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).

Potholes On Baker Street: More Issues With Their Bullish Sears Holdings Valuation ($SHLD)

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.

Baker Street Capital Management Bullish Thesis on Sears Holdings Begins to Show Cracks

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.

Is JC Penney Really Out Of The Woods?

Shares of JC Penney (JCP) are rising 9% this morning, to $9.50 each, after the department store chain reported that it lost a whopping $489 million during the third quarter. That loss equates to $1.94 per share, or about 20% of the entire share price. The actual amount of cash the company burned through (excluding the impact of non-cash accounting items) was even worse, coming in at $737 million. And yet the stock is very strong today and Bob Pisani of CNBC reported earlier that traders on the floor of the stock exchange were upbeat because it was clear that JC Penney was going to survive.

I found that conclusion to be quite interesting. I suspect they haven’t actually looked closely at the numbers. Claiming that JCP is out of the woods after losing more than $700 million in a single quarter strikes me as odd, even though the company’s sales have begun to stabilize (up less than 1% in October after a couple years of declines). I am not predicting JCP files for bankruptcy, but I will point out that the odds that it will are most certainly more than zero. Not only that, even if they do make it and return to profitability in the next couple of years (2014 is a stretch, but it could happen in 2015 if things go right), the stock today at $9.50 does not appear to be much of a bargain at all.

Take a look below at a three-year financial projection spreadsheet that I put together today. You will see that I assume that JCP can grow sales by 10%, 8%, and 5%, respectively over the next three years. Furthermore, I assume that the company’s gross margin can improve by 2-3% per year, and SG&A costs rise more slowly than sales. The end result is not very positive for equity investors, despite today’s strong market performance for the stock.



As you can see, JCP reaches EBITDA-breakeven in 2014 and by 2016 generates $1 billion of positive operating cash flow. The problem is that capital expenditures and interest on the debt they have raised over the last two years eats up most of that cash. The end result is very little value left for equity holders. By my calculations, if the stock is valued at 6x EBITDA like other department stores (Macy’s, Kohl’s, Dillards, etc), it would only fetch about $6 by 2016, about 33% below the current quote. And that assumes sales grow from $12 billion this year to $15 billion over the next three years (certainly possible, but far from assured) and margins expand by a similar percentage as well.

Color me skeptical as to why investors are lining up today to buy JCP at nearly $10 per share today.

Full Disclosure: Long JCP senior bonds at the time of writing, but positions may change at any time

The 2013 IPO Bubble Is Here, And Companies Are Lining Up Quickly Before The Window Closes

From Yahoo! Finance:

Zulily, Inc. operates as an online flash sale retailer in the United States, Canada, the United Kingdom, and internationally. It provides various merchandise products to moms purchasing for their children, themselves, and their homes, including children’s apparel; women’s apparel; children’s apparel products comprising infant gear, sports equipment, toys, and books; and other merchandise, such as kitchen accessories, home decor, entertainment, electronics, and pet accessories.”

Yes, Zulily (ZU). One of the latest hot initial public offerings. The company description above might sound fancy, but it’s a shopping site targeted at moms. Think of it as a specialty boutique store, with just an online presence. I don’t mean to minimize it, but there is no special sauce here. It’s a retailer, plain and simple. And a very popular one at that. For the first nine months of 2013, the company’s sales totaled $439 million, which generated $29 million of positive cash flow (7% cash flow margins).

So, how much is Zulily worth? $5 billion. And I’m not joking. The company went public last Friday at $22 per share and now trades at around $37. The initial expected price range for the IPO was set at $16-$18 but investors were willing to pay more than 35% above that before the stock even began trading. After it opened, the price was bid up another 70% on the first day.

Zulily is the perfect example of why the current IPO frenzy has gotten out of hand (and likely won’t last too much longer). The company is targeting what is likely an under-served niche within specialty retail (moms), and it has been very successful thus far. In fact, they are based here in Seattle and I hope they continue to make their customers happy. But the price of the stock makes no sense. And that’s where the IPO market, and many retail investors who are gobbling up any newly issued stock they can, will wind up having a problem.

There is nothing new here in terms of Zulily’s business model (at least with Twitter (TWTR) you can argue they created something new and were a first-mover, so perhaps they will be a unique case). They are a retailer. We have a good idea of how that business works and what kind of profit margins one can expect. Accordingly, we should be able to determine what kind of market valuation makes sense. We might not be able to pinpoint it exactly, because Zulily is growing very fast (2013 sales are running double those recorded in 2012) and its exact growth trajectory is difficult to predict, but at this point they are simply taking market share from existing retailers, both online and off. Moms across the country aren’t all of the sudden dramatically spending more on their children. There is not a retailing renaissance more generally throughout the U.S. The consumer economy has not suddenly taken off. Zulily, if they continue to execute well in the marketplace, will see its growth rate slow over the next few years and then find itself just like any other retailer vying for consumers’ discretionary dollars.

And that is why the company should not trade at 150 times cash flow. The business model at it currently stands does not justify a $5 billion valuation. Heck, even Amazon (AMZN) trades at 34 times cash flow and it is one of the few companies that can barely turn a profit (7% profit margins on a cash flow basis — same as Zulily’s interestingly enough) and not face any objections by investors. Is every dollar of sales generated by Amazon really worth 75% less than a dollar of sales booked by Zulily? That is what the market is saying right now.

And because of that other internet start-ups are preparing to test the IPO waters. Just in the e-commerce space we have heard rumblings that Gilt.com, Wayfair.com, and Fab.com are itching to cash in, and I don’t blame them. So I would caution everyone to stick to a valuation discipline when you pick stocks for your portfolio. The last time we had companies being valued based on a multiple of sales (not profits), or saw P/E ratios reach triple digits, or saw analysts justifying prices by using financial projections five years into the future, was the late 1990’s. And we all know how that turned out.

Full Disclosure: No positions in the stocks mentioned, but positions may change at any time

Sears Holdings Transformation Picks Up Steam, But Will Still Take Years

It’s been nearly ten years since Sears Holdings (SHLD) CEO and majority shareholder Eddie Lampert pulled off the Kmart/Sears merger that had investors salivating over the potential for enormous realization of the company’s real estate value. Since then however, real estate monetizations have been meager and Lampert has instead attempted the impossible task of turning around the retailing operations of Kmart and Sears. Predictably, he has failed. Take negative free cash flow and no real hope for a reversal, and throw in a few billion in debt as well as an underfunded pension plan (to the tune of about $1.5 billion), and you have a stock market disaster. Why then has the stock perked up strongly in recent weeks, as the chart below shows?



Well, a little-known firm based in California called Baker Street Capital Management recently put out a 100+ page presentation making the case for why it believes Sears Holdings shares are dramatically undervalued (the midpoint of its estimated sum-of-the parts valuation range is $13.9 billion or $131 per share, more than double the current stock price of $58). The slide deck provides detailed research showing that the Sears asset monetization plan that investors have been clamoring for since 2005 may very well be starting to take shape. Most interesting are bits of information regarding the company’s real estate portfolio, which is where the majority of the asset value within Sears lies.

First, store closings have accelerated in recent quarters. This could very well signal that Lampert is getting fed up with his unsuccessful attempt to make Sears and Kmart stores more profitable (or profitable at all). I decided to look at the historical data on Sears and Kmart store closings and it does appear that the company is shutting down money-losing stores at a faster pace lately. However, as you can see from the chart I put together below, the acceleration in that trend is both noticeable and relatively small compared with what many investors would prefer.


Second, Lampert has actually taken more than 200 properties and placed them into a newly formed wholly-owned entity called Seritage Realty Trust. Not only that, but a seasoned real estate executive has been brought in to run Seritage and the company is publicizing its plan to redevelop a property in downtown St Paul, Minnesota. An artist rendering for the mixed-use project (taken from the Seritage web site — yes, this subsidiary even has its own web site with no mention of its relationship to Sears) is below:


Okay, so as a former believer in Sears Holdings as an investment, you might be thinking that I am getting into the stock once again. Well, not exactly. I still have some huge issues with the equity right now (though I do hold a position in the bonds). First, although nobody can refute that there is tons of value within Sears’ real estate portfolio (billions of dollars), we can not ignore the fact that the retail operations are still bleeding cash. And as you can see from the pace of store closing shown above, there are still more than 2,000 of these stores open. Each day that passes brings with it more red ink. Even if Eddie Lampert decided to eventually shut down the retail stores completely, that process would take years. It could take a decade to transform Sears Holdings, in an orderly fashion, into a pure-play real estate company.

The reason that is a problem for would-be equity investors is that the time value of money shrinks how much that real estate is worth today. Let’s take Baker Street Capital’s estimate of Sears’ real estate portfolio; $8.6 billion. Even if this number is in the ballpark (given that they own the stock we can assume this figure is on the high side), if it takes 10 years for Sears to unlock this value through property closings, divestitures, redevelopments, etc. then the present value of these properties is actually a fraction of $8.6 billion. It’s not like they could just sell them all to somebody tomorrow.

The second problem I have with the stock is the supposed value ascribed to the company’s other assets. About half of the value of the company is outside of the real estate portfolio, according to Baker Street. The bulk of those assets include the Kenmore, Craftsman, and Die Hard brands, Lands End, the Sears online business, and the Sears home services and extended warranty businesses. Baker Street contends these assets taken together are worth another $6.8 billion. Keep in mind that the stock market values the entire Sears company at $6.2 billion today.

The core issue here is that Kenmore, Craftsman, Die Hard, Lands End, Sears Home Services, and Sears Extended Warranties all derive the vast majority of their revenue from Sears and Kmart stores. But what happens to these stores if Eddie Lampert decides to monetize the real estate by closing down stores, selling others, subleasing others, and redeveloping others? The value of all of these others brands declines dramatically. Good luck selling Lands End for a good price if you are in the midst of closing down Sears stores. Same goes for Kenmore, Craftsman, and Die Hard. Sure, those brands could be sold in other retail stores if they were independently owned, but the revenue gained would just be offset from the fact that Sears and Kmart stores were disappearing. In my view, Sears can either become a real estate company and shut down its money-losing stores, or it can continue to operate as a retailer with multiple owned brands. What it can’t do is realize the full value of both at the same time, and yet that is exactly what Baker Street Capital (and other bulls on the stock) claim.

If you ask me, Sears should go the real estate route. It may take a long time, but shareholders should see some tangible benefits over time. Consider Seritage Realty Trust, the new company within Sears that holds 200 properties (or about 10% of the total). According to the Seritage web site, those properties control about 18 million square feet of space. Let’s assume they are redeveloped and can generate $30 per square foot, on average. That equates to $540 million of annual net operating income. If Seritage was IPO’d it could be worth about $8 billion (at a 7% cap rate). That is why Sears shareholders have a margin of safety in the stock and why it is not going bankrupt. However, since that process would take so long to implement, it is also the reason why Sears stock today is not anywhere near the $100+ per-share valuations the bulls claim it is worth in a break-up scenario.

Full Disclosure: No position in Sears stock and long Sears bonds at the time of writing, though positions may change at any time.

Hedge Funds Move In As Ackman Sells, But JC Penney Still Far From Running At Break-Even

For some reason Pershing Square’s Bill Ackman decided to bail on his near-20% stake in struggling retailer JC Penney (NYSE: JCP) at a 50% loss after being instrumental in the company’s recent troubles. Classic buying high and selling low (when the pain becomes too great) case here. As has been the trend lately, hedge funds are coming in and buying what Ackman is selling (Herbalife being the most recent example). Glenview Capital and Hayman Capital have announced large stakes in recent days and now a handful of hedge funds (adding in Soros Fund Management and Perry Capital) own about a third of the company’s common stock. At $14 per share, JCP’s equity is worth about $3 billion, excluding net debt of more than $4 billion.

I have written quite a bit about JC Penney over the last year or two, since Ron Johnson was hired as CEO and then fired after implementing a disastrous plan, and I am baffled as to why these hedge funds are so bullish on JCP at this point in time. The seeds for a turnaround have certainly been planted with Mike Ullman’s return as CEO, but from what I can tell from the numbers, it is going to take a while before they really start to grow. Perhaps these funds are playing JCP for a quick trade to the upside, which would make sense given that Ackman’s sale represents capitulation at its best (or worst, depending on your perspective), but it appears premature to bet on a sure-thing turnaround at JCP longer term. Let’s look at the numbers.

Thanks to Ron Johnson’s blunders, JCP’s sales this year should come in around $12 billion, down from $17 billion a few years ago. Operating costs (SG&A) for the prior four quarters came in at $4.4 billion, and have been slashed lately to preserve cash. Although the company’s gross margins are nowhere near their historical average of 37% today, CEO Mike Ullman is making the right moves to reach those levels again, in 2014 if you are optimistic.

Retail companies are not that hard to analyze and from these few figures we can figure out what level of sales JCP needs to reach cash break-even again, a crucial goal post if you are going to see a prolonged turnaround in the company’s share price performance. With 37% gross margins and $4.4 billion in annual SG&A costs, JCP’s operating break-even point is $12 billion at first glance, but the company is losing lots of money right now due to elevated capital expenditures and a huge debt load, which has only risen as the company’s sales have plummeted. Throw in $300 million of annual capital expenditures going forward (guidance from management) and $500 million of annual interest costs, and JCP actual cash break-even level is $14 billion of annual revenue. That means sales would have to rise 15% from here just to reach break-even. Could that happen in 2014? It could, but that seems quite optimistic. 2015 is probably more likely.

But even if you assume that sales rebound and the company stops bleeding cash, I don’t think JCP shares are that exciting at today’s $14 price. Macy’s and Kohl’s are very good department store comps for JCP. Both trade at about 6 times cash flow. Let’s assume JCP’s sales continue climbing and reach $15 billion by 2016. Assuming margins hold steady, JCP will have annual cash flow of about $1.1 billion. Multiply that number by 6 times and net out $4.3 billion of net debt and the equity would be worth about $2.3 billion, or $10 per share. In order for JCP stock to zoom back into the 20’s and stay there, the company has to be cash flow positive and begin paying down some debt (every $100 million of debt repayment would boost that $10 fair value price by 50 cents). Given that it will take a year or two for JCP to reach break-even, it looks to me like these hedge funds might be too early to the JCP stock turnaround party.

Full Disclosure: Long JCP senior notes maturing in 2018 at the time of writing, but positions may change at any time

An Inside Look At Why Sears and Kmart Never Turned The Corner

Longtime readers of this blog will remember that for a while I was a believer in Eddie Lampert’s ability to breathe new life into Kmart and Sears by more efficiently allocating capital within the companies. I started writing about the investment idea in 2005 and followed up probably a dozen or two times over the years. Although the investment was a profitable one for me and my clients (I sold long ago after it was obvious that Lampert was not going in the same direction as many of us had expected), it was also one of the most frustrating investing situations I can remember because so much potential was squandered. Had Lampert used the profits from Kmart and Sears (yes, they actually did make decent money for a while under his ownership) to diversify into other, more attractive businesses, Sears Holdings could have been a huge success. Instead, he honestly believed that a hedge fund manager could run a retailer (from his office in Connecticut) better than retailing veterans could from the company’s headquarters outside Chicago (he has not).

If you are interested in some of the behind the scenes that has gone on at Sears and Kmart in recent years (it’s been an absolute debacle), Bloomberg BusinessWeek has published an excellent article that can be found at the link below:

At Sears, Eddie Lampert’s Warring Divisions Model Adds To The Troubles

It’s a great read. And no, the stock is not a bargain today. At the current price ($45 per share), the company has an equity value of $5 billion and another $3 billion of net debt. I can’t see how the enterprise is worth $8 billion. That said, the company’s debt looks interesting (I think it’s money good).

Full Disclosure: Long Sears Holdings bonds at the time of writing, but positions may change at any time

Sears: The Break-Up Plan Continues Without Any Payoff For Equity Holders

Sears Holdings (SHLD) continues its unofficial, informal break-up plan as it struggles to maintain adequate liquidity amid a money-losing core business. The company’s stock is the largest loser in the S&P 500 today as first quarter results showed EBITDA of about break-even. Chairman and majority shareholder Eddie Lampert has assumed the CEO position, but without any direct retail experience even a very smart investor is unlikely to lead a successful turnaround.

The latest tidbit from Sears is that they are contemplating a sale of their asset protection business. Sears is one of the only large retailers that actually offers extended warranties in-house (as opposed to partnering with a financial services company), giving it another asset it could sell or spin-off in order to realize value for shareholders. The company publicly stated yesterday that it believes the business to be worth in excess of $500 million. While breaking up Sears Holdings is the right decision for shareholders, several of the company’s first moves in that realm have not really helped boost the share price, mainly because the underlying business is so bad that all sale proceeds (Sears Hometown and Outlet Store spin-off, Orchard Supply IPO, Sears Canada share sale, etc) are merely offsetting those losses and not adding any value on a per-share basis.

Even after today’s drubbing, Sears’ stock still has a total market value of $5 billion. Add in nearly $3 billion of net debt and I simply cannot justify an $8 billion enterprise value for Sears Holdings in its current form. Not only that, but the company keeps selling off its most profitable segments (because the other ones aren’t profitable, read: valuable), which leaves them with a set of even more unattractive assets on a relative basis.

While I do not want to invest in SHLD common shares at $48 a share (it would have to drop into the 30’s for me to become even mildly intrigued), I think the company will slug along for many more years. As a result, the company’s debt may be a much smarter investment than the common shares. Long-term debt excluding leases totals about $1.6 billion. The majority of that consists of $1.24 billion of 2018 senior notes that pay a coupon of 6.625% per year. At current prices, Sears’ long-term debt yields about 7%, which is a very solid return for a five-year debt security.

Full Disclosure: Long Sears long-term debt securities at the time of writing, but positions may change at any time

Netflix and Tesla: Early Signs of Froth in a Bull Market

It is quite common for a bull market to last far longer than many would have thought, and even more so after the brutal economic downturn we had in 2008-2009. Only just recently did U.S. stocks surpass the previous market top reached in 2007. Although it does not mean that a correction is definitely imminent, the current stock market rally is the longest the U.S. has ever seen without a 5% correction. Ever. Dig deeper and we can begin to see some froth in many high-flying market darlings. Fortunately, we are not anywhere near the bubble conditions of the late 1990’s, when companies would see their share prices double within days just by announcing that they were launching an e-commerce web site. However, some of these charts have really taken off in recent weeks and I think it is worth mentioning, as U.S. stocks are getting quite overbought. Here are some examples:

TESLA MOTORS – TSLA – $30 to $90 in 4 months:


NETFLIX – NFLX – $50 to $250 in 8 months:


GOOGLE – GOOG – $550 to $920 in 10 months:



You can even find some overly bullish trading activity in slow-growing, boring companies that do not have “new economy” secular trends at their backs, or those that were left for dead not too long ago:

BEST BUY – BBY – $12 to $27 in 4 months:


CLOROX – CLX – $67 to $90 in 1 year:

WALGREEN – WAG – $32 to $50 in 6 months:



Ladies and gentlemen, we have bull market lift-off. My advice would be to pay extra-close attention to valuation in stocks you are buying and/or holding at this point in the cycle. While the P/E ratio for the broad market (16x) is not excessive (it peaked at 18x at the top of the housing/credit bubble in 2007), we are only 15-20% away from those kinds of levels. Food for thought. I remain unalarmed, but definitely cautious to some degree nonetheless, and a few more months of continued market action like this may change my mind.

Full Disclosure: No positions in any of the stocks shown in the charts above, but positions may change at any time