February 22, 2009

Value Idea: Sears Canada Bonds

Another fixed income issue to put my cash to work. Right now the yields on debt issues offer more than satisfactory rate of returns with more security. There are two issues trading in Canadian dollars with a yield of 8-8.5% maturing in 2010. I am indifferent to both issues as they have the same structure except for the coupon, (7.05 vs. 7.45%). Both issues are senior secured offering fixed semi-annually coupon.

The bonds are good opportunity because:

  1. Short term to maturity with very good spread to treasuries,
  2. Sears Canada is a wonderful business with a sound collection of assets and hidden values,
  3. Strong balance sheet and coverage ratio. The company has 40% of its market capitalization in cash alone. This cash is more valuable in this deflationary environment.

Sears Canada Overview
Sears Canada much like SHLD is not just a retailer, rather it is a collection of home and consumer related services among real estate holdings. Sears Canada in addition to its main business, the department stores, it operates a number of successful businesses:
  • warranty servicing,
  • appliances maintenance,
  • home installations of floors, HVAC, and other things,
  • cleaning services,
  • travel agency,
  • transport and logistics distribution business and
  • it owns prime real estate holdings. Sears operates a total of 187 stores, 19 of which are Company-owned with the majority of the remainder held under long-term leases, which most likely have under market rental rates, so these leases are also valuable.
Most of these businesses are hidden assets that can be sold without affecting the essence of the retail operations. Actually Sears Canada has sold its credit card operation to JP Morgan Chase in 2005 to monetize that business for $2.3 billion, and until 2015 it will receive a 10% revenue stream from all sales charged to sears credit cards. Moreover it has been systematically selling its interest in mall ownership over the past several years. Those real estate holdings are way undervalued on their books due to historical accounting.

The company is 72.4% owned by SHLD through a Canadian subsidiary, while Pershing Capital owns 17.31%. Actually Ackman has successfully thwarted Lambert from acquiring the whole company few years ago based on low priced offer. I think that was in 2006.

SHLD and Ackman continue to buy Sears Canada stock. SHLD increased its stake from 70% in early 2008 to 72.4% by end of 2008. Pershing raised its stake from 15% to 17.31% by end of 2008.

I think sooner or later SHLD will have to buy Sears Canada as the majority of cash on its balance sheet is from the Canadian subsidiary. SHLD, at current market price, can pay $552 million for the remaining stake in Sears Canada and get access to $810 million in cash sitting in its coffers. I think the buyout of Sears Canada by SHLD is just a matter of time.

SHLD vs Sears Canada Bonds?
A natural question the reader may ask why Sears Canada bonds offering 8.5% yield and not the SHLD bonds trading at anywhere from 14-19%? I have looked at those bonds and they are issues by Sears Roebuck Acceptance Corp. It is a wholly owned subsidiary by SHLD. The Company's principal activity is to
acquire short-term notes of parent company. The Company raises funds
from its unsecured short-term borrowing programs and long-term debt.
Short-term borrowings include commercial papers and long term debt
includes medium-term notes and discrete underwritten debt. The subsidiary may be a bankruptcy remote enity, i.e, the bonds will not be covered by SHLD other assets. Actually SHLD shelters several of its assets in similar manner. SHLD's brands are owned by a bankruptcy remote subsidiary as well. That's why I own the common rather the bonds in SHLD. Another thing I want to be aligned with Edward Lambert interests in case of liquidation.

Back to Sears Canada. The first thing to ensure my margin of safety is figure out the liquidation value of Sears Canada. I will do that by restating its most recent balance sheet

Balance Sheet Analysis
The balance sheet undervalues Sears economic assets. The biggest revision to assets values is in its real estate holdings.
  • Cash balances are significant and represent about $8 per share, the stock trade at $19. The balances is expected to increase as a result of continues sales of the company's assets and positive cash flow from operations.
  • Real estate: The company had joint venture interests in 12 shopping centres across Canada at Nov. 1, 2008. Joint venture interests range
    from 15% to 50%, and are co-owned with major shopping centre owners and institutional investors.
  • Long term leases in a liquidation scenario will be valuable to other
    retailers looking to take over prime space cheaply. The value of these
    leases have not been factored into my analysis.
  • Pension plan: sears is underfunding its assets plan but nothing significant but what is more importantly is the composition of its plan: 80% in fixed income, which should limit sears future contributions and expenses. Moreover its assumptions are conservative to actually give a far valuation of its future obligations.

On a liquidation scenario Sears Canada at the moment can cover most of its obligation and even give its shareholders 85 cents on the dollar. I feel Sears Canada has significant margin of safety to warrant the investment in its bonds.

On the strength of the company balance sheet alone, valuing its assets at their economic values rather than book value, Sears Canada should be trading at twice the market cap that it is trading currently.

Can the company pay me back?
The company have very decent coverage ratios as below. The company can cover all of its debt from cash on hand or by about 18 months from free cash flows.
Coverage Ratios
TTM EBITDA/ Total Interest
TTM EBITDA/ Total Interest+Rent3.2
TTM EBITDA-Capex/ Interest
TTM EBITDA-Capex/ Interest+Rent2.9

The operations may deteriorates from slow consumer spending but its results of Q3 did not show it. Their Q4 results are expected to be release by the end of Feb 09.

What Could go wrong?

  1. refinancing risks in this tight market but the company has enough cash on hand to do repay debt and satisfy its working capital needs.
  2. the issue gets called by sears.
  3. rapid deterioration in operation over the next 10 months to deplete its strong balance sheet. This is a possibility where collapse in sales would result in the company to use its cash on hand to pay for expenses.


Anonymous said...

Hi Sami,

Do you have CUSIP# for the sears canada bonds? This looks promising - I should do some research as well.

Also do you look at the short interest when buying a security etc? For instance the short interest in NRF is quite high with quite a few days to cover.


Peterborough Real Estate said...

Been doing research on this for a while an it seems as if it works.