What I'm Looking For To "Shop Sears' Way" ($SHLD)

After an impressive initial pop following the release of a bullish presentation by one of the company's larger institutional investors, shares of Sears Holdings (SHLD) have made a round-trip back to the mid 40's after two negative news developments. First, CEO Eddie Lampert increased the company's float after distributing more than 7 million shares of SHLD to limited partners who asked to exit his hedge fund. Second, Lampert decided to spin off clothing division Lands' End to shareholders and the company's financial statements previously undisclosed looked far worse than many had presumed. Even on a day when the Dow rose 300 points last week, SHLD stock could not manage to eek out a gain.

While there has rarely been any doubt (to those who have looked closely at the company anyway) that there is value within Sears Holdings' assets outside of the ongoing retail operations (Sears and Kmart stores don't make money), the questions pertinent to investors have always been "how much, how, and when?" as to the form in which that value would be extracted for their benefit. And on the issue of gaining clarity on those questions the results have been disappointing.

Eddie Lampert, Sears' CEO and largest shareholder, has been experimenting and shuffling deck chairs at the company now for nearly a decade, with little in the way of positive results. You can look at any number of metrics to judge success or lack thereof; free cash flow per share, book value per share, net debt per share. Every one has gotten worse since Sears Holdings was formed in 2005 after the merger of Sears Roebuck and Kmart.

Finally though it seems that Eddie may be getting impatient. Meaningful restructuring actions (including store closings and sales, spin-offs, rights offerings, special dividends, etc) have accelerated over the last couple of years, which leads many to believe (myself included) that over the next 2-3 years we may finally get a clearer picture as to what Sears Holdings will look like long-term. Progress on that front would very much be a welcomed development for SHLD watchers.

But despite undeniable value within Sears' assets (rights to brands such as Kenmore, Craftsman, and Diehard, over 80 million square feet of owned (not leased) real estate, a 51% stake in Sears Canada, over 700 Sears Auto Center locations, and Lands' End to name the bigger ones), Lampert still faces an uphill battle in the near-term. The bulk of Sears' revenue fails to generate any profit, annual capital expenditures and interest on Sears' rising debt load both number in the hundreds of millions per year, and Sears' pension plan, while frozen, is significantly underfunded. The result is that Sears is on track to burn through more than $1 billion in 2013, and unless the retail business improves next year (and there is no reason to believe it will to any material degree), will be set up to burn another $1 billion in 2014.

This is problematic because Sears will be forced to restructure, sell, and/or spin-off assets simply to replace the cash that is flowing out the door. It's not unlike blowing air into a punctured balloon; any progress you make inflating it simply goes out the other end. As long as Sears is forced to get smaller in order to merely tread water from a financial condition standpoint, it is hard for me to see how the stock is poised to go higher in the short term, and more importantly, stay there for any length of time.

For that to happen, one of two scenarios has to play out, in my mind (both would be ideal, but let's not get carried away). First, Sears has to figure out a way to get the retail operations to break-even or better on a free cash flow basis. This job will get a bit easier as time goes on as the pension expense is reduced and capital expenditure needs decline as more and more money-losing Kmart and Sears stores are closed. Still, there appears to be another year at least, and maybe more, where the weight of capex, pension needs, and interest expense cannot possibly be negated by retail cash flow. Even if the retail stores earn a small profit, it might not be enough to cover interest and capex needs, which together come to approximately $500 million per year.

The other scenario would involve Sears announcing a major asset sale. By "major" I mean something in the neighborhood of $1.5-$2.0 billion. To get a number that high, the company would likely have to part with some of its vast real estate holdings (it owns more than 800 of its 2,000 stores). Such a windfall would dwarf the annual cash needs of the entire company, leaving Lampert a cushion of a couple of years to restructure without having to worry about using any of the cash raised to cover operational losses in the meantime. It is not unreasonable that SHLD's retail operations could lose $1.0-$1.5 billion in cash in 2014 and 2015 combined. Selling some real estate to pre-fund two years of cash needs would not only reinforce to the market that the real estate value is vast and demand is there from buyers, but it would take near-term liquidity concerns off the table (by "concerns" I mean the need to sell assets to replace retail losses, nothing remotely like a bankruptcy situation) and allow further asset monetization proceeds to be used for the benefit of equity holders, rather than creditors.

Current Sears investors are quick to point out that since 2011, there is more and more evidence that asset monetization transactions are on the horizon. Over the last several years Sears has spun-off half its interest in Sears Canada, raised more than $400  million via a rights offering for its Hometown and Outlet store business, collected more than $300 million in special dividends from its Canadian subsidiary, and announced a spin-off of the Lands' End clothing business. All of that is true, but where has that money gone? The company has more debt outstanding today than it did before those deals were completed, so the company is in no better financial shape. All of that money has gone towards the various needs of the business. It has not been distributed to shareholders, or used to acquire other businesses to help Sears Holdings grow via acquisition, or to buyback stock, or to pay down debt. As a result, equity holders have not benefited from these monetization actions. That is what must change.

Before I can get comfortable with owning this stock given today's landscape, I have to at least see signs that we are making progress on one, if not both, of these objectives. If not, I firmly believe that asset sales will not be able to more than adequately cover retail store costs, pension obligations, debt service, and capital expenditure needs. And in that case, there will be very few catalysts that could turn around the fortunes for long-suffering investors in Sears Holdings. And if I have to pay more than the current $45 per share price when that time does come, I'm fine with that. Simply assuming Lampert has it all figured out given his intellect and vast ownership stake has not proven profitable for many, many years.

This is definitely a situation to watch carefully. If Lampert starts turning over a new page and shifts strategy, there could be plenty of good times ahead for investors. I simply do not have enough faith to assume he will come out smelling like roses, as he has proven over the better part of a decade that while he is a brilliant hedge fund manager, even this job is a lot more difficult than many initially believed. I would imagine he would agree.

Full Disclosure: No position in SHLD stock at the time of writing, but positions may change at any time (and in this particular case, you should know what to look for to know if they have).