I have been asking myself what's keeping Sears Holdings (SHLD) from massively closing all non-profitable locations and simply putting a big for sale or for lease sign up in front of those locations while keeping alive the profitable stores.
Could it be the case that there are not enough bidders for its real estate? Could it be the case that Sears Holdings is simply waiting for operations and retail real estate to turn around? Perhaps both are.
To be fair to the investment thesis that there's value in Sears Holdings real estate, I found some reports from Price Waterhouse Coopers and Colliers International showing pockets of opportunities throughout the US for Sears Holdings to unload some of its space. Recent real estate transactions suggest that there is value in Sears Holdings real estate. But continuing operations keep eating those real estate profits away. Sears Holdings real estate is like a gold mine with huge and proven reserves in Antarctica: if it exists, it's economically and perhaps legally unrecoverable.
For inspiration let's first have a look into Sears Canada (OTCPK:SEARF) 2012 Annual Report. Here's an excerpt:
The Company may be subject to legal proceedings if the Company violates the operating covenants in its real estate leases that could adversely affect the Company's business and results of operations.
As of February 2, 2013, the Company had operating covenants with landlords for approximately 100 Sears brand corporate stores. An operating covenant generally requires the Company, during normal operating hours, to operate a store continuously as per the identified format in the lease agreement. As of February 2, 2013, the remaining term of the various Sears operating covenants ranged from less than one year to 25 years, with an average remaining term of approximately seven years. Failure to observe operating covenants may result in legal proceedings against the Company and adversely affect the Company's business and results of operations.
The above risk statement informs us that lease operating covenants prevent the company from cutting its losses by simply closing unprofitable locations and paying the minimal rent, without incurring costs beyond normal store closing costs (legal proceedings against the company). Also assuming that Sears Canada continues operations, the statement above also gives us a time estimate of 6-7 years before that risk significantly lessens.
I believe that the risk of violating operating covenants also applies to Sears Holding but it is not mentioned in its 2012 Annual Report. Operating covenants would explain why Sears Holdings is not closing unprofitable locations faster. J.C. Penney Company (JCP) is also silent in its 2012 annual report on lease operating covenants.
The following links offer more explanations on the issue of operating covenants and gives us an idea of the extra legal liabilities arising from the failure to observe operating covenants:
Duty of Continuous Operation: Implication and Enforcement
Shedding Light when Anchor Tenants Go Dark
The Enforcement of Liquidated Damages Provisions for Breach of Continuous Operation Clauses
Moving on to balance sheet considerations
First consideration: According to Sears Holdings 2012 Annual Report, it had 750, 1520 and 278 owned, leased and independently-owned and operated stores respectively. From note 14, the total net minimum operating lease payments is $4343 million. $433 million of that are for Sears Canada . Looking at the minimum lease commitments ratios of capital and operating leases for year 2013, 2014, 2015, 2016, 2017 and later years I estimate that 13.6% of the 1520 leases are capital leases, roughly: 207 and 1313 capital and operating leases respectively.
Second consideration: In the 2013 Q3 filing, Sears Holdings is warning us ahead of time with the following risk:
Impairment of Long-lived Assets
In accordance with accounting standards governing the impairment or disposal of long-lived assets, the carrying value of long-lived assets, including property and equipment and definite-lived intangible assets, is evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred relative to a given asset or assets. Factors that could result in an impairment review include, but are not limited to, a current period cash flow loss combined with a history of cash flow losses, current cash flows that may be insufficient to recover the investment in the property over the remaining useful life, or a projection that demonstrates continuing losses associated with the use of a long-lived asset, significant changes in the manner of use of the assets or significant changes in business strategies. An impairment loss is recognized when the estimated undiscounted cash flows expected to result from the use of the asset plus net proceeds expected from disposition of the asset (if any) are less than the carrying value of the asset. When an impairment loss is recognized, the carrying amount of the asset is reduced to its estimated fair value as determined based on quoted market prices or through the use of other valuation techniques. Based on our assessment, management concluded that as of November 2, 2013, no events or changes in circumstances indicate that a potential impairment has occurred, other than as disclosed in Note 6. We generate a significant portion of our revenue and EBITDA during the fourth quarter. In the event the Company does not achieve expected results, key assumptions such as expectations of future financial results and recoverability of our investment in a property over the remaining useful life could be affected. These changes could result in an impairment charge in the fourth quarter of 2013.
If the sales in Q4 are bad, lower estimated undiscounted cash flows expected to result from properties will cause impairment losses. But how much impairment can we expect? Here's another excerpt from Sears Holdings Q3 to find inspiration from:
Wholly owned Insurance Subsidiary and Intercompany Securities
We have numerous types of insurable risks, including workers' compensation, product and general liability, automobile, warranty, asbestos and environmental claims and the extended service contracts we sell to our customers. In addition, we provide credit insurance to third party creditors of the Company to mitigate their credit risk with the Company. The associated risks are managed through Holdings' wholly owned insurance subsidiary, Sears Reinsurance Company Ltd. ("Sears Re"), a Bermuda Class 3 insurer.
In accordance with applicable insurance regulations, Sears Re holds marketable securities to support the insurance coverage it provides. Sears utilizes two securitization structures to issue specific securities in which Sears Re invests its capital to fund its insurance obligations. In November 2003, Sears formed a Real Estate Mortgage Investment Conduit, or REMIC. The real estate associated with 125 full-line stores was contributed to indirect wholly owned subsidiaries of Sears, and then leased back to Sears. The contributed stores were mortgaged and the REMIC issued securities that are secured by the mortgages and collateral assignments of the store leases. Sears Re and two other indirect wholly owned subsidiaries of Holdings own $1.3 billion (par value) of these mortgage-backed securities. Payments to Sears Re on these securities are funded by the lease payments… In May 2006, a subsidiary of Holdings contributed the rights to use the Kenmore®, Craftsman® and DieHard® trademarks in the U.S. and its possessions and territories to KCD IP, LLC, an indirect wholly owned subsidiary of Holdings. KCD IP, LLC has licensed the use of the trademarks to subsidiaries of Holdings, including Sears and Kmart. Asset-backed securities with a par value of $1.8 billion were issued by KCD IP, LLC and subsequently purchased by Sears Re, the collateral for which includes the trademark rights and royalty income. Payments to Sears Re on these asset-backed securities are funded by the royalty payments. The issuers of these mortgage-backed and asset-backed securities and the owners of these real estate and trademark assets are bankruptcy remote, special purpose entities that are indirect wholly owned subsidiaries of Holdings. Cash flows received from rental streams and licensing fee streams paid by Sears, Kmart, other affiliates and third parties, are used for the payment of fees and interest on these securities. Since the inception of the REMIC and KCD IP, LLC, these mortgage-backed and asset-backed securities have been entirely held by our wholly owned consolidated subsidiaries in support of our insurance activities. At November 2, 2013, October 27, 2012 and February 2, 2013, the net book value of the securitized trademark rights was approximately $1.0 billion. The net book value of the securitized real estate assets was approximately $0.7 billion at November 2, 2013, and approximately $0.8 billion at both October 27, 2012 and February 2, 2013.
If the content of the securitized real estate is the same, then the book value of 125 full-line stores decreased by 12.5% from $0.8 billion to $0.7 billion during 2013. I consider 125 full-line stores a sizeable sample representing Sears Holdings real estate. I'll use that 12.5% decrease as an estimate of the impairment for all of the real estate. This would also put in question Note 6 of Q3 which mentions only $16 million impairment for the 39-week period ended November 2, 2013, while a 125 full-line store subset book value decreased by $100 million.
Third consideration: the remaining goodwill of $379 million.
The goodwill impairment test depends on market approach as well as discounted cash flow model. The average stock price for SHLD in 2012 was $54.69 and the average stock price of SHLD in 2013 was $49.99. A decrease of 8.6% in average stock price suggests that market participants would be paying less for reporting units. As for the discounted cash flow model, the trend of worsening earnings and earnings estimates for Q4 2013 also substantiates goodwill impairment.
Balance sheet considerations and stock price predictions for Sears Holdings:
- Treating operating leases commitment as debt, I would add $4343 million to the long-term debt.
- If the 2013 Q4 are unusually bad the risk of impairment of real estate will materialize. The disastrous retail numbers portends further declines in operating performance at multiple locations. This will trigger massive impairment testing of the book value of the real estate resulting in also massive write-downs. I would decrease the Feb. 2, 2013 balance of $6053 million by 12.5% to $5296 million. ($757 million) off the assets under property and equipment.
- The downtrend on goodwill balances of $1392, $841, $379 million; changes of ($551) and ($462) million from 2011, 2012 and 2013, will continue and the remaining goodwill balance of $379 million will disappear. ($379 million) off the assets under goodwill.
- Prediction: Shortly after the release of 2013 Q4 numbers, the stock could rally because the disastrous operating performance will encourage the believers in Sears Holdings real estate value that the end is near and that company is worth 160 billion in pieces and also because of short position covering (60% of the float)... After a while, reality will hit again and the stock will plummet. Alternatively, the stock will plummet immediately or shortly after the release of 2013 Q4.
If Sears Holdings does not go bankrupt, it is not soon (5+ years from now) that shareholders will get any decent return on equity. It will take several years from now because of the lease operating covenant of its money losing locations. Meanwhile, the company is likely to have continuing operation losses and take on more debt and/or survive buy managing to sell a few pieces at a time. I would only consider Sears on the long side if its retail operation were to somehow return to profitability or break even. If Sears Holdings goes bankrupt, then there will likely be a fire sale of its real estate.