You may recall that the recent strength in shares of Sears Holdings (SHLD) had been largely attributed to the release of an investment presentation from Baker Street Capital Management, owner of 1.5 million SHLD shares (1.4% of the company). The stock reached a new 52-week high of $67 per share in November, just two months after Baker Street published its internal break-up analysis, which valued Sears at no less than $92 per share (and far higher in more optimistic scenarios), more than double the market price of $44 at the time.
A couple of recent company developments are starting to show that Baker Street's assumptions are indeed overly optimistic. The bulk of the value in Sears is the company's vast real estate holdings. Not only does the company own many of its stores, but even its leases come with below-market rents, which allows them to occasionally close a store and actually get paid by the landlord to vacate the property (to make room for another tenant, to whom they can charge a market rate). In Baker Street's least aggressive scenario, more than 70% of Sears' break-up value comes from their real estate holdings ($7.1 billion out of a total of $9.8 billion).
The problem is not with that assertion more generally (real estate is surely Sears' most valuable asset), but rather with the assumptions used to gauge that value. To give you an example of how upbeat Baker Street's figures are, consider slide #123 of their presentation:
As you can see, they estimate the value of the Sears lease at Eaton Center in Canada at a whopping $590 million. Now, why focus on a single lease when Sears Holdings has over 2,000 stores? Because this Eaton Center location is one of the company's most valuable properties. In fact, Baker Street assumes that this one store (which is leased, not even owned outright!) comprises 6% of the total value of Sears Holdings ($590 million out of $9.8 billion). With an asset this valuable, you should assume that Baker Street took a very detailed approach to estimating its value, and therefore it should be very, very accurate.
It turns out that on October 29th, Sears agreed to sell that lease back to the landlord at Eaton Center, along with leases on 4 other stores. Here is the text of the press release:
"Sears Canada Inc. announced today that it will terminate its leases in respect of five stores for a total consideration of $400 million. The agreement is definitive and only subject to customary closing conditions. The transaction is expected to close on or around November 12, 2013. Four of the five stores are owned by The Cadillac Fairview Corporation Limited (Cadillac Fairview) and are located in Ontario: Toronto Eaton Centre, Sherway Gardens, Markville Shopping Centre and London-Masonville Place. The fifth store is located at Richmond Centre in British Columbia and co-owned by Ivanhoé Cambridge and Cadillac Fairview."
Can you see the problem? Baker Street thought the Eaton Center lease alone was worth $590 million, but Sears sold 5 leases for a total of just $400 million. Even if you assume Eaton Center was by far the most valuable of the five stores (let's say $300 million versus $25 million each for the other four), Baker Street likely overestimated its value by 100%. And considering how it was one of company's most valuable stores, that is a problem. Is it unreasonable to think Baker Street could be that far off on many of its other estimates of value as well?
Switching gears to a second issue, we learned on Tuesday that Eddie Lampert's controlled stake in Sears Holdings was cut this week from 55% to 48%. This was the result of 7 million shares of Sears being distributed to the limited partners of his hedge fund due to their request to exit the fund. Why is this important, given that Lampert's investors make their own investment decisions in terms of when to request their money back? Well, one of the arguments Baker Street made was that Eddie Lampert was personally investing more of his own money in Sears stock. In fact, on slide #40 (see below) they tout Lampert's personal purchases over the last year as a sign that he believes the stock is dramatically undervalued.
Interestingly, Lampert acquired those shares directly from his hedge fund investors who asked to cash out of the fund in late 2012 and early 2013. Rather than sell Sears stock to pay his investors in cash, or give the investors Sears stock directly, he purchased their shares from them using personal funds, which allowed him to increases his Sears stake while allowing for cash payments to his exiting hedge fund investors.
I find this interesting because this time around Lampert decided not to buy the shares from his investors. Instead, he simply gave them Sears stock in lieu of cash, thereby reducing his controlled stake (the number of shares he controls as a hedge fund manager, not his personal holdings - which remained the same).
So what can we take away from this move? I don't think we should overthink it. Lampert thought the stock was quite cheap between $40 and $44 per share, but not nearly as attractive at $63 (the opening price on December 2nd, the day of the redemptions). For those who believe that Baker Street Capital is correct and the stock is worth $100 per share or more, that should be a concerning development.
I continue to agree with Sears investors who believe that the company's vast real estate holdings give them a margin of safety and will prevent the company from facing any serious liquidity issues, despite continued losses at the core Sears and Kmart stores. I simply disagree that the stock is worth anywhere near $100 today.
Even if you were to be optimistic and assume that Baker Street's "low-end" case for Sears' break-up value of $92 per share was a good estimate, it will take years for Lampert to actually break up the company and realize full value (if he closes one store every day from now on it would take 6 years to liquidate them all!). If you take present values into account and apply a 10% discount rate (a huge error in the Baker Street analysis, in my view, is that they ignored the time value of money), the stock is likely worth no more than $60 per share (versus yesterday's closing price of $55).
Full Disclosure: No position in Sears Holdings common, long Sears Canada common, and long Sears Holdings debt at the time of writing, but positions may change at any time.