Investors have been reallocating capital out of Amazon ($AMZN) shares fairly heavily since the company reported a lackluster fourth quarter earnings report. After peaking over $400 in January the stock has dropped about 75 points to the low 300’s. In fact, I actually think the stock is beginning to look compelling for long term investors, if you believe Amazon will continue to successfully enter new markets, as the shares now fetch only about 1.5 times 2014 revenue (after deducting net cash). While profit margins remain low (cash flow of $5.5 billion in 2013 equated to only 7.4% of sales), those that claim Amazon makes no money don’t seem to dig into the company’s financial statements very deeply.
All of that said, after looking at Amazon’s sales trends over the last 15 years, I believe that Wall Street is currently overly optimistic about sales growth at Amazon for the next two years. If you believe that investors will be focused on sales growth, in lieu of material profit margin gains in the intermediate term, it would imply that Amazon bulls can take their time building long-term investments in the stock over coming quarters.
So why do I think Amazon will be hard-pressed to achieve the current consensus estimates for sales in 2014 (up 21% to $89.9 billion) and 2015 (up another 20% to $107.6 billion). First, let’s look at Amazon’s annual sales since 1998:
Simply looking at this data may cause you to feel pretty upbeat about Amazon’s business. Over the past 15 years sales have grown an astounding 41% per year, rising from under $1 billion in 1998 to nearly $75 billion in 2013. Is it really a stretch to asssume that two more years of 20%+ growth could be in the cards?
The problem Amazon is going to begin to face is the fact that once you reach a certain size, it becomes nearly impossible to continue to grow at 40%, 30%, or even 20% per year. Finding an additional $15.4 billion of revenue in a single year (the incremental figure analysts estimate Amazon will book in 2014) is no easy feat. In fact, Amazon’s total revenue in 2007 was just $14.8 billion, so “2014 Amazon” must equal “2013 Amazon” plus “2007 Amazon.” With annual revenue approaching the $100 billion level, the company’s growth rate is likely to begin to slow soon.
Is there any way to know when exactly growth will decline significantly? Not really, but one of the numbers I like to focus on is incremental revenue growth, in dollars, from one year to the next. As a company gets larger and larger, the amount of incremental sales growth needed simply to maintain its growth rate rises fairly sharply. In fact, if we chart out Amazon’s incremental annual sales growth since 1999, we can see patterns emerge:
For instance, between 1999 and 2006 Amazon was able to grow sales by between $1-2 billion a year (roughly). That figure rose to $4-5 billion from 2007-2009, and accelerated to $10 billion in 2010 after the recession ended. Interestingly, over the last three years Amazon has hit a wall. In both 2012 and 2013, incremental sales growth at Amazon failed to eclipse 2011 levels. I believe this could be the beginning of a period where we see Amazon’s sales growth slow materially.
Perhaps problematic, the current Wall Street consensus forecast calls for Amazon’s incremental revenue growth in dollars to reaccelerate to more than $15 billion this year, and again to nearly $18 billion in 2015 (look at the orange bars in the above chart). While there is no assurance that this figure cannot continue to climb, there will be a time when Amazon simply cannot continue to find that much new revenue each and every year (without making large acquisitions anyway, not something they have typically done). Given that a disappointment in merchandise sales growth has been a key driver of Amazon’s recent stock market weakness, I believe it is entirely possible that both 2014 and 2015 sales forecasts are too high. Maintaining annual sales growth of 20% for much longer seems unlikely, perhaps even starting this year.
As I mentioned at the outset of this article, however, I don’t necessarily think this would spell the end of Amazon’s stock market stardom, at least not long term. If Jeff Bezos is willing to show investors that he is willing to demonstrate that profit margins can be susteained at levels above those currently being attained, investors would likely be very pleased and any short term stock decline would quickly be reversed. After all, annual sales approaching $100 billion offer Amazon the ability to generate some very impressive free cash flow, which would make the stock’s current market value of $150 billion seem not so unreasonable.
In coming quarters, I will be focused on Amazon’s sales trends and if I am correct and the current consensus forecasts are too aggressive, any continued short-term weakness in Amazon shares could present investors with an excellent opportunity to continue building a long-term position in the stock.
Full Disclosure: Long AMZN at the time of writing, but positions may change at any time
Sears doesn’t have a sales problem, it has a profit problem. Whether you agree or not (my personal view is that a sales problem both contributes to, and serves to exacerbate, an underlying profit problem), that’s the conclusion drawn by CEO Eddie Lampert. As a result, he is closing dozens of stores and trying to figure out ways to make others smaller (and therefore perhaps more profitable).
In fact, Sears has a relatively new subsidiary called Seritage Realty Trust that has been given the task of managing (read: restructure and/or redevelop) about 10% of Sears’ locations. Seritage has its own web site, with many of its projects listed. Included on that list are locations tagged for a “box split,” which means they would like to subdivide the current store and rent out space to another retailer. The thesis is that Sears will make more in rental income from the subleased square footage than it did using it to sell Sears’ inventory. In addition, they could see sales per square foot increase in the Sears store that remains open by rationalizing their product selection. Overall, it’s an interesting strategy with potential, but since it is early in the process it is also largely unproven.
There are only 9 “box split” store candidates listed on the Seritage web site and it just so happens that one of them (the Alderwood Mall store in Lynnwood, WA) is only about 30 minutes north of my home in Seattle. This past weekend my wife and I drove up there to check out a new mall (we’ve only lived here for about 6 months) and see what, if anything, of note was happening at the Sears store. Perhaps not surprisingly (given that we are talking about Sears after all), there were some good things, some bad things, and some strange things going on.
First, some good things if you are rooting for Sears to find its footing:
1)The Alderwood Mall is a high-end mall (owned by GGP) located in a suburb of a relatively wealthy city.Sears owns the store outright (it’s not leased). The two floors are 82,000 square feet each, excluding a 13,000 square foot Sears Auto Center attached. You might not think the fact that the mall is high-end jives with the core Sears customer (and I would not disagree), but the real value here is in the fact that the real estate is owned and high end mall space is worth top dollar.
2)This store (not surprisingly given it was selected for Seritage’s portfolio) appears to be an excellent candidate for a “box split.” At ~165,000 square feet it has more floor space than Sears really needs (you should see how many clothes this place is stocking), and it has two exterior entrances but just one mall entrance. This means Sears could split the box in such a way that another retailer could occupy half of the first floor (40,000 square feet) and have a dedicated entrance from the parking lot, while Sears could retain one exterior entrance as well as a mall entrance. Here’s a map of the mall:
3)Despite Sears being known for skimping on capital expenditures since Eddie Lampert took over as Chairman, this store was not falling apart like many others. In fact, it appeared to be in very good condition despite being built in 1979. It’s good to see that capex reductions are not happening at the “best of the best” locations in the Sears property portfolio.
So that’s the good news. But it’s not all good, especially considering that this idea is still very much a development concept. There were no signs of any construction or preparation work being done in the store that would lead one to believe any tenant is close to signing a lease at this location and has asked Sears to get the ball rolling.
You can probably guess what kinds of things stood out as being “same ol’ Sears.” My biggest gripe with the chain has always been that Sears stores are almost always terribly disorganized, making for a miserable shopping experience. It boggles my mind when I go inside one because all I can think to myself is, “has a senior manager ever walked this store, and if they have, how could they not realize that if you simply cleaned up the clutter and organized the inventory in a better way, you would likely see better sales production?” It really doesn’t take much money (or any) to focus on organizing stores better, it’s just time and effort.
How bad was it? Well, how about some pictures:
As for Jackson Hewitt, that’s not the only place they are advertising; they are also targeting shoppers before they even get to Sears:
We also checked out the Lands End section. This is a case where not only does the merchandise they pair with the men’s clothing section make absolutely no sense, but I question why Sears even carries the products at all (stuffed bears in the kid’s section at least would make sense).
My wife was actually looking for Lands End socks, but couldn’t find any on the floor, so we asked one of the dedicated Lands End employees for assistance. Despite the fact that she only works in a small section of the store (Lands End shops in Sears stores average 7,400 square feet, which is less than 10% of the first floor of this particular store), she didn’t even know if they had any socks in stock. “It’s really hard to keep track of where things are,” she said. “They move everything around so much.”
So not only is the store disorganized for shoppers, but the Lands End employees can’t even keep tabs on their own inventory. Again, management here is a serious problem. Sears gets called out for skimping on store upkeep, but this is simply an organizational and inventory management issue having nothing to do with money. We finally found maybe 10 pairs of women’s socks on display after wandering the department for a few minutes. None of them were black (a common sock color!?), the color my wife was looking for, so we left the Lands End department empty-handed.
This brings up another issue, because a big part of Eddie Lampert’s “integrated retail” strategy involves carrying less inventory in the actual stores, but installing kiosks that allow you to order online while in the store, in case you need a size they don’t have, or one of the various colors that they don’t stock in physical stores at all. In one of the rare interviews he agreed to do, Lampert explained his thinking to the Chicago Tribune:
“The integrated retail part of our strategy is really about how you work between online, mobile and store, not just from a customer standpoint, but from a supply-chain standpoint,” Lampert said. “If we have a shirt in the store in four colors, we might have that shirt in 10 additional colors online. To have 14 colors in the store may be too risky because what you don’t sell, you end up losing money on, (compared with) having a group of it online that serves all the stores so that if people want more variety, they can get more variety.”
This may sound like a good idea at first blush, but most people who prefer to shop online aren’t coming to your store to then order at a kiosk or their smartphone. More likely, they are in your store because they want to try on or see the actual item prior to buying. If you don’t have black socks in stock, and there 100 other stores in the mall, I think that customer is more likely going to go buy from a competitor. Contrary to what Lampert seems to think, ordering online from an actual store is not always convenient for the shopper. If they wanted to order from your web site, they never would have driven to the mall. And if they wanted to buy a physical product from a store, they are likely going to find better selection elsewhere in that very same mall.
In addition, I am baffled as to why Lampert believes those extra 10 colors sitting in a warehouse awaiting an online order are any more profitable than those same colors sitting in the store awaiting an in-person buyer. Sure you could argue that warehouse space is cheaper than store space, but aren’t the odds higher that someone will see the product and make an unplanned purchase if the item is in a store and not sitting in a warehouse somewhere? Not to mention the fact that Sears shoppers tend to be older, so they are less likely to be avid technology users and more likely to prefer seeing and touching the product before buying it. I think Lampert’s integrated retail strategy might work better for some businesses than others, and I don’t think Sears is a good fit relatively speaking. Perhaps that is a contributing factor as to why sales trends are so poor right now.
Before heading out of Sears, I also checked out the hard lines department, the biggest segment for Sears. I was impressed with the hardware and tools section (one of the largest Craftsman selections I’ve seen) and then I ventured upstairs to check out appliances and electronics.
This just felt strange. Not a very inviting shopping experience. There was one employee manning the jail, and I doubt it would deter you from browsing if you were looking to make an immediate purchase, but it just seemed so unneccesary, and the first of its kind I have seen. I’d be curious to see if shoppers are less likely to browse an enclosed area like this, assuming they weren’t looking for something specific, just because it would feel like the employees were more concerned with making sure you didn’t steal something, as opposed to enticing you to buy something. My wife and I had a good laugh (and we didn’t go inside, though we did have to raise our voice to ask the saleswoman through the glass where the nearest restroom was located).
All in all, it was an interesting trip. Nothing really has changed about my view of Sears though. They still don’t seem to know what they are doing when it comes to creating a positive shopping experience, relative to their competition, and although they aren’t skimping on upkeep at this valuable piece of real estate, they don’t seem to really be focused on maximizing the profits from the store either. The potential redevelopment opportunity from a real estate perspective is definitely there, but progress is slow. At a mall of this caliber (it’s a combined indoor-outdoor complex that very much represents the typical high-end GGP mall), you would think Sears could really turn their 165,000 square feet into something unique and profitable. Time will tell.
Full Disclosure: In order to attend the 2014 Sears Holdings annual shareholder meeting (Mr. Lampert rarely speaks publicly outside of this event and this year I decided to go) I am long a small “odd lot” (i.e. less than 100 shares) of SHLD stock. However, this is merely to permit me to attend the meeting and not for investment purposes. In addition, I am long Sears bonds as an investment. Positions may change at any time.
They never give specific numbers, but Amazon (AMZN) always takes plenty of time in crafting their holiday press releases. Here’s an excerpt from today’s:
Holiday Fun Facts:
Amazon shipped to 185 countries this holiday.
The last Prime One-Day Shipping order that was delivered in time for Christmas was placed on Dec. 23 at 10:22 p.m. PST and shipped to Carlsbad, California. The item was a Beautyrest Cotton Top Mattress Pad.
The last Local Express Delivery order that was delivered in time for Christmas went to Everett, Washington. It was a Plantronics Audio 655 USB Multimedia Headset in Frustration Free Packaging ordered at 12:26 p.m. PST on Christmas Eve and delivered at 3:56 p.m. PST that same day.
Amazon.com shipped enough items with Prime this holiday to deliver at least one gift to every household in America.
Prime was so popular this holiday, that Amazon limited new Prime membership signups during peak periods to ensure service to current members was not impacted by the surge in new membership.
On Cyber Monday, customers ordered more than 36.8 million items worldwide, which is a record-breaking 426 items per second.
More than half of Amazon customers shopped using a mobile device this holiday.
Between Thanksgiving and Cyber Monday, Amazon customers ordered more than five toys per second from a mobile device.
Amazon customers purchased enough Crayola Marker Makers to be able to draw a line around the world four times.
The new Xbox One and PlayStation 4 gaming consoles were so popular that at the peak of sales for each console, customers bought more than 1,000 units per minute.
Amazon customers purchased enough Rainbow Looms from third-party sellers that the bands can stretch around the circumference of the Earth.
Amazon customers purchased enough Hot Wheels from third-party sellers to stretch around the Daytona International Speedway racetrack.
Amazon customers purchased enough miniature flashlights to satisfactorily light four collegiate football fields in accordance with NCAA standards.
Amazon customers purchased enough running shoes to provide a pair to every participant in the top 10 largest marathons in the world.
Amazon customers purchased enough winter boots to keep everyone living in three of the coldest cities in America – Duluth, Minnesota, Butte, Montana, and Watertown, South Dakota – warm for the winter.
Amazon customers purchased enough cross-body purses to outfit every attendee at a typical Taylor Swift concert.
If you stacked every Himalayan Crystal Lamp purchased by Amazon customers this holiday season, the height would reach the top of Himalaya’s highest peak – Mt. Everest.
Amazon customers bought enough books in the Divergent Series – “Divergent,” “Insurgent,” “Allegiant,” and the complete box set – to wrap around Chicago’s Pier Park Ferris Wheel 263 times.
If you placed every upright vacuum purchased by Amazon customers end-to-end, they would reach 15 times the depth of the Marianas Trench, the deepest point in Earth’s oceans.
If the Nylabone Dinosaur Chew Toys purchased during this holiday season were stacked on top of each other, they would be the height of more than 950 T-Rex dinosaurs.
The number of “Star Trek Into Darkness” Blu-ray combo packs purchased would span the distance of 25 Star Trek Enterprise space ships.
If you had a single plain M&M for each Eminem album purchased on the Amazon MP3 Store over the holidays, you’d have nearly 100 lbs. of candy-coated chocolate.
Amazon customers purchased enough youth archery kits to outfit every resident of Katniss Everdeen’s hometown, District 12, four times over.
Amazon customers purchased enough Tovolo Sphere Ice Molds to fill Don Draper’s (of “Mad Men”) whiskey glasses for 251 years.
Amazon customers purchased enough Cuisinart Griddlers to place one in every McDonald’s restaurant in the world.
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 SHLDto 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 $45 per share price when that time does come, I’m fine with that. Simply assuming Lampert has it all figured out given his intellect and vast ownership stake has not proven profitable for many, many years.
This is definitely a situation to watch carefully. If Lampert starts turning over a new page and shifts strategy, there could be plenty of good times ahead for investors. I simply do not have enough faith to assume he will come out smelling like roses, as he has proven over the better part of a decade that while he is a brilliant hedge fund manager, even this job is a lot more difficult than many initially believed. I would imagine he would agree.
Full Disclosure: No position in SHLD stock at the time of writing, but positions may change at any time (and in this particular case, you should know what to look for to know if they have).
Shares of Sears Holdings ($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.
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.
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
“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
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.
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