I will be excited to read all of the screaming comments about the misleading headline of this article. But if you bear with me for about 5 minutes, you will find yourself either believing Warren Buffett is not a smart investor or that he is canny enough to realize Sears Holdings Corporation (NASDAQ:SHLD) is not in nearly as bad shape as most bearish articles would lead investors to believe. About 12 months ago, Sears spun off over 250 of its stores into a newly created REIT called Seritage Growth Properties (NYSE:SRG). In return, Sears received over $2.5B in cash while agreeing to lease back the properties from Seritage. If you're still with me, you're wondering what the heck this has to do with Warren Buffett and Sears. The initial part of the answer is that Warren Buffett personally took an 8% stake valued at ~$70M in Seritage less than six months after the IPO. Most of you are probably saying stop right there, because Seritage the REIT is not exposed to the well-documented struggles of Sears the retailer. But, if you believe that you know nothing about Seritage and thus nothing about the long-term viability of Sears as shown below.
Seritage Needs Sears To Succeed
It is important for investors to know that Seritage would be an abject failure itself if Sears were to fail. ~75% of the rental income received by Seritage comes from Sears. If Sears is going bankrupt or will be facing a liquidity event sometime soon, as bears constantly say, then Seritage will soon be staring at a loss of 75% of its revenue and would be unable to cover its annual debt service.
The reason Warren Buffett and other investors have valued Seritage as a thriving and viable REIT is because Sears is not going to fail any time soon. A Sears failure means that Seritage has to figure out a way to replace 75% of its revenue quickly. This would not happen. There would be court proceedings, legal battles, and then the whole matter of having to spend time and money to reconfigure all the Sears stores to make them small enough for new tenants.
Seritage Valuation of Sears Assets
I have read countless articles about Sears and Seritage here on Seeking Alpha and elsewhere. One constant theme is that the Seritage transaction, validates the bearish thesis that the remaining value of Sears owned- and leased- real estate is not enough to save Sears.
I would challenge this thesis from a slightly different perspective. I would argue that Seritage paid a significant discount to the true fair value of the Sears property they acquired. That may sound like an oxymoron or even illegal from the perspective of a Sears shareholder, but there is a reason why this makes sense. Seritage has over 40 million square feet of space, currently leased to Sears, at just over ~$4 per square foot on average. The leases that Seritage is currently signing, for redeveloped Sears, K-Mart or Auto Center properties is at almost ~$24 per square foot. That is called significant value creation. However, Seritage is limited both by their agreement with Sears and their limited financial resources to quickly redevelop all of the properties they are entitled to.
This then begs the question of why would Sears sell these properties at less than fair market value. Certainly another large REIT with additional resources would have paid more, if they could immediately boot Sears and their $4 rents in lieu of redeveloping into smaller leases with $24 rents. The answer is Eddie Lampert still believes Sears can be a viable retailer and Seritage offered him the best of all worlds. Sears received immediate cash, it can effectively walk away from the dog assets it gave Seritage for minimal money and it gets to keep 50% of the space in the stores that it wants to keep. Think about that for a minute. Sears will see the value of the bulk of the stores sold to Seritage increased over time. Seritage has to spend the money to reconfigure any store where it chooses to recapture 50% of the space. There is not a single Sears or K-Mart store that can put enough product on the sales floor to justify the amount of space they have today. But in somewhat of a stroke of genius if you ask me, Sears is able to force Seritage to incur the cost that Sears otherwise would have incurred to make their stores smaller and ultimately more efficient. Not only that, Seritage will bring in new tenants and drive new traffic, that will ultimately benefit Sears as well in the stores where they retain a presence.
Those writing the obituary should ask themselves, if Seritage was willing to purchase ~250 stores from Sears for over $2.5B, how much of a discount did they pay because 50% of the square footage they purchased could stay with Sears at lease rates ~20% less than fair market value? The answer is significantly more. Which bodes well for the value of the remaining Sears assets, both owned and leased.
The Final Takeaway
Sears is not going bankrupt. If you believe Sears is going bankrupt, then Warren Buffett is a bad investor because Seritage will turn out to the worst investment anyone could possibly make.
Sears will have to continue to sell some assets or dispose of non-core businesses, as the company continues to whittle down its store count and cull the unprofitable stores. With recent announcements surrounding Berkowitz joining the board and accelerated store closings of unprofitable stores, it appears the company is acting with more urgency than in years past.
The scary thing for Sears bears is that this is still a company doing $25B a year in revenue. Yes, this is down materially over the last few years and yes, it will continue to fall. But, there is a point where the company will be able to rid itself of the dead weight and reach an inflection point of revenue where it will be profitable.
The recession type fears permeating through department stores this week, with Nordstrom (NYSE:JWN) and Macy's (NYSE:M) in particular getting crushed on weak earnings and outlook, is not as big of an issue for Sears as some may think. While apparel and soft home goods make up the bulk of sales for Nordstrom and Macy's, this category is a manageable 25% of Sears' $25B in revenue from FY 2015. Will the softness in the category hurt Sears? Absolutely. Is Sears assuming its transformation is based on the success of selling $4 pairs of boxers and undershirts? Not likely.
Lost in the undercurrent of the negativity surrounding Sears is that the company is still the leader in appliance sales and still generates almost $4B a year in revenue not directly correlated to its in-store retail operation. This comes from service agreements, commission from SHOS and Lands End sales, warranty agreements, etc... This type of revenue is inherently higher margin than product revenue and is declining at a lower rate than the retail revenue.
I believe Sears survives and ultimately is a fantastic investment at today's levels. The stock at just over $11 per share with a $1.2B market cap, is sitting at decade-low valuations. This is in spite of the fact that Sears is aggressively cutting costs and transforming itself into a leaner and meaner retailer. Behind all of this stands a real estate portfolio with substantial value remaining, some of which will be monetized but a large portion of which will likely be converted to a higher and best use of generating ongoing cash flow for Sears in the future.
The story is not an easy one to grasp, but if you are short or bearish, count your profits and move on. Don't listen to me, listen to Warren Buffett.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.