Analyzing Sears and Bonds

Yesterday 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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Holding Sears

Inspired 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.”