Description

This is a well-known situation with obvious tension (a leveraged real estate company with the majority of its revenues coming from a now bankrupt retailer, Sears), so I won't rehash what Seritage is or debate its value (but I do also believe its valuation is very stretched).

While people have been focused on the financial impact of a master lease rejection from Sears, equity investors to-date have largely missed a potentially much bigger liability that could come as a result of the Sears Chapter 11 that would likely bankrupt Seritage as well.  An issue I believe will start to gradually make its way into the SRG valuation as the issue gains more attention.  For a quick background on some of the early tension in the Sears bankruptcy I'd urge people to read this Bloomberg article from today (the first that has focused on the big picture for how the bankruptcy is likely to play out):

https://www.bloomberg.com/news/articles/2018-10-17/lampert-sears-creditors-gird-for-battle-over-recent-asset-sales

Lawyers who are pitching the UCC will likely have recoveries from fraudulent conveyances asa a focal point for the unsecured recovery as prospects are dim otherwise.  But in a nutshell many transactions Mr. Lampert did pre-petition were at below market rates and will become subject to court scrutiny.  Seritage is the most obvious and largest example of such a transaction.  

For background, Seritage was established in July 2015 in a backstopped rights offering at $29.58 per share; this transaction stripped collateral out of the Sears estate and put it into the hands Sears shareholders who participated in the rights offering (to become Seritage shareholders).  At the time the transaction was entered into these rights had significant value, and this value was acknowledged by the company in its treatment of such rights as discussed in the S11:

"Will Sears Holdings’ directors and officers and Seritage Growth’s trustees and officers be able to exercise their subscription rights?

Sears Holdings’ directors and officers and Seritage Growth’s trustees and officers that hold shares of Sears Holdings’ common stock, excluding shares of Sears Holdings’ restricted stock that is unvested as of the record date, may participate in the rights offering at the same subscription price per share as all other holders of subscription rights, but none of Sears Holdings’ directors and officers nor our trustees and officers is obligated to participate.

Holders of Sears Holdings’ restricted stock that is unvested as of the record date will receive a cash award, to be paid on the applicable vesting date, in lieu of any right such holder may have to receive subscription rights with respect to such unvested restricted stock. Such cash awards will represent the right to receive, on the applicable vesting date, a cash payment from Sears Holdings equal to the value of the subscription rights that would have been distributed to such holder had such holder’s unvested restricted stock been unrestricted shares of Sears Holdings’ common stock, calculated on the basis of the volume-weighted average trading price per subscription right for the 10 trading-day period beginning on the first day on which the subscription rights trade on the NYSE. The subscription rights are expected to begin to trade on the NYSE on the first business day following the distribution of the subscription rights."

The first day of trading Seritage closed at $37.10 per share and has never traded below $33.  This clear paper trail establishes a value transfer from the Sears estate (and its creditors) to the Sears common shareholders, and one that was acknowledged by the the board and the company at the time -- a rare fact pattern for a fraudulent conveyance case.  For quick reference, the calculation above yields approximately a $500M value transfer from the Sears' estate to Sears shareholders (if one uses the unaffected price of SRG before rumors of the Sears filing then that liability grows to $1B).  Since the look back period for fraudulent conveyances in New York where they filed Chapter 11 is four years this value transfer falls squarely into scrutiny and potential clawback by a court.  Helping the creditors argument that the transfer was inappropriate is the circumstances under which it was effectuated -- the company was EBITDA negative in 2013/2014 and 2015 and this transaction made the cash flow situation got worse, and has clearly only benefitted the participating Sears shareholders of 2015 with no identifiable benefit to the estate.

So why does all this matter to Seritage?  Well in theory the value transfers beneficiaries were Sears shareholders, and since public shareholders are shielded from liability by the corporation, this liability now is on Seritage itself, exposing the corporate entity to a very large off balance sheet liability.

But the liability may not just be the value transfer as deemed by the fair market value of the assets, but also other payments from Sears to Seritage.  Since its inception in 2015 there have been approximately $530M in payments (both rents and expense reimbursements) from Sears to Seritage ($90M, $189M, $183M, $69M respectively for 2015/2016/2017/2018 YTD).  These payments would also need to be reimbursed to the Sears estate, and balloon the total potential claw back liability to $1B to $1.5B, an amount that would render Seritage insolvent.

So with an existential liability looming in plain sight, why is the stock still at $42 per share?  I think the answer to that is simple, this is a very odd situation, that is very few spin-offs have happened at identifiably below market prices in the zone of insolvency before a backruptcy.  It's also easy to overlook tangential concerns as the glaring concern has been the master lease rejection, and while that alone could wipe out nearly all of SRG's cash flows, and while this fraudulent conveyance risk poses an existential risk for SRG's current shareholders, it also one of the only hopes for Sears' unsecured creditors recoveries.  Fairholme Capital, a $300M unsecured creditor, noted to the court on day one that the liqudiation had been ongoing for many years without court supervision and that the Chapter 11 solely formalized what Eddie had already been doing with Sears' assets.  This language makes it clear that the transfers, with Seritage being the largest, are what he plans to focus on to get an unsecured recovery (i.e., it should've been supervised by a court years ago).

So as this issue starts to gain more media attention what will the impact be to Seritage common shareholders?  Well since Seritage already is a leveraged entity, and has an additional $880M of off balance sheet development obligations that will need to funded, an incremental $1B+ that would come through a court order would render the company insolvent. 

Most of us have seen this movie before.  Where's there's a credible existential threat to a company, the stock doesn't just hang out until it hits, the market tends to price in material odds of a complete capital loss and I suspect the shareholders of Seritage will slowly start to evaluate a healthy $42 price versus insolvency if the transaction is ultimately deemed a fraudulent conveyance.  It'd stand to reason some of them will want to take the risk as they realize the true bankruptcy risk is not necessarily the master lease rejection, but the fraudulent conveyance risk.

So what do I think the stock is worth?  Since Sears' is EBITDA negative, I expect the master lease to be rejected as it's unlikely that operations will improve to accept it by Christmas when their funding will run out.  But last quarter Seritage generated approximately $37.5M in cash NOI, of that revenue from Sears was $33M, and with G&A running at approximately $7M per quarter this a master lease rejection will put SRG into a cash flow negative before interest situation; a precarious spot when you have $1.2B of debt.  This combined with $880M of development obligations and an existential potential billion dollar springing liability on a fraudulent conveyance order are going to make Seritage unownable.

Adding it all up, I don't believe SRG will likely trade too much north of option value as investors begin to fully realize the risks they're taking. A sub $20 price is likely as investors begin to digest the new cash flow situation and the risks that they probably didn't know that they were taking.

Catalyst

• The formation of the UCC and hiring of counsel
• More media scrutiny on the Seritage transaction
• Investors realize that they're involved in a binary situation