March 2, 2008

Sears Holding Valuation: Another Attempt

I have wrote about SHLD being a value idea, read my earlier post here. I have attempted a back of the envelop valuation to see if I should go deeper into my analysis. In this post I will present a better attempt to value Sears Holdings.

I still hold that Sears as a retailer has a sub-par retail experience than its peers. And I also still think that the business economics and operations are inferior compared to competitors. However, the value potential is in its real estate holdings, which is the main attraction to this idea.

I will argue that the proper valuation technique for SHLD is the use of liquidation value. In this approach I assume no on-going concern for its retail operation and the company will cease those activities fr no return. I also assume that SHLD will be sold in pieces; the pieces being: real estate, working capital items less current debt, brands, and Sears Canada stake. My reasoning to value SHLD this way is mainly because retail turnarounds are long and hard to accomplish. Moreover they have high probability of failure in a competitive environment where competitors are better at merchandising and have strong capital positions.

The table below is a summary of the sum of the value drivers for SHLD. I estimate that SHLD can have $19.26 Billion in intrinsic value. SHLD commands a market cap of $13 Billion, which represents 48% discount from my calculated intrinsic value. The discount is adequate for several reasons:

  • I did not assign any value to the retail operation. The retail operation can be the margin of safety for this idea. The valuation arrived using this technique will be my floor value and if retail operations are turned around then it becomes the icing on the cake.
  • Also I did not count in this valuation several peices of SHLD holdings. I did not count the real estate value of SHLD's distribution centres, Kmart offices and the Hoffman estate, which can add additional margin to my intrinsic value.

ItemValue ($ Millions)
Net Working Capital542
Brands2,000
Sears Canada Stake1,590
Real Estate20,000
Less: LTM Debt2,606
Less: Taxes 2,300
SHLD Intrinsic Value19,226

Here is my explanation how I arrived to this valuation, I begin with the easy items and progress to the more difficult ones:

Net Working Capital:

Before I itemized this list, please note that you have to back out Sears Canada accounts from SHLD financials as we will value Sears Canada stake separately. Off course you know that due to SHLD 70% ownership of Sears Canada it has to consolidate both companies in its financials.

AccountAssigned Value Million $Note
Cash745No adjustment

Accounts receivable

595.5Less allowance of $30 M for bad debts
Inventory7,286I reduce the inventory by 20% for several reasons. SHLD inventory turnover was getting low, meaning inventory is sitting in their warehouses longer and longer compared to competitors. This leads to obsoletes and leakage. The other factor is SHLD uses RIM to value its inventory which opens the door for management biased estimates, so to be conservative you need to reduce this item by some margin due to possible high valuation by management.
Deferred Taxes0In a liquidation scenario it is unlikely that this item will ever be used.
Other256.6I make no adjustment here.
Less Current Liabilities8,342No adjustment here as debtors will get their money if their is a surplus and in this case there is.
Net Working Capital Value542This is what shareholders can expect in liquidation scenario.

Brands

SHLD owns good brands like Kenmore, Craftsman, Land's End, Diehard among others. However SHLD owns just the brand name with no ownership of the designs, IP or manufacturing of the items. Valuation here gets a bit tricky and uncertain. SHLD does not provide sales by category that we can apply multiples from other companies like Whirlpool, Energizer and other comparable to get a value for such brands. It even gets tougher as SHLD does not manufacture them, so how much do you discount this compared to Maytag, who is vertically integrated.

SHLD designated trademarks on its balance sheet to be worth $3.3 Billion and that will be a good starting point. In a liquidation value the sale will receive a hair cut lets ball park it as 40%. Therefore I will assign a value for the brands at $2 Billion.

SHLD in the past has transferred the ownership of Diehard, Kenmore, and Craftsman into a separate entity and issued bonds against them worth $1.8 Billion. Think of it as securitization of brands rather than sub prime. The value of that transaction is close to my estimate valuation so I will go with the $2 Billion as value in a liquidation scenario.

Sears Canada

The logical value to assign to this component is the publicly traded price of the entity. Sears Canada market cap is $2.23 Billion Canadian. SHLD owns 70% of Sears Canada making its ownership worth $1.59 Billion (adjusting for the exchange rate).

Real Estate

The major element of SHLD value driver is its real estate value. There are several ways to estimate the market value, obviously the best way is to hire a good commercial real estate agent to give you an estimate of ongoing transaction value for SHLD properties. Since all the agents I know are busy at the moment, I will take a stab at it in several ways:

  1. Compare SHLD to publicly traded REITS.
  2. Apply average market Net Income per square foot (PSF), arrived by averaging comparable retail REITS operators statistics, and apply the market observed cap rates.
  3. Apply price sale per Sqrft on recent retail transactions to SHLD real estate.
  4. Use SHLD's recent sale of some of its properties in 2004 and apply it to the entire portfolio adjusting to commercial real estate appreciation using S&P commercial property index.

Please note that I am excluding from my analysis all the speciality stores as that are independently owned and operated and Sears Canada store as I am evaluating it as a separate company.

These methods will give me a wide range of value, which should be close to each other, I will settle on the average and assign it as the valuation measure for SHLD properties.

Value ApproachValue BillionsNotes
As a REIT$19.48
  • Sears owns 266 Million square foot of retail space.
  • The average market value of retail REIT per owned square foot is $73.8 (end of 2007 figures)
  • I can apply this market value per owned and leased SHLD space to arrive at an estimate of what would the market value SHLD if it operated as REIT generating income from rental properties.
Using Market Cap rates to assumed NI$11.6
  • Retail REITs have an average Net Income PSF of $2.63. (end of 2007 figures)
  • I will assume if SHLD converts its real estate into a REIT it will achieve the average NI PSF of $2.63. Then SHLD will have NI of $699.5 Million.
  • DDR, Kimco, Regency Centers and Equity all said they're seeing cap rates on high-quality assets trading from 6% to 6.5%, and in some cases even lower.
  • I will assign to SHLD a cap rate of high-quality assets as observed by other developers.
  • Off course SHLD might have better average NI as its mall space will command higher premium but I will stick with my blended rate for the Kmart stores that are of a lower quality.
Recent Transactions$18.6
  • I surveyed Retail REITS recent acquisition and averaged the purchase price of those transactions PSF; the average purchase price is $123 PSF.
  • REITS surveyed: Kimco Realty, developers Diversified Realty, Simon Group, and others
  • I will apply the PSF to the owned store space by SHLD and I will use a discount factor of 60% of the leased space. I used 50% factor as an arbitrary number for the assignment of leased properties.
  • SHLD owns 94.6 million SqrFt while leases the balance. As such its owned value is $11.6 Billion and 7 Billion for assignment of the leased properties.
  • This approach may be conservative due to the discount factor I used. Actual transaction of lease assumption can be higher.
Appreciation since 2004 sale$47
  • SHLD/ Kmart in 2004 have entered with Home depot and each other to sell and assign stores. I will use the per store value of that deal and apply it to the current owned SHLD stores adjusting for appreciation from 2004 using the S&P commercial real estate index.
  • The value per store in that transaction was $12.6 Million
  • The retail real estate appreciation from 2004 to end of 2007 was 35%
  • The adjusted per store value of the 2004 transactions is $17 Million
  • SHLD owns and leases 2,817 stores
  • Obviously this is a very high valuation that I am not sure it will be realized and may have been biased by a small data points in the 2004 transaction, which might have been for primer space and it would be unfair to apply to the rest of the portfolio.

I will use $20 Billion as the market value for SHLD real estate. It is a value that have been repeated by other value investor and confirmed by approach 1 and 2.


Taxes

Given that SHLD liquidation yields a greater value compared to its book value, a payment to the IRS is due. How big of a tax liability is assumed, that is a good questions. It really depends on the method of the disposition and sale. But in the most likely scenario there will be a tax liability. I will use a rough estimate of corporate tax rate of 35% and SHLD current book value of $11 Billion, I estimate a tax liability of $2.3 Billion (sum of all of the sales proceeds in table 1 less book value times a corporate rate of 35%).

Risks

  • If Mr Lambert begins liquidating tomorrow I will put my entire networth in SHLD, but if this is not the case then how the value will be realized is big question and poses a big risk. A piece mail liquidation is not advantageous as slow sub par retail operation will eventually produce negative cash flows and start eating into the value being realized from the real estate sales. If SHLD liquidate all of its holdings at once they will receive a hair cut of the value of their holdings as real estate prices will drop with such a size of an offering. Another alternative is not to realize the real estate value and SHLD continues to attempt its turnaround, then the big returns from real estate is not monetized and the investment will earn returns on low margin business.
  • Commercial real estate construction has held up well, but there are clear signs this is about to come to an end, as lending for commercial real estate is becoming harder to get. Indexes which track commercial real estate are softening and commercial real estate credit default swap prices are soaring. Prices for credit default swaps have almost tripled in the last four months for highly rated investment-grade commercial paper. I can't do the math quickly, but the back-of-my-napkin analysis of CDS rates for the lowest-quality commercial paper (junk bond levels) suggests default rates approaching 50%. It means the securitization market for commercial mortgages is drying up, which means available capital for new construction is going to be much harder to find. This is going to be a drag on growth and the ability to do deals in the coming quarters.
  • Commercial real estate prices are dropping with the credit crises. This means that the intrinsic value of SHLD is declining each month until the credit crises is behind us. Retail real estate has been dropping in prices since they peaked earlier in 2007. The S&P commercial real estate index as shown in the graph illustrate the point. The index dropped more than 2% in very short few months. Off course this risk will be work itself out once we pass the crises but there is always the probability that the crises can deepen and worsen.
  • Litigation risks. SHLD is engaged is several litigation suits stemming from the Kmart bankruptcy and other issues. The outcome can dilute the value further.

2 comments:

al miller said...

It can be dangerous to factor receivables in to figure a company's net worth. So many co.'s are going bankrupt, leaving their receivables unpaid. So when you factor in an owed amount that isn't going to be paid, you might run into a financial gap.

Sami said...

hi Al,

I know what you are saying but Mr Perry which is one of the SHLD board owns a factoring company that factors AR for Sears on a regular basis.
I have no doubt in a bankruptcy situation that AR of SHLD will be factored through Perry's firm. Sure you are not collecting 100% but in several bankruptcy I have witnessed, you would collect 80%+ if the aging is not too bad.