Sears Holdings: A Once-In-A-Lifetime Investment Opportunity

| About: Sears Holdings (SHLD)

Summary

Sears Holdings Corp. hit a 52-week low of 16.27 last week, this creates an incredible buying opportunity.

Eddie Lampert is applying several investment strategies previously used by Steven Roth of Vornado, Bill Anders of General Dynamics and Warren Buffett of Berkshire Hathaway.

The successful spin-off of Seritage Growth Properties validated the value of the real estate portfolio.

The non-guarantor subsidiaries have $28 billion in bankruptcy remote assets on the consolidating balance sheet.

There is a difference between a "Turnaround" and a "Transformation.".

In this article, I will address the reasons I believe Sears Holdings Corp. (NASDAQ:SHLD) is an incredible investment opportunity, my research was extensive included uncovering previous situations that mirror what Eddie Lampert is doing with Sears Holdings Corp. If transformations were easy to recognize, Sears Holdings Corp. would be trading much higher: a caterpillar looks nothing like a butterfly and it seems even more unlikely that it will become a butterfly in the middle of the transformation, unless you have seen other caterpillars turn into butterflies.

The Moore case study investing method

I use what I call the case study method of investing, this is done be searching for companies in the past that faced the similar challenges that the company being studied has, and comparing them. I believe we can look to the past and see or at least recognize the future. For the purpose of this article the case studies were:

1) Failed retailer Alexander's, Inc.

2) Failed discount retailer Two Guys

3) General Dynamics under Bill Anders from 1991-1994

4) Berkshire Hathaway after the purchase of General Re in 1998.

As a prerequisite, to fully understand the opportunity with Sears Holdings Corp. the reader must have a good understanding of GAAP accounting, consolidated financial statements, bankruptcy remote entities and strategic inflection points.

I have read various informative articles here on Seeking Alpha that make the bear case including several recent ones from Dylan Street Capital, one of which was entitled Sears Holdings v Berkshire Hathaway found here.

After reading these articles. I was inspired to publish my thesis on Sears Holdings after I shared it with several high net worth friends, some of who unfortunately passed on my recommendation to invest in General Growth Properties common stock while they were in Chapter 11 Bankruptcy in 2009. To-date, this investment has returned over 50 times our investment (including the Howard Hughes Corporation spin-off, Rouse spin-off and dividends paid to-date) but like the GGP investment, Sears Holdings is for investors who understand bankruptcy, holding company structure, net operating losses, consolidated financial statements and GAAP convention, otherwise the opportunity will be misunderstood.

The bear case analyst

I notice that 99% of the articles and analysis about Sears Holdings deal with only the retail divisions of Sears and Kmart, and the fact that sales are declining at those subsidiaries, but Sears is a Holding Company, not just a retail store. The bear analysts ignore the real estate development/management division, the brand division KCD, LLC, the insurance division Sears re (which has $28.6 billion in bankruptcy remote assets on the non-consolidated balance sheet as of August 2015). When the case is made that the real estate is worth many multiples of the stock price, the bears simply dispute the value, but never refute it with appraisals and/or comps.

The Sears Holdings Real Estate

To-date, I have not seen any appraisals of the real estate that counter the numbers in the Baker Street Capital-Sears proposal found here, or this article entitled Between Berkshire Hathaway and Bankruptcy. Keep in mind the real estate values are listed using GAAP convention, meaning the real estate assets are listed at historical cost not market value, see page 8 here. Some of the properties were purchased in the 1960's and 1970's. Even after the successful spin-off of Seritage Growth Properties, the real estate values are highly disputed by bears such as analyst, Gary Balter of Credit Suisse but not refuted.

I approach my research on investments by first looking to see if there is a previous situation that closely mirrors the current situation. In the case of Sears Holdings, I looked for companies fitting the following criteria:

a) Failing retailer(s) with valuable real estate portfolios that successfully transformed into a Real Estate Investment Trust (Alexander's and Two Guys).

b) Companies that transformed by divesting core business, buying back stock and returning value to shareholders (General Dynamics)

c) The sale or merger of a reinsurance business similar in size and asset value to Sear Reinsurance division (Berkshire Hathaway and General Re)

Case Study: Sears Holdings Corp. v. Two Guys and Alexander's, Inc.

Two Guys was a once a very successful retail store that operated in NY metro for roughly 30 years until 1982, when they closed and decided to convert to a REIT, similar to Sears and Kmart they had years and years of declining sales and very valuable owned real estate. Before they closed, Two Guys merged with Vornado, a real estate development company run by Steven Roth. He agreed to the merger with the goal of developing the valuable real estate portfolio, he had no plans to turnaround the struggling retail business, the retail business was worth more dead than alive, Two Guys has been and is now a very successfully publicly traded REIT. The complete background of Two Guys can be found here

Alexander's, Inc. was once a very successful retailer with a plethora of stores in the NY area including a lease at the World Trade Center and very valuable owned real estate including an irreplaceable location at 731 Lexington Avenue which was eventually developed and named the Bloomberg Tower, now the 15th largest building in NY.

Back in the late 1980s and early 1990s before the bankruptcy, Alexander's was also seen as a "failing retailer" with no value because the owned real estate was listed in the bankruptcy using GAAP convention as were the Kmart real estate during their bankruptcy. Sophisticated real estate developers such as Donald Trump and Steven Roth understood GAAP convention and knew the true value of Alexander's, especially if it were converted into a REIT. Because of this speculation, when they filed bankruptcy in 1992, the stock rose significantly which is very, very rare. Investors who bought shortly before or during the bankruptcy have seen an incredible return investing in this "Failed Retailer" The complete background on Alexander's can be found here.

Steven Roth discussed his investment strategy in his 2005 annual letter found here. Mr. Roth noted that entrepreneurs like T.Boone Pickens, discovered he could "mine" for crude more cheaply by purchasing energy stocks than drilling oil wells. Roth also elaborates on his investment in Sears Holdings by comparing it to his investment in Two Guys and Alexander's.

The real estate value is grossly misunderstood due to lack of understanding of GAAP convention

Prior to Merging with Sears, Kmart Filed Chapter 11, creditors grossly underestimated the value of the Kmart real estate, and creditors such as Fred Campo sold their debt to Eddie Lampert which he later converted to equity giving him control of Kmart. Creditors like Campo performed no due diligence, and/or didn't understand GAAP Convention and therefore grossly underestimated the value of the real estate by assuming the GAAP convention meant Market price.

When Fred Campo discovered the true value of the real estate, he and others filed a lawsuit against Eddie Lampert and ESL which can be found here. In the Kmart amended disclosure statement presented to the bankruptcy court, using GAAP convention, the net book value of Kmart's real estate interests (stores, distribution centers corporate research centers and "other" was listed at $1,208,392,000) however less than two years later only 68 stores sold for the total of $846,900,000. These stores represented less than 5% of Kmarts real estate.

In this lawsuit, the plaintiffs uncovered that in late 2004, Deutsche Bank REIT analyst Louis Taylor valued just the Kmart side of the real estate at $152.95 a share or approximately $16 billion, but unfortunately they performed due diligence too late, perhaps history is repeating itself. In 2012, in the Fairholme presentation on Sears Mr. Lampert said:

"Sears Holdings has over $20 Billion of assets on our balance sheet. In some cases, the fair market value of our assets are not reflected on the balance sheet due to GAAP Convention, such as the value of our owned real estate and many of our below market leases [...] we have a portfolio of businesses and assets that deserve to generate substantial value for our shareholders." - February 23, 2012.

In a Barron's article in December 2005, Pershing Square founder Bill Ackman said that he believed the value of the Sears and Kmart real estate was worth over $22 billion, he called Sears a powerful value when the stock was trading at $115, in the same article he said:

" Eddie has been tabbed the next Warren Buffett, and in Sears Holdings you can see Lampert working for you for less than hedge-fund investors, who have to give him 20% of any winnings."

Short sellers and analyst speculate but the numbers on the balance sheet don't lie

The assets listed on the non-consolidated balance sheet of the bankruptcy remote subsidiaries (called non-guarantor) exceed $28 billion, meaning SHLD shareholders may still come out ahead even if the retail division eventually files bankruptcy as did Alexander's in the above-mentioned case study.

The consolidated statement reporting of Sears Holdings does not belie the true value of each individual subsidiary. In a 1999 shareholder letter, Warren Buffett warned about the misleading aspect of consolidated reported earnings, in the letter he said:

" Because of our two-prong approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore consolidated numbers. However, we report to you the earnings of each major business we control, numbers we consider of great performance. These figures along with other information we will supply about the individual businesses, should generally aid you in making judgments about them."

If we take the advice of Warren Buffett and Charlie Munger and ignore consolidated numbers and then look at the Sears Holdings non-consolidated balance sheet, we will see that the non-guarantor entities are bankrupt remote, profitable and have over $28 billion in assets.

Bruce Berkowitz and Fairholme are still buying

Bruce Berkowitz personally and through Fairholme Funds owns and/or controls roughly 25% of Sears Holdings. In July 2015, he purchased more stock at an average price of $40 a share. In December 2015, he purchased one million shares at roughly $20 a share. In January 2016, he purchased even more stock in the range of $17-$20 a share. I assure you he has a clear understanding of the transformation happening at Sears Holdings, he explained his rationale on Sears and investing in this interview.

Mr. Lampert is very transparent about his plans. In fact, in 2014, Mr. Lampert articulated his plan in a letter to Sears' alumni found here. He briefly spoke of the transformation of General Dynamics in the 1990s under CEO Bill Anders, I was not familiar with him so I dug deeper and researched his actions while CEO and put together a case study as shown below in Table 1 & 2 and afterwards I was able to understand a large part of what Eddie Lampert was doing at Sears Holdings Corp.

Case Study: Sears Holdings V. General Dynamics

Table 1

General Dynamic's divisions sold in 1991-1993

Sale Date

Division

Buyer

Sale Price in Millions

1991 Revenues in Millions (Millions)

6/91

N/A

Gen. Dynamics

N/A

Stock Repurchase

11/91

Data Systems

CSC

$184

$12

2/92

Cessna

Textron

600

797

8/92

Missiles

Hughes Aircraft

450

1,385

11/92

Electronics

Carlyle Group

52

218

3/93

Military Aircraft

Lockheed

1,525

2,719

12/93

Material Services

n/a

46

n/a

12/93

Space Systems

Martin Marietta

209

363

Total:

$3,066

$5,494

Click to enlarge

Sales of divisions and subsidiaries

Table 2 summarizes GD's sales of divisions between November 1991 and December 1993. GD sold the Data Systems Unit to Computer Sciences Corp. for $184 million, the Cessna Aircraft subsidiary to Textron for $600 million, its missile business to GM's Hughes Electronics subsidiary for $450 million, its Electronics Division to Carlyle Group for $52 million, and the lime and brick operations of its Material Services businesses for $46 million.

In December 1992, Lockheed offered to acquire GD's jet business for $1.525 billion. The divestiture of one of the company's "core businesses" prompted speculation that GD was on a liquidation path. In July 1992, Warren Buffett bought 14% of the outstanding stock in General Dynamics, in his annual letter he explained that the repurchase of 30% of the outstanding shares of the company and the successes of Bill Anders at the company in a short time motivated him to invest.

Bill Anders was highly motivated to return as much to shareholders as possible, because in January 1991, his compensation had been linked to the shareholder value created, therefore between 1991-1993 shareholders realized gains of $4.5 billion representing a return of 553%, Eddie Lampert's 55% interest in Sears gives him the same motivation that Bill Anders had to maximize shareholder value. (see Table 2 below)

Table 2

Sales and Spin-offs and divisions and subsidiaries

Sears Holdings assets sold/distributed to shareholders from 2011-2015

Sale Date

Division

Buyer

Sale Price Million

Shareholder Benefit/Cost

2005-2011

N/A

Sears Holdings

N/A

Stock Buybacks $5.9 Billion

12/2011

Orchard Hardware

Tax Free Spin-Off

N/A

1 Common/1 Preferred Share (no cost)

9/2012

Sears Hometown

Spin-Off

446.5M

Right to Purchase .218091 Share of SHO

11/2012

Sears Canada

Tax Free Spin-Off

$380M

Received 49% of Sears Canada (no cost)

4/2014

Lands End

Tax Free Spin-Off

500M

.30 share in Lands End (NASDAQ:LE) (no cost)

7//29/2015

Real Estate

Seritage Growth

$2.6 Billion

½ share of SRG per Share bought

Remaining

Guarantor

$8.582 Billion

Non-Guarantor

$28.692 Billion

Treasury Stock

$5.9 Billion

Click to enlarge

Table 2 summarizes Sears Holdings sales of divisions and/or spin-offs to Shareholders between December 2011 and December 2015. In December 2011, Orchard Hardware was transferred to shareholders, Sears Hometown in September 2012. In November of 2012, shareholders received 49% of Sears Canada on a pro-rata basis, on April 2014 Lands' End was transferred to shareholders through a public offering on a pro-rata basis and that company trades under the symbol.

In July 2015, Sears sold 235 of its stores to Seritage Growth Properties a publicly traded Real Estate Investment Trust. Shareholders were given a right to purchase ½ shares in the REIT at roughly $30 for every share of Sears Holding they owned.

Between 2004-2011 Sears bought back 56.9 million shares of common stock at an average cost of $103.70, the company spent $5.9 billion buying back stock at an average price of roughly 5 times its current trading price of $18.

Case Study: Berkshire Hathaway buys General Re

According to the 2005 10-K, the Sears Reinsurance division has roughly $28.6 billion in assets. Keep in mind this is the GAAP convention number, so it is likely the value is much higher. Because of its bankruptcy remote status, Mr. Lampert could separate this valuable subsidiary and take it public as he did with Lands End and Seritage Growth Properties, or merge it with another company similar to how General Re merged with Berkshire Hathaway in 1998. Sears Holdings could announce a transaction like this at anytime, the Sears Reinsurance division is the reason there is talk that Eddie Lampert could turn Sears Holdings into the next Berkshire Hathaway.

In 2012, Bruce Berkowitz said:

"I still have my mini-Berkshire Hathaway model working at Sears and I have not been able to disprove my theory yet"

Conclusion:

Eddie Lampert is a misunderstood genius who is not attempting a turnaround of the Sears and Kmart Retail divisions, he is successfully executing a transformation of Sears Holdings Corp. He has protected the profitable divisions from bankruptcy in the event the retail division ultimately fails as Two Guys and Alexander's did, he has invested heavily in the Shop Your Way web site and is prepared for the future, he has returned value to shareholders through spin-offs and stock buy-backs.

The case studies listed above demonstrate that other companies have transformed successfully using the strategies Mr. Lampert is using. Sears Holdings is a group of businesses that when separated or looked at as individual business, are worth many multiples of the current stock price of $17 a share.

The merchandise inventory alone exceeds $5 billion, which is more than double the current market cap of $2 billion, the owned real estate is worth over $20 billion, which is more than ten times the current market cap, the company has over $3 billion in credit and has paid down debt by a billion dollars in less than 18 months, the talks of eminent bankruptcy and a stock price of $0 are absurd and not based on the actual numbers as shown in the 2015 Sears presentation deck found here.

Sears Holdings is a once-in-a-lifetime opportunity to be partnered with two of the most successful investors of our time (Bruce Berkowitz, and Eddie Lampert) my case study investing method as exhibited above is a great way to get clarity on misunderstood geniuses like Eddie Lampert and Bruce Berkowitz. Short sellers beware, 90% of the stock is owned or controlled by long-term investors who understand the amazing transformation happening at Sears Holdings, this caterpillar will soon transform into a beautiful butterfly.

Disclosure: I am/we are long SHLD, SRG, SHOS, LE, SHLD.WS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have no association with Eddie Lampert or Bruce Berkowitz, ESL or Fairholme Capital or their affiliates.