Description

This write-up is long, but the investment case makes up the first section - much of the rest of the text is a detailed break-out of the support for the real estate liquidation value. I am posting this for two reasons: 1) because I think this is an incredibly interesting (and cheap) story that should be discussed on this board and 2) to see if others have information that would add substantially to my understanding of the value of SHLD. Finally, I am probably on one end of the spectrum in terms of my belief in the likelihood of a turnaround in the retail operations. I am sure someone will oblige me in describing why Wal-mart, Target, Home Depot, JC Penney, etc will continue to eat SHLD's lunch. Without further ado:

Kmart, now Sears Holdings, has been one of the most publicly debated companies in the retail space ever since Kmart’s bankruptcy in 2002. During bankruptcy one investor, ESL Investments, bought up over 50% of the post-bankruptcy equity. The company emerged from bankruptcy much faster than investors expected and was immediately a favorite short among retail-focused hedge funds. The stock then proceeded to go from $13/share to $108/share in one and a half years, at which point Kmart and Sears agreed to merge in a transaction where just over half of the Sears shares would receive cash, and the rest Kmart stock. The stock now trades at $140/share.

My analysis leads me to say that the company is still significantly undervalued relative to the risk in the position, despite the 10-fold increase over the past three years. Investors arguing the pros and cons of investing in SHLD tend to focus on either one of two mutually exclusive propositions: 1) what is SHLD worth if it liquidates? and 2) what is SHLD worth if it can turn itself around as a retailer and how likely is that? I believe the right way to value the company is to use the liquidation value as a floor valuation (it will be liquidated if necessary – it is a real option) but to focus on the retail value because I believe a turnaround is looking increasingly likely.

Note: It is important to realize that SHLD has a basket of options in choosing to liquidate –it can liquidate individual stores whose real estate is more valuable than the retail alternative. Furthermore, under the current major owner (ESL Investments), there is good reason to believe the operation will not be run in a typical retail manner. There is no incentive for ESL, and thus SHLD, to spend capital that does not generate a satisfactory IRR to ESL. Thus, capital allocation should be quite a bit better than in the average retail chain which has all sort of incentive issues (bigger chain means bigger salary for CEO, etc).

---) In a liquidation scenario, I believe the most likely case is a slow-paced contributing of large blocks of stores into either a REIT (that is then spun-off) or to competitors. While the slow-paced liquidation is occurring, I think it is likely the operations spit out cash at a decent rate (probably on par with the $11/share net of taxes and capex over the last year). I believe there are four components of a liquidation valuation:
i) working capital: $3.4B (assuming inventory goes out at cost)
ii) brands: $1B very conservatively, $3B+ slightly less conservatively
iii) real estate: $26.4B (and growing)
iv) taxes: -$5.7B
v) current Sears Canada stake (using $18/share, 63.2% and 0.88 fx rate): $1.0B

Net value: $26.1B, or $168/share, and increasing in value at $18.5/year. If you drop the re-lease rates for SHLD’s space to $10 psf, the net value per share drops to $141/share.

I break this down into significantly more granularity below, but to address the number likely to cause the most controversy – the real estate value is based on observations of new lease rates on similarly-sized stores (generally $14 per square foot (psf) to $18 psf), the blended lease rates on significantly aged portfolios of stores (KSS is $8.9 psf and JWN is $7.7 psf), comparable transactions (TOY price psf adjusting for leases came out to $262 psf). Using $12 psf re-lease rate (blended rate for Kmart higher re-lease rates and Sears lower re-lease rates), 3:1 leverage and a 15% equity rate of return, the value of SHLD net of its leases is $26.4B.

The value is increasing at the rate of cash production ($11/share) plus the rate that the real estate value increases ($7.2/share, or 3% per year (the rate of inflation) with operating leverage through fixed lease payments).

---) I believe a successful retail turnaround involves two things: 1) SHLD generating reasonable operating profitability given where it is now, and 2) SHLD generating enough cashflow to justify the opportunity cost of not selling the real estate.

As discussed above, the re-lease rate for a long-term lease is best-guess $12+ psf. The opportunity cost of re-leasing is lower than $12 currently, as $12 is the nominal rate at which a big box store would enter into a 10- or 20-year lease with constant annual rent rates. To understand current opportunity cost, we would need to know the current psf cost if SHLD entered into a 20-year lease with step-ups every year designed to match the increasing value of the property. Using a credit spread of 100 bps and a 3% real estate appreciation rate, the 2006 rent would be $9.4 psf, 2007 would be $9.68 psf, etc out til 2026 for $16.48 psf. The correct rate for the front year would be the rate where the average retail big-box credit would swap out the fixed payments for floating payments increasing at the rate of real estate value inflation.

Furthermore, when considering opportunity cost we need to consider the capital cost of current inventory plus accounts receivable minus accounts payable psf. This value is roughly $24 psf which equates to a $1.45 psf cost of capital at a 6% interest rate. Adding in the real estate opportunity cost and we have a total average opportunity cost of $10.85 psf.

SHLD, not including Sears Canada, generated EBITDAR (EBITDA plus rent expenses) of approximately $13.8 psf in 2005. If I assume long-term necessary maintenance capital expenditures average $4 psf, then SHLD currently generates $9.8 psf in EBITDAR – maintenance capex. Thus, SHLD’s current operating business already exceeds the opportunity cost of the real estate but does not cover the inventory cost of capital, on average, yet. Also, recalling the basket of options mentioned above, it is likely some properties (Kmart ones predominantely) may be better off being liquidated if they fall far below the opportunity cost.

Similar companies’ operating metrics (including catalog and internet sales) are (WMT ’05 EBITDAR and NI are estimates):
WMT05 TGT05 HD05 FD05 JCP05 JCP06 KSS06 SHLD06
Sales psf 418 295 364 188 185 181 218 204
EBITDAR psf 39 33 50 28 18 22 37 14
NI psf 25 14 25 8 6 10 15 3

Using $23 as an achievable EBITDAR psf turnaround near-term target, SHLD would generate discretionary cashflow of $23 psf - $3.8 rent - $5.3 taxes (38% marginal rate and using $4.16 psf depreciation shield) - $1 interest expense - $4 maintenance capex = $8.9 psf. Multiply * 266 million square feet for total discretionary cashflow of $2.4 billion. That is an 9.0x multiple on the current market capitalization.

Furthermore, it is likely that $23 EBITDAR can be exceeded by a healthy margin as Sears Holdings’s strategic positioning is better than many of the comps above. While Kmart probably won’t move much beyond $20 to $25 psf EBITDAR (given current levels of $10-ish EBITDAR in that segment and the competitive advantages TGT and WMT enjoy), Sears should be able to exceed the other traditional mall anchors.

A little historical context is helpful in understanding why Sears should be able to exceed the operating statistics of its competition. The past 10 to 20 years in American retailing might be summarized by three trends: Walmart, off-mall category killers, and mall-based specialty retailers.

1) Walmart. Sears Holdings, while unable to match Walmart’s economies of scale, is third in terms of aggregate purchasing among retailers (Home Depot is 2nd). This should allow them to capture the majority of the economies of scale, especially once inventory planning is fully-integrated and as they trim down the total number of SKUs (which I believe is part of their process of rationalizing inventory levels). Technology, which they will be investing in this year and next, should further allow them to bring their cost structure below that of the majority of their competitors.

2) Off-mall category killers. While Kmart certainly falls squarely within the label of discount retailer (and unlike Target, has as-of-yet done little to differentiate itself), Sears is a little more nebulous. Sears seems to be home, garage and garden with a large clothing section. It has undoubtedly been caught in no-mans land as powerful forces have risen in each category over the last 20 years. However, Sears is not left without options. First, Sears has powerful brands that signal quality – Kenmore, Craftsman, Diehard and Lands-End. Second, Sears now has an option to go off-mall via Kmart real estate IF that is a NPV positive proposition. Third, Sears (and Kmart) can and will experiment with shifting formats to emphasize various categories of their goods. Finally, Sears has continuous interaction with millions of homes nationwide via their home services unit.

3) Mall-based specialty retailers. This is the area where I believe Sears has a decent head-start on competitors like FD and JCP. If the future of mall anchor stores is to try to imitate and build-upon mall-based specialty retailers, I believe Sears can do this well. An example of a step in this direction is the recent remodel of many Northeastern Sears to highlight a Lands End store-within-a-store. My anecdotal evidence regarding the initial performance of this Lands End section is extremely positive. The merchandising is done well and shoppers are noticing. The company has gone so far as to package purchased goods in high-quality Lands End bags rather than Sears bags. I believe it is likely the store-within-a-store has been a highly successful “experiment”, and will be rolled out nationwide.

With proper execution and strategy, Sears Holdings isn’t that far away from good retailing operating statistics, and conceivably could achieve its desired result of being a great retailer. The change in operating metrics at Autozone has been dramatic and sustained over the last six years.

---) What do proper execution and strategy entail? Eddie Lampert, the chairman of Sears Holdings, has shared his thoughts in four shareholder letters, at least two in-depth interviews and at the shareholder annual meeting. It is pretty clear that he believes that the relative success of companies depends a great deal on the successful development of human capital. An organization with a strong and properly incentivised culture generally thinks and acts more like owners, works more productively and generates more value-adding ideas. Operationally this means a great company culture generates higher margins, more growth, handles competition better, and redeploys more capital at higher returns. These are all laudable goals, but Sears Holdings clearly isn’t there yet.

Since the merger has taken place, the upper management ranks have been gutted and replaced with a good deal of talent from outside of the retail industry. Incentive compensation plans have been changed company-wide to focus on profitability. Employees have been told that the culture of Sears Holdings will change, and that they had better “drink the kool-aid” or look for another job. The mission and values statement has been changed to emphasize testing, risk-taking, and making money. Based on looking at successful cultures (GE, Goldman Sachs, Walmart) and successful turnarounds (IBM, Kmart is partway there), it is pretty clear these are the right steps. Sears is taking them extraordinarily quickly, and not without strong negative feedback from public pundits and employee online message-boards. The sample size of turn-arounds with similar characteristics is small, and so it is impossible to say “based on how things like this have gone in the past, this is x% likely to succeed”. I am confident it will work though; while I believe cultural changes in organizations can create a lot of emotional pain as good employees are asked to leave based on not being on board with the new culture, I do think the likelihood of success is high.

Supposing I am right that the cultural change succeeds, how does the turnaround of Sears Holdings operations look? I believe many investors incorrectly see turnarounds as primarily the result of large strategic decisions. In my view, Sears Holdings success will be built on the fruits of a learning and testing culture. These fruits will include making thousands of little things better every day, and smart medium-sized tests that yield concepts that are expandable company-wide. An example of a failed test is the limited roll-out of Sears Essentials. Two examples of successful tests are Diehard batteries in Kmarts and flat panel-only TVs in Sears (getting rid of the cheaper tube-based TVs). I believe that Lands End will be another success, and it is not a stretch to say they could also create mall-based stand-alone Lands End stores in malls without Sears. In addition, Sears Holdings is on the verge of testing Kmart auto centers out as well as selling ready-to-assemble furniture in Sears. Finally, there are some completely redesigned high volume Kmarts (I haven’t seen one) that have apparently generated greater traffic and profitability.

One thing Lampert has repeatedly emphasized is the idea of only spending money if it creates strong long-term returns on invested capital. With more square feet than any other retail company than Walmart in the United States, Sears Holdings does not need to open new stores. They need to improve current stores, and if Autozone and Kmart are testaments to Lampert’s ability to influence operating results, there are good things to come. To give a sense of the upside, consider the following: if in three years, SHLD is generating $30 EBITDAR and has used $10B in cash generated to buy back 50 million shares at an average of $200/share (leaving 105 million outstanding), then after-tax and after-maintenance capex cashflow psf of $13.5 would imply earnings per share of $34.2. At a 20x multiple, SHLD would be worth $683/share. I’m not saying I believe this is likely, but I do think that the current stock price yields odds heavily stacked in shareholders’ favor.

---------- Valuation ----------

Price per share: $140
Fully-diluted SOS: 155 million
Market capitalization: $ 21.7 billion

---------- Working Capital ----------

Left side of balance sheet:
Cash and equivalents $ 4.4B
Inventories – AP $ 5.5B (I only mention bc I think some of this will move into cash once investment grade status is reached)

Right side of balance sheet:
S-t borrowings: $ 0.2B
Current l-t debt: $ 0.6B
L-t debt: $ 3.3B
Pension liabs: $ 2.4B (I would argue this should be lowered due to unlikely future contributions due to higher return on pension assets)

Net cash (if Investment Grade rating is achieved and $2B additional cash is generated from working capital):
In liquidation: $ 3.4B, or $21.2/share

As operating company
With pension liabs: $ -0.1B, or -$0.6/share
Without : $ 2.3B, or $14.4/share

---------- Brand Liquidation ----------

Valuing SHLD’s brands is dicey business. Clearly, the easiest and most conservative assumption is zero, but it seems a bit unfair when the names Craftsman, Diehard, Kenmore, and Lands End have value. Deutsche Bank did some work on determining estimated revenue for these brands in a report dated July 8th, 2005. The estimated revenues for 2004 were as follows:

Kenmore - $5.8B
Craftsman - $4.3B
DieHard - $0.3B
Lands’ End - $2.2B

While estimating Lands’ End value is a little more certain due to the recent transaction, it is less clear how to value SHLD’s other proprietary private label brands. There are two real problems with comparing to pure-play brand/manufacturing companies like Whirlpool and Black and Decker. First, the pure-plays already have distribution networks and it is not clear how valuable Kenmore is without SHLD to distribute it. Two, the pure-plays own the brand and manufacture the goods, while SHLD only owns the brand. While that still has enormous value (probably most of the value), there is a long way between here and there in imagining Kenmore’s value after SHLD has liquidated.

For Kenmore, a first attempt at proper comparisons are Maytag and Whirlpool. Both Whirlpool and Maytag trade for an EV/Sales of 0.46x. Kenmore is manufactured by Whirlpool ($2.3B sales for Whirlpool in 2005) and possibly others, and so SHLD, as mentioned above, should not get full credit for the EV/Sales ratio if it were to sell the brand. While necessarily arbitrary, I believe a 50% haircut is probably conservative, which would yield a value of $1.3B for Kenmore.

Black and Decker is a comparable for Craftsman – it trades at an EV/sales of 1.17x. With a similar 50% haircut, Craftsman’s value ex-Sears might be estimated at $2.4B.

For Diehard, Energizer seems like a reasonable comparison. ENR trades at 1.6x EV/Sales. Applying our 50% haircut again, Diehard would be worth $0.3B.

Lands’ End was purchased for $1.8B in June 2002. It is safe to say Sears has done nothing great with the brand, and probably diluted it a fair bit. Meanwhile, retail sales overall have risen. It seems Lands’ End could be resold for at least $1B, possibly much more.

While it seems likely SHLD could sell their brands for less of a haircut to independently traded brands within their verticals, for the purposes of a liquidation analysis, we’ll assume $5B (sum of my estimates), or $31/share. And, in a very conservative case, we’ll assume only Lands’ End has value thus lowering total brand value to $1B, or $6.2/share.

-- Market Rent PSF –-

Another cut at looking at the value of SHLD’s real estate would be to determine, if SHLD set up a REIT for all of its properties, at what rate they would sublease. Once again, I will use a blended cap rate of 8.25% on this theoretical REIT. I’m getting this by assuming a 15% pre-tax rate of return on the equity portion, leveraging 3:1, and a 6% rate on the secured debt. This would imply a multiple of 12.1x on the differential between current lease rates ($3.81 psf across the portfolio) and market lease rates. For instance, if SHLD were to lease out all 266 million square feet at $10/sqft/year, this would yield a cashflow psf of $10 - $3.81 = $6.19. Multiplying by 12.1x we get a value psf of $74.9 and a total value of $19.9B.

Trying to estimate the market rent of the portfolio is where it starts to feel really uncertain. I’ve heard $10 psf used as a conservative rate for the portfolio from some real estate consultants. I suspect this is overly conservative. Here is what I could engender from some big box retailers:

BBY: $18.6 rent per new sf (used change in lease payments divided by change in leased square footage)
TJX: $13.9 rent per new sf (used change in lease payments divided by change in leased square footage)
HD: $15 rent per new sf (rough, due to expanding leased distribution and office space)
KSS: $8.9 overall (very hard to tell due to number of owned with leased land, also significantly aged portfolio)
JWN: $7.7 overall (very hard to tell due to number of owned with leased land, also significantly aged portfolio)

As is easily seen above, new space tends to rent for $14+ (I would note TJX does not go for the “choice” shopping malls) and even companies with large seasoned portfolios have overall lease rates approaching $9. I believe it is likely Kohls and Nordstroms are lining up new space at similar rates to BBY, TJX and HD.

There are plenty of arguments to be made that new sf should be rented at premium to re-leased old sf due to newness attracting shoppers. In addition, aren’t anchor store spaces in relatively low demand due to shifting shopping patterns? While I agree, I also believe there is a strong argument to be made that Sears and Kmart locations were established many years ago in good spots, and that the communities they are in have grown denser and remained affluent over that time period. In addition, I suspect the lack of demand for anchor space is less pronounced than many believe. Other chains are figuring out ways to make it work (Target and Best Buy, for instance), and any large amount of supply coming online would be met with many bidders, both strategic, REIT and private equity I imagine. Finally, Kmart had and took the opportunity to jettison its low value real estate in bankruptcy 3 years ago.

I believe $12 is probably a conservative rate and $13.50 a more realistic rate. At $12, SHLD’s real estate is worth $26.4B and at $13.50, SHLD’s real estate is worth $31.2B, or $165/share and $195/share respectively.

This is above many other estimates, and there is a little liquidity problem . More on this after I share the sell-side estimates.

-- Sell-side estimates –-

A few sell-side analysts have done work on SHLD’s liquidation value, with valuations ranging as below:

Deutsche Bank – real estate $22B - $38B
Deutsche Bank – FF&E $1B - $3B
Deutsche Bank – brands $5B - $10B

Morgan Stanley – real estate $21B
Morgan Stanley – brands $6B
Morgan Stanley – taxes on sales $3B

I’m not sure how these numbers were derived, except to say they look suspiciously like they match up with SHLD’s trading value around when the reports were released. I’ve laid out the data I have been able to accumulate above, and believe the sell-side analysts are probably missing the value of the real estate on the low side.

-- Tax issue –-

Unless SHLD is bought by a larger company, it is likely that any liquidation will result in a large tax liability. How large a liability? Book value is around $11B, and so for anything above that we should see a corporate tax rate of 35%. Using $26B for real estate and $1B for brands, that would yield a tax liability of $5.6B on a $16B gain.

It is worth noting that, when TOY was bought by private equity buyers, they maintained TOY’s tax basis on its portfolio and thus likely paid less than they would have if they were able to adjust the tax basis up. So, any acquisitions of whole companies used as comparables include a likely deferred tax liability discount that makes those sales prices not completely comparable to SHLD selling real estate piecemeal.

It is also worth nothing that SHLD can avoid the current tax liability by disposing of real estate into an 80%+ owned REIT, that is then spun off at a later date. This, I believe, is their most likely course of action if they do begin liquidating real estate.

-- Timing of liquidation and lack of liquidity –-

As has been pointed out by everyone, SHLD can’t sell its entire portfolio in any small amount of time at market rates. Bidders will smell a firesale, and bid low. The only way to liquidate the portfolio at anywhere near market rates is piecemeal and slowly. This introduces an interesting question about how much it can be liquidated for in the future, and how much you are paid to wait.

Retail real estate has a long-term real return a few percent in excess of inflation including rents from tenants. I see no reason to expect this not to be the case for SHLD. I believe the value of the real estate generally rises at the risk-free rate (perhaps slightly below) while the rents from tenants provides the “few percent in excess of inflation”. As such, if SHLD can sell a Kmart for $150 psf this year I would expect that to rise at a rate of 3% per year. In addition, currently, we are being paid to wait via the cash generated from operations – after capex and taxes, Sears Holdings excluding Sears Canada generated $10.6/share in cash from operations.

If we assume real estate pre-taxes and pre-subtracting out leases (which have already been accounted for in cash from operationgs) is worth $241/share then we are getting $7.2/share out of the appreciation in value of the real estate plus $11/share in cash, yielding $18, or a 12.9% yield, on the stock at $140.

Catalyst

Continued increasing cashflow per share