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

Shares of Sears Holdings ($SHLD) have traded significantly lower since my last two articles on the company. On November 26th I wrote an article for Seeking Alpha highlighting how much of a disaster Sears’ merger with Kmart has been over the past nine years (Believers In Sears Holdings Transformation Are Ignoring Eddie Lampert’s 9-year Failure). The stock was trading at $65 per share at that time. A little over a week later I followed up with a post on this blog about how the bullish case made by Baker Street Capital Management in September appeared to me to be overly optimistic (Baker Street Capital Management Bullish Thesis on Sears Holdings Begins to Show Cracks). Today the stock sits at $45 per share, about 30% lower in less than a month (and in my mind a far more reasonable price). So am I a buyer? Not yet, but I am definitely paying closer attention after such a large decline.

As I have dug deeper into Sears Holdings, I even went as far as to mimic the process Baker Street Capital Management undertook to try and gauge the value of the company (albeit with far less aggressive assumptions given my initial trepidation with their extreme level of bullishness). My conclusions so far have not turned me into a bull on the stock, but I can certainly see a path that could get me there; essentially a combination of attractive stock price and more clarity on the cash flow of the company over the next year or two (they burned through $1.9 billion of cash during the first nine moths of 2013).

For those who have even a mild interest in Sears Holdings I figured I would share a couple of other issues I have found with Baker Street’s wildly optimistic valuation ($92-$169 per share, depending on various scenarios). My beef with their presentation had nothing to do with their process, but rather the inputs they chose to use (and therefore the magnitude of the conclusions they drew regarding the value of Sears). Accordingly, below I will highlight a couple of additional issues I took with their numbers, as I try and figure out how much I believe the company may be worth (and what price I may want to re-enter the stock after a more than five-year hiatus).

1) Baker Street Appears To Miscalculate Its Own Estimate of Sears/Kmart Retail Operations’ Value

On slide 37 of Baker Street’s presentation the firm provides its internal estimates for the break-up value of the company under three different scenarios. The share price range from $92 (low) to $169 (high), with $131 as the midpoint. If you look closely you will see that the assigned values in each scenario for the core bricks and mortar retail business in the U.S. are ($4.0 billion), ($3.6 billion), and ($3.2 billion), respectively. They get to those negative values by taking their estimate of net working capital and subtracting both debt/pension liabilities and their estimate of how much it will cost to wind down unfeasible stores.

While I take no issue with their methodology, look at the slide more closely (below) and see if you can spot the same summation errors that I did. I added a blue box highlighting the section detailing the calculations in question.

Baker-Street-Slide37-Errors

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-Slide37-Errors-2

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).

Sears-Svc-Rev-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.

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

  1. baker street definitely had some errors in their presentation, but nonetheless useful to compare to gary halter, credit suisse’s bearish analyst, and figure out which one is closer to the truth. he has a 20-50 dollar liquidation. now he statically uses 3.3 bin for his re figure which is literally insane. he hocked jcp’s debt analysis and erroneously assumes all the stores will be closed prior to sale. i don’t get how you can’t use wide ranges when discussing real estate purchased a hundred years ago. i think if you compare the two which barons has done, you’ll find baker street is way more accurate. also i just checked the most recent presentation and they updated the figures to 85-158

    • Chad Brand on January 14, 2014 at 12:03 PM said:

      I agree that $55/sf for Sears’ owned RE might be low, but I think Baker Street’s numbers are off as well, so the right figure is likely in the middle.

      The problem with using comps like GGP and SPG for Sears RE is that Sears has not yet vacated the properties, spent the money to divide them up into smaller spaces, given out tenant allowances to fix them up, or found new tenants. Using GGP or SPG per-sf values, when those companies have tenants currently paying rent, is way off-base.

      The best mall operators trade at 250-300/sf. Shopping center owners trade at around 100/sf. Sears has both types of RE and you have to discount their value by a lot due to the factors mentioned above.

      So while $55/sf might seem too low, I don’t think the RE value “today” is over $100/sf. It could be five years from now, but you have to discount back to present day dollars.

      Interestingly, I am willing to say the RE is worth $7B, it’s the other businesses that Sears owns where I think Baker Street’s numbers are far more off the mark. Using $7B you can still come up with a total value within Balter’s range if you don’t believe the rest of the analysis.

  2. Chad – I agree with a lot the comments you made on the baker street analysis. I also agree that is not out of the realm of possibility that the RE is worth $7bn on the down side.

    So if you look at $7bn in relatively to the current price of $34.50, that implies that the rest of sears (assets – liabilities) is worth ~ negative $3.3bn. Then the question is how reasonable is negative $3.3bn ?

    Assuming you get nothing from the net working capital (very conservative and unlikely), pay off LT debt/pensions ($5.3bn), and Mr. Lampert manages to limit cash burn to $2bn going forward, that implies the “other” sears assets are worth $4bn.

    $4bn for the brands, home services, lands’ end, 51% of sears canada, sears online, sears auto and the prescription biz is not overly aggressive – as a data point, it is 60% of baker’s low estimate. From what little research i’ve done, I think $3.75bn is a throwaway price for these assets.

    And so what do you get in return for ~$35 ?

    1. Upside in real estate
    2. Upside in brands/home services biz/lands’ end/sears online/sears auto/sears online/prescription biz.
    3. $10-15/share in potential in net working capital
    4. Upside in Pension Liabilities – one I analysis i read said that for every 100bps in interest rate increase, you get $500mm or $5/share back in pension contributions
    5. Over $1bn in NOLs (obviously you’ll need profits to realize this)

    That is a lot of potential levers to create value to get you a return on a $35 investment.

    Of course, the key assumption to the downside case is whether or not Sears will be able to keep the bleeding to under $2bn in cash. There is certainly a leap of faith required to just “hope” that Mr. Lampert will figure out how to stop the bleeding.

    • Chad Brand on January 14, 2014 at 1:49 PM said:

      I am with you. I think the current share price is close to a reasonable estimate of fair value (it’ll be less if the retail side keeps burning cash at this rate, and maybe more if Eddie is successful at pulling some of those levers you point out).

      But even if you think 35 is a very fair price, do you still pay that price today given the last 9 years? I don’t, for two reasons. One, I would want to pay a discount to incorporate a profit into the picture. If I build in 30% upside then I want to pay closer to $25. Second, I don’t want to pay $7B for the real estate today. I think people underestimate how much time and money it will take to lease out tens of millions of square feet. Not only that, but Eddie wants to keep a nice chunk of the sf for a leaner Sears retail operation, which will earn lower returns (if any) than the landlord business. For those reasons, I want to discount that real estate value too.

      So, while I don’t think $7B for RE is way off the mark, I don’t think its worth that today. And while $4B isn’t overly optimistic for the other assets, Eddie’s track record thus far, (and his letters and various quotes over time), give me little confidence that he will maximize the upside from those levers he could pull.

      At $20 I think I’d jump in regardless of my current opinions. At $25-$30 I might start to nibble. So I am getting close, but not there yet…

  3. chad,
    i wonder how far you are away from baker street regarding the other goodies sears has. i mean even if you say they overvalue them by 25%, which they don’t, you come in near 60-70 bucks. i also think they undervalue sears online which gets good traffic. also if you value r/e at 7 bin, do you throw out the 4 billion they have in operating leases? this would seriously lower their cash burn which i personally believe is around $30 at the midpoint. while the previous commenter is correct in stating a 1 pcnt increase in the discount rate lowers pension funding by 600 mill per year, it does not decrease the unfunded liability, just the cash burn. and then with the notes secured by the trademarks, which i think baker st most aggressively values, your still looking 50-60.

    • Chad Brand on January 21, 2014 at 10:11 AM said:

      @Jim:
      I agree that if you 1) believe KCD IP, Lands End, Warranty Protection, Home Services, Auto Centers, Sears.com, the Rx files are cumulatively worth $6 billion of equity (25% less than Baker Street’s $8 billion mid-point value) and 2) you ignore the fact that Sears currently burns cash from operations and will continue to do so for the foreseeable future (which Baker Street’s valuation does), then it is not hard to arrive at a $60-70 value.

      I simply don’t agree with either assumption. The upcoming Lands Ends spin-off I believe will support that. The dramatic decline in sales, coupled with accelerated store closures lately, is resulting in rapidly eroding value in those ancillary businesses. The fact that Eddie has been unsuccessful at selling them (warranties, LE, and now perhaps Auto Center) also says something to me. We should get more clarity in the upcoming 10-K filing.

  4. ok so you say real estate=7 billion and other operating business=6 billion. thats 13 billion of value for the stock. lets use 100 million shares just to make it easy i know its 106. but lets take the 5.2 billion of debt from that 13. so we are at 78. now i believe you said earlier you were more in the CS camp that they would lose 1 billion from liquidating inventory- current liabilities. so we are down to 68. now if you look at the last 3 years the cash burn has all been capex/pension expense(700 million a year) not including the asset sales/spinoffs. so essentially, at 37 a share, your telling me the pv of future loses has to equal 31 a share not including the pension ob because we included that in the long term debt. that would be the equivalent of losing $800 million year for 5 years discounted at 8 pcnt. that would be wildly aggressive given-pension ob 2011,2012 they act generated positive cash flow sans any asset sales. now could you be right? sure but whats the probability of lampert pissing 30 bucks a share away when the guy won’t spend more than 1% of revenue on capex and closed 45 stores ytd 2013 and are seemingly accelerating that process. I’m guessing in 2013 they lost somewhere around 600 million of cash excluding pension ob but including capex, again not including asset sales.

    so my point is there is a lot of negativity baked in the stock. to get to today’s price using your very conservative asset sale assumptions, you need to assume a ton of misery for the next 5 years that sears has never seen before. meanwhile if the next 5 years is more muted at say 300-400 million burn, your looking at 50%+ upside from these levels. so I’m pretty comfortable with the position i initiated in the high 35s and averaged down in the low 35s. not to mention i think the re is worth more than that based on the 4.8 billion of operating leases sears carries(which 75% are from kmart) , the significant stake vornado initiated in 2004 at the same levels on ev basis WITHOUT any kmart real estate, and the massive profits sears canada has booked from selling leases. i also think sears online will turn out to be worth a great deal more than currently assigned by numerous bears given the massive investments lampert has made there since 08 when he seemingly realized that retail was changing and shifted strategy.

    • Chad Brand on January 22, 2014 at 9:32 PM said:

      @Jim,
      That is certainly the bull case. I don’t think he can get $6B for the non-RE assets, but if he can you may be right. As far as whether he can piss away another $30/share, he might get close. I think he’ll burn $10/share in 2014 (the pension contribution alone is $500M).

      Even if he halts the losses, how long does it take to monetize these assets? If he could do it overnight then sure, I’d want to buy the stock at $37 for ~50% upside. But what if it takes him another 3-5 years? Then your return isn’t all that great on an annualized basis.

  5. @chad

    couple things wrong with your analysis. if we are calculating the pension with the long term debt (5.2 bin debt+PENSION), then you can’t count the cash outflow of ~400 million expected for 2014 for the pension cost. therefore you are expecting them to lose about 600 mill next year. you also don’t need to discount the cash-flow of the RE if you think it will maintain its value which historically it has. And you are right he could blow 30 bucks a share given he blew 40 bucks a share purchasing 6 billion of stock at 120 a share.

    I’m sorry I misread your statement on thinking the businesses are worth 6 billion. so i ask what do you think they are worth?

    my valuation is as follows
    debt(-5.2 billion)
    working cap(+1.3 billion) this assumes they break even on liquidation inventory- short term debt given they currently have 1.3 billion in cash. if you read the footnotes you’ll notice they actually made a bundle liquidating inventory above cost on all their store closings so far.
    real estate+8 billion
    lands end +1.2 billion
    brands + 2 billion
    home services +1.5 billion
    online +1 billion
    canada +800 million
    goodies/auto +800 million
    -24 a share ongoing value
    =83 share price

    therefore i feel the market either values the real estate at close to 3 billion which is an absolute joke, or assumes sears somehow starts losing magnitudes of what they are currently losing.

    • Chad Brand on January 22, 2014 at 11:21 PM said:

      I’m not going to break out my valuation in detail, but in total I’m about 25% below your $83 number and most of that comes from the Sears ancillary businesses. And even then I’m not loading up at $37 because 1) I don’t think Eddie will liquidate the entire company (a web site that loses money is not worth $1B, stores that stay open aren’t worth the full price of the RE, etc) and 2) even if he did it would take years to sell it all off piece by piece and things like home services/warranty protection/KCD/auto centers would plummet in value. I apply a discount rate, because the NAV is illiquid and not readily attainable.

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