The Curious Case of Sears Holdings

 

Sears Holding has been the topic of discussion recently in the investment media. Here is a collection of articles and resources covering the valuation of its common stock.

The Liquidation Begins

“Since 2006, we have closed just over 300 Sears Full-line and Kmart stores, or 13% of the Sears Full-line and Kmart stores we operated at that time, with about half of these store closings coming in our last fiscal year.”
Read more: Lampert Gives Baseline Liquidation Value for Sears Holdings (Feb. 2013)

Turn of events / Brief history

The fall in SHDL common has been quite dramatic:

In “Sears Holdings is Back at $31, Where’s the Value? Price/Book at 0.44 (SHLD)” (January 2, 2012) at Distressedvolatility.com, “Matt D’volatility” writes a good summary of how events have unfolded.

Lampert was considered the next Warren Buffett when Kmart took over Sears in 2004 by some of the investment media, such as Businessweek:
– “Eddie’s Master Stroke”
– “The Next Warren Buffett”

KCD – Kenmore, Craftsman and DieHard

From the article The New Alchemy At Sears (BusinessWeek, April, 2007)

Sears has disclosed that it has created a “separate, wholly owned, bankruptcy-remote subsidiary”—essentially a company within a company. Called KCD IP (for Kenmore Craftsman DieHard intellectual property), the entity has issued $1.8 billion worth of bonds backed by the intellectual property of Sears’ three biggest brands, according to filings with the Patent & Trademark Office.

Sears has, in essence, created licensing income from whole cloth. First it transferred ownership of the brand names into KCD. Now, KCD charges Sears royalty fees to license those brands and uses the royalties to pay the interest on the bonds. It has sold the bonds to the insurance subsidiary, where, like any other security on an insurer’s books, it serves as protection against future loss. The insurer, meanwhile, protects Sears from financial trouble—and because it’s a subsidiary, it does so at a lower cost than Sears could get from an outside party.

If you’re confused, that’s because it’s all circular: The payments net out to zero because Sears owns every piece. But that would change if Sears were to sell the bonds to outsiders. Then voilà, Sears would be holding up to $1.8 billion in cash, and investors would be holding the bonds.

[…]

Sears’ KCD deal is different in one important way: It didn’t involve preexisting royalty payments. The company created the payments in order to issue the bonds. Richard D. Rudder, a New York lawyer who specializes in securitization of intellectual property and consulted on the KCD deal, says it’s the first deal he has seen that hasn’t involved cash coming in from the outside. In filings, Sears has suggested it could potentially license the trademarks to other parties—for example, to another company to make a new line of Craftsman products—although it hasn’t done so yet. Sears declined to comment beyond what it has said in those filings.

Management and major owners

Edward S. Lampert

Sears Holdings is controled by Eddy Lampert´s hedge fund ELS. Lampert himself is the Chairman of Sears Holdings.

From “Sears: The Silent Partner Who’s Making Himself Heard” on Businessweek.com (2003):

“In the 15 years since he founded his ESL Investments Inc., Lampert, 41, has developed a reputation as a risk-taker with an eye for undervalued assets. That has paid off handsomely: Since 1989, his hedge fund has posted average returns of at least 25%. Kmart has been Lampert’s most attention-grabbing play. He and affiliated investors bought most of the discounter’s debt after it filed for bankruptcy in 2002. Then, after forcing Kmart to exit bankruptcy earlier than intended, Lampert converted his bonds into a controlling stake and became chairman of the board.

But Lampert’s investments in the floundering AutoZone (AZO ) in 1997 and troubled AutoNation three years later may provide a closer parallel to Sears. AutoZone has since focused on generating cash by cutting costs and squeezing suppliers. AutoNation has focused on its core dealership business and freed up cash by jettisoning noncore operations, including a credit business. Both companies bought back large chunks of stock. Improved profit performance, together with the lower number of shares, have sent the stocks soaring; since Lampert’s investment, AutoNation’s stock is up 80%, while AutoZone’s is up 205%.

“He made over a billion dollars for David Geffen, racked up better returns than Warren Buffett,   and talked four kidnappers into letting him go. Eddie Lampert is … THE BEST INVESTOR OF HIS GENERATION. So what is he doing with Sears?” by Patricia Sellers on CNNMoney.com (2006)

Lampert on
…being an active–not activist–investor: “You don’t need to revolutionize an industry or overhaul a company to make money. Often you need to change the way capital is allocated and maybe change compensation targets. I’d rather do these things privately than publicly.”

… capital spending: “A lot of managers say, “Here’s the rule of thumb: We have to spend X amount per year.” It gets written into the plan. You know who benefits? The consumer. There’s nothing wrong with that. But my job is to provide value for the investor.”

..on Wall Street guidance: “The world is just not predictable enough to give earnings guidance. The prevailing wisdom is, you set guidance at a level that you can beat, so the surprise is on the upside. Or you sell something on June 29 for $2.2 million even though you could have gotten $2.5 million on July 1.”

Eddie Lampert´s profile on hedgefundletters.com

“Buffett Vs. Lampert: A Tale Of Two Shareholder Letters“, Jeff Matthews compares Lampert´s and Warren Buffett´s 2011 letters to shareholders, at Business Insider:

“We will continue to make long-term investments in key areas that may adversely impact short-term results when we believe they will generate attractive long-term returns. In particular, we have significantly grown our Shop Your Way Rewards program, improved our online and mobile platforms, and re-examined our overall technology infrastructure. We believe these investments are an important part of transforming Sears Holdings into a truly integrated retail company, focusing on customers first.” 
—ESL

“Given the large proportion of the Sears Domestic business which is in ‘big ticket’ categories and linked to housing and consumer credit, Sears is much more susceptible to the macro-economic environment than Kmart. But I don’t accept this as an excuse: our results at Sears in 2010 were completely unacceptable. The profit erosion at Sears Domestic occurred primarily in appliance-related businesses and in the Full-line Store apparel and consumer electronics businesses….

“When industry margins are shrinking, an organization must respond by adding new innovative products and bundling them with services and solutions that meet customers’ evolving needs….

“The new management in our appliance business has already taken actions to rebuild leadership in this area and to further reinvigorate the Kenmore brand….

“In parallel to the efforts that we are making to increase the productivity of our Sears stores, we are also looking at adding world class third-party retailers to our space. Earlier this year we announced that Forever 21 will be taking over 43,000 square feet of Sears space at South Coast Plaza in Costa Mesa, CA…” 
—ESL

Bruce Berkowitz, Fairholm Funds

Bruce Berkowitz´s Fairholm Fund is the second largest shareholder: Profile on hedgefundletters.com

“If not now…then when?“, Bruce Berkowitz interview in Graham & Doddsville (2009):

“G&D: You mentioned on a public shareholder conferencecall last fall that you hadn’tactually spoken with [Sears Chairman] Eddie Lampert before making your investment in Sears. Is it fair to say that you were able to assess Eddie Lampert’s background from what he had donein previous stressful situations?

BB: Yes, we examined his career – how he behaved, his performance, and what kind of person he is. Is his hero in factWarren Buffett? Does hetaketo heart the tenets of Buffett, Benjamin Graham, Phil Fisher, and Charlie Munger? That helps us think about how he is going to behave in thefuture. The man is not as smart and he’s not the messiah that he was made out to beat one point, but he’s definitely a very sharp guy. And he’s nowhere near as bad as he is being portrayed right now.”

Fairholme Funds case study on Sears Holdings (August, 2012)

Francis Chou´s America Fund has around 4,5% of its portfolio invested in Sears as of January 9, 2012.

Current situation

Some very prominent retail experts, such as Davidowitz, have expressed their negative opinion of Sears´ competitive ability as well as the value of its real estate assets.
“Insight: Memo to Eddie Lampert – Dump Kmart” in the Chicago Tribute

Real estate value

From “Sears: The Silent Partner Who’s Making Himself Heard” on Businessweek.com (2003)

“Given Lampert’s zest for unlocking value, it stands to reason, say investors, that he may look to the real estate holdings. Sears owns 519 of its 872 mall stores. Richard C. Moore, an analyst at McDonald Investments Inc. and an expert on mall properties, thinks Sears’ properties could fetch $7.6 billion. Whether or not Lampert moves in that direction, he has already made his mark on America’s third-largest retailer.”

“A Storied Name on Sale?” by Jonathan R. Laing on Barrons.com (2007, pre-crash)

“To many observers, Sears’ real estate is what ultimately will deliver big returns to investors. Sears owns, among other things, 518 of the 861 legacy Sears general-merchandise stores, located in some of the best malls in the U.S., by virtue of the clout that Sears Roebuck’s onetime developing arm, Homart, was able to exert. Leased Sears stores generally pay below-market rents, and have lenient covenants as far as common-area maintenance obligations and building-use restrictions.

Most of the Kmart stores — 1,194 out of 1,333 locations — are leased on even more favorable terms. Rents are at rock-bottom levels. And the 100-year leases at many of these locations give Sears what effectively is ownership control.

As to the value of Sears’ real estate, Ackman of Pershing Square made some interesting observations at a recent charity event in Dallas. He reasoned that Sears Holdings is more a conglomerate than a pure retailer. He therefore deducted from its $20 billion enterprise value [stock-market capitalization of $19.3 billion plus net debt and capital leases of $700 million] the $2.2 billion value of its 70% holding in Sears Canada and $9.3 billion in noncore assets after working capital adjustments, valuing Sears’ U.S. retail real estate at just $8.5 billion of its total enterprise value.

According to Ackman’s calculations, Sears is rich in assets that could be easily sold. Among them are the company’s 15 million square feet of warehouse and distribution-center real estate; its headquarters campus and surrounding 200 acres in Hoffman Estates, Ill.; the Kenmore and Craftsman brands; the company’s enormously profitable home-services operations, which do everything from appliance repair to installation of home siding, and its popular Lands’ End unit.

Ackman used seemingly conservative break-up estimates. Yet the $8.5 billion enterprise value he assigned to Sears’ U.S. retail real estate both on and off the mall worked out to just $33.05 per square foot, based on an estimated 257 million square feet. The number pales beside the enterprise values per square foot of Sears’ various rivals.

Target and Kohl’s both boast implied real-estate values of more than $300 a square foot, or around 10 times Sears’ number, despite generating cash flow per square foot less than three times that of Sears. Appliance- and tool-heavy Home Depot (HD) and soft-goods-oriented Penney also have per-square-foot numbers that are multiples of Sears’, weighing in at $277 and $144 respectively. The comparison gets downright nutty when Sears is compared to, say, the retailing real-estate investment trust Simon Property (SPG), which, according to Ackman, has an implied mall value per square foot of $698.”

Further Reading

• Find More Investment Cases
• A Brief History of Value Investing
• Capital Allocation
• Continuous Compound interest