The Sears 'Real Estate Is Undervalued' Myth

| About: Sears Holdings (SHLD)
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Clearly, one of the theses helping Sears (NASDAQ:SHLD) put on a massive short squeeze, is the idea that it has a lot of real estate on its books, and that this real estate is hugely undervalued, because it's carried at cost from 50 years ago and things like that. There is just one problem with this theory - and that problem is that it is a myth. I will show in this article that there is NO undervaluation to Sears-owned real estate.

In fact this is rather easy to do. The reason is simple: Sears Holding wrote up the value of the real estate when it completed its merger with Kmart back in 2005. It wrote up the real estate value to fair market prices, and indeed, wrote up the value of a host of other things as well, to a point where instead of undervaluation, quite possibly there's massive overvaluation in the asset side of Sears' balance sheet.

The merger and revaluation

To check how Sears wrote up the values of owned real estate, we have to go back to 2005, which we will do by checking the Sears holding 10-Q from right after the merger. Here, you need to focus on "NOTE 2 - MERGER OF KMART AND SEARS" and there it is, in all its glory, "The purchase price for the acquisition, including transaction costs, has been allocated to the assets acquired and liabilities assumed based on estimated fair values at the date of acquisition, March 24, 2005"

The table below shows how these assets were allocated:

Now, there are a couple of important details here.

1) Even though the real estate was written up to fair value at the time, it was not enough to account for all the purchase price, so there had to be a $2 billion allocation to "goodwill";

2) $3.872 billion in assets were created as intangibles. $2.8 billion of this is the trade names of Sears, Kenmore, Craftsman, Lands' End and Diehard. Some of these names might have value; some clearly don't (Sears? Kenmore?). Yet this remains in the balance sheet today, to the tune of $2.9 billion. More about this later.

So is the real estate undervalued?

As we've seen above, the Sears real estate was written up to its fair value as of March 24, 2005. However, as we all know, from the end of 2007 to mid-2009, the U.S. economy was mired under the Great Recession and prior to that, there had been a residential and commercial real estate bubble. What this means, is that the Sears real estate was written up during that bubble, so what passed as "fair value" then, is not necessarily what is "fair value" today. The following chart, depicting the Moodys/REAL commercial property index (CPPI), shows this well:

And what do we gather from this retail sub-index? We gather that the retail properties at the national level went from an index of 1.593215 in the first quarter of 2005, to 1.293756 in the most recently available data - with the retail index also being the currently weaker type of property, due to over-retailing and online sales substitution. So this means that on average, "fair value" in March 2005 would mean a value 18.8% lower today. Yet, Sears has never written down its real estate (though it does depreciate buildings on a 50-year schedule, so might have depreciated them 14%, removing most of the overvaluation).

In short, not only there is no reason to believe the real estate in the books is undervalued, but there is some reason to believe it might be somewhat overvalued. Obviously, these are national averages, so there can always be variations in individual properties - but on the whole, this conclusion is solid.

What about the leases?

Part of the theory that Sears might have this incredible hidden value, rests on it having some long-term leases which are clearly below market. There is some truth to this thesis, as we can see from the sales of several profitable stores in the recent past. Yet, there is also a surprise here.

The leases were written up as well! This can be seen more clearly in the most recent 10-K, "NOTE 13-GOODWILL AND INTANGIBLE ASSETS" (which still pertains to 2010, the 2011 10-K should be out in days):

Here, a small concession: these favorable leases were written up during 2005. Back then, interest rates were higher, so the discounting process would produce a value that would be lower, than if the same calculations were made today. Still, at most Sears can have, what, double what it wrote up? $450 million more? That's a drop in the bucket.

Also, something must be understood about the recent store sales. The $250 million for the Hawaii store or the $172 million for the Canadian stores - those values were for very profitable stores, very well located stores, and are not representative of the kind of value that Sears has in many of its stores. In fact, many of the leases will have negative value, because they represent rent rates that are above what the badly located stores would get today. This negative value is impossible to estimate, but very real - there's a reason why leases can only be broken through the bankruptcy process. This means that to shutter many of the stores, Sears will have to keep on paying on their leases or pay to get out of the leases. Now, this negative value is something you don't see on the balance sheet anywhere. Neither do you see severance costs on thousands of employees who have to be let go, nor leasehold improvements that turn worthless if you shut down the store.

The balance sheet

The whole point of saying that there's hidden value in the balance sheet of an entity that's generating deep operating losses, is to say that if the company were to liquidate, it would somehow be worth more dead than alive. Yet, we've just seen that the value of the real estate on the books is at, or over, fair value. So there's no particular reason to believe that Sears' book value is much higher than what is stated in its balance sheet. And how much is that? (the source for following data is the most recent 2011 earnings report).

Well, if we take into account tangible book value - since Sears is still considering a lot of intangibles - then this comes to $4.341 billion minus ($0.841 billion + $2.937 billion), or $563 million … over 106.3 million shares, that's $5.30 a share.

And if you believe the intangible value really exists, which is a stretch at times, given that no one would pay for the Sears brand, for instance, then you come to $4.341 billion over 106.3 million shares, that's $40.84 a share.

Also, again, it should be noted that in a liquidation scenario the asset side of the balance sheet overstates values - inventory being liquidated is worth less, leasehold improvements are mostly worthless, etc. At the same time, the liability side of the balance sheet is inflated, by severance payments, by payments for leases that are over market. What this means, is that both values calculated above are potentially over the real value.

And obviously, outside of a liquidation scenario, there's no reason to think that the operational performance will turn meaningfully - and it certainly won't, if Sears keeps on selling the profitable stores. And the present operational performance implies losing at least $5 a share per year of those stated above.

Furthermore, it doesn't end here. One of the measures that Sears is counting on to generate cash is carrying fewer inventories. Indeed, in the last report they pride themselves of carrying $544 million less in inventory, versus the year before. This is not so little, on a $8,407 billion inventory line - it means the stores 6% less stuff than at the same time last year. 6% is noticeable, and might well have a further revenue impact. Now, even if revenues drop just 2% because of carrying 6% less stuff, 2% is still $831 million in revenues, which at Sears' 25.5% gross margin, means $212 less in gross margins. This measure is thus likely to provoke further operational losses.


There is more than enough reason to believe Sears real estate is carried on the books broadly at, or even above, market values. The real estate was written up during the 2005 acquisition to values which were higher then, than they are now. There is some hidden value in long-term leases but these too have been written up, so it isn't much. And at the same time, there's hidden negative value in long-term leases that are presently over market rates, in unattractive stores - precisely the kind that Sears needs to close if it wants to turn operations around.

Given all this, there's no reason to believe that the book value on Sears balance sheet deviates much from reality, and such book value is just around $5.30 per share taking into account tangible book value, or $40.84 taking into account stated book value. Both of these values overstate what could be gotten in a liquidation scenario since some assets would lose value in that scenario, and some liabilities would be created. And in a going concern scenario, Sears will most likely continue bleeding money, especially since it's selling its profitable stores.

So, once the present short squeeze ends, the stock will once again fall heavily as there's no value to be had here. In the meantime, though, the short rebate rates are so high (at 83%) that it's near impossible for shorts to profit from this situation. However, there still remains the obvious conclusion that the longs who don't sell into the squeeze will eventually see their share value greatly diminished.

Disclosure: I am short SHLD.