August 19, 2009 - 9:40am EST by
2009 2010
Price: 74.41 EPS $2.30 $1.93
Shares Out. (in M): 121 P/E 32.0x 39.0x
Market Cap (in $M): 8,981 P/FCF 10.0x 11.0x
Net Debt (in $M): 2,127 EBIT 750 700
TEV ($): 11,108 TEV/EBIT 14.5x 15.5x
Borrow Cost: NA

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Ticker                     L / S                                        Date                                        Name                                     Sector

SHLD                     Short                                      8/19/09                                  Sears                                     Retail Hardlines

    Consensus FY Jan '10 FY Jan '11
Stock Price $74.41 Sales 43,583 42,944
Fully Diluted Shrs M 121 EBITDA 1,612 1,498
Mkt Cap 8,981 EPS $2.30 $1.93
Debt 3,284 Price / Sales 0.21x 0.21x
Cash 1,157 EV / EBITDA 6.9x 7.4x
Net Debt 2,127 P / E 32.4x 38.6x
Enterprise Value 11,108      
    Trailing 12 Mth Financials    
    TTM EBITDA $M 1,701  
    TTM Capex $M Bitmap
TTM FCF $M  (ex working cap)
    Mkt Cap / TTM FCF (ex working cap) 9.9x  


Price Target:  $40's   Catalyst:  is Thursday 8/20 earnings reports after 2 quarters of EPS "beats" from low advertising spends and aggressive accounting that have moved street estimates from the breakeven range to $2+.  Expectations may have to be lowered after the report. 

Thesis Points:

1)  Bulls' hopes for liquidation value are overstated - net current brand & real estate value is vastly below the current equity valuation;

        anchor tenant spaces suffer continued deflation.

2)  Reported earnings quality has strongly declined in the last 2 quarters and EPS "beats" in Q4 and Q1 have rallied the stock and inflated expectations of earnings power.

3)  Balance sheet continues to deteriorate and terms of new credit facility are more restrictive.





1)  A reasonable liquidation value estimate is likely below $35 / share and declining with the continued stress in the commercial property market.


A simple estimate of owned real estate value comes in the $20's per share value after taxes:


Kmart Owned Stores # of units Avg Sq Feet (000) Total Sq Ft (000) Value / Sq Foot Value in $ M    
Discount 139 93 12,927 50 646    
Super 34 165 5,610 50 281    
Sears Domestic Owned Stores              
Full line Mall 518 112 58,016 45 2,611    
Essentials / Grands 20 105 2,100 45 95    
Specialty 55 105 5,775 45 260    
Sears Canada Owned Stores              
Full line Mall 17 120 2,040 40 82    
Specialty 2 120 240 40 10    
Total KMRT owned 173     Untaxed 3,983    
Total SHLD owned 612     Taxed 2,589    
Total Stores Owned 785     Shares Out 126    
% Stores Owned 28%     Value Per Share $20.48 Without a liquidation or time value discount
% Stores Owned that are Sears 78%            



To get to mid $30's per share in total liquidation value, you have to believe another $2B in value could be attained in the sale of the brands.


Below is the most recent asset value analysis by Morgan Stanley which arrives at a $28 per share value:

(I couldn't get VIC's application to past the graphic.  Go MSCO's May 27 SHLD note, by Gregory Melich, top of page 5)


SHLD hasn't completed a monetization of its real estate assets since Sept 2004.  The transaction was actually Kmart selling to Sears (2 months before Kmart bought Sears) - 4 stores and 45 long term lease assignments for a $576M deal (~$71 / square foot).  There is evidence Lampert's Kmart cherry-picked a few % of it's most highly valued stores and rationally extracted cash by monetizing those assets.  Irrationally, however, for years the market has extrapolated those transaction values to the 2800 combined store base of Kmart and Sears to estimate real estate values of near $100 / share.  The last arms- length real estate transaction was completed in June 2004 to Home Depot and involved 4 outright sales and 14 long term lease assignments.  This has persisted even after Lampert has given explicit guidance in recent annual reports that SHLD is not a "real estate" company, but a retailer (i.e. investors shouldn't expect a lot of new cash from real estate sales).


Here are the most recent transactions:


Generating Input Assumptions on R.E. Value Per Square Foot      
Using Past Transactions          
Home Depot Transaction 6/3/04 Units Sold $M Received $ Per Store M $ / Sq Foot % Leased
Super Kmart, 4 owned sales 4 59 14.8 89  
Super Kmart, 13 lease assignments 13 200 15.4
Since leases are very long term, lease reassignments have near equivalent value to property sales
Super Kmart, 1 lease assignment 1 23 23.0 139  
KMRT to SHLD Transaction Sept 2004          
Super Kmart, 4 sales & 45 lease assignments 49 576 11.8 71  
Average Per Square Foot Value (excluding the $139 for 1 unit)  
Average only for KMRT properties which are off mall real estate and worth more
Value Per Square Foot          
Kmart Properties:  40% reduction to adjust for "cherry picking" the best locations 50.78  
Sears Properties:  20% discount to Kmart because of less desirable mall anchor locations 40.62  



This is a very small % of the 2800 unit store base.  Morgan Stanley's estimate of real estate value above seems optimistic at best.  Anchor values have sharply deteriorated in recent months with consumer uncertainty, retail demand shifting away from traditional mall real estate and massive anchor supply coming to the market.  Steve & Barry's bankruptcy added almost 300 anchor units to potential supply.  Anecdotal reports of landlords signing extremely favorable terms to attract anchors further hurts the value of Sears' largely anchor real estate position.  Of SHLD's roughly 2800 stores, approximately 800 are owned and 80% of those are Sears units.  Incremental retail demand has shifted to "power centers" and the growth in TGT, HD, and WMT locations have been in "off mall" units seen as more convenient by the consumer.


There is further risk in Morgan Stanley's asset value estimate above.  Significant value per share is assigned to SHLD's owned brands (as is done by value investors long the stock such as Bruce Berkowitz).  It is unclear that those brands are easily separated from SHLD's business to be monetized, however.  An asian manufacturer or OEM is unlikely to be interested in paying hundreds of millions for a brand that would be captive to SHLD stores.  A competitor like Walmart or Target is unlikely to pay for a brand like Craftsman that has been advertised as exclusive to Sears for more than 50 years.



2)  EPS "beats" (largely responsible for rallying the stock since March) have been made by unsustainable items as earnings quality has declined.


SHLD took $437M of charges in FY08, $77M of which was non-cash.  Before Q408, SHLD's had not reported significant "non GAAP"

EPS that excluded store closing expenses.  With 2800 stores (of which they are closing 10-20 / quarter), closing expenses are likely to be a

recurring phenomenon.  In Q408, analysts excluded $74M of store closing expenses from SHLD's "non GAAP" earnings ($190M).  In Q109, $17M of store closing and severance costs were excluded from SHLD's $47M in "non GAAP" earnings.


SHLD also took a $44M gain in Q109 to recognize the previously deferred benefit of the sale of Sears Canada's headquarters.  This sale occurred in August 2007.  Although this gain was excluded from "non GAAP" results, the pension expense of $42M was also excluded.  With the chronic underfunding of SHLD's pension plan, this appears to be a recurring expense now.


There are many layers to the lack of earnings quality at SHLD.  Beyond the exclusion of charges from "non GAAP" analyst numbers, the appearance of positive earnings power has been maintained by drastic expense cuts.  These expense cuts have accelerated to an unsustainable pace in recent quarters.  Q109 advertising was cut by $109M, which was greater than the entire FY08 cut in advertising.  This represents a greater than 20% annualized decline in SHLD's ad spending after several years of ad spending cuts.  There is anecdotal evidence that SHLD's ad spending will have to increase to maintain sales and that it has increased since Q109.  This could cut into reported net income (GAAP reported net income of $26M in Q109 would not have been possible without that $109M YoY advertising expense cut).


Bulls have also cited the improvement in Kmart store comps in line with bottoming comps in the rest of the retail space.  This too, is an optical trick.  Kmart ceased its partnership with Footstar and brought its footwear department in house during Q109.  This effect is not separated in the "solid" Q1 Kmart comp report of -2.1%.  Here is the estimated effect:


KMRT Q1 Sales $M


Estimate Q1 Footwear Sales $M


Bump from bringing footwear in house


Reported Sears Comp


Actual Comp Without Footwear Benefit



Without the unreported benefit, Kmart's 2 year comp trend actually declined sequentially from -10% to -12%, for a deterioration in trends.  This is further evidence that the "turn" in SHLD's numbers is largely optical.  Future visibility to losses could return with coming earnings reports.  With analysts' estimating solid profitability for the next two fiscal years, this could lead to disappointment.



3)  Revolver duration has been shortened and has become more restrictive.  SHLD balance sheet risk is still significant with its large working capital needs.  Failure to generate cash may spook bank lenders and sources of vendor financing.


Although believed to be cash rich, SHLD has significant financial leverage that leaves it at risk during a consumer recession.  To operate in Christmas during any given year, SHLD needs to carry ~$11.3B in inventory and $1.1B in receivables on the asset side of its balance sheet.  A large part of these operating assets are financed with $4.5B in payables from vendors and the $4B revolving line that is close to fully drawn at Christmas.  The revolver is secured by inventory and credit card receivables.  Since Sears has sold its credit card operations, none of its $1.1B in receivables qualifies for the borrowing base calculation.


Availability was $1.1B Nov 1 2008 (not quite peak Christmas borrowing).  Although SHLD recently renegotiated its credit facility (removing an overhang on the stock), it is likely that SHLD will be nearing the limits of its shrunken borrowing capacity going into this Christmas.  If SHLD stocked to the same levels of inventory in Christmas 2010 that it did in Christmas 2008, it would need to seek permission from its lenders to use its accordion feature on the new credit agreement to achieve the same level of borrowing.


Declines in the equity markets have created cash demands from SHLD's pension plan of ~$200M in 2009 and ~$300M in 2010 (down from an earlier estimate of $500M in 2010).  Net income losses combined with increased pension contributions and declining benefits from Sears working capital reductions could create visibility for negative free cash flow on an annual basis going forward.


Here's an estimate of SHLD holding future cash balances using annual working capital changes in the slight negative range of -$200M.  This is in line with Morgan Stanley's recent estimates and starts to normalize for the $1B annual cash benefits they had been taking from working cap in recent years:

    $Millions Explanations
Start Unrestricted Consolidated Cash Balance 1033  
Subtract Sears Canada Cash (73% owned by SHLD) -626 Held for operating and $250M in near term bond maturities, very little of this is available for dividend to SHLD.
Subtract Remaining Estimated Total Change in Cash 2009 92 1) no refunding of $345M 2009 maturies (10-k page 65) 
2) continued rock bottom capex 
3) net income of $240M in 2009 (may be much worse) 
4) ~$100m in share repurchases (did $40M in Q109) 
5) $170M pension expense
Subtotal Free Cash Balance at Feb 1 2010 499  
Subtract Estimated Total Change in Cash 2010 -265 1) no refunding of $445M 2009 maturies (10-k page 65) 
2) continued rock bottom capex 
3) net income of $200M in 2010 (generous if ad spend normalizes) 
4) $50m share repurchases 
5) $325M pension exp (10-q disclosure)
Finish Free Cash Balance at Feb 1 2011 234  




SHLD holding could display a dwindling cash balance in coming quarters.  On top of weak profitability (that could head lower if recent earnings have been low quality) this could further enforce the view of SHLD as an at risk retailer that suppliers and creditors need to be concerned about.  When this view was last commonly held (in Q4 and Q1) SHLD spent most of the time trading below $45 per share.



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