Is Sears' Stock Buyback a Good Idea?

| About: Sears Holdings (SHLD)

I thought I'd revisit my thoughts on Sears Holdings Corp (Nasdaq:SHLD) mainly because my post last week was a bit rushed and may have obfuscated the situation more than it illuminated it.

The main issue I was looking at was the stock buyback that the company is doing and the potential effects to the stock price. All companies have to make decisions on how to best allocate resources, and a good manager will choose the options that will provide the best return on the company's investment. A company will often determine the most efficient capital deployment by doing some variant on a discounted cash flow analysis.

By way of illustration, a company like Sears may look at the amount of money that it would cost to implement an RFID tagging system versus what it would cost to upgrade their supply chain management software. They would estimate the cost savings that each would hopefully provide over each of the next ten years or so, use a discount factor to discount the returns back to today, and figure out which choice would provide a better return on the amount of investment that it requires. The same process could be used for building out new stores or deciding whether to start a Sears brand T-Shirt line.

Of course, all of the examples above are investments back into the company to either help the company grow or make operations more efficient. Sometimes, though, a manager will see that investments back into the company may not have a return greater than the company's cost of capital (I mentioned cost of capital in my recent post on valuing a stock) and so the best use of resources is to basically give back that capital. This could take the form of repaying debt or buying back stock.

In Sears' case, they have a bunch of cash on the balance sheet that's probably collecting somewhere in the realm of 2-4% interest. Meanwhile, their equity cost of capital is likely a good deal higher than that. From an investor's perspective the cash in the bank isn't earning a satisfactory return, so if the company can't find a good way to reinvest the money in the business it might as well just give the money back to the investors.

Imagine you had an extra $1,000 in your bank account. Your bills are all paid, though you do still have a $1,500 credit card balance on your 11% APR MasterCard. What do you do with the money? If a friend comes to you and offers you in on a real estate deal he's working on that is expected to return 30%/year over the next three years you'd probably be smart to take him up on it. Otherwise, you're probably not going to throw that $1,000 into an ING savings account at 4% - you're going to (hopefully!) pay down some of that credit card balance.

So the choice for Sears to buy back stock is probably a good one. And, in fact, there are a lot of actions that Lampert is helping to bring about at Sears like this that are ensuring capital is being used most efficiently. He's also helping to extend efficiencies out to the rest of the business which is allowing it to run more profitably.

Valuation-wise, though, I think that investors have already valued in the cash that Sears has on its books and discounted the effect that a massive share buyback would have on the stock price. Sears' P/E is above that of competitors Target and Walmart despite the fact that this is a turn-around story with declining same store sales. If you were to buy back a bunch of shares using the cash on the books and the stock price stayed the same, though, the P/E would fall down to around where Target and Walmart are (in my last post I left out the fact that EPS will rise as you pare down the number of shares - this is the reason that P/E would fall). I think that there is a high likelihood that this is why Sears is sporting the valuation that it is.

In an ideal world for Sears, they continue to refocus operations, get the operation's profitability up to par, and are able to successfully compete again and get some top-line growth going to complement their now higher margins. If this happens, I start kicking myself for selling my Sears shares. Another scenario, though, is Sears continuing to make operations and capital deployment more efficient, but also continuing to be bled of customers by Walmart (NYSE:WMT), Target (NYSE:TGT), Home Depot (NYSE:HD), Lowe's (NYSE:LOW), and the like. There is going to be a maximum point to improving profitability, and once that's hit flat-line or declining sales are going to be much more of a problem. And if they don't get a handle on their merchandise inventories as sales decline (as a SeekingAlpha reader pointed out), there could be even more problems in the meantime.

I will bow out here on Sears, as I do not consider myself much of a turn-around investor, and I'll go back to finding growth at a good value.