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:

BakerStreet-Slide123

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.

BakerStreet-Slide40

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.

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

  1. Thanks for taking the time to write the article. Couple comments/questions.

    First, it seems like you are attempting to negate the entire Sears Holdings real estate thesis by picking property from Sears Canada. Perhaps Baker Street over-estimated the Canada properties? Regardless, when I look at Sears I look at the real estate that Sears Holdings owns, anything in addition to that (like the large stake in Sears Canada), is just gravy.

    Second, paraphrased “he was buying around $40 but didn’t think the stock was nearly as cheap at $60.” Ummm, yeah? Neither do I! It seems like you are trying to get into the head of Lampert which I think can be very difficult. He didn’t sell any of his personal shares, which I think is key. If I was giving shares to partners who wanted to sell, to the tune of 7M shares, I probably wouldn’t rush out to buy them myself. I would likely wait a little while and see if the price drops.

    Your thoughts? Thanks.

    • Chad Brand on December 5, 2013 at 10:00 AM said:

      @Mark:

      Thanks for the comments. The first thing I thought when I read through the Baker Street presentation was that the core of the analysis was correct (very high margin of safety in the 40’s given the asset base, even if retail never returns to profitability), but that their estimates were too optimistic in many cases. I used the Eaton Center value example to show how that could play out.

      I would disagree that because it was a Canadian store (and therefore SHLD only has direct claims on 51% of its value) then the overestimation is less relevant. Baker Street’s real estate thesis was that most of the value was in the top 400 properties. Eaton Center is probably in the top 10 in terms of value. If they aren’t accurate on the most valuable properties, then you have to discount the total real estate value they projected for SHLD ($8 billion+). It should not be any more difficult to value a Canadian store vs a U.S. store as mall real estate is valued the same way in both countries.

      That said, I was not trying to say that the real estate “thesis” was negated. I am just saying their break-up values are more likely to be too high rather than too low. Their investment thesis is certainly correct, it’s just a matter of price.

      As for Lampert’s recent redemptions, we can only speculate. He is not exactly direct in communicating his views to his fellow shareholders. Plus, it’s one data point so we can’t draw any huge conclusions. That said, if he is buying personally between 40 and 45 and not buying in the 55-60 range, I believe that may very well help us understand what he believes to be fair value for the stock. If he agreed with Baker Street and thought SHLD was worth at least $92 today (and perhaps as high as $130 or whatever their high end figure was), I would think he would be aggressively buying in the 50’s too.

      Given that Baker Street ignored the time value of money, I think there is a huge difference between paying $40 and $60 today (from an ROI standpoint). Who knows if Eddie would agree, but his actions suggest perhaps he would. All we can do is speculate with SHLD, since he refuses to even issue a press release announcing something important for value-oriented holders, such as the formation of Seritage Realty Trust. As for the idea that he wants to keep the stock down so he can buy more (hence no PR about the accelerated transformation steps), he isn’t buying more so I’m not so sure that is the explanation…

    • Thanks for the response, Chad. I agree that Baker Street’s valuation may have been too high (and it may not have been too high), time will tell. The part I focus on in any investment, and the part we seem to agree on, is that there is a large margin of safety in the $40’s given the assets of SHLD. I would argue there is a margin of safety well above $40, but for argument’s sake we’ll just say $40.

      Lampert has never been one to talk about what he’s doing behind the scenes. It’s in his nature to keep his cards hidden. He realizes the odds would be pretty high that the stock would rally, and maybe never come back down, if he mentioned Seritage, Ubiquity, all the other subsidiaries, etc. He doesn’t need, or want, the stock to rally. Small investors and fund managers that have quarterly benchmarks to meet want immediate returns, Lampert seems like he just doesn’t care about the short-term. And I’m glad. I want an owner/operator focused 100% on value generating activities that will yield the best results 20+ years from now, not 20 days from now. That was my long-winded way of saying, as a shareholder, I don’t want him to disclose any more information than he already has. This all reminds me of a quote… Media mogul David Geffen, who has invested with Lampert since 1992, recalls insisting to him at one point, “I want to know where the hell my money is.” Lampert refused to tell him. http://money.cnn.com/2006/02/03/news/companies/investorsguide_lampert_stockpicking/index.htm

      By the way, glad you joined us over at the Corner of Berkshire & Fairfax message board :-)

    • Chad Brand on December 7, 2013 at 3:42 PM said:

      Glad to join you all on the board!

      I guess I’m not convinced he has a dual goal; maximize intrinsic value AND keep the stock as low as possible. If he had a ton of money invested elsewhere and we thought he was going to increase his stake in SHLD meaningfully in coming years, okay, stay quiet and reallocate your capital into it. But he already owns 25M shares and has full control. Unless you think he wants to acquire every last share and essentially have him and Berkowitz own the entire company, why would he care if the stock goes up? He can still ignore the press and go about his business privately. As an investor, I would want more disclosures about what exactly is in each subsidiary so I could come up with a solid estimate of intrinsic value. Just because he owns more than anyone else doesn’t mean he is entitled to any more information than other investors are.

    • I do think he wants every last share if he could possibly get his hands on it. “Eventually he’ll (Lampert) own one share and I’ll own one share…” – he was exaggerating, but I don’t think Berkowitz was far off on this comment.

      Check out SHLD’s liquidity position… it’s impressive. I’d be more surprised if he doesn’t do a buyback in the next 24 months than if he does. And Lampert has >$1B in other investments in ESL that he could turn into SHLD shares if he wants. Or he could do both.

      I definitely think he wants more of the company because he knows better than anyone the goldmine (with a margin of safety to boot!) he is sitting on.

      I can understand frustrated shareholders wanting more info, after all it’s a public company. But I believe operating a bit under the radar and not showing every card in his hand allows him to make moves (operationally and/or investment) that he otherwise wouldn’t be able to make.

    • And I should add that my perspective is probably different than most longs because I’ve only been a shareholder since earlier this year. I don’t have the emotional pain of having been invested for the past decade. But the reason I started to invest this year is that Lampert took over the CEO role (officially) and has been making a lot of moves. The hiring of Lukes and Schriesheim are just a few of the moves made in the past couple years that I really like… and moves like that get hardly any press.

    • Chad Brand on December 7, 2013 at 4:26 PM said:

      Well, if his goal is to own 80% (or whatever Bruce doesn’t own) then I can see what you are saying. But then why even be a public company at all? Just take it private.

      I’m surprised you are impressed with SHLD liquidity position; $600M of cash, plus $260M coming from the Sears Canada dividend, and $1.0B borrowing capacity left on the credit facility. Given the amount of money the company burns through every quarter. I don’t see how they can possibly start more buybacks anytime soon.

  2. Chad,

    Looked for an email but could not find one so have to post here:

    Coupe items:

    Eaton Center: Sears is keeping the top four floors of the complex to run HQ. They did not sell the entire building. there is no detail on how much sgft was sold in the sale but we can’t assume Baker was that far off without knowing the details. I am guessing the store itself not NOT 800K sqft and that the numbers included the space Sears is maintaining a presence in

    Lampert’s “non buy”

    Under the ESL Partners agreement, all redeeming holders have to be treated the same, so, either Lampert bought all ~$450M of the shares or none. Without knowing his personal finances, I’m gonna assume he does not have that in petty cash.

    If one knows that, his not buying is reasonable….

    I am going to post a rebuttle for this for my subs but not publicly (not my style) but I think you might want to revisit some of this

    • Chad Brand on December 5, 2013 at 11:21 AM said:

      @Todd:

      Office space is far less valuable than retail space in a major shopping mall. While Sears Canada is keeping office space in Eaton Center, the vast majority of the value to the landlord is the retail space. I don’t think there is any doubt they were pretty far off, though you are right that we don’t know exactly.

      As for the hedge fund redemptions, I don’t think you are correct that Lampert would have had to buy all 7M shares himself. Just because LPs have to be treated the same does not mean they have to accept all stock or all cash. They could all receive a 50/50 split, 25/75, 75/25, etc. If Eddie wanted to buy shares from them, he could have bought any amount he wanted, but he chose not to this time (for reasons we’ll never know).

  3. Brad,
    just a question: what debt of Sears are you holding? I personally held some of the long dated sears roebock acceptance bonds but I sold them over the past few months. They sport a very decent yield and trade substantially below par but after looking deeply into SHLD (as deep as I can being just a retail guy) I wouldn’t touch Sears’ debt, except for the senior notes coming due within a couple of years. those do not yield enough for me to hold them, though. The other notes could well end up being pretty much worth zero after Lampert is done restructuring SHLD. Almost all of them (if not really all of them) are not guaranteed by the holding company. You could end up holding bonds of a worthless subsidiary in the worst case scenario….

    • Chad Brand on December 5, 2013 at 12:01 PM said:

      @fxfx:

      My firm holds the debt that matures within the next five years (2017 and 2018 — both HoldCo and SRAC paper) and the positions are weighted based on the risk profiles. In my mind annual yields of 8-10% are solid given the current rate environment and the asset base of the company.

      I am not interested in the 2027-2032 maturities… too long of a time horizon for anything to happen…

    • Hi Chad,
      Is SRAC unsecured guaranteed by HoldCo?

      Thanks.

    • Chad Brand on December 6, 2013 at 2:58 PM said:

      It’s not guarantee by SHLD. SHLD didn’t exist when the 2018 debt was issued (1997). However, Sears Roebuck owns a heck of a lot of real estate.

  4. More bad news for supporters of the Baker Street analysis: Lands End spinoff means no cash raised for Sears Holdings AND the Baker Street’s $1.4B valuation estimate will be way too high. In 2012 Lands End had $1.59B of sales and $108M of EBITDA. I doubt it can get a public market valuation higher than 7-8x cash flow, which would mean about $750M. That shaves another $6 off of Baker Street’s “break-up” value for SHLD.

  5. “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).”

    Keep in mind that (1) Lampert is likely winding down his fund, and (2) SHLD’s liquidity position is notable.

    If he is winding down his fund and has plans on making SHLD his permanent investment vehicle, wouldn’t it make more sense to have SHLD buy shares instead of Lampert himself? He can use SHLD’s liquidity, and none of his personal money, to buy a huge chunk of shares. Get the outstanding share count down to 90M and he’s effectively increased his, and everyone else’s, ownership percentage by roughly 10%.

    Assuming he plans on closing ESL and using SHLD as his vehicle, why wouldn’t the above make sense long-term?

    • Chad Brand on December 7, 2013 at 3:51 PM said:

      It would be the first instance I can recall where the goal of the majority shareholder and CEO was to keep the stock price as low as possible for as long as possible. Yes, SHLD could buy back stock at low prices whenever it gets back to being free cash flow positive, but if the true value of SHLD is never actually able to be easily understood by investors, then the stock won’t rally. And if it doesn’t rally, then the buyback is not a good use of shareholder capital. Keeping things close to the vest is one thing, purposely refusing to give many details in SHLD’s SEC filings is quite another. The idea that he is very smart so we should just trust him sounds great on the surface, but how has that worked out for shareholders over the last decade?

    • “It would be the first instance I can recall where the goal of the majority shareholder and CEO was to keep the stock price as low as possible for as long as possible.”

      Me too. His goals are much different than most CEO’s. And most CEO’s aren’t the largest shareholders. Most CEO’s aren’t amazing capital allocators.

      “Yes, SHLD could buy back stock at low prices whenever it gets back to being free cash flow positive, but if the true value of SHLD is never actually able to be easily understood by investors, then the stock won’t rally.”

      It’s not easily understood right now because changing a bricks-and-mortar retailer into an all-out holdings company is not taught in business school. Did your professors ever discuss how to value that? Mine sure didn’t. And just because it isn’t simple to understand now doesn’t mean it won’t be in the future once Lampert has finished doing what he wants to do while limiting the spotlight being shined upon him. Reading the filings this year Lampert has been a bit more open about his plans and I would expect even more of that in the coming years.

      “And if it doesn’t rally, then the buyback is not a good use of shareholder capital.”

      As a shareholder I don’t care one bit if the stock rallies as a result of any buyback. I care that the share count shrinks and I own a larger piece of the pie.

      “The idea that he is very smart so we should just trust him sounds great on the surface, but how has that worked out for shareholders over the last decade?”

      When looking at an investment I look at where it’s going and compare that to the price being paid, instead of looking back. If I did the latter I would not have large positions in names such as AIG, BAC, and certainly not SHLD.

    • Chad Brand on December 8, 2013 at 12:49 PM said:

      All companies are valued the same. PV of future FCF. It doesn’t matter how many different businesses you have. There’s no secret formula to valuing SHLD, it’s just harder because the assets have and will continue to be shuffled around and we have very limited information.

      You should absolutely care if he buys back stock and it doesn’t rise above the purchase price in a reasonable amount of time (not “because” of the buyback, because the value of the business rises). If it doesn’t it was a poor allocation of capital and you would have been better off receiving a dividend and reinvesting the money elsewhere.

    • I simply don’t care what Mr. Market thinks about SHLD in the near future, buybacks or no buybacks. Buybacks would increase my ownership percentage and that’s the ONLY thing I’m focused on now and for the next few years. I know that’s an abnormal approach but in my career as a full-time investor it has resulted in abnormal returns. Patience is probably the most profitable of all disciplines when it comes to investing.

  6. By the way, congrats on being quoted in the recent Chicago Business article!

  7. I don’t disagree with your analysis. SHLD is a very complicated story.

    However, Baker Street Capital has been spot on (no affiliation to them) with multiple companies that I have seen.

    Another one this week is XRTX to which they purchased 22% of the company and advocated for change.

    • Chad Brand on December 24, 2013 at 11:32 AM said:

      @ Josh:

      I think the odds are very good that Baker Street makes some money on their SHLD investment, I just disagree with the magnitude of their figures, not the general thesis itself.

      Interesting you bring up XRTX, which announced a sale for $13.25 to Seagate. In their January 2013 letter to the board, Baker Street “conservatively” estimated a fair value range on XRTX of $13.88-$19.61 per share. And here they are selling for $13.25 with Baker Street’s support.

      I think that further supports my view that their estimates tend to be on the high side. I agree that the risk-reward looks attractive with SHLD. I just think the reward is not quite as high, and the time required will be substantial.

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