Holding Sears

sears_logo2Inspired by Warren Buffett’s recent forays into the fixed income and preferred stocks, I have spent more time looking through quotes in the bond market. And some very interesting anomalies you will find. Take, for instance, the 5.375 senior notes of AIG (cusip: 02635PRT2), due 10/01/2012, rated BAA1 (“investment grade”) by Moody’s and BB+ by S&P, trading at 44 cents on the dollar, with a yield to maturity of nearly 33%, and a spread over Treasuries of more than 3100 basis points. Let’s just say the rating agencies and the market have a slightly different view of AIG’s situation.

Now, for the retail investor, there are numerous mines in this market and plenty of ways to lose a leg. But one particularly interesting case is Sears Holdings, the fourth largest retailer in the United States. As of today (3/4/09), the market prices the equity of Sears Holdings at around 4.5 billion and over 50% of that equity is held by Eddie Lampert’s ESL Investments and ESL Investors. According to the press release accompanying their annual report, “total debt as of January 31, 2009 was $2.9 billion, down from $3.0 billion as of February 2, 2008.” Excluding $665 million of capital lease obligations and $559 million of non-recourse borrowings from Sears Canada and Orchard Supply Hardware, Sears Holdings has borrowings of $1.7 billion. Most of that debt derives from Sears Holdings wholly owned financing subsidiary—Sears Roebuck Acceptance Corp—whose outstanding notes total 1.25 billion (and will total less than 950 million by May 2009). These Sears Roebuck bonds currently carry a ‘junk’ rating of BA2 from Moody’s and BB from S&P and currently trade at yields to maturity of 20-25%.

So, the question is: with these facts, which is a better buy—the equity or the bonds? Now a fuller evaluation of Sears Holdings would likely push the analyst into considering the value of Sears’ real estate, its automotive serving business, its appliance serving business, Kmart, Lands’ End, its Sears Canada stake, and the value of its prominent brands—Kenmore, Craftsman, and Diehard. Yet, rather than valuing these assets separately, today let’s focus on Sears Holdings as an operating business, which, according to Morningstar’s data, has had an average annual free cash flow (FCF) of 1.03 billion over the last five years.*

Thinking most simplistically, what looks like the better buy? Equity priced at 4.5x average, levered FCF, or the bonds priced to yield 25%? If we think of FCF as an owners’ return on equity, the (levered) equity yields 22%. In this admittedly simplistic analysis, the bond holder looks to get better returns than the equity holder at current prices, and gets the added safety of having a superior claim if Sears were forced into liquidation or bankruptcy.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

*For Sears, it is important to note that its FCF far exceeds reported earnings because its annual depreciation is much higher than its capital expenditures. Many analysts point to this disparity and conclude that Sears is failing to sufficiently invest in its stores’ appearance and layout.  It remains to be seen whether the stores do need more capital expenditures to generate sufficient sales, but Chairman Eddie Lampert is aware of the criticism, observing in his recent letter to shareholders that “there has been significant expansion over the past five years in big box retail square footage and significant capital expenditures by our competitors, primarily for opening new stores, but also to refresh and expand their existing store base and infrastructure. At Sears Holdings, our investment principle is guided by the belief that capital invested in any area of our business deserves a reasonable return on that investment. If that return is not forthcoming, significant investments in the business will destroy value rather than create value for shareholders.”

16 responses to “Holding Sears

  1. Patrick Ritchie

    But isn’t the bond yield more susceptible to inflation?

    If we assume that Sears can grow FCF at a minimum of inflation + GDP growth isn’t Sears common stock a better deal for the long term investor?

  2. “But isn’t the bond yield more susceptible to inflation?”

    In general, yes. And this is true especially for lower coupon and longer term bonds (10+ years to maturity); their price will fluctuate more widely in response to inflation risk. Here though, the Sears bonds that I have in mind mature 2011-2012. Additionally, at such a high yield to maturity, I’m not sure inflation risk matters a lot here. If we were to have 10% inflation, we are still getting enough compensation with a 25% yield, in my lights.

    “If we assume that Sears can grow FCF at a minimum of inflation + GDP growth isn’t Sears common stock a better deal for the long term investor?”

    Yes, I agree. If your time horizon is 5-6 years, then I would see the common as the better deal. The 2012 bonds mature in a little over three years, so there is reinvestment risk for the bondholder that the equity holder wouldn’t have.

  3. Hi, very nice blog i read every post. im learning about DCF analysis and i have a rookie question, when u make your DCF calculations, why u add up the book value of de firm to the present value of the cashflows??

  4. Yes this is true if you are focused on downside protection, the bond is a “better buy.” That said, if you believe the thesis of owning both the going concern AND having the optionality of private market value or “sum-of-the parts,” the bond caps your upside and the IRR on the common would be the better bet.

    In sum, I’d say as a going concern, I’d still like the common, due to optionality.

  5. @Emiliano–Basically, I am trying to estimate what a private owner would pay for an entire business, and a business has two main sources of value–its assets and its earnings power. The FCF analysis values the earnings power, and the book value approximates the value of its assets.

    Let’s say you wanted to buy a lemon stand. If you were only willing to pay for the cash flows, you would likely underbid for the business and lose it to a competitor. A sharp capital allocator may be able to extract some cash from the lemon stand’s assets–e.g., by liquidating excess inventory, ‘renting’ excess counter space, etc. In short, the stand’s assets, if they have value, need to be approximated in an analysis of a business’ intrinsic value.

    @Evan–no doubt, the bonds cap the upside. Without going too deeply into it, I am reasonably confident that the IRR will be better on the bonds over a fixed time frame (say next 3 years). If Sears starts spinning off assets though, I would be inclined to change my assessment.

  6. Which bond did you buy?

    I have been pondering the Sears bond for a long time. THe downside with any bond is obviously inflation (not so important for high yield bonds with short maturities) and higher tax rate (at least in Canada.) In a taxable account, a 30% yield may be equivalent to a 20% earnings yield on a stock (but it depends on what country we are talking about, the tax bracket, etc). A lot of the Sears seem illiquid so selling them will also be tough (whereas you can sell the shares easily.) I’m in Canada and my broker is charging and arm & a leg for foreign junk bonds so I have been dissuaded from buying any :(

    There is also hte downside to the bonds in that management will not act in bondholder interest; instead, they will act for the shareholders.

    Anyway, your potential return on the bond is far higher than the 20% or whatever the yield is. The yield to maturity can be 50% or more. Nearly all those Sears bonds trade around 50% of par value. So if you bought it for 50 cents on the dollar, you have a 100% potential just from capital gains. If we are looking at a 3 year maturity, that’s like 30% per year on top of the 20% yield! Assuming Sears doesn’t go bankrupt, it’s hard to beat a bond that yields almost 50% per year :) (But if the shares keep declining, I think the shares will be more attractive soon.)

    I like the Sears bond investment a lot. Good luck with your investment…

  7. Here are a couple options, though I’ve seen many others that mature from 2011-2013:
    812404BH3 SEARS ROEBUCK ACCEP CORP NT 6.750% 08/15/2011
    8124JFAC0 SEARS ROEBUCK ACCEP CORP INTER 7.40000% 12/15/2012

    I haven’t seen any Sears bond yet that has a yield to maturity of 50% or more. Apparently, some of the 8/2011’s traded today at 55.44, which by my calculations is a yield to maturity of about 37%.

    One other interesting wrinkle is that the Chairman, in his annual letter, pointed out that Sears’ balance sheet is comparable or stronger than other retailers rated investment grade, remarking–“we believe that our credit metrics and balance sheet compare favorably to competitors like Macy’s and J.C. Penney, which carry higher and investment grade credit ratings.” So, if Sears were to get a ratings upgrade, that could be an added bonus for the bondholder.

  8. I like the sears bonds more as I look into it. Need to figure out how to buy them now..

  9. Very nice article!

    I have been following Sears but have not looked at the Bonds…interesting

  10. Pingback: Analyzing Sears and Bonds « Wide Moat Investing

  11. @Sivaram et al–Here is a useful list of Sears’ outstanding bonds.

  12. Thanks for that list WideMoat. I was already familiar with it but others may find it useful (does anyone know of a similar site for Canadian bonds?).

    There are also two exchange-traded bonds that trade on the Pink Sheets-OTC Grey Market under the tickers SBCKO and SBCKP. These are long term (20+ year) bonds and very risky (especially if we get high inflation or if Sears goes bust in say 15 years, at which point Edward Lampert may or may not own the firm.) I’m not recommending them but am just mentioning them in case someone can only buy an exchange traded bond.

  13. Long bonds are not much riskier at five dollars.
    If I discount four years of interest at 20% on the pink sheets 7.4% bond, (sbcko) I get a PV of $5.44

    sure, there is a risk that the 25 dollar face value is a long way off, but the price has a certain margin of safety against inflation

  14. Pingback: Follow Thy Neighbor (if he’s Buffett) « Wide Moat Investing

  15. another drop in Moody’s rating today by one notch. What is the risk of default? In this market, who knows.

  16. “Sears remains challenged in certain product segments, with the macroeconomic downturn impacting even its traditionally solid hardlines business,” Moody’s Senior Analyst Charlie O’Shea said.

    I do wish the journalists would press these analysts just a bit; otherwise what function do they serve–transcriptionist? For example, what segments are challenged? How much impact? What will be the effect on margins?

    Their balance sheet is as strong as it has ever been; its revenue sheet is weak, sure, but they have plenty of assets and plenty of friends with money. Of course, if they were a financial institution, we wouldn’t be even having this conversation. Maybe they should turn themselves into a bank holding company.

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