Compounding Machines

The Stock Wall Street Hates the Most

with one comment

Quick, name the stock Wall Street hates the most. Surely it must be either one of the large financial institutions like AIG, Freddie, Fannie or Citigroup, or one of the domestic auto manufacturers right? Wrong. According to Bloomberg, the average Wall Street analyst rating on a scale where 1 equals “sell” and 5 is a “strong buy,” Sears Holdings (SHLD) had an average rating of 1.29. This gives SHLD the worst score among 2,678 U.S. stocks with market caps over $250 million (GM was #2 incidentally). Therefore, using the collective genius of high-paid analysts, GM (or any other large U.S. company) is a better investment than SHLD. In short, I don’t get it.

Now, I read the news. I understand that consumers are collectively tying up their purse strings. People are losing their jobs, not buying Kenmore washing machines, etc. This showed up in SHLD’s December sales figures as Kmart’s sales were down 1.1% year-over-year (yoy) while Sears Domestic was off by 12.8%. Total retail sales (ex auto) were down a record 3.1% yoy in December.

Luckily the Chairman of SHLD, Eddie Lampert (whose investment vehicle is the largest shareholder owning nearly 54% of the company) has put the company’s balance sheet in a relatively strong position to weather the current economic storm. At the end of last quarter, SHLD had $4.48 billion of debt ($3.8 billion if you back out capital lease obligations). Recently, the company reported that it expects to end the fiscal year with $1.3 billion in cash and about $2.6 billion in debt ($1.9 billion ex cap. lease oblig.), down significantly from $4.86 billion at the end of fiscal 2005. The strategy over the past three years to reduce debt, keep capital expenditures under control and return excess cash to shareholders via share purchases was prudent in my view. (Note: I do acknowledge that the company did repurchase shares at what have proven to be rich prices over the past couple of years).

What was the competition doing while SHLD was getting its balance sheet in order? Home Depot’s debt balance went from $2.2 billion in 2005 to about $10.3 billion as of last quarter. Macy’s debt went from $3.9 billion to about $9 billion over the same period. What were these companies doing with this cash? In some cases (such as Home Depot) it was used to repurchase shares. However, over the last 5 years, SHLD’s retail competitors spent $140 billion on capital expenditures, opened 4,904 new stores adding 5 million square feet of new retail space. We now know that we have been extremely over-retailed. Retail industry investors, net, have basically seen no return on the $140 billion invested in building new stores or improving existing locations. Fortunately for SHLD shareholders, the company chose not to make similar large commitments to capital expenditures. Now, I agree that both Sears and Kmart are not the most beautiful stores around and this is partly attributable to the fact that the company simply has decided not to invest much cash to drastically improve store appearance. However, I know of many Circuit City and Linens n Things stores that were well-kept, bright, well-stocked and frequently busy, but both share the same fate…liquidation. A company doesn’t go bankrupt because its same-store-sales are down; it does so if it runs out of cash thanks to a heavy debt burden. It’s times like these where companies with ample cash and manageable debt should be applauded.

What does SHLD look like in 3-5 years? The short answer is that I have no idea. I’m agnostic on the future success of Sears/Kmart retail operations. Both have shown negative sales growth for quite some time now. Ultimately, this trend must reverse course. I do know, however, that there is plenty of value in Sears’ exclusive brands (Craftsman, Kenmore, Diehard, Lands End), the largest auto repair operation, as well as the largest appliance retailer and servicer. In addition, they own 810 stores in the U.S. and Canada, or approximately 96 million square feet of real estate. The following link contains an excellent analysis of the potential value tied up in SHLD’s owned real estate:

http://www.manualofideas.com/files/shld_moi_20081223.pdf

Finally, you have Eddie Lampert as Chairman. Through his hedge fund, Lampert controls nearly 54% of the stock (this figure increases every quarter has shares are repurchased). Reportedly, Lampert has basically all of his liquid net worth invested in his hedge fund and SHLD is one of its largest holdings (AutoZone is the other). Therefore, no one is more directly affected financially by the ups and downs of SHLD stock price than the Chairman. I like it when I can get an owner/operator who lists Warren Buffett as one of his heroes and whose interests are completely aligned with fellow shareholders/partners. Good things tend to happen over time.

As of today, SHLD sells for $49.21 per share. With 123.6 million shares outstanding as of 11/28/08, the company has a market cap of $6.1 billion. Net debt should be around $1.5 billion by the end of this month resulting in an enterprise value of around $7.6 billion. [Admittedly, the balance sheet always looks best right after the holiday season. The company will likely increase the debt balance gradually throughout the year based on working capital needs]. The company is expected to report fiscal year 2008 earnings of between $163 million and $243 million. Yes, the most hated stock is profitable. So for about $7.6 billion you get a profitable retailer which has produced on average $1.2 billion of free cash flow per annum from 2005-2007, real estate worth anywhere between $2.4 billion and $14.5 billion (note: the second largest shareholder, Fairholme Capital, conservatively values the real estate at $90/share or about $11 billion), four great American brands, and a highly incentivized and shareholder-oriented owner/operator. In my view there are many ways to create value for owners with the assets SHLD has at its disposal. I look forward to seeing exactly how it’s done over the next few years.

 

 

Disclosure:  I am long SHLD

Disclaimer: This article by no means should be considered investment advice. I am not an expert (you probably figured that out already) and make plenty of mistakes. Please do your own research before buying any stock.

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Written by sdinvest

January 17, 2009 at 1:46 am

One Response

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  1. I’m long Sears too. After my research, I think ESL is buying because he thinks it is undervalued and he is eating his own cooking. I think in a decade we’ll be pretty happy to have been long. See you.

    N Knapton

    N Knapton

    August 29, 2009 at 11:16 pm


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