Wednesday, November 24, 2010

Transaction Alert, Sears Holdings 2013 Call Options

Sears is a difficult company to analyze IMO, and as result any fair value estimate I can come up with has a huge amount of uncertainty.  So, instead of spinning my wheels trying to value the company, I'll group my thoughts into 3 buckets and see if I can back into a non-valuation-centric investment thesis:

A. What do I KNOW?
  1. Sears Holdings is controlled by Eddie Lampert (who is a legend in the world of value investing) through his hedge fund, ESL.  Mr. Lampert started ESL in 1988 at the ripe old age of 26, since then his returns have averaged somewhere between 25% to 30% returns per year... wow. 
  2. Eddie's reputation, financial track record, and personal wealth are all heavily dependant on the success of Sears Holdings as an investment (SH represents something like +40% of ESL's portfolio).
  3. SH's retail operations have thrown off considerable cash since Eddie took control in 2004, the vast majority of which has gone to share repurchases.  In fact, over the last three years SH has bought back almost $2B worth of shares at an average price around $77 (this is significant considering SH has a market cap around $7B)
  4. SH has an interesting collection of assets including owned real estate, real estate controlled through ultra long term leases, a portfolio of brands (Craftsmen, Kenmore, Lands End, and DieHard), and a 90% stake in Sears Canada.
B. What do I THINK?
  1. Eddie thinks the stock is significantly undervalued, which is why he's so aggressive with share buybacks (i.e. there's a ton of things he could've done with the cash like pay a dividend, modernize stores, acquire other companies, etc., BUT he has choosen to repurchase shares time and time again)
  2. Eddie probably bought SH with the idea of turning around the retail operations, however my guess is several years ago he determined this would not generate the best returns.  As a result the retail operations are essentially in run-off with the goal of maximizing cash flow.
  3. There is huge uncertainty over the value of SH's assets; and for shareholders this value is heavily dependent on HOW and WHEN these assets are monetized.  IMO the value of these assets could be quite a bit higher than the current EV of $9B.  For instance, the owned real estate of only the retail operations could easily be worth more than $4B ( 
  4. SH has already begun it's transformation from a retail company into something else.  For example, DieHard and Craftsmen are already being sold at non-Sears/Kmart stores and real estate is starting to be monetized (  Additionally, SH is in the middle of a massive effort to beef up their online presence.  Given that SH's free cash flow is quickly dwindling, this transformation could happen sooner than most people expect.
What could go wrong?
  1. Eddie could make a capital allocation or strategic mistake.  Truthfully there's a lot that could go wrong here - maybe the share buybacks were a mistake, maybe he'll try to revitalize the retail operations and be unsuccessful - just because Eddie has a lot riding on SH doesn't guarantee success.
  2. Maybe Eddie is already looking for a way out - one of the worst things that could happen IMO is to wake up one day and see the press release "ESL sells stake in SH."
  3. I could be flat out wrong.  The truth is my investment thesis is a lot of conjecture based around circumstantial evidence.  Additionally, I do not have any special insight into the value of SH's assets.  I think they're worth more than the current EV, and SH's share buybacks support this position, but that doesn't make it so...
Based on the 3 buckets above I'm actually more comfortable buying SHLD LEAPS, so today I purchased Jan 2013 $95 call options (10 contracts at $4.85).  Basically, I think something either really good or really bad is going to happen, and my guess is we'll find out what it is before the LEAPS expire in 2 years.  BTW, so you don't have to do the math, these 10 contracts (including commissions) cost $4,861.  At expiration, with SHLD trading at $95 these options will be worth $0, at $150 they'll be worth $55K, at $200 they'll be worth $105K... talk about an asymmetrical risk/reward!

PS: I've previously owned SHLD; in Feb 2008 I purchased 52 shares at $97, in June I purchased 28 shares at $82, in Sept I sold 15 shares at $105, in Oct I purchased 20 shares at $48, in Nov I purchased 30 shares at $34, in Feb 2009 I purchased 35 shares at $37, and then finally I sold out all 150 shares in March 2010 at $107.