Analyzing Sears and Bonds

sears_logo3Yesterday we briefly compared the equity of Sears Holdings to its outstanding “junk” bonds and found that an investor with a short time horizon (say 2-3 years) may find comparable or superior value in the bonds when compared to its equity. To be clear, we don’t mean to suggest that Sears bonds are without risk. One only needs to look to Circuit City, or Linens n Things to see that today’s retail environment is increasingly difficult. And we are assured that more retailers will seek bankuptcy as they watch American consumers begin to cultivate the lost art of saving.

Today, we will take some time to evaluate the risk of Sears bonds in greater detail. Though sophisticated bond analysis tools abound (some more useless than others), relative simplicity will rule this day. Benjamin Graham, in his widely acclaimed The Intelligent Investor, highlights a variety of criteria relevant for bond analysis. First, and most important, is “the number of times that total interest charges have been covered by available earnings for some years in the past” (148). Either the analyst should concentrate on the average multiple of interest coverage over the past seven years, or she can use the multiple of interest coverage in the “poorest” year. Graham concludes that, before income taxes, a retailer must have—at minimum—produced average earnings at least five times the interest charges, or at least four times the earnings of the poorest year.

A second test for bonds is the size of the business. Third, the analyst should assess the ratio of the equity’s market price to the business’ total outstanding indebtedness. And lastly, the analyst should discern the values of the assets on the debtor’s balance sheet.

In the case of Sears Holdings, it appears that its debt does not pass Graham’s first test. According to Sears’ most recent press release, interest expense for the fiscal year ending Jan 31, 2009 was around $272 million. Yesterday, we found Sears average annual FCF to be 1.03 billion; the ratio then is 3.8, below Graham’s 5x threshold.

The second criterion is fine, and the third as well, with Sears’ equity priced in the market at 4.3 billion (as of 3/5/09), compared to 2.9 billion in total long term indebtedness. The fourth criterion is quite interesting in Sears’ case. Given its wealth of real estate assets, its valuable brands, and its ownership stake in Kmart, Lands’ End, and Sears Canada, the balance sheet far understates its true value. For example, Bruce Berkowitz, manager of the Fairholme Fund, conservatively values Sears’ real estate at $90 per share, a valuation he has made using tax records and fairly detailed site analysis. By itself, the value of Sears’ real estate, largely hidden from the balance sheet, should provide the debt holder with an additional margin of safety.

All told, the analyst can see where Sears’ perceived weakness lies—its earnings power in its current state appears too meager. Given its assets however, combined with its cash balance of 1.3 billion, and the 3.5 billion available on its line of credit, some of the risk diminishes.  Diminished enough at least for this investor to seek the proffered returns.

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

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2 responses to “Analyzing Sears and Bonds

  1. Hi there,

    I am fairly new to Bond investing and can’t seem to find a good source for both bond screening and for actual issuance information.

    I currently use the Yahoo Bond Screener but I find the tool extremely weak.

    What do you use ? Also, where do you look for details about the debt issuance ?

    Thanks!

  2. Hi Phil,

    For searching, I use FINRA. In the past, I was happy with bond ETFs, but given the current market disarray, I have found what look to be mispricings. I don’t expect this condition to last too long.

    For screening, I am not as scientific. Basically, I survey (maybe twice a day) what is currently for sale at my brokers, and then do analysis like I would for an equity–looking at cash flows, assets, etc. I am selective, taking bonds where the coupon relative to the bond price is comparable (or cheaper) than the FCF relative to the equity price, AND where the business is something that I wouldn’t mind owning.

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