Heavy Duty Engineering to Sell Retailers

Parents of two hard-to-sell retail chains have pulled out all the financial and accounting stops in preparation for parting company with the troubled merchants. J.C. Penney Co. booked non-cash charges of more than $1.3 billion to dress up its Eckerd Corp. drug store subsidiary, which has been on the block for several months. Meanwhile, media and entertainment giant Viacom Inc. threw in the towel on trying to sell majority-owned Blockbuster Entertainment Inc. and decided to engineer the long-awaited divorce through a split-off, i.e., swapping shares of the video rental chain to investors willing to trade in Viacom shares. Both subsidiaries marked for disposition have been performing poorly because they are in retail sectors ravaged by intense competition and unfavorable business tides. Eckerd, for example, is, along with most of its key competitors, in a competitive vise resulting from cost, price, and other pressures that characterize the national debate over taming health care inflation. Drug chains have complained of low levels of reimbursement from health insurers while margins have been depressed by mounting competition from mail-order pharmacies, including those run by pharmacy benefits managers (PBMs), as well as an increased volume of American drug purchases from lower-priced Canadian suppliers. Blockbuster, the largest U.S. video rental chain, and its smaller competitors have been singed by the rising popularity of cheap DVDs that consumers can buy outright instead of renting the traditional videos that have to be returned. As the biggest player in the field, Blockbuster would also be the biggest headache to a buyer, either in the sector or on the outside. Penney wrote down the value of its investment in Eckerd, as well as goodwill, by $450 million. It also took another charge of $875 million to in effect offset an almost automatic gain on the sale of Eckerd, regardless of the purchase. A big gain is expected because Penney paid for its chief drugstore acquisitions in tax-free stock deals and, therefore, has a very low tax basis in Eckerd, i.e., the tax basis is lower than the book basis in the chain. However, that technique offers something of an ace in the hole to boost the ultimate price. The write-down clears the way for Penney and the ultimate buyer to file a 338-H10 election with the IRS under the U.S. tax laws, thus allowing the acquisition to be treated as an asset purchase and the buyer to step up the value of Eckerd assets so it can harvest tax benefits and cash flows from increased depreciation. That carrot, says Robert Willens, a corporate tax expert at Lehman Brothers, should redound to Penney’s benefit in “the form of a higher sales price.” In theory, a split-off should ease Viacom’s divorce from Blockbuster. The share swap is tax-free and will reduce the number of Viacom shares outstanding. The hang-up is whether enough Viacom shareholders will bite for an offer to give up stock in a growing media and entertainment company in exchange for shares of a troubled retailer with a rough future. One way to make it work is to structure the share exchange with a substantial premium that could give traders of Viacom shares something like 10% to 15% more in value than their current Viacom holdings. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com