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Sears Holdings: It Ain’t Over Till It’s Over

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 several 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.

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

15. Billions in tax credits.

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

In the future – and an ideal world – Holdings should 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.

Seen through that lens, 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, Mr. 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.

( EDIT: 10/2018)

The train wreck had to stop: after rejecting Mr. Lampert’s informal reorganization proposal, apparently to protect itself from litigation, the board gave in and filed for bankruptcy.

No doubt Mr. Lampert is experiencing night sweats at the prospect of losing control of his destiny now that it is handed over to the judges, especially given their record in liquidating failed retailers.

However, for those uber-contrarian investors who still believe that Holdings’ assets value outmatches liabilities – albeit to diminishing proportions – the court-supervised reorganization should amount to the catalyst they’ve been so impatiently demanding for years.

They will finally know whether they were right or wrong in their assessment of valuation and of Mr. Lampert’s “buffetesque” ethics – and whether they’ve been the patsy of a gifted financial engineer but disastrous corporate operator during all the time it took for the drama to unfold, or just unfortunate in their timing.

For these faithful but likely disgruntled investors, this is not the beginning of the end, but possibly the end of the beginning. Sifting through the bankruptcy filings, several remarkable elements stand out:

1. Pressure from vendors became unbearable, prompting the decision to seek court protection. Mr. Lampert used to claim that the company had “as much time as its partners were willing to give” to transform itself; the hourglass just ran out.

2. The company was burning $125 million a month, or $1.5 billion a year. This, coincidentally, matches estimates for the cost of the much-mocked “transformation” – closing unprofitable stores, paying severance and building up online capabilities – and gives grounds to the now infamous Mr. Berkowitz’s statement that “if you stop the transformation, you stop the losses”.

3. Mr. Lamperts’ reorganization strategy holds out, but may take a different path than initially planned: ESL will likely offer to buy the 400 “four-wall EBITDA positive” stores that remain, plus several other non-core assets – Parts Direct, etc. – in a “stalking-horse” bid; meanwhile, debt held by ESL – roughly half of the total – could be recharacterized as equity, thereby providing the liquidity needed for Holdings to repay its debts and clean its balance sheet.

4. These dealings, should they occur, may result in significant gains on the underlying assets’ amortized value. In that respect, restructuring advisors are working hard to safeguard the billions in carried tax credits. This may also explain why they didn’t oppose the NASDAQ delisting, as the company may be exposed to a change of control if a massive lot of new shares were issued and purchased on the open market by some high-profile, kamikaze activist investor.

5. According to Mr. Lampert’s comments in The New York Times, ShopYourWay, thought by many to be the crown jewel, could be discontinued. This admission of failure –”If I could have raised billions, I could have done things differently” – must irk Mr. Berkowitz who, almost three years ago, joined the board and made a dramatic plea to cease the cash-burn. With hindsight, he was right.

6. In a perfect world, Holdings will then be left operating one of the largest online marketplace in America – Sears.com sports a huge inventory and probably does billions in sales, which is no small feat – while its overall corporate structure will get simplified to the bone. The lineup of integrated capabilities – from merchandising to logistics, financing, and rewards programs – should then pop out as obvious as Mr. Lampert once claimed they were – “things are happening to the right but everyone is looking to the left”, etc.

There’s still a lot of value left in the real estate, the online marketplace, the brands, the tax credits and the services business. If Mr. Lampert is let free to reorganize astutely – and fairly for the common shareholders – he may save it, and put it to good use.

Regardless, this investment turned out so disappointing thus far that it could be dubbed after Berkshire Hathaway’s jet plane – The Indefensible.

All Lampert’s supporters, including yours truly, have long fancied themselves as sophisticated investors being capable of seeing things that others could not. But too much second-level thinking can be harmful, especially when it becomes third or fourth-level thinking – a.k.a total nonsense.

Indeed, the three key features longs were banking on have been proven wrong: the capacity for Holdings to cover its liabilities and fund the transformation via asset sales; the ability of top management to pilot the ship and “return to profitability”, as they committed themselves earlier this year, for instance by reducing subsidies to SYW; and, of course, the continuous support of trade partners, lenders, and other stakeholders.

Those who know him are used to portraying Mr. Lampert as prodigious but borderline autistic: save for a few grognards, current events show that he was completely alone to believe in the transformation endeavor; after the great length of support they provided, “partners” and like-minded investors deserted him one after another.

There’s nothing wrong with failure, especially in business – but there’s tons of wrong in refusing to recognize it once it punched you in the face. Hence the purpose of this short note is not to wrap a new bull case; with all prudence that humility commands, it is just to shed a ray of hope in a sea of desperation.

(Long SHLD at an average price of $2 a share.)

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