Sears Holdings Corporation Jan 2010 $55 Puts SHLD120121P00055000 S
July 06, 2010 - 3:43pm EST by
2010 2011
Price: 16.00 EPS $0.00 $0.00
Shares Out. (in M): 115 P/E 0.0x 0.0x
Market Cap (in $M): 6,924 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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I recommend a short position in the January 2012 $55.00 put options on Sears Holdings' common equity.  The most recent bid price for these

options was $16.00.  In a worst case scenario that assumes a liquidation of Sears Holdings ("Sears" or the "Company"), I estimate a share of

Sears Holdings' common equity ("SHLD") would be worth at least $66.15.  By shorting the January 2012 $55.00 put options, one is effectively

committing to buy SHLD at $39.00 ($55.00 strike price - $16.00 premium), a purchase price that would represent only 60.0% of a worst case

liquidation value.  With a satisfactory margin of safety relative to a worst case scenario, the risk of permanent loss of capital in this investment

is extremely low.

Most likely, these options will expire worthless.  Sears is a profitable, cash flow-positive company with a strong balance sheet.  The Company's

financial performance has improved across all three of its primary business segments over the past few quarters.  Sears' corporate governance

is highly owner-oriented and focused on creating and preserving shareholder value as a result of Eddie Lampert's involvement as Chairman of

the Board and ownership interest.  While one could make an effective argument that Sears faces competitive challenges over the long-term,

the probability of Sears' financial performance deteriorating over the next 18 months to such a degree that liquidation value would become

relevant is quite remote.

The expected return from this position is attractive, particularly when the low degree of risk is considered.  Assuming one were to set aside cash

to purchase the stock underlying the options should the options be exercised, the total and annualized returns on this investment would be 41.0%

and 25.0%, respectively, if the options were to expire worthless on January 20, 2012. [The returns are calculated with $39.00 per share in cash

as the "investment".  Shorting the options generates proceeds of $16.00 (ignoring commissions), which when combined with the $39.00 in cash

"investment" provides sufficient liquidity to purchase the underlying shares should that be required.] 


Liquidation Value & Margin of Safety

In my liquidation analysis, I value Sears Canada and Sears Mexico as on-going businesses.  I assume that Sears Domestic and Kmart are liquidated. 

Sears owns 90.4% of Sears Canada, and therefore consolidates it for financial reporting purposes.  I deconsolidate Sears Canada from Sears' balance

sheet in my analysis by adjusting Sears Canada's balance sheet as of May 1, 2010 from Canadian dollars into U.S. dollars using the USD/CAD exchange

rate as of April 30, 2010, 0.9835, and then subtracting the resulting balance sheet from Sears' consolidated balance sheet as of May 1, 2010.

(Figures in thousands, except per share values)

Book Value
Estimated Recovery Range
Implied Value


Domestic Cash & Equivalents $494,000
100.0% -- 100.0%
$494,000 -- $494,000

Domestic Accounts Receivable 585,785
25.0% -- 40.0%
146,446 -- 234,314

Domestic Inventories 8,415,311
68.6% -- 86.1%
5,772,831 -- 7,249,712

Domestic Prepaid Expenses & Other 282,243
45.0% -- 53.0%
127,010 -- 149,589

Brands 2,811,000
100.0% -- 100.0%
2,811,000 -- 2,811,000

Sears Domestic Real Estate

7,374,928 -- 7,374,928

Kmart Owned Real Estate

983,000 -- 1,769,400

Sears Mexico (15.0%)

100,000 -- 200,000

Sears Canada (90.4%) 97,342 shs
CAD 28.75 -- CAD 28.75
2,694,746 -- 2,694,746

Asset Value of Holdings

20,503,961 -- 22,977,689

Less: Domestic Liabilities 14,790,641

(14,790,641) -- (14,790,641)

Capitalized Lease Obligation Adjustment

626,000 -- 626,000

Tax Adjustment

1,259,575 -- 294,821

Liquidation Value of Holdings

$7,598,895 -- $9,107,869

Liquidation Value per Share 114,865           $66.15 -- $79.29

Margin of Safety - Equity $39.00

41.0% -- 50.8%

Domestic Accounts Receivable

Sears' domestic accounts receivable are comprised of pharmacy receivables as well as vendor-related and customer-related accounts receivable. 

I used the same recovery rates for accounts receivable that were used in the liquidation analysis done as part of Kmart's Plan of Reorganization

in conjunction with its emergence from bankruptcy in 2003.

I believe these recovery rates are quite conservative.  Pharmacy receivables, a significant portion of the total, are receivables from creditworthy,

third-party insurance companies.  Additionally, the firm that performed the liquidation analysis for Kmart assumed very low recovery rates on

merchandise allowance receivables from vendors.  The most likely reason is that some vendors were expected to have impaired pre-petition claims

that would offset against any receivables.  Clearly, there would be no impaired claims if Sears were to liquidate at this point in time, so a higher recovery

rate could very well be appropriate.


Domestic Inventories

I used the results of going-out-of-business sales that Kmart conducted related to 283 stores that were closed over a 10 week period in 2002 to estimate

the liquidation value of Sears' current domestic inventory.  On one hand, if Sears were to liquidate its domestic operations, the scale of the operation

would be much larger than Kmart's GOB sales in 2002.  The larger amount of inventory that would need to be sold in a weak economic environment could

conceivably lead to lower recovery rates.  On the other hand, if Sears were to liquidate, it would likely do so because it determined that liquidation would

maximize shareholder value relative to continuing as an on-going business, not because of immediate financial distress.  As a result, Sears would likely

have a high degree of flexibility in managing the timing of its liquidations in order the maximize shareholder value.  I believe Sears could achieve recovery

rates at least as favorable as those achieved in Kmart's 2002 GOB sales.

I assumed a merchandise margin range for Sears of 35.0% - 40.0%.  Sears' reported combined gross margin rate for its Sears Domestic and Kmart

businesses was 27.3% in 2009.  Sears' cost of goods sold includes expenses other than the cost of merchandise, such as retail store occupancy costs,

product repair, home service and installation costs, customer shipping and handling costs, buying costs, and warehousing and distribution costs. 

Consequently, Sears' merchandise margin rate should be meaningfully higher than its reported gross margin rate.  I believe my merchandise margin range

assumption is conservative.


(Figures in thousands)

2002 Kmart GOB Sale

% of Retail
% of Retail
% of Retail

Domestic Inventories @ Cost


-- $8,415,311

Assumed Merchadise Margin


-- 40.0%

Implied Inventories @ Retail $1,415,469


-- $14,025,518

Gross Revenue 890,303

Store Direct Expenses:

Total Employment Expense 118,479

Rent & Occupancy 47,132

Advertising 31,100

Other SG&A 4,435

Total Store Direct Expenses 201,146

Liquidation Fees 58,423

Total GOB Expenses 259,569

Net Cash Proceeds $630,734   44.6%   $5,772,831   44.6%   $7,249,712   51.7%

Domestic Prepaid Expenses & Other

I used the same recovery rate assumptions used in the 2003 Kmart liquidation analysis to estimate the liquidation value of Sears' domestic prepaid

expenses and other current assets.  The relatively high recovery rate assigned to prepaid expenses and other current assets in the 2003 Kmart

liquidation analysis was primarily due to the fact that fully-recoverable prepaid sales taxes accounted for a significant portion of the total prepaid

expenses and other current assets balance.



As part of the purchase price allocation process related to Kmart's acquisition of Sears Roebuck & Co. ("Sears Roebuck") in 2005, Kmart had to assign

a fair value to Sears Roebuck's indefinite-lived brands, among other assets.  At the time, Kmart valued Sears Roebuck's indefinite-lived brands,

specifically Kenmore, Craftsman, DieHard, Land's End and Sears, at $2.811 billion.  Importantly, this value reflects only the value of the brands themselves,

not the value of any associated operating infrastructure (e.g. Land's End's catalog business, stores, etc.).  Sears is required to test this $2.811 billion

carrying value annually for impairment, and continues to believe that the fair value of these brands exceeds their carrying value.  In light of this fact and

the fact that the $2.811 billion carrying value of the brands excludes any valuable portions of these brands' operations other than the brands themselves

(i.e. the relief from royalty), I believe this is a conservative measure of value for these brands/businesses.


Sears Domestic & Kmart Real Estate

Kmart also had to assign a fair value to Sears Roebuck's real estate as a result of the 2005 merger.  At the time of the merger, the gross carrying value

of Kmart's land and buildings was only about $238 MM (more on this later).  Since then, Kmart has acquired some stores and invested at least some capital

in existing stores, but I think it is fair to say that almost all of Sears' current gross carrying value of land and buildings relates to Sears Domestic and

Sears Canada, and that those gross carrying values approximate the fair value of those assets in 2005.


To get at the fair value of Sears Domestic's real estate, I convert the gross carrying value of Sears Canada's land and buildings as of January 30, 2010

from Canadian dollars into U.S. dollars using the exchange rate on January 29, 2010, 0.9353.  I then subtract that amount from the gross carrying value

of Sears' land and buildings as of January 30, 2010 to deconsolidate Sears Canada from Sears.  I believe the resulting number provides a reasonable

estimate of the fair value of Sears Domestic's owned real estate.  To that number I add the net carrying value of Sears' favorable lease rights intangible

asset, which was created as a result of the Kmart/Sears Roebuck merger and therefore relates to Sears Roebuck.


To estimate the value of Kmart's owned real estate, I once again looked to the liquidation analysis done related to Kmart's emergence from bankruptcy in

2003.  The projected fair value of Kmart's owned real estate at April 2003 was $1.2 B.  Rockwood Gemini Advisors, Kmart's real estate advisor during its

bankruptcy proceedings, estimated that Kmart's owned real estate would generate proceeds of between $522 MM and $662 MM in a liquidation.  At the time,

Kmart only owned about 135 stores with average sq. ft. of 95,000 per store.  That implies a fair value per sq. ft. of owned real estate of about $94 and a

liquidation value per sq. ft. range of $41 to $52.  In my liquidation analysis, I use a range of $50 per sq. ft. to $90 per sq. ft. to value Kmart's current owned

real estate.


For both Kmart and Sears Domestic, I exclude both the assets and liabilities related to capitalized leases for the sake of simplicity.  The implicit assumption in

doing that is that Sears' capitalized leases are at market rates and could be sublet or assigned without material cost.


It is noteworthy that I am not including any liability for operating leases in my analysis, nor am I assigning any value for Kmart's operating leases. 

Kmart's operating leases almost certainly have substantial value.  The fair value of Kmart's favorable leasehold interests, Kmart brand rights, pharmacy

customer relationships and other lease and license agreements was $2.2 billion upon exiting bankruptcy; however, the carrying value of these assets

was written down to zero as a result of the allocation of the negative goodwill created by the adoption of Fresh Start Accounting.  I believe the vast

majority of this $2.2 billion value likely related to favorable leasehold interests.  While the value of Kmart's favorable leasehold interests is likely lower

today as a result of the sale of certain highly-valuable leasehold interests and the utilization of the remaining leases over the seven years since Kmart

exited bankrtupcy, a significant amount of value likely still remains.  Kmart's store leases are generally for terms of 25 years with multiple five-year

renewal options that allow Kmart the option to extend the life of the lease for up to 50 years beyond the initial non-cancelable term.  As a result, 7 year

of utilization likely has not burned off too much of the total value of these favorable leasehold interests.  That said, Kmart and Sears Domestic probably

also have operating leases that would require some expense to terminate (i.e. that could not be easily sublet or assigned).  By neither assigning value to

Kmart's favorable leasehold interests nor assigning a liability for Kmart and Sears Domestic's operating lease obligations, I'm effectively assuming the

two offset each other.


Sears Mexico

There is very little information available in the public domain that can be used to accurately value Sears' ownership interest in Sears Mexico, which

is accounted for at cost.  From Sears' SEC filings, we know that Sears received dividends from Sears Mexico of $9.0 MM, $10.0 MM and $20.0 MM in

2009, 2008 and 2007, respectively.  Assuming Sears Mexico pays all of its earnings out in dividends and applying a conservative 10.0x P/E multiple

to Sears Mexico's dividend/assumed earnings in 2009 would result in a value for Sears' ownership interest in Sears Mexico of about $100 MM. 

I also found some additional information on Sears Mexico an English-version of the 2007 annual report for Grupo Carso, the majority owner of Sears

Mexico.  Sears Mexico had revenue and operating income of 14.696 billion pesos ($1.162 billion at the current exchange rate) and 2.117 billion pesos

($168 MM at the current exchange rate), respectively, in 2007.  Applying a conservative 8.0x capitalization multiple to Sears Mexico's operating income

would imply a $1.344 billion enterprise value.  I couldn't find any information about Sears Mexico's capital structure, so assuming Sears Mexico has no

debt or cash, Sears Mexico's equity value would also be $1.344 billion.  That would suggest a $200 MM value for Sears' 15% ownership interest in

Sears Mexico.  I use a range of $100 MM to $200 MM in valuing Sears' stake in Sears Mexico.


Sears Canada

Sears' owns approximately 90.4% of Sears Canada.  Sears Canada's common equity ("SCC.TO") is publicly-traded on the Toronto Stock Exchange. 

SCC.TO most recently closed at CAD 26.50.  This price is net of a CAD 3.50 special dividend that was paid on June 4, 2010.  Because Sears' domestic

cash and equivalents balance as of May 1, 2010 does not reflect receipt of this special dividend, I have added the per share amount of the special

dividend to the most recent closing price of SCC.TO to arrive at a per share value.  I then converted the value of Sears' stake in Sears Canada

from Canadian dollars into U.S. dollars at the current exchange rate, 0.9629.


Tax Adjustment

The tax consequences of a liquidation are somewhat unclear.  In my analysis, I assumed Sears would get an incremental tax benefit if it liquidated for

less than book value and would incur incremental taxes if liquidated for more than book value.  It is not clear where on Sears' balance sheet it classifies

its deferred tax assets and liabilities and to what extent the Company classifies those items on a net basis.  Because I am not assigning any value to my

estimate of Sears' domestic non-current other assets, $783 MM, in my liquidation analysis and I am subtracting the entire amount of my estimate of Sears'

domestic liabilities, I am probably over-estimating the tax burden prior to making my tax adjustment (i.e. I am probably reducing liquidation value for some

deferred tax liabilities that would be offset by the losses related to the liquidation and deferred tax assets that may be included in non-current other

assets, the value of which I am not capturing).  Additionally, the vast majority of Sears' total deferred tax liability relates to the excess of the carrying

value of its brands and other intangible assets for financial reporting purposes over their tax basis.  Sears could easily avoid paying this liability in a

liquidation by spinning-off its brands to shareholders in a tax-free transaction as opposed to selling them.  These two factors give me confidence that my

tax adjustment in the low case is appropriate.




i) While I think the risk of permanent loss of capital is very low, this position could result in short-term, paper losses for a variety of reasons.  SHLD could

decrease in price, causing the put options to increase in price.  Implied volatility could increase, resulting in an increase in the price of the put options. 


ii) Being short a put creates a potential call on one's liquidity (i.e. if the put were exercised).  In my opinion, this put option would only get in the money

in a truly disastrous scenario.  Such as disastrous scenario would most likely require an incredibly weak economic environment that would have negative

implications for all security prices.  As a result, this position could create a call on one's liquidity at the worst possible time.  This is not an insurmountable

risk, just one that needs to be managed.


iii) Liquidation values are inherently uncertain and subject to change.


Other Considerations


i) Over the course of the remainder of its current fiscal year, I expect Sears to generate about $770 MM in levered free cash flow before contributions to its

pension and post-retirement plans (the degree to which those plans are underfunded is reflected as a liability on the balance sheet, and so the future

required contributions are effectively already accounted for in the liquidation value), which would increase the liquidation value per share by about $6.70. 

In other words, the risk of loss in this position will decrease over time if Sears is able to generate cash and increase its liquidation value.


ii) The potential return on this position is capped by the price at which the put options are sold.


iii) The annualized return on this position could be higher than 25.0% if the price of the put options were to decline materially at some point prior to

expiration (e.g. SHLD trades up materially) and if one were to then trade out of the position.

iv) Because these options are deep out-of-the-money, the delta is low.


Expiration on January 20, 2012
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