Flaws in Jim Cramer's Sears Analysis

As I've mentioned before here, I'm a fan of Cramer. I unfortunately do not make it home most nights in time to watch his TV show, but I usually listen to his radio show Podcast on my commute home, and also will catch an article on TheStreet.com every so often. While I don't know that I agree with his investing time frame for most individual investors and I don't tend to follow any of his suggestions because of the "Cramer Effect," I do think that he knows a lot about investing and he is very entertaining to boot.

Sometimes, though, I do disagree and tonight was one of those times. On his show I was listening to him talk through his take on Sears Holdings Corp (Nasdaq:SHLD), his largest holding for his charitable trust. On the show Cramer walked through the seemingly simple idea of how Sears, currently the third largest diversified retailer, is valued at a market cap of $24 billion versus $42 billion and $190 billion, respectively for Target Corp (NYSE:TGT) and Wal-Mart Stores Inc (NYSE:WMT), and how the company is currently buying back some of what small amount of stock is outstanding and not in the hands of Eddie Lampert (or his "friends"). At the rate that the company is buying back stock, Cramer estimated that they could retire up to half of the outstanding non-insider controlled stock (he approximated 60 million of these shares) in the next twelve months or so.

With the stock trading at $150/share, that amount of buyback action would lop a cool $4.5 billion off the market cap. Surely, Cramer argued, the company isn't worth $4.5 billion less, so the stock price will have to come up to keep the market cap around where it is now. Now I certainly may be unintentionally misconstruing Cramer's words, but will the company be worth $4.5 billion less? In a word, yes. The buyback and retiring of the stock isn't going to happen out of thin air, it's going to be bought using the cash that the company has on it's balance sheet - $3.7 billion as of the most recent 10-Q. And as cash disappears off the balance sheet, whoosh, you magically have a company that's worth less.

Certainly if revenue and profits grow the value of the company should go up, or at least stay steady as shares disappear, but getting a stock to rise consistently by simply taking out shares would be a tough trick. Think about it this way: if you look at Sears right now, it's trading at about 17.8x expected 2006 earnings. If you keep the market cap the same and pull out 30 million shares you're now looking at roughly a $188 share price - now a 22.0x multiple of '06 earnings, and for what? No additional value was created, you just retired a bunch of shares.

As we all know, stock prices are determined by supply and demand - when more people want to buy the stock than want to sell it, prices go up, and when more people want to sell than to buy it, the price falls. So when a company goes to market with an aggressive stock buyback the way Sears is, it creates greater demand for the stock and can push the price higher if there aren't enough sellers in the market. As the price starts to creep up, though, more and more holders are going to start to see the new, higher price as a nice time to make an exit. Generally, when a stock is undervalued, you'll be able to see the stock climb more before too many new sellers come into the market, while when the stock is fairly valued or overvalued, you're more likely to see new sellers come to the market quickly as the price starts to rise.

Which brings me to my last point on Sears, especially with regard to Cramer's comments. Cramer likes to concentrate on finding the "best of breed" company in each different industry - you know the Microsofts and the Best Buys of the world. But is Sears really best of breed? It certainly is valued like it is - while it's currently trading at 17.8x forward earnings both Target and Walmart are down around 15x. In part of his comments tonight, Cramer quipped "There is more to a store than just how it looks. There are the profits, and at Sears the profits are immense."

While I agree that profits are key, if the store can't continue to compete with what I consider to be better-of-breed stores like Target and Walmart it's sure going to be tough to keep those profits growing. And more to the point, it's more than likely that Sears will not be able to support a valuation much above its current level, aggressive buyback or not.

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Comments

[Adam Greenberg:]

You said: "Think about it this way: if you look at Sears right now, it's trading at about 17.8x expected 2006 earnings. If you keep the market cap the same and pull out 30 million shares you're now looking at roughly a $188 share price - now a 22.0x multiple of '06 earnings"

Please explain how with your math SHLD's P/E would increase as a result of a share buyback - there appears to be a flaw in the math. Your calculation is not clear, but you appear to be adjusting the share price but not the pro forma EPS?...

2006 Sep 07 08:39 PM

[CrossProfit_:]

Well said. The whole purpose of a buyback is to increase earnings per share. If a company doesn’t see an opportunity to grow the bottom line by putting cash on hand to use in growing the business organically or through acquisitions then it may resort to a buyback program to increase earnings.

Average Joe is correct in the overall assessment that retiring shares does not give an immediate lift to book value.

Perhaps Cramer sees SHLD going private over the next few years and is counting on a LBO premium.

Disclosure: This is a personal comment by a CrossProfit analyst and may not reflect the opinion of CrossProfit.com.
www.crossprofit.com

2006 Sep 08 05:53 AM

[Average Joe...:]

Adam - good catch and thanks for pointing that out. Maybe we could retitle the post "Flaws in Average Joe's Analysis of Flaws in Jim Cramer's Sears Analysis." You are correct that as shares go down the EPS is going to go up by an equal amount and the p/e will stay at 17.8x.

I still stand by my underlying theme, though, that Cramer is oversimplifying the share buyback process and discounts the fact that the company burns through balance sheet cash as it buys up these shares. Though you will not see the rise in p/e that I mentioned, what you will see is a rise in both enterprise value / sales and ent value / EBITDA.

The argument for using cash to buy back shares could be that Lampert wants to unlock the value of the large amount of cash on the balance sheet. My best guess is that the share price already accounts for this as SHLD (which has around $25/share in cash) trades at a premium to TGT and WMT on a p/e basis but at a discount to the two on a EV/rev and EV/EBITDA basis. Using hopefully better math here, if you use up the cash hoard, take out the shares mentioned and keep the per share price the same you'll see the p/e drop down to just under the level of TGT and WMT and the EV/rev and EV/EBITDA multiples creep up closer to what the other two are at.

Which brings me around to the other point - is Sears as a business worth as much or more than Target or Walmart? I wouldn't be surprised if we see a short term rise in the stock just based on the financial engineering that Lampert is doing, but as a long term investment I am not a Sears bull for sure...

Joey

2006 Sep 08 01:35 PM

[Teresa Blac...:]

I have two problems with Sears. The first is rising inventory levels in conjunction with declining sales. Everyone seems to think Sears is immune from the consequences of this dynamic but when sales go down for a retailer the fixed costs usually don't. Light bills, taxes, salaries etc. have to be paid with fewer sales to cover the expenses. Sears has realized impressive savings by cutting administrative staff but I suspect they are running pretty lean now and can't get much leaner.

Rising inventory levels are even more problematic with the retail inventory method (RIM) which Sears uses. Under retail inventory method Sears counts its physical inventory at retail and applies a cost factor to determine lower of cost or market. That cost factor is an ESTIMATE based on historical sales data. When sales are declining that estimate can get out of whack in a hurry. Rising inventory levels in an inventory calculated on RIM are usually a sign that markdowns aren't being taken, as well. Inventory could be significantly overstated. Since the retail markup is applied to inventory that means sales could be overstated as well.i

My second issue with Sears is the "big cash hoard" that is supposed to exist. Per the most recent quarter $3,690 million is available, but read the fine print and you discover that $441m is o/s checks, $533m is pledged to a letter of credit, $233m is slotted to pension plans in 2006 and $85m is due to claimants in a recently settled lawsuit. That leaves just under $2,500 m for working capital. That is a comfortable amount for a company the size of Sears but not enough to go on a shopping spree.

2006 Sep 09 10:29 AM