By Ryan Barnes. Edited By Douglas A. McIntyre

Sears Holding Corp. (SHLD) – Price $ 187.65; Break-up Value $205(1), $325(2)

Sears Holding has a few things going for it, and a few things going against it.  Eddie Lampert and real estate are both big pluses.  Sears and Kmart, as stores and as brands, are both minuses.  Lampert is generally considered one of the top ten investing minds at the helm anywhere today, having put up crazy-sounding returns like 30% annualized over a 17-year period at his hedge fund.  But can a break-up value include the value of a manager’s ability to generate investment returns?  Our analysis of Sears Holdings Corp. will try to answer the question, or at least dress it up real nice and send it back to you.

Much has been made of Lampert’s Buffett-molded, value-laden approach to running Sears Holdings since the Kmart “merger” in 2005.  Sears being bought out by a third party in a private equity deal is laughably impossible, as Chairman Lampert owns over 40% of SHLD stock at present, and he was known as a lethal shareholder activist before coming to his current post.   Nobody is getting his shares, at least not as long as he’s able to manage the assets – and who in their right mind would really want to detach him from that job?  By all accounts he’s been doing a fantastic job, adding over $110 million  in income last year from investing activities, and that was off a relatively small asset base.  No, any major shakeup in the asset and operating structure will be thought up and spearheaded by Lampert himself.

Buffet has said in Berkshire’s letters for years that he wouldn’t buy back stock unless it was trading at a massive discount to intrinsic value.  Since SHLD bought back some $400 million in the first quarter of 2006 and 289m in the last, you better believe that when Lambert crunches the numbers, that massive discount is there. 

Investors rarely think of retailers being classic cash cow business models, and rightly so.  The margins just aren’t there.  So retailing is taught to be a volume story, where someone like Wal-mart becomes a winner by outselling everyone on the planet.  But consider the scenario in play at Sears Holdings.  Kmart is the worse brand, but its locations are what retailing is all about now – the “big box” store.  Sears has the bulk of the real estate, but it’s mostly stuck at the end of shopping malls.  So start moving the Sears product – the Kenmore and the Craftsman and the Lands End – into the preferred big box Kmart stores (a.k.a. Sears Essentials, or Sears Grand or whatever they’re called these days), while simultaneously paring off the Sears real estate as you can, using the cash infusions along with predictable, if not growing, cash flows from retail operations to fund an investing unit run by Lampert. 

And given that retailing is spinning off $50b plus a year in sales, every extra basis point that Lampert can squeeze out of operating margins amounts to a whole lotta’ extra cash to invest.  Sears Holdings squeezed out 60 of them last year, bringing operating margins back in line with peers at around 5%. He shouldn’t try, and we shouldn’t expect, too much more improvement to be had.

The ironic thing is that the Berkshire Hathaway textile company that Buffet used to provide his beginning cash flow was methodically buried after years of avoiding capital expenditures of any kind.  If he tries to pinch too many pennies, Lampert is likely to do the same thing over at Sears Holdings.  For our analysis, we’re going to assume that most of the operating performance improvements have peaked, and that the story going forward is how much money Lampert can put safely into the investment pool without cutting off blood flow to the retailing business. 

To this end, we have calculated the value of the Sears real estate and the run-rate in operating cash flow that would be left over after the hypothetical sale of these assets.  The real estate, comprising over 450 Sears stores, would take a couple of years to sell off at reasonable rates.  The scattered sales of 2005 were done at nearly $125/sq ft, levels almost unheard of and reflecting their status as truly prime properties.  More moderate estimates would call for the remaining real estate to go for in the range of $70-$100/sq ft.  Our estimates will use the mid-point of $85, giving us a value of $11.9 billion based on last reported square footage figures.  Figure Lampert to use part of these proceeds to whittle down debt to minimal levels.

The loss of the revenue from these stores will obviously cut revenue and op income figures, but based on a 5% operating margin the remaining 2,900 stores (not including Sears Canada) would still generate over $2b per year in operating income for investment use.

As for Sears Canada, now 70% owned by Sears Holdings, the stock has soared on the takeover attempt, with Sears Holding’s share currently worth over $2b at market prices.  To account for this we won’t count Sears Canada’s operating results in our analysis.

So what are we left with?  We’ve got a poorly-performing retailer with flat sales at best, only deserving of a .4 or .5 P/S multiple (or $18b), and one of the most sought-after money managers in the world sitting on potentially $13 billion in liquid assets. 

This takes us back to the original question of whether a money manager deserves their own break-up value.  If you are in the camp that says no, then the total break-up value of the company is just north of $205 bucks per share, and Lampert is treated like any other executive.  If, however, you think the guy can deliver 20% or so returns on his assets annually, you’ll be interested in a break-up value that instead of cash includes an investment portfolio/hedge fund at a PEG of 1 (much less than Fortress Group) and gives a total-breakup value of $325/share.  The question may be left unanswered for now, but it appears there’s some solid upside either way. 

Ryan Barnes

Ryan Barnes has over 10 years’ experience in portfolio management and investment research, covering equities, fixed income, and derivative products. Ryan spent the past 5 years working as an institutional trader & manager for high-net worth investors, working with Merrill Lynch, Charles Schwab, Morgan Stanley, and many others.  Ryan is currently working as a writer and financial modeling consultant on hedging and capital appreciation strategies, and does not own securities in the companies being covered.

Methodology

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