Sears Holdings (SHLD) has been the Cinderella story of the 2012 market, which came out of nowhere to lead the pack as the best performing S&P 500 stock. Beaten down last year on news of store closings and possible bankruptcy, the stock suffered a fifty point drop at the end of 2011. That all ended the second week of January, and since then it has risen to within three points of its October high. What is behind the sudden reversal, and how has Sears Holdings' Chairman and former hedge fund manager, Eddie Lampert, accomplished this feat? The first piece of this series will examine the recent explanations given for the revitalization of SHLD, namely the strength of their brands and the value of their real estate.
Let's go back to January of 2008 when SHLD had just finished an 85 point free fall. The week of January 14th Lampert announced a restructuring plan for Sears which prompted a twenty point swing in the stock over the next two weeks. At the time his hedge fund, ESL, owned 48% of SHLD shares and found themselves slipping further into oblivion. SHLD reached a high of 195 the previous April, was at 85 for the announcement and eventually reached 30 by the end of the 2008. It wasn't until January of 2010, two years after the restructuring announcement, that SHLD returned to 85. In January of 2011 Sears reached another low at 28, but is now on pace to reach 85 in under three months. While the economy has been recovering since 2008, Sears Holdings has not. That being said, what is said to be behind the dramatic 2012 rise of Eddie Lampert's retail love child?
The merger of Sears and Kmart was partially built upon the concept that the combination of Sears' brands and Kmarts' real estate locations could provide a combined boom for both entities. The results, however, were depressing, and by 2008 sales had fallen to levels prior to the merger. Lampert knew that in 2004 the value of Sears real estate was low, due to the fact that most of their stores were mall anchors. The rise of online sales and the growth of competition like Walmart (WMT), Macy's (M), and Target (TGT) has led to a steady decline of mall customers and sales. This decline previously led to the sale of their mall development company, Holmart, which was sold to General Growth Properties (GGP) in 1995.
Over the years Lampert attempted many different compartments and spinoffs with Sears, and many in the following years would end in failure (Sears Grand, Sears Essentials, Great Outdoors). They have also attempted various online platforms which have failed to gain ground, including one which prompted a class action lawsuit. His policy of cutting overhead costs while raising prices did little to bolster the dying brands. The reductions in inventory and slapstick approach to merging Sears and Kmart resulted in reduced customer sentiment and widened the gap between Sears and the growing American culture. It also hurt Sears' relations with their vendors and suppliers because the increased costs and reduced inventories hurt their margins.
The newest strategies for Sears have been to reduce inventory (by $580 million) and to shut down stores (at least 79). These strategies claim to provide more short term cash flow for the retailer, but we have already seen how this hurt their business relations and sales in the past. Recently CIT Group (CIT) announced that it would halt loans to Sears' suppliers, a cut at the future profitability for the suppliers and Sears alike. Without funding from CIT, the suppliers will begin to ask for cash advances or lines of credit from Sears. This will begin to eat into Sears Holdings' cash and in fact was a contributing factor to the demise of Circuit City. Once financial concessions have been given to some suppliers the others will begin to demand the same offerings. The new cash inflows that the stock appears to be rising on may be eroded or overtaken by their suppliers' demands for payment upfront, not to mention the future cost of shutting their stores down.
Earnings Report: The Softer Side of Sears
Let's take a look at one of their statements in their 2011 full year earnings report:
Operating loss was $1.5 billion for the year ended January 28, 2012, compared to operating income of $437 million for the year ended January 29, 2011. The decrease in our operating income of $1.9 billion includes the impact of non-cash impairment charges related to goodwill balances, charges related to store closures and severance and other significant items. Excluding these items, operating income declined $1.1 billion, primarily related to a decline in our gross margin dollars, given lower sales, and a decline in gross margin rate of 180 basis points, and an increase in selling and administrative expenses.
They had a $1.9 billion dollar swing in operating income last year. $500 million of that was partially due to closing stores and paying severance to laid off employees. The other $1.1 billion was because they're losing gross margin, selling less, and it's costing them more to sell when they manage to do it.
This shows that they lose money when they close stores, so the $270 million they made from selling eleven stores to GGP will be offset by closing and severance costs next year. Those stores will remain operational until 2013. Looking at their previous earnings reports they have always reported losses to income due to closing stores, pension, and severance pay: 2011 - ($328m) 2010 - ($156m) 2009 - ($301m) 2008 - ($79m).
There don't seem to be any compelling arguments (neither are people found making them) for the idea that the recent increase in share price for Sears is related to a revival of the brand. The primary reasoning lies in the unlocked or hidden value of their real estate, yet what has Sears done to improve their stores in the past few years? Prior to the market crash in 2008 people were questioning the value of their properties because they spent very little money investing in them, choosing instead to buyback shares. In May of 2008, Gary Balter, a Credit Suisse analyst, reduced his buy outlook on SHLD because of their real estate and brands declining value. How is it that Sears is making the market comeback of 2012 on the back of their RE value and brands? What innovation or renovation has occurred to improve the value of Sears Holdings when sales have continued to diminish since 2008 and we know they've spent little on capex?
SHLD Real Estate: A Game of Homes
Instead of addressing the real estate, Lampert pursued a series of aggressive buybacks. SHLD has spent over $4.7 billion dollars on share buybacks in the last five years ($2.9b - 2007 $678m - 2008, $490m - 2009 , $471m - 2010 $183m - 2011) instead of investing in their stores ($2.3b in capex over the same period). They later touted this lack of capex (averaging less than half of what its competitors spend) as a reason they made it through the 2008 market, yet it left them incapable of improving sales because the condition of their stores had deteriorated so much.
In 2010 Balter stated this about Sears Holdings real estate, "Of the 2000 [SHLD stores], there's 1,500 that you don't want to be in, that nobody's going to buy … Where Sears and Kmart are making their money - if you sell those, what are you going to be left with?" This is exactly what Sears is doing right now, they have recently sold a few of their most attractive locations to boost cash and market sentiment, but what happens when they only have properties in aging, long abandoned malls or forgotten districts of town? There is no reason to believe that the locations or value of Sears' primary RE assets has been improving over the years or that people will be more willing to pay for them at a time when Sears is in free fall.
One analyst stated that, "There is not enough value in the real estate to do much with. Who is going to buy the stores? There are no buyers. There is no one growing in U.S. Retail." Sears sold eleven properties to General Growth Properties, of the $270 million in the GGP deal, one store accounted for $200 to $250 million of the total. Which means the other ten stores were sold for two to five million a piece. The packaging of the Ala Moana center in Hawaii with the other ten stores was a PR move for SHLD. Had they come out and said they sold ten stores for $20 to $50 million, the public outlook would have been much worse. They were sold to GGP because they owned the malls that the Sears were located at, but what remains to be seen is what the company will do with them. The most likely outcome is that the malls will demolish and rebuild them as GGP and other mall owners would be better off destroying the building rather than allowing Sears to wither away. The owners of the malls have some incentive to reclaim their property, but who will be interested in purchasing the stores outside of malls? What major retailers are looking to expand into areas of town which haven't been nice since the 1960s? The rise of the outlet or outdoor malls has isolated Sears away from many new shopping districts. The oft quoted top rule of real estate is location, and while Sears may be heavy on real estate assets, it is low on location. Don't ask yourself about the last time you went to Sears, just ask yourself the last time you went somewhere near a Sears.
Sears has been increasingly passed over in the market place by cheaper (Walmart), more specialized (Home Depot (HD), Lowes (LOW)), and online stores (Amazon (AMZN)). The only reason to visit Sears in recent years was for the exclusivity of their three primary brands: Kenmore, Craftsman, and Diehard. The poor in-store sales, however, led to Craftsman being sold in Ace Hardware and Costco, while Diehard is being sold at Meijer. If the value of Sears is tied up in its brands, why are they allowing customers to shop for their products in other stores? One might argue that if the value is in the brands, Sears could improve cash flow by selling in other stores while reducing their inventory or RE costs. One of the big problems with this is that Sears does not make their three major brands. The once powerful middle man of the 80s mall or 70s catalog has failed to provide a platform for their value. Their catalog was discontinued in 1993 due to poor sales, and their attempts to launch online platforms have yet to be successful.
Giving up the exclusivity of their brands is another sign that Sears is failing to capitalize on the value it once possessed. Why should Whirlpool, GE, LG (Kenmore), Husqvarna (Craftsman), or Johnson Controls (Diehard) continue to produce these products for Sears when they have become increasingly incapable of selling them? SHLD has taken recent losses attributed to goodwill impairment, which means that the value of their company image and brands fell far below the carried value on their books. The hope for Sears' retail future, which are their flagship brands, have been losing sales and leaving the stores. This is hardly any reason to see investors clamoring to add SHLD to their portfolio.
It was announced on March 8th, 2012 that the President of their Home Appliances division is leaving, the third person to leave this position in four years. The position is expected to be filled in a few weeks. It could be said that this speaks volumes about their ability to effectively manage their home appliance division. Marketwatch and other news media have chosen to attribute their March 8th rise of nearly 5% to the news of this change but it is hard to imagine how another failure and open position could drive the price so much on low volume.
The future of Sears as a retail operation is no longer in question, between 2005 and 2010 Sears Holdings revenues fell 23.5% while Walmart and Target saw over 25% gains in revenue. They ranked first in losses among large retailers edging out Dillards and Office Max. What is in question is the direction that Eddie Lampert plans to take Sears Holdings. The choices that Lampert and company have made are not conducive to recovering the brand. Their attempt to create spinoffs is a slow dismantling of the company, and perhaps this is Lampert's goal. Since the Sears and Kmart merger, Lampert has operated Sears like a third party investor, not as a retailer. His lack of retail experience was not so noticeable at Autozone (AZO), where he led the successful recovery of their business. Lampert's attempt to repeat his Autozone success with SHLD has been met with failure for the past five years, so why the sudden reversal? If the store closings and brands are losing value and costing them capital, what is Lampert's end game? The only thing at this point that is certain is the money made by Lampert and his investors. Part two of this series will examine Lampert's personal investment in SHLD, how it relates to the 153.24% YTD gain, and where he sees the future of Sears Holdings.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SHLD over the next 72 hours.