Sears Spin-Off: The Hardware Side Of Sears, Part II

| About: Sears Holdings (SHLD)

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Part I of this article outlined several pertinent aspects of the Sears-Orchard spin-off transaction, along with an overview of Orchard Supply Hardware Stores Corporation's (OSH) operations. In Part II we will seek to estimate the fair value of Orchard. This is done only to identify whether the post spin-off trading price represents a sufficient discount to the fair value of the underlying business to justify a more detailed examination. Or in other words, at what price must the shares trade for us to consider an investment and compel us to dig a little deeper?

Estimation of Fair Value

Registration Fees

As was reported in June 2011 when Orchard first filed Form S-1, the company incurred an SEC Registration Fee of $9,020.20.[i] This fee denotes an $82 million registered value when applying the SEC Section 6(b) fee rate applicable to the registration of securities in fiscal year 2011.[ii] With just over six (6) million common shares outstanding, this valuation indicates that in June of 2011 management was projecting the shares should trade at approximately $13.67 per.

A number of significant events occurred subsequent to the initial registration (namely the property sales discussed below), but these events appear to have been anticipated at the time of management's fair value calculation. Although we do not know what deviations may ultimately have existed in the details, we may at least take a small level of comfort in knowing management had foreseen the need for these asset sales when valuing the company.

"Ares" Investment

During November 2005, Ares management LLC, through an affiliate, provided Orchard with $58.7 million in cash in exchange for 19.9% of the company's voting stock, along with a three-year option to acquire additional stock. That option ultimately expired unexercised. We raise this to highlight the fact that the Ares recapitalization implied a value of at least $295 million one or two years prior to the bottom falling out of the housing market. Although this doesn't help us much now, it does at least serve as a reference point.

Industry Comparison

Orchard considers its true benchmark companies to be True Value and Ace Hardware, but as public data is available for the big-box stores, a comparison of Orchard's financials has been made to that of The Home Depot, Inc. (NYSE:HD) and Lowes (NYSE:LOW) below. With the exception of Orchard's 2010 financials, which were obtained from the Form S-1, the following financial results are derived from the most recent quarterly filings for each company.

Revenue (TTM) 518.9M ** 648.0M * 49.06B 69.51B
Gross Profit 172.5M ** 226.4M * 17.15B 23.30B
GM% 33.20% ** 34.94% * 34.85% 34.40%
EBITDA 27.1M ** 60 * 5.27B 8.09B
Net Income (7.2M) ** 7.2M * 1.79B 3.7B
Net Profit % 5.22% ** 9.32% _ 10.74% 11.64%
Revenue Per Share 86.33 ** 107.80 * 37.68 43.87
Earnings Per Share 1.2(d) ** 1.20 * 1.37 2.32
Book Value Per Share (mrq) 15.15 ** 16.31 _ 13.34 11.53
P/E TBD _ TBD _ 18.58 18.12
PEG (5 yr expected) TBD _ TBD _ 1.23 1.24
P/S TBD _ TBD _ 0.65 0.93
Shares Outstanding 6.01M ** 6.01M _ 1.25B 1.54B
Share Price (mrd) TBD _ TBD _ 25.38 42.04
Market Capitalization (mrd) TBD _ TBD _ 31.79B 64.81B
Enterprise Value (12/27/11) TBD _ TBD _ 37.44B 73.36B
Debt (mrq) 246.5M ** 271.5M _ 6.62B 10.78B
Debt Per Share (mrq) $41.01 ** $45.17 _ $5.30 $7.00
Debt as % of Market Cap 300.6% ** 331.10% _ 20.82% 16.63%
*Represents pro-forma amounts from FYE January 29, 2011 as only trailing three months of stand-alone data is currently available. Pro-Forma reflects new terms under the Brands and Appliance Agreements entered into with a subsidiary of SHLD as a part of the spin-off.
**Represents YTD FY 2011 amounts (39-weeks ending October 29, 2011

A review of the respective companies' gross margin percentages reveals remarkable parity, though Orchard's gross margins have been depressed in 2011 year-to-date due to increased markdowns to move inventory and increase sales. Thru 2010, the companies' EBITDA percentages were comparable, though Orchard's EBITDA came under tremendous pressure in 2011. A couple percentage points may be explained by the recognition of the $14.6 million loss Orchard incurred on the sale of its Tracy distribution center, but there has also been a marked decline in operating results. Of course, as discussed earlier, the company's excessive debt-loads have significantly reduced Orchard's net income relative to its competitors, but when removing the loss on sale of assets, Orchard remains surprisingly profitable. [Note the debt numbers for Orchard above represent only its debt, and do not take into account the company's sizeable capital and operating lease obligations, which adds another $70 million.]

Back-of-the-Envelope Valuation

We will merely run a quick calculation to double-check management's estimation of fair value for purposes of its registration fee. By adding back $20 million of interest expense to the company's 2011 YTD income, and excluding the one-time loss on sale of the Tracy distribution center, we see that a more reasonable debt-load would allow Orchard to report net income of roughly $27 million.

This result is fairly similar to the result we would obtain if using the 2010 annual numbers, and as the company's lease expenses will increase materially in 2012 (see note on property sales below),we will forego annualizing the result to approximate go-forward earnings. By applying the same trailing-twelve-months (P/E = 18) and forward (P/E = 15) multiples enjoyed by Lowes and Home Depot, we would arrive at a value in the range of $408-$490 million. If we then were to pretend the company assumed the current debt and capital lease obligations of $320 million, and subtract that number from the results, we would arrive at a market capitalization somewhere between $86-$170 million. Therefore, we have reason to expect that management's fair value estimation of $82 million is reasonable, and perhaps represents a significant discount.

With 80% of shares held by Insiders, trading is apt to be volatile initially; therefore, it may be prudent to await an initial equilibrium. If the shares settle in the mid-to-high teens, we will be incentivized to take a closer look at projecting normalized future earnings and analyzing the company's balance sheet in an effort to value its real estate holdings.

Balance Sheet Method

An investor may seek to value the company using a Balance Sheet method to determine the fair market value of the company's real assets. To determine the fair value of the company's real estate, we have available to us a number of very recent sales. For the one store sold on December 12, 2011 and the three stores sold on December 20, 2011, the company received $36 million. At an average price of $9 million per location, one might identify the number of the 89 stores in operation for which the company still owns the real estate and then multiply accordingly. One would then add the balance of the net assets, perhaps reserving the inclusion of intangibles, and take into account any necessary adjustments (for instance, the company employs the LIFO method for calculating its inventory and a $1-2 million adjustment would be required to arrive at liquidation value, etc.). Finally, one may subtract the debt, contractual obligations, such as the capital and lease obligations, the value of the preferred, and arrive at a reasonable fair value. As we have not yet found the necessary information for the company's real estate holdings, and as we don't wish to expend the necessary time and effort at this stage, we have not taken this approach.

A Note on Debt and Refinancing Efforts

If Orchard's market capitalization does indeed fall in the $82 million range, the company will have a debt load roughly three times (3x) the value of its shares; whereas Lowes and The Home Depot have debt loads of 21% and 17% of their market capitalizations, respectively. This leverage presents the most likely near-term opportunity in the shares, as a relatively small percentage improvement in the value of Orchard's assets will have a significant upward impact on the price of its shares. Then again, the reverse will also hold true.

Thus, an investment in OSH is likely to hinge on 1) the company's ability to service its debt while progressively deleveraging, and 2) a lack of further deterioration in Orchard's financial performance. As both of these conditions are uncertain, it would be prudent to insist on a sizable margin of safety. If this margin of safety cannot be found in the company's operations, assets, or competitive position (we have certainly not discovered it thus far); we must insist it exist in the purchase price of the shares.

Refinancing and extending the maturity of the senior secured term loan is critical. To that end, on December 12, 2011 the company closed the sale of its Hollywood store, and a short-term lease was subsequently entered into for the property. On December 20, 2011 the company closed the sale of three additional stores to another purchaser via a sale-long-term-lease-back transaction. These last stores were Pismo Beach, Cottle Road (San Jose), and Capitol Expressway (San Jose).

$21.6 million of the proceeds for the four stores and the Tracy distribution center were used to pay down principal on the Real Estate Secured Term Loan.

The remaining proceeds of approximately $36 million before fees, will be used to pay down the Senior Secured Term Loan. Orchard 'expects' to be able to use that prepayment to negotiate an extension on the maturity of the bulk of the remaining Senior Secured Term Loan principal until December 21, 2015. [It is important to note Orchard will incur $3.2 million in additional rental expense annually as a result of the "leaseback" portion of the four store sales, and an additional $1.7 million for the Tracy distribution center. This added expense will further depress prospective operating results.]

Disclosure: I do not hold a position in SHLD, OSH, HD, or LOW; nor do I intend to establish a position in any of those shares within the next 72 hours.

Disclaimer: Investment analysis is the process whereby we determine how best to strategically allocate scarce resources. While this applies to the allocation of investment funds, it is also applicable to how one chooses to allocate their time, which is in similar short supply. Thus, this article is not meant to represent an exhaustive technical analysis or enterprise valuation. The discussion above is intended merely to represent a back-of-the envelope, rough approximation of the company's value in order to determine whether, or more precisely at what price, the operations and assets of Orchard deserve further consideration and analysis.

[i] S-1, Part II: Information Not Required In Prospectus, p. II-1.

[ii] Fee Rate Advisory #5 for Fiscal Year 2011