August 25, 2016 - 4:34am EST by
2016 2017
Price: 46.01 EPS 0 0
Shares Out. (in M): 33 P/E 0 0
Market Cap (in $M): 1,522 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT 0 0
Borrow Cost: Available 0-15% cost

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I think SRG is a short as it is too exposed to SHLD which I believe will collapse as a business sooner than people think. And SRG has a massive exposure to SHLD.

I am not saying there is no value at SRG, but in the event of a Chapter 7 filing for SHLD, which I believe not to be a question of if, but more of when, SRG has an enormous exposure and liquidity problem.

So how is SRG exposed to SHLD going out of business?

Base Rent SRG 2016

Leased GLA

Annual Base Rent 2016 (including pro-rated share from JVs)




In Place Third Party Leases




So as one can see, SHLD going out of business would be a huge hit for SRG. But it gets worse. Basically the Master Lease with SHLD is a triple net lease. If I make a conservative estimate, it is difficult to see that the triple net charges would not be at least $2 a square foot. So if I multiply the 35 million square feet by $2 then I get another $70.2 million. After all, real estate taxes and other expenses do need to get paid.

So if SHLD files for Chapter 7 tomorrow morning it would have a huge impact on SRG. Today the $38.8 million it gets in rents from Third Party Leases would be all that is left in rental income and that is before expenses.

Now I know there are Signed But Not Yet Open Leases for 1,044 million square feet that have a projected additional income of $23.793 million, but the first of those projects isn’t even delivered yet. The first two projects are expected to be delivered in Q4 2016 with the rest of those projects to be delivered by Q2 2018, all at a budgeted cost of $172.5 million.

So what happens when SHLD files chapter 7? Well SRG will lose $150.94 million in base rent. It will also have to pay about $70 million in NNN expenses that used to be paid by SHLD based. All the while based on the latest Q SRG has already committed to spending $170.5 million to redo the Signed But Not Yet Open Stores by the end of 2018.

Now if I compare that to the cash flow statement from Q2 2016 I see that SRG generated $65 million in operating cash in the first six months of the year. If I annualize that I get to $130 million. You can see that the SRG problem will become quite acute as it will see a swing of about $220 million on an annualized basis. (Also, did I mention yet that as part of its debt it is required to maintain at least $125 million of NOI.) It is not hard to see the stock sell down in a big way on that new. I just do not see how SRG will bridge such a massive gap all the while it is already committed to spending $170 million through the end of 2018 for the redevelopment of new projects for already signed leases.

FYI. For those wondering, I don’t think there will be much to be had for SRG from a SHLD Chapter 7 filing. There are too many people ahead of the line. And anyway it will be a long time before those claims will be paid out if there is much money to be had. Time SRG will not have.

But it gets worse. Suddenly SRG is going to get 33 million square feet of ex JV space in its lap. And where is the cash to develop all that at the same time? Here are some thoughts:

·         If you look at the development cost in Q2 2016, I get to an estimated number of $171 per sq. foot. $171 per sq. foot times 33 million is $5.64 billion. I am quite sure SRG does not have access to this amount of money on short notice.

·         Not a chance that SRG has the talent to develop that much space in a short period of time. After all, if all things go well SRG will have ended up developing about 1 million square feet by the end of 2018 based on the Q2 filing. Would it be possible to do more? Sure, maybe SRG can find enough talent to develop two million square feet a year or even 3 million square feet, ignoring costs. But even at 3 million square feet a year it would take 11 years. I do know that there will be opportunities to sell properties or JV on those. But prices of undeveloped properties will be a lot lower than of developed projects. And JV partners will want their slice of the economics too, no one works for free after all.

·         Lastly if SHLD goes chapter 7 it won’t be just 33 million square feet of SHLD retail space owned by SRG that will hit the market. Another 1350 stores, 419 of which are owned by SHLD, will hit the market at the same time. It is not hard to infer that will create quite a supply of retail space. I wonder want the impact will be on rents. And also when you think that another company will just come in and buyout SRG, remember that there will be a total of around 1,600 SHLD stores for sale, not just the SRG inventory will be on the market. Anyway, renters aren’t stupid either and will want lower rents. When Mervin’s went out of business the expectation at that time too was to get $14 a square foot. I know someone that was closely involved in that situation and they didn’t get close to the expected rent. Some of the stores ended up renting for $8 a square foot. After all, the market can absorb only so much retail space every year. This all assumes that things are expected to go smoothly for big box retail space, which is not the case. When Walmart has issues with the growth of its retail business and starts closing stores, I can only wonder how great the retail environment is for other big box retailers. This is just from personal experience, but there seems to be accelerating momentum around home delivery. From a good source I heard Amazon is thinking of a “pick up” concept of 15,000 square feet pickup locations where you can pick up your ordered goods by car and where the location will know when you arrive based on a cellphone app so all items will be ready to be put in your trunk. There are also a lot of Amazon vans driving around my city delivering things. In addition there are also many Walmart trucks driving around delivering orders. Anyway, it is just an observation of mine, but it seem that this online momentum is here to stay at the long-term detriment of big box retailers.


So what is going on at SHLD? I wrote up SHLD about a year ago and while I exited the idea a while ago I just couldn’t stop thinking about it. The way it looks to me SHLD can’t be far away from a liquidity event. Now this liquidity event does not take into account a major economic calamity. If we would have a minor version of the financial crisis it is game over for SHLD. But even without the potential recession, I feel the end is closer for SHLD than many people think. So what is happening with SHLD?

·         Competitors are circling aggressively and looking to profit from SHLD’s coming demise. Especially JCP wants a piece of SHLD. In the latest conference call they even openly admitted that they benefited each time a SHLD store closed, which seems logical as the profile of both retailers customers overlap. So suddenly JCP is opening appliance departments in 500 of its stores. JCP overlaps with Sears in about 400 of its stores. It seems clear to me that they want to grab a piece of the sales that SHLD does in the hope SHLD goes away so they can grab a much larger piece of the pie. JCP was already offering 20% off on appliances + free financing for 24 months + free delivery and installation for items that cost more than $299. All the while JCP stated that they will start a broad awareness and marketing campaign once all appliance departments are in place. That all can’t be good for SHLD’s margins and SSS going into the holiday season, especially since SHLD keeps saying that appliances is a stronghold of theirs. FYI. For those interested SHLD’s market share in appliances was 23.5% in 2014, in 2015 it was 19.5%. So much for a stronghold sales category. And this is happening all the while that the US appliance market has been growing since the last recession.

·         That gets me to SSS. Things are just bad on that front and the decline is continuing it seems. Ignoring 2007 through 2009, SSS had been declining at a leisurely 2% to 3%, but suddenly in Q1 2015 the negative SSS number accelerated with Kmart have (7.0%) and Sears having (14.5%) SSS. And that continued all the way through Q4 2015 with Kmart doing (7.2%) and Sears doing (6.9%). Now since these SSS comparables are TTM I thought that after Q4 2015 things would not be as bad. After all Q1 2016 were to compare with the horrible Q1 2015 number of minus 7.0% for Kmart and minus 14.5% for Sears. And here are the Q1 2016, minus 5.0% for Kmart and minus 7.1% for Sears. This even surprised me. It seems that the declines are continuing unabated, which I think is happening. It is truly crazy, SHLD has had negative SSS % since 2006 and now the SSS comps are even accelerating. Not a chance that SHLD’s business model can handle these size hits to its operating leverage for much longer. I believe SSS for 2016 will be horrendous too.

·         Another interesting operating element at SHLD is the capex. In 2014 SHLD spent $270 million on capex on stores and other initiatives like online. Well they did even better in 2015 with $211 million. On a per square foot basis that must be a world record for lowest spend every. All other retailers spend at least 5 times as much as SHLD on a per store basis. No wonder that the stores are so run down. They must be skipping on maintenance to an extreme. This is does not correlate very much with the quarterly presentations by SHLD management where they seem to have these great online and membership plans. It is hard to square this with the idea that all these initiative supposedly cost little money, especially when you see that Walmart spends more than $1.5 billion in capex just on its online effort.

·         What about the pension benefit deficit? At the end of 2015 it was $2.2 billion, which is around 60% funded, with a return assumption of 7.5%. All the while the fund was 34% invested in equities and the rest in fixed income. Given that current interest rate environment and the current stock market valuation it is pretty hard for me to see how 7.5% is a reasonable expectation to have. What would happen if the correct return expectation was let’s say 5.5%. I do not know the exact number, but it would increase the deficit markedly.

·         Which brings me to the PBGC. In the 2016 Q1 it notes that SHLD came to an agreement with the Pension Benefit Guarantee Corporation where SHLD will ring fence certain assets and give the PBGC a springing lien based on the following (a) failure to make required contributions to the Company’s pension plan, (b) prohibited transfers of ownership interests in the relevant subsidiaries, (c) termination events with respect to the plan, and (d) bankruptcy events with respect to the company or certain of its material subsidiaries. In short, the PBGC has its eye on the prize and is clearly worried that soon it will get stuck with a multi-billion dollar bill. The PBGC can stop the sale or spinoff of any assets in case it is worried that assets are being removed from the company to the detriment of the PBGC. So this does not look good for those that think there are many other assets to sell.

·         So when it comes to closing down the stores (and selling the assets), I would like to point out the fact that it seems to cost about $2 million to close a store using Q1 2016 data. Well SHLD still has a little more than $1,600 stores. 1,600 times 2 million is $3.2 billion. Don’t forget that this is also a huge liability. I keep reading thesises where people mention that after we close the stores there is still $5 billion (Q1 2016) in inventory minus 1.4 billion in payables to be sold. No can do … closing those stores outside of BK is expensive. And if you accelerate the pace of closings the costs will only increase. In short, the thesis of putting much value on the inventory without taking the cost of closing stores into account is incorrect, after all either you have the stores and inventory or you do not.

·         Which brings me to the payables … At the end of Q1 2016 there was $5 billion in inventory and about $1.3 billion in merchandise payables. From talking to a friend that used to do business with SHLD he told me it has been difficult to impossible to get credit insurance against SHLD. I wonder who the companies are that are still extending a total of $1.3 billion in payables credit to SHLD, but this could easily turn into a liquidity event in case the last vendors decide it becomes too risky. How long before that happens?

·         And what about the borrowings? Total borrowing for Q1 2016 was $3.758 billion of which $180 million was capitalized lease obligations. But what stood out to me was the Secured Loan Facility from April 2016 that involved Bill Gates’ Cascade Investments. It was a $500 million facility with a maturity date of July 7, 2017. What stood out first was that Cascade was willing to take down 25% only if ESL took the other 25%. The plan was then to syndicate the loan out, but no one was interested and both Cascade and ESL each ended up with 50% of the loan or $250 million each. Interesting that they couldn’t get other parties to sign on, given that you were investing beside Cascade and that the loan is secured by a first priority lien on 21 properties. In addition the total return was pretty costly. The annual return was 8% with a 1% upfront commitment fee, a 1% funding fee, an additional 0.5% fee of the balance was still outstanding after 9 months and another 0.5% of the balance still outstanding after 12 months. Now this is in essence a 14 months loan and the cost was around 11%.

Or look at the 2016 term loan which is priced at Libor plus 7.5%.

·         This brings me to the negative equity of $2.36 billion from Q1 2016. It is a good start to start thinking about SHLD’s net asset position. But we can make some adjustments. SHLD did not have much cash at $286 million. If for some reason the $1.3 billion in payables shut down it would be a problem. Then we have the accounts receivable, merchandise inventory and prepaid expenses for a total of 5.834 billion. I will assume that that is money good. On the other hand there is the Goodwill of $269 million which I don’t think is money good. And what about the trade names and intangible assets of $1,907. I assume that is mostly related to the Kenmore, Craftsman and Die Hard brands. Let us assume that is money good. So I take a hit of 269 million because of Goodwill which brings my adjusted net negative equity then to $2.629 billion. Then I get to liabilities where I assume that those are 100% good, but I feel that the pension deficit is too low. A return rate expectation of 7.5% is too high. If we change that to 5.5% I would assume we have at least another $1 billion in additional pension deficit. This brings my adjusted net negative equity to $3.629 billion.

·         And this brings me to the cost of closing stores … as I mentioned before, I costs about $2 million to close a store. With 1,600 stores still open that is a potential hit of $3.2 billion if we want to close the stores outside of filing bk. This is important, because all the thesis I read about SHLD are all centered on closing stores and monetizing assets. But you can’t monetize all the assets if you don’t close the stores. So that brings my net adjusted negative equity to $6.8 billion for SHLD. Anyone think that there are enough assets to offset a Chapter 7 filing? I don’t think so.

·         Let us look at the assets to monetize. Starting with the brands, Kenmore, Diehard and Craftsman. First let’s keep in mind that they are already valued at $1.907 billion under Trade Names and Other Intangible Assets. So we need to get more for these brands than $1.9 billion to make a difference. The big fish seems to be Kenmore, especially since GE sold its appliance business to Haier for $5.4 billion, after the deal for $3.3 with Electrolux was nixed by regulators. It seems to me that Haier likely overpaid as Electrolux had massive economies of scale advantages with buying GE, where Haier had little. After all Electrolux had a 23% share in appliances and GE 28% so it made sense to merge those to create more economies of scale. And still Electrolux was willing to pay only $3.3 billion to get the deal done. Now GE appliances is a growing business with a 28% market share. It is a real business that designs and produces goods with a very strong representation in the new built market. Compare that with Kenmore, which is just a brand that mainly older people know. Kenmore does not develop or design, it just is a brand that soon only old people will remember. It had a 40% share a long time ago. Now the market share is around 10% and falling. So what exactly would someone be willing to pay for this compared to GE which is a growing brand with 28% that produces and develops appliances? It should not be $3.3 billion, that I am confident off. Maybe $1 billion makes sense.

Or let’s look at Diehard. It has about 5% market share in the aftermarket replacement battery business. Again, it is just a name attached to dying business. What is this worth? I would guess less than $200 million.

Or what about Craftsman? Craftsman has a 28% market share of the hand tools market and a 9% share of the portable power tools market. Both categories we down 5% in the last 4 years. So we got a brand in a declining market. I don’t believe anyone will be willing to pay much for the power tool business. Overall the quality of the Craftsman power tool items is low. Now the Craftsman hand tool business could be attractive to someone, but let us not forget that until a few years ago they had a lifetime warranty. Your dad could have bought an item in 1968 and return in today for a replacement. But let us be generous and give it a $1 billion value.

So that gives me a value of $2.2 billion for the brands, or $300 million in excess value over the $1.9 billion that the brands are already on the books. And let us not forget that the buyer has to assume that his main distribution channel might be out of business very soon. And can SHLD afford to give up a margin to the buyer? The buyer will likely also want to sell the brands into other channels, which will be expensive to do and also it will dilute sales away from SHLD and the last thing SHLD needs is worse SSS.

Lastly, I understand that these brands are collateral for the captive insurer. The regulator will want something to replace that.

But what if SHLD decides to sell the brands in other sales channels? It could potentially drive sales, but it would dilute sales away from SHLD stores which it cannot afford. Actually I don’t see many retailers being eager to sell these brands. It is not as if there is a shortage of appliance, car battery or tool vendors.

So OK, we got $300 in excess value which lowers the adjusted net negative equity balance to $6.5 billion.

·         So then we got the businesses. Starting with the warranty business, I read somewhere that someone wants to put a 5 multiple on that business? But aren’t these warranties sold through the SHLD stores? There isn’t going to be much warranty business left to do if there are no stores. The same argument counts for the service and repair business. It is losing revenue fast and again it is attached to the stores. No stores no value. A famous investor even mentioned that the pharmacy business we very valuable. Again, no stores no value. I never understand how some keep arguing for a fast closure of the stores, seemingly assuming there is no cost to that, while at the same time putting a value on businesses that can only exist if there are stores. So it is fine with me that one puts a value on these businesses, but then one must at the same time also include the negative present value related to the losses from keeping the stores open. I am not giving any value to these business for that reason. So my adjusted net negative equity is still $6.5 billion.

·         Let us now get to the real estate. I do not believe that there is much value in those low cost leases. Borders was supposed to have a lot of value in below market leases and it turned out to not be there. Landlords often need to agree with changing tenants and why would they allow SHLD to get all the economics from the low cost lease.

Then there is about $2 million square feet of office space. If I give it a value of $200 a square foot then that make for $400 million.

Then there are the owned stores. At the end of 2015 SHLD owned 419 stores. 97 discount stores, 302 mall stores and 20 specialty stores. Again I see a logical disconnect in many investors presentation. They see a lot of stores owned and then assume that these stores can be redeveloped and rented out for a lot more money. Well it costs about $170 a square foot to redo a store. Let us just assume there is 30 million square feet in these stores. Well then the redevelopment cost would be $5.1 billion. Where does SHLD get this cash? And it will take up to a decade or more to redevelop all these properties. Not just because of labor and cost, but also because often it takes a long time to rezone.

So these stores have a value, but SHLD will not be able to get the full repurposed value for the buildings. It will have to sell that real estate at a discounted price. And it will have to be a seriously discounted price as at the same time as 1,600 stores will become empty at the same time, with a resulting pressure on rents.

But let me be generous and give the real estate a $4 billion value, which I think is very generous. That gets me an adjusted net negative equity of $2.5 billion.

·         And now comes the last piece … just in 2016 I think SHLD will blow through $1.5 to $2.5 billion in cash. Here are some numbers

o   Interest expense in 2015 was already $323 million and likely to be higher in 2016 given that every year SHLD needs more borrowings to cover operating needs.

o   On an annual basis SHLD will pay an additional $120 million rental run rate to SRG and its JV. (Actually the number is a little higher as I am not including the JV portion of the rental income.)

o   Also last year SHLD contributed $311 million in for retirement benefits.

o   SHLD is closing about 100 stores this year. Given the numbers in the past that will cost about $200 million.

o   Over the last 3 years SHLD has lost $1 billion (2015), $1.5 billion (2014) and $927 million (2013) in operating income. To the operational loss for 2016 we need to ad interest expense and the additional pro-rated cost of the SRG rents. It is just not very hard to see losses hit $1.5 billion again, given SHLD’s continued expectation of negative SSS and pressure on margins.

So to end I will deduct another $1.5 billion from the adjusted net negative equity balance of $2.5 billion which gets me an adjusted net negative equity balance of $4.0 billion.

And this gets me to the point where I think that when SHLD files for BK, it will be chapter 7 instead of chapter 11. The hole is too deep and the business has been too mismanaged for it to come back. Honestly I don’t think there will be a person under 70 years of age that will miss either Sears or Kmart. They are the corporate version of the living dead. P.S. Don’t mention all of Eddie’s pet online projects. In my eyes these projects are totally discredited.

So what will bring SHLD to its knees? I think most likely it will be a liquidity event. Either the last few vendors that are offering payables credit pull it. Or maybe SHLD will not be able to refinance that Cascade loan next year. Or maybe the business deterioration will accelerate and the business will just collapse onto itself. It could be one of many things, but it seems quite certain there will be one trigger at one point.

So that brings me back to SRG. As I showed above, the cash flow negative impact of $220 million would be huge for SRG, while at the same time SRG based on the latest filings would still be on the hook for $175 million in development expenses for the SNO stores. And at the same time there would be 1,600 old SHLD stores in the market looking for tenants. Now the stores will have a value, but that value would be much lower than many people think.

Now what happens if SHLD does not go bk soon? Well if it never goes bk, then SRG should do fine. Now I do have some time for SHLD to go bk. As you can see, it is taking SRG a lot of time to develop these stores. Based on the latest filings it will only have redeveloped 1 million square feet by the end of 2018. That leaves 32 million sq. feet ex JVs to redevelop. At a cost of $170 that will also mean a lot of cash cost to redevelop this area. So it will take some time for SRG to redevelop most of the space and honestly I have a very hard time imagining SHLD being around in 2 to 3 years. Even if SRG goes bk in 3 years, the cash flow hit to SRG would still be crippling.

Some more comments around SRG:

·         Has anyone noticed that neither Macerich, nor Simon has recaptured any of the JV stores? It seems obvious what they are doing. Why recapture 50% of a store, when you can recapture 100% not too far down the line. It seems they too think SHLD will be history soon. GGP has recaptured space, but they have also publicly said they want to do more deals with SRG, so I guess they are hoping to generate goodwill.

·         People seem to under estimate the cost and time it takes to redevelop. Currently SRG is going around and working on the low hanging fruit. But a lot of the hard work still needs to be done. In most malls you have reciprocal usage agreements. Basically you need to submit a plan and other stakeholders need to agree. Now the other stakeholders tend to want money/favors from you to agree to what a developer wants to do.

·         Regarding the really valuable properties especially the timelines extend out far into the future. A friend of mine works for a developer and for example regarding the Santa Monica property if they chose to rezone, in that location he thinks it would be 8 to 10 years before you could finish a project.

·         I have read multiple times now that investors expect the rate of return on redevelopment by SRG to be in the double digits, even close to 20% unlevered. On the other hand when I spoke to my developer friend he had a hard time coming up with high single digits numbers on the JV properties … time will tell.

Anyway, this is only ancillary stuff. The core of the thesis is SHLD filing for chapter 7.



I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


SHLD filing for chapter 7.

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