in substantially the form filed as an exhibit to the Registration Statement on Form S-1 of which this Prospectus is a part, shall be in effect; and

 

•

the IRS Ruling received by Sears Holdings shall not have been revoked or modified in any material respect.

The fulfillment of the foregoing conditions will not create any obligation on the part of Sears Holdings to effect the spin-off. We are not aware of any material federal or state regulatory requirements that must be complied with or any material approvals that must be obtained, other than compliance with SEC rules and regulations and the declaration of effectiveness of the Registration Statement by the SEC, in connection with the Distribution. Sears Holdings has the right not to complete the spin-off if, at any time, the board of directors of Sears Holdings determines, in its sole discretion, that the spin-off is not in the best interests of Sears Holdings or its shareholders, or that market conditions are such that it is not advisable to effect the Distribution. In addition, Sears Holdings may at any time and from time to time until the Distribution decide to abandon the Distribution or modify or change the terms of the Distribution, including by accelerating or delaying the timing of the consummation of all or part of the Distribution.

 

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Treatment of 401(k) Plan Shares for Current and Former Employees

Orchard Employees Invested in the Sears Holdings Stock Fund of the Orchard Supply Hardware Retirement Savings Plan.

Orchard employees were previously eligible to participate under the Sears Holdings 401(k) Savings Plan. Effective July 18, 2011, Orchard established the Orchard Supply Hardware Retirement Savings Plan (the “Orchard Savings Plan”). The account balances of our employees, including any shares of Sears Holdings common stock held in the Sears Holdings Stock Fund under the Sears Holdings 401(k) Savings Plan, were transferred by a trust to trust transfer from the Sears Holdings 401(k) Savings Plan to the Orchard Savings Plan on August 4, 2011, and under the Orchard Savings Plan this is a closed fund. Based on the record date for the Distribution, the trust of the Orchard Savings Plan will receive on the distribution date one share of our Class A Common Stock and one share of our Preferred Stock for every 22.141777 shares of Sears Holdings common stock held in the Sears Holdings Stock Fund under the Orchard Savings Plan. The Orchard Savings Plan fiduciary will direct the trustee of the trust of the plan to take steps to liquidate the Orchard shares in an expeditious and prudent manner and then to allocate the proceeds in the same manner as a cash dividend under the Sears Holdings Stock Fund of the plan.

Participants of the Orchard Savings Plan are no longer permitted to make new purchases of Sears Holdings common stock through their plan accounts. As to those shares of the Sears Holdings common stock held by the Orchard Savings Plan at the time of the Distribution, participants may direct that the shares be exchanged for a different investment alternative in accordance with plan terms or may decide to remain invested in the shares until such time as the applicable plan fiduciary decides that the Orchard Savings Plan will no longer permit any investment in Sears Holdings common stock. At that time, the plan will dispose of all remaining Sears Holdings shares held in participant accounts and invest the proceeds in another investment alternative to be determined by the plan fiduciary. (This will not prohibit diversified, collectively managed investment alternatives available under the Orchard Savings Plan from holding Sears Holdings common stock or prohibit Orchard Savings Plan participants using self-directed accounts, if available, from investing these accounts in Sears Holdings common stock).

Sears Holdings Employees Invested in the Sears Holdings Stock Fund of another Company-Sponsored Savings Plan within the Sears Holdings Controlled Group of Corporations.

Current and former Sears Holdings employees hold Sears Holdings common stock under the Sears Holdings Stock Fund in an account under the Sears Holdings 401(k) Savings Plan, the Sears Puerto Rico Savings Plan, the Kmart Retirement Savings Plan for Puerto Rico Employee and the Lands’ End, Inc. Retirement Plan (collectively, the “Savings Plans,” which excludes the Orchard Savings Plan). Based on the record date for the Distribution, the trust of each Savings Plan will receive on the distribution date one share of Orchard Class A Common Stock and Preferred Stock in the Distribution for every 22.141777 shares of Sears Holdings common stock held in the Sears Holdings Stock Fund under the applicable Savings Plan. The applicable Savings Plan fiduciary for each Savings Plan will direct the applicable trustee or custodian of the trust of such plan to take steps to liquidate the Orchard shares in an expeditious and prudent manner and then allocate the proceeds in the same manner as a cash dividend under the Sears Holdings Stock Fund of such plan.

 

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Reason for Furnishing this Prospectus

This Prospectus is being furnished solely to provide information to Sears Holdings shareholders who will receive shares of Class A Common Stock and Preferred Stock in the Distribution. It is not to be construed as an inducement or encouragement to buy or sell any of our securities or any securities of Sears Holdings, nor is it to be construed as a solicitation of proxies in respect of the proposed distribution or any other matter. We believe that the information contained in this Prospectus is accurate as of the date set forth on the cover. Changes to the information contained in this Prospectus may occur after that date, and neither we nor Sears Holdings undertakes any obligation to update the information except in the normal course of our respective public disclosure obligations and practices.

 

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DIVIDEND POLICY

We do not expect to pay dividends on our Class A Common Stock, Preferred Stock or any other shares of our capital stock for the foreseeable future. The terms of the Preferred Stock will provide that dividends and other distributions may not be paid on any shares of our capital stock until all outstanding shares of the Preferred Stock have been redeemed or repurchased unless such dividend or distribution (i) has been unanimously approved by our board of directors, (ii) relates to a “poison pill” stockholder rights plan or (iii) is a distribution of cash in lieu of fractional shares made in connection with this Distribution. In addition, the terms of the Preferred Stock do not entitle the holders thereof to any dividends.

 

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CAPITALIZATION

The following table presents our capitalization as of July 30, 2011 on (i) an actual unaudited historical basis and (ii) on an unaudited pro forma basis as adjusted to give effect to the Distribution and the transactions related to the Distribution, including:

 

•

a 6 to 1 forward stock split of our Class A Common Stock, Class B Common Stock and Class C Common Stock, effected on December 8, 2011;

 

•

causing our Amended and Restated Certificate of Incorporation that authorizes our Class C Common Stock to become effective;

 

•

the exchange by ACOF I LLC of its 1,194,000 shares of Class A Common Stock for 1,194,000 shares of Class C Common Stock;

 

•

causing our Preferred Stock to be issued to Sears Roebuck;

 

•

the distribution by Sears Roebuck to Sears Holdings of all of the Class A Common Stock and Preferred Stock held by Sears Roebuck; and

 

•

the effectuation of the Distribution.

 

		As of July 30, 2011
		(unaudited) (in thousands, except share numbers)
		Actual				Pro Forma
Debt Outstanding:
Current maturities of long-term debt, including due to Sears Holdings		$	13,407			$	13,407
Long-term debt, net, including due to Sears Holdings			310,532				310,532
Total debt		$	323,939			$	323,939
Shareholders’ Equity:
Class A Common Stock, par value $0.01 per share authorized 1,049,000 shares; issued and outstanding 1,000,000 shares; issued and outstanding 4,806,000 shares pro forma			10				48
Class B Common Stock, par value $0.01 per share authorized 1,049,000 shares; issued and outstanding 1,440.67798 shares; issued and outstanding 8,644.06788 shares pro forma			—				—
Class C Common Stock, par value $0.01 per share no shares authorized; no shares issued and outstanding; issued and outstanding 1,194,000 shares pro forma			—				12
Preferred Stock, par value $0.00001 per share no shares authorized; no shares issued and outstanding; issued and outstanding 4,806,000 shares pro forma			—				—
Total Capitalization (debt plus shareholders’ equity)		$	323,949			$	323,999

This table should also be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the consolidated financial statements and accompanying notes and the “Unaudited Pro Forma Consolidated Financial Statements” and accompanying notes included elsewhere in this Prospectus.

 

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The number of shares of capital stock shown as issued and outstanding in the above table excludes:

 

•

options to purchase 206,928 shares of Class B Common Stock with a weighted average exercise price of $33.33 per share outstanding as of July 30, 2011, exercisable into an equal number of shares of Class B Common Stock, reflecting a 6 to 1 stock split, effected on December 8, 2011;

 

•

461,154 shares of Class B Common Stock reserved for future issuance under our 2010 Stock Incentive Plan; and

 

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SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA

The following table includes the historical selected consolidated financial and other financial data of Orchard. The consolidated statements of operations data set forth below for the fiscal years ended January 31, 2009, January 30, 2010, and January 29, 2011 and the consolidated balance sheet data as of January 30, 2010 and January 29, 2011 are derived from our audited consolidated financial statements included elsewhere in this Prospectus. The consolidated statements of operations data for the fiscal years ended February 3, 2007 and February 2, 2008 and the consolidated balance sheet data as of February 3, 2007, February 2, 2008, and January 31, 2009 are derived from consolidated financial statements that are not included in this Prospectus. The consolidated statements of operations data set forth below for the 13 weeks and 26 weeks ended July 31, 2010 and July 30, 2011 and the consolidated balance sheet data as of July 31, 2010 and July 30, 2011 are derived from our unaudited condensed consolidated financial statements included elsewhere in this Prospectus.

The selected historical consolidated financial and other financial data presented below should be read in conjunction with our consolidated financial statements and accompanying notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Prospectus. Our consolidated financial information may not be indicative of our future performance and does not necessarily reflect what our financial position and results of operations would have been had we operated as a publicly traded company independent from Sears Holdings during the periods presented, including changes that will occur in our operations and capitalization as a result of the Distribution and spin-off from Sears Holdings.

 

		Fiscal Year																				13 Weeks Ended								26 Weeks Ended
		2006				2007				2008				2009				2010				July 31, 2010				July 30, 2011				July 31, 2010				July 30, 2011
		(in thousands, except per share)
Consolidated Statement of Operations Data(1):
Net sales		$	888,558			$	834,741			$	761,489			$	682,393			$	660,701			$	195,032			$	196,437			$	364,683			$	360,205
Net income (loss)(2)			25,944				14,389				(243,367	)			19,305				8,717				8,140				3,891				12,574				2,901
Basic and diluted incomes (loss) per share(3)			4.31				(0.36	)			(40.47	)			3.21				1.45				1.35				0.65				2.09				0.48
Basic and diluted weighted average common shares outstanding(3)			6,013				6,013				6,013				6,013				6,013				6,013				6,010				6,013				6,011
Consolidated Balance Sheet Data:
Total assets		$	947,467			$	914,348			$	636,166			$	621,546			$	629,992			$	632,767			$	613,031			$	632,767			$	613,031
Long-term debt and capital lease obligations(4)			416,179				382,167				357,903				238,261				318,928				236,846				310,532				236,846				310,532
Other long-term liabilities			6,402				10,830				14,881				15,797				16,338				15,162				18,029				15,162				18,029
Other Financial Data:
Adjusted EBITDA(5)		$	112,128			$	93,593			$	84,831			$	80,746			$	69,392			$	24,919			$	19,660			$	44,734			$	30,826

 

(1)	Our fiscal year end is the Saturday closest to January 31 each year. Accordingly, our fiscal 2006 results contain a 53-week period, whereas fiscal years 2010, 2009, 2008, and 2007 contained 52 fiscal week periods. Our fiscal first quarter end is the Saturday closest to April 30 each year.

(2)	We recorded a goodwill impairment charge of $262.8 million in fiscal 2008.

(3)	We effected a 6 to 1 stock split on December 8, 2011. All share and per share information relating to our capital stock in this prospectus reflects such 6 to 1 stock split.

(4)	Excludes current portion. At the end of fiscal 2009 and May 1, 2010, $120.0 million of debt under the commercial mortgage-backed securities loan was classified as short-term, matured in December 2010.

(5)	Adjusted EBITDA is calculated as described below.

 

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In addition to our net income (loss) determined in accordance with GAAP, for purposes of evaluating operating performance, we use an Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization (“Adjusted EBITDA”). In addition, it is adjusted to exclude certain significant items as set forth below. Our management uses Adjusted EBITDA to evaluate the operating performance of our business, as well as executive compensation metrics, for comparable periods. Adjusted EBITDA should not be used by investors or other third parties as the sole basis for formulating investment decisions as it excludes a number of important cash and non-cash recurring items. The Adjusted EBITDA should not be considered as a substitute for GAAP measurements.

We believe Adjusted EBITDA is used by and is useful to investors and other users of our financial statements in evaluating our operating performance because it provides them with an additional tool to compare business performance across companies and across periods. We believe that:

 

•

EBITDA is widely used by investors to measure a company’s operating performance without regard to items such as interest expense, taxes, depreciation and amortization, which can vary substantially from company to company depending upon accounting methods and book value of assets, capital structure and the method by which assets were acquired; and

 

•

investors commonly use Adjusted EBITDA and Adjusted Net Income to eliminate the effect of restructuring and stock-based compensation expenses, which vary widely from company to company and prevent comparability.

While Adjusted EBITDA is a non-GAAP measurement, management believes that it is an important indicator of operating performance because:

 

•

EBITDA excludes the effects of financings and investing activities by eliminating the effects of interest and depreciation costs;

 

•

management considers gain/(loss) on the sale of assets and impairments to result from investing decisions rather than ongoing operations; and

 

•

other significant items, while periodically affecting our results, may vary significantly from period to period and have a disproportionate effect in a given period, which affects comparability of results.

Adjusted EBITDA was determined as follows:

 

(in thousands)		Fiscal Year																				13 Weeks Ended								26 Weeks Ended
		2006				2007				2008				2009				2010				July 31, 2010				July 30, 2011				July 31, 2010				July 30, 2011
Net income (loss)		$	25,944			$	14,389			$	(243,367	)		$	19,305			$	8,717			$	8,140			$	3,891			$	12,574			$	2,901
Interest expense, net			37,684				30,135				22,875				16,770				17,392				4,236				5,517				8,458				11,071
Income tax expense			16,758				12,491				10,304				12,749				5,573				5,150				2,672				8,039				2,073
Depreciation and amortization			31,127				35,324				31,410				29,870				31,187				7,247				7,504				15,316				14,667
Goodwill impairment											262,763
(Gain) loss on disposal, sale and impairment of assets							(484	)							275				633				11				12				145				97
Stock-based compensation			615				325				125				495				329				135				64				202				210
Other significant items							1,413				721				1,282				5,561																(193	)
Adjusted EBITDA		$	112,128			$	93,593			$	84,831			$	80,746			$	69,392			$	24,919			$	19,660			$	44,734			$	30,826

The Adjusted EBITDA is not the same as the EBITDA as defined in our Senior Secured Term Loan.

Other significant items include certain reserves and charges not in the normal course of our operations periodically affecting the comparability of our results. In fiscal 2007, the Company settled two class action wage and hour lawsuits that alleged certain violations of the California Labor Code. We accrued $5.0 million in fiscal 2007 for these two lawsuits and subsequently received $3.6 million from Sears Holdings pursuant to the Sears indemnification. We have recorded $0.7 million and $1.3 million in severance charges in fiscal 2008 and 2009, respectively, in connection with our cost cutting initiatives. In fiscal 2010, we recorded a $5.6 million legal settlement reserve pursuant to the Save Mart case. In the first quarter of fiscal 2011, we reversed $0.5 million of the Save Mart accrual as we no longer expected to pay that amount. We have also recorded a $0.3 million severance charge in the first quarter of fiscal 2011 due to changes in our management structure.

 

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UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL DATA

The following unaudited pro forma financial statements are derived from the historical consolidated financial statements of Orchard, which are included elsewhere in this Prospectus. The pro forma adjustments give effect to the spin-off and the related transactions, as described in the notes to the unaudited pro forma financial statements. The unaudited pro forma financial data for fiscal 2010, the second quarter of fiscal 2011 and the first half of fiscal 2011 give effect to the spin-off as if it has occurred on January 31, 2010, the first day of fiscal 2010. The unaudited pro forma statements include adjustments to reflect the following transactions:

 

•

the new terms under the Appliances Agreement with a subsidiary of Sears Holdings, and

 

•

the new terms under the Brands Agreements with a subsidiary of Sears Holdings.

The assumptions underlying the pro forma adjustments are described in the accompanying notes, which should be read in conjunction with the unaudited pro forma consolidated financial information. The assumptions used and pro forma adjustments derived from such assumptions are based on currently available information, and we believe such assumptions are reasonable under the circumstances.

The following unaudited pro forma financial statements should be read in conjunction with the historical consolidated financial statements for Orchard and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Prospectus.

The unaudited pro forma information has been presented for informational purposes only. The pro forma information is not necessarily indicative of our results of operations or financial condition had the spin-off and the related transactions been completed on the dates assumed. Also, they may not reflect the results of operations or financial condition which would have resulted had we been operating as a publicly traded company independent from Sears Holdings during such periods. In addition, they are not necessarily indicative of our future results of operations or financial condition.

 

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Orchard Supply Hardware Stores Corporation

Unaudited Pro Forma Consolidated Statement of Operations

Fiscal Year Ended January 29, 2011

(in millions, except per share data)

 

						Pro Forma Adjustments
		Historical				Appliances Agreement				Brands Agreements				Pro Forma
NET SALES		$	660.7			$	(12.7	)						$	648.0
COST OF SALES AND EXPENSES:
Cost of sales (excluding depreciation and amortization)			431.8				(10.7	)		$	0.5				421.6
Selling and administrative			166.0												166.0
Depreciation and amortization			31.2												31.2
Total cost of sales and expenses			629.0												618.8
OPERATING INCOME			31.7												29.2
INTEREST EXPENSE, NET			17.4												17.4
INCOME BEFORE INCOME TAXES			14.3												11.8
INCOME TAX EXPENSE (BENEFIT)			5.6				(0.8	)			(0.2	)			4.6
NET INCOME		$	8.7											$	7.2
INCOME PER COMMON SHARE:
Basic and diluted income per common share		$	1.45											$	1.2
Basic and diluted weighted average common shares outstanding			6.0												6.0

 

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Orchard Supply Hardware Stores Corporation

Unaudited Pro Forma Consolidated Statements of Operations

For the 13 Weeks and 26 Weeks Ended July 30, 2011

(in millions, except per share data)

 

		13 Weeks Ended July 30, 2011
		Pro Forma Adjustments
		Historical				Appliances Agreement				Brands Agreements				Pro Forma
NET SALES		$	196.4			$	(4.6	)						$	191.8
COST OF SALES AND EXPENSES:
Cost of sales (excluding depreciation and amortization)			130.6				(4.1	)		$	0.2				126.7
Selling and administrative			46.2												46.2
Depreciation and amortization			7.5												7.5
Total cost of sales and expenses			184.3												180.4
OPERATING INCOME			12.1												11.4
INTEREST EXPENSE, NET			5.5												5.5
INCOME BEFORE INCOME TAXES			6.6												5.9
INCOME TAX EXPENSE (BENEFIT)			2.7				(0.2	)			(0.1	)			2.4
NET INCOME		$	3.9											$	3.5
INCOME PER COMMON SHARE
Basic and diluted income per common share		$	0.65											$	0.58
Basic and diluted weighted average common shares outstanding			6.0												6.0
		26 Weeks Ended July 30, 2011
		Pro Forma Adjustments
		Historical				Appliances Agreement				Brands Agreements				Pro Forma
NET SALES		$	360.2			$	(8.8	)						$	351.4
COST OF SALES AND EXPENSES:
Cost of sales (excluding depreciation and amortization)			239.2				(7.7	)		$	0.3				231.8
Selling and administrative			90.3												90.3
Depreciation and amortization			14.7												14.7
Total cost of sales and expenses			344.2												336.8
OPERATING INCOME			16.0												14.6
INTEREST EXPENSE, NET			11.0												11.0
INCOME BEFORE INCOME TAXES			5.0												3.6
INCOME TAX EXPENSE (BENEFIT)			2.1				(0.4	)			(0.1	)			1.6
NET INCOME		$	2.9											$	2.0
INCOME PER COMMON SHARE
Basic and diluted income per common share		$	0.48											$	0.33
Basic and diluted weighted average common shares outstanding			6.0												6.0

 

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Orchard Supply Hardware Stores Corporation

Notes to Unaudited Pro Forma Consolidated Financial Statements

 

1.	THE APPLIANCES AGREEMENT

On October 26, 2011 the Company entered into an appliances agreement (the “Appliances Agreement”) with a subsidiary of Sears Holdings pursuant to which Sears Holdings authorizes us to sell certain appliances and related protection agreements on a consignment basis through our designated retail locations. The Appliances Agreement requires that Sears Holdings pay us commissions on the sales of these consigned products and protection agreements sold at our retail locations. The appliances covered by the Appliances Agreement include specified categories of Kenmore, Bosch, Electrolux, GE, LG, Samsung and Whirlpool branded appliances. The agreement generally incorporates arm’s length terms and conditions, including market-based pricing and term of duration.

Under the Appliances Agreement, we transferred to Sears Holdings our entire inventory of major appliances purchased from Sears Holdings for $1.9 million in cash, which represented our cost of the purchased appliances, subject to adjustments based on, among other things, the results of a physical inventory of the purchased appliances and the cost of certain clearance markdowns realized by Sears Holdings during the 60-day period following the effective date of the Appliances Agreement.

The Company entered into an appliances sales agreement with Sears Holdings on November 23, 2005, as amended (the “Appliances Sales Agreement”), which was terminated on October 26, 2011. All appliances purchased and sold as of that date were made under the Appliance Sales Agreement. If the terms of the Appliances Agreement with certain Sears Holdings subsidiaries were effective on January 31, 2010, the first day of fiscal 2010, all Sears Holdings proprietary branded appliance sales of $14.5 million, $5.3 million and $10.0 million would have been removed from net sales of fiscal 2010, the second quarter of fiscal 2011 and the first half of fiscal 2011, respectively. Replacing these amounts would be approximately $1.8 million, $0.7 million and $1.2 million in commission income for sales of such appliances in fiscal 2010, the second quarter of fiscal 2011, and the first half of fiscal 2011, respectively. The net effect on net sales would be a reduction of approximately $12.7 million, $4.6 million and $8.8 million in fiscal 2010, the second quarter of fiscal 2011 and the first half of fiscal 2011, respectively. The pro-forma commission income figures were derived based on a blended commission rate based on our product mix applied on the total actual sales. Accordingly, any associated cost of sales would be eliminated under the Appliances Agreement. The pro-forma cost of sales eliminated were derived based on the product costs of appliances sold during the respective periods. The Company also estimates that there will be incremental savings in selling and administrative costs with respect to credit card processing fees, marketing, and payroll costs. These savings are estimated to range from $1.0 million to $2.0 million annually. These selling and administrative cost savings estimates are not included in the pro forma tables above.

 

2.	THE BRANDS AGREEMENTS

The Company entered into three brands license agreements, subject to the approval of the audit committee of Sears Holdings (the “Brands Agreements”), with a subsidiary of Sears Holdings effective at the Distribution pursuant to which Sears Holdings will allow us to purchase a limited assortment of Craftsman products, Easy Living and Weatherbeater paints, Kenmore-branded water heaters and consumer household products directly from vendors. Under the Brands Agreements, we will pay specified license fees to Sears Holdings. The agreements generally incorporate arm’s length terms and conditions, including market-based pricing and term of duration. The agreements have a three year term and may be extended subject to the mutual agreement of the parties.

The Company entered into a brands sales agreement with Sears Holdings on November 23, 2005, as amended (the “Brands Sales Agreement”), which will be terminated as of the Distribution. All Sears Holdings proprietary branded products purchased and sold to date were made under the Brands Sales Agreement. If the terms of the Brands Agreements with certain Sears Holdings subsidiaries were effective on January 31, 2010, the first day of fiscal 2010, the Company estimates that they would have recorded incremental costs of $0.5 million,

 

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$0.2 million and $0.3 million in fiscal 2010, the second quarter of fiscal 2011 and the first half of fiscal 2011, respectively. The pro-forma incremental costs figures were derived based on the specific products sold during the respective periods and the new pricing and additional vendor subsidies specified under each of the Brands Agreements.

 

3.	INCREMENTAL SPIN-OFF COSTS

We are currently a majority owned indirect subsidiary of Sears Holdings. After the spin-off, we will operate as a publicly traded company independent from Sears Holdings, which will have a range of impacts on our operations:

General Administrative and Separation Agreement Costs. We will incur increased costs as a result of becoming a publicly traded company independent from Sears Holdings, primarily from higher charges than in the past from Sears Holdings for transition services and from establishing or expanding the corporate support for our businesses, including information technology, human resources, treasury, tax, risk management, accounting and financial reporting, investor relations, legal, procurement and other services. These additional annual operating charges are estimated to be approximately $3.0 million to $4.0 million annually.

Increased Costs for Goods and Services. We expect an impact on prices for goods and services purchased from third parties as a result of the loss of Sears Holdings’ buying volume and processes. We estimate these cost increases to be approximately $2.0 million to $4.0 million annually.

These estimates are not included in the pro forma tables above.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and notes contained elsewhere in this Prospectus. This discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in these forward looking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this Prospectus, particularly in “Risk Factors” and “Cautionary Statement Concerning Forward-Looking Statements.”

EXECUTIVE OVERVIEW

We are a California specialty retailer primarily focused on the consumer segment of the home improvement market. As of July 30, 2011 we operated 89 stores that are designed to appeal to convenience-oriented customers, whose purchase occasions are largely driven by their repair, maintenance and improvement needs throughout the home, garden and outdoor living areas. We also serve the small professional customer whose purchases are largely motivated by a need for incremental supplies and tools to complete construction projects.

Our stores average approximately 43,600 square feet of enclosed space plus approximately 8,300 square feet of nursery and garden area. Our stores carry a broad assortment of repair and maintenance, lawn and garden and in-home products. We operate in one reportable segment and provide a merchandise mix which consists of various product categories. Our repair and maintenance category consists of plumbing, electrical, paint, tools, hardware, and industrial products. Our lawn and garden category consists of nursery, garden, outdoor power and seasonal products. Our in-home category consists mainly of our housewares and appliances products.

We believe that our market is significantly driven by our customers’ desire for an enjoyable home with wonderful amenities. Since 2008 however, households in the U.S. have been borrowing less and saving more as they have struggled to cope with the effects of the worst national recession in decades. The external pressures facing the home improvement retail industry over the past several years continued in 2010, as the effects of rising unemployment, declining home values, tighter consumer credit, modest growth in personal disposable income and low housing turnover and general economic uncertainty led to a reduction and hesitancy among consumers to spend on discretionary projects for their homes.

In California, unemployment continues to be higher than the national average, ending 2010 at 12.5%, foreclosure rates remain amongst the highest in the nation, and home prices continued to decline, though at a slower pace than during 2008 and 2009. As a result, consumers have reordered their priorities and have become more deliberate in their spending decisions, as evidenced by the significant decline in the rate of consumer spending, and the increase in the national personal savings rate above levels seen from 2000 through 2008. Household spending increased modestly in 2010 over the prior year, but in many cases, consumers have delayed or reduced the scope of their home improvement projects, or are trading down, focusing on mini projects and small enhancements versus major renovations as they develop strategies to address the current macroeconomic climate. As consumers’ priorities have shifted and the home improvement retail industry market has tightened, we have adjusted our marketing efforts to address these changes by taking a number of actions, including, in particular, by significantly increasing our pricing promotions and discounts.

The home improvement industry in California is highly competitive and we are positioned between large warehouse home center competitors and smaller independent hardware stores. We consider The Home Depot, Lowe’s, Ace Hardware and True Value as our primary competitors. Based on publically available information, we believe that in California each of The Home Depot, Ace Hardware and True Value currently has between two to three times as many stores as we do and that Lowe’s has, by number of stores, over 20% more stores in the state than we do. In response to the increased competitive environment, we have increased our pricing promotions in the past years. Historically, we have been adversely impacted by competitors opening new store

 

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locations within our markets. These openings have slowed in recent years as a result of the downturn in the economy as well as the market saturation that has occurred as a result of their earlier rapid expansions.

We do not expect to see a significant change in the immediate future in our number of stores relative to our primary competitors, our use of pricing promotions in response to competitive pressures or the pace at which our competitors will open new stores in California.

Fiscal Year

Our fiscal year end is the Saturday closest to January 31 each year. Fiscal years 2010, 2009 and 2008 all consisted of 52 weeks. Unless otherwise stated, references to years in this report relate to fiscal years rather than to calendar years. The following fiscal periods are presented in this report.

 

Fiscal year		Ended		Weeks
2008		January 31, 2009		52
2009		January 30, 2010		52
2010		January 29, 2011		52

Our results of operations are discussed using several key metrics:

 

1.

Comparable store sales. Measured by the increase or decrease in net sales year over year, excluding new and closed stores and E-commerce.

 

2.

Comparable transaction volume. Derived from the increase or decrease in the number of transactions year over year, excluding new and closed stores and E-commerce.

 

3.

Average ticket comparables. Derived using net sales divided by the number of transactions year over year.

A store is included in the calculation of comparable metrics above if it has been opened for at least 12 months, including relocated and remodeled stores. The key metrics discussed above are intended only as supplemental information and are not a substitute for information presented in accordance with generally accepted accounting principles.

We experience seasonal fluctuations in our revenues and operating results and we have historically realized a significant portion of our net sales and earnings for the year in the spring selling season, including March, April, May and June. For example, we generated 29% and 30% of our net sales in the second fiscal quarter of 2009 and 2010, respectively. We believe that our customers are more likely to begin the home improvement projects for which they shop with us during periods of warm and dry weather. By contrast, wet, windy and/or cold weather conditions can reduce foot traffic in our stores. Extended cold or wet weather conditions in California, particularly during the spring months, can significantly reduce our revenues and have a disproportionately adverse effect on our results of operations for the first and second quarter and have an adverse impact on our annual operating results. Furthermore, lower than anticipated net sales during the spring selling season may cause us to increase inventory markdowns and promotion expenses, thereby reducing our gross margins and operating results.

The following represent some of our key strategic initiatives for developing our business in 2011, which will require financing on an ongoing basis:

Improve Gross Margin Performance through Enhanced Marketing and Merchandising Initiatives. We are focused on developing new marketing initiatives to increase the number of customers and frequency of customer visits in our stores as well as increase the average amount of time they spend in our stores. Our marketing initiatives include development of a new campaign to improve our brand awareness, which involves beginning to standardize the look and feel of our stores as well as how we communicate our “Orchard Supply Hardware” brand, and continuing to more efficiently utilize our advertising expenditures to better communicate our value proposition to our target customers.

 

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We are continually focusing on various merchandising initiatives intended to improve our gross margin performance, including accelerated line reviews, increasing our private label offerings and expanding the sourcing of merchandise from overseas. Our line reviews are focused on enhancing the overall quality and value proposition of our merchandise through targeted negotiation with our vendors. We continually identify product lines for review and work with our vendors to strive for the best possible quality, pricing and terms for a particular product category. In keeping with the industry trend, our private label products typically generate higher gross margins compared to similar national brands. We believe our private label merchandise provides our customers with high quality products at excellent values and therefore allows us to compete effectively in the market. For fiscal 2010, private label sales accounted for approximately 6% of our total net sales.

Provide Multiple Sales Channels. In today’s competitive environment it is essential that we offer our customers the convenience of shopping for our products through multiple channels. The retail industry is rapidly evolving as retail is increasingly impacted by new technologies and social media. We believe that this evolution will provide us with growth opportunities if we are able to leverage our existing store network with emerging technologies and a much wider range of products enabled by an E-commerce merchandising operation. As such, we launched our E-commerce website with approximately 7,000 products in late 2010. Although ecommerce sales to date have been insignificant, our goal is to continue to expand the number of products offered on the E-commerce site in order to increase future revenues. Distribution of products for our website is handled through our existing distribution center and has not involved a material capital investment. Establishing the E-commerce website required capital expenditures of $0.7 million and we expect to spend $0.4 million in fiscal 2011 for our E-commerce website, which we expect to fund from cash flows from operations.

Store Expansion. New store growth has been limited in recent years due to economic conditions and Company’s performance. However, assuming market conditions improve in future years, we plan to increase the expansion of our store base within California. We have also developed a new store prototype in both our Clayton and Santa Rosa stores that we believe will provide an enhanced and more enjoyable shopping experience for our customers, which we expect to integrate into future store openings and existing stores. Our capital investment budget for fiscal 2011 for store expansion and prototypes is $3.8 million, which we expect to fund from cash flows from operations.

Offer Competitive Pricing. We employ a value driven pricing strategy. We continually review our pricing strategy through routine competitor price checks. Everyday prices are complemented by periodic off price item promotions and storewide discount events which form a key part of our marketing strategy such as “We Pay the Sales Tax” weekends. “Dollar Days” events featuring low priced products are used to underscore our value pricing and to reassure our customers that they cannot overpay at Orchard stores. Also, to compete with low price competitors, we have a “Match Any Price” policy.

IMPACTS FROM THE SPIN-OFF

We are currently a majority owned indirect subsidiary of Sears Holdings. Sears Holdings has determined to spin-off the Company by distributing all of our Class A Common Stock and Preferred Stock to the shareholders of Sears Holdings as a dividend. Immediately following completion of the spin-off, Sears Holdings shareholders will own 100% of the outstanding shares of our Class A Common Stock and Preferred Stock. ESL Investments, Inc. and affiliated entities (“ESL”) will own approximately 61% of our outstanding Class A Common Stock, representing approximately 61% of Class A Common Stock voting power and 49% of the voting power of our outstanding capital stock, and ESL will own approximately 61% of our outstanding Preferred Stock, which is our outstanding nonvoting capital stock. After the spin-off, we will operate as a publicly traded company independent from Sears Holdings, which will have a range of impacts on our operations:

General Administrative and Separation Agreement Costs. Historically, we have used the corporate functions of Sears Holdings for a variety of services including treasury, accounting, tax, legal, and shared services, which include the costs of payroll, employee benefits and other payroll related costs. Sears Holdings also contributes to other corporate functions such as the members of our board of directors and centrally

 

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managed employee benefit arrangements. We allocated $0.5 million in fiscal 2010, $0.4 million in fiscal 2009 and $0.6 million in fiscal 2008 of shared services costs incurred by Sears Holdings. We believe that the assumptions and methodologies underlying the allocation of these expenses from Sears Holdings are reasonable. However, such expenses may not be indicative of the actual level of expense that would have been or will be incurred by us when we operate as a publicly traded company independent from Sears Holdings. We expect to enter into agreements with Sears Holdings for continuation of certain of these services, but the terms and prices on which such services are rendered may be different than the terms and prices in effect prior to the spin-off.

We will also incur increased costs as a result of becoming a publicly traded company independent from Sears Holdings, primarily from higher charges than in the past from Sears Holdings for transition services and from establishing or expanding the corporate support for our business, including information technology, human resources, treasury, tax, risk management, accounting and financial reporting, investor relations, legal, procurement and other services. These additional annual operating charges are estimated to be approximately $3.0 million to $4.0 million. We believe cash flows from operations will be sufficient to fund these additional corporate expenses.

We also expect to incur a one-time, non-recurring expenditures between approximately $1.0 million and $2.0 million primarily relating to costs for setting up certain stand-alone functions and information technology systems. A portion of these expenditures may be capitalized and amortized over their useful lives and others will be expensed as incurred, depending on their nature.

Spin-Off Transaction Costs. One-time, non–recurring transaction related costs related to the consummation of the spin-off will be the responsibility of Sears Holdings. These costs are expected to consist of, among other things: accounting, financial, legal, tax and other advisory fees.

Increased Costs for Goods and Services. We expect an impact on prices for goods and services purchased from third parties as a result of the loss of Sears Holdings’ buying volume and processes. We estimate these cost increases to range from approximately $2.0 million to $4.0 million annually.

Sears Holdings Merchandising. We have historically procured appliances and other merchandise from Sears Holdings suppliers pursuant to the Appliances Sales Agreement and the Brands Sales Agreement. We will continue to procure merchandise from Sears Holdings, but will sell certain appliances and related protection agreements supplied to us by Sears Holdings on a consignment basis pursuant to the Appliances Agreement, entered into on October 26, 2011, which we expect will result in a reduction of net sales ranging from $14.0 million to $17.0 million on a going forward annual basis due to transitioning to commission-based sales. We expect the impact to net income to range from $1.0 million to $2.0 million annually under the new Appliance Agreement and Brands Agreements.

RESULTS OF OPERATIONS

Our results of operations are presented using key accounting policies that are further described in Note 1 of the Notes to the Consolidated Financial Statements. Key definitions include:

Revenue Recognition—The Company recognizes revenues from merchandise sales at the later of point of sale or delivery of goods to customers. Merchandise sales are reported net of estimated returns and allowances, customer rebates excluding sales taxes. The reserve for returns and allowances is calculated as a percentage of sales based on historical return percentages. Net sales are presented net of any taxes collected from customers and remitted to governmental authorities. The Company also records deferred revenue for the sale of gift cards and recognizes this revenue upon the redemption of the gift cards.

Cost of Sales—Cost of sales includes the cost of merchandise, distribution, warehousing and delivery costs and store occupancy costs, offset by vendor allowances and rebates received by the Company.

Selling and Administrative Expenses—Selling and administrative expenses primarily include selling and support payroll, advertising and other administrative expenses.

 

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Depreciation and Amortization—The Company’s buildings, furniture, fixtures and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized using the straight-line method over the original term of the lease or the useful life of the improvement, whichever is shorter. The Company’s property and equipment is depreciated using the following estimated useful lives:

 

Asset type		Life
Buildings and leasehold improvements			15 – 40 years
Furniture, fixtures and equipment			3 – 10 years

Income Taxes—The tax balances and income tax expense recognized by the Company are based on management’s interpretation of the tax laws of multiple jurisdictions. Income tax expense also reflects the Company’s best estimates and assumptions regarding, among other things, the level of future taxable income, interpretation of the tax laws and tax planning. Future changes in tax laws, changes in projected levels of taxable income and tax planning could affect the effective tax rate and tax balances recorded by the Company. The Company provides deferred income tax assets and liabilities based on the estimated future tax effects of differences between the financial and tax bases of assets and liabilities based on currently enacted tax laws.

Adjusted EBITDA—In addition to our net income (loss) determined in accordance with GAAP, for purposes of evaluating operating performance, we use an Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization (“Adjusted EBITDA”), which is adjusted to exclude certain significant items as set forth below. Our management uses Adjusted EBITDA to evaluate the operating performance of our business, as well as executive compensation metrics, for comparable periods. Adjusted EBITDA should not be used by investors or other third parties as the sole basis for formulating investment decisions as it excludes a number of important cash and non-cash recurring items. The adjusted EBITDA should not be considered as a substitute for GAAP measurements.

While Adjusted EBITDA is a non-GAAP measurement, management believes that it is an important indicator of operating performance because:

 

•

EBITDA excludes the effects of financing and investing activities by eliminating the effects of interest and depreciation costs;

 

•

Management considers gain/(loss) on the sale of assets and impairment to result from investing decisions rather than ongoing operations; and

 

•

Other significant items, while periodically affecting our results, may vary significantly from period to period and have a disproportionate effect in a given period, which affects comparability of results.

Adjusted EBITDA was determined as follows:

 

(in thousands)		Fiscal Year												13 Weeks Ended								26 Weeks Ended
		2008				2009				2010				July 31, 2010				July 30, 2011				July 31, 2010				July 30, 2011
Net (loss) income		$	(243,367	)		$	19,305			$	8,717			$	8,140			$	3,891			$	12,574			$	2,901
Interest expense, net			22,875				16,770				17,392				4,236				5,517				8,458				11,071
Income tax expense			10,304				12,749				5,573				5,150				2,672				8,039				2,073
Depreciation and amortization			31,410				29,870				31,187				7,247				7,504				15,316				14,667
Goodwill impairment			262,763
Loss on sale and impairment of assets							275				633				11				12				145				97
Stock-based compensation			125				495				329				135				64				202				210
Other significant items			721				1,282				5,561																(193	)
Adjusted EBITDA		$	84,831			$	80,746			$	69,392			$	24,919			$	19,660			$	44,734			$	30,826

 

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The Adjusted EBITDA is not the same as the EBITDA as defined in our Senior Secured Term Loan.

Other significant items include certain reserves and charges not in the normal course of our operations periodically affecting the comparability of our results. In fiscal 2007, the Company settled two class action wage and hour lawsuits that alleged certain violations of the California Labor Code. We accrued $5.0 million in fiscal 2007 for these two lawsuits and subsequently received $3.6 million from Sears Holdings pursuant to the Sears indemnification. We have recorded $0.7 million and $1.3 million in severance charges in fiscal 2008 and 2009, respectively, in connection with our cost cutting initiatives. In fiscal 2010, we recorded a $5.6 million legal settlement reserve pursuant to the Save Mart case. In the first quarter of fiscal 2011, we reversed $0.5 million of the Save Mart accrual as we no longer expected to pay that amount. We have also recorded a $0.3 million severance charge in the first quarter of fiscal 2011 due to changes in our management structure.

The following table sets forth items derived from our consolidated results of operations for fiscal 2008, 2009, 2010 and the 13 weeks and 26 weeks ended July 31, 2010 and July 30, 2011:

 

		FISCAL YEAR																								13 Weeks Ended																26 Weeks Ended
		2008				% of Net Sales				2009				% of Net Sales				2010				% of Net Sales				July 31, 2010				% of Net Sales				July 30, 2011				% of Net Sales				July 31, 2010				% of Net Sales				July 30, 2011				% of Net Sales
NET SALES		$	761,489				100.0	%		$	682,393				100.0	%		$	660,701				100.0	%		$	195,032				100.0	%		$	196,437				100.0	%		$	364,683				100.0	%		$	360,205				100.0	%
COST OF SALES AND EXPENSES:
Cost of sales (excluding depreciation and amortization)			486,222				63.9				438,060				64.2				431,839				65.4				127,056				65.1				130,596				66.5				235,221				64.5				239,237				66.4
Gross Margin			275,267				36.1				244,333				35.8				228,862				34.6				67,976				34.9				65,841				33.5				129,462				35.5				120,968				33.6
Selling and administrative			191,282				25.1				165,639				24.2				165,993				25.2				43,203				22.2				46,257				23.5				85,075				23.4				90,256				25.0
Depreciation and amortization			31,410				4.1				29,870				4.4				31,187				4.7				7,247				3.7				7,504				3.8				15,316				4.2				14,667				4.1
Goodwill impairment			262,763				34.5
Total cost of sales and expenses			971,677				127.6				633,569				92.8				629,019				95.3				177,506				91.0				184,357				93.8				335,612				92.1				344,160				95.5
OPERATING (LOSS) INCOME			(210,188	)			(27.6	)			48,824				7.2				31,682				4.7				17,526				9.0				12,080				6.2				29,071				7.9				16,045				4.5
INTEREST EXPENSE, NET			22,875				3.0				16,770				2.5				17,392				2.6				4,236				2.2				5,517				2.8				8,458				2.3				11,071				3.1
(LOSS) INCOME BEFORE INCOME TAXES			(233,063	)			(30.6	)			32,054				4.7				14,290				2.1				13,290				6.8				6,563				3.4				20,613				5.6				4,974				1.4
INCOME TAX EXPENSE			10,304				1.4				12,749				1.9				5,573				0.8				5,150				2.6				2,672				1.4				8,039				2.2				2,073				0.6
NET (LOSS) INCOME		$	(243,367	)			(32.0	)%		$	19,305				2.8	%		$	8,717				1.3	%		$	8,140				4.2	%		$	3,891				2.0	%		$	12,574				3.4	%		$	2,901				0.8	%
(LOSS) INCOME PER COMMON SHARE
Basic and diluted (loss) income per common share		$	(40.47	)						$	3.21							$	1.45							$	1.35							$	0.65							$	2.09							$	0.48
Basic and diluted weighted average common shares outstanding			6,013								6,013								6,013								6,013								6,010								6,013								6,011
OTHER FINANCIAL DATA ADJUSTED EBITDA		$	84,831				11.1	%		$	80,746				11.8	%		$	69,392				10.5	%		$	24,919				12.8	%		$	19,660				10.0	%		$	44,734				12.3	%		$	30,826				8.6	%

The following table presents the Company’s sales by product categories for fiscal 2008, 2009, 2010 and the 13 weeks ended and 26 weeks ended July 31, 2010 and July 30, 2011 (in thousands):

 

		Fiscal Year														13 Weeks Ended										26 Weeks Ended
		2008				2009				2010						July 31, 2010				July 30, 2011						July 31, 2010				July 30, 2011
Repair and maintenance		$	401,180			$	349,237			$	328,685					$	88,884			$	87,861					$	168,953			$	165,447
Lawn and garden			269,323				252,902				252,578						85,999				86,946						156,454				153,066
In-home			90,986				80,254				79,438						20,149				21,630						39,276				41,692
Total		$	761,489			$	682,393			$	660,701					$	195,032			$	196,437					$	364,683			$	360,205

 

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13 Weeks Period Ended July 30, 2011 Compared to the 13 Weeks Period Ended July 31, 2010

Net sales

For the quarter ended July 30, 2011, net sales increased $1.4 million, or 0.7%, to $196.4 million as compared to net sales of $195.0 million for the quarter ended July 31, 2010. The increase in net sales was primarily due to a $1.5 million increase in our in-home category and a $0.9 million increase in our lawn and garden categories due to favorable weather conditions in the months of May and July 2011. Offsetting these increases was a decrease of $1.0 million of net sales in our repair and maintenance category, which was primarily driven by lower paint and plumbing sales.

Our comparable store sales declined by 0.8%, which was driven by a decline in comparable transaction volume of 5.2%, offset by an increase of 4.4% in average ticket comparables for the quarter ended July 30, 2011, as compared to the quarter ended July 31, 2010. We believe the decline in transaction volume was primarily due to unfavorable weather conditions in the early part of June 2011 as well as continued weakness in consumer demand from volatility in the capital markets and uncertainty around the macro-economic and political environments. Our average ticket benefited from the sale of bigger ticket items, such as appliances, barbeques, and furniture.

Gross margin

Gross margin was $65.8 million, or 33.5% of net sales, for the quarter ended July 30, 2011, as compared to $68.0 million, or 34.9% of net sales, for the quarter ended July 31, 2010. The decrease of 134 basis points in gross margin was primarily due to an increase in markdowns of approximately 56 basis points and inventory shrink of 55 basis points. The increase in markdowns was due to increased clearance and promotional activities as a result of management’s efforts to manage inventory levels, clear slow moving inventory, and increase sales.

Selling and administrative

Selling and administrative expenses increased $3.1 million for the quarter ended July 30, 2011 to $46.3 million, or 23.5% of net sales, from $43.2 million, or 22.2% of net sales, for the quarter ended July 31, 2010. The increase in selling and administrative expenses was primarily due to an increase in consulting, legal, insurance, payroll, and other administrative costs. Consulting costs increased by $0.8 million primarily due to consultations on our strategic initiatives such as e-commerce and merchandise pricing analysis. Insurance costs increased by $0.6 million as a result of increases in claim reserves. Payroll costs increased by $0.6 million as we increased labor hours at our stores to improve customer service levels.

Depreciation and amortization

Depreciation and amortization expense was $7.5 million, or 3.8% of net sales, for the quarter ended July 30, 2011 as compared to $7.2 million, or 3.7% of net sales, for the quarter ended July 31, 2010. The increase of $0.3 million of depreciation and amortization expense was primarily due to depreciation of new assets placed in service.

Interest expense, net

Interest expense increased for the quarter ended July 30, 2011 by $1.3 million to $5.5 million, or 2.8% of net sales, as compared to $4.2 million, or 2.2% of net sales, for the quarter ended July 31, 2010. The increase in interest expense was primarily due to the increase in our applicable interest rate spreads as a result of the amendment of both our Senior Secured Term Loan and the new Real Estate Secured Term Loan.

Income taxes

Income tax expense of $2.7 million and $5.2 million were recorded for the quarter ended July 30, 2011 and July 31, 2010, respectively. The effective tax rate was 40.7% in quarter ended July 30, 2011 and 38.8% in the

 

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quarter ended July 31, 2010. The change in our effective tax rate was primarily due to differences in tax credits applicable year over year.

Net income

We recorded net income of $3.9 million for the quarter ended July 30, 2011 as compared to net income of $8.1 million for the quarter ended July 31, 2010. The decrease in net income was primarily attributable to the factors discussed above.

Adjusted EBITDA

Adjusted EBITDA was $19.7 million, or 10.0% of net sales for the quarter ended July 30, 2011 as compared to $24.9 million, or 12.8% of net sales for the quarter ended July 31, 2010. The decrease in Adjusted EBITDA of $5.2 million was primarily due to an increase of $3.1 million in selling and administrative costs.

26 Weeks Period Ended July 30, 2011 Compared to the 26 Weeks Period Ended July 31, 2010

Net sales

For the first half of fiscal 2011, net sales decreased $4.5 million, or 1.2%, to $360.2 million as compared to net sales of $364.7 million for the first half of fiscal 2010. The decline in net sales was primarily due to a $3.4 million decline in our lawn and garden category and a $3.5 million decline in our repair and maintenance category, both of which were impacted by unfavorable weather during the months of March and June 2011. Partially offsetting these declines was an increase of approximately $2.4 million of net sales in our in-home category, which was primarily driven by appliances. The number of our stores that sell appliances increased from 19 in the first half of fiscal 2010 to 34 in the first half of fiscal 2011.

Our comparable store sales declined by 2.6%, which was driven by a decline in comparable transaction volume of 5.9% and partially offset by an increase of 3.3% in average ticket comparables for the first half of fiscal 2011, as compared to the first half of fiscal 2010. We believe the decline in transaction volume was primarily due to unfavorable weather during the months of March and June 2011 as well as continued weakness in consumer demand resulting from volatility in the capital markets and uncertainty around the macro-economic and political environments. Our average ticket benefited from the sale of bigger ticket items, such as appliances, barbeques and furniture.

Gross margin

Gross margin was $121.0 million, or 33.6% of net sales, for the first half of fiscal 2011, as compared to $129.5 million, or 35.5% of net sales, for the first half of fiscal 2010. The decrease of 192 basis points in gross margin was primarily due to increases of 109 basis points in markdowns, 58 basis points in occupancy costs, and inventory shrink of 30 basis points. The increase in markdowns was due to increased clearance and promotional activities as a result of management’s efforts to manage inventory levels, clear slow moving inventory, and increase sales. Occupancy costs for the first half of fiscal 2011 were higher as compared to the first half of fiscal 2010 due to a favorable deferred rent adjustment in the first half of fiscal 2010.

Selling and administrative

Selling and administrative expenses increased $5.2 million for the first half of fiscal 2011 to $90.3 million, or 25.1% of net sales, from $85.1 million, or 23.3% of net sales, for the first half of fiscal 2010. The increase in selling and administrative expenses was primarily due to an increase in consulting, insurance, maintenance, and legal costs. Consulting costs increased by $1.6 million primarily due to consulting spending on our strategic initiatives. Insurance costs increased by approximately $1.0 million as a result of increases in claim reserves. Maintenance costs increased by approximately $0.5 million primarily due to equipment lease conversion in the first half of fiscal 2010. In addition, an increase in legal costs of $0.4 million was due to the Save Mart Supermarket v. Orchard Supply Hardware, LLC case.

 

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Depreciation and amortization

Depreciation and amortization expense was $14.7 million, or 4.1% of net sales, for the first half of fiscal 2011 as compared to $15.3 million, or 4.2% of net sales, for the first half of fiscal 2010. The decrease of $0.6 million of depreciation and amortization expense was primarily due to a capital lease conversion in the first half of fiscal 2010.

Interest expense, net

Interest expense increased for the first half of fiscal 2011 by $2.6 million to $11.1 million, or 3.1% of net sales, as compared to $8.5 million, or 2.3% of net sales, for the first half of fiscal 2010. The increase in interest expense was primarily due to a $2.0 million increase in interest expense as a result of higher interest rate spreads from the amendment of both the Senior Secured Term Loan and the new Real Estate Secured Term Loan. In addition, amortization of deferred financing costs increased by $0.6 million due to increased financing costs from the amendments.

Income taxes

Income tax expense of $2.1 million and $8.0 million were recorded for the first half of fiscal 2011 and the first half of fiscal 2010, respectively. The effective tax rate was 41.7% in the first half of fiscal 2011 and 39.0% in the first half of fiscal 2010. The change in our effective tax rate was primarily due to differences in tax credits applicable year over year.

Net income

We recorded net income of $2.9 million for the first half of fiscal 2011 as compared to net income of $12.6 million for the first half of fiscal 2010. The decrease in net income was primarily attributable to the factors discussed above.

Adjusted EBITDA

Adjusted EBITDA was $30.8 million, or 8.6% of net sales for the first half of fiscal 2011 as compared to $44.7 million, or 12.3% of net sales for the first half of fiscal 2010. The decrease in Adjusted EBITDA of $13.9 million was primarily due to a $4.5 million decline in net sales and a $5.2 million increase in selling and administrative costs.

Fiscal 2010 Compared to Fiscal 2009

Net sales

For fiscal 2010 net sales decreased $21.7 million, or 3.2%, to $660.7 million as compared to net sales of $682.4 million for fiscal 2009. The decrease of $21.7 million in total net sales was primarily due to a decline of $20.6 million in our repair and maintenance category, which was primarily driven by declines in sales of plumbing, industrial, paint, and electrical products. In addition, net sales in our in-home category decreased by $0.8 million, which was primarily driven by reduced demand for housewares, offset by the improvement in appliance sales. Appliance sales benefited from U.S. government energy/green consumer subsidies. Additionally, from fiscal 2009 to fiscal 2010, we also increased the number of stores offering appliances from 19 to 34 stores.

Our comparable store sales for fiscal 2010 declined by approximately 4.4%, which was driven by a decline in comparable transaction volume of 4.8% and offset by an increase of 0.4% in average ticket comparables. We believe that the decline in comparable transaction volume was primarily due to reduced consumer spending as California continues to be impacted by macro-economic factors including high unemployment, reduced consumer credit, and a difficult housing market.

 

 

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Gross margin

Gross margin was $228.9 million, or 34.6% of net sales, for fiscal 2010, as compared to $244.3 million, or 35.8% of net sales, for fiscal 2009. The decrease of 117 basis points in gross margin was primarily due to an increase of 104 basis points in markdowns. The increase in markdowns was due to increased clearance and promotional activities as a result of management efforts to manage inventory levels, clear slow moving inventory, and increase sales.

Selling and administrative

Selling and administrative expenses increased $0.4 million in fiscal 2010 to $166.0 million, or 25.1% of net sales, from $165.6 million, or 24.3% of net sales, in fiscal 2009. The increase in selling and administrative expenses was primarily due to an increase in legal and administrative costs offset by a decrease in payroll costs. Legal costs increased by $7.3 million, primarily due to a $5.1 million accrual in respect of the Save Mart Supermarkets v. Orchard Supply Hardware LLC case (see the “Business—Legal Proceedings” section of this Prospectus) and increases in legal fees to prepare for the trial. Administrative costs increased by $0.7 million primarily due to higher advertising costs. Payroll costs declined $7.7 million driven primarily by reduced store payroll costs as a part of management’s efforts to respond to the decline in sales and economic conditions.

Depreciation and amortization

Depreciation and amortization expense was $31.2 million, or 4.7% of net sales, for fiscal 2010, as compared to $29.9 million, 4.4% of net sales, for fiscal 2009. Depreciation expense as a percentage of net sales increased primarily due to the decline in net sales.

Interest expense, net

Interest expense increased in fiscal 2010 by $0.6 million to $17.4 million, or 2.6% of net sales, as compared to $16.8 million, or 2.5% of net sales, for fiscal 2009. The increase in interest expense was primarily due to an increase in commitment fees of $0.4 million on the Senior Secured Credit Facility and the increased interest rate associated with our new Real Estate Secured Term Loan.

Income taxes

Income tax expense of $5.6 million and $12.7 million was recorded in fiscal 2010 and fiscal 2009, respectively. The effective tax rate was 39.0% in fiscal 2010 and 39.8% in fiscal 2009. The change in our effective tax rate is primarily due to differences in tax credits applicable year over year.

Net income

We recorded net income of $8.7 million for fiscal 2010 as compared to $19.3 million for fiscal 2009. The decrease in net income was primarily attributable to the factors discussed above.

Adjusted EBITDA

Adjusted EBITDA was $69.4 million, or 10.5% of net sales for fiscal 2010 as compared to $80.7 million, or 11.8% of net sales for fiscal 2009. The decrease in Adjusted EBITDA was primarily due to the $21.7 million decline in net sales.

Fiscal 2009 Compared to Fiscal 2008

Net sales

For fiscal 2009, net sales decreased $79.1 million, or 10.4%, to $682.4 million as compared to net sales of $761.5 million for fiscal 2008. Net sales decreased in all three of our categories. The most significant decline came from our repair and maintenance category, which declined by $51.9 million as a result of declines in sales

 

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of tools, plumbing, industrial, electrical, hardware, and paint. The decline in net sales in our lawn and garden category of $16.4 million was primarily driven by a decline in sales of seasonal, nursery, and outdoor power tools products, offset slightly by an increase in sales of garden products. The decline in net sales in our in-home category was $10.7 million, primarily driven by reduced demand for housewares and appliances.

Our comparable store sales for fiscal 2009 declined by 11.1%, which was driven by a decline in comparable transaction volume of 5.6% and a decrease of 5.5% in average ticket comparables. The decrease in our net sales was primarily due to reduced customer spending and significant retail pricing pressures through increased promotional activity and discounts. We believe these declines reflect the challenges resulting from the macro-economic environment, wherein we saw the consumer reduce their purchasing frequency as well as migrate away from certain bigger ticket purchases such as appliances.

Gross margin

Gross margin was $244.3 million, or 35.8% of net sales, for fiscal 2009, as compared to $275.3 million, or 36.1% of net sales, for fiscal 2008. The decrease of 34 basis points in gross margin was due to a 87 basis points increase in occupancy costs as a result of lower net sales, partially offset by a 56 basis points favorability in vendor subsidies.

Selling and administrative

Selling and administrative expenses decreased $25.7 million, or 13.4%, in fiscal 2009 to $165.6 million, or 24.3% of net sales, from $191.3 million, or 25.1% of net sales, in fiscal 2008. The decrease in selling and administrative expenses was primarily due to cost management initiatives to mitigate the impact of reduced net sales. For fiscal 2009, payroll, advertising, and administrative costs declined $16.6 million, $7.6 million and $1.5 million, respectively.

Depreciation and amortization

Depreciation and amortization expense was $29.9 million, or 4.4% of net sales, for fiscal 2009 as compared to $31.4 million, or 4.1% of net sales, for fiscal 2008. The percentage increase was primarily due to the decline in net sales.

Goodwill impairment

We recorded a $262.8 million goodwill impairment charge in fiscal 2008 as a result of the decline in our net sales and projected future cash flows.

Interest expense, net

In fiscal 2009, interest expense decreased $6.1 million to $16.8 million, or 2.5% of net sales, as compared to $22.9 million, or 3.0% of net sales, for fiscal 2008. The decrease in interest expense was due to lower outstanding debt of $295.5 million versus $309.0 million in fiscal 2008 and a decline in the London Interbank Offered Rate (“LIBOR”) of approximately 250 basis points.

Income taxes

Income tax expenses of $12.7 million and $10.3 million were recorded for fiscal 2009 and fiscal 2008, respectively. The effective tax rate was 39.8% in fiscal 2009 and 4.4% in fiscal 2008. The difference in the effective tax in fiscal 2009 versus fiscal 2008 was primarily due to a nondeductible goodwill impairment charge of $262.8 million in fiscal 2008.

Net income

We recorded net income of $19.3 million for fiscal 2009 as compared to net loss of $243.4 million for fiscal 2008. The decrease in net income was primarily attributable to the factors discussed above.

 

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Adjusted EBITDA

Adjusted EBITDA was $80.7 million, or 11.8% of net sales for fiscal 2009 as compared to $84.8 million, or 11.1% of net sales for fiscal 2008. The decrease in adjusted EBITDA was primarily due to the $79.1 million decline in net sales.

ANALYSIS OF FINANCIAL CONDITION

Liquidity and Capital Resources

 

		Fiscal Year												26 Weeks Ended
		2008				2009				2010				July 31, 2010				July 30, 2011
		(in thousands)
Consolidated Statements of Cash Flows Data:
Cash flows provided by operating activities		$	43,208			$	25,892			$	52,548			$	39,646			$	21,319
Cash flows used in investing activities			(7,234	)			(11,462	)			(12,042	)			(4,809	)			(6,058	)
Cash flows used in financing activities			(30,080	)			(18,248	)			(33,863	)			(4,497	)			(20,269	)

For fiscal 2010 and 26 weeks ended July 31, 2010 and July 30, 2011, we primarily financed our operations and investments with cash generated from operations. Our primary need for liquidity is to fund inventory purchases and capital expenditures and for general corporate purposes, including debt repayment. At January 29, 2011 and July 30, 2011, our cash and cash equivalents totaled $15.6 million and $10.6 million, respectively. At January 29, 2011 and July 30, 2011, $44.4 million and $74.1 million, respectively, was available under our Senior Secured Credit Facility.

We believe that our existing cash and cash equivalents, cash flows from our operating activities and available borrowings under our financing arrangements will be sufficient to meet our anticipated liquidity needs for at least the next 12 months. Our liquidity is dependent upon the continued availability of borrowings under our current financing arrangements and certain transactions that we have entered into or may enter into in the future to increase liquidity. The adequacy of our available funds will depend on many factors, including the macroeconomic environment, the operating performance of our Company stores and continued compliance with our financing arrangements.

As discussed below under “Financing Arrangements,” the Senior Secured Term Loan and Real Estate Secured Term Loan are subject to a maximum adjusted leverage ratio covenant (the “Leverage Covenant”). The Leverage Covenant is calculated on the last day of each fiscal quarter as (a) consolidated total funded debt on such date minus unrestricted cash over $3 million on such date (as defined in the Senior Secured Term Loan) to (b) trailing four fiscal quarters adjusted EBITDA (as defined in the Senior Secured Term Loan), which includes debt under our financing arrangements and capital leases. As of October 29, 2011, we were in compliance with the Leverage Covenant under our financing arrangements, and we currently believe that we will continue to be in compliance with this covenant (and other covenants under our financing arrangements) through at least the end of the third quarter of fiscal 2012. However, the decline in our operating results through the third quarter of fiscal 2011, coupled with continued economic weakness in the markets in which we operate, may adversely impact our prospective compliance with the financial covenants under the Senior Secured Term Loan and the Real Estate Secured Term Loan. On October 24, 2011 we entered into a sale and lease-back transaction with respect to our distribution center located in Tracy, California and received proceeds of $21.3 million, and on October 26, 2011 we entered into the Appliances Agreement with a subsidiary of Sears Holdings that we had planned to enter into at the Distribution, pursuant to which we transferred Sears appliance inventory purchased from Sears Holdings to a subsidiary of Sears Holdings for $1.9 million in cash. Although these actions were not necessary for us to remain in compliance with our financial covenants as of the end of the third fiscal quarter, they reduced our leverage. In addition, through our subsidiaries, we expect to sell one of our stores and concurrently enter into a short term lease agreement with respect to the property. We also intend, through our subsidiaries, to sell three other stores to another purchaser and concurrently enter into long-term leases for the

 

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properties. These sale-leaseback transactions have been approved by our board of directors but the transactions have not yet closed, and there can be no assurance that they will actually be consummated. We expect the long-term sale-leaseback transaction to generate tenant improvement allowances to help update the stores to enhance the shopping experience for our customers. We intend to use a portion of the net proceeds to pay-down our Senior Secured Term Loan and Real Estate Secured Term Loan, and we also are approaching the lenders under our existing financing arrangements to discuss, among other things, the extension of the maturity date under our Senior Secured Term Loan, improved terms of the financial covenants under our Senior Secured Term Loan and Real Estate Secured Term Loan, and certain technical amendments under each of our Senior Secured Term Loan, Real Estate Secured Term Loan and Senior Secured Credit Facility.

The Company seeks to remain in compliance with its financing arrangements and generate sufficient liquidity by executing its sales growth strategy by, among other things, making improvements to its stores and store operations and upgrading and differentiating its product assortment. Notwithstanding the foregoing, the Company continues to examine a number of alternatives with respect to future compliance and liquidity, including asset sales and/or sale-leaseback transactions. In addition, if necessary or advisable, we may seek to strengthen our financial position by monetizing additional owned store properties or by seeking to renegotiate our financing arrangements in order to remain in compliance while continuing to follow our current business plan, which includes plans for store expansion. In such case, if such renegotiations were necessary but unsuccessful, we would expect to take certain actions that would allow us to remain in compliance. Such actions could include, among others, a reduction of capital expenditures by delaying or reducing new store openings and store remodels, a reduction in payroll and benefit costs, deferring certain maintenance and other expenditures, as well as generating additional cash through sale or sale leaseback of certain real estate assets in order to reduce leverage. However, the implementation of these actions could result in slower growth and could potentially reduce future sales. Notwithstanding our expectations, if our operating results were to continue to decline or if market conditions were to worsen, we may be unable to meet our financial covenants, and lenders could demand repayment of the amounts outstanding under our financing agreements. Under such circumstances, no assurances can be given that our financing arrangements could be renegotiated, or that alternative financing would be available on terms acceptable to us, if at all. In addition, any refinancing could be at higher interest rates and may require us to comply with more onerous covenants which could further restrict our business operations.

On June 24, 2011, Standard & Poor’s Ratings Services lowered the corporate credit rating on Orchard Supply Hardware LLC, a wholly owned subsidiary through which we conduct substantially all our operations (“OSH LLC”), from “B” to “B-” due to our operating performance and the narrowing of our covenant cushion on the Leverage Covenant during the fiscal quarter ended April 30, 2011. On June 28, 2011 Moody’s Investor Service lowered our corporate family credit rating, probability of default rating and the rating on the Senior Secured Term Loan from “B2” to “B3” due to our operating results in the fiscal quarter ended April 30, 2011 that resulted in a decline in EBITDA of more than 40%, as compared to the same period prior year. The terms of our current financing arrangements are not impacted by changes to our credit ratings. Ratings changes may, however, impact our ability to renegotiate our financing arrangements or obtain additional financing and the terms at which such renegotiated or alterative financing would be available to us.

Our debt and capital lease obligations as of January 30, 2010, January 29, 2011, July 31, 2010, and July 30, 2011 are as follows (in millions):

 

		January 30, 2010				January 29, 2011				July 31, 2010				July 30, 2011
Senior Secured Credit Facility		$	—			$	48.0			$	—			$	32.0
Real Estate Secured Term Loan			—				50.0				—				49.7
Senior Secured Term Loan			175.5				173.5				174.5				172.5
Commercial Mortgage-backed Loan			120.0				—				120.0				—
Capital Lease Obligations			69.4				66.7				69.2				68.0
Total Debt and Capital Lease Obligations		$	364.9			$	338.2			$	363.7			$	322.2

 

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Financing Arrangements

Our lending arrangements on January 29, 2011 and as of July 30, 2011 are as follows:

Senior Secured Credit Facility—In December 2006, we entered into an amended and restated five-year, $130.0 million senior secured revolving credit facility (the “Senior Secured Credit Facility”) with a syndicate of lenders. On January 29, 2010, we amended and extended the Senior Secured Credit Facility, reducing the revolving commitment to $120.0 million (subject to borrowing base limits). The amendment bifurcated the facility into a $20.0 million tranche maturing December 2011 with lenders who elected not to extend and a $100.0 million tranche maturing December 2013 with lenders who elected to extend. As of January 29, 2011, $48.0 million was borrowed under the facility, with approximately $8.0 million due in December 2011 and approximately $40.0 million due in December 2013. As of July 30, 2011, $32.0 million was borrowed under the facility, with approximately $5.3 million due in December 2011 and approximately $26.7 million due in December 2013. The Senior Secured Credit Facility permits us to obtain letters of credit, provided that our obligations with respect to letters of credit issued under our Senior Secured Credit Facility cannot exceed $25.0 million. As of January 29, 2011 and July 30, 2011 we had $7.3 million and $8.2 million, respectively, of outstanding letters of credit.

The Senior Secured Credit Facility is available for our general corporate purposes. The borrower under the Senior Secured Credit Facility is OSH LLC. The Senior Secured Credit Facility is guaranteed by Orchard Supply Hardware Stores Corporation, and our wholly owned subsidiary, OSH Finance Corporation (together, the “Guarantors”). Borrowings under the Senior Secured Credit Facility are collateralized by a first lien on substantially all of the assets of OSH LLC and the Guarantors, other than the Term Loan Collateral (as defined below), and a second lien on the Term Loan Collateral.

Borrowings under the Senior Secured Credit Facility are either base rate (“BR”) loans or Eurodollar loans, at our discretion. BR loans owing to non-extending lenders bear interest at the greater of (a) the prime rate as publicly announced by Wells Fargo Bank, N.A., or (b) the federal funds rate plus 0.5%, plus the “BR applicable rate”, with the “BR applicable rate” ranging between 0% to 0.75%. BR loans owing to each extending lender bear interest at the greater of (a) the prime rate as publicly announced by Wells Fargo Bank, N.A., (b) the federal funds rate plus 0.5%, or (c) one month London Inter-Bank Offered Rate (“LIBOR”) plus 1.0%, plus the “BR extended term applicable rate”, with the “BR extended term applicable rate” ranging between 1.50% and 2.25%. Eurodollar loans owing to each non-extending lender bear interest at LIBOR, plus the “Eurodollar applicable rate,” with the “Eurodollar applicable rate” ranging between 1.0% and 1.75%. Eurodollar loans owing to each extending lender bear interest at LIBOR plus the “Eurodollar extended term applicable rate,” with the “Eurodollar extended term applicable rate” ranging between 2.50% and 3.25%. The interest rate spreads applicable to our borrowings fluctuate based upon the performance of OSH LLC and the Guarantors as measured by their leverage ratio. In addition, we are required to pay unused commitment fees, based on OSH LLC’s and the Guarantors leverage ratio; such fees were 0.25% and 0.75% at January 29, 2011 and July 30, 2011 for non-extending lenders and for extending lenders, respectively.

Availability under the Senior Secured Credit Facility is determined pursuant to a borrowing base formula based on inventory and accounts and credit card receivables, subject to certain limitations. The Senior Secured Credit Facility subjects us to certain restrictive covenants, including a fixed charge coverage ratio that is triggered when availability under the Senior Secured Credit Facility reaches a minimum threshold of 10% of the total availability for three consecutive days. The fixed charge coverage ratio requires OSH LLC and the Guarantors to maintain a minimum ratio of 1.1 to 1.0 EBITDAR (EBITDA plus rent expense) to certain fixed charges.

Our Senior Secured Credit Facility, Senior Secured Term Loan and Real Estate Secured Term Loan impose operating and financial restrictions on us, including, among other things, limitations on our ability to:

 

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incur or guarantee additional indebtedness;

 

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pay dividends or redeem, repurchase, retire or make distributions in respect of our capital stock;

 

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•

make certain loans, acquisitions, capital expenditures or investments;

 

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sell certain assets, including stock of our subsidiaries;

 

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enter into sale and leaseback transactions;

 

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create or incur liens;

 

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consolidate, merge, sell, transfer or otherwise dispose of all or substantially all of our assets;

 

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enter into certain transactions with our affiliates;

 

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undergo a change in control;

 

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enter into certain swap agreements;

 

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engage in a different type of business, including in the case of the Company, holding assets or liabilities other than holding the stock of OSH LLC;

 

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make payments on certain types of debt;

 

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enter into agreements that limit the ability of a subsidiary to pay dividends or distributions or make or repay loans or advances or to transfer assets to OSH LLC or guarantee debt of OSH LLC;

 

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enter into agreements that limit the ability of OSH LLC and the Guarantors to incur liens on their property;

 

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amend certain material documents;

 

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make changes to accounting treatment and reporting practices;

 

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change the fiscal year; and

 

•

use proceeds of credit extensions to purchase or carry margin stock.

Senior Secured Term Loan—In December 2006, we entered into a $200 million senior secured term loan agreement (the “Senior Secured Term Loan”), which requires quarterly principal payments of $0.5 million and matures in December 2013. On January 28, 2011, we amended the Senior Secured Term Loan to change the maximum adjusted leverage ratio covenant, applicable interest rates, definition of EBITDA and excess cash flow prepayment percentage rate. In addition to the quarterly principal payments discussed above, in the event we have excess cash flows at the end of a fiscal year, we are required to apply between 25% and 75% of such excess cash flows (reduced by previous voluntary prepayments) to repay outstanding loans. The annual excess cash flow prepayment percentage rate is a percentage of our excess cash flows determined by Orchard’s leverage ratio. We did not pay any excess cash flow prepayments in fiscal 2010 and do not anticipate making any prepayments in fiscal 2011.

The borrower under the Senior Secured Term Loan is OSH LLC and the loan is guaranteed by the Guarantors. Borrowings under the Senior Secured Credit Facility are collateralized by a first lien on OSH LLC’s and the Guarantors’ subsidiary stock, equipment, real property, intangibles relating to such stock, proceeds and products of the foregoing (the “Term Loan Collateral”) and a second lien on substantially all of OSH LLC’s and the Guarantors’ other assets.

Borrowings under the Senior Secured Term Loan are either alternate base rate (“ABR”) loans or Eurodollar loans, at our discretion. ABR loans bear interest at the greater of (a) the prime rate as publicly announced by JPMorgan Chase Bank, and (b) the federal funds rate, plus 0.5%, plus the “ABR applicable rate”, with the “ABR applicable rate” ranging between 3.50% and 3.75%. Eurodollar loans bear interest at LIBOR, plus the “Eurodollar applicable rate”, with the “Eurodollar applicable rate” ranging between 4.50% and 4.75%. The interest rate spreads applicable to our borrowings fluctuate based upon the performance of Orchard as measured by its leverage ratio.

The Senior Secured Term Loan subjects us to certain restrictions, including a maximum adjusted leverage ratio covenant. In addition, the Senior Secured Term Loan requires us to make certain mandatory

 

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repayments in connection with the transfer of or damage to property securing the loan or in the event we incur certain types of debt.

The maximum adjusted leverage ratio covenant (as defined in the Senior Secured Term Loan) is calculated on the last day of each fiscal quarter as (a) consolidated total funded debt on such date minus unrestricted cash over $3 million on such date (as defined in the Senior Secured Term Loan) to (b) trailing four fiscal quarters adjusted EBITDA (as defined in the Senior Secured Term Loan). The following table provides our maximum leverage ratio during the remaining term of the Senior Secured Term Loan.

 

For the trailing four fiscal quarters ending		Maximum Leverage Ratio
January 29, 2011 through and including May 5, 2012		5.50 to 1.00
August 4, 2012 through and including February 2, 2013		5.25 to 1.00
May 4, 2013 through and including February 1, 2014		4.75 to 1.00

We believe that we were in compliance with the Senior Secured Term Loan covenants, including the maximum leverage ratio, which, at January 29, 2011, July 30, 2011, and October 29, 2011 were 4.89 to 1.00, 5.44 to 1.00, and 5.02 to 1.00, respectively. At January 29, 2011, July 30, 2011, and October 29, 2011 assuming our current level of consolidated total funded debt remains constant, we estimate that a 11.0%, 1.1%, and 8.8% or greater decline in our trailing four fiscal quarters adjusted EBITDA, respectively, would cause us to exceed our maximum leverage ratio covenant for that period.

Real Estate Secured Term Loan—On October 27, 2010, we entered into a $50 million real estate secured term loan (the “Real Estate Secured Term Loan”) that requires quarterly payments of $0.1 million and matures in December 2013. The proceeds from the Real Estate Secured Term Loan, together with $33.0 million of available cash and a $37.0 million borrowing on our Senior Secured Credit Facility, were used to

repay our then existing $120.0 million commercial mortgage-backed securities loan in full on October 27, 2010. The Real Estate Secured Term Loan requires us to meet the leverage covenant set forth in our Senior Secured Term Loan, subject to certain maximum thresholds. On February 17, 2011, we amended the Real Estate Secured Term Loan to raise the maximum thresholds on the loan’s leverage covenant for certain periods and change the definition of EBITDA.

Interest on the Real Estate Secured Term Loan is based on LIBOR plus 4.25% per annum (4.511% and 4.436% at January 29, 2011 and July 30, 2011, respectively), and is payable in monthly installments. In connection with the Real Estate Secured Term Loan, we entered into an interest rate cap agreement, which establishes a maximum interest rate on the Real Estate Secured Term Loan for LIBOR at 4% with a $25 million notional amount.

The Real Estate Secured Term Loan is secured by a first lien mortgage on 19 properties, which includes 15 properties owned and 4 properties on ground leases, each owned or leased by our wholly owned subsidiary, OSH Properties LLC. The loan is subject to a lapsing prepayment premium and breakage costs in the event we elect to repay all or a portion of the loan early.

On October 24, 2011, a subsidiary of the Company entered into a Purchase and Sale Agreement pursuant to which a subsidiary of the Company sold for $21.3 million, all of its interest in its distribution center located in Tracy, California, which is comprised of a building containing approximately 458,000 square feet and the underlying land. In connection with the closing of the sale of the distribution center, a subsidiary of the Company entered into a lease agreement with respect to the distribution center. The commencement date of the lease was October 28, 2011. The lease is a 20-year lease and provides for three five-year extension options. The initial base rent under the lease is $1.7 million per year with 10% increases every five years. The Company will record a loss in the amount of approximately $14 million on the sale of the distribution center in the third quarter of fiscal 2011. In connection with the transaction, the Company repaid $7.6 million of the Real Estate Secured Term Loan and removed the distribution center from the loan collateral. The Company paid $0.1 million in fees, penalties, and interest.

 

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Each of the Senior Secured Credit Facility, Senior Secured Term Loan and Real Estate Secured Term Loan required the payment of upfront and arrangement fees of between 1.0% and 2.25%.

Our Senior Secured Credit Facility, Senior Secured Term Loan and Real Estate Secured Term Loan contain an event of default resulting from a change of control default, which includes the following: (i) certain mergers, consolidations, sales or transfers of all or substantially all of the assets of OSH LLC and OSH LLC’s subsidiaries to persons other than ACOF, ESL and Sears Holdings; (ii) adoption of a plan of liquidation of OSH LLC; (iii) prior to an initial underwritten public offering of common stock of the Company, Sears Holdings, ESL and ACOF ceasing to collectively hold directly or indirectly at least 50% of the total voting power of all shares of our and OSH LLC’s voting capital stock; (iv) following an initial underwritten public offering of common stock of the Company, a person or group, other than Sears Holdings, ESL and ACOF, collectively holding directly or indirectly at least 40% of the total voting power of all shares of our and OSH LLC’s voting capital stock and Sears Holdings, ESL and ACOF collectively holding less than such person or group; and (v) our board of directors not consisting of continuing directors (“Change in Control”).

Immediately following the Distribution:

 

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Sears Holdings will not own any capital stock of the Company;

 

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ESL will beneficially own approximately 61% of our outstanding shares of Class A Common Stock and approximately 49% of the general voting power of our capital stock; and

 

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ACOF will beneficially own 100% of our outstanding shares of Class C Common Stock and approximately 20% of the general voting power of our capital stock.

Neither ESL nor ACOF have agreed to maintain their shareholding in the Company following the Distribution. If, following the Distribution, one or both of ESL and ACOF dispose of all or part of their shareholding in the Company such that their combined total voting power drops below 50%, this may trigger a Change in Control event of default under the Senior Secured Credit Facility, Senior Secured Term Loan and Real Estate Secured Term Loan. An event of default could trigger certain acceleration clauses and cause those and our other obligations to become immediately due and payable and we may not have sufficient cash funds available to repay our debt obligations upon such a Change in Control.

Cash Flows from Operating Activities

For the first half of fiscal 2011, we primarily financed our operations and investments with cash generated from operations. Cash provided by operating activities was $21.3 million in the first half of fiscal 2011 as compared to $39.6 million in the first half of fiscal 2010. The $18.3 million decrease in cash provided by operating activities was primarily due to a decrease of $9.7 million in net income due to lower net sales as a result of unfavorable weather conditions in the months of March and June 2011. The decrease of $4.4 million in cash provided by merchandise inventories was due to the Company’s efforts to reduce its in-stock levels in 2011. In addition, a decrease of $6.5 million was due to the timing of our payable to Sears.

Cash provided by operating activities was $52.5 million for fiscal 2010 as compared to $25.9 million for fiscal 2009. The increase in cash provided by operating activities was primarily due to the timing of our intercompany payments to Sears Holdings for goods and services received as well as the timing of payments for our merchandise payables. Cash provided by the change in merchandise payables improved year over year as we were less aggressive in pursuing early payment discounts from vendors in fiscal 2010. The increase is partially offset by the ramping up of our merchandise inventories for purposes of improving our in-stock merchandise.

Cash provided by operating activities was $25.9 million for fiscal 2009 as compared to $43.2 million for fiscal 2008. The decrease in cash provided by operating activities was primarily due to the timing of merchandise payables, inventory and accruals. The timing of merchandise payables was due to a more aggressive strategy to pursue early payment discounts from vendors in the last quarter of fiscal 2009 as compared to the last quarter of fiscal 2008.

 

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Cash used in Investing Activities

Cash used in investing activities was $6.1 million for the first half of fiscal 2011 as compared to $4.8 million for the first half of fiscal 2010. The increase in cash used in investing activities is primarily due to new store spending. In fiscal 2011, we spent $6.2 million on capital expenditures, allocated as follows: 47% for new stores, 33% for maintenance, 13% for core technology, and 7% for merchandising.

Cash used in investing activities was $12.0 million for fiscal 2010 as compared to $11.5 million for fiscal 2009. In fiscal 2010 we spent $11.5 million on capital expenditures, allocated as follows: 34% for new stores, 21% for maintenance, 17% for core technology, 9% for merchandising and 19% for other initiatives. In fiscal 2010, we added one new store. We also set aside $0.6 million in restricted cash for property improvements in accordance with our new $50 million Real Estate Secured Term Loan.

Cash used in investing activities was $11.5 million for fiscal 2009 as compared to $7.2 million for fiscal 2008. In fiscal 2008, we released $3.3 million of restricted cash to pay for a legal settlement based on a court order issued in September 2007.

Cash Flows from Financing Activities

Cash used in financing activities was $20.3 million for the first half of fiscal 2011 and $4.5 million for the first half of fiscal 2010. The increase of $15.8 million in cash used in financing activities was primarily due to $16.0 million of net repayments under the Senior Secured Credit Facility.

Cash used in financing activities was $33.9 million for fiscal 2010 and $18.2 million for fiscal 2009. Cash used in financing activities for fiscal 2010 increased due to the repayment of $120.0 million commercial mortgage-backed securities loan, a $50.0 million borrowing on the Real Estate Secured Term Loan, and a $48.0 million net borrowing on our Senior Secured Credit Facility.

Cash used in financing activities was $18.2 million and $30.1 million for fiscal 2009 and 2008, respectively. The decrease in cash used in financing activities was primarily due to no net pay down on the Senior Secured Credit Facility during fiscal 2009 as compared to a $17.0 million net pay down during fiscal 2008. In accordance with our Senior Secured Term Loan, during fiscal 2009 we made an $11.0 million prepayment for excess cash flows generated by the Company, as compared to a $7.0 million prepayment for excess cash flows made during fiscal 2008.

Contractual Obligations and Off-Balance Sheet Arrangements

For fiscal 2010 and fiscal 2009, the Company had non-cancelable commitments of $0.2 million and $1.5 million, respectively, related to merchandise purchase contracts and capital projects. Other than in connection with executing operating leases and purchase commitments, we do not have any other off-balance sheet financing that has, or is reasonably likely to have, a material current or future effect on our financial condition, cash flows, results of operations, liquidity, capital expenditures or capital resources.

Contractual Obligations

The following table summarizes our contractual obligations as of January 29, 2011.

 

(in millions)		Total				Less than 1 Year				2-3 Years				4-5 Years				After 5 Years
Long-Term Debt		$	271.5			$	13.5			$	258.0			$	—			$	—
Capital Lease Obligations (includes interest)			123.6				12.0				24.4				24.1				63.1
Operating Leases			165.3				28.8				52.9				40.7				42.9
Purchase Obligations			0.2				0.2				—				—				—
Total Contractual Obligations		$	560.6			$	54.5			$	335.3			$	64.8			$	106.0

 

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Certain reserves and contractual obligations were excluded from the table above due to the uncertainty in timing or amounts of such payments. These include $1.7 million of reserves for uncertain tax positions, $5.9 million of casualty insurance reserves, and variable interest on our long-term debts. If both interest rates and debt remain constant, the Company expects interest obligations to be $11.7 million within the next 12 months. A 25 bps change in interest rates, assuming consistent borrowings, could result in a $0.6 million change in interest obligations annually. A $1.0 million change in debt, assuming consistent interest rates, could result in a $0.1 million change in interest obligations annually. In the past 12 months, we have experienced a 19 bps change in interest rate and $40.3 million change in debt. If we were to experience the same fluctuation in the following 12 months, it could potentially change our interest obligations by approximately $2.2 million or approximately 20% of the $11.7 million in expected interest obligations.

There are no significant changes to our contractual obligations and off balance sheet arrangements during the first half of fiscal 2011, with the exception of when we are planning to repay our long-term debt. We have reclassified $3.0 million of our Senior Secured Credit Facility debt from long-term to short-term. In addition, we paid down $14.7 million of our debt in the second quarter of fiscal 2011. We do not foresee paying down on our Senior Secured Credit Facility during the next 12 months, through the second quarter of fiscal 2012.

On October 24, 2011, a subsidiary of the Company entered into a Purchase and Sale Agreement pursuant to which a subsidiary of the Company sold for $21.3 million in cash, all of its interest in its distribution center located in Tracy, California, which is comprised of a building containing approximately 458,000 square feet and the underlying land. In connection with the closing of the sale of the distribution center, a subsidiary of the Company entered into a lease agreement with respect to the distribution center. The commencement date of the lease was October 28, 2011. The lease is a 20-year lease and provides for three five-year extension options. The initial base rent under the lease is $1.7 million per year with 10% increases every five years. The Company will record a loss in the amount of approximately $14 million on the sale of the distribution center in the third quarter of fiscal 2011. In connection with the transaction, the Company repaid $7.6 million of the Real Estate Senior Secured Term Loan and removed the distribution center from the loan collateral. The Company paid $0.1 million in fees, penalties, and interest.

Critical Accounting Policies and Estimates

In preparing the financial statements, certain accounting policies require considerable judgment to select the appropriate assumptions to calculate financial estimates. These estimates are complex and subject to an inherent degree of uncertainty. We base our estimates on historical experience, terms of existing contracts, evaluation of trends and other assumptions that we believe to be reasonable under the circumstances. We continually evaluate the information used to make these estimates as our business and the economic environment change. Although the use of estimates is pervasive throughout the financial statements, we consider an accounting estimate to be critical if:

 

•

it requires assumptions to be made about matters that were highly uncertain at the time the estimate was made, and

 

•

changes in the estimate that are reasonably likely to occur from period to period or different estimates that could have been selected would have a material effect on our financial condition, cash flows or results of operations.

We believe that the current assumptions and other considerations used to estimate amounts reflected in the financial statements are appropriate. However, if actual experience differs from the assumptions and the considerations used in estimating amounts, the resulting changes could have a material adverse effect on our consolidated results of operations, and in certain situations, could have a material adverse effect on our financial condition.

The following is a summary of our most critical policies and estimates. See Note 1 of the Notes to the Consolidated Financial Statements for a listing of our other significant accounting policies.

 

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Merchandise Inventories

Our inventory is valued at the lower of cost or market determined primarily using the retail inventory method (“RIM”). RIM is an averaging method that is commonly used in the retail industry. To determine inventory cost under RIM, inventory at its retail selling value is segregated into groupings of merchandise having similar characteristics, which are then converted to a cost basis by applying specific average cost factors for each grouping of merchandise. Cost factors represent the average cost-to-retail ratio for each merchandise group based upon the year’s purchasing activity for each store location. Accordingly, a significant assumption under the retail method is that inventory in each group is similar in terms of its cost-to-retail relationship and has similar turnover rates. We monitor the content of merchandise in these groupings to prevent distortions that would have a material effect on inventory valuation.

RIM inherently requires management judgment and certain estimates that may significantly affect the ending inventory valuation, as well as gross margin. The methodologies utilized by the Company in its application of the RIM are consistent for all periods presented. Such methodologies include the development of the cost-to-retail ratios, the groupings of homogenous classes of merchandise, the development of shrinkage and obsolescence reserves, and the accounting for retail price changes. We believe that the Company’s RIM provides an inventory valuation that reasonably approximates cost. Among others, two significant estimates used in inventory valuation are the level and timing of permanent markdowns (clearance markdowns used to clear unproductive or slow-moving inventory) and shrinkage. Amounts are charged to cost of sales at the time the retail value of inventory is reduced through the use of permanent markdowns.

Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise, fashion and design trends and weather conditions. In addition, inventory is also evaluated against corporate pre-determined historical markdown cadences. When a decision is made to permanently markdown merchandise, the resulting gross margin reduction is recognized in the period the markdown is recorded. The timing of the decision, particularly surrounding the balance sheet date, can have a significant effect on the results of operations.

Vendor Rebates and Allowances

The Company receives various vendor-funded rebates and allowances through a variety of programs and arrangements intended to offset the Company’s costs of promoting and selling certain vendor products. These vendor payments are recorded as a reduction to the cost of merchandise inventories when earned and, thereafter, as a reduction of cost of sales, as the merchandise is sold. Up-front consideration received from vendors linked to purchases or other commitments is deferred until performance of the specified activity is deemed to be complete. The Company received $30.3 million, $29.2 million and $28.3 million in vendor rebates and allowances in fiscal 2010, fiscal 2009 and fiscal 2008, respectively. For the 13 and 26 weeks ended July 30, 2011, the Company received vendor rebates and allowances of $7.8 million and $15.1 million, respectively. For the 13 and 26 weeks ended July 31, 2010, the Company received vendor rebates and allowances of $7.0 million and $14 million, respectively.

Goodwill and Intangible Assets Impairment

Goodwill

The Company does not amortize goodwill, but tests it for potential impairment on an annual basis in December of each year or whenever events or changes in circumstances indicate that its value may not be recoverable. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include, among others, a significant decline in the Company’s expected future cash flows, a significant adverse change in legal factors or in the business climate, unanticipated competition and slower growth rates.

The Company’s goodwill resided in one reporting unit. The goodwill impairment test involves a two-step process. The first step is a comparison of each reporting unit’s fair value to its carrying value. Potential

 

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impairment exists if the carrying amount of net assets, including goodwill, is greater than the fair value of net assets, which is based on the income approach using a calculation of discounted estimated future cash flows. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in net sales, costs, estimates of future expected changes in operating margins and cash expenditures. Other significant estimates and assumptions include terminal value growth rates, future estimates of capital expenditures and changes in future working capital requirements. If the carrying value of the reporting unit is higher than its fair value, there is an indication that impairment may exist and the second step must be performed to measure the amount of impairment loss. The amount of impairment is determined by comparing the implied fair value of reporting unit goodwill to the carrying value of the goodwill in the same manner as if the reporting unit was being acquired in a business combination.

During fiscal 2008, the Company recorded a goodwill impairment charge of $262.8 million and since then has no remaining goodwill.

Trade Name Asset Impairment

We review indefinite-lived trade name assets for impairment by comparing the carrying amount of the assets to the sum of undiscounted cash flows expected to be generated by the assets. Potential impairment exists if the carrying amount of trade names is greater than their fair value, which is determined using the relief from royalty method. We did not record any intangible asset impairment charges in any period presented in this Prospectus.

The use of different assumptions, estimates or judgments in our trade name asset impairment testing process, such as the estimated future cash flows of the asset and the discount rate used to discount such cash flows, could significantly increase or decrease the estimated fair value of the assets, and therefore, impact the related impairment charge. At the 2010 annual impairment test date, the above-noted conclusion that no indication of intangible asset impairment existed at the test date would not have changed had the test been conducted assuming: (1) a 100 basis points increase in the discount rate used to discount the aggregate estimated cash flows of our assets to their net present value in determining their estimated fair values (without any change in the aggregate estimated cash flows of our reporting unit), (2) a 100 basis points decrease in the terminal period growth rate without a change in the discount rate of the reporting unit, or (3) a 10 basis points decrease in the royalty rate applied to the forecasted net sales stream of our assets. If the decline in our net sales continues, this could have a material effect on our trade names valuation and could result in an impairment change.

The Company’s trade name assets, OSH and Orchard Supply Hardware, are not subject to amortization, as management expects the trade names to generate cash flows indefinitely.

The impairment analysis for trade names is performed as of the last day of the Company’s November accounting period each year.

Impairment of Long-Lived Assets

Long-lived assets, primarily property and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If the carrying value of the asset exceeds the expected future cash flows expected to result from the use of the asset, on an undiscounted basis, an impairment loss is recognized. The impairment loss recognized is the excess of the carrying value of the asset over its fair value. The fair market value of these assets is determined using the income approach and Level 3 inputs, which require management to make estimates about future cash flows. We estimate the amount and timing of future cash flows based on historical experience and knowledge of the retail market in which each store operates. We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate impairment losses of long-lived assets. The Company’s recorded asset impairment charges have not been and are not expected to be material. However, if

 

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actual results are not consistent with our estimates and assumptions used in the calculations, we may be exposed to losses that could be material.

Casualty Insurance Reserves

The Company has historically participated in Sears Holdings’ insurance programs, which has provided the Company with comprehensive insurance coverage. On February 25, 2008, the Company entered into its own insurance contracts for exposures incurred after that date with third-party insurance companies for a number of risks including workers’ compensation and general liability claims. The Company records insurance reserves based on the expected ultimate settlement value of claims filed and claims incurred but not yet reported. The Company’s estimated claim amounts are discounted using a risk-free rate based on the duration that approximates the expected period to settle such claims. The discount rate used was 4% in each of fiscal years 2010, 2009 and 2008. A 25 basis point change in the risk-free rate would change our reserve by less than $0.1 million. In estimating this liability, the Company utilized loss trend factors based on Company-specific data to project the future loss rate. Loss estimates are adjusted based upon actual claims settlements and reported claims. These projections are subject to a high degree of variability based upon future inflation rates, litigation trends, legal interpretations, benefit level changes, and claim settlement patterns.

Although the Company does not expect the amounts ultimately paid to differ significantly from its estimates, insurance reserves could be affected if future claim experience differs significantly from the historical trends and the actuarial assumptions.

Quantitative and Qualitative Disclosures about Market Risk

We face market risk exposure in the form of interest rate risk. These market risks arise from our debt obligations. We have no international operations. Our exposure to foreign currency fluctuations is not significant to our financial condition or results of operations.

Interest Rate Risk

All interest-rate derivative instruments are considered non-trading. At January 29, 2011, 80.3% of our total debt portfolio, including capital leases, was variable rate. Based on the size of this variable rate debt portfolio at January 29, 2011, which totaled approximately $271.5 million, an immediate 100 basis points change in interest rates would have affected annual pretax funding costs by $2.7 million.

 

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BUSINESS

Our Business

We are a California specialty retailer primarily focused on the consumer segment of the home improvement market. Our stores are designed to appeal to convenience-oriented customers, whose purchase occasions are largely driven by their home repair, maintenance and improvement needs throughout the home, garden and outdoor living areas. As of July 30, 2011, we operated 89 full-service hardware stores in California. We opened four new stores in California within the past three years—one in 2010, two in 2009, and one in 2008. Our stores average approximately 43,600 square feet of enclosed space, plus approximately 8,300 square feet of nursery and garden area. Our stores carry a broad assortment of repair and maintenance, lawn and garden and in-home products.

We strive to provide our customers with best-in-class customer service by staffing our stores with knowledgeable managers and employees. We design our stores to be easy to shop, using lower profile shelving than is typically found in our larger warehouse home center competitors, and high visibility signage for ease of navigation.

We operate in one reportable segment and provide a merchandise mix which consists of various product categories. Our repair and maintenance category consists of plumbing, electrical, paint, tools, hardware, and industrial products. Our lawn and garden category consists of nursery, garden, outdoor power and seasonal products. Our in-home category consists mainly of our housewares and appliances products.

We also focus on the convenience-oriented purchases of the small professional customer. The professional customer’s convenience-oriented purchases are largely motivated by a need for incremental supplies and tools to complete construction projects.

Industry

The U.S. home improvement industry is an estimated $266 billion market consisting of the consumer and professional segments. We compete primarily in the $194 billion consumer segment where, according to the Home Improvement Research Institute, sales have grown during 2010 at a 3.4% average growth rate. The consumer segment of the U.S. home improvement industry is also expected to grow at a 5.6% compound annual growth rate from 2011 through 2015.

Competition

The home improvement industry in California is highly competitive and we are positioned between larger warehouse home center competitors and smaller independent hardware stores. We consider The Home Depot, Lowe’s, Ace Hardware and True Value as our primary competitors. Based on publically available information, we believe that in California each of The Home Depot, Ace Hardware and True Value currently has between two to three times as many stores as we do and that Lowe’s has, by number of stores, over 20% more stores in the state than we do. In addition, discount retailers such as Walmart, Target and Kmart, and multi-line retailers such as Sears Roebuck, compete with us in certain product areas. In addition, our garden centers compete against smaller local nurseries and Armstrong Garden Center in Southern California. Online and catalog businesses, which handle similar lines of merchandise, also compete with us.

Many of our competitors have a larger number of stores, substantially greater financial, distribution and marketing resources, larger market shares and a more widespread, national presence. Such factors may provide our competitors with greater financial resources to expand, grow and allow for stronger relationships and aggressive pricing with vendors and third party suppliers; however, we do have vendors for whom we are a large customer and we continue to leverage these relationships to improve our competitive advantage. We compete against the larger warehouse home centers and the discount and multi-line retailers on the basis of the convenient shopping experience we provide and by striving to provide better customer service than our competitors. We compete against the smaller independent hardware stores based on the breadth of our product offerings and on the basis of price.

 

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Our Competitive Strengths

Our success depends on our ability to remain competitive with respect to our stores’ shopping convenience, the in-stock availability merchandise and superior customer service by knowledgeable sales professionals. The performance of our competitors, as well as a change in their pricing policies, marketing activities, new store openings and other business strategies, could have a material adverse effect on our business, financial condition and results of operations. We believe our competitive strengths are the following:

Our Stores Carry a Wide Variety of Merchandise.

We offer our customers a broad selection of products, including well-known consumer brand names, and we strive to offer high in-stock levels. A typical Orchard store offers a selection of repair and maintenance products comparable to larger warehouse competitors and carries more products than the typical smaller independent hardware store.

Each of our stores offers a wide selection of well known consumer brand names, such as 3M, Ames/Tru-Temper Tools, Black & Decker, Craftsman, DeWalt, Dickies, Dutch Boy, General Electric, Leviton, Makita, Milwaukee, Miracle-Gro, Moen, Quikrete, RainBird, Rubbermaid, Scotts, Stanley, Toro and Weber. Our private label brands typically generate higher gross profit margins than third-party brands and include Aqua Vista, Bridgewater, Orchard, OSH, Pacific Bay and Western Hawk; these private label brands also add to the distinctive nature of our product selection.

In addition, we believe our year-round lawn and garden categories are key in drawing customers to our stores and will provide a platform for our growth. While we believe participating in these categories better positions us to successfully compete against the larger warehouse home centers, it also acts as a competitive advantage over smaller independent retailers that typically do not carry the same breadth of assortment as we do in these categories. We believe our lifetime plant guarantee policy also drives customer loyalty.

We Stock High Margin Product Categories.

While our stores offer a wide range of merchandise, in contrast to our larger warehouse home center competitors, we stock repair and maintenance products, not construction materials that typically yield lower gross margins and requires a substantial amount of selling space. Our limited offerings in these areas allow us to dedicate valuable selling space to higher-margin items which meet the needs of our convenience-oriented customers.

Our Stores Are Easy to Navigate and Convenient to Shop.

To facilitate the shopping experience, our stores are generally designed in a conventional format using lower profile shelving and higher visibility signage than is usually found in our larger warehouse home center competitors, which are typified by warehouse racking and over-stacked aisles. Customers can generally view the majority of our store upon entering, helping them to easily and quickly locate items. Related departments are generally located adjacent to each other, and most merchandise is displayed according to centrally developed floor plans that are designed to optimize space utilization. Product labels and descriptive signage assist customers in easily identifying merchandise. In addition, we strive to select store sites that are easily accessible, conveniently located and have ample parking capacity. These features are intended to provide customers with a comfortable and convenient shopping environment.

We Strive to Deliver Outstanding Customer Service and Value Added Services.

We believe that our customers associate us with providing outstanding customer service and attractive value added services. We drive customer loyalty by striving to deliver outstanding customer service, a broad selection of products and high in-stock levels through friendly, experienced and knowledgeable sales people and store

 

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managers. Many of our in-store personnel have repair experience and our associates pass written tests on store policies and products in their respective departments. In addition, we offer repair services on gas outdoor power products through our Eager Beaver Engine House, which we believe distinguishes us from many of our competitors. We also provide pickup and delivery services.

We Have an Experienced Management Team and Store Leadership

We have recruited an experienced executive management team with the objective of increasing our profitability and stimulating our growth. Our executive management team has an average of over 18 years of retail related experience and an average of 8 years in the home improvement industry.

Our executive management is supported by what we believe is one of the more stable and experienced groups of store-level managers in the industry. The average tenure of an Orchard store manager is approximately 15 years. In addition, we believe that we have a pool of highly qualified assistant store managers who are experienced and ready to become store managers as we continue to expand. The average tenure for an assistant store manager with Orchard is approximately 10 years.

Our stores are generally open seven days per week. Depending on the size and sales volume of the store, the total number of personnel at a particular store varies from about 35 to 105, with about 10 to 35 of whom are full-time employees. Our stores are operated by store managers, who report to one of eight district managers. Our store managers are responsible for day-to-day store operations, subject to operating procedures established at our store support center. A typical store is staffed with a store manager, two assistant managers and seven department leads.

Our Vision and Strategy

We plan to continue to enhance our competitive position, grow our business and increase our net sales and profitability. Key components of our growth strategy are as follows:

Increase Net sales through Enhanced Marketing and Merchandising. We are focused on developing new marketing initiatives to increase the number of customers and frequency of customer visits in our stores as well as increase the average amount of time they spend in our stores. Our marketing initiatives include a new campaign to improve our brand awareness, which involves beginning to standardize the look and feel of our stores as well as how we communicate our “Orchard Supply Hardware” brand, and continuing to more efficiently utilize our advertising expenditures to better communicate our value proposition to our target customers. We continually test new marketing offers and media to optimize our return on investment on our advertising programs.

We focus on offering the complete solution for customers to satisfy their home repair and maintenance, lawn and garden needs. Our merchandising initiatives are focused on enhancing our in-store merchandising and store layouts to drive incremental revenue and improve gross margin performance. For example, we have added “off-shelf” merchandise, stocked with relevant accessories that tend to be low-price, high-margin impulse purchases at the end of each aisle and rearranged our store layout to improve cross-selling across departments.

Improve Gross Margin Performance. We are continually focusing on various initiatives intended to improve our gross margin performance, including accelerated line reviews, increasing our private label offerings and expanding the sourcing of merchandise from overseas. Our line reviews are focused on enhancing the overall quality and value proposition of our merchandise through targeted negotiation with our vendors. We continually identify product lines for review and work with our vendors to strive for the best possible quality, pricing and terms for a particular product category. In keeping with the industry trend, our private label products typically generate higher profit margins compared to similar national brands. We believe our private label merchandise provides our customers with high quality products at excellent values and therefore allows us to compete effectively in the market. For fiscal 2010, private label sales accounted for approximately 6% of our total net sales.

 

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Provide Multiple Sales Channels. In today’s competitive environment it is essential that we offer our customers the convenience of shopping for our products through multiple channels. As such, we launched our E-commerce website with approximately 6,400 products as of July 30, 2011. In 2011, our goal is to continue to expand the number of products offered on the site which we believe will drive future revenue growth.

Expand Our Store Base. We believe that we are positioned to leverage our competitive advantages and grow our store base over the long term. We target densely populated markets and sites adjacent to existing retailers that create a high traffic retail corridor that is attractive to customers. We continue to identify expansion opportunities in California and we believe that California offers a compelling opportunity for retailers based on its favorable demographic composition and expanding market potential.

Our near term store expansion is predicated on leveraging our brand equity in markets where we currently have a well established presence. We expect to continue expanding into Northern and Southern California and we are contemplating expanding beyond California into contiguous states. We believe that our brand equity and market presence in the San Francisco Bay Area and Central Valley regions will allow us to leverage our existing advertising awareness and economics of scale in these markets and open successful stores in a relatively short timeframe. We believe that the Southern California market presents our biggest expansion opportunity within California. With significantly increased store penetration in Southern California, we believe that we will develop better economies of scale and improved customer awareness in that market.

We developed a new store prototype in both our Clayton and Santa Rosa stores that we believe will provide an enhanced and more enjoyable shopping experience for our customers, which we expect to integrate into future store openings and into existing stores.

Offer Competitive Pricing. We employ a value driven pricing strategy. We continually review our pricing strategy through routine competitor price checks. Everyday prices are complemented by periodic off price item promotions and storewide discount events like “We Pay the Sales Tax” weekends. Additionally, “Dollar Days” events featuring low priced products are employed to underscore our value pricing. To reassure our customers that they cannot overpay at Orchard stores and to compete with low price competitors, we have a “Match Any Price” policy.

Our Products and Suppliers

Our focus on the repair, maintenance and improvement needs of convenience-oriented customers drives our merchandise selection. Our merchandise mix is offered through various product categories each of which represents from 2% to 15% of our fiscal 2010 revenue. Our three major revenue generating categories in 2010 were seasonal, plumbing and garden and our three smallest were appliances, outdoor power and industrial. Appliance net sales are limited as we do not sell appliances at every store location. In 2010, we expanded the number of stores which sell appliances from 19 to 34 locations. Our goal is to offer our customers a large selection of brands and products within each of our product categories.

We maintain excellent relationships with our nearly 2,000 vendors and greatly value our long-standing partnerships. In 2010, our largest supplier accounted for 3.5% of our merchandise and our top ten suppliers accounted for approximately 24.4% of our total purchases. Most of our merchandise is available from multiple suppliers and the loss of any single one would not materially impact our business.

We believe our merchandising program effectiveness is enhanced by systematically sharing point-of-sale and inventory data with many suppliers. Vendors provide substantial financial support that allows us to partially mitigate costs associated with marketing, product liquidation, merchandise program rollouts, full store resets and new store openings. In-store support, such as associate training, order placement, merchandise layout and maintenance is routinely provided by vendors.

 

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Seasonality

We experience seasonal fluctuations in our net sales and operating results and historically have realized a significant portion of our net sales and earnings for the year in the spring, primarily during our second fiscal quarter. In 2009 and 2010, we generated 29% and 30% of our net sales in the second fiscal quarter, respectively. Thus, lower than expected second quarter net sales could have an adverse impact on our annual operating results.

Distribution and Systems Infrastructure

A majority of our orders from our stores are filled by our distribution facility and 40,000 square foot warehouse, both located in Tracy, California which process and deliver orders to all of our stores. Our distribution center stocks the majority of products that are offered in our stores and cross-docks additional products to provide our stores with approximately 63% of our merchandise needs. The remainder of our merchandise, including all of our live goods, comes directly from our vendors or distributors to our stores. We operate a private fleet of 25 leased tractors and 162 owned and leased trailers to deliver merchandise to most of our Northern California stores. We contract with a third party common carrier to deliver our merchandise to selected coastal and more distant Northern California and Southern California stores.

Our distribution system allows our stores to perform key services and to promote efficient store operations. For example, our distribution system allows store department managers to place emergency orders to quickly replenish fast selling merchandise. We also use a two-way transportation system that assists us in minimizing non-selling space and markdowns by eliminating unproductive inventory and logistics related materials.

We utilize a computerized point-of-sale system, which supports an in-store system, which in turn supports a purchase order management system. Our in-store system integrates store sales, credit, inventory and data collection systems. Our point-of-sale system includes enhanced systems for check verification and acceptance, and provides alternative pay choices, including most nationally recognized financial institution debit and credit cards. Each store is linked to our host computer, which provides efficiencies in data transfers to the store support center. The in-store system is coupled with the point-of-sale system and processes transmitted store orders. In addition, we are in the process of implementing a new automated replenishment system in 2010, which we believe will reduce future inventory costs and logistics and improve the in store availability of our products.

Employees

As of July 30, 2011 we had approximately 5,800 employees, approximately 35% of whom were full-time employees. None of our employees are unionized. We believe that we have an excellent working relationship with our employees and we have never experienced an interruption of business as a result of labor disputes.

Facilities and Store Locations

As of July 30, 2011 we operated 89 retail stores, one appliance center (owned), one distribution center (owned) and one store support center (leased). Of the 89 retail stores, we owned 14 stores and lease 75 stores, six of which are situated on ground leases. Nineteen of our locations (composed of our 14 owned retail locations, four ground leases and the distribution center) were collateralized pursuant to our $50.0 million Real Estate Secured Term Loan agreement.

On October 24, 2011, a subsidiary of the Company entered into a Purchase and Sale Agreement pursuant to which a subsidiary of the Company sold for $21.3 million, all of its interest in its distribution center located in Tracy, California, which is comprised of a building containing approximately 458,000 square feet and the underlying land. In connection with the closing of the sale of the distribution center, a subsidiary of the Company entered into a lease agreement with respect to the distribution center. The commencement date of the lease was October 28, 2011. The lease is a 20-year lease and provides for three five-year extension options. The initial base

 

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rent under the lease is $1.7 million per year with 10% increases every five years. The Company will record a loss in the amount of approximately $14 million on the sale of the distribution center in the third quarter of fiscal 2011. The Company will continue to operate the facility consistent with its existing use throughout the term. In connection with the transaction, the Company repaid $7.6 million of the Real Estate Secured Term Loan and removed the distribution center from the loan collateral.

We believe that our facilities are well maintained and are sufficient to meet our current and projected needs. We review leases that will expire in the short term in order to determine the appropriate action to take with respect to them.

Intellectual Property

We have registered a number of trademarks and service marks in the United States including OSH^®, ORCHARD SUPPLY HARDWARE^®, BRIDGEWATER^®, OSH ORCHARD SUPPLY HARDWARE^®, WESTERN HAWK^{® ®} and PACIFIC BAY^®. We have 12 trademark registrations pending. Generally, our right to use our trademarks and service marks continues so long as we use them.

We believe that our trademarks and service marks are material to our success and are important to building our name recognition.

Environmental Matters

Item 103 of SEC Regulation S-K requires that we disclose legal proceedings to which the Company and a governmental authority is a party and that arise under laws dealing with the discharge of materials into the environment or the protection of the environment, if the proceeding reasonably involves potential monetary sanctions of $100,000 or more. Disclosure also is required as to any such proceedings known by us to be contemplated by governmental authorities. In that connection, we note that we have received a notice of violation from the California South Coast Air Quality Management District (“SCAQMD”) alleging that Orchard stores that are located in the SCAQMD jurisdiction sold architectural coating products that exceed the current SCAQMD limitations on volatile organic compounds.

We are currently negotiating toward a resolution of this matter and do not expect it to have a material impact on our operations. During fiscal 2010, compliance with federal, state and local laws regulating the discharge of materials into the environment or otherwise relating to the protection of the environment did not have a material effect on capital expenditures.

Legal Proceedings

Save Mart Supermarkets v. Orchard Supply Hardware LLC—On April 1, 2011, a judgment was entered against us in the case of the Save Mart Supermarkets v. Orchard Supply Hardware LLC, in California Superior Court in Fresno, California. Save Mart obtained a $5.1 million verdict on claims of breach of contract and breach of the implied covenant of good faith relating to the termination by Orchard Supply Hardware LLC of a contract for the lease of a store to be built by Save Mart. On August 24, 2011, the Company entered into a settlement agreement with Save Mart to satisfy the $5.1 million judgment, release the Company of all liabilities, and waive all rights of appeals by both parties. The settlement includes three parts: 1) a $0.5 million cash consideration paid to Save Mart, 2) the amendment and extension of an existing lease between Save Mart and the Company for a store unrelated to the one originally in dispute and 3) the lease of a new property to the Company. As of July 30, 2011, we had recorded a $5.1 million reserve for this matter. The Company estimates that this liability will be reduced by approximately $1.0 million to $2.0 million as a result of the settlement.

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certified in one of these cases, an unfavorable judgment or settlement might be material. Based on the information currently available, management does not believe that any such legal proceedings that may be currently pending would have a material adverse effect on the consolidated financial position or results of operations of the Company.

In addition, we are from time to time subject to claims of employment discrimination, unlawful employment practices and other Americans with Disabilities Act claims. These claims have not involved members of senior management and do not ordinarily involve damage claims that are material to our business.

In the ordinary course of business, we are subject to product liability litigation as a result of the sale of certain products, including products that have included asbestos. We are currently a party in two such cases, both pertaining to asbestos. These asbestos cases are early in the proceedings and it is not currently possible to evaluate the likelihood of an unfavorable outcome and not, therefore, possible to estimate with any degree of certainty any range of possible loss. However, in similar litigations we have been routinely dismissed and in those cases that Orchard has settled, the settlement has not been material.

We are subject to various legal and governmental proceedings arising out of the ordinary course of business. We believe we have valid defenses with respect to proceedings pending against us. Nevertheless litigation is inherently unpredictable and any proceedings, claims or regulatory actions against us, whether meritorious or not, may be time consuming, result in significant legal expenses, require significant amounts of management time, result in the diversion of significant operational resources, require changes in our methods of doing business that could be costly to implement, reduce our net sales, increase our expenses, require us to make substantial payments to settle claims or satisfy judgments, require us to cease conducting certain operations or offering certain products in certain areas or generally, and otherwise harm our business, results of operations, financial condition and cash flows, perhaps materially.

Defending the aforementioned lawsuits requires significant management attention and financial resources. The costs required to defend these lawsuits are unpredictable and vary from year to year. In the past, these sums have been material.

Our Relationship with Sears Holdings

We were originally formed as a purchasing cooperative by a group of farmers in California’s Santa Clara Valley. We opened for business in March 1931 with a single store in San Jose, California and we were incorporated in Delaware on March 31, 1989. In 1996, we were acquired by Sears Roebuck and we are currently an indirect majority owned subsidiary of Sears Holdings. Sears Holdings is the parent company of Sears Roebuck and Kmart Holding Corporation. Immediately following the spin-off, Sears Holdings shareholders will own 100% of the outstanding shares of our Class A Common Stock and Preferred Stock. ESL Investments, Inc. and affiliated entities (“ESL”) will own approximately 61% of our outstanding Class A Common Stock, representing approximately 61% of Class A Common Stock voting power and 49% of the voting power of our outstanding capital stock, and ESL will own approximately 61% of our outstanding Preferred Stock, which is our outstanding nonvoting capital stock. After the spin-off, we will operate as a publicly traded company independent from Sears Holdings.

Before the Distribution, we will enter into the Distribution Agreement and other agreements with Sears Holdings to effect the Distribution and provide a framework for our relationship with Sears Holdings after the Distribution. These agreements will govern the relationship between Sears Holdings and us subsequent to the completion of the spin-off and provide for the principal steps to be taken in connection with the spin-off and other matters. For a detailed description of these agreements, see “Certain Relationships and Related Party Transactions—Agreements with Sears Holdings” in this Prospectus.

 

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Corporate Information

We were incorporated in Delaware on March 31, 1989. We conduct substantially all our operations through our wholly owned subsidiary, Orchard Supply Hardware LLC. Our principal executive offices are located at 6450 Via Del Oro, San Jose, California 95119 and our telephone number is (408) 281-3500. Our website address is www.osh.com.

 

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MANAGEMENT

Directors and Executive Officers Following the Distribution

The following table sets forth information regarding the individuals who are currently expected to serve as our executive officers and directors following the Distribution and their anticipated titles following the Distribution. All of our executive officers are currently employees of Sears Holdings or its subsidiaries. After the Distribution, none of our executive officers and directors will be employees of Sears Holdings.

 

Name		Age				Position with Orchard
Mark R. Baker			53			Chief Executive Officer, President and Director
Chris D. Newman			46			Senior Vice President, Chief Financial Officer and Treasurer
Steven L. Mahurin			51			Executive Vice President, Merchandising and Director
Stephen W. Olsen			39			Senior Vice President, Supply Chain, IT and Chief Strategy Officer
Thomas J. Carey			53			Senior Vice President, Chief Marketing Officer
David I. Bogage			57			Senior Vice President, Human Resources
Mark A. Bussard			46			Senior Vice President, Operations and Director
Michael W. Fox			52			Senior Vice President, General Counsel and Secretary
William C. Crowley			54			Director and Chairman
Matthew D. Cwiertnia			40			Director
Kevin R. Czinger			52			Director
Susan L. Healy			45			Director
David B. Kaplan			44			Director
Karen M. Rose			63			Director
Bryant W. Scott			56			Director

On October 3, 2011, Michael W. Fox was appointed as our Senior Vice President, General Counsel and Secretary, replacing Roger L. Smith, who had served as our Vice President, Real Estate, General Counsel and Secretary until September 30, 2011.

On November 7, 2011, Chris D. Newman was appointed interim Senior Vice President, Chief Financial Officer and Treasurer, replacing William C. Robertson, who served as our Senior Vice President, Chief Financial Officer and Treasurer until that time.

MARK R. BAKER: Chief Executive Officer, President and Director.

Mr. Baker has been President and Chief Executive Officer and a Director of Orchard since March 2011. Mr. Baker served as President and Chief Operating Officer of The Scotts Miracle-Gro Co., a leading manufacturer and marketer of branded consumer lawn and garden products, from September 2008 to October 2010. He served as Chief Executive Officer and President of Gander Mountain Company, an outdoor retailer specializing in hunting, fishing and camping gear, from September 2002 to September 2008. Prior to Gander Mountain Company, Mr. Baker served as Chief Merchandising Officer and Executive Vice President of Merchandising at The Home Depot, Inc. from October 2000 to 2001. From June 1999 to October 2000, he served as Group President and Senior Vice President of Merchandising at The Home Depot. From 1997 to 1999, he served as President of the Midwest Division at The Home Depot. From 1992 to 1996, Mr. Baker served as Executive Vice President of Merchandising at HomeBase, Inc. He was Vice President of Merchandising and Marketing of Scotty’s Home Improvement Centers from 1988 to 1992. Prior to Scotty’s Home Improvement Centers, Mr. Baker held various management positions for Knox Hardware and Lumber from 1980 to 1988. He has been a Director of Orchard Supply Hardware since March 2011. He served as a Director of The Scotts Miracle-Gro Co., from January 2004 to October 2010. Mr. Baker was a Director of Gander Mountain Company from April 2004 to September 2008 and currently serves as a Director of Andersen Windows, a private company.

 

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Mr. Baker brings extensive operational leadership and merchandising experience within the home improvement retail industry to our board of directors. As President and Chief Operating Officer of Scott’s Miracle-Gro and Chief Executive Officer and President of the Gander Mountain Company, Mr. Baker gained extensive experience in supervising finance, supply-chains, merchandising and real-estate functions in consumer-facing retail companies. We believe that Mr. Baker possesses specific attributes that qualify him to serve on our board of directors, including his experience in managing and acting as a director of a publicly traded company as well as experience as a director of private retail companies.

CHRIS D. NEWMAN: Senior Vice President, Chief Financial Officer and Treasurer

Mr. Newman joined Orchard as interim Senior Vice President, Chief Financial Officer and Treasurer on November 7, 2011. From March 2006 to July 2011, Mr. Newman was Chief Financial Officer, Senior Vice President and Secretary of Restoration Hardware, Inc. Prior to Restoration Hardware, from September 2005 to March 2006, Mr. Newman served as Vice President and Chief Financial Officer of Store Operations at Limited Brands, Inc. Mr. Newman also worked in various other executive-level positions at Limited Brands, including Vice President of Finance, Bath & Body Works, and Vice President of Finance, Victoria’s Secret Stores.

STEVEN L. MAHURIN: Executive Vice President, Merchandising and Director

Mr. Mahurin joined Orchard on May 1, 2011 as Executive Vice President, Merchandising and will join our board of directors on the date of the Distribution. Mr. Mahurin served as Executive Vice President of Merchandising for Office Depot Incorporated, a multi-channel office supply and technology retailer and distributor, from March 2008 until April 2011. From March 2004 until March 2008, Mr. Mahurin served as Senior Vice President, Chief Merchandising Officer for True Value Company, a $2 billion hardware cooperative. He served as Vice President of Merchandising and Marketing at Golf and Tennis Pro Shop, Incorporated, a golf and tennis superstore retailer, from September 2002 to February 2004. From July 1989 until March 2002, Mr. Mahurin worked for The Home Depot where he held a number of ever increasing senior management roles ultimately serving as a Senior Vice President of Merchandising. We believe that Mr. Mahurin possesses specific attributes that qualify him to serve as a member of our board of directors, including extensive experience in the retail hardware industry and his experience as a manager.

STEPHEN W. OLSEN: Senior Vice President, Supply Chain, Information Technology and Chief Strategy Officer

Mr. Olsen joined Orchard in June 2010 as Senior Vice President, Merchandising. In April 2011, Mr. Olsen was promoted to Senior Vice President, Supply Chain, Information Technology and Chief Strategy Officer. Previously, Mr. Olsen served as Vice President of Merchandising, Supplies at Office Depot, Inc., a global supplier of office products and services, from 2004 to May 2010, where he was responsible for retail, catalog, online and contract channels. From 1996 to 2004, Mr. Olsen held various positions of increasing responsibility ultimately serving as a Senior Manager at Accenture plc.

THOMAS J. CAREY: Senior Vice President, Chief Marketing Officer

Mr. Carey joined Orchard in July 2007 as Vice President and Chief Marketing Officer, he was promoted to Senior Vice President and Chief Marketing Officer in August 2009, responsible for marketing, advertising, branding and public relations. From 2003 to 2007, Mr. Carey served as Senior Vice President of Marketing for West Marine, Inc., the world’s largest boating supply retailer. From 2002 to 2003, Mr. Carey served as Senior Vice President of Marketing and Advertising for Goody’s Family Clothing. Mr. Carey was Senior Vice President of Marketing for Sunglass Hut International from 1999 to 2001. Additionally, Mr. Carey served in various executive roles at Bloomingdale’s, Inc. from 1997 to 1999, and Builders Square, Inc. from 1994 to 1997. Prior to his retail experience, Mr. Carey spent 12 years from 1982 to 1994 with various marketing and advertising agencies, including Ogilvy & Mathers, N.W. Ayer Advertising, Young & Rubicam Advertising, and MARS Communication.

 

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DAVID I. BOGAGE: Senior Vice President, Human Resources

Mr. Bogage joined Orchard as Senior Vice President of Human Resources in April 2011. Mr. Bogage served as Senior Vice President, Talent and Organizational Development of The Scotts Miracle-Gro Co., a leading manufacturer and marketer of branded consumer lawn and garden products, from February 2009 to January 2011. He served as Senior Vice President, Human Resources and Organizational Development for The Haskell Company from August 2003 to March 2008. He served as Vice President, Human Resources at The Home Depot, Inc. from 1994 to 2003.

MARK A. BUSSARD: Senior Vice President, Operations and Director

Mr. Bussard joined Orchard of Senior Vice President, Operations in June 2011 and will join our board of directors on the date of the Distribution. From October, 1994 until October, 2010 Mr. Bussard served in ever increasing leadership roles with Gander Mountain, a retail industry leader in hunting, fishing, camping equipment and outdoor apparel ultimately becoming the Senior Vice President of Retail Sales. From 1989 until 1994, Mr. Bussard served in various management roles with Quality Farm and Fleet, a retail chain of stores offering home improvement, agriculture, lawn and garden maintenance, and livestock, equine and pet care products. We believe that Mr. Bussard possesses specific attributes that qualify him to serve as a member of our board of directors, including extensive experience in the retail industry and his experience as a manager.

MICHAEL W. FOX: Senior Vice President, General Counsel and Secretary

Mr. Fox joined Orchard in October 2011 as Senior Vice President, General Counsel and Secretary. Previously, from August 2008 to September 2011, Mr. Fox served as Senior Vice President and General Counsel of Jamba, Inc. and was its Corporate Secretary since November 2006. Mr. Fox joined Jamba Juice Company as Vice President, Legal Affairs in February 2005.

WILLIAM C. CROWLEY: Director and Chairman

Mr. Crowley has been a member of our board of directors since November 2005. He is the President and Chief Operating Officer of ESL Investments, Inc. and has served in that capacity since 1999. From March 2005 to January 2011, Mr. Crowley served as an Executive Vice President of Sears Holdings and, from September 2005 to January 2011, as its Chief Administrative Officer. He also served as Chief Financial Officer of Sears Holdings from March 2005 to September 2006 and as interim Chief Financial Officer from January 2007 to October 2007. From 2003 to 2005, Mr. Crowley was as an officer of Kmart Holding Corporation and, since December 2006, he has served as Chairman of the board of directors of Sears Canada Inc. and has been a director of Sears Canada Inc. since March 2005. He is currently a director of AutoNation, Inc., an automotive retailer, and AutoZone, Inc., a retailer and distributor of automotive replacement parts and accessories. He served as a director of Sears Holdings from March 2005 to May 2010. We believe that Mr. Crowley possesses specific attributes that qualify him to serve as a member of our board of directors, including extensive executive, financial and operational experience in the retail industry as well as substantial investment and financial market knowledge.

MATTHEW D. CWIERTNIA: Director

Mr. Cwiertnia has been a member of our board of directors since November 2005. He is a Senior Partner in the Private Equity Group of Ares Management LLC. Prior to joining Ares in 2005, Mr. Cwiertnia worked in the Financial Sponsors Group of Credit Suisse First Boston (“CSFB”) providing advisory and financing services to financial sponsors and their portfolio companies. Prior to CSFB, Mr. Cwiertnia was a member of the investment banking department of Donaldson, Lufkin & Jenrette Securities Corp. (“DLJ”), primarily focused on high yield financings, restructurings and private equity placements. Prior to DLJ, Mr. Cwiertnia was at Jefferies & Co. Inc. in the Investment Banking Group. Mr. Cwiertnia currently serves on the boards of directors of Sotera Defense Solutions, Inc. and Stream Global Services, Inc., and he also serves on the Investment Committee, Finance

 

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Committee and Board of Governors of The UCLA Foundation which manages over $1 billion of endowed assets. We believe that Mr. Cwiertnia possesses specific attributes that qualify him to serve as a member of our board of directors, including extensive management experience and financial and investing knowledge.

KEVIN R. CZINGER: Director

Mr. Czinger will join our board of directors on the date of the Distribution. Mr. Czinger has been the Senior Strategic Advisor of CODA Automotive, Inc., an electric car and battery company, since January 2011. From January 2008 to December 2010, Mr. Czinger served as Co-Founder, President and Chief Executive Officer of CODA Automotive, where he oversaw the management and strategic direction of the company. From October 2005 to April 2007, he was a Co-Founder and Managing Principal of San Shan Partners Limited, a private equity fund based in China. Previously, he served as a partner and Senior Managing Director at Fortress Private Equity, an alternative asset management firm and an Entrepreneur-in-Residence at Benchmark Capital. We believe that Mr. Czinger possesses specific attributes that qualify him to serve as a member of our board of directors, including extensive executive and management experience.

SUSAN L. HEALY: Director

Ms. Healy will join our board of directors on the date of the Distribution. Ms. Healy was the Chief Financial Officer at Virent Energy Systems, Inc. from June 2010 to February 2011 and Senior Vice President and Chief Financial Officer at Lands’ End, Inc. from April 2006 to August 2009. From December 2004 to April 2006, Ms. Healy served as the Chief Financial Officer of East Coast Power LLC and as co-Chief Financial Officer of Cogentrix Energy, Inc. She served as a Vice President of J. Aron and Company, a subsidiary of The Goldman Sachs Group Inc., from January 2004 to April 2006, as a Vice President, Corporate Treasury at Goldman Sachs from September 2000 to January 2004, as a Vice President, Investment Banking from April 1998 to September 2000 and an Associate from August 1994 to April 1998. We believe that Ms. Healy possesses specific attributes that qualify her to serve as a member of our board of directors, including extensive financial reporting, internal control, management and financial analysis experience.

DAVID B. KAPLAN: Director

Mr. Kaplan has been a member of our board of directors since November 2005. He is a founding member and Senior Partner of Ares Management LLC, where he serves on the Executive Committee and co-heads the Private Equity Group. Mr. Kaplan joined Ares from Shelter Capital Partners, LLC, where he was a Senior Principal from June 2000 to April 2003. From 1991 to 2000, Mr. Kaplan was a Senior Partner of Apollo Management, L.P. during which time he completed multiple private equity investments from origination through exit. Prior to Apollo Management, Mr. Kaplan was a member of the Investment Banking Department at Donaldson, Lufkin & Jenrette Securities Corp. He currently serves as Chairman of the board of directors of FDO Holdings, Inc., the indirect parent of Floor and Decor Outlets of America, Inc., and as a member of the boards of directors of Stream Global Services, Inc. and GNC Holdings, Inc. Mr. Kaplan has also served on the boards of directors of Maidenform Brands, Inc. (as its Chairman), Dominick’s Supermarkets, Inc. and Allied Waste Industries Inc., each public companies. Mr. Kaplan currently serves on the Board of Governors of Cedars-Sinai Medical Center, is a Trustee of the Center for Early Education, is a Trustee of the Marlborough School and serves on the Los Angeles Advisory Council to the University of Michigan. We believe that Mr. Kaplan possesses specific attributes that qualify him to serve as a member of our board of directors, including extensive experience in investment banking and private equity as well as experience gained during his service as a director of both public and private companies.

KAREN M. ROSE: Director

Ms. Rose will join our board of directors on the date of the Distribution. Ms. Rose has been the Chair of the Board of Directors of Maidenform Brands, Inc. since January 2009 and a director of Maidenform since January

 

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2005. She also serves as Chair of Maidenform’s audit committee and is a member of its compensation and nominating and governance committees. She was Group Vice President and Chief Financial Officer of The Clorox Company from December 1997 until her retirement in October 2003. Prior to that, Ms. Rose held various management positions including Director of Finance, Household Products Company and Vice President and Treasurer since joining Clorox in 1978. Ms. Rose currently serves on the board of directors of Wilton Brands, Inc., where she chairs the audit committee and is a member of its nominating and governance committee. Previously, Ms. Rose has served on the boards of directors of Fairmont, Inc. from 2004 to 2006 and Bare Escentuals, Inc. from 2006 to 2010. We believe that Ms. Rose possesses specific attributes that qualify her to serve as a member of our board of directors, including extensive management, financial and director experience with public companies.

BRYANT W. SCOTT: Director

Mr. Scott will join our board of directors on the date of the Distribution. Mr. Scott has been the President and Chief Operating Officer of Floor and Decor Outlets of America Inc. since November 2009. From October 2005 to October 2009, he was the President and CEO of Game On Retail Services, providing retail consulting primarily focused in China and Taiwan. Mr. Scott was the Co-Founder and Senior Vice President of Merchandising for Home Decor Liquidators from February 2003 to September 2005. In 1980, Mr. Scott joined Home Depot Inc. when the company had three stores and then spent twenty-three years with the company, where he held a variety of positions, including lot man, Hardware Sales Associate, Assistant Store Manager, Store manager, Regional Manager, Vice President of Operations for the West Coast, Vice President of Merchandising for the Southeast U.S. and President of the EXPO Design Center. We believe that Mr. Scott possesses specific attributes that qualify him to serve as a member of our board of directors, including extensive experience in the retail home improvement industry and as a manager.

Board Structure

Our board of directors currently consists of six directors and will expand to seven directors as of the time of our listing on the NASDAQ Capital Market. On the distribution date, our board of directors will expand to ten directors and consist of the individuals named above. All of our current directors except Messrs. Kaplan and Cwiertnia have provided us with resignations dated as of December 7, 2011 contingent upon and effective as of the Distribution. Messrs. Kaplan and Cwiertnia have provided us with resignations dated as of December 7, 2011 contingent upon and effective as of their respective appointments as Class B/C Directors of the Company in connection with the Distribution.

At the time of the Distribution, we expect to have an appropriate number of independent members on our board of directors as required by the federal securities laws and the rules of the NASDAQ Capital Market. All of our directors will stand for election at each annual meeting of our shareholders. There are no family relationships among any of our directors or executive officers.

Committees of the Board

We expect that, immediately following the Distribution, the standing committees of our board of directors will consist of an audit committee, a compensation committee and a nominating and corporate governance committee.

Audit Committee

The duties and responsibilities of the Audit Committee will be set forth in its charter available on our website, and will include the following:

 

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to oversee the quality and integrity of our financial statements and our accounting and financial reporting processes;

 

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to prepare the audit committee report required by the SEC in our annual proxy statements;

 

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to review and discuss with management and the independent registered public accounting firm our annual and quarterly financial statements;

 

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to review and discuss with management and the independent registered public accounting firm our earnings press releases;

 

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to appoint, compensate and oversee our independent registered public accounting firm, and pre-approve all auditing services and non-audit services to be provided to us by our independent registered public accounting firm;

 

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to review the qualifications, performance and independence of our independent registered public accounting firm; and

 

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to establish procedures for the receipt, retention and treatment of complaints received by us regarding accounting, internal accounting controls or auditing matters and the confidential, anonymous submission by our employees of concerns regarding questionable accounting or auditing matters.

At the time of listing on the NASDAQ Capital Market, at least one member of the audit committee will be “independent,” as defined under and required by the rules and regulations of the SEC and the NASDAQ Capital Market, including Rule 10A-3(b)(1) under the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), and we expect that one member will be the “audit committee financial expert” as defined under and required by the rules and regulations of the SEC and the NASDAQ Capital Market. A majority of the members of the committee will be “independent” within 90 days of listing on the NASDAQ Capital Market and all members will be independent within one year of listing on the NASDAQ Capital Market.

Our board of directors has adopted a written charter for the audit committee effective as of the Distribution which will be available on our website.

Compensation Committee

The duties and responsibilities of the compensation committee will be set forth in its charter available on our website, and will include the following:

 

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to determine, or recommend for determination by our board of directors, the compensation of our chief executive officer and other executive officers;

 

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to establish, review and consider employee compensation policies and procedures;

 

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to review and approve, or recommend to our board of directors for approval, any employment contracts or similar arrangement between the company and any executive officer of the company;

 

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to review and discuss with management the Company’s compensation policies and practices and management’s assessment of whether any risks arising from such policies and practices are reasonably likely to have a material adverse effect on the Company; and

 

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to review, monitor, and make recommendations concerning incentive compensation plans, including the use of stock options and other equity-based plans.

At the time of listing on the NASDAQ Capital Market, at least one member of the committee will be “independent.” A majority of the members of the committee will be “independent” within 90 days of listing on the NASDAQ Capital Market and all members will be independent within one year of listing on the NASDAQ Capital Market.

Nominating and Corporate Governance Committee

The duties and responsibilities of the nominating and corporate governance committee will be set forth in its charter available on our website, and will include the following:

 

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to recommend to our board of directors proposed nominees for election to the board of directors by the shareholders at annual meetings, including an annual review as to the renominations of incumbents and

 

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proposed nominees for election by the board of directors to fill vacancies that occur between shareholder meetings;

 

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to make recommendations to the board of directors regarding corporate governance matters and practices; and

 

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to recommend members for each committee of the board of directors.

At the time of listing on the NASDAQ Capital Market, at least one member of the committee will be “independent.” A majority of the members of the committee will be “independent” within 90 days of listing on the NASDAQ Capital Market and all members will be independent within one year of listing on the NASDAQ Capital Market.

Compensation Committee Interlocks and Insider Participation

No member of our compensation committee serves as a member of the board of directors or compensation committee of any entity that has one or more executive officers serving as a member of our board of directors or compensation committee. Additional information concerning transactions between us and entities affiliated with members of the compensation committee is included in this Prospectus under the heading “Related Party Transactions.”

Code of Ethics

Our board of directors has adopted a code of ethics applicable to our directors, officers and employees, including our Chief Executive Officer, Chief Financial Officer and other senior officers effective as of the time of our listing on the NASDAQ Capital Market, in accordance with applicable rules and regulations of the SEC and the NASDAQ Capital Market. Our code of ethics will be available on our website.

Corporate Governance Guidelines

Our board of directors has adopted a set of corporate governance guidelines that sets forth our policies and procedures relating to corporate governance effective as of the Distribution. Our corporate governance guidelines will be available on our website.

 

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COMPENSATION OF DIRECTORS

After the Distribution, the policy of the board of directors will be to compensate certain non-employee directors who are also independent of ESL and ACOF with a mix of cash and equity-based compensation. Director compensation will be reviewed by the board of directors annually and from time to time to ensure that compensation levels are fair and appropriate, with any changes generally becoming effective commencing after the annual meeting of stockholders. All directors will be entitled to reimbursement by the Company for reasonable travel to and from meetings of the board of directors, and reasonable food and lodging expenses incurred in connection therewith.

After the Distribution, certain non-employee directors who are also independent of ESL and ACOF will be compensated according to our Director Compensation Policy in the following manner:

 

		Cash Compensation(1)				Equity Compensation(2)
Annual Retainer: