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?

shld-sept-2013

 

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.

sears-store-counts

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:

st-paul-office

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.

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9 Thoughts on “Sears Holdings Transformation Picks Up Steam, But Will Still Take Years

  1. “If Seritage was IPO’d it could be worth about $8 billion (at a 7% cap rate).”

    And how many times have you heard the media mention Seritage? How many people even know it exists? To be conservative, cut that $8B estimate in half to $4B and you’re still looking at 75% of the entire market cap of SHLD (or ~$37/share) tucked away in one subsidiary, based on SHLD’s market cap today of $5.3B ($50 * 106.5M shares).

    • Chad Brand on December 5, 2013 at 10:23 AM said:

      @Mark:

      Two points:

      1) SHLD has an enterprise value of $10B. You can’t ignore the debt. You need to compare Seritage’s potential value to that number, not the equity market cap. If Seritage was spun out it would not take any of the debt with it, so the stub’s value would go down because it would have to support all of the debt with far less of an asset base.

      2) You are making the same mistake Baker Street made re: ignoring the time value of money. Seritage could be worth $8B after it leases out all 200 properties/18M square feet, but that will take years to accomplish. So it’s not worth anywhere near $8B (or even $4B) today. You have to use the present value of Seritage’s future free cash flow, since it has no free cash flow right now.

    • (1) See my comment to #2, they more or less go hand-in-hand.

      (2) Yes, definitely not worth those amounts today. I’m a former senior accountant and understand present value, discounted cash flows, etc. There’s no way to place an accurate value on Seritage today, but given that $4B-$8B is even within the realm of possibility (even if it’s 3-4 years from now) still hints at the tremendous value within SHLD.

    • Chad Brand on December 7, 2013 at 3:34 PM said:

      And I guess that’s really where we likely disagree (re: the true intrinsic value of SHLD). Even using Baker Street’s low-end value for the real estate assets ($7B), which at this time I think is quite generous, I don’t come to the conclusion that SHLD is enormously undervalued. I can get to a $50-$60 value and still not feel like any of my assumptions are unfairly pessimistic.

  2. What do you think about the comment below? This comment was indirectly responding to your article:
    “Those who believe it will be impossible to shrink K-Mart and Sears Roebuck without causing massive operating losses and destroying the value of associated brands and businesses haven’t been paying attention. If this is a high-wire act, Lampert has built a substantial safety net in which to catch all of his valuable assets.”
    http://seekingalpha.com/article/1712152-has-sears-holdings-reached-the-tipping-point

    Seeking Alpha, I know, I know. 🙂 …but still curious of your thought on that comment.

    • Chad Brand on December 7, 2013 at 9:12 PM said:

      I read the entire article (I was even cited!) and the main problem I have with it is that there were absolutely no numbers backing up any of the assertions. It did a great job of articulating the bullish thesis (as many SHLD longs do quite frequently) but the numbers simply do not support the conclusions.

      For instance, Eddie has been shrinking the retail business for many years now and the pace is picking up year-to-year. Maybe not as fast as many would like, but to the tune of several hundred stores so far nonetheless. And what has happened to cash flow and the value of the company’s brands? Massive losses and deteriorating value of the brands due to falling sales (exactly what the author claims is NOT happening).

      SHLD reported negative free cash flow of $300M in 2010, $700M each in 2011 and 2012, and $1.9 billion through the first 3 quarters of 2013. That’s $3.6 billion of losses in under 4 years. How much stock market value has been lost since the beginning of 2010? Well, SHLD stock has gone from 83 to 48. That’s a market cap loss of $3.5 billion. Coincidence? I think not. So no, he has NOT been able to avoid massive losses while shrinking the business. Debt is rising to cover the difference between the asset monetizations and the retail losses.

      And then there are the brands. That article mentioned a $1.5B value for LE, but I would guess the stock will open at half that. Why? It’s a poorly positioned brand that is not managed well. Will that change? Unlikely. Rather than get out of Sears retail stores (where they make no money — we just learned) they are not only staying put but are even going to start paying rent! So the losses in-store will get worse! Yes, Eddie swaps an apparel company for rental income to fit the real estate mold, but trading $100M in annual EBITDA for a a fraction of that in rental income reduces the value of SHLD post-spin off.

      Orchard Supply was supposed to thrive as an independent company outside of SHLD. What happened? It went bankrupt. Why? Because it was weak company all along. LE won’t go under, but it’s revenue was the same in 2012 as it was in 2002 when Sears bought them. They are losing market share and are in no position to grow strongly. That is why no private equity firms were interested in buying it from Eddie.

      The same goes for Kenmore, Diehard, Craftsman, Sears Auto Centers, Sears Home Services, and Sears Warranties. Sales of those products go down as traffic through existing stores drops and other stores are closed completely. Most of SHLD’s assets (outside of the real estate holdings) are intertwined so together they are a melting ice cube.

      I understand the bullish argument, and I actually want to buy into it (who wouldn’t want to invest in a misunderstood undervalued security with little correlation to the broad market?), but when I look at the assets they have and run the numbers, I don’t see how this company is worth $100+ like Baker Street asserts. Not with what is actually happening in terms of cash flow, debt, asset sales, etc.

    • Only have a minute so this will be short. They are much closer to being FCF positive than people think. Pension liability payments are, what, about $350M/yr? And SYW points cost $250M-ish. Regarding the pension, every 1% rise in interest rates cuts about $500M off the pension… and those numbers don’t hit the financials until year-end according to GAAP.

    • Chad Brand on December 8, 2013 at 12:43 PM said:

      I see no evidence that the retail operations are improving, so I don’t see why FCF would all of the sudden turn around.

  3. If pension liability payments were removed the company would be FCF positive. I know that’s like saying “If the Redskins didn’t have 10 losses then they’d be a pretty good team” but the falling interest rates have hurt SHLD bad, and rising rates will help them tremendously.

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