Sears Holdings (NYSE: SHLD) — May 23, 2008
Down from its high of $193 on April 17, 2007, the stock of Sears has been cut by more than half — despite stock buybacks (see graphic, below) and purchases by insiders.
Moreover, free cash flow and cash return on invested capital remain positive for the most recently reported year.
More recently, company prospects have taken a downturn along with the economy, as have other retailers. More importantly, the market has turned decidedly negative on the company, its management, and future prospects. When last reported, short interest has ballooned to 24,606,800 shares (19.31 % percent of float, a decrease of just 4.29 % over the prior reporting period), with days to cover at 12.7.
Given this pessimism, we are left to wonder whether a company which is evidently not a candidate for bankruptcy represents a short squeeze opportunity for long investors. So, let’s take a look at identifying intrinsic value, the financial health of the company, and whether there is a catalyst for a short squeeze.
Intrinsic Value
First, let’s turn to identifying the company’s intrinsic value.
Beyond supporting the earlier contention that cash return on invested capital is positive and that free cash flow provides borderline coverage for current liabilities, the previous graphic calculates the median for shareholder’s equity, free cash flow, and cash return on invested capital during rolling five-year and seven-year time frames and takes the median of each. This is designed to eliminate the disproportionate influence of outliers (i.e., extreme results) common with averages. Because of the short number of years (just three) since the K-Mart / Sears merger, there is no result for free cash flow. For the purposes of performing discounted cash flow analysis, we will, therefore, assume a 0% growth rate in free cash flows in the future. Here are the assumptions:
And the resulting projections:
At today’s share price of $86.25, the stock appears to be selling at nearly a 26% discount to its intrinsic value of $116.54 per share.
The price-to-free-cash-flow yield significantly exceeds the risk-free cost of capital (10-year bond yield, which is currently 3.88 percent) by a healthy margin, as well.
Sensitivity analysis indicates the discount to intrinsic value at varying rates of free cash flow growth:
It should be noted that these results assume growth at the indicated rate for the first three years, followed by 10% reductions for the next three years and four years, respectively, followed by a further 10% reduction for years 10 through 20. Reading the chart, assuming a 10% growth rate for the next three years, the stock is undervalued by 41%.
Next, we identify the compounded annual return if assuming a 0% rate of free cash flow growth at various holding periods.
If assuming that it will take 18 months for the market to realize the company’s intrinsic value, the expected compounded annual growth rate comes in at 22.22%.
By conventional accounting, the company’s book value is $80.81 a share, rendering a price-to-book value of 1.11. If, however, we calculate the replication value, the adjusted book value becomes $81.17 and the price-to-adjusted-book value becomes 1.06.
The longs supporting the stock assert that, at minimum, the company represents a real estate play, while the shorts argue that, in a down real estate market, the intrinsic value of the land holdings are less significant than the Longs maintain. It should be noted that the book value of the real estate holdings are typically recorded at the original purchase price. While the real estate market is down, the question becomes whether the value of those holdings have, in the aggregate, increased by just 6% — the premium at which the stock is currently trading over its adjusted book value. Recall, as well, that the company is profitable and generating, both, free cash flows and cash return on invested capital. The discounted value of those future free cash flows should be factored into whether this current 6% premium is adequate.
In order to calculate the company’s Earnings-Power Value, it is necessary to first determine its weighted average cost of capital and compare that to the cash return on invested capital. To do this, we reduce the weighted average cost of capital by the influence associated with the stock’s beta (1.06%) and the market risk factor of 8.6%, since neither is germane to calculating the company’s intrinsic value.
This generates an opportunity cost of 3.8% for the equity portion of weighted average cost of capital. Equity, at 91.7 percent, accounts for the majority of the end result, which is a weighted average cost of capital of 5.02%. The cash return on invested capital from the most recent year (6.1%) exceeds the weighted average cost of capital by more than one percent — which should be adequate, given the stability of capital structures over time.
Note that the Earnings-Power Value exceeds the Replication Value, providing an indication that the company enjoys significant franchise value. While this may change, the short argument that the company lacks a franchise among its customer base is not supported by the actual figures. Please note that the Earnings-Power Value is not a reflection of intrinsic value but, rather, a point of comparison with replication value. As long as Earnings-Power Value exceeds Replication Value (over time), intrinsic value should increase.
Reading the various stock investment message boards indicates strong conviction among shorts concerning the financial health of the company, with many predicting out-right bankruptcy. A review of the financials, however, does not support this.
Bankruptcy Threat?
Next, we turn to whether the company is in imminent threat of bankruptcy, and do so starting with consideration of the summary chart depicting liabilities and equity from the balance sheet.
The point of the previous slides is to note that the financial posture of SHLD has not appreciably changed over the last three years. There has been a reduction in cash as the company reduced the number of shares outstanding. This level of relative stability may change with the current economic downturn, but $1.622 billion in cash and cash equivalents seems more than adequate to cover current liabilities — of which short-term debt accounts for just $162 million.
At 1.339, the current ratio, however, is below the value investing target of 2.0, and total debt-to-equity, at 0.32, is marginally above the upper-end value ideal of 0.25. Neither indicates an immediate threat of bankruptcy.
The company’s Altman Z-Score (3.009) is just beyond the grey zone and well above the high-end threat threshold of 1.81.
Based on these considerations, it appears that bankruptcy is unlikely. This should not be confused with an assertion that the stock is positioned to move aggressively in the current year. One predictive measure of such a move is the Piotroski matrix, where scores of 8 or 9 tend to predict strong up-side price potential. Sear’s has a current score of 6 — down marginally from last year’s score of 7.
Short Squeeze Possible?
And this brings us to the question of whether a short squeeze is possible. Given the financial health of the company and the nearness of its current stock price to its book and adjusted book values, short investors are compelled to ask whether sufficient down-side potential remains to make the stock an attractive short position. The short investor need not believe the company to be competitive with Target, Wal*Mart, Lowes, or other competitors to question whether current short positions represent a viable wager with a sufficiently attractive return on their investment likely. If viewed in this light, short positions seem to have been milked for all, or nearly all, that is available.
But what is the catalyst for a squeeze? Often, short squeezes follow from one or more unexpectedly good earnings reports, prompting an increase in long investors, a rising stock price, and a stampede for the doors by short sellers. Assuming continued economic weakness, this scenario seems unlikely.
Instead, with limited downside remaining, shorts may voluntarily exit their positions — seeking more lucrative opportunities, given the seemingly limited remaining downside (which, for short positions, is the target). As long as departing short positions remain orderly, no one will get hurt (as last month’s 4.29 percent decline in short positions indicate). If, however, short departures increase — perhaps realizing the size of those with similar positions (19.31 percent short-to-float and 12.7 days to cover) –, the shorts may constitute the biggest threat to themselves. If nothing else, 12.7 days to cover and stock price’s proximity to book value explains the stock’s resilience in the $80 to $90 per share range.
Disclosure
[Note: The writer has a small long position in the stock (less than $1,000).]
Any followup given SHLD poor 1st quarter numbers? Sears and KM have had declining SSS for 12 quarters now, they’ve gone from $60B a year in sales right before the merger to being on pace for $47-48B this fiscal year. And now their gross margins are shrinking thanks to poor inventory management. There go earnings and cash flow. Cash on hand is down to 1.4B from 3.5B last year and 1.6B the prior quarter. And they still use cash to buy their stock which stresses the bond rating.
Really, the case for SHLD is how much is it worth liquidated?
With regards to their real estate, Credit Suisse did a study earlier this year where they estimated the value of the RE at $4.7 Billion. Hank Greenburg at Marketwatch had an anonymous analyst say that he could make a case for a negative value of Sears RE (take that with a grain of salt though). Their premiere brands still have value, though even that value shrinks every year as Sears/KM sales shrink.
Dingojoe
June 1, 2008 at 10:46 pm
DingoJoe,
Thanks for the comments and assessment. I tend to do updates on a yearly basis, especially with retail. As you know, retail is principally a fourth-quarter enterprise. Moreover, as a value investor, I am not one to make buying and selling decisions based on a single quarter’s results or change. While my assessment of Sears was principally designed to answer the question of whether the stock at current prices represents a potential short squeeze, I’ve had a small position (less than $1000) in the stock for some time, as disclosed. Consequently, it represents a small portion of my portfolio and, as such, represents a more speculative wager — as a turnaround play. To this end, it may be beneficial to view the Lew Sanders presentation before Bruce Greenwald’s Value Investing class at Columbia’s business school — http://merlin.gsb.columbia.edu:8080/ramgen/video1/greenwald/B8399_07s/Greenwald_B8399_U142_545-845_4-19-07_35482.rm — concerning “reversion to the mean.”
As for the earnings, keep in mind that earnings per share includes such non-cash items as depreciation and amortization. The better measure is free cash flows, which remained positive by around $170 million. Subtract depreciation and amortization from cash from operations, and the figure goes up to $240 million.
The various estimates concerning real estate value are problematic. They represent best-guess estimates (pro formas). Plus or minus 5 percent is a reasonable standard for pro forma budgets created by insiders. When conducted by outsiders, the accuracy variance tends to increase. That is why I did not attempt it when conducting my analysis.
As for the decline in sales, it is necessary to compare SHLD results with other retailers. The 8 percent decline is in line with Nordstroms, Home Depot, etc. The economy for retailers is poor, in general, and it would be a mistake to mentally inflate its impact on Sears absent other fiscal constraints — such as financial leverage. The company’s stock repurchase authorization indicates, either, foolishness or a lack of concern on this front. Of the various items in your question, this is the most debatable. The company began the year with a debt to equity ratio of 0.37 — higher than my general comfort level but not beyond the pale in comparison to other retailers.
Ultimately, Peter Lynch got it right when he said the key to success in investments is not getting frightened out of them. If properly diversified, single issue losses become minor drains on over-all results. My small position in Sears is down significantly, while my overall portfolio of value stocks is beating the market by more than 8 percent. If Sears declines to just below $80, I’ll be adding to it for the reasons outlined in the posted assessment. Regardless of how you value the property holdings and brands, the downside on the stock strikes me as small in comparison to the upside.
rcrawford
June 2, 2008 at 7:00 am
Thank you for the reply and for the follow-up post. I should mention that my interest in value investing has more to do with their impact on the retail industry rather than as an investment opportunity.
I am uncertain of Sears ultimate value as an investment, though I agree that the downside is most likely limited. I’m also fairly certain that the value will have to be realized by a dismantling of the company, preferably sooner than later. I believe this because as a retailer, ESL pretty much stinks and he’s given no indication that he’s going to do anything to improve Sears as a retailer.
Twelve straight quarters of declining SSS combined with the lowest capex rate in the industry pretty much covers it all. SHLD had $54B is sales in 2005 and is looking at $47B in sales in 2008. Sure JC Penney SSS were down 7% in 1Q but they were up the previous year 4% and JCPenney does grow at a modest rate. Even Best Buy has had trouble with SSS lately, but of course they continue to grow rapidly and will actually pass Sears as a retailer in the next couple of years. On the subject of capex, ESL in his yearly missive said that Sears doesn’t spend money on capex because they don’t think they have figured out a way to translate capex into more sales, or more accurately, more cash flow. That’s basically an admission that he and his team have got nothing (again with regards to running a retailer). Try to run a business where you basically tell the employees, “we’re just trying to maximize cash flow while not losing too much market share and sales while spending as little as possible on the business and our people as possible.”
Can Lampert keep the cash flow going as sales and margins dwindle? And for how long? The CFO said that they would beat last year’s EBITDA and with declining sales and declining margins the only way to do that is slash people and capex even further and when you’re already at the bottom of the industry you run the risk of a pretty rapid death spiral.
Of the 1st quarter sales numbers the KMART decline of 7.1% is pretty shocking, since KMART is supposed to be in the seqment that people are trading down to–discounters. KMART did $19B in sales in 2005 and they’re on track for $16B this year. They’re gross margins are weak and they are the weakest part of cash flow.
They look likely to go cash flow negative first. What does Eddie do then? And keep in mind that KMart probably has the least Real Estate value as SHLD only own 160 stores and Eddie probably already maximized the RE value from KMart earlier.
Also, KMART never seemed to get any benefit from the adding of Sears brands to the stores, at least it was never reflected in sales. Concurrently, the Sears brands did not seem to benefit from the added locations either. The Sears appliance business is the most worrisome as it’s gone from 39% of market share in 2002 to 26% of market share in 2007.
It seems like ESL is in a tricky place, the company’s brand name value shrinks every year as sales and market share shrinks, so maximizing that value means now. The real estate value has probably eroded badly and would be beneficial to hang on to for several years so that means wait.
Personally, and even viscerally, I wish Eddie would just take Sears/KMart out a shoot it for whatever value it has. A company that won’t invest in it’s business or people is a pretty crappy company and while there would be short term trauma and dislocation for the employees, it would be better for them in the long run.
On a side note, I just noticed that another retailer, Borders, heavily influenced by another big money value investor, Bill Ackman, has just dropped the company match to the employee 401K in an attempt to survive.
I know that my interests in Sears and value investing are only tangentially related to yours and given that you only have $800 bucks on the line, I’ve certainly taken enough of your time. Again, thank you for the links and response as I’m definitely interested in how the value investor mind works.
Dingojoe
June 4, 2008 at 1:11 am
Thanks, Joe. Look at the Earnings-Power Value (EPV) for Sears — which remains positive. Moreover, consider the effects of prior and announced repurchase of shares on the percentage ownership of ESL — factoring in the likely support of large block holders (such as Price, Pabrai, et. al.).
The first (EPV) measures the franchise value of the brands and real estate, while the second indicates the degree of effective control by Lambert (where control is measured by shares owned minus civil liability).
The shorts are convinced that Lambert is an inept retailer and entirely discount his history as a capital allocator. I may be wrong, but I don’t think he underwent a lobotomy when buying K-Mart or electro-shock therapy when purchasing Sears. In fact, he has been abundantly clear when it comes to strategy — noting that reducing costs increases deployable capital, expressing his willingness to sell assets in order to realize their value (renting them to support operating requirements), repurchasing shares to increase effective ownership, sustaining (not growing) the retail arm for its cash flows, using the proceeds to expand “holdings,” and viewing the process as possessing a five-year ROI window. The company went public on May 2, 2003 at a price of $15 per share. It now sells at $85. The company has been in existence for six years and, thus far, has generated a 33.52 percent compounded annual return.
rcrawford
June 4, 2008 at 6:33 am
When Kmart bought Sears. We ended up with cash which we did not want instead of the shares of the merged companies. I was not happy about that having to go back and find the cost basis. As I recall there were significant capital gains which meant taxes due. The purchase of Sears by Kmart looked like the work of a corporate undertaker. I go to the malls and see the Sears stores look like they are suffering from a lack of interest but that is not necessarily true when it comes to certain departments. Craftsman tools and the appliances do fine. The sears service centers often have a line to be waited on. I don’t necessarily share everyone’s excitement on the new sears even with the real estate . The reason why is no mall needs another macy’s or nordstroms or marshalls or kohls? The big box stores carry competitive items from china. Ok the big boxes are still going up and some old sears properties are well situtated. many old sears properties are closer in toward urban centers as they did not usually get built out as far as the suburbs now go. That is a plus. Mad still about being handed cash when i asked for shares I am thinking there maybe better places to put money than in Sears and Kmart. Buffet was right about target as a possible alternative to walmart but sears and kmart?
One thing about Buffet and the reason why you see him purchase both shares in home depo and loews which seems a little strange is that he might be doing it sometimes because he owns and controls companies that manufacture building supplies. One company he owns manufactures carpets. It makes good sense to take a fianancial possition in a company that maybe able to sell a lot of the carpets you produce to the general public. I guarantee it can help with marketing being a home depo shareholder. Some investments are about corporate relationships.
lex
June 16, 2008 at 4:14 pm
[...] Posted in General, Investments by rcrawford on August 5th, 2008 In late May, I wrote about Sears Holdings (SHLD) and its value — declaring it undervalued at around $86 per share. [...]
Sears Update « RTCrawford’s Weblog
August 5, 2008 at 2:50 am