Sears Holdings: The Second Coming of AutoZone

Shares of Sears Holdings (SHLD) are down about 5% today after reporting quarterly earnings of 65 cents per share, two cents ahead of estimates. Without news of any real estate related deals, the combination of a 1 percent profit margin and same store sales down year-over-year aren’t making investors too excited today. Even still, if you haven’t gotten into this stock yet, this is an opportunity to do so in the 140’s.

There is one thing you should understand though, before you do invest. This company is not going to compete with Wal-Mart (WMT) and Target (TGT). They’re not going to try to. Same store sales growth at Sears Holdings will lag those of both arch rivals. I saw a quote in an AP story today saying something like it’s impossible to survive in retail without same-store sales growth that translates into maintained or increased market share.

If you believe this to be true, shares of SHLD are not for you. I can tell you right now that Sears Holdings is not going to gain market share. The company is going to be run just like AutoZone (AZO) has been in recent years. The focus is going to be on profits, not sales. AutoZone has been lagging its competitors in both sales store sales growth and market share for years. However, judging from the stock’s performance (it’s risen from $20 to nearly $100 in the last 5 years) you’d never know it.

Eddie Lampert’s ESL Investments owns a third of AZO stock, as well as half of SHLD. Lampert has been influential in AutoZone’s strategy of maximizing earnings per sahre, not sales, and he will do the same thing at Sears. Oftentimes this is accomplished by choosing to invest money in share buybacks, as opposed to store expansion. The way Lampert sees it, if buying back stock is more profitable than opening a new store, he’s going to buy back the stock. Retail analysts will focus on normal metrics of the retail business, but shareholders will see earnings per share rise,which will boost the price of SHLD shares.

If you hear analysts and retail experts knock the prospects of Sears Holdings due to the reasons I have mentioned, the appropriate reaction is to laugh, and buy the stock if it has fallen due to those negative comments. The day to sell SHLD will come when they can no longer increase earnings at a meaningful rate. I think that time is years away, which is why I continue to like and recommend the stock.

The Wal-Mart Bear Market – Part 2

How is it possible that a large cap industry leader can grow its earnings more than 90% over half a decade and yet return a negative 15% to shareholders? Did Wal-Mart do anything wrong, and if so, what?

No, Wal-Mart management did nothing wrong from 2000 to 2005. In fact, they did exactly what their job was, to grow the business into the world’s most dominant retailer. The fault lies with the shareholders who bought the stock at $55 five years ago.

Now you might think that accusation is absolutely preposterous. After all, aren’t investors who saw the growth potential in Wal-Mart back then very perceptive? Didn’t they do exactly what a good growth investor should do?

I would argue against that notion. In fact, Wal-Mart investors made a very common mistake, a mistake that hundreds of people fall victim to every single day on Wall Street. They wanted to own shares of WMT but didn’t pay any attention to how much they were paying for them.

I’m not talking about share price. Many people conclude a $5 stock is “cheap” and a $100 stock is “expensive.” In fact, share price alone does not make a stock good or bad, cheap or expensive. Investors who bought WMT shares at $55 in May of 2000 forked over a whopping 40 times earnings for the stock ($55 per share divided by $1.39 in earnings).

Contrary to the common belief that stock prices follow earnings growth, there are many exceptions. When stock have enormous P/E ratios (a P/E of 40 is about 3 times the average stock’s P/E since 1900) it is often a signal that investors are getting a bad deal, regardless of the company’s future growth potential. If the P/E multiple that investors are willing to pay decreases dramatically over time, not even a 91% gain in profits can make up for the damage shareholders will incur.

Today Wal-Mart stock trades at $47, or 18 times this year’s expected earnings. If you have a company’s P/E ratio fall from 40 to 18, and earnings grow 91%, you are left with a 15% loss on your investment. This can explain why the high-flying tech stocks on the late 1990’s are down so much from their peaks. Cisco Systems (CSCO) is making more money now than they ever did during the Nasdaq bubble, but instead of trading at $82, which was its all-time high in early 2000, the stock is under $20 a share today.

This example should help investors realize that oftentimes the key to growth stock investing is the price you pay, and not the future growth of the company you are investing in. Even though the hype for many promising growth companies can be hard to ignore, try not to lose sight of that.

The Wal-Mart Bear Market – Part 1

Let me give you a couple of statistics and then I’ll ask a question. Wal-Mart (WMT) has grown its annual sales from $180 billion in 2000 to an estimated $317 billion this year, a total increase of 75%. Earnings per share since 2000 have soared from $1.39 to an estimated $2.66 for 2005, an increase of 91%.

Investors are constantly searching for growth when they try and pick winning stocks. People who foresaw the growth that Wal-Mart could sustain so far this decade clearly have done well, right? There is little doubt that having achieved revenue growth of 75% and profit growth of 91% over a 5 year period would be reflected in a very strong gain for Wal-Mart stock. This leads me to my question. How have shares of Wal-Mart performed during that 5 year span?

If you ask former Fidelity star mutual fund manager Peter Lynch this question, he would most likely tell you that over time stock prices follow corporate earnings. As a result, estimating WMT shares have risen 91% in the last 5 years would be a good answer, because for the most part, Lynch’s statement proves correct.

The only problem is, there are exceptions to that rule. Just because a company grows at a very rapid pace, this does not ensure significant price appreciation of that company’s stock. In fact, despite sales growth of 75% and earnings growth of 91% since 2000, Wal-Mart shares have lost 15 percent of their value during that time, falling from $55 to $47 per share.

Part 2 of “The Wal-Mart Bear Market” will be published shortly, and will examine why WMT investors have suffered and what we can learn from this example.

The Kmart/Sears Restructuring Begins

We haven’t heard much out of Sears Holdings since the company was created from the Kmart/Sears combination. Many people thought the stock, symbol SHLD, was too high at $125 when the merger closed in late March, fearing the merger of two bad retailers would simply create one large bad retailer.

However, there is still real estate value locked in the company that will be unleashed. Assets such as Lands End, Sears Canada, and Orchard Supply Hardware will add shareholder value once Chairman Eddie Lampert decides how to proceed with them. It appears after weeks of silence, Sears Holdings is beginning to revamp the company (see below). I hope investors got in a long time ago, but even if they didn’t, the current $145 price tag has plenty of room left to grow.

From the company’s May 9th press release:

Sears Holdings Corporation announced today that it intends to pursue alternatives for the separation of the company’s Orchard Supply Hardware business, which could include a sale of the business or initial public offering. Orchard Supply Hardware is a leading chain of 82 hardware and garden retail stores located throughout California.

Alan Lacy, CEO of Sears Holdings, said, “Sears Holdings is focusing its management attention and capital on the opportunities in our core business presented by the merger of Sears and Kmart. While we continue to believe in Orchard’s business model and growth strategy, we are pursuing alternatives to provide Orchard Supply Hardware with the capital to grow its store base, while at the same time providing appropriate value to Sears Holdings.”

Trading Aeropostale

I’ve already played shares of Aeropostale (ARO) for a trade earlier this year, and the stock is getting back to an attractive level to duplicate that feat. It’s fairly rare to have a stock that, when it gets to a certain price, looks very attractive from both a technical and valuation perspective. ARO shares at $26 each present such an opportunity.

The stock is fairly volatile and has been hit this week after releasing lackluster April sales numbers. Even still, the stock is cheap and has come down to its recurring support level as you can see from this chart. Trading at $26 and change, I think there is limited downside and this is the kind of stock that could run to $30 pretty quickly from here. However this is more of a short-term trade for 2 or 3 points, as opposed to a long term investment.

Playing the Neiman Marcus Arbitrage

Shares of Neiman Marcus are trading down $5 this morning, to $93.25, on news that the company is being purchased for $100 in cash. Many investors were looking for more money out of a buyout. Existing shareholders may be upset with the price, but today’s drop gives others a great chance to play an arbitrage trade.

The deal is for cash and is expected to close by November 1st, so we’re looking at a 6-month time frame. The share price of $93.25 trades at a 7.2% discount to the buyout price, plus there will a 15-cent dividend payment in August. Buying the stock and holding until closing will net investors nearly a 15% annualized return with very little, if any, risk.

Side notes:

(5:35pm)

Sirius Satellite CEO Mel Karmazin on CNBC is quoted as saying “We don’t think of XM Satellite Radio as our competitor.”

Really? Perhaps that explains why they are so far behind XM in terms of subscribers, cost structure, and technology.

(2:50pm)

FBR’s food and beverage analyst just said on CNBC that he would not recommend selling Starbucks (SBUX) stock at its current price of $49.67 per share. When asked what his target price was, he said $50. I can’t help but laugh outloud when I hear things like this. Do people really take comments like these seriously?

Watch for Downgrades of Home Depot

With interest rates on the rise and talk of a housing bubble not slowing down, I am anxiously awaiting some downgrades of Home Depot (HD). The stock is already fairly cheap, trading at $37 and change or 14.8x 2005 EPS estimates. However, in the current environment that multiple could contract further.

I wouldn’t be surprised to see analyst downgrades of the stock shortly. The argument they’ll make will be pretty straightforward and logical. As interest rates rise, the housing market will slow and existing homeowners will have less money to spend on home improvements. As a result, HD’s sales will slow and earnings will be at risk.

These types of comments, while mostly true, will present investors will an opportunity to buy the stock, not sell it. Worries about these things tend to be overly dramatic. And stocks tend to overreact to news as well, especially negative Wall Street comments. If HD shares drop into the low 30’s, the stock will trade at about 13x earnings. At that point, I think investors should use the doom-and-gloom scenario to step and buy the stock.

There is no guarantee the downgrades will come, but with 13 research departments rating Home Depot a “buy” and only 1 a “sell,” there are plenty of possibilities. We only need a couple of those analysts to pull their buy ratings to get a meaningful reaction.

Maytag Needs A Repair Man

Take a look at this chart of Maytag (MYG) stock. Talk about brutal. The analysts hate it. More sell recommendations than all other ratings combined. It’s the kind of situation that gets a contrarian’s attention. I’ve yet to buy the stock, but it will be something I plan to look at very closely in coming days, as the stock looks too cheap despite its problems. Anybody have any thoughts on MYG? Let me know!

Hottest Trend in Retailing: Department Stores?

Group 1: Best Buy, Walmart, Target, Home Depot, Lowes.

Group 2: Federated, May, Kmart, Sears, JC Penney.

Rewind the investment landscape a year and see which retailers Wall Street was talking about. It was the first group of companies listed above. However, nowadays it’s the second group that is getting all of the attention.

First it was Kmart buying Sears. That was supposed to be a unique situation. Kmart had come out of bankruptcy. Eddie Lambert already owned a chunk of Sears, so it made sense to buy the rest with the fortune he was making on his contrarian purchase of Kmart. Kmart owns most of its locations and has cheap lease agreements dating back decades for the rest of its attractive off-mall locations. However, once the real estate strategy was uncovered by Kmart, Wall Street analysts turned their attention to every other major retailer to try and quantify how much hidden value was there.

Federated recently announced they were buying fellow mall-based department store giant May. The stock have been on fire ever since. JC Penney has jumped 25% since rumors of that deal heated up. All of the sudden, department stores in malls across the country are the hottest investment idea in retail. But does this make any sense? Will every retail merger result in a Kmart-like jump in shareholder value?

Not likely. Merging two poorly-run retailers does not create a larger better-run, more profitable company. Shoppers have abandoned mall department stores over the years for good reason. And they’re not coming back. The attractiveness of the Kmart/Sears deal is less about improved operations as it is about creating shareholder value via other means. This will be done by selling real estate and other non-core assets. Sears can sell its stake in Sears Canada and its Lands End subsidiary. Kmart can sell more store locations since there is usually a Sears within a few miles of Kmart. The cash flow is not going to come from an influx of new customers beating down the doors of the recently renovated Kmart store that now is called Sears and carries Craftsman tools.

Why then, are the share prices of Federated, May, and Penney through the roof? It’s a valid question. A lot of people think every retailer can harness the Sears/Kmart model. If that was the case, wouldn’t they all have done it long ago? To show how speculative some investors have gotten, you only need to look at rumors that helped Circuit City stock rally. They were rumored to be looking at selling some of their real estate, given their dismal track record competing with Best Buy. Only one problem, though. Circuit City doesn’t own any real estate, they lease their stores.

I would be leary of the rallies in Federated/May and JC Penney. I hope they can get their acts together and increase profitability. It just seems unlikely that the people that have driven customers away and created an abundance of poorly-run and unappealing department stores would all of the sudden be able to turn their companies into gold, simply by merging and trying to duplicate someone else’s strategy.

Kmart Gets Another Nod from UBS

With hundreds of investment firms employing thousands of equity research analysts, you would think Wall Street would be paying a little more attention to Kmart (KMRT). How many analysts do you think cover the company? I bet very few people would say only one, but they’d be right. What sets UBS retail analyst Gary Balter apart, even moreso than his lack of fellow Kmart followers, is his track record.

Balter initiated coverage of Kmart with a “buy” rating on April 4, 2004. Back then, investors thought he was crazy. After emerging from bankruptcy, KMRT shares rose from $15 to $41 before Balter recommended them to investors. Baffled by such a move, given Kmart’s horrible track record as a money-losing retailer, people ignored Balter’s advice and many shorted the stock. That was a decision many would live to regret.

Balter was one of the few who realized that not only did Kmart rid itself of its massive debt load after its reorganization, but that its real estate was a hidden crown jewel. As the company began to sell off some valuable stores to the likes of Home Depot and Sears, investors began to realize that Kmart had potential for a monumental turnaround. Short sellers were forced to cover their positions, and investors who listened to Gary Balter and bought the stock in the low 40’s saw it soar to $109 per share by November of last year.

At that point, Balter pulled his buy rating on Kmart, reducing shares to “neutral” after the stock had jumped more than 150% since his initial recommendation and announced plans to acquire Sears. Concerns over merger integration and short selling by arbitrageurs proved the UBS downgrade to be very timely. The stock, after hitting nearly $120 when the merger was announced, fell to as low as $86 within several weeks.

In early January, I wrote a piece alerting readers that KMRT (then at $92 per share) was a smart buy amid the merger-related concerns. Once the deal closed in late March, shorts would be forced to cover and more value in the Kmart/Sears combination could be realized. Since then, the stock has risen to $112, with the deal expected to close within weeks. Tonight, sensing the deal will prove to be a success, Gary Balter is once again slapping a “buy” rating on Kmart stock, raising his price target to $160 per share. The stock is trading up $7 in after-hours trading as a result.

Investors can choose to continue to voice skepticism about the Kmart/Sears combination, but betting against Balter at this point seems risky. Eddie Lampert, the chairman and majority shareholder of the combined company, has a great track record in retail and should be able to improve operations and sell off more real estate to unlock value for all KMRT shareholders, himself included.

Below is a 1-year chart of KMRT stock. Balter’s initial recommendation, subsequent downgrade, and latest upgrade are labeled A, B, and C.