Analyzing Sears Holdings (SHLD)

By Yaser Anwar, CSC of Equity Investment Ideas

• SHLD Reported Q4 EPS of $5.36 vs. $3.98 previous year, which beat Street estimates of $5.18. Results were driven by improved gross margins and EBITDA (which grew at robust 15.8% annually and EBITDA margins expanded +133bp, the 8th consecutive Q of expansion), which were better than expected at Sears Domestic & Kmart but not so great at Sears Canada. SG&A rose $100 million and the resulting deleverage limited margin expansion to 8.7%.

• SHLD has always focused on increasing ROE for shareholders, be it through dividends or acquisitions, especially through Eddie Lampert’s trading acumen (i.e. Total Return Swaps) of wisely investing SHLD’s cash horde. During all this time, Eddie Lampert has kept his eye on improving the profitability of the core business.
• Sears Domestic Business was better than expected in Q4 even with SSS decline of 4.9%, which was better than Street estimates of 5.6% decline. While SSS declined across the board, i.e. home appliances, these declines were partially offset by a comp-store sales increase in women’s apparel, which benefited if looked at from a YoY comparison.

Also, here’s a part of the letter (which was awesome) that I believe needs special attention-

Excerpt 1-

“It is certainly our intention to grow Sears Holdings. Some commentators have asserted that we want to shrink the Company, but that is simply not so. No great company would aspire to become smaller, and we certainly do not. But before embarking on a growth plan, it is critical to provide a sound base from which to grow.
To this end, we have set out to improve the profitability of our business model. Our objective is disciplined growth. We do not want to grow simply for the sake of becoming bigger. Rather, our aim is to become more profitable, and as such we need to ensure that any revenue growth occurs at an appropriate level of profitability.”

Excerpt 2-

“With 6.9% EBITDA margins, we have the second-lowest margins among the top ten – ahead of only Costco, whose membership-based business model is by design low-margin. Today, Lowe’s, Kohl’s, Home Depot, and Target all have EBITDA margins above 10%.

We also lag many of our competitors on a sales and profit-per-square-foot basis. Narrowing these gaps in margins and space productivity represents a significant value-creation opportunity for Sears Holdings shareholders."

• In Q4 SHLD realized a $27 million pre-tax Total Return Swap loss after a gain of over $100 million in Q3. Also, management fell $200 million short of its early-January guidance to reach $3.5 billion in domestic cash by year end. For now keep a close eye on the 10K for more detailed updates. Investors should understand the volatility that comes with investing in derivative products.
• According to management, as of Feb 3rd 07, SHLD’s swaps position had a notional amount of $375 million and a FV of $5 million vs FV of $38 million at the end of 3Q06. Management included again the warning within its press release that “these investments are highly concentrated and involve substantial risks”.
• That said, SHLD still remains attractive based on projected cash flow generation, as it continues to have the highest FcF yield of 8% vs 4% of the industry average. SHLD ended Q4 with $3.3 billion in cash on the balance sheet and generated $1.7 billion in after-tax cash flow in 06, and given the current growth, this cash horde can rise to the $2-2.5 billion per year level.

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