Is Sears The Ultimate Value Stock?

Aug.21.12 | About: Sears Holdings (SHLD)

At Valuentum, we think identifying the most undervalued stocks on the market and identifying the best time to consider buying them is the core to significant portfolio outperformance. This remains core to our stock-selection methodology, the Valuentum Buying Index. In this article, let's discuss whether Sears meets the first pillar of our stringent investment criteria: is it undervalued?

In 2004, legendary hedge fund manager Eddie Lampert created a masterful plan to merge Sears (NASDAQ:SHLD) with the then-bankrupt K-Mart. Several people speculated the merger was related to creating a massive real estate portfolio which Lambert would divest over the coming years and turn the firm into the new Berkshire (NYSE:BRK.A), investing the cash in equities and other securities. However, it turned out that Lampert was interested in transforming retail-but not really. Instead, Sears issued more debt and has repurchased over $6 billion in shares (not including Lampert's personal investment).

Simply buying back stock worked for a while; shares soared from the $50 range to just shy of $200. However, the same period was marked by massive under-investment in its own stores, and the firm let literally the entire retail cohort steal market share. Unfortunately, given Sears' extremely diverse business lines, that's not an exaggeration. Due to liquidity needs, Sears has begun to spin off businesses--including Orchard Supply (OSH)--and plans to divest of some of Sears Canada in the second half of this year. The firm will also take Sears Hometown public in an IPO later this year. The company also sold 11 stores to General Growth Properties (NYSE:GGP) for a nice sum of $270 million. Although this isn't the first time Sears has done massive divesting, this is the first time Sears has really sold off its own branded names. Last time, when Sears spun off Allstate (NYSE:ALL), Discover (NYSE:DFS) and Coldwell Banker, the company unlocked serious shareholder value. Yet, we can't be sure that it will happen this time around.

Actual performance of the retail stores has been absolutely abysmal. Same-store sales have fallen every year since 2007, and we expect similar performance this year. Same-store sales at Sears Domestic fell 2.9% in the second quarter, while Sears Canada fell 7.1% and K-Mart tumbled 4.7%. Though we believe the company has some valuable brands, including Kenmore, Craftsman, Lands' End and DieHard, we think the general weakness at Sears is hurting the images of these once-legendary brands. We think the value of these brands really comes from years of customers flocking to Sears. Now, it's very possible that people under the age of 20 have never done anything at Sears except walk through it on their way to the mall. A few years ago, Nike (NYSE:NKE) even pulled products from the store because it thought the brand reputation reflected upon Nike in an unfavorable light.

Undoubtedly, Sears has been hurt by broader economic weaknesses and the housing collapse. A significant portion of the company's business relies on appliance sales, which have been sluggish since 2007. However, we fear that consumers might opt for one of the several different retailers, ranging from Amazon (NASDAQ:AMZN) to Best Buy (NYSE:BBY) to purchase appliances. With digital delivering usurping demand for physical copies of music, movies and games, Best Buy and hhgregg (NYSE:HGG) are dedicating more space to appliances to fill big box stores. Is there really any advantage to buying a refrigerator at Sears versus Best Buy?

Meanwhile, the firm's apparel business is terrible. We've addressed the struggles that remain for apparel competitors like J.C. Penney (NYSE:JCP) and Kohl's (NYSE:KSS), but Sears is worse-off than both stores (the apparel mix is not good, in our view). Lands' End remains a pretty valuable brand, in our view, but we think the brand would be better monetized on its own.

The picture certainly seems grim, but not everything is awful at Sears. Shockingly, the company's website is fantastic. Web sales grew 16% in 2011, and the firm has an excellent marketplace operation. We mentioned how Sears itself no longer sells Nike products, but its marketplace contains all of the popular, high-end products. Its website's layout is fairly similar to Amazon.com, and it is one of the best online shopping experiences, in our opinion. Though search is trending downward year-over-year, Google (NASDAQ:GOOG) shows a nice upward trend over the past 3 years, indicating likely gains in web traffic.

Where's the real value? Famous mutual fund manager Bruce Berkowitz thinks it lies in the real estate. If Berkowitz is correct, Sears is incredibly undervalued. Sears and K-Mart have accumulated massive real estate portfolios, both via owned real estate and below-market rate operating leases. As Berkowitz so eloquently put it:

"Generally Accepted Accounting Principles ("GAAP) mandate valuating (its) real estate at lower of cost or market. GAAP would force the Dutch settlers to value Manhattan today at the 1626 purchase price of $23.70."

According to his presentation and SEC filings, Sears has over 256 million square feet of real estate which can be monetized over the next several years. Berkowitz compared Sears' 256 million square feet of holdings and $6 billion market capitalization to REITs with less property and higher market capitalization. The big objection to this argument is that brick-and-mortar retail is dying, which is a fair criticism. However, this view may be over-estimated. Plenty of retailers like Ross Stores (NASDAQ:ROST) and Dick's Sporting Goods (NYSE:DKS) are still looking to expand, but the firms are struggling to find good real estate. Sears has plenty of solid real estate, and if it can't be used for retailing, the relatively large network could be used to store inventory for several large retailers.

At the end of the day, Sears is still a struggling retailer with a dim future outlook. We just can't get behind the core business' future outlook, and we think shares are fairly valued at current levels, on a DCF basis (click here to learn more about our valuation process). However, if Lampert and Berkowitz are correct, Sears could be valued at a substantial discount to its net asset value. At this time, we think investing in Sears is a risky proposition, since we can't fairly assess its entire real estate portfolio. As a result, we're continuing to avoid the firm in our market-beating Best Ideas Newsletter portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.