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Sears Holdings: A Hard Nut To Crack

The poster child of disruption in retail, Sears Holdings remains a hard nut to crack for value investors. The turnaround (2006-2013) failed, the legacy brick and mortar business lingers in runoff mode, and so far most – if not all – of the new initiatives have fallen short of expectations.

As cash burn accelerated, valuable assets were sold or spun off to fund operations and investments in the so-called “transformation” towards an online and service-oriented company. Meanwhile, the stock price cratered to all time lows and Bruce Berkowitz – Holdings’ second largest shareholder – is bailing out, or being driven out by his disgruntled mutual fund investors.

Yet interesting news broke out lately: Sears won’t file for bankruptcy as many predicted, but instead will go through to a bespoke, informal reorganization. We got used to seeing chairman and chief shareholder Eddie Lampert pull out funny rabbits out of his hat, but this one should prove a game-changer.

In the upcoming months, following the sale of Kenmore, two of Home Services’ divisions and $1,2 billion of real estate, plus the debt exchange and the conversion to equity, Sears should wind up as an almost debt-free holding company, running several businesses, sitting on billions of tax credits, and led by an owner-operator who keeps increasing its stake methodically.

Among these businesses:

1. One of the largest online marketplace – sears.com, kmart.com – likely doing several billion in sales.

2. Shop Your Way, an integrated loyalty program open to third parties and doing $1 billion in sales according to a director.

3. Sears Home Services, the largest setup and repair service in America, responding to 7 million calls annually, and likely doing between $1 and $3 billion in sales.

4. Innovel, a logistic company that makes 4 million deliveries per year, owns 7 million square feet of storage surface, and offers a 24 to 48-hour delivery capability for 85% of households in the United States – for clients such as Sears, Costco or the U.S Army.

5. Roughly 100 million square feet of commercial real estate across the United States – Hoffman Estates headquarters not included – which value has been demonstrated by recent transactions on the private and public markets.

6. Warranties and financing services.

7. Kenmore – still a leading appliance brand – DieHard, fifteen years of Craftsman royalties, plus plenty of small consumer brands.

8. A portfolio of highly promising startups, among which Monark Premium Appliances, DieHard Auto Centers, WallyHome, new Sears specialty stores, etc.

9. Large IT infrastructures and databases of consumer data, usable within the Sears galaxy – Sears, Kmart, Shop your Way, Hometown & Outlet Stores, Lands’End, Monark, Seritage – or monetizable to other merchants.

10. A powerful purchasing organization that provides a competitive advantage to the various entities within the Sears galaxy and/or other merchants willing to rely upon its long-reaching capabilities.

11. A captive insurance company to serve entities within the Sears galaxy, and perhaps other merchants.

12. A bunch of other miscellaneous assets and businesses, such as Parts Direct or Sears Auto Centers.

13. $4 billion in current assets, among which $2,8 billion in inventories.

13. Roughly $1 billion in short-term liabilities and $4.5 billion in long-term ones, which burden should be significantly lightened following the reorganization.

This inventory provides a convenient canvas for a sum-of-the-parts valuation. It is hard to project a reliable post-dilution share count as many variables factor in, but for the sake of prudence 300 million units should do – a threefold increase.

In the future – and an ideal world – Holdings will focus on running the online ecosystem, seeding promising ventures and providing purchasing, loyalty, insurance, financing, logistic, as well as setup and repair services to a vast portfolio of affiliates and third parties.

So the vast redeployment of assets undertaken several years ago sheds light on a rational strategy. Playing the adjusted earnings game – Sears’ investments are traceable through operating expenses, not capital expenditures – we do see where the money went: in building up an integrated retailer supposedly able to prosper in the digital age.

These positive developments link up with Mr. Lampert’s commitment to get back in the black in 2018. It will be interesting to figure if his team manages to achieve such an ambitions objective – and thus if they remain in control of the ship, or if indeed all hope is lost.

A good deal of value from brands, smaller stores and parts of the real estate portfolio has already been externalized via three spin-offs – Hometown, Lands’End and Seritage – and the sale of Craftsman. Since then, Eddie Lampert has been starving the legacy business to death – only $80 million in capex last year, for a retailer doing $13 billion in sales – while he was aspiring its leftovers towards the new online capabilities.

Nobody but himself – or perhaps Citi, who just granted Holdings a $425 million payment to sponsor the Shop Your Way program – knows if the transformation is working. But if it does, we shall expect the stock to quote for a multiple of its current price as soon as a piece of positive information is released, if it ever does.

There is obviously a huge element of blind trust in this investment, akin to a venture play rather than a value one. So far it has been a disaster, and unless clear evidence of the contrary, Holdings losing large sums of money in 2018 would prove the bull case definitely wrong.

(Long SHLD at an average price of $3,50 a share, SHOS at an average price of $5 a share, and SRG at an average price of $38 a share.)

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