February 21, 2008

Sears Holdings is the hype real?

It is a question I always struggle with when it comes to Sears (SHLD), as the who's who of value investors have taken significant positions in SHLD. Lets run down the list:
  • Bill Ackman; SHLD represents 46% of his portfolio
  • Mohnish Pabrai; SHLD represent 13% of his assets
  • Bruce Berkowitz; SHLD represent 9.5% of his portfolio
  • Martin Whitman
  • Whitney Tilson
  • And many others to list
SHLD has went down 47% over the last 12 months. Is not that enough to consider it a bargain? But you forget that SHLD had a strong performance over the last few years compared to its peers. The Stock has appreciated by more than 300% since 2004 to-date, 2004 was the merger between Sears and K-mart. Compare that performance to Target's 57%, Wal-Mart's decline of 5%, Costco's 86%, and the department store as a group appreciation of only 18.71%. So I would not consider SHLD to be a bargain because it went down 47% from its multi year high.

So let us look at some fundamentals of the business.

Retail Economics
As a retail investment I do not think SHLD is sound for many reasons.

First, the shopping experience is not very attractive. I find myself not motivated to go to SHLD for anything to buy. And when I wander into the store I feel very depressed; it gives me the feeling of old and tired. Moreover I find some of their merchandise in same manner as my overall impression of the stores that is old and tired. I opt to shop at other retailers and I have no doubt you would to. Ask yourself the following:
  • Do you drive past Macy's to shop for clothes at Sears?
  • Do you drive past Best Buy to shop for TV's at Sears?
  • How many people pass up driving to Costco, Walmart or Target to shop at K-Mart?
Sears have many competitors that offer appliances and many other items that Sears sells and they do a much better job at advertising and promotion than Sears. I'd maybe buy an appliance, or Craftsman tools from Sears but I can even buy those from Home Depot and other places. The retail shopping experience is the life ot any retailers and sadly Sears does not have any of it.

Second, the business economics is not that good. Sears inventory days have been creeping up over the years and that is not a good sign for retailer to hold older and older inventory. Holding to inventory drives your costs up, slows your cash conversion cycle and makes your merchandising less relevant.

Third, retail turnarounds are notoriously hard and long and have low probabilities of success. Actually as a rule of thumb never invest in a retail turnaround story as you can earn better returns elsewhere.

I doubt that most of those investors who hold SHLD missed some of these points. However I think they are not in it for the retail business. So the question is, is it a matter of faith in Eddie Lampert, who is undoubtedly a brilliant money manager?

He is very accomplished and has a proven track record that will silence lots of his critics. He turned his mere investment of $900 Million in K-mart to $6.7 billion by taking K-mart from bankruptcy and merging it with Sears to create SHLD. He is currently using SHLD cash to buy back stock to increase his ownership in the company and its underlying value. But do you invest on faith alone?

Real Estate and Brand Value
A lot of loyalists are expecting a similar feat in monetizing SHLD real estate and its brands. SHLD has taken steps to do that by reorganizing itself along those lines, which I like very much. Several investors in Sears highlight the primary drivers of Sears value as:
  1. the underlying value of its real estate,
  2. the value of its brands, if sold to third parties: Kenmore, Craftsman, DieHard...etc,
  3. the cash that the retail business can earn over the next five years, and
  4. the potential returns on that cash that Lampert can generate over the life of the investment.
So lets assign values to those drives:
  1. Sear's Free Cash Flow that the retail business generates going forward. The TTM free cash flow is $949 Million. Its Present Value, assuming no growth or decline and Cost of capital of 10%, is: $9.5 Billion,
  2. The value of the firms underlying real estate is: $4.7 Billion,
  3. The value of the firm's brands: $3.4 Billion ( Book value of its trademarks), and
  4. Lamperts magic to reinvest the free cash in attractive opportunities is: Priceless.
Applying no premium for Mr. Lamperts ability as a master capital allocator, that puts the intrinsic value of Sears at $17.6 billion, or $127 per share, compared to its market value of $13.3 Billion, or $96 per share. SHLD is trading at about 30% discount to its intrinsic value.

The estimates above are conservatives as real estate has appreciated some from the time of purchase and will be worth more once the credit and real estate issues are resolved. Also, the brands value of $3.4 is a conservative estimate that can go much higher is sold or monetized through licensing agreements.

I still need to do more homework but at roughly the $97 a share that SHLD shares are currently offered for, and possible turnaround in its retail operations, SHLD looks more and more as a value idea that needs a long term viewpoint that will likely generate good returns over the next 3-5 years.


Anonymous said...

I think the credit suisse analysis is rubbish as it entails the real estate is worth 50% less now, the same CS analysis has been peddled by Herb Greenberg who penned an equally silly argument on Fairfax Financial.

Reducing the value of the real estate as CS do by 50% from their prior estimate implies that the entire commerical real estate sector in the US has lost half its value (ridulous) alternatively that Sears is a forced seller (they owe no debt & will not be forced into selling anything)

Bruce Berkowitz recently made Sears a 10%+ shareholding & these guys are relentless at doing their research , given they paid $120+ a share I am pretty sertain they know better than CS.

I would suggest you don't rely on CS and start again with your real estate analysis.



Sami said...

sure I get your point. like I said these are back of the envelope calculations that as i said are conservative and I needed to do more analysis. But the case even with the most conservative numbers show that SHLD is selling at a discount so whatever upside to the analysis is good.