Sears Is Taking It in the Shorts

Summary:

  • The demise of Sears is inevitable.
  • Sales have gone down the toilet; its same store sales have been negative for the past several years.
  • Like Elvis, cold hard cash has left the building. Sears is losing billions of dollars in cash money every year.
  • Assets with value have been transferred out of Sears and into independent equity vehicles.
  • Eventually Sears will be left with only the worthless money-losing retail business.
  • It’s not a question of “if”, but only a question of “when”. And I believe the “when” is accelerating.

Sears’ demise is inevitable

We all know that Sears will ultimately fold into bankruptcy–there’s a huge short interest of over 56%. But, I have to lay it out here briefly, because omitting it would be simply irresponsible. So here’s the quick rundown.

Nobody shops at Sears anymore. OK, maybe one person you know still does.

sears-one car

Sears is in a death spiral; there is really no turnaround for it as a retailer. Total revenues have declined dramatically and comp store sales are turning increasingly negative.

Sears Sales Chart

Source: Sears Annual Reports.

Stores are still not throwing off enough gross margin to cover selling and admin costs (and that’s before depreciation interest or other expenses). That’s not good news for Sears in their effort to reach operating profitability. 

But the key measure for its near-term viability is cashflow (not accounting profits, but cold, hard cash). For this, I’m using cashflow from operations less capital expenditures. For the last three years, Sears racked up negative operating cashflow of $(5.5) billion. And this trend continues to widen with the quarter on quarter comparison operating cash loss of $(762) million for Q1 2016 versus $(579) million for Q1 2015.

In millions 2013 2014 2015 2015Q1 2016Q1
Sales $36,188 $31,198 $25,146 $5,882 $5,394
Cost of sales, buying and occupancy $27,433 $24,049 $19,336 $4,364 $4,217
Gross margin $8,755 $7,149 $5,810 $1,518 $1,177
Selling and administrative $9,384 $8,220 $6,857 $1,681 $1,503
Gross margin coverage -$629 -$1,071 -$1,047 -$163 -$326
Net loss -$1,365 -$1,682 -$1,129 -$303 -$471
Cash from ops & capex -$1,438 -$1,657 -$2,378 -$579 -$762

Sears is flailing (I spelt that correctly) as a physical retailer and it will not succeed as an online retailer through its new Shop Your Way online membership program.

Its other recently announced initiatives should fare no better:

  • While it does make sense on the surface to reduce the footprint of the stores and focus on the appliance business, this new format seems to replicate the format of Sears Hometown Outlet (SHOS) which Sears spunoff in 2012. If it’s any indication of the success of that format, SHOS stock is currently trading at $6, which is far from its all-time high of $55. Sorry, that’s just mean. Anyways, a quick look at SHOS’ financials will show you that it’s not a highly profitable business either. That being said, I think Eddie has an ulterior motive here. Shrinking the stores to a new format will make it appear more “justified” when Seritage REIT exercises its recapture rights. Seritage, not Sears, benefits by re-leasing space to third party tenants who pay much higher rents.
  • Closing Kmart and Sears stores makes sense too, but that alone will not reverse the cash losses. Sears’ sales are declining and the gross margins per store are thin, so overhead needs to be slashed at a much higher rate. And the 16% reduction by $1.4 billion in 2015 was already quite severe.
  • Potentially selling KCD (Kenmore, Craftsman, Diehard) products through other retailers might boost profits for the brands, but it most certainly would be offset by losses in sales at Sears and Kmart stores. I think the KCD exploration is really just a smokescreen for another asset extraction.

It started as a way to unlock the hidden value

CEO Eddie Lampert is the controlling and majority shareholder of Sears. Eddie, personally, and through his hedge fund, ESL, own about 53 million shares or 50% of the stock, so it’s hard to get away from the fact that everything that Eddie is doing as the CEO is ultimately for his benefit. With that frame of mind, Eddie is trying to make sure he gets back the hundreds of millions he invested in Sears SHLD stock (original investment from Kmart debt and bankruptcy).

As commonly believed, Eddie took over Sears because it was undervalued primarily based on its real estate assets. And like most, I believe his plan when he merged Kmart and Sears together in 2005 was to unlock the value of the real estate and other assets. This is a summary of the spinoffs he has done to unlock the hidden value of Sears:

  • Orchard Supply Hardware Stores Corporation (OSH) was spun off on January 3, 2012. Shareholders received shares in OSH stock. OSH eventually filed for bankruptcy and was purchased out of bankruptcy by Lowes.
  • Sears Hometown Outlet (SHOS) was spun off on September 13, 2012. Subscription rights to purchase (i.e., new money had to be invested to purchase new shares) shares of common stock of SHOS were distributed to Holdings’ shareholders. SHOS currently trades around $6 per share.
  • Sears Canada (SRSC) was spun off on November 13, 2012, the distribution date of such shares to Holdings’ shareholders (distributed approximately 45 million common shares of Sears Canada held by Holdings on a pro rata basis to holders of Holdings’ common stock). And on October 17, 2014 subscription rights to purchase shares of common stock of Sears Canada (SRSC) that Sears held were distributed to Holdings’ shareholders. SRSC currently trades around $3 per share.
  • Lands’ End (LE) was spun off on April 7, 2014, with the distribution of LE shares to Holdings’ shareholders. LE currently trades around $16 per share.
  • Subscription rights to purchase (i.e., new money had to be invested to purchase new shares) shares of common stock of Seritage Growth Properties (SRG) on June 12, 2015 were distributed to Holdings’ shareholders. This was the crown jewel transferring the best 266 properties to SRG and leaving Sears with no ongoing interest after the gross proceeds of $2.7 billion was used to pay down debt. SRG currently trades around $49 per share.

It has turned into a “sacrifice” play

Usually when you are unlocking value and spinning off assets, you are left with two viable entities (think eBay spinning off PayPal–both valuable and viable entities). But Sears is a different story.

Back in 2006, the first full year as a merged entity, the retail operations of Sears and Kmart were profitable and generated $1.5 billion in net income and $931 million in operating cash less capex. But in 2010, operating cash less capex turned negative and, in 2011, Sears started to report net losses. The loss of cash and earnings has accelerated ever since. As cited above, Sears now loses $2 billion in cash a year. This is now a really big problem.

This enormous negative cashflow burden has transformed his “unlocking the value” strategy into a “sacrifice play”. The sacrifice play is to extract all of the good out and leave all of the bad in to wither and die. In this case, all of the good has been going out as equity in spinoffs passed along to the shareholders and all of the bad is SHLD stock being left with only the money losing retail operations. In other words, Sears shareholders now have shares of stocks in the spinoffs (SRSC, SHOS, LE, SRG), which have value, along with stock in SHLD, which has less and less value as time goes on.

Eddie is actually doing his own internal Chapter 11 bankruptcy orderly sale. By doing this, he can make sure the sales go to buyers in which he has an ownership interest. The real estate assets will be sold to SRG in order to pay down debt. But the upside and value of the real estate will eventually be unlocked by SRG, in which Eddie owns a large stake. SRG will benefit by replacing Sears, as an under-market $4 psf tenant, with third parties that pay over $20 psf. SRG is already in the process of doing this with some stores in which it has recapture rights. Here’s a good article on Value Investors Club showing how SRG benefits.

In summary, Eddie has been smart enough to realize that the demise of the retail operation is inevitable–he started the asset extraction back in 2012. He’s also been smart enough to realize that those assets have much more upside potential without the weight of the under-performing retail stores hanging around their necks. But, most importantly, Eddie realizes that if he sits here and does nothing, then the money-losing retail operation will eventually overcome any remaining value hidden in its assets. So, while he may lose money in his SHLD shares, he stands to make money from his ownership in the new Sear’s spinoffs. Thus, the sacrifice play on SHLD and the equity transfer into new surviving entities (SRG, LE, SHOS, and SRSC).

Catalysts, preludes, signals to bankruptcy:

With $2 billion of cash losses every year, Eddie will be trying to accelerate the extraction of these assets before the impending doom. I am keeping my eyes out for some of these signals of acceleration.

The true value of Sears is in the real estate of 419 stores that Sears still owns and this is what Eddie wants to unlock and transfer out. But he might be restricted from doing so. Sears is a complex beast with lots of guarantor and non-guarantor subsidiaries. Its recent agreement with the Pension Benefit Guaranty Corporation (“PBGC”) that gives the Sears Fund first claim on the bankruptcy remote vehicles as well as its debt have onerous covenants that restrict Sears from selling some of its real estate and other assets. Note: I’m not an expert at bankruptcy and bankruptcy-remote vehicles. I’ve based my thesis on some of Sears’s filing and articles about the bankruptcy vehicles included in the sources I’ve listed at the end of this article.

Look for Eddie to eliminate some of these restrictions as signals:

  • The Senior Notes due October 15, 2018 have “restrictive covenants that, among other things, (1) limit the ability of the Company and certain of its domestic subsidiaries to create liens and enter into sale and leaseback transactions and (2) limit the ability of the Company to consolidate with or merge into, or sell other than for cash or lease all or substantially all of its assets to, another person.” Source: Sears Annual Report. In order to eliminate this restriction, Eddie has been paying them down and there’s only $302 million notes outstanding. Look for the remaining notes to be retired to eliminate the sale and leaseback restriction for the properties they own.
  • With regards to the Pension Fund agreement, “the 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, 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. Sears pension obligations are $5.3 billion, its assets are $3.2 billion, leaving it with a shortfall of $2.1 billion. In order to reach the 85% mark of $4.5 billion, Sears would need to contribute $1.3 billion. This might be too much to unlock the protected 125 properties, but watch for big contributions into the pension fund from future asset sales.
  • Kenmore, Craftsman and Diehard (KCD) Assets. Recently, Sears announced that it was exploring options to sell or license the KCD brands. Book value is around $1 billion, but recent M&A activity like Haier’s acquisition of GE’s appliance business for $5 billion indicates potential upside here. KCD IP ownership is tied up in Sears Reinsurance so there are a bunch of restrictions there too. The pension fund agreement also prevents Sears from making cash distributions while it is still heavily underfunded. But if KCD could fetch a huge sale premium, a deal could be struck with the pension fund to use the sale proceeds to fund the pension and, thus, allowing, excess proceeds to be distributed to the shareholders (50% to Eddie) as a cash dividend.

Look to Sears debt and the maturity dates for signals:

  • Eddie and his hedge fund has been providing short-term secured debt and most recently a Secured Loan Facility of $500 million with a maturity date of July 7, 2017, which is secured by 21 properties. Keep an eye on a renewal when it gets closer to maturity and if renewal terms get more favorable for Eddie (secured by more properties, etc.).
  • Other debt maturity dates: Sears has $300 million of Senior Notes due on 10/15/18, $625 million of Senior Unsecured Notes due on 12/15/19, and $1.7 billion on its Domestic Credit Agreement and Term Loan due on 7/20/20.

Finally, look to another big asset sale of valuable real estate properties to Seritage (Eddie owns 9.8% voting rights of SRG and 43.5% of the partnership units of Seritage Limited Partnership). The real estate is what Eddie is really playing for. So if he can remove some of the restrictions mentioned above and unlock the real estate into another equity vehicle he owns (SRG), then SHLD will be free and clear to go into bankruptcy.

Key risks

The biggest risk to a short play is that Eddie and his hedge fund can continue to provide cashflow funding to Sears via short-term loans secured by real estate, of course. He will continue doing so with more favorable terms and secured with real properties (that he wants to extract), so, in a default, his short-term loans are covered and he gets what he wants. I have to believe he will continue to do this until he has extracted as much value out of Sears and into Seritage (or another independent equity vehicle) before the other creditors cry foul. He will have to continue to close stores and reduce overhead in order to get closer to operating break even, but that’s a long way to go. I think he will have to do this in controlled stages rather than in severe and drastic cuts because that would signal capitulation (good for the short play). That being said, it creates a risk that this will be a long and drawn out process and extend out the date for a bankruptcy filing.

The Trade

First, shorting stocks and buying/selling options are high risk. Personally, I don’t like shorting stocks; that’s really short-term trading, whereas I’m more of a long-term investor. And I don’t like to short high-flying stocks that people think are way overvalued but still are good viable entities. I don’t like shorting companies with potential because they might actually reach that potential and then your loss is theoretically unlimited (the stock could rise multiple times higher). However, there are some instances where shorting fits my investing/trading style and that’s with complete dogs like Sears. Sears is a big, hairy, ugly dog with almost no chance for long-term survival.

The two main short trades I considered are: straight shorting and buying put options. Both have their pluses and minuses.

The problem with straight shorting is that it comes at a very high and ongoing cost especially with a highly-shorted stock like SHLD (over 56% short). I called up my brokerage and they quoted me a 24% margin rate, and it was subject to change at their discretion (i.e., it can go up) and had a high minimum trade amount. So, while you can hold the short position for an unlimited amount of time until the stock drops, you will be paying out the nose with a margin rate of 24%. With a rate that high, you need to expect a severe drop in stock price in the next few months or, on the outer range, within two years where you might be able to double your money. The other problem with straight shorting the stock is that you are responsible for any dividends, subscription rights and other things of value offered to the shareholders. If you look back at the spinoffs above, there were plenty subscription rights and share distributions for which a short seller would be responsible. And it’s not just asset spinoffs; Eddie even puts the pain to short sellers with his debt offerings where he provided shareholders with subscription rights to the bond and warrant offering. Our thesis is that the pattern of additional asset spinoffs and similar debt offerings will continue, so those costs have to be factored in to a short position.

The second alternative is buying put options. I’m looking at long-term options (also called LEAPS) that expire January 19, 2018, which provides a year-and-half time frame for SHLD stock to crater. With SHLD currently trading at $13 per share, January 19, 2018 put options with a strike price of $10 have a premium of $3 (bid-ask is wide $2.85-3.20), giving you a breakeven at $7 per share and potential to more than double your money if SHLD drops to zero (cost is $3 and profit is $7). Puts with an $8 strike price have a $2 premium (bid-ask is wide $1.85-2.41) and a breakeven at $6 per share and potential to triple your money (cost is $2 and profit is $6).

While that return is nice, the leverage doesn’t seem to be there at the premiums for those puts versus straight shorting the stock. Options are high risk, so I’m looking more for option premiums of closer to $1-2 for puts with the same strike prices that generate higher potential returns like 4x ($10 strike less $2 premium = $8 profit if SHLD goes to zero) and 7x ($8 strike less $1 premium = $7 profit if SHLD goes to zero). I’m kicking myself because back in mid-April when SHLD spiked up over $18, the premiums were in that range, but I didn’t pull the trigger (still synthesizing my analysis). Anyways, the rub with options is the defined time frame, and 18 months, in this case, may not be enough for Sears to go over the cliff. I think Sears will fall significantly, but to get a real return, the stock has to fully crater.

An even more bearish play on Sears is to double-down and sell call options to offset the cost of the put premiums you buy. For example, you could sell January 19, 2018 calls with strike price of $20 for $1.30 premium (bid-ask of $1.00-1.57). Assuming SHLD heads lower, you would pocket your call premium and have an overall net cost for all of your option of $1.70 ($3.00-$1.30). But selling calls opens you up to additional risk. Normally, I like to cap my risk at my investment, but this is an option to consider if one is all-in on the demise of Sears.

Conclusion

Sears’ demise is inevitable. It’s sales have been dropping every year for the past decade and it’s currently burning through $2 billion in cash annually. Eddie Lampert realizes this and is stripping assets from Sears as an equity swap to sacrifice the “cash-bleeding and debt-laden” SHLD equity for new “free-standing” equity in the Sears spinoffs (primarily into SRG). Once the real assets are stripped, Sears will just bleed red ink and will not be able to repay its debts and obligations and, ultimately, Sears and its debt holders (including the retired employees with an underfunded pension plan) will be left holding the bag.

So for now, I’m watching the signals for Sears’ demise and waiting for my price target (SHLD bounces around, so trying to time it in the $15-18 price range.) that gives me the profit leverage I’m looking for to open a position with put options. Yeah, I know, this is kind of a wuss position to take (ha ha). But this is a trade (make a fast buck by buying right), not an investment (buy and hold something you know is going to grow over time). So timing and price are everything. It’s not the demise of Sears that I question; it’s just the timing.

Other great articles and sources:

Sears Holdings Corp (SHLD): Evercore Says Liquidity Event Just A Matter Of Time.

Sears’ REIT Is An Extraction Of Company Assets.

The Logic Behind Sears’ REIT (SHLD, SRG).

SERITAGE GROWTH PROPERTIES.

Sears Holdings: The Assets That Remain After The Real Estate Sale.

Why Sears Holding Corp. Will Go Bankrupt. A great research paper by some college kids.

Sears: Death by Debt. A great research paper by some college kids or MBA students.

Sears Has a Deal to Offer Its Shareholders.

The Butcher of Sears Holdings.

Why Sears Holdings Corp. Investors Should Hate Eddie Lampert.

Sears Holdings Risk Rises as Vendors Get Nervous … Again.

Sears Suffers — Eddie Lampert Wins.

One of the Only Analysts Still Covering Sears Says It Isn’t Viable.

Sears Holdings (SHLD) “Base Case” Is Liquidation: Evercore.

Sears Reinsurance and Securitization Transactions.

Lessons to my kids: Always do your homework and formulate your point of view before making an investment. Have a price target and measure and weigh your risk/reward. This article is about short-term trading, not long-term investing. Note–I don’t actually teach my kids this stuff yet. I just have this as a ready example in case it comes up in the future…although, my son did like the one car in the Sears parking lot joke. Ha ha!

Disclosure: The author is not currently invested in 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.

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