Sears Holdings' True Value

Finance 101: "A company is worth the discounted present value of its future cash flows." Well, not exactly. Morningstar analyst Kimberly Picciola's November 2007 brief on Sears Holding (SHLD) uses four components to arrive at a $240.00 fair value estimate. Her model reflects a lot of discussion that I have seen on Sears Holding and each component is assigned a percentage contribution to the value of Sears Holding.

Retail profits (24% of fair value)

This is the easy stuff, just estimate sales, margins and profits as with any other retailer. Looking at last quarter, Sears Holding's sales slowed with the housing market and it acknowledged big inventory issues. K-mart and Sears have relentless competition; Best Buy (BBY) and Costco (COST) on electronics, Home Depot (HD) on tools, Wal-Mart (WMT) and Target (TGT) on general merchandise. In the current economic environment, it is hard to see Sears or K-Mart excelling. Also, Sears Holding is criticized for under-investing in its stores but management disagrees profusely and I personally think my local Sears is a great place to shop. I see great appliances, yard equipment, and tools. I also see a first class kid's department (I have two small kids), a robust men's department, and a store that is clean, organized, and well staffed (albeit pretty empty last visit).

In any case, don't over-think this part of the equation. The numbers are reported quarterly and, according to Morningstar (see below), all retailing will cease in 10 years anyway.

Real Estate (45% of fair value)

Morningstar's analysis includes an eye-opener:

After 10 years, we expect the retail business will cease and value will be unlocked by selling the real estate assets and the brands. This accounts for roughly 45% and 8% of our fair value, respectively.

I had to chuckle when I read about "unlocking" real estate value. That is so 2005. Unfortunately, real estate valuation in 2008 is summed up daily in the press by one word, "declining."

Brand value (8% of fair value)

Sears has exclusive brands like Kenmore, Craftsman and Land's End. Brands have value and can be sold. Maybe Wal-Mart buys Kenmore. Maybe J.C. Penny wants Land's End. Maybe Lowe's wants Craftsman. No argument from me.

Eddie Lampert (23% of fair value)

I hope Lampert is in good health. His brain is apparently worth exactly 1% less than the entire value of the Sears and K-Mart's combined. You must believe in him (Cramer does) to go long on Sears Holding. Here is how Morningtar looks at it:

Finally, given Lampert's successful investing record, we believe he will be able to allocate the company's excess cash to generate an average annual return of 20% over the next 10 years. This accounts for 23% of our fair value estimate. We think there is room for Sears Holdings to add leverage to the balance sheet, particularly if its debt is upgraded to investment grade.

I read the letters from Lampert to shareholders posted on the Sears Holding website. He wrote quarterly until March of 2006 and once in November of 2007. I wanted to see how he thinks and I respect Lampert for what he wrote. He is obviously passionate and cares deeply about what others think and say. Like everyone else, however, he sets a very high standard for himself. Here is my take-away and some excerpts:

1. Lampert as Jack Welch

I view Sears Holdings as a $55 billion revenue, 350,000 person start-up…my goal is to see Sears Holdings become a great company whose greatness is sustainable for generations to come…When Jack Welch took over, he completely reinvented GE...as part of Sears Holdings' efforts to adapt, I am focusing on providing direction, raising issues, asking questions, and suggesting ideas – on challenging and collaborating – and I rely on the experience and ability of our talented management team to make those ideas come alive.

2. Lampert as Warren Buffet

Warren Buffett makes clear that his goal is to increase the per-share value of Berkshire Hathaway. Similarly, our goal is to increase the per-share value of Sears Holdings..

3. Lampert as the underdog

We welcome the challenge of being the underdog, and we will let our performance speak for us.

Obviously, Lampert believes in himself and he has re-purchased $3 billion of Sears Holding stock to prove it. Morningstar also mentions that Lampert has begun investing excess capital in derivatives such as "total return swaps" and acknowledges the increased risk.

If you invest in Sears Holding you get Craftsman tools on Aisle 1 and "total return swaps" on Aisle 2. You don't get that with Wal-Mart! Of course, you also get Lampert's brain and you will need it.

Besides competitive issues in the best of times, Lampert must now navigate a housing slump, credit crunch and slowing economy. The challenges seem overwhelming and I have a small short position in Sears Holding.

Nevertheless, I have a secret theory that might justify investing long in Sears Holding. Don't tell anyone, but I really think Eddie Lampert might be Superman. What do you think?

Disclosure: Author has a short position in SHLD

Comments

[BULRUN100:]

Moron! Bunch of useless chatter!Do they read these blogs before they post them?Sounds like a 12 year old wrote this.

2008 Jan 13 06:36 PM

[Richard Shi...:]

Thank you very much for the compliment. I collaborated with my 3-year old on this one. She really wants the miniature Ducati motorcycle that they sell at Sears.

Anyway, the point that I was trying to make with Sears is that it really all just hinges on one guy. More than any other company that you might look at-even Bershire Hathaway.

Anyway, thank you again for the constructive criticism, please post a link to something that you have written so that I can have something to shoot for.

2008 Jan 13 08:00 PM

[jud:]

let's compare b/s's of SHLD vs. M, JCP, TGT, etc...

2008 Jan 13 11:01 PM

[Richard Shi...:]

Jud,

Book value per share is a problem I think (I think that is what you mean) as the real estate values are screwed up from what I understand (depreciation, and a basis that could have been carried forward for years). How about simple forward PE: (SHLD 15.2, M 8.2, Tgt 13.0, JCP 7.9). If you have any input on why book is an ok metric, let me know. A lot of the Lampert premium has come out of Sears Holding though.

2008 Jan 14 01:20 AM

[Richard Shi...:]

Sorry, meant to add the numbers. Here is the book values: SHLD 1.2, M 1.0, Tgt 2.6, JCP 1.9, so Sears Holding looks cheap. Macy's looks like a screaming deal?

2008 Jan 14 01:32 AM

[Richard Shi...:]

Woke up this morning to see the big decline. All I can say at this point is that SHLD will have even bigger problems if Cramer goes negatvie on the stock despite his friendship with Lampert-and Cramer just might because his reputation is on the line here.

2008 Jan 14 10:24 AM

[retail101:]

Your 'Superman' seems to have forgotten his cape at home for 2007 -- it's probably on top of the Bosch washer he bought at Lowe's. Eddie's cost cutting drives, which folks like yourself applauded him for in the past, are finally taking their toll on the stock price/value, and have now gotten your attention. Eddie's days of just playing "store" are now ending, and his non-retail background is very apparent: to customers, employees, and, at last, to Wall Street, which always seems to be the last to catch on to trends like this. (Cramer's rose-colored glasses prevent him from noticing, and he'd still hawk SHLD no matter what the price, or his "reputation".) Maybe you should read the article that appears in the February Portfolio magazine for a better understanding of your 'Superman'. If you haven't already heard, the phone booths have all but disappeared, according to AT&T. Eddie has no place to "change" now, except to maybe hang up the tights, or to finally ask for his superfriends (Hoffman Estates executives) for their help ... before they all move on elsewhere with their expertise, and become an "ex" for comments in the next magazine article.

2008 Jan 14 11:31 AM

[Richard Shi...:]

Retail 101

I thinked you missed the point of my article and the fact that I am short SHLD, albeit a small position. I personally do not know whether "underinvestment" in its stores is the issue but the faith that people put in Lampert is a big issue because it is simply impossible for him to be the Superman that his supporters (including Cramer) wish him to be-that was the point. In other words, even being "good" is not enough for this guy to live up to the hype.

Finally, I think you are dead wrong about Cramer, he would go negative despite the personal relationship-he just might be a little slower in doing it than he should.

Thank you very much for the thoughtful comment though and I will read the article that you suggested.

2008 Jan 14 01:27 PM

[gokou3:]

Well, I would argue that there's not much profit to make from your short. Let's apply discount factors to the 4 components of values based on the negativity of your comments: 50% on retail, 80% on RE, 80% on brand, and 50% on EL. I get
240*(0.5*0.24+0.8*0.45... The discount factors are of course arbitrary (perhaps you can spell out what d.f. you think are appropriate), but the $158 estimate is 76% higher than its current PPS of $90. In fact, my discounted RE value is $86.4 (i.e. 240*.8*.45) which is almost equal to its PPS.

2008 Jan 14 04:37 PM

[Passerby37:]

Geez -

The gallery sure hates this one.

Buffett bought Berkshire, not because it was a great business - it was lousy - but for the cash flows. He then took the returns from the textile mill and reinvested them in growing enterprises with high Returns on Capital which eventually created the mountain of money that is Berkshire is today. Note: the original mill did eventually go under in the early '80s.

I'm impressed with Lambert because he has managed to gain control of not one but two large cash generators(Sears and Kmart) and... their undervalued land holdings to boot. Sweet move. Now, these two entities will probably never develop the 'moats' that their competition have and grow effectively, but they don't need to. They are already providing, IMHO, what Lambert intends: Cash Flows. He runs tight operations not with the intention reinvesting profits for growth, but to maintain position.

His challenge, as I see it: Can he find places to put this loot to work in new places for a better return - a la Buffett?

Nice work Rich.

2008 Jan 14 04:38 PM

[Richard Shi...:]

Gokou3 : you are right, not much profit in the short. I wrote some simple vertical call spreads, limited upside and downside and am just looking for SHLD to stay below $95 through February. Beyond that we will just have to see where the economy goes, it is still a retailer after all.

Passerby 37: Yep, he sure is gonna be challenged on that one, so far he has spent $3billion to buy his own stock and now we have the Restoration Hardware thing. Buffett diversified... have not seen that yet.

2008 Jan 14 05:53 PM

[Andrew Horo...:]

Interesting fodder. Seems that the mention of Sears brings out the hecklers. I wrote here about the downward potential on 9/23/07 when Sears was $132 and got an amazing amount of hate email saying that I was an idiot.

Too bad that emotions always get in the way of logic. Full article

www.thedisciplinedinve.../

2008 Jan 15 12:49 AM

[the_Bird:]

As to the "Brand Value" aspect of the argument, anybody who's been in the market for lots of tools and lots of appliances for a new house knows that part of the Sears cost-cutting initiatives has resulted in a MASSIVE deterioration in the quality of the Kensmore and Craftsman brands. Craftsman tools, at least those targetted at the typical consumer (rather than the professional) are garbage. Kenmore appliances have also developed a reputation for being trash.

So, you've got a crappy retailer (if you've got a clean, well-stocked Sears store, I guess that makes one of us)... with a continued, long-term decline in same-store sales... in an environment that's likely going to see continued deterioration in overall retail sales... with another potential time bomb waiting of credit card receivables (my opinion, the "new subprime" for 2008)... with real estate holdings that are no longer appreciating in value... and deteriorating brand quality....

What's the bull case again?

2008 Jan 15 09:02 AM

[BULRUN100:]

Does everyone not notice just about every retailer is down even the good ones.That retail stocks as a whole are down 30-40%. Sears gets a lot of bad ink because people want to see Eddie fail.Longs and shorts can a agree that sears is a mid tear retailer and Kmart is the ugly step child but take it for what it is a retail down turn.Sears will never be a kolh's(unless they buy'em) but they will generate huge profits when the economy turns.Eddie may look foolish for buying back stock at $130.00 but the last time I heard crystal balls don't work.With 20-30 million shares being bought back they could earn 12-13.00 dollars a share when the economy does turn.

2008 Feb 16 01:56 PM