Berkshire Ruminations

Thursday, November 16, 2006

Sears Holdings - Part 1

I was excited to see that shares of Sears Holdings (SHLD) were down yesterday on lower same-store sales in the third quarter. This is a beautiful reaction to one of my favorite companies, as any pullback tempts me to plow more money in to it. The company is still seen as a retailer and, as such, retail analysts insist on evaluating it based on their favorite metric, same-store sales. But SHLD is much more than that now and, moreover, sales don’t put money in your pocket. Earnings do. And the company’s operating earnings were actually up, by more than 58%, after adding back in a large restructuring charge reflected in last year’s Q3 earnings.

To put is simply, although the stores’ sales may not be rising, their profitability is. This is due to two things: higher gross margins (from 27.4% in Q3 2005 to 28.3% in Q3 2006) and reduced expenses as a percentage of sales (from 24.4% to 23.7%). In English, this means that Chairman Eddie Lampert, et al have stopped selling unprofitable products, focusing on high margin products, and have also cut out a lot of costs.

But don’t fool yourself in to thinking that the retail operations of this company are of complete concern. SHLD has started engaging in many other investment activities unrelated to Sears and Kmart. In fact, these “investment activities” contributed a third of its Q3 earnings. The company attributes this to the investment of its “surplus cash,” of which it held about $2 billion of at the close of the quarter. Sound familiar? To some this sounds a lot like a certain New England textile operation that floundered in the late 1960s.

Eddie Lampert’s ESL Investment Management currently owns 41% of SHLD. But to many people, including me, it is clear that Lampert intends to turn SHLD in to something similar to Berkshire Hathaway. That is, Kmart and Sears may hang around for a while and produce decent cash flow, but the growth of the company will come from its other investments.

I owe a great deal to my friend Chad at the Peridot Capitalist for turning me on to this stock about a year ago. He has a ton of great insights in to the company as well.

FD: I own shares of Sears Holdings.

4 Comments:

  • Thanks for the mention, Andy. Have a great weekend!

    By Blogger Chad Brand, at 16 November, 2006 14:43  

  • Hi:
    How do you feel about this stock's P/E? It is about 30. I have been looking at the stock for a while, but cannt find a good timing to buy it. Is it currently expensive based on P/E?

    By Anonymous Anonymous, at 21 November, 2006 06:02  

  • Well, I feel basing an investment decision on a PE alone is always pretty shallow, but to answer your question, I think a PE of 30 for SHLD is reasonable. If anything, too low for a company whose earnings are growing at such a rate. But there is a lot more to this company than its growing earnings and profitability. Take a look at its cash flow, particularly that portion available for reinvesment and/or distribution. Clearly the company is creating value and shareholders seem to be benefiting nicely from owning the stock.

    By Blogger Andy Kern, at 21 November, 2006 12:01  

  • SHLD's P/E is not 30. Based on 2006 earnings it is 20. However, investing is a forward looking game, so really if we look at 2007 estimates we are dealing with a 16 P/E. I can't say a 30 P/E would be reasonable, but to give Lampert's team an above-market multiple makes logical sense to me.

    As for whether or not using a P/E to value SHLD at this point makes sense, one can argue that it doesn't show the whole picture. After all, for some odd reason investment gains are being excluded from analysts' estimates, so the P/E will be artificially high.

    By Blogger Chad Brand, at 04 December, 2006 14:29  

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