Don't Forget Sears' Housing Connection 20 comments
an article to
-
Font Size:
-
Print
- TweetThis
Well, it's official, the boo-birds are back out on Eddie Lampert after Sears Holdings' (SHLD) recent quarter. Now, it should be noted this is after Q1 results that “surprised” everyone being better that expected and the stock rallied from $35 to near $80.
So, who is right, the cheerleaders or the boo-birds? Neither.
Unlike any other retailers, Sears is mainlined to the US housing market. With 40% of the US market share for appliances, what happens in housing is acutely felt at Sears. With that appliance share, when housing is good, Sears will do well; unfortunately, the opposite also holds true. When folks comes to Sears for an appliance for a new home, they will pick up paint in the paint dept., lawn tools, bedding, TVs etc…
Let's look at some numbers more closely. In Q1 2007, Americans were buying (at an annualized rate) $281 billion in “Furnishings and durable household equipment” (furniture, appliances). That represented the high water mark for that category (wasn’t that the peak in most housing markets also?). FY ending 2/2007 also marks the high water mark for Sears Holdings earnings (the annual average in 2006 vs. 2005 for consumer expenditures rose appreciably). By the time Q4 2008 rolled around, consumers were now buying $259 billion a year of those products, a $22 billion annual decline. Remember, Sears holds 40% of the US appliance market. (Note, not all of the $22 billion is appliance sales but with Sears selling appliances and furniture, it is safe to say a significant chunk of the revenue declines at Sears can be traced directly here.)
As of Q2 2009, that number is now at $251 billion annually. As of just Q2 2008, the number was $276 billion, an unprecedented one year drop. Anyone still wondering why Sears is seeing declines?
Appliances are the main reason folks come to Sears; absent that reason, Sears is just another retailer. So, when housing rebounds, one ought to expect Sears to once again show top-line growth. For that reason, the Q1 Cheerleaders came out way too soon and will probably stay hidden until Q1 or Q2 2010 when housing begins to gain some footing. The good news for them is that by then competitors will be so low that Lampert & Co. will be able to step over them.
Now for the boo-birds. You will be correct for now. But, let's look at what Lampert has done. He has steadily used Sears' cash to repurchase shares. This is meaningless now but when housing does turn, the 20%+ fewer shares there will be outstanding will mean that a $1 million profit next year will equate to a 20% higher per share number - that is huge. For that reason, Lampert will not even have to deliver profit dollars in absolute numbers anywhere near what he did in the past for shareholders to reap large gains.
For several years the boo-birds have been saying Sears is “dead”, “dying” etc. Yet it has maintained a balance sheet healthier than almost every large retailers with the exception of Wal-Mart (WMT) and Target (TGT). Sears is not going to become extinct. The stories you are reading today are essentially reprints from any bad quarter over the last 4 years. Ignore them. Will Sears still be a big box retailer 5 years from now? Maybe, maybe not. The point is, “Sears Holdings” will still exist.
Sears is also radically changing its online presence in a way that will differentiate it from all other brick and mortar retailers. It's way too soon to know if this will pay off but if it does, the payoff will be multiples of what was invested. Pay attention to MyGofer; my gut tells me there is something there consumers will flock to.
My friend “Davidson” has this take on Sears:
While Lampert has improved the financial structure and efficiencies, he has not yet unlocked the value of the brands, i.e. Lands End, Die Hard and Craftsman. He needs to lay out a plan of attack in my opinion that lets investors understand his thinking on expanding brand distribution. At the moment they appear to be locked-up within a dull plain wrapper that is frayed at the corners.
He is right. Lampert’s silence is just fine when things are going great, but when things are shaky, nervous investors need to be reassured or communicated with more. Lampert need not hold investors' hands or bother giving guidance to Wall St., but an occasional letter to shareholders would not hurt. Davidson is right in his call for Lampert to communicate the strategy; shareholders “think” they know the strategy, but no one really “knows”.
I do get the whole “long term approach” Lampert espouses, but if folks are not clear where the ship is ultimately headed, I’m not sure they can accurately look at where it is today and make an accurate assessment of progress.
A note: After Q2 Morningstar raised its “fair value” for Sears to $105 (hat tip reader Justin).
Just remember, most of what is said out there is simply “noise”.
Sears = Housing, don’t forget it.
Disclosure: Long SHLD, WMT
Related Articles
|
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largestSee all
increase in followers
in the last 7 days
Fastest Climbers » -
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most active
Instabloggers.-
1
David Fry
-
2
TraderMark
-
3
Don Dion
-
4
Cliff Wachtel
-
5
Mike Havrilla
Top Instabloggers » -
1
-
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
Now, here's the kicker, in their 10-k, under "Competition" SHLD states that appliances make up approximately 15% of overall sales. That would make appliance sales of 7.0B overall and would make their share of the US market under 25%. It also happens that in every 10-k since 2005, under "Competition" it says that 15% of overall sales are appliances. I guess that means that appliance sales have fallen at the same rate that overall sales have fallen every year since Lampert took over, or that indicates a careless error on the part of those producing the 10-k. Given how little information SHLD, under Lampert, any misinformation in the 10-k is unacceptable.
Putting the math aside, yes SHLD,or at least Sears US, is wedded far more to the housing market than other department stores, however they do sell a considerable amount of soft goods and even have some categories, like gardening, hand tools, automotive, that you would expect to benefit marginally from the DIY efforts that rise during recessions. However, Sears SSS lag both the home improvement retailers and the department store (save for the luxury retailers). Barron's had a nice graph showing that Sears sales lagged the industry in both good times and bad.
Gary Balter in his preview for SHLD he expected SHLD to benefit from the closing of some competitors, presumably Circuit City, Linens and Things, and Mervyns (Balter then did a 180 and proceded to kick the snot out of SHLD when that didn't materialize) and in fact SHLD may have had a marginal benefit as Kmart did show some increase in Home Elecronic sales. Circuit City, like KMart, had more locations in poorer demographics than Best Buy so KMart could have pickup up some sales just from shear geography. Instead, Sears has to face some healthy competitors trying to fill the voids and take share away from Sears-- Kohl's, Forever 21, hhrgreg, and Lowe's being the most prominent (WalMart is, of course, the 800 lb gorilla in any retail room).
I've barely mentioned Kmart thus far, because it seems that they barely exist. Actually, and amazingly, a couple of articles had popped up in the last quarter touting Kmart because their SSS in the 1Q dropped less than Target. The reasons for that--Kmart closing locations (ultimately about 60 this year) while Target continues to open locations (though TGT is bringing that process to virtual halt in 2010), Kmart had a particularly lousy 1Q in 2008, Kmart has a greater presence in small farming towns which actually felt the recession later than most, and a boring accounting issue involving how shoe sales are counted. Inded for the 1Q TGT overall sales were actually flat while Kmart 's dropped about 4%.
None of that was discussed, and indeed much of that isn't of primary importance. What is of primary importance is that the average Kmart does $11M in sales while the average Target does $38M in sales. Kmart already lives pretty close to the edge of oblivion and any drop in sales puts them that much closer. Many Kmarts have long term leases (which was supposed to be an asset in the go-go days of Real Estate) which means it will take quite some time to close the underperformers. Not sure if what's left will even be viable after the underperformers are weeded out.
Retail real estate, especially big box real estate will be glutted for a long, long time. Lands End probably has some value on it's own or since it's not closely tied to Sears, another retailer may be interested. The other brands, Kenmore, Craftsman, and Die Hard, are closely tied to Sears and it's questionable just exactly who would be willing to buy them and as sales go down the value of the brands go down too. Sears Canada seems capable of functioning as retailer on it's own so it has value.
I've never been in the SHLD is going bankrupt camp, but I do think SHLD is a lousy retailer who can't monetize it's assets in the foreseeable future and those assets will continue to deteriorate in value year after year. The Barron's article did make very good points regarding FCF vs EBITDA and Eddie's retort is unconvincing. It's quite the box Eddie is in.
I am still not sure where Eddie Lampert is headed with this company. I also believe that the company will avoid bankruptcy, but the long-term strategy remains unclear.
Just slap a Willy Wonka hat on Eddie and it all makes sense.
On Sep 11 10:37 PM Dan Braem wrote:
> I still don't get how anyone can defend these buybacks. When companies
> buy their own shares regardless of price, that is a huge warning
> sign that management lacks intelligent capital allocation. Was
> SHLD so well capitalized that it could afford such buybacks? If
> the answer is yes, why not pay the cash (in the form of a dividend)to
> shareholders?
>
> I am still not sure where Eddie Lampert is headed with this company.
> I also believe that the company will avoid bankruptcy, but the long-term
> strategy remains unclear.
you say, regarding Kmart, that you're not sure "whats left will be even viable when the underperformers are weeded out"... Considering that Kmart is profitable, at least annually, then whats left after closing underperforming should be a more profitable company. Not sure how you could assume anything different.
Buybacks are an easy target now that nearly all stocks are down significantly from their highs years ago. I can give you a long list of companies that bought back stock too high, and many of them financed it with tons of debt. Sears, atleast didn't finance any buybacks with debt. I would make the case that the prices Eddie Lampert paid were not high considering the situation at that time. Sears has $50 per share of Net Inventory, I think you'd have a hard time finding anyone in 2006 and 2007 that thought Sears real estate values were worth less than $70 per share. Lands End was purchased for $1.9 billion in 2002 and has just finished three consecutive years of record profitability. To think it's worth less than it's purchase price doesn't make sense, which means Lands End alone is worth $16 per share. Add it all up and consider that in 2007, Sears was generating about $13 per share of free cash flow and I don't see how you could say that Eddie Lampert was paying too much for the shares when he was purchasing them for $145 per share. Rather it would seem that he was paying something close to liquidation value at that time. Today while nearly all others have suspended their buybacks, Eddie Lampert is still buying in millions of shares. No one talks about the fact that he's purchased 5% of the company at half of book value in the past year. Also remember that when Sears stock was at $190 per share, Eddie wasn't repurchasing stock. He instead was hoarding cash, and investing in total return swaps. People seem to have forgotten that he actually earned tens of millions of dollars for Sears through total return swap investing. Anyone that argues against that can go back and add up the gains and subtract the losses between 2006 and 2007.
Another thing i think people fail to realize is that Eddie Lampert's investment in Sears began with a $750 million investment in distressed Kmart debt while it was bankrupt. He was buying debt at 20-40 cents on the dollar. Kmart was taken out of bankruptcy and Eddie's Stake is today worth $4.3 billion dollars. Roughly a 500% return since 2002. Is that what you would consider a failure? I've met very intelligent people that seem to think his Kmart/Sears investment was a terrible mistake. I can't see how it's possible to think that..
Sears may be a failing retailer, but I'd make the arguement that Sears being a retail turnaround isn't the strategy. It's more likely that it's a retailer in runoff. At the rate Eddie is repurchasing stock, there won't be any float left to buy in about two years. At that point, Eddie can do anything he wants with whatever cash flow and assets are left. Thats the lure of owning the stock. Fortunately, for anyone who can look at Sears objectively from this viewpoint, the price today is a once in a lifetime opportunity to partner with Eddie at an incredible price. If it doesn't work out, the $50 per share of net inventory alone makes for a great backstop.
It clearly is the weakest by EBITDA and in fact may not be profitable when you factor in things like capex, store closing costs, and it's share of the interest.
It will take some time to close nonperforming KMarts because of leases, many of them long term. In the meantime the remaining stores continue to see SSS decrease and as stores close shared costs (advertising, home office salaries, etc...) are spread across fewer stores. Kmart already has the lowest margins and lowest payroll costs of the segments, so there's not much for sales decline and not much left to cut. By the time they close the current nonperforming stores, there may be a whole new batch of nonperforming stores. It's an ugly spiral and given, as you said, Lampert may be more interested in a runoff than a turnaround there's good reason to believe Kmart is in danger.
I'm not trying to argue that Kmart is a nice store. I live very close to one. The store is old, the floor tiles are cracked, the sign out front is dirty, things ring up at the wrong prices sometimes, the shopping carts are old and rusty... but there are always people there shopping. always. I don't think they spend much at all on CapEx, nor should they. Whats the point? The typical Kmart customer could care less if the floor tiles are cracked or the lighting isn't great. Wait for Q4 to be released. Kmart will have hundred of millions of operating income on lower sales. Thats all they need. I think Eddie's strategy is the right one. What would you do? Spend all the cash flow on remodeling the store knowing that Wal-Mart will still kill you in the end, or milk it for cash and run off the leases, pay off debt, and wind it all down? Eddie's doing the right thing, in my opinion.
Also, your statement that Eddie will do well but others may not, while somewhat true, implies that most people purchased the stock high and are underwater. I for one did not. Not that it's relevant to business analysis, but I think the general attitude of most out there is that anyone who's long bought at $190 and is suffering, hanging on to a dream.
When i say "float" i refer to shares outstanding minus Eddie's, and I also net out Thomas Tisch, Bruce Berkowitz, and Bill Miller. Could they sell? Sure, but Tisch is on the board of directors and has owned 3+% of the company for years, Berkowitz owns over 10% and seems very content to hold, Bill Miller is a friend of Eddie Lamperts and seems to believe very much in him and his strategy. I also net out the millions of shares held by index funds, SPY spiders, QQQQ's, RTH, Vanguard S&P500 index funds, they own probably 5 million shares between them. There's really only about 26 million shares out there actually trading. If Sears continues to generate a mediocre $600-700 million free cash flow as it now is, after funding it's pension, it could wipe out 38% of this remaining float in the next six quarters. The rest of the float is sold short. I don't see how it could be a good idea to bet against it here.
What do you think Eddie will do with hundreds of millions of free cash flow when there is no float left? What would the market response be if he bought 25 million Philip Morris and 25 million Pfizer one quarter? The stock would skyrocket. I'm not saying it will happen, but he's not going to pay a dividend. The worst case scenario is he begins selling his ESL shares directly to Sears and cashes out while maintaining the same ownership %. Could I be wrong about all of it? Sure, but again, there's a massive pile of inventory backing up today's purchase price, so even if I am wrong, I don't see much downside.
Sears has generated about 250 million of free cash flow during the first half of this year. It was ugly how they did it, as most came not out of GAAP earnings but rather out of the difference between the depreciation charge and actual Cap Ex. Ugly may be ugly, but cash is still cash. The 4th quarter is when SHLD will make most of it's money. Last year they earned $2.94 per share during the 4th quarter, so assume it's less this year, assume it's $2.50 per share. Then add back $100 million of of depreciation not spent and you get around 413 million of cash flow. Subtract pension and you're around $650-700 million free cash flow for the year. Assume next year is roughly the same, but you have to subtract more of a pension cash drain next year, so next years free cash flow is more like $450million. Now as you said earlier, Sears must decrease inventory as sales decrease. Assume sales fall 7% next year. 7% of $6 billion of net inventory and you have $420 million of cash that should be taken out of inventory. No long term debt is due until 2011, and obviously Eddie Lampert will not pay a dividend. One would have to assume that all free cash flow and most of that inventory that was converted to cash will be used to repurchase stock. $700 million+ $450 million +420 million equals $1.57 billion cash. At today's prices thats 24 million shares, and remember, there's only about 26 million of float. This of course assumes the stock price stays the same, which it probably won't, but it also assumes Sears fails to earn more free cash flow than we are projecting, even though they probably can. It also assumes that none of the four mentioned majority holders decide to sell, and if they do, I withdraw my entire case.
As for the 401K, many companies have pulled the match, however, I'm not sure how many of those companies also spend money on stock buybacks. It does not send an impressive signal to employees when management skimps on capex, cuts 401Ks, but has money for stock buybacks. The brighter, more motivated, and more talented ones see the writing on the wall and start jumping ship. Circuit City's demise was probably inevitable, but they hastened it with some boneheaded moves affecting employees. As cash flow keeps getting tighter and sales lower, don't put it past Eddie to start slashing commissions , and if that happens watch out.
The disconnect is when people apply that thinking to the stock and assume it must be a terrible investment. It's not. Kmart generates hundreds of millions of free cash flow. It was used as a platform to acquire Sears which generates hundreds of millions of free cash flow as well. The whole company is priced like it's going to die. Hey, tobacco use has been declining for 40 years in this country, and cigarette companies keep churning out cash. Kmart and Sears will do the same, and when it's all said and done, Eddie and whomever is remaining owning the shares will be sitting on a huge pile of cash too.
Kmart generated a ton of cash when most of the Real Estate was sold, that enabled the purchase of Sears. Sears also generated a ton of cash when the credit card business was sold. That was great because you couldn't get near that amount for either of those segments now. The FCF generated for actually selling stuff keeps sinking, because they are a bad retailer that basically relies on residual loyalty. It just harder to generate FCF from 42B of sales than the 55B in sales that Sears-Kmart had when they combined. It'll even be harder when they're down to 30-32B in sales three years from now.
I stated in my initial post that i don't think SHLD is a bankruptcy candidate, I just think Eddie is stuck in a bad place, a bad retailer whose assts can't be monetized until the retail recession is a memory and that could be a decade out. In the meantime, Eddie has to keep it going as a retailer until that day arrives. How long that day arrives, how much of SHLD is left and how many shares exist at that point, I know not. I do think it's harder and harder to make the case that SHLD will be some kind of Berkshire-Hathaway vehicle.
I'm sure if Eddie could do it all over, he would get in a time machine, go back to 2007, and sell everything not nailed down. And then get a hammer and sell anything nailed down.
Yes Sears has declining sales, but did you not notice the improvements in gross margins over the past year, with the exception of this quarter? Was that a fluke? The major hit to margins this past quarter was at Kmart, due to liquidation of inventory at stores that are closing. Remember in the most recent press release, Sears only expects $5 million in store closings expenses for the rest of the year. Sounds to me like they are winding down this round of store closings, so we should get a clear view if the margin trends that were in place come back. A small improvement in gross margin rate on even $35 billion is still huge. All things equal, a 1% improvement in gross margin on $35 billion equals $3.00 of earnings. The other side of being so leveraged to gross margin, in my opinion, was the problem in the past. Eddie never had intentions of growing the store base, yet he did increase inventory levels in 2007, which turned out to be a bad decision. In my opinion, that glut of inventory was the cause of the sharp decline in margins and massive drop in earnings during 2008. Assuming inventory is under control, Sears should still generate FCF sufficient to repurchase the remaining float over the next couple years, and I still do see a Berkshire Hathaway type vehicle in the works. What else would Eddie do with the cash? Declare a big dividend and go home? That's not his style. I think once the float is gone, Eddie will be more open to making open market purchases of stocks, more total return swap investing. Couldn't he do that today? Sure, but as soon as he does, the stock would no longer sell below book value. In an old letter to shareholders, Eddie said that his goal, just like Warren Buffets goal, is to increase the per share value of the company. Whats more beneficial to the per share intrinsic value of Sears, buying stock well below book value, or investing elsewhere? There's always a bargain out there. In the mid 90's bull market he found IBM right before it rallied 500% in five years. His Autozone position has run from $20 to $150 during this ten year bear market. Eddie can find winners to invest Sears cash in. I'd much prefer there be fewer shares outstanding before he begins to do so.
And yes, if Eddie could do it over again, he probably would have sold much more real estate in 2006-2007. He even hinted at that at the annual meeting in May, saying, that Sears was never a real estate play, but whether or not that was the right decision remains to be seen.
Eddie's a smart dude. Sears will generate a lot more cash than most think. The inventory values alone provide a massive margin of safety. It's fun to watch this unfold and I'm happy to be a shareholder, even if they are a crappy retailer.
I expect deflation, not inflation, will be the problem the next several years. Sears probably will get a modest bounce, or lessening decline, from the appliance rebate, but that like the housing bump should fade next year. The excesses of the last decade aren't that easy to wash away, and Sears/Kmart are the laggard.
As for margins, I've look thru the annual and quarterly report for sometime now, and I don't see any great trends in margins. The inventory seems a little high now, a 10% drop in sales yoy and only a 5% drop in inventory yoy, so they don't seem particularly well position for any dramatic improvement in margin.
I'm not a share holder, but I do agree it's fun to watch.
If you expect deflation, then i understand your forecast of down 25% sales three years for now. I don't. I think inflation will pick up, and moderate inflation is the friend of the retailer.
The margin trend i'm referring to is Kmart between Q3 2008 and Q1 2009, margins up steadily each quarter. Q4 op. income for Kmart was $274 mil, up from $237 mil the year before, even on 5% lower sales. You don't need sales increases to generate higher margins and profits, you really just need sales to be somewhat stable. I don't expect sales to rise, I do however expect them to flatten out, which would allow gross margins to improve.
Also, first quarter this year, total company margins were the 2nd highest since the merger, so It's possible for Sears to make tons of cash, but it's frustrating to not have any idea what to expect.
(Hope this is readable once posted)
Kmart gross margins:
Kmart 1Q Kmart 2Q Kmart 3Q Kmart4Q
2005--23.4 24.0 24.3 24.9
2006--23.8 24.2 23.4 26.3
2007--23.9 24.2 21.7 23.9
2008--23.2 22.9 22.1 24.5
2009--23.9 22.1
Kmart is a discounter and it's a very competitive segment. All of their competitors, WMT, TGT, Dollar General, Big Lots, hold much stronger hands, so it's just not realistic to expect any vast improvement. The other thing that will keep a cap on profits is SGA. Kmart already lives close to the bone, and even little things like the increase in minimum wage midsummer probably impacts them more than most retailers. Also, spreading advertising costs across fewer stores, means the cost for individual stores increases.
Regarding the pre-Christmas store closings, even if the lease expired, many landlords will give you a short term lease thru the holidays, as the landlord 90% of the time doesn't have anyone who can jump into that space immediately. Perhaps they've burned their bridges so much the landlords don't want to work with them. More likely is that they have another group of stores on deck to close after the holidays, and are trying to do this in orderly fashion.
It would be great if Sears was a more open company. Virtually all retailers hold conference calls will analysts after quarterly earnings are announced, but SHLD doesn't so it's kind of like an old fashioned Kremlin watch to figure out whats going on.
What is your opinion on how low domestic cash can safely go considering the revolver will get reduced in March 2010, and, being majority owned but not wholly owned, what could Eddie do to repatriate cash from Canada??
As you noted, the US cash has been drifting down. it will be interesting to see what SHLD does in the 3Q and 4Q. The 3Q is always the weakest for retailers, lowest sales, weakest margins, have to get rid of any summer merchandise, and get your 4Q merch in the building. Last year, domestic operations produced a whopping 33M in EBITDA in the 3Q, meaning that they were essentially cash flow negative for the Q. Will SHLD continue to buy back shares in the 3Q? or will they take a Q off? Domestic operation will certainly generate big cash flow in the 4Q (the best Q for retailers) will SHLD use the cash to rebuild their cash? or pay down debt? or buyback stock?
Really, SHLD given their decline in sales and their declining need for inventory should be able to function within the new revolver unless they do something really stupid and while I don't think much of Eddie as a retailer, I don't think the financing part should trip him up.
It's easy to see why there are so many opinions on SHLD, many issues, an awful lot of opacity.