Wednesday, October 1, 2014

Why I Bought Sears Holdings and Promptly Sold It

Sears Holdings (SHLD) and I go back to late 2007, when I read the famous bullish Barron's article. After I read the article, I got the stock at $135 per share. Later, I managed to average down in the following year. I sold out the last of my position last year, and overall probably broke even. Last week, the stock hit a recent low when CEO Eddie Lampert announced he would lend Sears $400M for a short term through entities that he controls. That piqued my interest in the company again. The stock reached a low of $24.50 last week. From the time when I first bought seven years ago to now, they have spun off Sears Hometown, OSH, Sears Canada and Lands End to shareholders. I have heard people estimate these spinoffs at $23 per share. That means the stock has dropped 64% from when I first bought.

As the original Barron's article suggested, it is the real estate and other assets that makes SHLD attractive to investors. SHLD owns or leases about 2000 locations in the US. Sears also owns the Kenmore, Craftsman and Diehard brands. The company also operates the Sears Auto Centers. But in the last seven years we have not really seen any large-scale monetization of the real estate. The company has closed hundreds of stores because of underperformance. In the process, the company may make a gain on the sale of the real estate or on the sale of the lease if the store is not owned. Right now, the company's equity is less than $1 B and it has lost more than $5 B in the last 3 years alone!

So the company's income and balance sheet steadily declined over the last 7 years. No wonder then that the company stock has dropped 64%. Even if investors believed in the real estate story, it is very unclear how long it takes. And many gave up, myself included. But in investing, I can like any security at the right price. And I like SHLD at $24.

In my analysis, I am trying to be objective. Bad mouthing Eddie Lampert or being hysterical doesn't serve much purpose in making the correct decision. As I mentioned earlier, Sears has shed several businesses that it owns. Sears is still left with its main assets which has the most optionality. The following summarizes Sears' real estate associated with their full-line stores only and shows their change over the last two years.

Date No. of Stores Total Sq ft (mil) Owned vs. Leased
Sears Domestic 2012 867116 60%
Kmart 20121305 125 16%
Sears Canada 2012122 16 11%
Sears Domestic 2014 798109 60%
Kmart 20141221 115 16%
Sears Canada 2014 (prorated 51%)59 8 11%

The company has gradually been downsizing. In the process it had gains of $0.67 B and $0.47 B and $0.06 B in 2013 2012 and 2011, respectively, from property sales or sale of leases. The company also closed 145, 60 and 247 stores in 2013, 2012 and 2011 respectively, at a cost of $0.14 B, $0.16B and $0.34 B respectively.

Because Sears is bleeding money so badly the company is openly discussing harvesting the real estate value. The consensus view is that the company will have negative operating cash flows between $1B - $2B per year. The CEO resorted to lending the company $400M because of this urgent need for cash. Whatever the CEO was trying for the last seven years to revive the company has proven to be a failure. The is no other out for the company but liquidation or major downsizing of the Sears' retail business. The following lists Sears' financial position and how I estimate it would fare in a liquidation.

Value (bil) Total value (bil)
Market cap2.6 Total EV: 18.3
Long-term debt 2.8
Pension and other liability 4.7
Current liability 8.2
Inventory and current assets 8.4 Liquidation value: 20.7
Sears Canada
Trademarks 1.8
Store Real Estate 8.5
Other Property 0.5
Auto Center 0.5
Home Warranty & Repair 0.5
Difference 2.4

I used $8.5 B for the store real estate because that is a number I've heard floating around. That means the company can realize a gain of about $4 M a store or $40 per square feet. The above also does not put any value on Sears online though Sears is the third biggest online retailer today! So the reader may argue that I am being too conservative, but that's my nature. And to me the overall $2.4 B potential gain is too small a margin considering it is bleeding so much cash everyday. Also there is just so much unknown regarding value of the company's real estate. Are the remaining store locations more or less valuable on average versus the hundreds that were closed before? A retail investor like me simply does not have the resources to research the answer.

With that in mind, who is backing the company becomes a major consideration for me. The company is owned by three of my most respected value investors: Eddie Lampert, Bruce Berkhowitz of the Faireholm Fund and David Chou of the Chou Funds. Berkowitz and Chou have two of the best track records over the last two decades in the USA and Canada. And both of them have a sizeable 10% position in their funds.

So, there I was on Friday, thinking about the issues with SHLD. I also reminded myself that I spent more money at Sears than any other retailer in recent years — mostly for appliances and at the Sears Auto Center. I then decided to reopen a position. However, I hadn't completed this blog entry and I didn't have the entire analysis clearly in mind. When I completed this entry during the weekend, I reconsidered my purchase and thought that the problems outweighed the potential upside. By Monday, I decided to put SHLD in the too-hard pile and sold my position.

This was a small mistake that didn't harm me, thankfully.

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