Should Investors Revisit Sears Holdings Now That Eddie Lampert Appears To Be Shifting Strategies?

Longtime readers of this blog are familiar with my history with Sears Holdings (SHLD) and its predecessor, Kmart. A brief summary goes something like this.

Hedge fund manager Eddie Lampert loaded up on the debt of Kmart for pennies on the dollar as it fell into bankruptcy (nobody else wanted to come anywhere near the stuff). When the struggling retailer emerged post-restructuring, Lampert owned a majority stake and began cutting costs and reduced the company’s focus on competing with Wal-Mart on price (a losing proposition). The changes worked. Kmart was making money again and the stock soared from $15 to $100 before anyone really knew what had happened. Lampert merged Kmart with Sears in 2005 and investors cheered the move, imagining the magic he could work with strong brands and valuable real estate. Investors assumed he would close money-losing stores, sell off real estate to other retailers, ink deals to sell proprietary products (Kenmore appliances and Craftsman tools) in other chains, and use the cash flow to buyback stock and make acquisitions to diversify the company away from Kmart and Sears, which were clearly dying a slow death. Sears Holdings stock hit a high of $195 in 2007, for a gain of 1,200% in just four years.

Then something strange happened. Those grand ideas never materialized. People close to Lampert were convinced that was the route he would take, based on his experience and philosophy, but he never came out and said it himself. Investors had resorted to blind faith. While Lampert has closed some stores and sold off some real estate, the total store count has actually risen from 3,800 to over 4,000. Lampert cut costs and bought back stock (shares outstanding have fallen from 165 million to 107 million) but he has spent most of his time trying to turn around the retail operations. Couple that flawed strategy with an economy that went bust (the Sears deal closed in the heat of the housing bubble) and profits at Sears Holdings have plummeted. Despite the 35% reduction in shares outstanding, earnings per share dropped like a rock from $9 in 2006 to $1 in 2010. Like many others, upon realizing faith alone was not enough, I sold the last of my Sears stock in 2008 after it had dropped back down to the $100 area. Sure I had a huge profit from the early Kmart days, but the potential for Sears Holdings was just too great to be squandered.

So why rehash the past when readers could get all of that information just be reading all of the posts I penned back then about Sears Holdings? Because it appears Lampert might finally be getting his act together and not putting all of his eggs in the “make Kmart and Sears popular again” basket. It started last year with some subtle moves like splitting up the company into smaller divisions (including one for brands and one for real estate). Then the company reached a deal to sell Craftsman products in Ace Hardware stores (a much better idea than just putting them in Kmart stores). None of these moves were big but maybe they indicated a larger shift in strategy.

This year we have seen further movement in that direction. Sears has announced plans to spin off its Orchard Supply hardware store business into a separate public company. Craftsman tools can now be found in Costco stores and indications are that Kenmore appliances might be next. Diehard batteries are now going to be sold in 129 Meijer stores across the country. Floorspace is now available for other retailers to lease within most of the company’s existing 4,000 Kmart and Sears locations. In Greensboro, North Carolina, for instance, there is a Whole Foods Market store located inside of a Sears. For the first time since the Kmart/Sears merged closed in early 2005 we are seeing signs that Sears Holdings might finally be focused on extracting value from the company’s assets in ways other than trying to turn back the retail industry’s clock several decades. As a result, it makes sense to keep close eyes on the company’s stock once again.

Caution should be advised here, however. Annual revenue at Sears Holdings, while down from $54 billion in 2005, is still formidable at about $43 billion. Selling a few screwdrivers here and leasing some floor space there won’t have a huge impact on their financial results. However, one can certainly see the potential if these efforts prove successful and are adopted in widespread form across not only the company’s 4,000 stores, but within other retailers’ four walls as well. It is too early to predict a turnaround, but the stock price is not factoring in much of this strategy shift, if indeed it is real and sustainable. After dropping from $195 in 2007 to $100 in 2008, Sears Holdings stock has been cut in half again over the last 18 months and now fetches just $55 per share. If we see these moves start to bear fruit on the income statement, the bull market for the stock just may well resume after a five-year hiatus.

Full Disclosure: No position in Sears Holdings at the time of writing but positions may change at any time

Buffett, Of All People, Should Know It Hurts Shareholders to Telegraph Buybacks Ahead of Time

One of my pet peeves is how frequently public companies announce stock buyback programs before they buy a single share. If you are buying back your stock because you believe it is undervalued, and you know that announcing your intentions is going to give a boost to the stock, you are essentially screwing over your shareholders. Why pay more than you have to for the shares you want to repurchase? Today we learned that Berkshire Hathaway (BRKa /BRKb) has authorized share buybacks at prices up to 110% of book value. I am kicking myself because I took a hard look at this stock last week, concluded it was very attractive, but didn’t rush in to buy any. After all, what catalyst near-term could possibly boost the stock that much in a volatile market? Well, a telegraphed buyback program is about the only thing. And today the “B” shares are up nearly $5, or 7%, to just under $71 per share. They looked good at $66, but much less so now.

Isn’t Buffett smarter than this? If he could have bought the stock at $66 why put out a press release and drive your potential cost basis up so much? Skeptics will say he has no intention of actually buying the stock… that it is just a way to give the stock a boost without committing any capital. Perhaps this will prove true (Buffett thought hard about it decade ago but never actually bought any) but I hope not. The stock really is cheap, and Buffett of all people knows this. I cannot figure out why he wouldn’t buy the stock first, and then announce the amount purchased and price paid. That too would give the stock a jolt to the upside, but it would actually benefit shareholders too. This announcement really seems silly. Other companies do it all the time, but I expect more from Buffett.

Some might argue that disclosing the buyback authorization is a Reg FD issue but I would respectfully disagree. Reg FD is supposed to protect certain investors from getting information earlier than others, thereby providing a level playing field for everyone. Failing to disclose the buyback plan ahead of time does nothing to give anyone a leg up on others. In fact, it treats everyone equally (nobody learns of the plan) and beneficially (all shareholders profit from the accretive nature of the repurchases, which were done at the lowest price possible).

We will see if Berkshire stock holds today’s 7% gain. If it does and Buffett doesn’t buy any shares, not only will this announcement have been a waste of time, but more importantly, he will have balked at a great opportunity to make money for Berkshire shareholders.

Full Disclosure: No position in BRKa or BRKb at the time of writing, but positions may change at any time

Dell: The Anti-Hewlett-Packard?

Following up to yesterday’s post on the outright ridiculous valuation being assigned to shares of Hewlett-Packard (HPQ) these days, it is worth playing devil’s advocate and exploring the merits of anti-H-P plays if you believe they will have a hard time convincing its customers that it finally is on the right track. Dell (DELL) should be the primary beneficiary if enterprise customers seek out new vendors, so it would be a perfect way to play the continued demise of H-P.

How does that stock look? Very, very cheap. At $14 per share, Dell fetches about 8 times earnings. But if you dig deeper the stock is even cheaper. Dell has about $10 billion of net cash on the balance sheet, which equates to $5 per share. So investors are really only paying about $9 a share for Dell’s operations, which generate north of $60 billion in annual revenue. With about $5.5 billion in trailing twelve-month EBITDA and an enterprise value of about $16.5 billion, Dell currently trades at 3 times cash flow. Heck, that is not that much more than H-P (2.5 times). Both of these stocks may make a lot of sense at current prices.

Full Disclosure: Long shares of HPQ at the time of writing but positions may change at any time

Hewlett-Packard Revisited: Lowest Tech Valuation in 20 Years

You can bet that there will be a Harvard Business School case study written about the last year in the board room at PC hardware giant Hewlett-Packard (HPQ). A little over a year ago I wrote that I thought the stock was pretty cheap after falling to $38 from a high of $55 per share. Mark Hurd, a cost-cutting guru praised by investors, had just been fired as CEO and the company later filled that position with Leo Apothekar, the former CEO of software-focused SAP, a job he held for about seven months before being ousted. At the time Wall Street was reeling from Hurd’s exit and given that H-P is the largest hardware company in the world, most everyone wondered why the Board hired Apothekar of all people. At $38 each, the stock fetched only 8.4 times earnings per share of $4.50, about as low as large tech company valuations ever get. Sure, Apothekar was unproven and hardly an inspiring hire, but unless the company’s business really was about to fall off a cliff, there appeared to be minimal downside risk given the single-digit multiple. Or so it seemed.

Here we are a year later and the H-P story has been downright bizarre. Apothekar was fired last night and replaced by former eBay CEO Meg Whitman. If you thought hiring Apothekar, a software guy, was an odd choice for the world’s leading hardware company, Whitman’s career experiences at eBay, Hasbro, Proctor and Gamble, Disney, Stride Rite, and FTD.com is certainly questionable. Not surprisingly, H-P stock fetches $22 today, the lowest level since 2005 and less than five times earnings. According to an analyst that covers H-P who was on CNBC this morning, a large cap tech stock has not traded at that price in more than two decades.

From an investor’s perspective, the most interesting thing is that H-P’s business has not actually fallen apart, as the stock price would have you believe. Earnings per share for the current fiscal year will likely grow about 5% to $4.80, on flat revenue. So while large technology companies never usually trade for less than 7-8 times earnings, today Hewlett-Packard trades at 4.6 times earnings, which is simply unheard of. To me, that doesn’t make any sense unless H-P’s business crashes. And if that didn’t happen over the last year, I am not sure it is a wise bet that it will happen now. After all, Apothekar’s strategic decisions seem to be correct (focus on growing software and services, dump unprofitable tablet hardware that is bleeding hundreds of millions of dollars, etc), even when the leadership and communication to Wall Street and customers was unclear, inconsistent, and confusing.

So where do I stand on Hewlett-Packard stock now, with clients sitting on a loss over the last year? Given that the company remains a major player that is extremely profitable and trades at a valuation not seen in decades in the technology space, I am strongly considering doubling down here. There may not be many catalysts short term to get the stock higher, unless Whitman was to inject strong leadership and clear priorities quickly, but earnings would have to collapse from here to justify anything near a $22 stock price longer term. The selling pressure in recent months appears to be capitulation from investors who are fed up with the sheer incompetence of the prior board of directors, rather than significant weakness in the underlying businesses at H-P.

Assuming that management can’t get much worse going forward (seems reasonable), there is little reason to think H-P won’t fetch at least a 7-8 P/E in the intermediate term (a higher multiple is certainly possible — the stock fetched 10 times earnings under Hurd — but at this point conservative assumptions seem prudent). That would imply significant share price upside even without earnings growth (though I do think EPS growth is coming — it will be +5% this year even after all that has happened). There are just too many ways to get a higher stock price from here, even without making optimistic assumptions.

In summary, the last year has been brutal for the company and its stockholders, but at its current valuation, the stock price just doesn’t make much sense, based on what we know today.

Full Disclosure: Long shares of Hewlett-Packard at the time of writing, but positions may change at any time

Europe’s Woes Crushing U.S. Stocks, Creating Longer Term Opportunities

You can certainly argue whether the TARP program was a good idea or not, but you cannot accuse the U.S. government of dragging their feet. They took decisive action, injected much-needed capital into the banking sector, brought confidence back into the system, and the end result was a well capitalized banking industry and a profit on the U.S. taxpayer’s $700 billion investment. Unfortunately, the powers that be in Europe are taking their good ol’ time to take meaningful action. Greece may be the size of Ohio, as I have repeatedly reminded investors, but as long as the markets freak out about it anyway, strong action must be taken to settle the financial markets down. We have yet to see that (hence the market’s continued concern this morning), but let’s keep our fingers crossed that we are getting closer.

In the meantime, there are plenty of strong companies that are being dragged down by this prolonged bailout process. Not surprisingly, most of these opportunities are in the financial sector, but in many ways are not directly in the middle of the European crisis but rather only marginally impacted. In my view, a perfect example is Aflac (AFL), the supplemental health and life insurance company whose two largest markets are Japan and the United States. As you can see from the chart below, shares of Aflac have been crushed from $59 to $33, a 44% drop from earlier in the year.

Now Aflac is not exactly the first company that comes to mind when you think about the European debt crisis. So why the huge sell-off in the stock? As a large insurance company, Aflac collects premiums from its customers and invests that capital to earn income until it needs to pay out claims. Aflac’s investment portfolio amounts to a relatively large $90 billion. When investing that much money, and doing so in mostly shorter term fixed income securities, an insurance company will own a little bit of everything, and that includes debt of European countries. And therein lies the problem for the stock in 2011.

Aflac has already sold all of its Greece exposure and over the next year or so will de-risk its holdings in the other smaller European countries that people are worried about (Italy, Portugal, etc). Of course, most of Aflac’s investments are outside of the troubled European countries and their underlying business is very strong. But in times of stress investors focus only on the negatives, and if any losses at all are possible from Europe, that will drive the stock down quickly.

Given the health of Aflac’s business, any losses should be more than manageable. The company right now is earning more than $6 per share. At $33 per share, that puts the stock’s P/E at 5.5. Such territory is nothing new for Aflac stock. During the U.S. sub-prime crisis Aflac stock also got killed, dropping from $68 in early 2008 to $10 in early 2009. The company’s sub-prime exposure back then also proved to be very manageable (most of the losses were marked-to-market and never actually realized) and the stock soared nearly 500% over the following two years. I have little reason to think this time around will be much different in terms of how the company can weather the storm in the financial markets and the European debt crisis.

Full Disclosure: No position in AFL at the time of writing, but clients of Peridot Capital have owned the stock in recent years and may again in the near future