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Sears Acknowledges That it is in the Real Estate Liquidation Business (Sort of)

October 12, 2011
 
Back in 2005, when Sears merged with Kmart (following Kmart’s Chapter 11 reorganization), the controlling shareholder instigating the transaction insisted that he was interested in operating the combined retail business as a going concern. My thinking at the time was that he was: 1. eyeing the cash hoard on the books; 2. intent on milking the retail business for as much additional cash as possible; and, 3. wanting to dump the undervalued real estate, essentially liquidating the retail business. This position has been denied fairly consistently, but now it is official: Sears is leasing space to outside retailers.
Sears was and continues to be a slow liquidation story. Consider the following:
 
One – The Cash: In a November 29, 2004, article in Business Week, it was estimated that the merged companies (Sears-Kmart) would have $1.5 billion in cash post-merger.
 
Two – Killing the Retail Business: Sears has been a poor performer, and its cash is being drained for stock buybacks and other non-operating considerations. As Charts 1 and 2 illustrate, sales and return on capital have not been heading in the right direction since the time of the merger. In 2009, sales were 5.83 percent below 2008; 2010 sales were 1.63 percent below 2009; and 2011 sales are estimated to be 1.5 percent below 2010. Revenue growth in July 2011 was -2.5 percent versus the prior year; compared with a +2.4 percent for its competitors. Gross margin at Sears for the trailing four quarters ending July 2011 was 23.6 percent versus 29.3 percent for its peer group; net margin was -1.4 percent compared with +1.8 percent for its counterparts.

Chart 1.

Source: EVA Dimensions
 
Chart 2.

Source: EVA Dimensions
 
As Chart 3 further demonstrates, this poor performance and lack of investment point to a failing business model. Consider that it is estimated that Sears per-square-foot store investment is at the bottom of the retail industry at $1-2 in 2010. Chart 4 demonstrates how this has impacted its share price.
 
Chart 3.

Sears Holdings
2011
2006
Tangible Book Value (per share)
$36.51
$41.80
Cash Flow (per share)
$9.40
$12.24
Earnings (per share)
$1.19
$6.17
Cash ($ billions)
$1.375
$4.440
Return on Assets
0.6%
4.8%
Return on Equity
1.7%
11.8%
 
Chart 4.

Source: Verus Analytics

Three – The Real Estate: At the time of the 2005 merger, Sears disposing of its real estate for $4 billion+ was a possibility considering retail real estate demand and price trends. As the following Chart 5 illustrates, demand for retail real estate outstripped supply in 2005, pushing up prices (note Chart 6). But by 2007, demand topped out and so did prices (again see Chart 6, and note the top line indicated as TBI, or transactions-based index, an indicator of price movement).
 
Chart 5.

 
Source: MIT Center for Real Estate           
 
Chart 6.

Source: MIT Center for Real Estate                                     
 
Our Real Estate Liquidation Thesis:The above illustrates that the cash and real estate of Sears in 2005 was worth more than the retail business. The lack of investment in the stores and lackluster performance supports the proposition that Sears’ cash and real estate motivated the transaction. And now, due to the downturn in the real estate market, Sears is looking for new ways to monetize its real estate. Not only is it trying to lease its empty stores, it is leasing real estate to other retailers in its stores. For example, Gonzalez Grocery will lease 41,000 square feet inside a 104,000 square foot Kmart in San Diego, and Forever 21 now leases 15 percent of a Sears store in Costa Mesa, California.  
 
In summary, Sears cannot shrink its way to profitability. It is now basically acknowledging this by leasing its in-store real estate. The company is worth more broken-up because it cannot successfully compete in the retail business. 

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