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As filed with the Securities and Exchange Commission on June 23, 2011

Registration No. 333-            

 

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

Orchard Supply Hardware Stores Corporation

(Exact Name of Registrant as Specified in its Charter)

 

Delaware

 

5200

 

95-4214109

(State or Other Jurisdiction of

Incorporation or Organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification No.)

 

 

6450 Via Del Oro

San Jose, CA 95119

(408) 281-3500

(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)

 

 

Roger L. Smith

Vice President, Real Estate, General Counsel and Secretary

Orchard Supply Hardware Stores Corporation

6450 Via Del Oro

San Jose, CA 95119

(408) 281-3500

(Name, Address, Including Zip Code, and Telephone Number, Including Area Code, of Agent for Service)

 

 

With Copies To:

 

Dane A. Drobny

Senior Vice President, General Counsel and

Corporate Secretary

Sears Holdings Corporation

3333 Beverly Road

Hoffman Estates, IL 60179

(847) 286-2500

 

William H. Hinman, Jr.

Simpson Thacher & Bartlett LLP

2550 Hanover Street

Palo Alto, CA 94304

(650) 251-5000

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement becomes effective.

If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  x

If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act of 1933, please check the following box and list the Securities Act Registration Statement number of the earlier effective Registration Statement for the same offering.  ¨

If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act of 1933, check the following box and list the Securities Act of 1933 Registration Statement number of the earlier effective Registration Statement for the same offering.  ¨

If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act of 1933, check the following box and list the Securities Act of 1933 Registration Statement number of the earlier effective Registration Statement for the same offering.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Securities Exchange Act of 1934. (Check one):

 

Large accelerated filer  ¨

    Accelerated filer  ¨

Non-accelerated filer  x

(Do not check if a smaller reporting company)

    Smaller reporting company  ¨

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of Each Class of Securities

to be Registered(1)

  Proposed Maximum Aggregate
Offering Price(2)
  Amount of Registration
Fee(3)

Class A Common Stock, par value $0.01 per share

  $82,000,000   $9,520.20

Series A Preferred Stock, par value $0.01 per share

   
 

 

(1) This Registration Statement relates to an indeterminate amount of shares of Class A Common Stock, par value $0.01 per share, and Series A Preferred Stock, par value $0.01 per share, of Orchard Supply Hardware Stores Corporation (the “Registrant”) which will be distributed pursuant to a spin-off transaction to the holders of common stock of Sears Holdings Corporation (“Sears Holdings”) and shall result in an aggregate initial offering price for all securities in an amount not to exceed $82,000,000.
(2) Estimated solely for the purpose of determining the registration fee pursuant to Rule 457(o) under the Securities Act of 1933, based on the proposed maximum aggregate offering price of the Class A Common Stock and the Series A Preferred Stock being distributed pursuant to the spin-off transaction described above. Rule 457(o) permits the registration fee to be calculated on the basis of the maximum offering price of all of the securities listed and, therefore, the table does not specify by each class, information as to the amount to be registered, the proposed maximum offering price per unit or the proposed maximum aggregate offering price.
(3) Calculated by multiplying 0.0001161 by the proposed maximum aggregate offering price.

 

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to Section 8(a), may determine.

 

 

 


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EXPLANATORY NOTE

This Registration Statement has been prepared on a prospective basis on the assumption that, among other things, the spin-off of the Registrant from Sears Holdings (as described in the Prospectus which is a part of this Registration Statement) and the related transactions and approvals contemplated to occur prior to or contemporaneously with the spin-off will be consummated as contemplated by the Prospectus. There can be no assurance, however, that any or all of such transactions will occur or will occur as so contemplated. Any significant modifications to or variations in the transactions contemplated will be reflected in an amendment or supplement to this Registration Statement.


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The information in this Preliminary Prospectus is not complete and may be changed. We may not issue these securities until the Registration Statement filed with the Securities and Exchange Commission is effective. This Preliminary Prospectus is not an offer to sell nor does it seek an offer to buy these securities.

 

SUBJECT TO COMPLETION DATED JUNE 23, 2011

PROSPECTUS

LOGO

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 $0.01 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 $0.01 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, 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.

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              shares of Sears Holdings common stock outstanding as of the close of business on                     , 2011, the record date for the spin-off (the “record date”), will entitle the holder thereof to receive              shares of Class A Common Stock and              shares of Preferred Stock. The Distribution will be made in book-entry form. Fractional shares of Class A Common Stock or Preferred Stock will not be distributed. Instead, promptly following the Distribution, 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., Eastern Daylight Time on                     , 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;

 

   

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

 

   

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. However, we expect that a limited market, commonly known as a “when issued” trading market, for our Class A Common Stock and Preferred Stock will develop on or shortly prior to the record date for the Distribution, and we expect “regular way” trading of our Class A Common Stock and Preferred Stock will begin the first trading day after the completion of the Distribution. We expect to list our Class A Common Stock on the NASDAQ Capital Market under the symbol “OSHS” and quote our Preferred Stock on the OTC Bulletin Board, or the “Pink Sheets” or another over-the-counter (“OTC”) quotation system under the symbol “            ”.

In reviewing this Prospectus, you should carefully consider the matters described under “Risk Factors” beginning on page 19 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                     , 2011.


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TABLE OF CONTENTS

 

Summary

     1   

Questions and Answers About the Company and the Spin-Off

     11   

Risk Factors

     19   

Cautionary Statement Concerning Forward-Looking Statements

     42   

The Spin-Off

     44   

Dividend Policy

     54   

Capitalization

     55   

Selected Historical Consolidated Financial Data

     57   

Unaudited Pro Forma Consolidated Financial Data

     59   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     64   

Business

     82   

Management

     89   

Compensation of Directors

     94   

Executive Compensation

     95   

Security Ownership by Certain Beneficial Owners and Management

     110   

Certain Relationships and Related Party Transactions

     115   

Description of Our Capital Stock

     121   

Shares Eligible for Future Sale

     129   

Use of Proceeds

     131   

Determination of Offering Price

     132   

Legal Matters

     133   

Experts

     134   

Where You Can Find More Information

     135   

Index to Consolidated Financial Statements

     F-1   

Index to Unaudited Interim Condensed Consolidated Financial Statements

     F-24   

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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SUMMARY

This summary highlights information contained elsewhere in this Prospectus and may not contain all of the information that may be important to you. For a more complete understanding of our business and the spin-off, you should read this summary together with the more detailed information and financial statements appearing elsewhere in this Prospectus. You should read this entire Prospectus carefully, including the “Risk Factors” and “Cautionary Statement Concerning Forward-Looking Statements” sections. “Orchard,” “we,” “our,” and “us” refer to Orchard Supply Hardware Stores Corporation and our subsidiaries.

Our Company

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 April 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 40,600 square feet of interior and exterior selling space and 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 in, by using high visibility signage for ease of navigation and lower profile shelving than is typically found in our larger warehouse home center competitors.

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.

Our Competitive Strengths

Our success depends on our ability to remain competitive with respect to our stores’ shopping convenience, the in-stock availability of merchandise and superior customer service by knowledgeable sales professionals. We believe that 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

 

 

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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 that our year-round garden and nursery categories are key in drawing customers to our stores and will provide a platform for our growth. While we believe that 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 this category. We believe that 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 require substantial selling space. Our limited offerings in these areas allow us to dedicate valuable selling space to higher-margin items that 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 that 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 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 eight 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.

 

 

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Our stores are generally open seven days per week. Depending on the size and sales volume of the store, the total number of personnel assigned to a particular store varies from about 35 to 105, approximately 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 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 Co. (“Sears Roebuck”), a company that is now a wholly owned subsidiary of Sears Holdings. Sears Holdings is the company that was formed in connection with the merger of Sears Roebuck and Kmart Holding Corporation (“Kmart”) on March 24, 2005, and Sears Holdings is the parent company of Sears Roebuck and Kmart. 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 (collectively, “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. Immediately following the Distribution, ACOF I LLC (“ACOF”), a wholly owned subsidiary of Ares Corporate Opportunities Fund, L.P. (“ACOF I”), an affiliate of Ares Management LLC (“Ares Management”), will own 100% of our Class C Common Stock, representing approximately 20% of the general voting power of our outstanding capital stock. 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 certain shareholders following the Distribution.

Historically we have had agreements with Sears Holdings subsidiaries to sell certain Sears Holdings proprietary branded products and in preparation for the Distribution we will negotiate and enter into new agreements. In connection with the Distribution, we have entered into or will enter into various agreements with Sears Holdings or certain of its subsidiaries 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 certain of its subsidiaries, see “Certain Relationships and Related Party Transactions—Agreements with Sears Holdings” in this Prospectus.

Trademarks and Service Marks

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 also use the following trademarks, some of which are pending registration as intend-to-use applications: ORCHARD SUPPLY HARDWARE EST. 1931® and PACIFIC BAY®. All other trademarks or service marks appearing in this Prospectus are the property of their respective owners.

 

 

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Corporate Information

We conduct substantially all our operations through our direct, 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.

Risk Factors

Our business is subject to various risks. For a description of these risks, see the section entitled “Risk Factors” beginning on page 19 and the other information included elsewhere in this Prospectus.

 

 

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Summary of the Spin-Off

The following is a summary of the terms of the spin-off. See “The Spin-Off” in this Prospectus for a more detailed description of the matters described below.

 

Distributing company

Sears Holdings Corporation (“Sears Holdings”) is the distributing company in the spin-off. Immediately following the Distribution, Sears Holdings will not own any capital stock of Orchard Supply Hardware Stores Corporation (“Orchard”).

 

Distributed company

Orchard is the distributed company in the spin-off.

 

Primary purposes of the spin-off

For the reasons more fully discussed in “Questions and Answers About the Company and The Spin-off—What are the reasons for the spin-off?”, the Sears Holdings board of directors believes that separating Orchard from Sears Holdings is in the best interests of both Sears Holdings and Orchard.

 

Distribution ratio

Each holder of Sears Holdings common stock will receive          shares of Class A Common Stock and          shares of Preferred Stock for every          shares of Sears Holdings common stock held on                     , 2011, the record date for the Distribution. Cash will be distributed in lieu of any fractional shares of Class A Common Stock and Preferred Stock you are otherwise entitled to, as described below.

 

Securities to be distributed

All of the shares of Class A Common Stock and Preferred Stock owned by Sears Holdings, which will be 100% of our Class A Common Stock and 100% of our Preferred Stock outstanding immediately prior to the Distribution. The Class A Common Stock will represent approximately 80% of the general voting power of Orchard’s outstanding capital stock (subject to the discussion under “Description of our Capital Stock” regarding relative rights of our Class A Common Stock, Class B Common Stock and Class C Common Stock to vote for the election of directors) and the outstanding shares of Preferred Stock will represent 100% of Orchard’s outstanding nonvoting capital stock. Based on the approximately          shares of Sears Holdings common stock outstanding on                     , 2011, and applying the distribution ratio of          shares of Class A Common Stock and          shares of Preferred Stock for every          shares of Sears Holdings common stock, approximately          of our shares of Class A Common Stock and          of our shares of Preferred Stock will be distributed to Sears Holdings shareholders who hold Sears Holdings common stock as of the record date. The number of shares of Class A Common Stock and Preferred Stock that Sears Holdings will distribute to its shareholders will be reduced to the extent that cash payments are made in lieu of the issuance of fractional Class A Common Stock and Preferred Stock.

 

Record date

The record date for the Distribution is the close of business on                     , 2011.

 

 

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Distribution date

The distribution date will be                     , 2011.

 

The spin-off

On the distribution date, Sears Holdings will release all of its shares of Class A Common Stock and Preferred Stock to the distribution agent to distribute to Sears Holdings shareholders. The Distribution will be made in book-entry form. It is expected that it will take the distribution agent up to eight business days following the Distribution date to electronically issue shares of Class A Common Stock and Preferred Stock to you or your bank or brokerage firm on your behalf by way of direct registration in book-entry form. You will not be required to make any payment, surrender or exchange your Sears Holdings common stock or take any other action to receive your shares of Class A Common Stock and Preferred Stock.

 

Class B and C Common Stock

Immediately following the Distribution, Orchard will have              shares of Class B Common Stock outstanding that collectively represent less than 1% of the voting power of Orchard and              shares of Class C Common Stock outstanding that collectively represent approximately 20% of the general voting power of Orchard.

 

Post-Distribution ownership

Based on the ownership of Sears Holdings common stock outstanding on                     , 2011, we anticipate that immediately following the Distribution, ESL will own approximately 61% of our outstanding Class A Common Stock, representing approximately 61% of the voting power of our outstanding Class A Common Stock and approximately 49% of the general 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. Immediately following the Distribution, ACOF I LLC will own 100% of our Class C Common Stock representing approximately 20% of the general voting power of our outstanding capital stock. 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 certain shareholders following the Distribution.

 

No fractional shares

No fractional shares of Class A Common Stock or Preferred Stock will be distributed. Instead, the 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 to each holder who otherwise would have been entitled to receive a fractional share in the Distribution. Accordingly, if you hold fewer than              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. Recipients of cash in lieu of fractional shares will not be entitled to any interest on payments made in lieu of fractional shares. The receipt of cash in lieu of fractional shares generally will be taxable to the

 

 

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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,” in this Prospectus.

 

Conditions to the spin-off

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 OTC Bulletin Board, or the “Pink Sheets” or another OTC quotation system, subject to official notice of issuance in each case;

 

   

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 Internal Revenue Code of 1986 (“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

 

 

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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 mailed to the holders of Sears Holdings common stock as of the record date;

 

   

the individuals listed as members of our post-Distribution board of directors in this Prospectus shall have been duly elected, and such individuals shall be the members of our board of directors immediately after the Distribution; provided, however, that our current directors shall appoint one independent director prior to the date on which when-issued trading of our common stock commences on the NASDAQ Capital Market and such director shall serve on our audit committee;

 

   

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 after the Distribution and who is an officer or director of Orchard immediately prior to the Distribution;

 

   

immediately prior to the distribution date, our amended and restated certificate of incorporation (“Amended and Restated Certificate of Incorporation”) and Amended and Restated By-laws (“Amended and Restated By-laws”), 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 private letter ruling from the Internal Revenue Service (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

 

 

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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.

 

Trading market and symbol

We intend to list our Class A Common Stock on the NASDAQ Capital Market under the ticker symbol “OSHS” and quote our Preferred Stock on the OTC Bulletin Board, or the “Pink Sheets” or another OTC quotation system under the ticker symbol “    ”. We anticipate that, on or prior to the record date for the Distribution, trading of our Class A Common Stock and Preferred Stock will begin on a “when-issued” basis and will continue up to and including the distribution date. See “The Spin-Off—Trading Prior to the Distribution Date,” in this Prospectus.

 

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 do not entitle the holders thereof to any 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 repurchased or redeemed 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. 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.

 

Tax consequences to Sears Holdings shareholders

Assuming that the spin-off qualifies as a tax-free transaction under Section 355 of the Code, Sears Holdings shareholders are not expected to recognize any gain or loss for U.S. federal income tax purposes solely as a result of the Distribution except to the extent of any cash received in lieu of fractional shares. See “The Spin-Off—Material U.S. Federal Income Tax Consequences of the Spin-Off” in this Prospectus for a more detailed description of the U.S. federal income tax consequences of the Distribution.

 

 

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  Each 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.

 

Relationship with Sears Holdings after the spin-off

We will enter into the Distribution Agreement and other agreements with Sears Holdings and certain of its subsidiaries related to the spin-off. These agreements will govern the relationship between Orchard and Sears Holdings up to and subsequent to the completion of the Distribution. The Distribution Agreement, in particular, will provide for the principal steps to be taken in connection with the spin-off, the settlement or extinguishment of certain obligations between us and Sears Holdings and certain aspects of our relationship with Sears Holdings following the Distribution. We will enter into a transition services agreement with a subsidiary of Sears Holdings pursuant to which certain services will be provided on an interim basis following the Distribution (the “Transition Services Agreement”). Further, in 2005 we entered into an agreement with Sears Holdings regarding the sharing of tax liabilities (the “Tax Sharing Agreement”) in connection with our deconsolidation from Sears Holdings’ consolidated U.S. federal income tax group that governs certain indemnification rights with respect to tax matters. We also intend to enter into an appliances agreement with a subsidiary of Sears Holdings relating to our sale of certain appliances and related protection agreements supplied to us by Sears Holdings on a consignment basis (the “Appliances Agreement”) and a brands agreement with a subsidiary of Sears Holdings relating to our acquisition and sale of certain Sears Holdings proprietary branded merchandise (the “Brands Agreement”). We also intend to enter into brand license agreements (the “License Agreements”) with a subsidiary of Sears Holdings pursuant to which Sears Holdings will allow us to purchase a limited assortment of Sears Holdings’ proprietary branded paints, water heaters and household products directly from vendors. We describe these arrangements in greater detail under “Certain Relationships and Related Party Transactions—Agreements with Sears Holdings” and describe some of the risks of these arrangements under “Risk Factors—Risks Relating to the Spin-Off.”

 

Transfer agent

 

Distribution agent

 

Risk factors

You should carefully consider the matters discussed under the section entitled “Risk Factors.”

 

 

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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 44 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, $0.01 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. We will authorize the creation of Class C Common Stock, and Class A Common Stock owned by ACOF I LLC (“ACOF”) immediately prior to the spin-off will be exchanged for Class C Common Stock, which will not be distributed in the spin-off. 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. 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.

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 1% 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”), and represents approximately 20% of the voting power of Orchard.

 

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 April 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 40,600 square feet of interior and exterior selling space and carry a broad assortment of repair and maintenance, lawn and garden and in-home products.

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

 

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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 own 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.

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:

 

   

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.

 

   

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.

 

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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              shares of our Class A Common Stock and              shares of our Preferred Stock for every              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              shares of our Class A Common Stock and              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:

 

   

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 $        , but shall not be entitled to any further payment or other participation in any distribution of the assets of Orchard.

 

   

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.

 

   

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 $         upon a date and time, or the happening of an event, determined by the affirmative vote of a majority of our board of directors and, for as long as holders of Class B Common Stock and Class C Common Stock shall elect at least one director, such vote must include the vote of at least one such director. 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

 

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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.

 

   

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

 

   

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                     , 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                     , 2011. We expect that it will take the distribution agent up to eight 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.”

 

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.

 

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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 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              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 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

 

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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 “OSHS” and quote our Preferred Stock on the OTC Bulletin Board, or the “Pink Sheets” or another OTC quotation system under the symbol “            ”.

We anticipate that trading will commence on a “when-issued” basis on or shortly prior to the record date and before the distribution date. 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. When-issued trades generally settle within four trading days of the distribution date. On the first trading day following the distribution date, any when-issued trading in respect of our Class A Common Stock and Preferred Stock will end and “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 before or after the distribution date or whether an active trading market for either security will develop.

 

Q: What are the OTC Bulletin Board, the “Pink Sheets” or other OTC quotation system?

 

A: We expect that the Preferred Stock will be quoted on the OTC Bulletin Board, or the “Pink Sheets” or another OTC quotation system. 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.

 

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The OTC Bulletin Board and the “Pink Sheets” are only a quotation medium, not an issuer listing service, and should not be confused with The NASDAQ Stock Market. Market makers for OTC Bulletin Board 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 are currently eligible to participate under the Sears Holdings 401(k) Savings Plan. However, Orchard is currently in the process of establishing the Orchard Supply Hardware Retirement Savings Plan (“Orchard Savings Plan”), which is expected to be effective on or about July 25, 2011. The account balances of our current employees will be transferred by a trust to trust transfer from the Sears Holdings 401(k) Savings Plan to the Orchard Savings Plan, as soon as administratively feasible upon or after the estimated July 25, 2011 establishment date of the Orchard Savings Plan, including any shares of Sears Holdings common stock held in the Sears Holdings Stock Fund under the Sears Holdings 401(k) Plan as of the transfer date. Participants in the Orchard Savings Plan who hold shares of Sears Holdings common stock in their plan account as of the record date for the Distribution will, like all shareholders, receive shares of our Class A Common Stock and Preferred Stock in the Distribution. On the distribution date, for every              shares of Sears Holdings common stock held in such employee’s Sears Holdings stock fund account,              shares of our Class A Common Stock and              shares of our Preferred Stock will be included in a new Orchard stock fund account under the Orchard Savings Plan.

Following the trust to trust transfer of their account balances from the Sears Holdings 401(k) Savings Plan to the Orchard Savings Plan, participants of the Orchard Savings Plan will no longer be 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 after the trust to trust transfer or 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 who 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 Kmart Retirement Savings Plan for Puerto Rico Employee or the Lands’ End, Inc. Retirement Plan (referred to hereinafter as “Savings Plan(s)”, which definition, for the avoidance of doubt, excludes the Orchard Savings Plan to the extent that such plan is established and receives a trust to trust transfer from the Sears Holdings 401(k) Savings Plan as of the Distribution) as of the record date for the Distribution will, like all Sears Holdings shareholders, receive              shares of our Class A Common Stock and             

 

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shares of our Preferred Stock in the Distribution for every              shares of Sears Holdings common stock held in the employee’s Sears Holdings stock fund account.

Orchard shares received in the Distribution will be held in a new, temporary Orchard stock fund under each of the Savings Plans, but participants will not be permitted to purchase additional shares of Orchard common stock through this fund. A participant may direct that the Orchard Class A Common Stock and Preferred Stock held in the participant’s account following the Distribution be exchanged for a different investment alternative in accordance with plan rules or may decide to remain invested in Orchard shares until such time as the applicable Savings Plan fiduciary decides that the plan will no longer permit investment in Orchard stock. At that time, the plan will dispose of all remaining Orchard 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 Savings Plans from holding Orchard Class A Common Stock and Preferred Stock or prohibit employees who use self-directed accounts in the Savings Plans from investing these accounts in Orchard Class A Common Stock and Preferred Stock).

 

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 19 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:

 

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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. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us may also negatively impact our business.

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, under which $44.4 million was available for borrowing on January 29, 2011 and which matures in part on December 21, 2011 with the remainder maturing on December 21, 2013;

 

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a $200 million senior secured term loan agreement 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.

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 and senior 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 our wholly owned subsidiary Orchard Supply Hardware LLC (“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) 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, Sears Holdings, ESL and ACOF ceasing to collectively hold directly or indirectly at least 40% of the total voting power of all shares of our and OSH LLC’s voting capital stock; 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 and senior secured term loan and a cross-default under the real estate 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 repay our debt obligations upon such a Change in Control. Although there are currently no restrictions on our ability to repay our debt obligations, future debt agreements may prohibit us from repaying our debt obligations. If we are prohibited from repaying our debt obligations, we could seek consent from our lenders at the time to repay our debt obligations. If we are unable to obtain their consent, we could attempt to refinance our debt obligations. If we were unable to obtain a consent or refinance our debt obligations, it would result in an event of default under the debt arrangements described above.

 

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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.

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. 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.

 

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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.

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.

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:

 

   

incur or guarantee additional indebtedness or issue certain preferred shares;

 

   

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

 

   

make certain loans, acquisitions, capital expenditures or investments;

 

   

sell certain assets, including stock of our subsidiaries;

 

   

enter into sale and leaseback transactions;

 

   

create or incur liens;

 

   

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

 

   

enter into certain transactions with our affiliates; and

 

   

undergo a change in control.

As a result, our ability to respond to changing business and economic conditions and to secure additional financing, if needed, may be significantly restricted, and we may be prevented from engaging in transactions that might further our growth strategy or otherwise benefit us and our shareholders without obtaining consent from our lenders. In addition, our financing arrangements contain certain financial covenants, including a fixed-charge coverage ratio, with respect to our senior secured credit facility, and leverage ratios, with respect to our senior secured term loan and real estate secured term loan. A failure by us to remain in compliance with these required financial ratios could lead to an event of default under the applicable financing arrangement. We may not be able to satisfy these ratios, especially if our operating results deteriorate as a result of, but not limited to, adverse economic conditions or the impact of other risk factors, which could adversely affect our ability to respond to changes in our business and manage our operations. Additionally, a default by us under one of our financing arrangements may trigger cross-defaults under our other financing arrangements. Upon the occurrence of an event of default or cross-default under any of our senior secured credit facility, senior secured term loan or real estate secured term loan, our lenders could elect to declare all amounts outstanding to be due and payable and exercise other remedies as set forth in the credit agreements governing our other financing arrangements.

In addition, we have pledged substantially all of our assets as collateral under our current financing arrangements. If we are unable to repay amounts owed under any of our senior secured credit facility, senior secured term loan or real estate secured term loan when due, our lenders could proceed against the collateral securing such unpaid indebtedness, which could have a material adverse effect on our business, financial condition, results of operations or cash flows. In the event of our insolvency, liquidation, dissolution or reorganization, our lenders would be entitled to payment in full from the applicable collateralized assets before distributions, if any, were made to our shareholders and we cannot assure you that our assets would be sufficient to repay in full that debt and any potential future indebtedness, which would cause the market price of our common shares to decline significantly.

 

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As of April 30, 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 first quarter of fiscal 2012. However, the decline in our operating results for the first quarter of fiscal 2011, coupled with continued economic weakness in the markets in which we operate, has adversely impacted our prospective compliance with the financial covenants under the Senior Secured Term Loan and the Real Estate Secured Term Loan. As a result, we may seek 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. If such renegotiations are unsuccessful, we would expect to modify our business plan in a manner that would allow us to remain in compliance. Such a modification would likely 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 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.

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 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 and our current site is limited, 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 property 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

 

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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 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.

Persons associated with ESL who are elected by the holders of our Class A Common Stock (the “ESL Directors”) following the Distribution, will, following the Distribution, beneficially own approximately 61% of

 

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our outstanding shares of Class A Common Stock and approximately 49% of the general voting power of our capital stock. Persons associated with ACOF who are 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 Directors 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 Directors 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 1% of the voting power of our capital stock).

The interests of such persons associated with ESL and ACOF, which have investments in other companies that may compete with us, including Sears Holdings, may from time to time 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. We are currently a party in two such cases, both pertaining to asbestos. In addition, 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 Supermarkets 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 Supermarkets. We intend to appeal the judgment, which will require posting a

 

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bond of one and a half times the value of the judgment. At this time, we cannot assess the likelihood of success of the appeal, and therefore as of April 30, 2011 we have recorded a $5.1 million reserve for this matter. 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 April 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 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. We currently have two cases pending of this nature. For a description of certain current legal proceedings, see “Business—Legal Proceedings.”

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

 

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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 April 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 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

 

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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:

 

   

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

 

   

increases in shipping costs;

 

   

transportation delays and interruptions;

 

   

adverse fluctuations in currency exchange rates; and

 

   

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

 

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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 Sears Holdings. Prior to the completion of the Distribution, we will have entered into agreements with Sears Holdings related to the Distribution including, among others, the Distribution Agreement, Transition Services Agreement, Appliances Agreement, Brands Agreement and License Agreements.

Pursuant to the Transition Services Agreement, 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 12 months from the date of the agreement. The transition services will be priced at two tiers: tier one will extend for the first six months and tier two for the remaining six months or less. Additionally, all unanticipated out-of-pocket expenses necessary for the provision of transition services from Sears Holdings to us will be passed to us at cost. The Transition Services Agreement may be terminated by (i) mutual agreement of the parties, (ii) for cause by either party, or (iii) for convenience by Orchard upon 60 days’ prior written notice to Sears Holdings.

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.

 

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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, Brands Agreement and License 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 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:

 

   

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

 

   

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

 

   

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

 

   

major business combinations involving us;

 

   

employee retention and recruiting; and

 

   

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, Brands Agreement and License 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.

 

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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-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

 

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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 business fundamentals, which may limit our trading volume. 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 OTC Bulletin Board, or the “Pink Sheets” or another OTC quotation system 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 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:

 

   

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

 

   

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;

 

   

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

 

   

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     % of the collective voting power of our Class B Common Stock and Class C Common Stock voting together and approximately     % 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%, 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 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%, 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 addition, as of the distribution date, ESL will have the ability to control the election of those members of our

 

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board of 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 1% 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.

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.

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 favorable tax treatment under the Code. Although a private letter ruling, like the IRS Ruling Sears Holdings has received, is binding upon the Internal Revenue Service, if the factual representations or assumptions made in the IRS Ruling request are untrue or incomplete in any material respect then we and Sears Holdings will not be able to rely on the IRS Ruling. 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

 

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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 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, unless, for certain transactions, we obtain the consent of Sears Holdings or we obtain a private letter ruling from the Internal Revenue Service or an unqualified opinion of a nationally recognized law firm that such action will not cause the Distribution to fail to qualify for favorable treatment under the Code, and such letter ruling or opinion, as the case may be, is acceptable to Sears Holdings. 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 have an indemnity obligation to Sears Holdings if the Distribution is treated as a taxable transaction.

Under the Distribution Agreement, we will be required to indemnify Sears Holdings for losses and taxes resulting from our taking actions that cause the Distribution to fail to qualify for favorable treatment under the Code. If we are required to indemnify Sears Holdings for such actions, we may be subject to liability as a result, and which could adversely affect our financial position and results of operations.

 

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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

 

   

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.

 

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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 Related 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. It is anticipated that before the distribution date for the spin-off, trading of shares of our Class A Common Stock and Preferred Stock will begin on a “when-issued” basis and such trading will continue up to and including the distribution date. However, 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;

 

   

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

 

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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 outstanding common stock that is less than 5%. 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.

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.

 

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Provisions in our Amended and Restated Certificate of Incorporation and Amended and Restated By-laws 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 By-laws 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 will apply to list our Class A Common Stock on the NASDAQ Capital Market under the symbol “OSHS” and quote our Preferred Stock on the OTC Bulletin Board, or the “Pink Sheets” or another OTC quotation system under the symbol “    ”. 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.

It is expected that our Preferred Stock will be quoted on the OTC Bulletin Board 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 OTC Bulletin Board, or the “Pink Sheets” or another OTC quotation system 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 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,

 

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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 within the meaning of the Private Securities Litigation Reform Act of 1995. 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;

 

   

availability of 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                     , 2011, the distribution date, each Sears Holdings shareholder will receive              shares of Class A Common Stock and              shares of Preferred Stock for every              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.

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.

 

   

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,

 

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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.

In determining whether to effect the spin-off, the board of directors of Sears Holdings also considered the costs and risks associated with the transaction, including those associated with preparing Orchard to become a publicly traded company independent from Sears Holdings, the risk of volatility in our and Sears Holdings’ stock price that may occur immediately following the spin-off, including the potential impact on the price of our Class A Common Stock and Preferred Stock due to sales by our shareholders whose investment objectives may not be met by our Class A Common Stock and Preferred Stock and the time that it may take for us to attract our optimal shareholder base. Notwithstanding these costs and risks, however, Sears Holdings’ board of directors determined that a spin-off, in the form contemplated by the Distribution, and the combined but separate ownership of Sears Holdings common stock and Orchard Class A Common Stock and Preferred Stock is the best alternative to enhance long-term shareholder value relative to other strategic alternatives involving Orchard.

Manner of Effecting the Spin-Off

For every              shares of Sears Holdings common stock that you own as of the close of business on                     , 2011, the record date, you will receive              shares of our Class A Common Stock and              shares 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              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 eight 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                     , 2011, the distribution date.                      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

 

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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.

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              shareholders of record, based on the number of registered holders of Sears Holdings common stock on                     , 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              shares of Class A Common Stock, approximately              shares of Class B Common Stock, approximately              shares of Class C Common Stock and approximately              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.

 

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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.

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 favorable tax treatment under the Code. Although a private letter ruling, like the IRS Ruling Sears Holdings has received, is binding

 

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upon the Internal Revenue Service, the continued validity of the IRS Ruling is subject to factual representations and assumptions from us and Sears Holdings that certain conditions that are necessary to obtain tax-free treatment under the Code have been satisfied.

In connection with 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 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.

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 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

 

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dividend income will not be eligible for the dividends received deduction that might otherwise be applicable to corporate U.S. Holders. However, provided that 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. However, 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 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.

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.”

The preceding summary of the anticipated U.S. federal income tax consequences of the spin-off is for general informational purposes only. 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.

 

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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, although a “when-issued” market in our Class A Common Stock and Preferred Stock may develop prior to the Distribution. See “—Trading Prior to the Distribution Date” below for an explanation of a “when-issued” market. We intend to list our shares of Class A Common Stock on the NASDAQ Capital Market under the symbol “OSHS” and quote our shares of Preferred Stock on the OTC Bulletin Board, or the “Pink Sheets” or another OTC quotation system under the trading symbol “    ”.

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 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 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

It is 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 a “when-issued” market in our Class A Common Stock and Preferred Stock. When-issued trading refers to a sale or purchase made conditionally because the security has been authorized but not yet issued. The when-issued trading market will be a market for our Class A Common Stock and Preferred Stock that will be distributed to Sears Holdings shareholders on the distribution date. If you own Sears Holdings common stock at the close of business on the record date, you will be entitled to shares of Class A Common Stock and Preferred Stock distributed pursuant to the spin-off or a cash payment for your fractional shares as described above in “—Manner of Effecting the Spin-Off” or both. You may trade this entitlement to shares of Class A Common Stock and Preferred Stock, without the Sears Holdings common stock you own, on the when-issued market. On the first trading day following the distribution date, we expect when-issued trading with respect to our Class A Common Stock and Preferred Stock will end and regular-way trading will begin.

Following the distribution date, we expect our Class A Common Stock to be listed on the NASDAQ Capital Market under the trading symbol “OSHS” and our Preferred Stock to be quoted on the OTC Bulletin Board, or the “Pink Sheets” or another OTC quotation system under the trading symbol “    ”. We will announce our when-issued trading symbols when and if they become available.

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 Class A Common Stock and Preferred Stock distributed pursuant to the

 

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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 OTC Bulletin Board, or the “Pink Sheets” or another OTC quotation system, subject to official notice of issuance in each case;

 

   

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 mailed 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; provided, however, that our current directors shall appoint

 

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one independent director prior to the date on which when-issued trading of our common stock commences on the NASDAQ Capital Market and such director shall serve on our audit committee;

 

   

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 after the Distribution and who is an officer or director of Orchard immediately prior to the Distribution;

 

   

immediately prior to the distribution date, our amended and restated certificate of incorporation (“Amended and Restated Certificate of Incorporation”) and Amended and Restated By-laws (“Amended and Restated By-laws”), 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.

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 are currently eligible to participant under the Sears Holdings 401(k) Savings Plan. Orchard is currently in the process of establishing the Orchard Supply Hardware Retirement Savings Plan (“Orchard Savings Plan”), which is expected to be effective on or about July 17, 2011. The account balances of our current employees will be transferred by a trust to trust transfer from the Sears Holdings 401(k) Savings Plan to the Orchard Savings Plan, as soon as administratively feasible upon or after the estimated July 25, 2011 establishment date of the Orchard Savings Plan, including any shares of Sears Holdings common stock held in the Sears Holdings Stock Fund under the Sears Holdings 401(k) Plan as of the transfer date. On the distribution date,              shares of our Class A Common Stock and              shares of our Preferred Stock will be credited to such employees’ account and held in a new Orchard Stock Fund under the Orchard Savings Plan for every              shares of Sears Holdings common stock held in each such employee’s Orchard Savings Plan account. Following the trust to trust transfer of their account balances from the Sears Holdings 401(k) Savings Plan to the Orchard Savings Plan, participants of the Orchard Savings Plan will no longer be permitted to make new purchases of Sears Holdings common stock through their plan accounts. As to those shares of Sears Holdings common stock held by the Orchard Savings Plan after the trust to trust transfer or at the time of the Distribution, participants may direct that the shares be exchanged for a different investment alternative in accordance with plan term or may decide to remain invested 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 shall 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).

 

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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 who 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 (referred to hereinafter as “Savings Plan(s)”) (excludes the Orchard Savings Plan to the extent that such plan is established and receives a trust to trust transfer from the Sears Holdings 401(k) Savings Plan as of the Distribution) as of the record date will receive shares of Orchard Class A Common Stock and Preferred Stock in the Distribution. Orchard shares received in the Distribution will be included in a new, temporary Orchard Stock Fund under the Savings Plans, but participants will not be permitted to purchase additional shares of Orchard stock through this fund. A participant may direct that the Orchard Class A Common Stock and Preferred Stock held in the participant’s be exchanged for a different investment alternative in accordance with plan rules or may decide to remain invested in the Orchard shares until such time as the applicable Savings Plan fiduciary decides that the plan will no longer permit investment in Orchard shares. At that time, the plan shall dispose of all remaining Orchard 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 Savings Plans from holding Orchard Class A Common Stock and Preferred Stock or prohibit employees using self-directed accounts in the Savings Plans from investing these accounts in Orchard Class A Common Stock and Preferred Stock).

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 April 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:

 

   

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              shares of Class A Common Stock for              shares of Class C Common Stock;

 

   

a             –for–             forward stock split of our Class A Common Stock, Class B Common Stock and Class C Common Stock that we intend to effect prior to the Distribution;

 

   

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 April 30, 2011  
     (unaudited)
(in thousands, except
share numbers)
 
     Actual      Pro Forma  

Debt Outstanding:

     

Current maturities of long-term debt, including payable to Sears

   $ 12,020       $ 12,020   

Long-term debt

     329,605         329,605   
                 

Total debt

   $ 341,625       $ 341,625   

Stockholders’ 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              shares pro forma

     10         [—

Class B Common Stock, par value $0.01 per share authorized 1,049,000 shares; issued and outstanding approximately 1440 shares; issued and outstanding              shares pro forma

     —           [—

Class C Common Stock, par value $0.01 per share authorized              shares; issued and outstanding              shares; issued and outstanding              shares pro forma

     —           [—

Preferred Stock, par value $0.01 per share authorized              shares; issued and outstanding              shares; issued and outstanding              shares pro forma

     —           [—
                 

Total Capitalization (debt plus stockholders’ equity)

   $ 341,635       $ [—
                 

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.

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

 

   

options to purchase 47,850 shares of Class B Common Stock with a weighted average exercise price of $344.32 per share outstanding as of April 30, 2011, exercisable into an equal number of shares of Class B Common Stock, on a pro forma basis reflecting a             -to-             stock split that we intend to effect prior to the Distribution;

 

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             shares of Class A Common Stock reserved for future issuance under our 2011 Equity Incentive Plan, which will become effective in connection with the Distribution; and

 

   

63,497 shares of Class B Common Stock reserved for future issuance under our 2010 Stock Incentive Plan.

We have not yet finalized our post-Distribution capitalization. We intend to update this Prospectus to reflect our post-Distribution capitalization.

 

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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 ended May 1, 2010 and April 30, 2011 and the consolidated balance sheet data as of May 1, 2010 and April 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  
     2006      2007     2008     2009      2010      May 1,
2010
     April 30,
2011
 
     (in thousands, except per share)  

Consolidated Statements of Operations Data(1):

                  

Net sales

   $ 888,558       $ 834,741      $ 761,489      $ 682,393       $ 660,701       $ 169,651       $ 163,768   

Net income (loss)(2)

     25,944         14,389        (243,367     19,305         8,717         4,434         (990

Basic and diluted income (loss) per share

     25.89         (2.14     (242.88     19.27         8.70         4.43         (0.99

Basic and diluted weighted average common shares outstanding

     1,002         1,002        1,002        1,002         1,002         1,002         1,002   

Consolidated Balance Sheet Data:

                  

Total assets

   $ 947,467       $ 914,348      $ 636,166      $ 621,546       $ 629,992       $ 633,159       $ 631,376   

Long-term debt and capital lease obligations(3)

     416,179         382,167        357,903        238,261         318,928         238,650         329,605   

Other long-term liabilities

     6,402         10,830        14,881        15,797         16,338         14,642         16,519   

Other Financial Data:

                  

Adjusted EBITDA(4)

   $ 112,128       $ 93,593      $ 84,831      $ 80,746       $ 69,392       $ 19,815       $ 11,166   

 

(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) 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, maturing in December 2010.
(4) Adjusted EBITDA is calculated as described below.

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

 

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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 gains/(losses) 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  
     2006      2007     2008     2009      2010      May 1,
2010
     April 30,
2011
 

Net income (loss)

   $ 25,944       $ 14,389      $ (243,367   $ 19,305       $ 8,717       $ 4,434       $ (990

Interest expense, net

     37,684         30,135        22,875        16,770         17,392         4,222         5,553   

Income tax expense (benefit)

     16,758         12,491        10,304        12,749         5,573         2,889         (598

Depreciation and amortization

     31,127         35,324        31,410        29,870         31,187         8,069         7,163   

Goodwill impairment

          262,763              

(Gain) loss on disposal, sale, and impairment of assets

        (484       275         633         134         85   

Stock-based compensation

     615         325        125        495         329         67         146   

Other significant items

        1,413        721        1,282         5,561            (193
                                                            

Adjusted EBITDA

   $ 112,128       $ 93,593      $ 84,831      $ 80,746       $ 69,392       $ 19,815       $ 11,166   
                                                            

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. 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 have reversed $0.5 million of the Save Mart reserve as we are no longer expected to pay that amount. We have recorded a $0.7 million and $1.3 million severance charge in fiscal 2008 and 2009, respectively, in connection with our cost cutting initiatives. 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 and the first quarter 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 Brand Agreement and License 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
Agreement
and License
Agreements
    Pro
Forma
 

NET SALES

   $ 660.7       $ (12.2     $ 648.5   

COST OF SALES AND EXPENSES:

         

Cost of sales (excluding depreciation and amortization)

     431.8         (10.7   $ 1.3        422.4   

Selling and administrative

     166.0             166.0   

Depreciation and amortization

     31.2             31.2   
                     

Total cost of sales and expenses

     629.0             619.6   
                     

OPERATING INCOME

     31.7             28.9   

INTEREST EXPENSE, NET

     17.4             17.4   
                     

INCOME BEFORE INCOME TAXES

     14.3             11.5   

INCOME TAX EXPENSE (BENEFIT)

     5.6         (0.6     (0.4     4.6   
                     

NET INCOME

   $ 8.7           $ 6.9   
                     

INCOME PER COMMON SHARE:

         

Basic and diluted income per common share

   $ 8.70           $ 6.90   

Basic and diluted weighted average common shares outstanding

     1.0             1.0   

 

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Orchard Supply Hardware Stores Corporation

Unaudited Pro Forma Consolidated Statement of Operations

For The 13 Weeks Ended April 30, 2011

(in millions, except per share data)

 

           Pro Forma Adjustments  
     Historical     Appliances
Agreement
    Brands
Agreement
and
License
Agreement
    Pro
Forma
 

NET SALES

   $ 163.8      $ (4.0     $ 159.8   

COST OF SALES AND EXPENSES:

        

Cost of sales (excluding depreciation and amortization)

     108.6        (3.6   $ 0.8        105.8   

Selling and administrative

     44.0            44.0   

Depreciation and amortization

     7.2            7.2   
                    

Total cost of sales and expenses

     159.8            157.0   
                    

OPERATING INCOME

     4.0            2.8   

INTEREST EXPENSE, NET

     5.6            5.6   
                    

LOSS BEFORE INCOME TAXES

     (1.6         (2.8

INCOME TAX BENEFIT

     (0.6     (0.2     (0.3     (1.1
                    

NET LOSS

   $ (1.0       $ (1.7
                    

LOSS PER COMMON SHARE:

        

Basic and diluted loss per common share

   $ (0.99       $ (1.70

Basic and diluted weighted average common shares outstanding

     1.0            1.0   

 

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Orchard Supply Hardware Stores Corporation

Notes to Unaudited Pro Forma Consolidated Financial Statements

 

1. THE APPLIANCES AGREEMENT

The Company intends to enter into an appliances agreement (the “Appliances Agreement”) with a subsidiary of Sears Holdings pursuant to which Sears Holdings will authorize us to sell certain appliances and related protection agreements on a consignment basis through our designated retail locations. The Appliances Agreement provides that Sears Holdings will 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 certain 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.

The Company entered into an appliances sales agreement with Sears Holdings on November 23, 2005, as amended (the “Appliances Sales Agreement”), which will be terminated as of the Distribution. All appliances purchased and sold to 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 and $4.7 million would have been removed from net sales of fiscal 2010 and the first quarter of fiscal 2011, respectively. Replacing it would be approximately $2.3 million and $0.7 million in commission income for sales of such appliances in fiscal 2010 and the first quarter of fiscal 2011, respectively. The net effect on net sales would be a reduction of approximately $12.2 million and $4.0 million in fiscal 2010 and the first quarter of fiscal 2011, respectively. Accordingly, any associated cost of sales would be eliminated under the commission model. The Company also estimated 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 AND LICENSE AGREEMENTS

The Company intends to enter into a brands agreement (the “Brands Agreement”) with a subsidiary of Sears Holdings pursuant to which Sears Holdings will supply certain Craftsman, Easy Living and Weatherbeater branded products to us on a non-exclusive basis for resale through our retail locations. Pursuant to the Brands Agreement, our cost for the products provided to us by Sears Holdings under the agreement is generally based upon a pricing schedule by specific products. The agreement has a five year term and may be extended subject to the mutual agreement of the parties. The Company also intends to enter into brand license agreements (the “License Agreements”) with Sears Holdings effective at the Distribution pursuant to which Sears Holdings will allow us to purchase a limited assortment of Kenmore branded water heaters and consumer household products directly from vendors. Under the License Agreements we will pay certain license fees to Sears Holdings. The agreements generally incorporate arm’s length terms and conditions, including market-based pricing and term of duration.

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 Agreement and License 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 $1.3 million and $0.8 million in fiscal 2010 and the first quarter of fiscal 2011, respectively.

 

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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 April 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 40,600 square feet of interior and exterior selling space and 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 be 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 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 were 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 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. Following the spin-off, 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, which we expect will result in a reduction of net sales ranging from $16.0 million to $18.0 million on a going forward annual basis due to transitioning to a commission based sales model. We also expect to incur a range of additional recurring costs of approximately $1.0 million to $2.0 million, net of taxes, annually under the new Appliance Agreement and Brand Agreement.

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 and exclude 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 includes 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”). 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.

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 gains/(losses) 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  
     2008     2009      2010      May 1,
2010
     April 30,
2011
 

Net (loss) income

   $ (243,367   $ 19,305       $ 8,717       $ 4,434       $ (990

Interest expense, net

     22,875        16,770         17,392         4,222         5,553   

Income tax expense (benefit)

     10,304        12,749         5,573         2,889         (598

Depreciation and amortization

     31,410        29,870         31,187         8,069         7,163   

Goodwill impairment

     262,763              

Loss on sale and impairment of assets

       275         633         134         85   

Stock-based compensation

     125        495         329         67         146   

Other significant items

     721        1,282         5,561            (193
                                           

Adjusted EBITDA

   $ 84,831      $ 80,746       $ 69,392       $ 19,815       $ 11,166   
                                           

 

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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 2010, we recorded a $5.6 million legal settlement reserve pursuant to the Save Mart case. In the first quarter of fiscal 2011, we have reversed $0.5 million of the Save Mart reserve as we are no longer expected to pay that amount. We have recorded a $0.7 million and $1.3 million severance charge in fiscal 2008 and 2009, respectively, in connection with our cost cutting initiatives. 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 ended May 1, 2010 and April 30, 2011 (in thousands, except per share amounts):

 

    FISCAL YEAR     13 Weeks Ended  
    2008     % of
Net
Sales
    2009     % of
Net
Sales
    2010     % of
Net
Sales
    May 1,
2010
    % of
Net
Sales
    April 30,
2011
    % of
Net
Sales
 

NET SALES

  $ 761,489        100.0   $ 682,393        100.0   $ 660,701        100.0   $ 169,651        100.0   $ 163,768        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        108,165        63.8        108,641        66.3   

Gross Margin

    275,267        36.1        244,333        35.8        228,862        34.6        61,486        36.2        55,127        33.7   

Selling and administrative

    191,282        25.1        165,639        24.3        165,993        25.1        41,872        24.7        43,999        26.9   

Depreciation and amortization

    31,410        4.1        29,870        4.4        31,187        4.7        8,069        4.8        7,163        4.4   

Goodwill impairment

    262,763        34.5                   
                                                 

Total cost of sales and expenses

    971,677        127.6        633,569        92.9        629,019        95.2        158,106        93.2        159,803        97.6   
                                                 

OPERATING (LOSS) INCOME

    (210,188     (27.6     48,824        7.1        31,682        4.8        11,545        6.8        3,965        2.4   

INTEREST EXPENSE, NET

    22,875        3.0        16,770        2.5        17,392        2.6        4,222        2.5        5,553        3.4   
                                                 

(LOSS) INCOME BEFORE INCOME TAXES

    (233,063     (30.6     32,054        4.6        14,290        2.2        7,323        4.3        (1,588     (1.0

INCOME TAX EXPENSE (BENEFIT)

    10,304        1.4        12,749        1.9        5,573        0.8        2,889        1.7        (598     (0.4
                                                 

NET (LOSS) INCOME

  $ (243,367     (32.0 )%    $ 19,305        2.7   $ 8,717        1.4   $ 4,434        2.6   $ (990     (0.6 )% 
                                                 

INCOME (LOSS) PER COMMON SHARE

                   

Basic and diluted (loss) income per common share

  $ (242.88     $ 19.27        $ 8.70        $ 4.43        $ (0.99  

Basic and diluted weighted average common shares outstanding

    1,002          1,002          1,002          1,002          1,002     

OTHER FINANCIAL DATA

                   

ADJUSTED EBITDA

  $ 84,831        11.1   $ 80,746        11.8   $ 69,392        10.5   $ 19,815        11.7   $ 11,166        6.8

13 Weeks Period Ended April 30, 2011 Compared to the 13-week Period Ended May 1, 2010

Net sales

For the first quarter of fiscal 2011, net sales decreased $5.9 million, or 3.5%, to $163.8 million as compared to net sales of $169.7 million for the first quarter of fiscal 2010. Most of the decline in net sales came from our lawn and garden category, which was primarily impacted by an extended period of cold and wet weather during March 2011. Partially offsetting the decline was an increase in net sales of appliances. The number of our stores that sell appliances increased from 19 in the first quarter of fiscal 2010 to 34 in the first quarter of fiscal 2011.

Our comparable store sales declined by 4.7%, which was driven by a decline in comparable transaction volume of 6.6% and partially offset by an increase of 2.0% in average ticket comparables for the first quarter of fiscal 2011

 

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as compared to the first quarter of fiscal 2010. We believe the decline in transaction volume was primarily due to the inclement weather during March 2011. Our average ticket benefited from the sale of bigger ticket items, such as appliances, barbeques and furniture.

Gross margin

Gross margin was $55.1 million, or 33.7% of net sales, for the first quarter of fiscal 2011, as compared to $61.5 million, or 36.2% of net sales, for the first quarter of fiscal 2010. The decrease in gross margin as a percentage of net sales was primarily due to increased markdowns and under leveraging of fixed occupancy costs. The increase in markdowns was due to increased clearance and promotional activities.

Selling and administrative

Selling and administrative expenses increased $2.1 million for the first quarter of fiscal 2011 to $44.0 million, or 26.9% of net sales, from $41.9 million, or 24.7% of net sales, for the first quarter of fiscal 2010. The increase in selling and administrative expenses was primarily due to an increase in consulting and other administrative costs. Consulting costs increased by $0.8 million primarily due to consulting spending on our strategic initiatives. Other administrative costs increased $1.2 million primarily due to higher maintenance costs and insurance costs.

Depreciation and amortization

Depreciation and amortization expense was $7.2 million, or 4.4% of net sales, for the first quarter of fiscal 2011 as compared to $8.1 million, or 4.8% of net sales, for the first quarter of fiscal 2010. The decrease of $0.9 million of depreciation and amortization expense was primarily due to a capital lease adjustment in the first quarter of fiscal 2010.

Interest expense, net

Interest expense increased for the first quarter of fiscal 2011 by $1.4 million to $5.6 million, or 3.4% of net sales, as compared to $4.2 million, or 2.5% of net sales, for the first quarter of fiscal 2010. The increase in interest expense was primarily due to higher interest rates from the amended senior secured term loan and the new real estate secured term loan.

Income taxes

Income tax benefit of $0.6 million was recorded for the first quarter of fiscal 2011 as compared to an income tax expense of $2.9 million for the first quarter of fiscal 2010. The effective tax rate was 37.7% in the first quarter of fiscal 2011 and 39.5% in the first quarter 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 loss of $1.0 million for the first quarter of fiscal 2011 as compared to net income of $4.4 million for the first quarter of fiscal 2010. The decrease in net income was primarily attributable to the factors discussed above.

Adjusted EBITDA

Adjusted EBITDA was $11.2 million, or 6.8% of net sales for the first quarter of fiscal 2011 as compared to $19.8 million, or 11.7% of net sales for the first quarter of fiscal 2010. The decrease in adjusted EBITDA was primarily due to the decline in net sales.

 

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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. Most of the decline in net sales came from our repair and maintenance category, which was primarily driven by net sales declines of plumbing, industrial and electrical products. This is partially offset by our lawn and garden category with an increase net sales of outdoor power and seasonal products, which benefited from an enhanced selection of barbeques, patio furniture, outdoor storage, lawn mowers and fireplaces. Also offsetting the decline was an increase in our appliance sales, which we believe was primarily driven by U.S. government energy/green consumer subsidies. Additionally, from fiscal 2009 to fiscal 2010, we increased the number of stores offering appliances from 19 stores 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 0.3% 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.

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 in gross margin as a percentage of net sales was primarily due to the decline in net sales in our higher margin repair and maintenance categories, increased markdowns and under leveraging of fixed occupancy costs. The increase in markdowns was due to increased clearance and promotional activities.

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 an increase in legal costs offset by a decrease in payroll and administrative 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). Payroll costs declined $7.7 million, or 6.1%, as compared to fiscal 2009 driven primarily by reduced store payroll costs. Administrative costs decreased by $0.7 million, or 1.9%, as a result of cost management initiatives.

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 for the senior secured credit facility and higher interest rates under our Real Estate Secured Term Loan.

 

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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 2010 and 39.8% in 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 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 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 most of our categories. The most significant declines in repair and maintenance category were in tools and plumbing. The decline in in-home categories was primarily driven by reduced demand for appliances. The decline in our lawn and garden category were primarily driven by net sales declines in nursery products, offset by net sales increase in seasonal products.

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 5.8% 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 in gross margin as a percentage of net sales was due to the under leveraging of occupancy costs as a result of lower net sales partially offset by lower markdowns.

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, or 11.6%, $7.6 million, or 25.8%, $1.5 million, or 8.2%, respectively, as compared to fiscal 2008.

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.

 

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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 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 and lower interest rates.

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 2009 and 4.4% in 2008. The difference in the effective tax in fiscal 2009 versus fiscal 2008 is 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 2008. The decrease in net income was primarily attributable to the factors discussed above.

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 decline in net sales.

ANALYSIS OF FINANCIAL CONDITION

Liquidity and Capital Resources

 

     Fiscal Year     13 Weeks Ended  
     2008     2009     2010     May 1, 2010     April 30, 2011  
     (in thousands)  

Consolidated Statements of Cash Flows Data:

  

       

Cash flows provided by operating activities

   $ 43,208      $ 25,892      $ 52,548      $ 4,734      $ 2,225   

Cash flows used in investing activities

     (7,234     (11,462     (12,042     (1,953     (2,069

Cash flows used in financing activities

     (30,080     (18,248     (33,863     (2,649     (4,228

For fiscal 2010 and the 13 weeks ended April 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 April 30, 2011, our cash and cash equivalents totaled $15.6 million and $11.5 million, respectively. At January 29, 2011 and April 30, 2011, $44.4 million and $55.7 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 credit agreements, 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. As discussed below under “Financing Arrangements,” the Senior Secured Term Loan and Real Estate Secured Term Loan are subject to our Leverage Covenant. As of April 30, 2011, we were

 

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in compliance with the Leverage Covenant 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 first quarter of fiscal 2012. However, the decline in our operating results for the first quarter of fiscal 2011, coupled with continued economic weakness in the markets in which we operate, has adversely impacted our prospective compliance with the financial covenants under the Senior Secured Term Loan and the Real Estate Secured Term Loan. As a result, we may seek 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. If such renegotiations are unsuccessful, we would expect to modify our business plan in a manner that would allow us to remain in compliance. Such a modification would likely 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 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.

Our debt and capital lease obligations as of January 30, 2010, January 29, 2011, May 1, 2010, and April 30, 2011 are as follows (in millions):

 

     January 30,
2010
     January 29,
2011
     May 1,
2010
     April 30,
2011
 

Senior Secured Credit Facility

   $ —         $ 48.0       $ —         $ 46.0   

Real Estate Secured Term Loan

     —           50.0         —           49.9   

Senior Secured Term Loan

     175.5         173.5         175.0         173.0   

Commercial Mortgage-backed Loan

     120.0         —           120.0         —     

Capital lease obligations

     69.4         66.7         70.4         69.2   
                                   

Total debt and capital lease obligations

   $ 364.9       $ 338.2       $ 365.4       $ 338.1   
                                   

Financing Arrangements

Our lending arrangements on January 29, 2011 and as of April 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 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 April 30, 2011, $46.0 million was borrowed under the facility, with approximately $7.7 million due in December 2011 and approximately $38.3 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 April 30, 2011 we had $7.3 million and $9.7 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 Orchard Supply Hardware LLC, a wholly owned subsidiary through which we conduct substantially all our operations (“Orchard 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 Orchard LLC and the Guarantors, other than the Term Loan Collateral (as defined below), and a second lien on the Term Loan Collateral.

 

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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, 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, (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 Orchard LLC and the Guarantors as measured by their leverage ratio. In addition, we are required to pay unused commitment fees, based on Orchard LLC’s and the Guarantors leverage ratio; such fees were 0.25% and 0.75% at January 29, 2011 and April 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 for three consecutive days. The fixed charge coverage ratio requires Orchard LLC and the Guarantors to maintain a minimum ratio of 1.1 to 1.0 EBITDAR (EBITDA plus rent expense) to certain fixed charges.

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 Orchard LLC and the loan is guaranteed by the Guarantors. Borrowings under the Senior Secured Credit Facility are collateralized by a first lien on Orchard 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 Orchard 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 leverage ratio covenant. In addition, the Senior Secured Term Loan requires us to make certain mandatory repayments in connection with the transfer of or damage to property securing the loan or in the event we incur certain types of debt.

 

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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 4.494% at January 29, 2011 and April 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.

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%.

Cash Flows from Operating Activities

In the first quarter of fiscal 2011, we primarily financed our operations and investments with cash generated from operations. Cash provided by operating activities was $2.2 million in the first quarter of fiscal 2011 as compared to $4.7 million in the first quarter of fiscal 2010. The $2.5 million decrease in cash provided by operating activities was primarily due to a decrease of $5.4 million in net income primarily due to lower net sales as a result of an extended period of cold and wet weather in March 2011. The decrease is also attributable to the timing of payment of our payable to Sears. This decrease was partially offset by the timing of our merchandise inventory purchases and payments of our merchandise payables.

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 $2.1 million for the first quarter of fiscal 2011 as compared to $2.0 million for first quarter of fiscal 2010. In fiscal 2011, we spent $2.1 million on capital expenditures, allocated as follows: 43% for maintenance, 34% for core technology, 12% for merchandising, and 11% for new stores.

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 $4.2 million for the first quarter of fiscal 2011 and $2.6 million for the first quarter of fiscal 2010. The increase of $1.6 million in cash used in financing activities is primarily due to $2.0 million of net borrowings 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.

There are no significant changes to our contractual obligations and off balance sheet arrangements during the first quarter of fiscal 2011, with the exception of when we are planning to repay our long-term debt. We have reclassified $11.0 million of debt from short-term to long-term in the first quarter of fiscal 2011 as we do not foresee paying down on our senior secured credit facility during the next 12 months, through the first quarter of fiscal 2012.

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.

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

 

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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. The Company received vendor rebates and allowances of $7.3 million and $7.0 million in the first quarter of fiscal 2011 and in the first quarter of fiscal 2010, 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 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

 

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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 point 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 point decrease in the terminal period growth rate without a change in the discount rate of the reporting unit, or (3) a 10 basis point 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 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.

 

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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 point 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 April 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 40,600 square feet of interior and exterior selling space and 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 that 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 7,000 products in late 2010. 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 located in Tracy, California which processes and delivers 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 April 30, 2011 we had approximately 5,500 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 April 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 own 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) are collateralized pursuant to our $50.0 million real estate secured term loan agreement.

We intend to cease operations at one store that we lease and our owned appliance center during fiscal 2011. Management plans to sell our appliance center thereafter. We intend to open a new store in a nearby location in fiscal 2011.

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.

 

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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 Supermarkets 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 Supermarkets. We intend to appeal the judgment, which will require posting a bond of one and a half times the value of the judgment. At this time, we cannot assess the likelihood of success of the appeal, and therefore as of April 30, 2011 we have recorded a $5.1 million reserve for this matter. We will continue to incur legal fees until this matter is resolved.

We are from time to time subject to class action claims of wage and hour violations. We are currently a party in two such lawsuits containing class-action allegations in which the plaintiffs are current and former hourly and salaried associates who allege various violations, including that they are misclassified as exempt employees and are owed overtime pay, that they are owed pay and penalties for missed meals and/or rest breaks, and that they are owed penalties for improper wage statements. The complaints generally seek unspecified monetary damages including back pay and statutory penalties, injunctive relief, or both. These wage and hour 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. If a class were certified in one or both cases, an unfavorable judgment or settlement might be material. However, based on the information available to us at this time, we believe that it is not reasonably possible that a material loss will occur on these cases.

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. We currently have two cases pending of this nature.

 

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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.

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 following the Distribution and their anticipated titles following the Distribution. All of these individuals are currently employees of Sears Holdings or its subsidiaries. After the Distribution, none of these individuals will continue to be employees of Sears Holdings. Additional executive officers may be appointed prior to the Distribution and information concerning those executive officers will be included in an amendment to this Prospectus. We are in the process of identifying the individuals who will be our directors following the spin-off, and we expect to provide details regarding these individuals in an amendment to this Prospectus.

 

Name

   Age     

Position with Orchard

Mark R. Baker

     53       Chief Executive Officer, President and Director

William C. Robertson

     36       Senior Vice President, Chief Financial Officer and Treasurer

Steven L. Mahurin

     51       Executive Vice President, Merchandising

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

Roger L. Smith

     65       Vice President, Real Estate, General Counsel and Secretary

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. 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.

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. In addition, Mr. Baker brings to our Board of Directors 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.

WILLIAM C. ROBERTSON: Senior Vice President, Chief Financial Officer and Treasurer

Mr. Robertson joined Orchard in March 2007 as Vice President, Controller. In May 2008, he was promoted to Vice President, Chief Financial Officer and then subsequently promoted to Senior Vice President, Chief

 

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Financial Officer and Treasurer in January 2009. Previously, Mr. Robertson was the Director of Finance and Treasury at Hines Horticulture, a leading national operator of commercial nurseries, from 2004 to 2007. He also served as Assistant Corporate Secretary and as a member of the Internal Disclosure and Sarbanes Oxley Committees of Hines Horticulture. Prior to 2004, Mr. Robertson held various roles of increasing responsibility with Axcelerant, Inc., Core, Inc. and Kieckhafer, Schiffer & Company LLP.

STEVEN L. MAHURIN: Executive Vice President, Merchandising

Mr. Mahurin joined Orchard on May 1, 2011 as Executive Vice President, Merchandising. 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.

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.

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

Mr. Bussard joined Orchard of Senior Vice President, Operations in June 2011. From October, 1994 until October, 2010 Mr. Bussard served in ever increasing leadership roles with Gander Mountain, a retail industry

 

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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.

ROGER L. SMITH: Vice President, Real Estate, General Counsel and Secretary

Mr. Smith joined our parent, Sears Roebuck, in 2001 and served as Assistant General Counsel, Automotive providing guidance and oversight for Sears Automotive Group. He was promoted to Associate General Counsel of Sears Roebuck in October 2003 providing support for merchandising, commercial sales and other specialty retail businesses. In November 2007, Mr. Smith became Vice President, General Counsel and Secretary of Orchard, responsible for all legal affairs. In March 2008, he was promoted to Vice President, Real Estate, General Counsel and Secretary of Orchard.

Board Structure

Our board of directors currently consists of six directors. 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, prior to the Distribution, the standing committees of our board of directors will consist of an audit committee, a compensation committee and a governance committee.

Audit Committee

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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;

 

   

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

 

   

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

 

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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 will adopt a written charter for the audit committee prior to the completion of this 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 we expect they will include the following:

 

   

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

 

   

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

 

   

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;

 

   

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

 

   

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.

Corporate Governance and Nominating Committee

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

 

   

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

 

   

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

 

   

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

 

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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

We expect that prior to the completion of the Distribution our board of directors will adopt a code of ethics applicable to our directors, officers and employees, including our Chief Executive Officer, Chief Financial Officer and other senior officers, 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

We expect that our board of directors will adopt a set of corporate governance guidelines that sets forth our policies and procedures relating to corporate governance. Our corporate governance guidelines will be available on our website.

 

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COMPENSATION OF DIRECTORS

We expect to enter into a new Stockholders’ Agreement with ESL and ACOF that will provide for the compensation of directors, certain provisions of which will be described in an amendment to this Prospectus.

 

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EXECUTIVE COMPENSATION

Compensation Discussion and Analysis

Named Executive Officers

For fiscal 2010, the following individuals were our Named Executive Officers (“NEOs”) and were employed directly by us in such capacity: (i) our former Chief Executive Officer, (ii) our former Chief Administrative Officer who served as our principle executive officer through the hiring of our current President and Chief Executive Officer in March 2011, (iii) our Chief Financial Officer and (iv) the three other most highly compensated executive officers who were serving as executive officers on January 29, 2011.

 

   

Robert M. Lynch, former President and Chief Executive Officer, or CEO, (whose employment with us ended on December 27, 2010);

 

   

Allen R. Ravas, former Chief Administrative Officer (who commenced employment with us on December 20, 2010 and ended employment with us on April 26, 2011);

 

   

William C. Robertson, Senior Vice President, Chief Financial Officer and Treasurer;

 

   

Stephen W. Olsen, Senior Vice President, Supply Chain, IT and Chief Strategy Officer (formerly Senior Vice President, Merchandising, who commenced employment with us on June 28, 2010);

 

   

Thomas J. Carey, Senior Vice President, Chief Marketing Officer; and

 

   

John S. Beasley, III, former Senior Vice President, Retail Operations and Administration (whose employment with us ended on April 16, 2011).

Effective March 7, 2011, Mark R. Baker became our President and Chief Executive Officer. In connection with the Distribution, Mr. Baker will be designated as an executive officer for securities law reporting purposes. However, in accordance with SEC regulations, since Mr. Baker was not an executive officer as of the end of the most recent fiscal year for which compensation information is being presented, he is not an NEO for fiscal 2010.

Overview of Compensation Objectives and Philosophy

Prior to the Distribution, we have been a majority-owned indirect subsidiary of Sears Holdings and our approach to executive compensation has been focused on providing total cash compensation commensurate with the levels necessary to attract and retain senior-level executives within our industry, as well as providing equity-based compensation that aligns the interests of our executive team with those of our shareholders.

Historically, we have generally not used, and have not had the need to use, many of the more formal compensation practices and policies employed by publicly traded companies subject to the executive compensation disclosure rules of the SEC and Section 162(m) of the Internal Revenue Code (the “Code”). We have not had, and currently do not have, a separate compensation committee to administer our executive compensation arrangements. However, we intend to establish a compensation committee concurrently with the Distribution that will be responsible for setting policies for executive compensation and administering all cash-based and equity-based plans and programs for our senior management.

Compensation Determination Process

Our board of directors, along with our former Chief Executive Officer and our former Vice President, Human Resources, have historically been responsible for making compensation decisions for our NEOs except that our former CEO’s compensation was determined exclusively by our board of directors. Our board of directors has relied on, and will continue to rely on, its judgment in making compensation decisions after reviewing factors including, but not limited to, our performance (including our short- and long-term strategies and current economic and market conditions) and evaluating an executive’s performance during the year against

 

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our overall strategic goals and generally assessing an executive’s leadership qualities, business responsibilities, career with us, current compensation arrangements and long-term potential to enhance our value.

Our main objective in establishing compensation arrangements has been and will be to set criteria that are consistent with our business strategies. Generally, in evaluating performance, we have and will continue to review the following criteria:

 

   

Strategic goals and objectives, such as profitability;

 

   

Individual management objectives that relate to our strategies; and

 

   

Achievement of specific operational goals of the executive officers.

Our executive compensation programs and policies have and will continue to depend on the position and responsibility of each executive officer and will remain consistent with our objectives. However, we do not specifically weigh these goals and objectives in our assessment of executive compensation arrangements, and we may not rely on these goals exclusively in making compensation decisions. We have designed our compensation packages to not only reward past performance, but also to proactively encourage long-term future performance through a combination of cash and equity incentive awards.

Role of Our Chief Executive Officer in Compensation Decisions

The compensation package of our former Chief Executive Officer and of our former Chief Administrative Officer was determined as a result of arm’s length negotiations with our board of directors at the time each of them commenced employment with us. Compensation for the other NEOs was determined by our former Chief Executive Officer and our former Vice President, Human Resources, and approved by our board of directors.

Generally, the compensation packages of our NEOs are determined at levels commensurate with each executive’s position and scope of responsibilities with us. While our board of directors, our former Chief Executive Officer and our former Vice President, Human Resources took into consideration various factors as noted above (none of which was individually weighted) in determining our executive compensation packages, no specific methodology or decision-making process was utilized in making such decisions. In addition, the compensation packages for our newly hired NEOs were generally the product of arm’s length negotiations with each such NEO.

Following the completion of the Distribution, the compensation committee will administer our executive compensation plans and programs and make all determinations with respect to the compensation of our NEOs.

Compensation Strategies and Use of Peer Groups

We have not historically utilized specific peer groups or formal benchmarking in determining the compensation packages for our NEOs. Instead, compensation was determined based on the factors as discussed above, including (i) each executive’s performance, (ii) our financial performance, (iii) current economic and market conditions, and (iv) our general knowledge of the market for executive talent. In addition, we reviewed aggregated compensation data from pre-selected compensation surveys utilized by Sears Holdings in setting compensation ranges for its workforce to assist us in negotiating the compensation packages of newly hired executives, as well as in connection with executive promotions.

Components of our Executive Compensation Program

The key components of our executive compensation program are:

 

   

Base salary;

 

   

Short-term cash incentives;

 

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Long-term equity incentives;

 

   

Severance benefits; and

 

   

Other benefits.

We did not and do not currently have formal policies relating to the allocation of total compensation among the various elements of compensation. However, the more senior the position an executive holds, the more influence he has over our financial performance, and for this reason, our former Chief Executive Officer (Mr. Lynch) received a greater amount of total cash compensation than our other NEOs. He also received equity-based awards of higher value than were awarded to other NEOs to reflect his status and level of responsibility within our organization and his enhanced ability to drive our overall financial performance.

Base Salary

We set base salaries to reflect each NEO’s performance and experience, the executive’s expected future contributions to our Company, the responsibilities, impact and importance of the position within our Company, internal pay equity and competitive pay research. The timing and amount of base salary increases depends on each NEO’s past performance, promotion and other changes in responsibilities, expected future contributions and current market competitiveness. However, none of the foregoing factors received a specific weighting in the compensation decision-making process. Rather, they were used as overall guidelines in determining the appropriate levels of compensation needed to retain and incentivize our NEOs to remain with us and to grow our portfolio base and future profitability. In making their decisions regarding each NEO’s base salary, our former Chief Executive Officer (Mr. Lynch) and our former Vice President, Human Resources relied on their general knowledge and business experiences in our industry, without using any formal peer group analysis or analysis of any specific group of competing companies, but did utilize the Sears Holdings compensation market data described above from time to time. The compensation package of NEOs hired during fiscal 2010 was determined pursuant to arm’s length negotiations with such NEOs.

For fiscal 2010, the annual base salary of each of our NEOs was as follows:

 

Named Executive Officer

   FY2010 Base Salary  

Robert M. Lynch

   $ 450,000   

Allen R. Ravas

   $ 450,000   

William C. Robertson

   $ 260,000   

Stephen W. Olsen

   $ 350,000   

Thomas J. Carey

   $ 334,800   

John S. Beasley, III

   $ 269,241   

Except for Mr. Robertson, whose base salary was increased to $284,200, effective May 8, 2011, none of our NEOs received salary increases for fiscal 2011, as our board of directors determined that the level of base salaries remains appropriate for purposes of retaining and incentivizing our executives in light of our current performance and overall economic conditions.

Short-Term Cash Incentives

Each of our NEOs participates in our annual cash incentive plan, or Annual Incentive Plan, along with other members of our management. The Annual Incentive Plan is intended to provide performance-based cash compensation designed to reward our executives for their contribution to our fiscal performance. The NEOs are eligible to earn bonuses under the Annual Incentive Plan based on our achievement of financial performance objectives, including EBITDA, revenues, gross margin and productivity targets (i.e., rate of inventory turn and payroll expenses as a percentage of revenues).

 

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For purposes of the Annual Incentive Plan, EBITDA is calculated as net income after adding back income taxes, depreciation and amortization, interest expense, stock-based compensation, rent equalization, loss on fixed assets, disposals and other one-time restructuring charges. Under the Annual Incentive Plan for fiscal 2010, the threshold, target and maximum bonus potential for our NEOs was as follows:

 

Executive Officer

   Threshold Bonus
Potential (90% of Plan)
(% of Base Salary)
    Target Bonus Potential
(100% of Plan) (% of
Base Salary)
    Maximum Bonus
Potential (125% of
Plan) (% of Base
Salary)
 

Robert M. Lynch

     45     75     150

Allen R. Ravas

     45     75     150

William C. Robertson

     30     50     100

Stephen W. Olsen1

     30     50     100

Thomas J. Carey

     30     50     100

John S. Beasley, III

     30     50     100

 

1 

Mr. Olsen was contractually entitled to receive a minimum guaranteed bonus of $125,000 for fiscal 2010.

Bonus awards for the NEOs were based on one or more financial and productivity metrics, as set forth below.

 

Named Executive Officer    Performance Objectives    Weighting  

Robert M. Lynch

   EBITDA      100

Allen R. Ravas

   EBITDA      100

William C. Robertson

   EBITDA      100

Stephen W. Olsen

   EBITDA      50
   Revenues      20
   Gross margin      20
   Inventory turn to plan      10

Thomas J. Carey

   EBITDA      60
   Revenues      20
   Gross margin      20

John S. Beasley, III

   EBITDA      70
   Revenues      20
   Payroll expenses as a % of sales      10

The bonus opportunity available to our Chief Executive Officer was higher than for our other NEOs on the basis of his level of responsibility for our overall performance, and because it serves as a key pay-for-performance component of a total cash compensation package that we believe is competitively appropriate for a Chief Executive Officer in our industry. The range and weightings of performance metrics applicable to our other NEOs are a reflection of each NEO’s particular level and scope of responsibility and influence with our organization.

Under the terms of the Annual Incentive Plan for fiscal 2010, we were required to achieve at least 90% of our EBITDA objective in order for any bonus amounts to be paid. No bonus amounts were paid to the NEOs for fiscal 2010, with the exception of Mr. Olsen’s minimum guaranteed bonus of $125,000 and his sign-on bonus of $137,000, under the plan because we did not meet our minimum EBITDA threshold. As a general matter, achievement of target performance objectives is difficult, requiring significant and sustained effort on the part of our executives and members of our senior management team. The targeted performance objectives require superior performance under our annual operating plan, although, as a general matter, we anticipate the minimum performance thresholds necessary to earn the threshold bonus amounts to be more readily achievable.

 

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Long-Term Equity Incentives

We believe that successful performance over the long-term is aided by the use of equity-based awards, which create an ownership culture among our executives. To accomplish this goal, in May 2010, our board of directors approved the OSH Stores Corporation 2010 Stock Incentive Plan, or the 2010 Plan, to provide certain key employees, including our NEOs, with incentives to align their interests with the interests of our shareholders. The 2010 Plan provides for grants of stock awards, incentive stock options, nonqualified stock options, restricted stock, performance awards, or any combination of the forgoing. As of January 29, 2011, the aggregate number of shares of our Class B Common Stock which could be issued under the 2010 Plan for such awards was 111,347 shares.

In connection with the adoption of the 2010 Plan, we canceled our prior long-term equity incentive plan and all outstanding options thereunder because the exercise price of such options was significantly higher than the fair market value of our Class B Common Stock. We issued new option grants for our Class B Common Stock in May 2010. Specifically, time-vesting stock options to purchase 26,723 shares of our Class B Common Stock (equal to approximately 2.6% of our fully-diluted shares of common stock at the time of grant) were granted to Mr. Lynch, all of which options were forfeited in connection with his termination of employment with us on December 27, 2010. In addition, time-vesting stock options to purchase 8,017 shares of our Class B Common Stock were also granted to each of Messrs. Robertson, Olsen, Carey and Beasley. As our Senior Vice Presidents, each of these executives received an option grant representing approximately 0.8% of our fully diluted shares of common stock at the time of grant. The number of options granted to our NEOs was determined by taking into consideration each executive’s seniority, position and responsibilities, internal pay equity and our strategic goals, financial condition and performance.

All of the options awarded to our NEOs were granted in three tranches: 33.34% was granted at an exercise price of $100 per share, 33.33% was granted at an exercise price of $200 per share and 33.33% was granted at an exercise price of $300 per share. All of the option grants were made at a premium to fair market value, as the valuation of our Class B Common Stock at the time of grant was equal to approximately $87 per share of Class B Common Stock. The options granted during fiscal 2010 to our NEOs, under the 2010 Plan, vest over four years and become exercisable as to 25% on each of the first, second, third and fourth anniversaries of the grant date prior to an initial public distribution, but, after an initial public distribution, become exercisable as to 33.33% on each of the first, second and third anniversaries of the grant date following such distribution, with vesting credit given retroactively to the grant date. However, options granted after fiscal 2010, under the 2010 Plan, will generally vest over a period of five years and become exercisable as to 20% on each of the first, second, third, fourth and fifth anniversaries of the grant date with no accelerated vesting at the time of an initial public distribution. The more favorable vesting terms awarded by our board of directors for options granted during fiscal 2010 was to provide NEO’s vesting credit for their previous years of employment with the Company.

In the event that we terminate an executive’s employment without “Cause” (as defined in the 2010 Plan) or the executive terminates employment for “Good Reason” (as defined the executive’s employment or severance agreement, if applicable) within 12 months of a “Change in Control” (as defined in the 2010 Plan), all of his stock options will become fully vested and exercisable upon the date of such termination. For a discussion of the vesting of stock options under the 2010 Plan in connection with a Change in Control, see “Potential Payments upon Termination or Change in Control—Vesting of Stock Options under the 2010 Plan” below.

In connection with this Distribution, we intend to adopt a new equity incentive plan for our employees, directors and consultants, to be called the “2011 Equity Incentive Plan.”

Severance Protections

In addition to providing accelerated vesting of stock options provided upon a qualifying termination following a change in control, as discussed above, we have entered into severance agreements with each of our

 

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NEOs which provide for severance payments and other benefits upon a qualifying termination. The severance agreements do not include change in control triggers. We provide severance to our NEOs as a component of a competitive compensation package. We believe that severance payments provide our executives a window of time to locate a new position in the marketplace should their employment with us terminate. In addition, we believe that it is important to provide our NEOs with a sense of stability, both in the middle of transactions that may create uncertainty regarding their future employment and following termination as they seek future employment. We believe that severance protections allow management to focus their attention and energy on the business transaction at hand without any distractions regarding, for example, the impacts on future employment as a result of a transaction.

Under the terms of the severance agreements, in the event a termination without “Cause” or resignation for “Good Reason” (as each such term is defined in the applicable severance agreement), NEOs with a title of Senior Vice President are generally entitled to severance payments and/or benefits equal to: (i) six months of salary continuation, (ii) continued participation in a subset of the Company’s benefit plans as an active employee for six months, and (iii) up to six months of company-paid outplacement services. Our CEO is generally entitled to greater severance payments and benefits to reflect his seniority and position with us, as well as competitive pay practices in relation to severance payable for comparable positions in our industry. The severance payments and benefits for our CEO are generally equal to: (i) 12 months of salary continuation, (ii) continued participation in a subset of the Company’s benefit plans for 12 months as an active employee, and (iii) up to 12 months of Company-paid outplacement services. For a further discussion of the severance payments and other benefits provided in connection with a qualifying termination of employment under the severance agreements, see “Potential Payments upon Termination or Change in Control.”

Other Benefits

We may pay sign-on bonuses to our executives when determined necessary or appropriate to attract top executive talent from other companies. Executives we recruit often have unrealized value in the form of unvested equity and other forgone compensation opportunities. Sign-on bonuses are an effective means of offsetting compensation opportunities an executive may lose when he or she leaves a former company to join us. During fiscal 2010, a sign-on bonus was awarded to Mr. Olsen in connection with the commencement of his employment with us. Furthermore, we typically pay bonuses to cover relocation costs incurred by executives who are required to relocate in connection with the commencement of their employment with us. For more information regarding other benefits, see “—Summary Compensation Table—All Other Compensation” below.

Tax Considerations

Section 162(m) of the Code generally disallows a tax deduction for certain compensation in excess of $1.0 million per year paid by a publicly held company to its chief executive officer or any of its three other most highly paid executive officers (other than the company’s chief executive officer and chief financial officer). Qualifying performance-based compensation is not subject to the deduction limitation if specified requirements are met. In addition, “grandfather” provisions may apply to certain compensation arrangements that were entered into by a company before it was publicly held. We generally intend to structure the performance-based portion of our executive compensation, when feasible, to comply with exemptions in Section 162(m) so that the compensation remains tax deductible to us. However, to remain competitive with other employers, the board of directors may, in its judgment, authorize compensation payments that do not comply with the exemptions in Section 162(m) when it believes that such payments are appropriate to attract and retain executive talent.

Recovery of Certain Awards

We do not currently have a formal policy for recovery of annual incentives paid on the basis of financial results which are subsequently restated. Under the Sarbanes-Oxley Act, a company’s chief executive officer and chief financial officer must forfeit incentive compensation paid on the basis of financial statements for which they were responsible and which need to be restated. We intend to implement a formal policy whereby, in the

 

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event of such a restatement, we would expect to recover affected bonuses and incentive compensation. In addition, following the completion of the Distribution, we intend to implement a formal policy for the recovery of incentive-based compensation paid to current and former executives, in compliance with regulations pursuant to the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act, following the enactment of such regulations.

Summary Compensation Table

The following table provides summary information concerning compensation paid or accrued by us to or on behalf of our NEOs for services provided to us during the 2010, 2009 and 2008 fiscal years:

 

Name and Principal Position

  Year     Salary(1)
($)
    Bonus(2)
($)
    Option
Awards(3)
($)
    Non-Equity
Incentive Plan
Compensation(4)
($)
    All Other
Compensation(5)
($)
    Total
($)
 

Robert M. Lynch

    2010        398,077        —          1,257,636 (6)      —          —          1,655,713   

Former President and Chief Executive Officer

    2009        450,000        —          —          263,372          713,372   
    2008        426,462        —          —          314,322          740,784   

Allen R. Ravas

    2010        51,923        —            —          17,355        69,278   

Former Chief Administrative Officer

             

William C. Robertson

    2010        260,000        —          377,300        —          —          637,300   

Senior Vice President, Chief Financial Officer and Treasurer

    2009        204,615        —          —          69,929          274,544   
    2008        201,558        —          —          85,749        —          287,307   

Stephen W. Olsen

    2010        208,654        262,000        377,001        —          193,792        1,041,447   

Senior Vice President, Supply Chain, IT, and Chief Strategy Officer

             

Thomas J. Carey

    2010        334,800        —          377,300        —          —          712,100   

Senior Vice President, Chief Marketing Officer

    2009        329,415        —          —          172,915        —          502,330   
    2008        323,692        —          —          132,660        —          456,352   

John S. Beasley, III

    2010        269,241        —          377,300        —          —          646,541   

Former Senior Vice President, Retail Operations and Administration

    2009        269,241        —          —          153,488        —          422,729   
    2008        268,323        —          —          145,378        —          413,701   

 

(1) The salary amounts reported in this column for Messrs. Lynch, Ravas, Robertson, Olsen, Carey and Beasley represent salary earned in fiscal 2010. Mr. Lynch, our former President and Chief Executive Officer, whose employment with us ended on December 27, 2010, had an annual base salary of $450,000. The salary amount reported in this column for Mr. Lynch is pro-rated for the number of days he worked during fiscal 2010. Mr. Ravas, who commenced employment during fiscal 2010 as our Chief Administrative Officer, had an annual base salary of $450,000. The salary amount reported in this column for Mr. Ravas is pro-rated for the number of days he worked during fiscal 2010. Mr. Olsen, who joined us on June 28, 2010, had an annual base salary of $350,000 for fiscal 2010. The salary amount reported in this column for Mr. Olsen is pro-rated for the number of days he worked during fiscal 2010.
(2) The bonus amount reported in this column for Mr. Olsen represents his minimum guaranteed bonus of $125,000 for fiscal 2010 and a sign-on bonus of $137,000, pursuant to the terms of his offer letter.
(3) The amounts reported in this column for fiscal 2010 represent the aggregate grant date value of the time-based stock options granted under the 2010 Plan, calculated in accordance with FASB ASC Topic 718. See Note 7 to the Notes to the Consolidated Financial Statements included elsewhere in this Prospectus for a discussion of the assumptions used to calculate these values. For a discussion of the 2010 Plan, see “Compensation Discussion and Analysis–Components of our Executive Compensation Program–Long-Term Equity Incentives” above.

 

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(4) No bonus amounts were paid to the NEOs for fiscal 2010 under the Annual Incentive Plan because we did not meet the minimum EBITDA threshold for any bonuses to be paid under the terms of the plan. For a discussion of the Annual Incentive Plan, see “Compensation Discussion and Analysis –Components of our Executive Compensation Program–Short-Term Cash Incentives” above.
(5) The amounts reported in this column include the incremental cost of perquisites and other benefits received by our NEOs in excess of $10,000 during fiscal 2010. With respect to Mr. Ravas, the amount in this column is equal to his commuter expense benefit for travel between his home and our head office. With respect to Mr. Olsen, the amount in this column is equal to his relocation reimbursement, received in connection with his hiring.
(6) All of Mr. Lynch’s time-vesting stock options were cancelled during fiscal 2010 in connection with his resignation effective as of December 27, 2010.

 

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Grants of Plan-Based Awards

The following table provides supplemental information relating to grants of plan-based awards made to our NEOs during fiscal 2010:

 

Name

  Grant Date     Estimated Future Payouts
Under Non-Equity Incentive
Plan Awards(1)
    All Other
Option Awards:
Number of
Securities
Underlying
Options(2) (#)
    Exercise or
Base Price of
Option
Awards
($/Sh)
    Grant Date
Fair Value of
Option
Awards(3)
($)
 
          Threshold
($)
    Target
($)
    Maximum
($)
                   

Robert M. Lynch

Former President and Chief Executive Officer

      202,500        337,500        675,000         
    5/26/2010              8,909      $ 100      $ 505,067   
    5/26/2010              8,907      $ 200      $ 406,361   
    5/26/2010              8,907      $ 300      $ 346,208   

Allen R. Ravas

Former Chief Administrative Officer

      22,192        36,986        73,973         

William C. Robertson

Senior Vice President, Chief Financial Officer and Treasurer

      78,000        130,000        260,000         
    5/26/2010              2,673      $ 100      $ 151,537   
    5/26/2010              2,672      $ 200      $ 121,904   
    5/26/2010              2,672      $ 300      $ 103,859   

Stephen W. Olsen

Senior Vice President, Supply Chain, IT and Chief Strategy Officer

      61,849        103,082        206,164         
    1/13/2011              2,673      $ 100