Sunday, January 13, 2008

Sears Holding

I wrote this article for Seeking Alpha. Sears Holding is a very interesting story, how many retailers do you know where analysts are positive on the stock but expect the company to cease operations in 10 years. It is really all about Lampert. Funny thing is that Lampert is actually trying to save the thing and he just might, I was really impressed with the stores and Sears does have a lot of cash and debt resources. So, my short postion, very conservative (vertical call spreads) is really a short term bet that the market will lose faith in this story for the time being, not a bet against Lampert. Don't bet against billionaires in the long run, bad idea.



Finance 101: “A company is worth the discounted present value of its future cash flows.” Well, not exactly. Morningstar analyst Kimberly Picciola’s November 2007 brief on Sears uses four components to arrive at a $240.00 fair value estimate. The Morningstar model reflects a lot of discussion that I have seen on Sears Holding and it is a good illustration of how Sears Holding is viewed. Each component is assigned a percentage contribution to the value of Sears Holding.

Retail profits (24% of fair value)

This is the easy stuff, just estimate sales, margins and profits as with any other retailer. Looking at last quarter, Sears Holding’s sales slowed with the housing market and it acknowledged big inventory issues. K-mart and Sears have relentless competition; Best Buy and Costco on electronics, Home Depot on tools, Wal-Mart and Target on general merchandise. In the current economic environment, it is hard to see Sears or K-Mart excelling. Also, Sears Holding is criticized for under-investing in its stores but management disagrees profusely and I personally think my local Sears is a great place to shop. I see great appliances, yard equipment, and tools. I also see a first class kid’s department (I have two small kids), a robust men’s department, and a store that is clean, organized, and well staffed (albeit pretty empty last visit).

In any case, don’t over-think this part of the equation. The numbers are reported quarterly and, according to Morningstar (see below), all retailing will cease in 10 years anyway.

Real Estate (45% of fair value)
Morningstar’s analysis includes an eye-opener:

“After 10 years, we expect the retail business will cease and value will be unlocked by selling the real estate assets and the brands. This accounts for roughly 45% and 8% of our fair value, respectively.”

I had to chuckle when I read about “unlocking” real estate value. That is so 2005. Unfortunately, real estate valuation in 2008 is summed up daily in the press by one word, “declining.”

Brand value (8% of fair value)
Sears has exclusive brands like Kenmore, Craftsman and Land’s End. Brands have value and can be sold. Maybe Wal-Mart buys Kenmore. Maybe J.C. Penny wants Land’s End. Maybe Lowe’s wants Craftsman. No argument from me.

Eddie Lampert (23% of fair value)
I hope Lampert is in good health. His brain is apparently worth exactly 1% less than the entire value of the Sears and K-Mart’s combined. You must believe in him (Cramer does) to go long on Sears Holding. Here is how Morningtar looks at it:

“Finally, given Lampert's successful investing record, we believe he will be able to allocate the company's excess cash to generate an average annual return of 20% over the next 10 years. This accounts for 23% of our fair value estimate. We think there is room for Sears Holdings to add leverage to the balance sheet, particularly if its debt is upgraded to investment grade.”

I read the letters from Lampert to shareholders posted on the Sears Holding website. He wrote quarterly until March of 2006 and once in November of 2007. I wanted to see how he thinks and I respect Lampert for what he wrote. He is obviously passionate and cares deeply about what others think and say. Like everyone else, however, he sets a very high standard for himself. Here is my take-away and some excerpts:

Lampert as Jack Welch.

“I view Sears Holdings as a $55 billion revenue, 350,000 person start-up…my goal is to see Sears Holdings become a great company whose greatness is sustainable for generations to come…When Jack Welch took over, he completely reinvented GE...as part of Sears Holdings’ efforts to adapt, I am focusing on providing direction, raising issues, asking questions, and suggesting ideas – on challenging and collaborating – and I rely on the experience and ability of our talented management team to make those ideas come alive.”
2. Lampert as Warren Buffet:
“Warren Buffett makes clear that his goal is to increase the per-share value of Berkshire Hathaway. Similarly, our goal is to increase the per-share value of Sears Holdings..”
3. Lampert as the underdog;
“We welcome the challenge of being the underdog, and we will let our performance speak for us.”
Obviously, Lampert believes in himself and he has re-purchased $3 billion of Sears Holding stock to prove it. Morningstar also mentions that Lampert has begun investing excess capital in derivatives such as “total return swaps” and acknowledges the increased risk. If you invest in Sears Holding you get Craftsman tools on Aisle 1 and “total return swaps” on Aisle 2. You don’t get that with Wal-Mart! Of course, you also get Lampert’s brain and you will need it. Besides competitive issues in the best of times, Lampert must now navigate a housing slump, credit crunch and slowing economy. The challenges seem overwhelming and I have a small short position in Sears Holding. Nevertheless, I have a secret theory that might justify investing long in Sears Holding. Don’t tell anyone, but I really think Eddie Lampert might be Superman. What do you think?

2 comments:

Alex Morrow said...

To paraphrase Buffet"combine a bad business with good management and the business will usually win."

Having said that, Berkshire was originally a low profit manufacturer of fabrics. Buffet tried everything and couldn't make it work well so he turned it into an insurance business and moved on from there.
Sound very much like the analyst expectations for Sears. Retail to real estate.
My preference is to look for more predictable investments. It's always a roll of the dice.

MSF said...

OK,I HAVE HEARD THESE ISSUES ON SEARS BEING A HOLDING COMPANY AND NOT JUST RETAIL AND I AGREE.

BUT WHY DOES NOT EVERYONE IN THE INVESTMENT WORLD AGREE.

WHY DO THEY STILL LOOK AT RETAIL ONLY.

AM I STUPID OR ARE THEY.