Description

I read the latest Q for SHLD and my interest was piqued when I saw SHLD’s SSS percentages. Wow, minus 10% SSS. OK, JC Penney’s love affair with Ron Johnson was in the same league, but one doesn’t see these kind of numbers very often. So then I do some more reading and I see Mr. Lampert mentioning he raised $2.4 billion in 2014. Cool, let’s take a look at his balance sheet. Hmmm, there is only a total of $250 million in cash on it. So, let’s go to the cash flow statement. SHLD started the year with $1,098 million in cash. But where is that $2,400 million? Well it turns out Eddie was a little disingenuous. Yes, he raised $2,400 million, but of that close to 1,000 million was a loan that was used to pay a $1,100 million loan back. So instead of 2,400 million it looks he raised net about $1,300 million. So let me recap SHLD’s year. It started out with $1,098 million, raised some $1,300 million … and still ended 2014 with $250 million in cash. Here is some more data:

As one can see there was quite the amount of cash spent by SHLD over the last few years.

So let’s see take a longer time horizon and see how SHLD has done over the last 8 years:

These numbers are just plain horrible. For every $100 SHLD sold in Jan 2006 SHLD now sells $72. But the picture is actually worse because SHLD has killed off the worst performing stores, the ones that have the worst SSS. Thus … for years now I keep hearing about “the good stores” and that SHLD is getting rid of the bad stores but every year the SSS still suck. In 2006 SHLD had 3,820 stores, at the end of 2014 it had 1,725 stores. How many more stores does SHLD have to sell or close before it gets to the “good” stores? Actually it seems to me SHLD doesn’t have (m)any, but I’ll address that comment below.  Anyway the operating leverage around SSS matters a lot. The operating leverage of SSS growth is large for any store and it works just as much against you when they go negative.

Let’s say I have a store that sells $1,000 and I have a 10% operating margin or $100. Let’s now assume that the store has SSS of minus 2% or $20 in sales revenue. Sadly its expenses will not decline in line with the 2%. Let’s assume the store can lower its costs by 1%. Well then my operating profit has just fallen by 11%. So sales just went from $1,000 to $980 and profit went from $100 to $89 or down 11%. Do that exercise on SHLD since 2006 and you get my point. Since 2006 on average annual SSS have been minus 3.63%. SSS of minus 3.63 takes your profit down by 20% under this scenario.

So why do I believe SHLD might not have many of the “good” stores people tend to bring up? Well I decided to use Google Earth and go to many cities, look up freestanding Kmart and Sears stores and check out the number of cars in the parking lot. It seemed to be a decent proxy for the number of people in the store. Then I would move the map around and look for Walmarts and Targets in the surrounding areas as a comparison. Anyway it was even worse than I thought. Every one of these SHLD freestanding store parking lots was just empty compared to the parking lots of the Walmarts or Targets. The difference was striking. You’d see 10 to 40 cars in the Kmart or Sears parking lots while on the Walmart and Target parking lots there’d be 100 or many more cars parked. And one has to take into account that most SHLD employees do park in front of the store too.

Here are some other stats:

As a follow up to my parking lot research, I looked at sales per store. Expected sales per store are horrendous compared to the competition. And every year it keeps getting worse. And look at Capex per store. Now I know that in the capex numbers of the competition there is a fair amount of growth capex, but still, the difference is still huge. And here is the kicker, not even all of the SHLD capex is going to its stores. After all, Mr. Lampert keeps talking about all his member initiatives and online efforts, which obvious does require some capex. It is obvious that SHLD is underinvesting in its stores, actually it has done so for many years. And it can be seen in the stores. They are not well staffed, customer service is left to be desired and the stores aren’t clean and often lack merchandise. Actually that has been the case since before ESL bought SHLD.

In addition to all its cash drain SHLD has been experiencing, things are going to get even more difficult because of the Seritage IPO SHLD will be on the hook for an additional $140 million a year in rents. Now given SHLD’s cash balance at the end of 2014, SHLD really had no choice but to initiate this transaction.

Another problem becomes salaries. Recently Walmart, Target, McDonalds have increased salaries for their lowest paid workers. In addition some cities are starting to implement $15 an hour minimum wages. I do believe the impact of its competitors raising salaries is going to be more impactful over time that the few cities that are raising minimum wages, but if the increased minimum wage becomes a nationwide thing it will impact Kmart and Sears significantly.

Kmart and Sears customers also tend to be older than the average which means it is not replacing its current customers with new younger ones fast enough. Obviously this is a serious issue.

In short, the SHLD retail business is draining lots of cash and that drain will continue and likely even accelerate. Given the operating leverage, every % of negative SSS exponentially impacts cash flow. Even the current cash infusion from the Seritage and other transactions will not suffice as it is my prediction that SHLD will continue to bleed cash profusely.

Anyway, Sears and Kmart have no value anymore as brands, that much is obvious.

But what about the argument that SHLD sits on a boatload of assets? True, but many of these assets sure aren’t worth as much and many have already been removed from the company, like Lands End. The most troublesome thinking I find that people seem to value certain parts of SHLD’s retailing business apart from the retailing business. For example, take the pharmacy business, one cannot separate the pharmacy business from the brick and mortar retail business. If the Kmart stores close then there won’t be any more pharmacies. The same argument can be made for Sears Home Services. If the stores close so that you aren’t selling something then it’ll be hard to deliver it or repair it. The same argument can be made for Sears Protection Company as those protection agreement contracts are sourced from sales. No sales … no protection agreement contracts going forward. One could even make the argument that much of the online effort is integrated with the store base. Now you can make an argument that these above mentioned businesses have value, but then you also have to include the negative NPV of the losses that will be generated by the rest of the retail business that needs to stay in business in order to have these other business be valuable.

What about the balance sheet? Well at the end of Q1 it had about $1.2 billion more in liabilities than assets. Outside of Chapter 11 it is hard to get rid of liabilities. I for one always assume liabilities will have to be paid for 100%. On the pension side, SHLD uses a 7% return expectation. In a world where interest rates stay low and where many asset classes are expensive it is not hard to imagine this being an aggressive assumption.

On the asset side one has to address the real estate. It is on the books for about $4.4 billion and it is highly likely that the real estate is worth more than it is listed on the balance sheet. One famous money manager threw out a $100 billion number which seems very aggressive. Actually somehow he included the leased stores into that portfolio. I for one do not believe that there is much value in the leases. On paper it looks great, but in practice it seems harder to extract value from leased properties than people think. Remember that Borders was supposed to have had all those great leases that had held value … how come then that those leases ended up as part of Borders’ Chapter 7. Or JCPenney’s business had great leases, but it was driving itself straight into a wall and the leases weren’t helping at all. Anyway, if we exclude value related to leased properties then a $100 billion value would have meant that the average SHLD property was worth $146 million. And if we include the leased stores, then the average value would be considered $58 million. I do feel confident those locations are not worth that much, not even close. And again, I do not believe the leased stores have much value embedded in them. More realistic is to use the Seritage transaction as a base. We do know that SHLD is planning on selling 235 fully owned properties and a 50% ownership in 31 properties to Seritage properties for about $2.6 billion or about $10.3 million a property. After this transaction it means there should be about 318 owned stores left within SHLD. And with the Seritage transaction it seems that the most valuable real estate assets are being moved outside of SHLD. If one looks at the S-11 for Seritage one will see that Seritage will have a lot of opportunity to recapture properties from SHLD so it can reposition them and rent them to better tenants. In the master lease it states that Seritage has the right to recapture 50% of each store, including other assets without payment to SHLD and it can recapture the whole property from SHLD after making a specific lease termination fee. Given how eager ESL and Fairholme seem to be to get their piece of Seritage and given the language in the Master Lease it seems likely the better properties made it into the Seritage portfolio. So a reasonable assumption seems to be that the left over 318 properties have about the same value as the properties included in the Seritage transaction. So let’s assume that the left over 318 properties are worth $2.6 billion. Then that will mean that the real estate is worth about $5.2 billion pre the Seritage transaction, an excess of 850 million of the $4.35 billion that is listed on the balance sheet for Q1. P.S. For those that feel that the Seritage real estate is worth a lot more than $2.6 billion, remember that an outside firm valued the real estate. I am willing to agree they might have erred on the low side, but there are limits to how much they get to lowball. In today’s audit and legally driven world there is only so much cheating one can do without exposing oneself to significant liabilities.

There are also the Kenmore, Craftsman and Diehard businesses that have value. GE is currently in the process of selling GE Appliances to Electrolux for $3.3 billion. I find it hard to assume that the SHLD business would have the same value or even close. GE appliances is just a much more valuable business with a massive presence in the new built market and very solid distribution and brand awareness. Kenmore, Craftsman and Diehard are brands that are losing significant value by still being exclusively connected with the rapidly dying SHLD retail businesses. And in case SHLD sells the brands the new owner has to reboot distribution, something that will cost a lot of effort and money. It is not as if those brands bring anything special to the table and in general stores already have plenty of brands on offering. In order to gain shelf space these SHLD brands would have to compete aggressively. Also if one believes that these brands have true brand value, then the logical outcome of a sale would be that sales would slump at SHLD stores when other stores are allowed to carry the brands. Either the brands have real sale/brand value because they drive people to the store or they do not have have that value but that would mean they should not fetch much in a sale.

Then there is SRe Holding Corporation, which is a wholly owned Bermuda based insurance sub, for SHLD. The unit is used to self-insure its risk, being workers comp, product and general liability, automobile, warranty, asbestos and environmental claims and the extended service contract Sears and Kmart sell to their customers. SHLD funded SearsRe through a real estate transaction with 125 owned properties and through another transaction where it used the Kenmore, Diehard and Craftsman brands as collateral. Then in Q4 2013 SHLD rolled SearsRe into SRe. The consolidated net book value of both transactions was about $1.7 billion on May 2, 2015 and is included into the asset side of the balance sheet. I feel there is more risk related to SRe than benefit. It is a self-insurance vehicle where there is risk that might have been underpriced. In addition, as I said before, the extended warranty business is part of the retail business of SHLD. Take the retail business away and there will not be an extended warranty business beyond run off. Also since I am giving value the real estate assets and the brands separately on an unencumbered bases I cannot count the book value of this insurer as it would represent double counting. So for me SRe represents no value beside the extended warranty business.

There are 12 million shares of Sears Canada that traded today for $6.24 a share.

Then there is the online/loyalty/member business that Mr. Lampert seems to love, the business where he likes to mention how Sears was the pioneer in store pickup … 14 years ago. It makes me wonder how truly innovative you are in the internet space when you have to keep mentioning an innovation you executed 14 years ago. Here is my thought about that business. It seems to be partially reliant on the store base. So no store base, much less business. When I tried Shop Your Way a few times the site did not work well at all. Initially the shop section would not work. Also Amazon is spending $4.9 billion in capex, Walmart is spending $1.8 billion in its online business and SHLD last year spent $270 million in capex for its entire business. Now not all of the Amazon and Walmart spending is focused on the US and/or just the internet, but again the gap is so big that that doesn’t make much difference for the message I am trying to convey which is that SHLD is too late to the party and is bringing way too little capex to the party in order to matter long-term.

To wrap up, based on the balance sheet, we know that liabilities outpace assets by about $1.2 billion. We know that the excess value of the real estate on the books is about $0.8 billion. We know that the brands are worth something, but not that much. In the SearsRe transaction they were valued at $1.8 billion many years ago and are surely worth less now. We have about $70 million in value from Sears Canada on the books and I put no value on the internet business. So after this valuation exercise it seems true asset value exceeds liabilities with about $1 to $2 billion. And on the other hand we have a retail business that is draining lots of cash on a continuous basis and things continue to worsen. Just in Q1 there was the minus 10% SSS number. This downward spiral is overwhelming SHLD’s retail business and in most businesses it is really hard to catch a falling knife, but in retail experience tells me it is close to impossible.

Catalyst

Accelerating losses caused by further deterioration of the retail business.