Description

Short-story view: There's a fairly-sized confidence interval on this one, but I am comfortable you’re not going to lose money at this price and there’s a reasonable path to doubling your money.

Short-story valuation metrics: $975mm EV comprised of $933mm market cap, $237mm cash, no debt and $279mm tax-adjusted pension.  Company has an undrawn $800mm revolver with around $450mm of availability at 3Q12 (lower availability due to pension-related effect).

In my view, the company’s worth $15 to $20/share versus a current share price of $9.16.  Tangible book value is relevant and stands at ~$10.21/share, so there’s downside protection with 2x upside potential and likely near-term movement toward recognizing that value.

SCC is about real estate value.  There are neither brands nor a multitude of operating subs.  SCC is a smaller, simpler story than SHLD.  What are the real estate and other assets worth relative to the liabilities and what do Lampert’s incentives and actions indicate? 

Real Estate

There are three primary components of real estate value: (1) 118 mall-based stores representing 16mm sqft, (2) six distribution centers with 6.9mm sqft and (3) JV ownership of 13 properties primarily comprised of operating malls across Canada.

I’ll handle the cleanest assumptions first – distribution centers and JV interests.

Distribution Centers

The distribution centers were valued by Colliers as part of a 2006 fairness opinion at $276mm, which equates to $40/sqft.  The same fairness opinion valued multiple corporate-owned properties.  All property dispositions subsequent to the Colliers valuation have transacted for prices at or above those contained in the valuation.  I’m assuming $275mm for the DCs.

Mall JV Interests

The JV interests were marked to fair value as part of the 2011 transition from GAAP to IFRS.  The December 2012 $43mm monetization of SCC’s JV interest in Medicine Hat Mall suggests the IFRS fair value mark is a conservative estimation of asset value.  Further, the company was incentivized to be conservative in marking the assets as SCC has been a consistent repurchaser of shares.  In keeping with Lampert’s MO, he likes to know the value of his assets while letting the market vacillate.  I’m assuming balance sheet value for the JV interests.

Mall-Based Store Real Estate

The more dynamic analysis relates to the 118 mall-based stores.  Sixteen of the stores are owned with the remainder held under long-term leases a la Sears Domestic.

As a starting point, Canadian mall real estate is scarcer and held at more of a premium than in the U.S, and SCC has some of the best mall real estate in Canada.

• Sales per sqft at Canadian malls are 50% higher than American malls, and vacancy rates in some areas are 0%
• Malls are trying to expand to accommodate the movement of U.S. retailers north, but there’s a dearth of space
• Consistent with my discussions with Canadian CRE folks, “Sears has some of the best large-format real estate in Canada”   
• Sears has some really, really premium locations – e.g., Toronto’s Eaton Centre (CN’s largest mall in which SCC controls 818k sqft) and Yorkdale Centre (CN’s second most productive mall with $1,300 sales/sqft) – that will be monetized for choice value: "Wayne Barwise, vice-president of development at landlord Cadillac Fairview, said the mall developer would also love to put a Nordstrom in the downtown Toronto Eaton Centre, but there is no available space".  It appears that Nordstrom and SCC are arm-wrestling over Eaton Centre and perhaps a few other locations.

So what’s the 16mm sqft of mall-based real estate worth?  I’m assuming $1.6bn based on $100/sqft.  There are a number of markers for this being a reasonable, if not conservative, estimation.

• Zellers – Target paid $1,825mm for 189 Zellers leases, which equates to roughly $103/sqft (TGT is investing another $100/sqft into renovations for all-in costs of $200/sqft).  Zellers are located in many of the same malls as SCC, and serves as a good general proxy.  However, I view the comp as conservative because (a) Target likely received a wholesale discount from buying in one large transaction, something SCC’s not likely to do and – even more importantly – (b) Zellers is a discount store without SCC’s major, urban SCC locations that will trade at a material premium, skewing SCC’s average upward from Zellers.  Lastly, if you take a look at Primaris REIT, SCC's average rent is $4.71/sqft versus Target's (i.e., Zellers) of $5.75/sqft, suggesting SCC's leases are at least as attractive as Zellers'.
• Loblaws – Loblaws, a Canadian grocery chain, is in the process of creating a REIT subsidiary.  Contributing  35mm sqft at a valuation of $7bn ($200/sqft – consistent with Target's all-in cost).  Like Zellers, this comp also doesn’t capture the value of the premium locations SCC controls.
• Medicine Hat Mall – SCC sold its 40% interest in Medicine Hat Mall in December 2012.  The price was $43mm, implying mall value of $108mm.  Medicine Hat has 522k sqft of GLA.  That suggests value of around $206/sqft.

In short, there are multiple indicators that the $100/sqft valuation I’m utilizing is appropriate for SCC’s mall-based real estate, and again you’ve got the outlier upside of the fact that SCC also has some choice urban real estate that should skew the average higher.  Most importantly, there is actually demand for much of the space.

Putting It All Together

Funneling these assumptions into SCC’s balance sheet suggests an NAV of over $20/share.  This stands against TBV of $10.21/share and a current share price of $9.16.  Further bolstering the view of downside protection are the gains reaped on 2012 asset sales.  Although PPE was conceptually marked to market with the IFRS transitions SCC’s recent $170mm sale of three leases produced a $164mm gain and the sale of a weak Calgary location for $5mm produced a $2.8mm gain.  Both these transactions suggest tangible book value of $10.21/share is a conservative marker of downside protection.  In sum, SCC offers downside protection with perhaps 100% upside.  For the strong case, assuming $150/sqft on the mall-based real estate suggests share value of $25.50/share, over 150% upside.

I should add that given the number of SCC mall-based stores is manageable (118), one can get more granular by location.  A complete store location list is available online for $50.

As a kicker, there’s an additional 2.9mm sqft of Sears Home and Outlet real estate that are not considered here. 

Further, SCC owns SLH Transport, a leading Canadian LTL trucking and distribution firm.  SCC created the firm in 1985 to serve as in-house distribution but has grown it to serve other customers and outsourced logistics.  It appears the website is new - could be an effort to more fully develop and highlight this subsidiary.  Internet indicates company does $225mm in revenue, presumably most from SCC, on the back of 620 trucks and 3,700 trailers.  No separate value assigned here.

Time Horizon Considerations & Lampert Incentives / Actions

Another attractive aspect of SCC is just how horrible operating performance has been.  This fact should accelerate movement on the real estate front.  Aside from one quarter of slightly positive performance, SCC has comped down mid to high single digits each of the past eight quarters.  Revenue has declined from $6.3bn in 2008 to $4.3bn in 2012 while EBITDA has fallen from $540mm to $62mm over the same timeframe.  The declines have been broad-based with strength limited to appliances and mattresses.  This performance is likely to be exacerbated with the emergence of Target in the next year.

Lampert has been through this drill on the domestic front, and it strikes me as highly unlikely he will allow SCC to become a material drag on cash.  Recently, the company announced layoffs of 700 employees without associated store closures, so its appears the company continues to take action and cash flow is prized.

In terms of Lampert specifically, there are a couple of relevant considerations.  First, the company has consistently repurchased shares over the past few years (2010 – $43mm at $18.50/share; 2011 – $42mm at $14.75/share; 2012 – $10mm at $10.50/share [all per share prices downward adjusted for Dec 2012 dividend]), in the face of SCC business deterioration and the cash flow drain within Sears Domestic.  The plight of SCC’s business has been evident for some time, so I do not believe these purchases were premised upon a sanguine view of SCC’s retail prospects as currently situated.  Further, cash was dear at Sears Domestic, so all the SCC cash could have been utilized by Sears Domestic; Lampert clearly judged the SCC repurchases to be accretive.  In this same vein, Lampert and ESL Partners bought $4.2mm and $7.5mm of SCC shares on 19 Nov 2012 for $10.98 ($9.98 adjusted for the dividend), so at $9.16 you’re buying SCC for less than Lampert did a couple of months. 

Second, the nature of SHLD’s recent 44% spin-off of SCC is relevant.  SHLD conducted a partial spin, which triggered a taxable dividend for shareholders.  This appeared to be inefficient and was covered as so by the press.  However, there’s lengthy and painful wording in the prospectus that makes clear that taxed recipients of SCC shares from the spin-off will receive associated tax breaks on “future distributions” from the company.  The document also notes the partial spin “preserves flexibility as to how [SHLD] may realize the value of its remaining holdings in Sears Canada over time.”  Whether this all points to large-scale real estate transactions, conversion to a REIT or otherwise, the structure certainly indicates the intent for future distributions (and I don’t see these intended distributions being driven by the retail operations).  In any event, the structure of the spin-off suggests the incentive for a future deal(s) that will drive a distribution(s).  From a time value of money perspective, taking the tax hit today for tax savings far in the future doesn’t appear to make sense, especially for someone as attuned to these issues as Lampert.  This consideration combined with the plight of retail operations suggests relatively near term corporate action by SCC.

Surrounding this entire situation are the qualitative aspects that make the investment interesting: opacity, substantial negative press commentary focused on retail ops, lack of liquidity discouraging serious institutional investment (trades around $500k of dollar volume and prior to the spin there was no liquidity), etc.  These aren’t sufficient to make an investment case, but they are part of what creates opportunity.

Catalyst