Description

Thesis: SHLD is probably a mispriced perpetual option at these levels.

Don’t everyone rush in to buy this at once! For other ideas I might argue that the animosity towards the investment will explain ‘why the opportunity exists.’ That’s not the case here. Assuming there is any opportunity at all this opportunity exists only because of an absolute mismanagement of the operating business and capitulation by a long-time shareholder. Turns out consensus was right and Eddie Lampert got his butt kicked. Good job everyone.

However, we are at the point in the saga where Eddie Lampert’s more relevant circle of competence (financial engineering) is more important than any further damage he can do to the retail business. I'm not sure how you could possibly damage this business further. Then again, here we are. It is impressive to see the company still lose 18% in same store sales even after ceding significant sales to other competitors over the years. I didn’t realize Sears still had that many more customers to lose.

On October 13^th, 2017 Bruce Berkowitz decided to shut down his partnership and distribute the holdings in-kind, including a large quantity of 2019 unsecured notes. Pre-distribution, the 2019 unsecured notes traded at roughly $87. Since then they have collapsed down to $43. A flurry of ‘insider’ filings by former Fairholme LP’s followed as they sold out of their 2019 notes. It also led to a collapse in SHLD and SHLDW as the float expanded from their own in-kind distributions. Previously hard to borrow stock became easy to borrow, breaking years of difficulty in betting against the stock.

But let’s take a look at the capital structure today without considering 1) the current debt exchange proposal, and 2) the market value of a significant amount of upcoming maturities.

Equity:

$266 million                   108 million shares @ $2.47

Debt:

$3000 million                     1L

$300 million                       2L

$300 million                       Senior secured

$625 million                       Senior unsecured

$1600 million                     Pension

Sears recently announced an exchange offer for the senior notes maturing in 2018 and 2019. 2018 notes are offered an equity conversion with a $5 strike, a PIK coupon, and a 2019 maturity without a reduction in principal amount. 2019 notes are offered an equity conversion with a $8.33 strike, a PIK coupon with no maturity extension, and without a reduction in principal. Except the stock is now at $2 and change! I have a suspicion that without the massive Fairholme related selling the stock might be a tad higher and make this exchange offer more palatable. At the moment, it would appear that a limited number of holders will be willing to take that exchange. It’s also an exchange into 144A debt which limits participation to a handful of the larger holders. I should note that ESL holds the majority of 2019 notes. Their 2L’s are also being converted to PIK and being given a $5 equity conversion feature. I was surprised to see that feature being placed on the 2L's given their security on the capital structure if this does eventually file for bankruptcy.

In total, around $600 million of debt held by ESL has the option to convert to equity at an average of $6.75/share.

What does Sears still own?

I could spend months traveling around estimating what all the real estate is worth like some of the long-suffering shareholders have done but I don’t think that’s going to give me much of an edge here. I’d rather be somewhat directionally right and call it a day.

I count roughly 225 Sears owned boxes and 475 Kmart boxes, almost entirely leased.  In the 2017 Q3 supplemental Sears showed roughly $800 million of gains on Kmart asset sales. I can’t tell if this includes the Craftsman sale or not but I think it’s safe to say a lot of these Kmart leases actually have considerable value. In fact, from a recent Vornado call referring to a Kmart lease purchase for $46 million:

What made this deal unique is that we bought back the floor from Kmart who had 18 years remaining on their lease at $33.50 per square foot. This is the first deal we've done with Kmart and Kmart still has 82,000 square feet at 770 Broadway and 141,000 square feet at One Penn Plaza at the same low rents.

According to a recent 8-K, the 125 properties previously held by the PBGC were appraised (using the same process as the SRG rights offering) at around $7 million per property. I don’t think it’s a giant stretch to say on average the remaining property value is somewhere in the ballpark of $7 million per property. That’s down quite a bit from the roughly $12 million per asset in the SRG portfolio even with SHLD occupying nearly half the space at $3-4/foot. Across all 700 remaining properties, that should be around $4.7 billion of rough fuzzy math value.

Then there is maybe $500 million to $1 billion of ‘other stuff.’ Innovel (https://nypost.com/2016/07/14/sears-finds-a-new-way-to-rake-in-cash/), 500+ Sears auto locations, the home services business, the royalty stream from Craftsman, DieHard, Kenmore, and other small assets here and there. To be safe I’ll say this is worth $500 million but I’m guessing it’s probably north of a billion. Then there is $3 billion of inventory. Mark it down to $2 billion to be safe.

All together that is still around $7.2 billion of assets against $4.2 billion of debt excluding the pension obligation. The pension recently gave SHLD reasonable forbearance terms that makes their liability irrelevant for equity holders in the short term. Either the company stops burning cash or it doesn’t. If it does stop burning cash the stock will be a lot higher and they can fund the pension over time. If it doesn’t, well the pension and the rest of the debtholders will be fighting over the remaining equity and the stock is a zero. To be clear I’m not saying you should entirely ignore this liability but based on the mechanics of the previously mentioned debt-to-equity conversion feature, if this trade works out the pension gap is not going to be an overhang in the near term.

That leaves us with a roughly $3 billion equity cushion before accounting for all the cash burn.

Something that has left me perplexed (as I briefly mentioned in the beginning), is how SSS declines have accelerated as they accelerated closures. I would have expected the exclusion of underperforming locations would help SSS. It’s been quite a feat to see 15% SSS declines at this point. In fact, as recently as four years ago SSS was flat.

My thesis here is that the rapid pace of closures is causing SSS to worsen in the short-term. If true, it would imply that a reduction or halt in closures could stabilize sales a bit. I don’t know for sure but the correlation as they have accelerated closures is far and beyond above what other mall anchors are experiencing on average. 

At this point I think one of three things will happen with the debt load coming due into 2019 and upcoming cash burn as sales have shrunk faster than cost cuts. Either ESL sticks with the terms of the original exchange terms, in which case the $600 million of 2L and unsecured notes owned by ESL have the strong potential to convert to equity. Upcoming maturities would be significantly reduced in this situation and with upcoming asset sales, the minorities can likely be paid off at par. Or there will be a modification of the exchange terms due to recent selling pressure and we’ll see higher levels of dilution as the conversion prices are adjusted lower. Another possibility: the exchange offer fails and the company chooses a more drastic path by exchanging the 2019 notes into new 2L notes that would have an effective market value well short of par. I noticed their 8-K today that bumped the 2L capacity up to $600 million from $300 million. Whichever path ESL takes, this is likely to be a strong catalyst in the short-term.

Here is an example of a pro-forma capital structure post-exchange:

Equity:

???                   220 million shares @ ???

Debt:

$3000 million                     1L

$300 million                       Senior secured

$200 million                       Senior unsecured

$1600 million                     Pension (no payments until 2020)

With $7.2 billion of assets and now only $3.5 billion of debt, you have around a $3.7 billion cushion for equity while they finish closing down stores and seeing if they can turn this thing into a cash flow positive situation. On 220 million shares, that gets you to a ‘fair value’ around $16 before accounting for all the cash they will probably burn over the next couple years. Since the stock is at $2, I think the market is pretty certain (99%?) that the eventual outcome here is zero. It looks to me like ESL still has some options on the table, can be particularly aggressive with debt swaps if the current exchange fails, and probably wants to see this through to the bitter end. The trade here is that there is still a few puffs left in the cigar absolutely no one wants except ESL. The tenacity to keep pushing through what should have been a bankruptcy last year has me thinking the odds might be better than 1% of a nice payoff here. Not your typical margin of safety trade but I think the situation is interesting and there may be ways to make money in other parts of this complex (2019 notes?) depending on how this exchange works out.

Risks that keep me up at night

SSS keep falling at a brisk 15% rate

Non-store comp sales should be growing as store comps are falling but so far they haven’t

ESL throws in the towel, already sits in a position to prime everyone

There is actually less value in the real estate and leases than I roughly calculated

Catalyst

Successful debt exchange that gives some value to the equity holders