Shares of Sears Holdings (SHLD) have traded significantly lower since my last two articles on the company. On November 26th I wrote an article for Seeking Alpha highlighting how much of a disaster Sears' merger with Kmart has been over the past nine years (Believers In Sears Holdings Transformation Are Ignoring Eddie Lampert's 9-year Failure). The stock was trading at $65 per share at that time. A little over a week later I followed up with a post on this blog about how the bullish case made by Baker Street Capital Management in September appeared to me to be overly optimistic (Baker Street Capital Management Bullish Thesis on Sears Holdings Begins to Show Cracks). Today the stock sits at $45 per share, about 30% lower in less than a month (and in my mind a far more reasonable price). So am I a buyer? Not yet, but I am definitely paying closer attention after such a large decline.
As I have dug deeper into Sears Holdings, I even went as far as to mimic the process Baker Street Capital Management undertook to try and gauge the value of the company (albeit with far less aggressive assumptions given my initial trepidation with their extreme level of bullishness). My conclusions so far have not turned me into a bull on the stock, but I can certainly see a path that could get me there; essentially a combination of attractive stock price and more clarity on the cash flow of the company over the next year or two (they burned through $1.9 billion of cash during the first nine moths of 2013).
For those who have even a mild interest in Sears Holdings I figured I would share a couple of other issues I have found with Baker Street's wildly optimistic valuation ($92-$169 per share, depending on various scenarios). My beef with their presentation had nothing to do with their process, but rather the inputs they chose to use (and therefore the magnitude of the conclusions they drew regarding the value of Sears). Accordingly, below I will highlight a couple of additional issues I took with their numbers, as I try and figure out how much I believe the company may be worth (and what price I may want to re-enter the stock after a more than five-year hiatus).
1) Baker Street Appears To Miscalculate Its Own Estimate of Sears/Kmart Retail Operations' Value
On slide 37 of Baker Street's presentation the firm provides its internal estimates for the break-up value of the company under three different scenarios. The share price range from $92 (low) to $169 (high), with $131 as the midpoint. If you look closely you will see that the assigned values in each scenario for the core bricks and mortar retail business in the U.S. are ($4.0 billion), ($3.6 billion), and ($3.2 billion), respectively. They get to those negative values by taking their estimate of net working capital and subtracting both debt/pension liabilities and their estimate of how much it will cost to wind down unfeasible stores.
While I take no issue with their methodology, look at the slide more closely (below) and see if you can spot the same summation errors that I did. I added a blue box highlighting the section detailing the calculations in question.
So I see two errors. First, the adjusted working capital figure of $1.4 billion appears to be overstated by $100 million ($8.8 billion less $7.5 billion equals $1.3 billion, not $1.4 billion). Second, if you subtract the debt/pension liability line and the wind down cost line from the adjusted working capital line, you get numbers that are $400 million (low case), $600 million (mid case), and $800 million (high case) lower than the values they show for "Sears Roebuck and Kmart Retail."
As a result, if you simply use the same formula they use and each line item figure that they provide, but you sum the items up yourself rather than simply look at their totals, you realize that they seem to have overstated the value of Sears/Kmart retail even using their own assumptions.
Now, you might say that in a 139-page presentation of any kind there are bound to be errors, and I would agree. Nobody is perfect and I am sure I have made multiple errors in presentations I have given in the past. I am not pointing these out just to be picky. Rather, it is the magnitude of the error in the context of the conclusions drawn that make them seem important to me.
Let's take Baker Street's "low" scenario of $92 per Sears Holdings share. If we take $8.8B - $7.5B - $4.9B - $0.9B, we get a negative value for the retail business of ($4.5 billion), or a delta of $500 million. That amounts to approximately $5 per SHLD share. Now, if you are using Baker Street's estimates to provide a higher degree of confidence that SHLD shares at their current price are a good investment, a $5 per share differential will be material to your analysis. After all, it is ~10% of the current stock price and ~5% of their "low" break-up value.
Now, let's assume you are very bullish on SHLD stock and prefer to use Baker Street's "high" scenario. Again, let's use their own figures and calculate the negative value attributable to the retail operations. If we take $8.8B - $7.5B - $4.9B - $0.5B, we get a value for the retail business of ($4.1 billion), for a delta of $900 million. Now we are talking about a $9 per share difference. That is 20% of the current share price!
If I am reading these numbers right, this is material to the analysis. It might not change one's view of the stock by itself, but it's worth noting in my view. Let's move on to another part of the Baker Street valuation, and in this case the mistake appears to be due to more than just a simple mathematical error.
2) Baker Street's Revenue Assumptions for Sears' Services Businesses Appear Overstated By $800 Million
It is no secret that the service businesses within Sears Holdings are important for investors. In fact, they are some of the only segments of the company that actually make a profit. Accordingly, in their analysis Baker Street assigns a value of between $1.6 billion and $3.1 billion to three Sears services businesses; Auto Centers (700+ service centers), Home Services (in-home repair and installation), and Protection Agreements (extended warranty contracts). These businesses in total account for 16%-17% of the total value of SHLD, according to Baker Street's analysis.
Baker Street gets to their value estimates by assuming annual revenue of $2 billion for Sears Auto Centers and $2.5 billion for the combined Sears Home Services/Protection Agreement businesses. Based largely on that $4.5 billion total service revenue assumption, they value these business at between $15 and $29 per SHLD share, so the services business are very material to the value equation for both current and potential investors.
So what's the problem? Well, it should be very easy to estimate the revenue of Sears' services businesses because they disclose revenue by segment in their annual report. Sears Holdings does not disclose operating profits by segment, but they do provide sales figures (see below for the actual results recorded in 2012).
Since Sears Canada (SEARF) is a separate publicly-traded company and Baker Street assigns a value to it separately in its calculations, we can ignore the Canada column. Total services revenue in the U.S. was $3.73 billion last fiscal year. This figure includes total services revenue from the three businesses in question, as well as approximately$20 million in annual revenue earned from its agreements with Sears Hometown and Outlet Stores (SHOS). Accordingly, Baker Street has overestimated sales of Sears' services businesses by $800 million, or nearly 20%. If we similarly adjust their value estimates by a comparable percentage, their estimated break-up value for SHLD would fall by an additional $3-$5 per share.
Taken together these two issues alone result in a reduction of Baker Street's break-up values for SHLD by $8-$14 per share. That might not sound like a lot, but it tells me that my initial take on the Baker Street report might very well be right, and their numbers in general are likely overly aggressive. I point this out because it is easy to conclude that if the stock is trading at $45 and a hedge fund that owns 2 million shares of the company thinks it is worth at least $92 per share, then it must be a screaming buy. So far, I'm not so sure, especially given that it could take years for Sears to extract "break-up" values from their asset base, a fact that Baker Street seems to have ignored in their presentation.
There is no doubt that Sears Holdings has an asset base underlying its stores that has the potential to outshine the core retail business that the company continues to operate at a loss. While the retail side is shrinking, with the smaller size has not yet come better financial results. In fact, the company's cash losses have been getting larger lately, not smaller. The question for me is not whether the 800+ stores Sears Holdings owns outright are worth a lot, or if there is a lot of value in some of their better leases if they chose to terminate them early, or if there is some real value within ancillary businesses such as Sears Auto Centers, Lands End (due to be spun off to shareholders in early 2014), or their proprietary brands (Kenmore, Craftsman, and Diehard). Clearly all of these assets taken together have value, to the tunes of billions of dollars.
The big questions for me, and the reason behind why I have not yet purchased the stock again (I invested in Kmart in 2004 and held the merged Sears Holdings shares until 2008), is how exactly those assets get monetized, how much they fetch, and how much of that value will actually be left for the shareholders after CEO Eddie Lampert figures out what to do with the money-losing retail business. As long as you have the largest part of the business burning cash, the value that accretes to equity holders by monetizing the other smaller businesses is capped to some extent.
I'm planning at least one more Sears post soon, which will discuss what I have to see over the next several quarters to start to seriously consider taking a sizable position in the stock, both personally and for my clients. Stay tuned.
Full Disclosure: Long Sears debt and Sears Canada stock only at the time of writing, but positions may change at any time.