The Sears Holdings Dismantling Begins... Years Too Late

It is February 23rd and shares of Sears Holdings (SHLD) have already risen 100% this year, after a more than 20% jump today to nearly $64 per share. Such gains seem irrational, given how poorly the retailer's business has been, but keep in mind that the stock opened 2011 about 10 points above where it currently trades, so you had to be quite nimble (and daring) to capitalize on the recent surge.

Today's stock strength is due to the fact that the company seems finally ready to start splitting itself up, as it believes (probably correctly) that the sum of its parts are worth more than the whole. Sears will spin off its Hometown, Outlet, and Hardware stores (about 1,250 of the company's 4,000 stores) via a rights offering to existing shareholders. This comes on the heals of the recently completed spin off of the Orchard Supply Hardware (OSH) division. Sears Holdings expects to reap $400-$500 million from the separation, which equates to about 7 times annual EBITDA of ~$75 million.

Splitting up the company is the right call, and should have been done many years ago when the retailer was far more profitable. Annual cash flow at SHLD peaked in 2006 above $3 billion and has collapsed, coming in at just $277 million in 2011. Interestingly, however, Sears has been spinning out its small and less desirable assets. Orchard Supply, now public, is a small cap stock, as will be the specialty store business later this year. The company's crown jewels (Kenmore, Craftsman, Die Hard, Lands End) remain deeply hidden within the parent company, making it very hard for investors to figure out their intrinsic value.

In fact, Sears also announced today the sale of 11 stores for $270 million to a large mall operator (General Growth Properties). Selling just 11 of its full line Sears stores will bring in more than half as much cash as a complete spin off of their 1,250 unit specialty store business. It is a nice way of padding their balance sheet and alleviating concerns about a cash crunch and a possible bankruptcy (those rumors are completely baseless by the way), but it doesn't really create all that much in the way of shareholder value.

The biggest problem Sears Holdings faces is that even with its crown jewels, the operating businesses are barely profitable (cash flow margins came in at less than 1% in 2011). Many of their stores are worth more to a strategic buyer like GGP ($24 million each) than they are on the public market inside SHLD. Before today's stock jump the company had $5.5 billion of store inventory that was fully paid for. The equity value of the entire company was also $5.5 billion. Similarly, Lands End and Kenmore would both likely garner multi-billion dollar valuations as standalone companies, but aren't inside SHLD. By spinning out the specialty business (32% of the store base and 27% of cash flow) for just $450 million, you can easily see that SHLD is worth more busted up than it is as a retailer.

Which brings us to the problem for investors with the stock now well north of $60 per share (a $9 billion enterprise value). As long as SHLD management is content doing smaller breakup transactions to pad the balance sheet, and not large ones to truly show Wall Street how much their brands and real estate could be worth on a standalone basis, it is hard to see how a pure play retailer with less than $300 million in annual EBITDA is worth $9 billion as an operating conglomerate. Management would argue that they will be able to improve profit margins by retooling the company's retail strategy, but we are talking about Sears and Kmart here. That argument holds no water. Those stores are dying a slow death plain and simple.

The bottom line from my perspective is that with bankruptcy talk in the media and this stock at $30 (as was the case a few months ago) it is a very cheap stock. With only small moves being consummated to create value and those cash crunch rumors off the table, $64 per share is a tough sell for would-be buyers of the stock. The right number is probably somewhere in between as long as SHLD continues to focus most of its attention on improving the retail operations. If and when the focus becomes monetizing their various brands and real estate assets no matter what path that leads them on, then investors can start to get serious about the stock as an investment.

Full Disclosure: No position in Sears Holdings at the time of writing, but positions may change at any time