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Bruce Berkowitz is one of the most highly respected mutual fund managers. His Fairholme Fund (FAIRX) is one of the best performing mutual funds of the decade. For several years, I have been reading about one of Berkowitz's favorite positions, Sears Holdings Corp. (NASDAQ:SHLD).

One of my concerns with mutual fund managers, however, is that sometimes they appear to "oversell" their ideas, perhaps in order to generate excitement for their funds and attract investor money.

1) Berkowitz's Claim About Sears' Inventory Value:

One pitch I have read Berkowitz make again and again is based on Sears' asset values. Berkowitz likes to calculate Sears' inventory value per share and use that fact as an argument in favor of investing in the stock.

In a recent interview, Berkowitz said,

"The liquidation value of its inventory approaches its stock price. Forget the real estate."

Now if you are an investor in the Fairholme Fund (or Sears) that sounds great. Let's double check the math, though: the article is dated November 26, 2012. At that time, Sears traded at $46, about where it trades today. So Sears had a market valuation of roughly $5 billion. And in the October 2012 quarter, Sears had $9.6 billion in inventory. If you subtract Sears' accounts payable (this is necessary because by subtracting accounts payable from inventory, we get the value of inventory that Sears owns outright) of $4.9 billion, that is a net inventory value of $4.7 billion, sure. But that does not mean that Sears could liquidate its inventory and distribute that $4.7 billion to shareholders, because Sears has other liabilities of $13 billion.

Investors cannot simply ignore these liabilities in order to justify an investment in the stock.

Sears liabilities are as follows (as of the most recent 10-Q):

  • Amounts due on the revolving line of credit of $1.8 billion
  • Accounts payable: $3.8 billion.
  • Other current liabilities $3.8 billion
  • Unearned revenues $940 million
  • Tax liabilities: $1 billion
  • Long-term debt and capitalized leases: $1.96 billion
  • Pension and postretirement benefits: $2.26 billion
  • Other long-term liabilities: $2.1 billion
  • Long-term deferred tax liabilities: $870 million.

The "other current liabilities" and "other long-term liabilities" include things like checks cut but not yet cleared (after clearing the liability is removed and cash is decreased by the same amount).

In summary as of the last quarter, Sears had $17.9 billion of liabilities (or about $13 billion of other liabilities in addition to inventory accounts payable). This is clearly a substantial number. I do not know if Berkowitz meant to imply that the company can liquidate its inventory at which point it is home free, with the ability to distribute that cash to shareholders - but this is definitely not the case.

2) Sears Real Estate Values:

Another point Berkowitz has made quite often is that Sears' real estate is worth $160 per share (assuming, I guess, one ignores liabilities as discussed above).

Berkowitz even made a case study to stress this point, which can be found on Fairholme's website.

In the case study, Berkowitz compares Sears' total retail square footage with that of REITs such as Simon Property Group, whose shares are more highly priced in the market:

Is Square Footage Alone The Correct Yardstick?

The total square footage used by Berkowitz may not be the most accurate metric that should be used to compare these companies, however. For one, Simon Property Group (NYSE:SPG), in its most recent 10-K, on page 13, says:

"These properties contain an aggregate of approximately 242.2 million square feet of gross leasable area, or GLA, of which we own approximately 153.9 million square feet. A total estimated retail sale at the properties in 2011 was approximately $65 billion."

Simon Property Group Owns Outright A Far Larger Percentage of Its Real Estate:

So SPG owns 63% of its total square footage. In addition, SPG provides the sales that these properties produced: $63 billion, roughly 50% more than Sears' sales of around $40-45 billion. So in effect in SPG you have: (1) more productive properties; (2) more of that property is owned outright, as opposed to leased. In addition, many of SPG's properties are more well-maintained than Sears', as those tenants have probably been spending more on capital expenditures than Sears.

On the other hand, of Sears 4,010 stores, only 821 are owned and the rest are leased. This is only 20%. I know people will say that the leased stores operate at below-market leases, and this may certainly be the case - but still, nowhere are the details of these leases disclosed in Sears' financial reports. So it is basically impossible for most individuals (without substantial research resources) to evaluate Sears' leases.

Yes But Can Sears' Past Real Estate Transactions Be Used As a Guide?

Unfortunately, while Sears has sold stores in the past to REITs like General Growth Properties (NYSE:GGP), it is difficult to form a conclusion about Sears' overall real estate value from these transactions.

For instance, Sears recently sold eleven properties to GGP, however, the Wall Street Journal reported that ten of the properties were essentially worthless and the prize in the deal was ONE $200-$250 million anchor store in Hawaii. So much for the value of below-market leases.

One cannot know what Sears' stores are worth individually or in the aggregate, especially because Sears does not disclose which of its 4,000 store locations are owned, which are leased, and which are leased at below-market rates. In addition, Berkowitz has failed to disclose his methodology used to determine the value of Sears' real estate.

Conclusion:

Sears may be a terrific investment. The problem is that there appears to be insufficient public information about the company. What little information does exist appears to be used to entice people to invest. Obviously, everyone must do their own due diligence, and it appears that crucial pieces of information are missing that would enable people to make a complete investigation on the values of this company's assets.

Source: Does Bruce Berkowitz's Sears Math Add Up? Do Your Own Diligence