During the last twelve months, Sears Holdings' (NASDAQ:SHLD) share price decreased by 65%. The recent sell-off, -38% year-to-date, is a quite clear signal: investors consider that E. Lampert will not be able to straighten out the company. From a superficial point of view, the transformation of the company from a "traditional store network model" to a "member-centric integrated retail model" is a complete fail, the balance sheet exhibits a negative equity of $3.4 billion and, according to many commentators, the company is expected to file bankruptcy in the coming quarters because of its fast-burning cash. Sears Holdings is at the point of maximum pessimism.
As you will see, my study of Sears Holdings shows that the situation is much better than Mr. Market perception. Technically, the holding is effectively burning about half a billion dollars quarterly, but investors are focused on the consolidated losses and do not take into account that the other entities are generating positive cash flow and will continue to generate comfortable profits even after the massive shrink of the retail entity. Investors are focused on the death of the retail and misunderstand the dynamic of the holding and the transformation operated by E. Lampert. The time required to transform the company activities is much longer than the patience of most investors and speculators (I assume that a large part of investors are actually speculators), people should remember that Rome wasn't built in a day. From an operational point of view, the closure of most of the non-profitable stores in next semesters will raise the EBITDA. At the same time, the company will continue to monetize assets to pursue its transformation.
This article focuses on the asset valuation, I present a sum-of-part analysis of the valuable entities of Sears Holdings. This analysis is based on publicly available data gathered from reliable sources and relies on a conservative estimation of the asset values.
Sears Holdings possesses several entities with significant value, but before talking about the positive side, let's look at the negative one, namely the liabilities. This is the easy part of the analysis, according to the 3Q 2016 quarterly report, the total long term liabilities equals $8.5 billion, this figure includes pension and post-retirement benefits. Now, let's detail the assets.
Real Estate Portfolio
The real estate portfolio is the largest and the best known asset of Sears Holdings. To date, the company owns about four hundred stores and many leases with significant value.
We can read in the sheet balance of the Q3 2016 quarterly report that the real estate value is $2.4 billion, taking into account the depreciation of $2.9 billion, it represents $5.3 billion. As everybody knows, this figure is the historical cost of acquisition and does not reflect the up-to-date value of the real estate. But there are some expenditures to maintain the stores and we do not want to over-estimate the asset, so we will just consider the balance sheet figures.
According to the Q3 2016 earnings release presentation, the company also owns 1,100 leases and many properties are leased "under long-term lease below market rental rates". Keep in mind that few years ago, Sears Canada sold 11 leases for $762 million. Unfortunately, we do not have a precise estimation of Sears Holdings leases, but some of them are significant assets that E. Lampert may easily sell to fund the company transformation.
We can confidently valuate the total real estate portfolio around $6 billion.
In 2012, Sears Home Service generated $3 billion in revenue. In 2013, Baker Street estimated the entity value around $2 billion. It seems that Sears Home Services is working on disruptive ways to operate its business. New processes and technologies are being developed. In addition, Home Services is expanding its repair activity outside of Sears with A&E Factory Service, a joint venture between Whirlpool and Sears Holdings. I estimate the entity value around $2 billion.
Craftsman has recently been sold to Black & Decker for $900 million plus royalties for the 15 next years. The transaction has been well detailed in the SA article of Christophe Spadone who valued the deal at more than $2 billion, which is much higher than the $900 million announced in business headlines. To date, Sears Holdings only receives a cash component of $500 million from Black & Decker.
The other big part of KCD is Kenmore. Kenmore is an iconic appliance brand with 14% market share. Its revenues are estimated around $4 billion. Baker Street valued KCD around $3 billion, this is higher than the estimation of Credit Swiss, since Craftsman's deal is about $2 billion, we can estimate the Kenmore's value around $1 billion.
Diehard sales represents almost nothing in the KCD's valuation. Thus, I will not attempt to estimate its value. In sum, we can confidently say that the remaining value in KCD is about $2 billion.
Years ago, E. Lampert anticipated the death of the retail in its current form. From an operational point of view, E. Lampert strongly decreased the capital expenses compared to its competitors. In 2012, Sears spent only $1.51 per square foot on its Sears stores and $1.04 on its Kmart stores compared to $5.56 and $6.25 per square foot for Home Depot and Macy's, respectively. So, we already knew that many stores would be closed. Interestingly, some investors seem to discover this information, and emphasis the deteriorated condition of several stores. It was planned 5 years ago, serious investors should not worry about these stores.
The retail entity is currently losing money at an impressive rate. This entity is embedded in the guarantor subsidiaries. In the 2015 annual report, we can read that the operating loss of the guarantor subsidiaries was $1.6 billion. Similar figures are expected for 2016. In a recent press release, Sears Holdings announced the additional closure of 150 stores that generated an adjusted EBITDA loss of approximately $60 million annually. This information may suggest that the operating losses spread over a larger number of stores, since the closure of 10% of the store will save only $60 million. Actually, the retail entity is consolidated with the online retailer, namely Shop Your Way. Investors have to know that a significant part of the operating losses are due to the online retail expenses and membership loyalty program. The transformation attempted by E. Lampert aims to accompany customers from brick and mortar to online services. In concrete terms, we learned in the Q3 2016 report that:
"$110M unfavorable gross margin rate impact attributed to an increase in promotional markdowns, including an increase in Shop Your Way points expense."
These figures indicate that the retail situation is not as bad as some analysts suggest. However, despite the fact that many stores are profitable, the closure of the non-profitable stores will burn cash. In its current form, I estimate the retail entity is worth $0.
Shop Your Way
This entity is possibly the most tricky to analyze since Sears Holdings does not disclose its revenue. So, what about the value of Shop Your Way? I guess the pessimist valuation shared by many investors is $0. Keep the cool head, our pair comparison indicates that Shop Your Way has a significant value.
In 2009, Priceminister, a French privately held company operating an online seller-channel was acquired for about €200 million by Rakuten, the transaction represented 5 times the acquired company's revenue, about €40 million. We can confidently say that Shop Your Way generates much higher revenue since Sears Holdings has already invested over $2 billion in the Shop Your Way membership program. Another way to glimpse the value of Shop Your Way is to compare it with Etsy (NASDAQ:ETSY). This popular e-commerce website is mainly dedicated to the sales of handcraft and vintage items, its current market capitalization is $1.45 billion. Its revenue is growing-fast, +33% year-over-year for the Q3 2016, but for now Etsy is focused on a niche market and it will have to compete with Amazon to extend market share to mainstream products. The total value of the goods transacted in the marketplace for the Q3 2016 was $677 million. To date, Etsy market capitalization equals about 4 times its expected revenue for 2016. The marketplace of Shop Your Way may also become a great mouse trap.
We agree that Amazon (NASDAQ:AMZN) is increasing market share at an impressive pace, using a predatory pricing model. Some people believe that Bezos' company will ultimately monopolize the entire e-commerce, but for now, this objective is far from being achieved. Actually, Shop Your Way may be a relevant target for a third party wishing to expand its market share.
Removing the pessimism surrounding Sears holdings entities, the two pair comparisons presented above indicate that Shop Your Way value exceeds $1 billion.
Sears Auto Centers
In 1994, Revenue from Sears Auto Centers was $3.25 billion. Since then, the sales dropped noticeably, now this entity generates about $2 billion revenues. In November 2013, Matt McGinley, of International Strategy & Investment Group, says that the auto centers could be worth $900 million. In a more conservative manner, the normalized EBIDTA, assuming it equals 5% of the $2 billion of revenue, would represent $100 million. Let's evaluate the entity only 5 times its EBITDA, the entity worth about $500 million.
Like most of the other entities, we do not have a lot of information about the revenue and profits of Innovel Solutions. However, we know that this activity operates with 1,100 trucks and owns 7.5 million square feet of warehouse space. Assuming a truck worth around $50,000 and a warehouse cost of $25 per square foot, the assets are worth at least $243 million. This asset valuation does not take into account the 106 market delivery centers, the information technology and logistic systems. Innovel Solutions is expanding its activity outside of Sears Holdings, establishing relationships with Costco or the U.S. Military for example. There is no reason to valuate this activity less than its assets. Innovel Solutions value is likely around $500 million.
Sears Re is one of the most impenetrable entity. We only know that it underwrites more than 20% and less than 50% unrelated business since it is a class 3 insurer registered in Bermuda. Unfortunately, its revenue and operating performance are not disclosed and there is not publicly available data to glimpse the potential of this entity. I have no information allowing a valuation of this insurance company and I challenge you to do so. Moreover, insurance is out of my circle of competence. For this reason, I will not attempt to value this entity.
Summary of the asset values
|Entity||Valuation ($ billion)|
|Shop Your Way||1|
The sum of all entity values listed above equals $12 billion. By subtracting the total long-term debt of $8.5 billion, we obtain a net asset value of $3.5 billion, or about $32.7 per share. Given the current cash-burn rate of $500 million per quarter, the asset monetization could be pursue up to 2 additional years.
The share is priced like if the cash burn will continue until 2019, which is not the objective of E. Lampert. Indeed, one year ago, the CEO announced that:
"It is neither our goal nor our intention to use our asset value to fund continued operating losses."
Since then, the store closures have effectively accelerated but the cash burn has remained high due to massive coupon operation to boost online sales. Nevertheless, the closure of additional stores will raise the EBIDTA and the cash burn should cease within the two next years. For now, we do not have much information about the performance of Shop Your Way, but the recent launch of new offer program indicates that E. Lampert believes that the online store can provide a satisfying return on investment.
To summarize my analysis, every entities have been prudently valued and it appears that the asset value of Sears Holdings far exceeds the long-term liabilities. In fact, this valuation does not even take into account the up-to-date value of the real estate, also the leases and Sears Re were valued at $0, it constitutes an additional margin of safety. Funding the transformation by asset monetization can be pursue for several semesters before the net asset value goes below the market capitalization. Even in the case where the retail and Shop Your Way fail, there are some valuable entities which could be sold or spun-off. E. Lampert announced that the operating losses will be stopped and he has effectively the possibility to achieve this goal by closing additional stores and diminishing Shop Your Way points expense.
The current share price of $6, compared with the net asset value exceeding $30, reminds us of B. Graham's well-known quote:
"You don't have to know a man's exact weight to know that he's fat."
In the case of Sears Holdings, there are several valuable entities and as soon as most of the non-profitable retail stores will be closed, the EBITDA will raise and investors will realize how fat the holding is.
My share price target is in the range from $20 to $30.
Disclosure: I am/we are long SHLD.
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.