Description

This long investment idea is based on the investment thesis that the sum of the parts is worth substantially more than the market value of the company and there are several potential catalysts that could unlock this hidden value.

Background

Sears Canada Inc. is a multi-channel Canadian retailer with 122 department stores, 144 dealer stores, 47 furniture and appliance stores, 2,233 catalogue/on-line pick-up locations, 14 outlet stores, 50 floor covering centres, 49 auto centres, 110 Sears Travel offices and a maintenance, repair and installation network. This retail network supports a profitable financial services unit that includes the Sears credit card and the recently introduced Sears Mastercard.

Sears is a well known retailer in Canada with strong geographic representation across the country. The company reports that 93% of Canadians live within 10 minutes of a Sears location.

The company recently announced the sale of their auto centre business as it would require substantial capital investment to remain competitive and was considered by management to be non-core. This appears to be an intelligent business decision as both capital and management’s attention are better utilized by focussing on the core retailing business and new banking operation.

Sears Canada Inc. is 54% owned by Sears, Roebuck and Co. (USA).

Sears Canada has 3 major business segments:

Merchandising

Same store sales declined 4.6% in 2003 as the retail environment in Canada for retailers was dismal. In addition to competition from Walmart and others, the impact of the Iraq war, SARS, forest fires in Western Canada and a long winter made it a tough year. The company hopes to achieve same store sales growth in the low single digits for FY2004.

The merchandising segment generated $87.5 million in operating profit in FY03 on revenues of $5,812, assets of $2,354 million and capital employed of $900 million. For valuation purposes, I estimate this segment to be worth $1740 million (0.3x revenue).

The merchandising segment includes a wholly owned transportation and logistics division – S.L.H. Transport Inc. This division consists of an estimated 500 trucks and 3200 trailers that service approximately 300 third party customers. This division also services the Sears distribution network. This is a hidden asset that could have a net market value of around $300 million in addition to the segment value above.


Credit

The company has 9.5 million Sears Card accounts representing $2.7 billion in receivables. Only about 45% of Sears cardholders are active. At the end of FY03, the Sears Mastercard had 130,000 active account holders (up from 125,000 in FY02) representing $163 million receivables (up from $150 million in FY02). Sear’s strategy is to try and convert qualified inactive Sears Card holders over to the Sears Mastercard. There are 5 million inactive Sears Card accounts of which 75% or 3.75 million would qualify for the Sears Mastercard.

In December the company was granted approval to begin operations of the Sears Canada Bank as a federally regulated Schedule I bank. This opens another area of growth from which the company should be able to leverage its existing relationship with customers by offering other financial products such as lines of credit, mortgages and insurance.

The credit operations generated an operating profit of $87.5 million in FY03 on revenues of $347.8 million and average capital employed of $1417 million. For valuation purposes, this segment could have a market value of about $700 million (2x revenues or 8x operating profit).

Real Estate
The company owns an interest in 16 shopping centres across Canada through joint ventures with major shopping centre owners and institutional investors. The book value (Sears portion) of these real estate assets is $177.8 million and generates an operating profit of $29.5 million. Using a 9% capitalization rate, these properties have a market value of $327 million (many real estate investment trusts would probably pay even more for these assets in today’s environment). Sears estimates the market value to be $330 million.

Historic Performance
The financial results for the company show a 3.9% five year average annual revenue growth rate although the past 3 years has shown a declining trend. The net income is lumpy from year to year although the company reported positive net income for more than the past 10 years as shown by the consistent growth in book value from year to year.

FY Revenues Net Income Operating Reported
(000’s) (000’s) EPS EPS
2003 $6,223 135 $1.50 $1.26
2002 $6,536 52 $1.30 $0.49
2001 $6,726 94 $0.62 $0.88
2000 $6,356 226 $1.72 $2.12
1999 $5,777 200 $1.88 $1.88
1998 $5,132 146 $1.38 $1.38

Based on forecast eps of $1.48/share in FY04, the shares are trading at a p/e of 12, which is at the lower end of its historic p/e trading range.

FY BV Yr/Yr
Per share Growth
2003 $16.96 10.0%
2002 $15.42 1.6%
2001 $15.18 4.3%
2000 $14.55 14.8%
1999 $12.67 15.4%
1998 $10.98

The company’s share price has been well supported by its Book Value over the years. The average low price in a year has averaged 1x book value over the past 5 years. With SCC trading at a current price of $17.50, it is well within its low target price range for the year. Using a conservative 2004 year end book value of $18.00, SCC is trading a slightly less than 1.0x estimated book. The book value gives good downside protection. On the upside, the ratio has ranged from 1.3x book value (2003) to over 3x. This gives a target price range anywhere from $23.40 to $54.00.

Valuation

A sum of the parts valuation of the company is as follows:

Value net of debt
Merchandising $1740
SLH Transport $300
Credit Card $700
Real Estate $327 million
Total $3,067 million

With 106.8 million shares outstanding, each share has a value of $28.71/share, a 64% premium to the current trading price. If the company is successful in its strategic initiatives, then this value should grow nicely over time. This target price is 1.6x estimated FY04 book value which is also well within the historic market price range based on stated book value.

Catalyst

1. Sears, Roebuck Inc. (USA) buys out the 46% it does not own. With over US$9 billion in cash on Sears Roebuck’s balance sheet, this acquisition would barely make a dent.
2. Selling the credit card operations as Sears Roebuck Inc. recently did to Citigroup.
3. The company is successful in increasing operating margins and/or in its other strategic initiatives such as growing its new banking operation resulting in greater net income and/or being awarded a higher valuation multiple.
4. Spinning out or selling the wholly owned transport division SLH Transport.