It appears that when things at a company are so bad, any glimmer of hope can result in an outsize upside stock-price reaction that is often unjustified on the basis of fundamentals. This appears to be what happened to Sears’ (SHLD) stock last week. The company was at the center of a massive short squeeze Friday, to a magnitude we haven’t seen in some time. We don’t think fundamentals at Sears have changed all that much.
The struggling retailer said that EBITDA in the third quarter of 2014 would be equally as poor as that of the same period in 2013. The measure could be a $325 million loss (-$325 million) in the quarter, and this would be worse than the $178 million loss and $298 million loss the company registered in the first and second quarters of 2014, respectively. Though management indicated that the loss was an improvement versus recent trends, we’re not ready to celebrate over the biggest loss so far in 2014. Sears’ same store sales are expected to be flat during the third quarter, with the company holding the line against what we would describe to be as very easy comparisons. The company also said that, to deal with dwindling liquidity, it is exploring a REIT transaction involving 200-300 owned properties through a rights offering to the company’s shareholders.
Not only is Sears still unable to turn the corner with respect to EBITDA performance, but it has to pursue nontraditional financing measures via selling off its real estate portfolio in order to stay afloat. Both events should be viewed as bad news, but yet, Sears’ stock rallied 30%+ Friday on hopes that operating performance is stabilizing and liquidity is shoring up. In our view, however, the rally was nothing more than a massive short squeeze with shorts taking profits off the table on moderately-positive (less-bad) news. Based on estimates, a whopping 65% of Sears’ float was held short before the news, or 17.35 million of 49.44 million shares.
We believe Sears’ stock price overreacted to the upside on the news, but what should investors be thinking now? Will the shorts pile back on? Let’s have a look at a few excerpts from our 16-page report on the company.
Sears’ Investment Considerations
Sears’ Investment Highlights
• Sears Holdings’ average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there. Clearly, the firm does not have an Economic Castle.
• Sears is the leading home appliance retailer as well as a leader in tools, lawn and garden, fitness equipment and automotive repair/maintenance. Key proprietary brands include Kenmore, Craftsman and DieHard. It also operates Kmart Corp.
• We’re not confident in CEO Eddie Lampert’s ability to right the ship. The firm continues to engage in a significant transformation, but it has been doing so for years, and performance is getting worse. As of May 2014, the company had liquidity of ~$6 billion on a consolidated basis.
• Housing is likely to represent the best potential upside catalyst for Sears, including appliance sales and tool sales. Given the higher average ticket prices of these items, same-store sales could start to come in better than forecasts. However, the company is losing money hand over fist.
• The only real ‘hope’ for holders of Sears’ equity, in our view, is its real estate portfolio. With firms such as JC Penney (JCP), Radio Shack (RSH), and GameStop (GME) likely facing shrinking brick-and-mortar bases, increased supply has likely reduced its portfolio’s attractiveness, however.
Business Quality
Economic Profit Analysis
The best measure of a firm’s ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm’s economic profit spread. Sears Holdings’ 3-year historical return on invested capital (without goodwill) is -12.6%, which is below the estimate of its cost of capital of 8.6%. As such, we assign the firm a ValueCreation™ rating of VERY POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Valuation Analysis
We think Sears Holdings’ shares are worth between $15.00 – $31.00 each. It should be noted that such forecasts assume the ROIC trajectory modeled above. Even after considering a turnaround, the firm’s share price, which is north of $40, is trading above the fair value range. All value is based on the future. The future is unpredictable. The greater the unpredictability of a firm’s future free cash flows, the larger the fair value range. The margin of safety around our fair value estimate is driven by the firm’s HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
We estimate Sears’ shares are worth $23 each, the midpoint of the fair value range. Our model reflects a compound annual revenue growth rate of -3.7% during the next five years, a pace that is higher than the firm’s 3-year historical compound annual growth rate of -5.8%. We’re modeling in a slowdown in sales losses, which is consistent with the stabilization of same-store-sales this quarter. Our valuation model reflects a 5-year projected average operating margin of -0.7%, which is above Sears Holdings’ trailing 3-year average. Our near-term forecasts consider material losses at the firm.
Beyond year 5, we assume free cash flow will grow at an annual rate of 0.7% for the next 15 years and 3% in perpetuity. For Sears Holdings, we use a 8.6% weighted average cost of capital to discount future free cash flows. We use a slightly lower-than-average discount rate to factor in Sears’ potential monetization of its real estate portfolio, which is a source of cost of funds.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm’s fair value at about $23 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Sears Holdings. We think the firm is attractive below $15 per share (the green line), but quite expensive above $31 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Wrapping It Up
There are some firms that we’d never consider adding to our Best Ideas portfolio, and Sears is one of them. The company’s investment thesis is one that involves a turnaround of massive proportions in a day-and-age where brick-and-mortar is going away. Sears has been trying to right the ship for years, and the US economy, albeit opinions vary, could be considered the healthiest in a long time. Unemployment, for example, has reached 5.8%, which many economists consider to be full employment. If Sears is only now stating that things are only “less-bad” than before, long-term investors should be very worried about the next recession. Sears may not be a survivor.