Compounding Machines

Archive for the ‘Investment Ideas’ Category

The Stock Wall Street Hates the Most

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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

Western Sizzlin’

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What is Western Sizzlin’ (WEST)?  At first it looks to be a boring, perhaps dying, buffet restaurant chain.  To me, I think it might be a Compounding Machine.  I will defer to the following write-ups that do a top-notch job describing the history of the company and its Chairman, Sardar Biglari. A couple of the links also take a stab at putting a value on WEST…

http://www.noisefreeinvesting.com/blog/?p=53

http://www.fatpitchfinancials.com/719/valuing-western-sizzlin/

http://www.circleofcompetenceblog.com/2008/06/dissecting-western-sizzlin-corporation/

http://www.circleofcompetenceblog.com/2008/06/looking-through-western-sizzlin/

Determining what WEST is worth is rather difficult as there are several moving parts.  You have the 6 company-owned, 106 franchised and 1 joint venture restaurant operations which produced about $2.3 million in free cash flow in 2007 after accounting for maintenance capital expenditures (what I will refer to as free cash flow).  I think this figure is lower on a normalized basis partly because a $636,000 franchise royalty amortization expense goes away soon.  For valuation purposes, I assume restaurant and franchise FCF will be roughly $1.875 million per year (average of 2006 and 2007 FCF minus $636,000 * 37% tax rate). 

Next you have WEST’s common stock holdings which include Steak n Shake, ITEX and “Other.”  WEST owns about 1.6 million shares of ITEX worth $704,340 at $0.45/share, about 1.3 million shares of Steak n Shake (after deducting minority interest) worth $8,027,774, and Other worth $146,191 (after deducting minority interest) as of the last 10-Q.  Adding these up you have a total marketable securities portfolio worth $8.88 million as of December 22, 2008, or about 30% of WEST’s market cap.

Third you have a 23 acre piece of real estate in Bexar County, Texas that was purchased in December 2007.  The purchase price was $3,745,152 financed partly by a note now in the books at $2,641,220.  For valuation purposes, I assume the real estate is worth what WEST paid for it less what it owes on it, or about $1.1 million. No specific plans have been outlined for this investment. WEST has a director named Kenneth Cooper that specializes in real estate law that could be instrumental in what eventually becomes of this investment. As Jeff Annello of the Circle of Competence blog puts it, this is a “trust Sardar moment for shareholders.”

Finally, you have Mustang Capital Advisors, a hedge fund with about $50 million of assets. WEST owns a 51% interest in the General Partner and thus receives about $255,000 per year in management fees. For valuation purposes, I give no credit for any potential income should Mustang generate a return in excess of 4% per year. WEST is entitled to its pro rata share of 20% of the profits above a 4% return.   

Because I want to value WEST with a margin of safety, I do not want to make any assumptions regarding any share price appreciation potential of SNS or ITEX, any appreciation of the Bexar County land value, nor any aggressive assumptions in terms of the free cash flow potential of the restaurant operations.  Basically, I want to mark all real estate investments and marketable securities to market and see what free cash flow multiple the market is applying to the operating businesses (restaurant and money management). At $10.35 per share, I believe I am paying conservatively about 9x free cash flow of the operating businesses. Not a screaming bargain, but a fair price to pay in my view given the sagacity Sardar Biglari brings to the company, as well as the admittedly conservative cash flow assumptions. 

WEST’s average cost of SNS shares is about $12.32 per share, or about 51% below where the stock trades today.  If WEST could somehow get back to breakeven (timing highly uncertain, but probable in my view), WEST’s current stock price implies a 5x multiple on the free cash flow of the operating businesses.

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Disclosure: I am long WEST

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.

Written by sdinvest

December 23, 2008 at 11:32 pm