Fast Eddie Is Hustling to Run the Table on Sears

The Hustler: A Movie Classic

If you’re a fan of sports movies, Paul Newman, or Tom Cruise, The Hustler and The Color of Money are both must-see movies. The Hustler is Paul Newman at his finest. In The Color of Money, Tom Cruise, as my friend Mas used to mock, plays his prototypical “best fill in the blank” role–you know, the best fighter pilot (Top Gun), best entrepreneur (Risky Business), best bartender (Cocktail), best spy (Mission Impossible), best race car driver (Days of Thunder), best lawyer (The Firm), etc.– as the best pool shark. The Color of Money is the sequel to The Hustler and is set a couple of decades later when “Fast” Eddie Felson (Paul Newman), retired from his pool playing days, sees Vincent Lauria (Tom Cruise) hustling in a pool hall and instantly spots his talent to be a top money player and takes him on as his protegé. Anyways, both are must-see movies in my book.

I bring these movies up, not only because the stars are both hustlers, but also to point out the distinction between the kinds of hustlers that exist. Do you know the difference between the “Fast” Eddie Felson kind and a hustler like “Fast” Eddie Lampert?

One kind pretends to be bad, but is actually very, very good. That’s “Fast” Eddie Felson. He pretends to be a bad pool player by missing shots and losing the first few games to lull his opponents into a false sense of security. But when the money is on the line, the real pool shark emerges and we find out who the suckers really are.

Hustler Fast Eddie2

Paul Newman as “Fast” Eddie Felson and Tom Cruise as Vincent Lauria in The Color of Money, the sequel to The Hustler.

Now, the other kind of hustler pretends to be good, but is actually really, really bad. That kind of hustler is the one on the street corner peddling a three card monte game asking all of the looky-loos to find the Ace of spades. You think you kept your eye on the card, but the truth is that the Ace is not one of the three cards on the table. It’s the card that you can’t see in the palm of the hustler’s hand. “Fast” Eddie Lampert is this kind of hustler. He pretends to do good by, most recently, loaning Sears $300 million of his own money, but he’s actually just setting up Sears and its other stakeholders for the fall.

The Stakes

Sears has an ever-growing shareholders’ deficit of $2.7 billion (total assets of $10.6 billion are less than total liabilities of $13.3 billion), which means that, on paper, if it were to get liquidated, it would not have enough money to pay off all of its obligations. I think the key liabilities are its $2.1 billion pension plan shortfall and its $3.7 billion mountain of debt, including the new $300 million junior lien loan from Eddie. It’s helpful to see the debt that Sears has alongside the pieces that Eddie himself owns. Here’s a good write-up on Seeking Alpha that has Eddie’s debt ownership (Sears: Shuffling The Deck Chairs On The Titanic). The primary components and maturity dates are as follows:

 $ in millions Sears Eddie/ESL
Secured Loan Facility with Cascade and JPP II, LLC and JPP, LLC (ESL affiliates) due July 7, 2017 and secured by a first priority lien on 21 real properties $489 $216
Senior Secured Notes due October 15, 2018 $302 $46
Senior Unsecured Notes due December 15, 2019 $404 $299
Senior Secured Term Loan due on July 20, 2020 $723 $150
Domestic Credit Agreement expiring July 20, 2020 which includes a Revolving Facility, liens and term loan $1,332  $0
New Junior Lien Debt due July 20, 2020 $300 $300
Unsecured commercial paper $101 $100
Total $3,651 $1,111

The Hustlers

“Fast” Eddie Lampert (ESL, JPP, etc.) and Bruce Berkowitz (Fairholme Fund), collectively, own over 76% of SHLD’s stock and both sit on the board of directors, which means that they control all of the moves at Sears. These guys are sharp and you don’t want to be on the other side of their trades.

As you can see from the table above, Eddie has been pot committed for a long time. His newest $300 million junior lien loan made on September 1, 2016 should leave no doubt. Eddie now owns over $1.1 billion of Sears debt and approximately $0.6 billion of SHLD stock (50% owner), bringing his direct exposure in Sears to $1.7 billion (this does not include his ownership in Seritage, Sears Canada, Sears Home and Outlet Stores, and other Sears spin-offs).

The Suckers

The current employees. All Sears employees stand to lose their jobs when Sears eventually goes bankrupt. Many of them already have with the hundreds of stores closing every year. In this year alone, Sears has announced the closing of 142 stores and counting (78 Sears and Kmart stores announced in April and an additional 64 stores in September). Sears currently operates 1,592 stores, which is now less than half the 3,510 total stores they had in January 2012.

The past employees. Sears froze its pension plan effective January 1, 2005, which means that only employees who worked at Sears for years prior to that date have pension benefits. But those pension benefits are not guaranteed. In fact, Sears reports that it is behind $2.1 billion in pension obligations. And even this might be understated. Motley Fool’s Sears Holdings Corp. Is Sitting on a Ticking Time Bomb does a good explanation of the accounting gimmickry.

The other longer-term creditors. These are the banks and the vendors that are tied up with Sears and can’t pull themselves away from Sears before bankruptcy happens. While the main credit facility is secured by inventories and credit card receivables, those loans are not secure. If Sears declared bankruptcy and the inventories had to be liquidated at fire sale prices, they would return only pennies on the dollar, which is much less than the borrowing base of 70% of the inventory value specified by the primary credit facility covenants.

Anybody else who is left holding the bag on the Sears retailer side.

The Payoff

Eddie’s premise has always been that Sears is severely undervalued based on the value of its real estate assets and under-market leases. Sears still owns 414 properties which are estimated to be worth $4.5 billion (source: CNBC’s article Sears still has plenty of levers to pull to avoid bankruptcy), which is $2 billion more than what it has on its books (net PPE is $2.5 billion per most recent 10-Q). Now that $4.5 billion figure is probably how much the properties are worth if sold based on Sears as a tenant. However, the rents for these properties have the potential to be jacked up 3-4x higher than what Sears is currently paying, so the potential redevelopment value of the properties could be worth much, much more.

The Setup

Eddie’s no dummy and he knows, as well as we all do, that Sears as a retailing entity has absolutely zero chance of survival over the long-term. Sears’ business model is broken and it’s burning through cash like crazy (over $1-2 billion of negative operating cashflow per year). The longer this lasts, the more value erodes from the Payoff. So he knows he’s running out of time to execute his hustle. But you can’t make your moves overnight, so Eddie has been playing the long game for a while. Check out some his major moves to set up Sears for the final hustle.

Purportedly used to create liquidity, spinning off its businesses has been Eddie’s way to pay himself through special dividends related to those spinoffs. For example, Sears spun out Lands’ End (LE) into a separate company in March of 2014. In connection with the IPO, Lands’ End took out a loan and made a $500 million separation payment to Sears. Despite its liquidity issues, Sears distributed 32 million shares of new LE stock worth around $950 million to its shareholders at no cost. The biggest beneficiary of this special dividend was Eddie Lampert who received 48.4% of it or approximately $475 million. Bottom line, this was just shuffling debt from one entity to another in order to pay himself.

Again, with the primary purpose to create liquidity, Sears spun out the Seritage REIT on July 6, 2015. But in doing so, Eddie created a vehicle to unlock the value of Sears’ real estate. Through the IPO, Sears simply received $2.7 billion, which it used to reduce debt, fund the pension plan and to absorb operating losses. Seritage entered into sale leasebacks with Sears covering 235 of its best properties and 31 joint venture properties at what appeared, on the surface, to be fair market value (Seritage bought the properties based on the low rental cap rates in the Sears master lease). However, all of the upside and the redevelopment value for raising rents 3-4x goes to Seritage, of which Eddie is the largest economic shareholder.

With the primary purpose to provide assurances that the employees pension fund will become funded, Sears, on March 18, 2016, finalized an agreement with the Pension Benefit Guaranty Corporation (PBGC), which put the regular interest certificates of the 125 REMIC properties and Kenmore, Craftsman, and Diehard (KCD) brands, held in Sears’ subsidiary Sears Reinsurance Ltd., into a bankruptcy remote vehicle for benefit of the Pension fund. The interest in the REMIC and KCD rights seemingly provides “just in case” assets to help use to cover the $2.1 billion pension fund deficit (Sears has pension obligations of $5.3 billion but pension assets of only $3.2 billion). However, Eddie has outs. The PBGC “document provides three ways Sears can remove the terms of the document: 1) the document will expire automatically after five years, 2) if the pension plan reaches 85% funding as of the last day of two consecutive plan years of the Pension Plan (UPDATE 9/29/16), 3) if the company uses a standard termination for the pension plan.” Source: Seeking Alpha, Sears Pension Fund Has First Claim On The Bankruptcy Remote Vehicles. In other words, Eddie does not need to fully fund the pension obligations of $5.3 billion, he only need to get it to the 85% mark of $4.5 billion. That’s a 15% discount to unlock the 125 REMIC properties and the KCD brands.

Through his hedge fund ESL (JPP, JPP II, etc.), Eddie has been providing Sears with liquidity as the lender of last resort. Here are the loans he’s made to Sears:

  • On September 15, 2014, Eddie provided Sears with a $400 million short-term loan secured by a first priority lien on certain real properties. Sears repaid the loan including upfront fees of $7 million, extension fees of $2 million, and interest of $6 million. This term loan has since been retired.
  • On April 8, 2016, Sears obtained a $500 million secured loan facility provided by Eddie and Cascade, an outside investment fund. The Secured Loan Facility has a maturity date of July 7, 2017, pays 8% base interest plus 1%-1.5% funding fees, and is guaranteed by the Company and is secured by a first priority lien on 21 real properties.
  • On September 1, 2016, Eddie provided another $300 million term loan secured by a junior lien on the inventories and credit card receivables. The loan matures July 20, 2020 and bears an interest rate of LIBOR plus 7.50% or prime plus 6.50%.

The loans were necessary and Eddie did provide a much-needed service for which he paid himself handsomely. But it also wouldn’t surprise me to see the board, that Eddie controls, paying off these new loans before the other debt on Sears’ books as bankruptcy and liquidity issues become more imminent. In addition, I believe that these lack of “public market” fundings will be used as justification for future sales of its real estate assets (i.e., there is no other alternative but to sell the real estate).

The Hustle

Eddie Lampert owns 50% of SHLD stock worth about $600M and another billion of its debt.  He’s not letting Sears go bankrupt before he gets his money out first. At the same time, he’s not really interested in simply getting his money paid back. He wants a return on his money. And the only way to get a good return on his money is by getting his hands on the real estate. So my thesis is that he is doing his own orderly bankruptcy-like liquidation of Sears to get his return. Continuing with the moves above, I am looking for him to make the following moves:

Shot #1: Sears needs some big liquidity soon, and only way to do that (besides Eddie providing additional loans) is by selling some of the real estate. Eddie does not benefit by Sears simply selling the real estate to any random third-party, but he does benefit by Sears selling the properties to Seritage. Again, Seritage benefits when Sears eventually vacates its leases and Seritage is then able to re-lease the properties to third parties at 3-4x higher rents. So another big sale leaseback arrangement with Seritage will be his next major move. Remember, 125 of the properties are pledged according to the pension agreement, which leaves 289 out of a total of 414 properties that can be sold to Seritage in this first round.

Shot #2: With the proceeds from Shot #1, Sears will pay down some debt and use some of the cash for short-term liquidity. But I think the primary use of proceeds will be a payment of $1.3 billion to the pension fund to bring it to the 85% funding mark to put Sears on the path towards removing the onerous terms of the PBGC agreement. UPDATE>> He has to do this quickly to minimize “the last day of two consecutive plan years of the Pension Plan” time requirement. If he gets it in by 1/30/17, then he fulfills the requirement by 1/30/18 (assuming pension plan year is the same as Sears’ fiscal year). The rights to the 125 REMIC properties and KCD brands will then be returned to Sears Reinsurance Ltd. without restrictions.

Shot #3a: With the pension restrictions eliminated after 1/30/18, Sears could then spin-off the Sears Reinsurance arm, along with its ownership in the 125 REMIC properties and the KCD brands, into a separate company. Taking a page from the Lands’ End spinoff playbook, Sears Reinsurance could take on some debt to pay Sears a separation fee, and Sears could then distribute shares of the new publicly traded Reinsurance company stock to existing SHLD shareholders. From here, Sears Reinsurance could then wind down its insurance operations as Sears goes out of business, and, eventually, sell the 125 properties to Seritage.

Shot #3b: If spinning off Sears Reinsurance is not feasible, then I would expect Sears to do another sale leaseback arrangement with Seritage for the remaining 125 properties. KCD brands could be sold to an outside buyer or the assets could be spun out in a similar manner to the Lands’ End transaction.

Shot #4: All of these asset sales would provide some liquidity and cash to pay down as much of the $3.7 billion of debt Sears has on its books. Eddie’s loans will be the first ones that get paid.

In the end, all that will be left in Sears will be the assets of the non-viable retail business. At that point, Sears can go into bankruptcy and SHLD stock can go to zero.

The Trade

As I highlighted in my original post Sears Is Taking It in the Shorts, one of the biggest risks to timing of a bankruptcy is Eddie’s ability to provide liquidity to Sears. With the new $300 million loan from Eddie, that appears to be the case. Certainly, it’s in Eddie’s benefit to provide temporary liquidity to Sears in order to have his increasingly larger stake in Sears (and its spin-offs) eventually pay off.  So I now think that Sears may continue to avoid bankruptcy well into 2018 and potentially beyond.

I think this will be a bumpy ride with plenty of ups and downs and I expect to stock price to spike up with each unlocking of capital. The market will look favorably upon what appears to be Sears cleaning up its balance sheet. But reality will sink in that the cash infusions from asset sales are merely short-term band-aids.

This is how I’ll be trading Sears:

  • I still think that Sears will continue to trade in a $10-18 trading range for a while. I still plan to continue buying put options when it reaches the top of that range and lock in some profits when it nears the bottom of the range. When I first started writing this post, I had some short-term September 2016 puts that were in the money, but most of my position is tied up in longer-term January 2018 puts (also positive on the trade). But knowing that the bankruptcy may take another year or two, I plan to shift some of my purchases to nearer-term expirations rather than have it so heavily weighted in long-term puts, which are more expensive. I have to switch to more of a trader’s mentality and take my short-term profits when the price hits a trough and roll it back into a new position when it tops out rather than holding until expiration.
  • I may write some OTM calls when the stock approaches the high end of the range, but I will protect them with a spread in case the market reacts more positively than I expect for some of these future asset sale transactions.
  • I will also be looking into Seritage (SRG) for opportunities to buy on dips as I think SRG will be the primary beneficiary vehicle from the Sears asset extraction. But I need to do my research on SRG first.

Conclusion

After going through this analysis and flowing out what I think “Fast” Eddie’s game plan is, I think that bankruptcy could very well extend beyond 2018 because it’s in Eddie’s best interest to continue to provide liquidity in order to make those real estate transfers come to fruition. And, they could take a long time. How deep Eddie goes to extract the assets depends on how successful Sears is at reducing the cash burn. Ultimately, I still firmly believe that Sears has no place as an ongoing retailer and that it will eventually declare bankruptcy. For me, it just looks like it will take longer than I had originally thought. So I’ll be watching for “Fast” Eddie to line up his shots and I’ll make my trades accordingly.

And, always remember, there is no Ace of spades.

Sources and references:

Sears 10-Q

Sears Q2 Earnings Presentation

Sears 10-K

8-K of new junior debt

Sears: Shuffling The Deck Chairs On The Titanic

Sears still has plenty of levers to pull to avoid bankruptcy

Sears Is Taking It in the Shorts

Disclosure: The author is currently short on SHLD. Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation. The views expressed in the article are the author and the author’s alone.

2 Comments

  • reader1 says:

    Fairly good analysis but forgetting sears online sales and services business. Lampert will use asset sales like you said, but his goal is to keep a very thin retailer coupled with the profitable online and service business. I think it will succeed. Remember, each time he closes stores, the online and service revenue as %age of sales increases.

    • chrischen says:

      Thanks. You could be right. But I personally think that the best scenario for the case you laid out is just a breakeven retailing business. Sears will not win the online sales business. Sears is no longer a viable retailing entity, in my opinion. So I think Eddie is just angling to get his money out and banking on returns through his ownership in SRG.