In depth discussion of Sears Holdings (from October 2009 Partner Letter)

1. SEARS HOLDINGS – PARTNER LETTER EXCERPT
Jason C. Norbeck, CFA
Managing Partner
JCN Investments, LLC
OCTOBER 2009 - SEARS HOLDINGS - In the last partner letter I highlighted Sears’ improved operating performance over the last two quarters amidst a weakening
industry. In August, Sears reported a slight loss during its second quarter according to GAAP (Generally Accepted Accounting Principles) due in part to a non-cash
charge for its closure of a handful of underperforming stores and an elevated pension expense. Sears generally earns the majority of its annual profits during the
holiday season and the non-cash charges had an overstated impact on what is generally a very light quarter for Sears. Nonetheless, Sears’ weaker than expected
results made major headlines, as an analyst from Credit Suisse immediately issued a report titled “SHLD: Put a Fork in it”. That following Saturday Barron’s ran a
cover story titled “Washed Out” that featured a cartoon picture of Sears Chairman Eddie Lampert stuck in a washing machine (no doubt a Kenmore washing
machine) and armed with quotes from a Morgan Stanley analyst predicted the demise of the company. Even the yahoo.com main home page (which generally
features stories on Brad Pitt or the Octomom) ran a story titled: “Eddie Lampert has killed Sears”, which featured quotes from a hedge fund manager (and author of a
book about Warren Buffett) who proclaimed Sears was unable to compete against the likes of Wal-Mart and described the situation as beyond repair.
Not to be outdone, one retail consultant wrote:
The second quarter "surprise" loss by Sears may now become the order of the day. Opportunities continue to be squandered as this once greater retailer
looks more and more like a rudderless ship. Continuing efforts to cut costs and reduce inventories do nothing to bring customers into the stores. Without
new customers and customers who keep coming back, Sears is headed toward an unfortunate and untimely end.
Sears Holdings is the partnership’s largest holding and I believe its most attractive investment opportunity. There are obviously many intelligent and educated
individuals who see this situation differently. The difference of perspective relates largely to how one incorporates capital into the evaluation of a company’s
operating performance (if at all) and can be illustrated through a discussion of two metrics: Owner’s Earnings and Sales/Invested Capital.
“Owner’s Earnings” is a method to calculate earnings that substitutes the non-cash charge for Depreciation according to GAAP (Generally Accepted Accounting
Principles) with the money actually spent on Capital Expenditures during the given period.
Depreciation is a charge to earnings that is management’s “best guess” as to the amount its Capital Investments lost value during the given time period. For a retail
company, capital investments subject to depreciation largely consist of assets related to its stores (buildings, furniture, fixtures etc . . .), its distribution facilities and its
investments in technology. Because Owner’s Earnings adds back the non-cash charge for depreciation and subtracts from earnings the cash actually spent on Capital
Expenditures, it more accurately represents how the owner of a business views his/her economic profit during the given time period and also usually represents the
amount of earnings that can be “taken out” of the business by its owners.
To illustrate, take as an example, my first home which I now utilize as a rental property. In between tenants, I recently spent $1,500 to replace worn out carpet on
two staircases with laminate flooring. The “floor guy” suggested that I view the money spent as an “investment” and not an “expense”. While it is possible that the
upgraded flooring will increase my rental income over time, when I wrote the check for the new floor, the transaction felt much more like an expense than it did an
investment. Under GAAP the $1,500 would not be immediately charged to earnings but instead added to the value of the property and charged off over its estimated
life, which according to the “floor guy” is 10 years. For Owner’s Earnings the $1,500 is charged off immediately.
Following is an illustration of the difference between GAAP Earnings and Owner’s Earnings for my Rental Property assuming a Capital Investment of $250,000
relating to the property:
Capital Investments Annual Rental Income Capital Expenditures
$250,000 (50 year life) $24,000 (net of expenses) $1,500 (New Floor - 10 year life)
GAAP Earnings = Annual Rental Income minus Depreciation
GAAP Earnings = $24,000 - $5,150 = $18,850
Owner's Earnings = Annual Rental Income minus Capital Expenditures
Owner's Earnings = $24,000 - $1,500 = $22,500
In this example the $22,500 as measured by Owner’s Earnings is the actual amount of profits that I as owner could take out of the property during the year, while the
$18,850 as measured by GAAP is an estimate as to the earnings for the year incorporating an estimated rate in which my Capital Investments lost value. Owner’s

2. Earnings is greater than GAAP Earnings because the $1,500 spent for new flooring is less than the $5,150 non-cash charge for Depreciation ($5,150 = $250,000/50
years + $1,500/10 years).
Now assume as an alternative to the new flooring I am presented with the following offer:
Instead of new flooring, replace the two staircases with an Elevator for a total cost of $50,000. The Elevator will last 50 years and result in an
additional $2,000 per year in net rental income (after Elevator maintenance expenses).
Is the purchase of a new elevator economically attractive? The results for the year for GAAP Earnings and Owner’s Earnings assuming purchase of an elevator are as
follows:
Capital Investments Annual Rental Income Capital Expenditures
$250,000 (50 year life) $26,000 (net of expenses) $50,000 (New Elevator - 50 year life)
GAAP Earnings = Annual Rental Income minus Depreciation
GAAP Earnings = $26,000 - $6,000 = $20,000
Owner's Earnings = Annual Rental Income minus Capital Expenditures
Owner's Earnings = $26,000 - $50,000 = (-$24,000)
In this example GAAP Earnings are greater than Owner’s Earnings because the $50,000 spent for the elevator is greater than the $6,000 charge for Depreciation.
Obviously, it would be foolish to spend $50,000 to build an elevator in my rental unit (I felt bad enough about the flooring) as it is not guaranteed that the $2,000 in
extra income per year is sustainable nor is it guaranteed that the elevator would last 50 years. Even if those assumptions hold true, it would still take 25 years to earn
back my $50,000 “investment”. Owner’s Earnings, which shows a loss of $24,000, better reflects the economics of that poor decision but more importantly also
reflects the fact that I have spent more money on the elevator then I made during the year, requiring additional capital be put into the property.
It is also important to note that under GAAP the elevator is economically preferable to the new floor as earnings actually increased by 6.1% (from $18,850 to
$20,000). This is because the $50,000 spent for the elevator results in a relatively small charge ($1,000 per year) to earnings. As a result, large amounts of capital
spending can cause GAAP to overstate the true profits of a business. For example, a retailer might spend $10 million to build a new store and earn $1 million per year
for the next few years until new competition causes the store’s earnings to drop to $0. The company would have reported net earnings on the store for each of the
years it earned $1 million even though the company had yet to make back its initial $10 million investment. Conversely, GAAP can understate the economic
earnings of a business if the charge for Depreciation is greater than the capital expenditures required to maintain its income stream, like in the example of the new
flooring.
In effect, there is a deficiency in GAAP reporting due to the lack of differentiation between a $2 Million investment with a 20 year life and a $200,000 investment
with a 2 year life. Both result in a charge to earnings of $100,000 per year however the $2 Million investment is considerably less desirable because of the
uncertainty associated with its longer estimated life. Owner’s Earnings better addresses this deficiency.
Following is a chart of the financial results for Sears Holdings and its competitors since the time of the partnership’s initial investment:
Financial Results 2007 - 2Q2009 ($s in millions)
Owner's
GAAP Earnings Cap Ex Owner's
GAAP Earnings + Capital Owner's as a % of as a % of Earnings
Company Earnings Depreciation Depreciation Expenditures Earnings GAAP Earnings Depreciation Yield*
Sears Holdings $2,170 $2,484 $4,654 -$975 $3,679 169.5% 39.3% 39.4%
Home Depot $14,414 $4,719 $19,133 -$5,758 $13,375 92.8% 122.0% 22.6%
Wal-Mart $55,849 $16,513 $72,362 -$32,156 $40,206 72.0% 194.7% 17.0%
JC Penney $3,196 $1,136 $4,332 -$2,516 $1,816 56.8% 221.5% 16.3%
Lowe's $10,618 $3,714 $14,332 -$8,298 $6,034 56.8% 223.4% 16.3%
Target $11,851 $4,435 $16,286 -$8,958 $7,328 61.8% 202.0% 13.6%
Kohl's $3,990 $1,278 $5,268 -$2,892 $2,376 59.6% 226.2% 12.5%
Best Buy $4,607 $1,506 $6,113 -$4,691 $1,422 30.9% 311.5% 8.3%
Macy's -$2,381 $3,186 $805 -$1,946 -$1,141 47.9% 61.1% -7.1%
* Based on Enterprise Value
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3. Note the rather large discrepancy between Sears’ charge for Depreciation ($2,484 million) and its Capital Expenditures ($975 million). When viewed as a percentage
of Depreciation, Sears’ Capital Expenditures at 39.3% are materially below that of its competitors, many of whom have spent more than double what they Depreciate.
This results in Owner’s Earnings for Sears Holdings that is 169.5% higher than its GAAP Earnings. Not all Capital Spending is economically unattractive, but a
retailer’s GAAP results should be viewed in the context of the size of its Capital Spending because that spending provides a boost to GAAP Earnings that may or may
not be economically accurate. This is something many analysts critical of Sears fail to do.
Over the last two and a half years (since the partnership’s initial investment) which was the worst two and a half year period for the retail industry in over 40 years,
Sears Holdings’ Owner’s Earnings were still $3.679 Billion, which means it generated $3.679 Billion of “take out” profits for its owners/shareholders a 27.6%
cumulative return on its invested capital. This is hardly the results of a dying company. Sears’ “take out” profits over that timeframe yield a 39.4% return based on its
current Enterprise Value (Enterprise Value is the market value of a firm’s equity plus its debt) which means that if you purchased the entire company at today’s
current valuation (equity plus debt) and Sears earned an equal amount for the next two and a half years as it did for the last two and a half years, those earnings
would yield a 39.3% return on your investment. This is a big reason why the company continues to prudently buyback its stock. While current earnings are low in
relation to the company’s future earnings potential, Sears Holdings still earns an attractive annual profit for its owners/shareholders.
However, much of the criticism facing Sears relates to its poor Sales (Revenue) performance. Analysts often look at the trends in aggregate Sales numbers and/or
Same Store Sales to gauge the future viability of a retailer. This leads many to conclude that Sears faces an uncertain future. To quote the retail consultant from
earlier: “ Without new customers and customers who keep coming back, Sears is headed toward an unfortunate and untimely end.” If you substitute “new customers
and customers who keep coming back” with “Sales Growth and/or Same Store Sales Growth” one can decipher the basis this consultant used for his prediction that
Sears faces an “untimely end”.
Indeed much of the industry shares a similar viewpoint especially as it relates to Same Store Sales (Revenue per Store).
“We consider comparable store sales to be a key indicator of our current performance measuring the growth in sales and sales productivity of existing
stores. Positive comparable store sales contribute to greater leveraging of operating costs, particularly payroll and occupancy costs, while negative
comparable store sales contribute to de-leveraging of costs. Comparable store sales also have a direct impact on our total net sales and the level of cash
flow.” - JC Penney 2008 Annual Report
“Yet, in spite of this difficult environment, our company accomplished a great deal in positioning ourselves for the future. We outperformed nearly all of
our major competitors in same-store sales in a year when we initiated significant organizational changes.” - Macy’s CEO Terri Lundgren’s 2009 Letter to
Shareholders
It is true that there are financial benefits to increasing revenue and it is also true that Sears’ Sales and Same Store Sales numbers have not been impressive over the
last few years as illustrated below.
Sales ($s in millions) Same Store Sales
Company 2007 2008 2Q2009 % Change 2007 2008 2Q2009
Best Buy $40,023 $45,015 $47,341 18.3% 2.9% -1.3% -3.9%
Wal-Mart $374,526 $401,244 $400,676 7.0% 1.6% 3.5% -1.2%
Target $63,367 $64,948 $65,575 3.5% 3.0% -2.9% -6.2%
Kohl's $16,474 $16,389 $16,483 0.1% 0.8% -5.9% -2.3%
Lowe's $48,283 $48,230 $47,388 -1.9% -5.1% -7.2% -9.5%
Macy's $26,313 $24,892 $23,790 -9.6% -1.3% -4.6% -9.5%
JC Penney $19,860 $18,486 $17,904 -9.8% 0.0% -8.5% -9.5%
Sears Holdings $50,700 $46,770 $44,546 -12.1% -4.3% -8.0% -8.6%
Home Depot $77,349 $71,288 $67,637 -12.6% -6.7% -8.7% -8.5%
However aggregate Sales numbers do not adjust for capital spending.
Returning to the example of my rental property listed below are the Sales and Invested Capital results assuming an investment in a new elevator:
Year 1 Year 2 Growth
(w/o Elevator) (w/ Elevator)
Sales $24,000 $26,000 8.3%
Invested Capital $250,000 $300,000 20.0%
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4. Sales / Invested Capital $0.096 $0.087 -9.7%
Building the elevator not only generated earnings growth (according to GAAP), but it also produced Sales growth of 8.3% (and Same Store Sales growth of 8.3%).
Just as the capital spending for the elevator distorts the economic earnings of the rental property, it also distorts revenue performance as higher revenue was achieved
through a large and economically unattractive capital expenditure. While traditional metrics like Sales and/or Same Store Sales favor building the elevator each
showing 8.3% growth, it is Sales/Invested Capital that unmasks the poor economics of the decision by showing a 9.7% decline.
When one views the Sales/Invested Capital trends over the last two and a half years, the numbers show a very different picture.
Sales / Invested Capital
Company 2007 2008 2009YTD % Change
Sears Holdings $2.78 $3.01 $3.24 16.5%
Best Buy $1.81 $1.98 $1.81 0.2%
Macy's $1.19 $1.19 $1.17 -1.4%
JC Penney $3.32 $4.08 $3.25 -2.0%
Target $3.44 $3.44 $3.19 -7.2%
Home Depot $1.97 $1.62 $1.73 -12.0%
Wal-Mart $2.09 $1.93 $1.71 -18.5%
Kohl's $2.48 $1.93 $1.93 -22.0%
Lowe's $1.71 $1.43 $1.29 -24.7%
Sears Holdings’ has achieved strong relative performance in Sales/Invested Capital because the firm decreased the amount of capital required to run its business
(capital largely returned to shareholders through stock buybacks) at a rate that is greater than its sales declines. Meanwhile its competitors have generally expanded
their use of capital at a rate that is greater than their sales increases. It is interesting to note that the performance of companies generally considered “best in class”
like Wal-Mart, Kohl’s and Lowe’s look considerably less impressive when viewed in this context as those firms have spent large amounts of capital over the last few
years with little to show for it.
While a rational owner would never spend $50,000 to put an elevator in my rental property, the CEO of a public company judged by the results according to GAAP
will often build an elevator even if it is not economically attractive to do so. Money spent on “capital investments” experiences a minimal charge to earnings and thus
provides a short term boost to widely used performance metrics like Sales Growth and Earnings Growth. Sears Holdings’ GAAP Earnings greatly understate the true
profits available to shareholders and its Sales performance is distorted by the fact that it is shrinking its use of capital (which is a good thing). In addition, Sears’
results are viewed in the context of its competitors whose results are likely overstated by higher levels of capital spending. This leads many analysts to wrongfully
conclude that Sears is destined to fail and is why Sears’ improved operating efficiencies and strong relative performance have gone unidentified by the majority
market participants (at least the ones who like to be quoted in articles).
Two additional points related to the partnership’s investment in Sears Holdings. First, as I have discussed at great length in prior letters, the value of Sears’ net assets
is conservatively 3 to 5 times greater than its current trading price with very little debt. Second, beyond the assets related to its vast distribution system (4,000 stores,
280 million square feet of retail selling space, 80 distribution centers) what makes Sears unique in its industry (its sustainable competitive advantage) is the firm’s
strong independent brands (Craftsman, Kenmore, Diehard, Land’s End).
Retail is an intensely competitive business that favors the company that owns a differentiated brand. This factor will only become more pronounced as more buying
shifts to the internet. Take for example a quick comparison of Nike and Foot Locker. Both are in the business of selling shoes, however a customer is more likely to
buy a pair of shoes because they are branded Nike than because those shoes are sold at Foot Locker. As a result, Nike garners a much larger share of the economic
profits related to the sale of its shoes. Foot Locker competes with any other retailer that sells Nike shoes with little differentiation. While Nike does compete with
other branded shoe companies, it is much more difficult (and expensive) for Foot Locker to differentiate itself from another shoe store in the sale of Nike shoes than it
is for Nike to differentiate itself from Addias or Reebok. As a result, firms like Foot Locker generally compete (or differentiate) based on their ability and willingness
to spend the capital required to build nicer stores in better locations and to stock a larger inventory and selection than its competitors. And in order to protect their
advantage firms like Foot Locker must continually spend.
This might appear to be a subtle difference but it is a critically important difference and is why generally speaking, Nike is an attractive business to own and Foot
Locker is not. The power lies with the brand because the brand provides a better opportunity to differentiate. If you look at all of Sears major competitors, whether
it be Home Depot, Lowe’s, Target, Wal-Mart, Kohl’s, Best Buy, Macy’s, each one competes in a position more comparable to Foot Locker, as they largely sell either
undifferentiated brands or brands owned by other companies that can be purchased at a similar price at the stores of their competitors.
The hedge fund manager quoted in the article “Eddie Lampert has killed Sears” said that Sears could not compete with Wal-Mart and cited as an example the fact that
Wal-Mart spent $13 Billion on Capital Expenditures in the latest quarter, while Sears spent only $200 million (as if Capital Spending should be accompanied by a
badge of honor). This viewpoint is flawed. In reality I believe the opposite to be true. The large spending signifies weakness in Wal-Mart’s ability to differentiate in
ways other than through capital spending. Sears is in a more economically attractive position because it can grow and sustain earnings while simultaneously
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5. shrinking its capital base by focusing on its brands. The fact that Sears does not aggressively spend capital (by building and remodeling stores) as a way to compete is
ironically viewed as a negative when in reality it is a big positive. While this does not guarantee success from one quarter to the next, it is still of great benefit to
shareholders.
Although Sears Holdings continues to be profitable its retail operations still possess considerable upside leverage potential. As an example, Sears Holdings has used
the turmoil in the economy as an opportunity to cut over $1 Billion in annual costs from its expense structure something that during more normal economic
conditions might cause an employee revolt. If those cuts were to go straight to the bottom line that alone would cause the company’s earnings to double. The fact
that the firm continues to repurchase its deeply undervalued shares simply compounds the degree of upside leverage for shareholders. When I ask myself (as I often
do) whether the partnership’s allocation in Sears Holdings is “too much” or “not enough”, I tend to shade toward the latter. Sears Holdings represents a uniquely
attractive investment opportunity as the gap between common perception and economic reality is enormous. The biggest obstacle to an increased position remains
the degree to which the other positions in the partnership are also undervalued.
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