The Math Behind a Bullish Call on Sears

With the stock of Sears Holdings (SHLD) down 25 percent from its high, concerns are mounting, good news goes unnoticed, and sentiment has waned. Why then am I still bullish? Why is this the third time I’ve mentioned SHLD this month? Don’t worry, in the days and weeks ahead I will try to move on from talk of Google, Sears, and the airlines and explore some new companies.

Let me throw some numbers out there that show why I feel SHLD shares at $120 are a steal. After this, I’ll try and stop talking about it so much. Current estimates for 2006 call for Sears to earn $7.88 per share on $56 billion in sales. This equates to a 2.3% net profit margin. I happen to think this margin projection is too low. The way I see it, the best two comparables for Sears are J.C. Penney (JCP) and Federated (FD). After all, the Sears model is moving toward Sears and the newly created Sears Essentials stores, which very much will be traditional department stores.

Now, let’s look at consensus estimates for JCP and FD. For next year, JCP is expected to earn $4 on $19.5 billion in sales, with FD slated to make more than $5 per share on $16.6 billion. Both of these estimates come out to a 5 percent net margin. Call me optimistic, but I think the turnaround at Sears should net margins very close to JCP and FD. There is no reason to think a solid management team cannot attain department-store-like margins.

It is possible that Kmart was so screwed up that it is beyond repair, at least to get to the same level of profitability as these other stores. For sake of being conservative, I’m going to assume SHLD can get to a 3% profit margin by the end of 2006. Since the Sears model is going to be to sacrifice sales in order to boost profits, I’m going to combine my 3% margin estimate with $55 billion in annual sales, one billion dollars less than analysts currently expect. All of the sudden, SHLD is earning $1.65 billion per year, which makes for an easy calculation with 165 million shares outstanding; that’s $10 per share in earnings.

At $120 per share, the stock is only 12 times these profit estimates. And remember, this model does not include the $900 million cash Sears will get from Sears Canada, the $500 stock buyback program recently announced, or any real estate sales of any kind. There is a lot of upside here, and while it is by no means assured, given the recent negative sentiment and a 25 percent drop in the share price, SHLD looks very attractive. Just imagine if SHLD can ever get to a 5 percent margin, that would get us to nearly $17 per share in EPS. Put a market P/E on that and you get a stock price of $250.