Sears Holdings: Transformation or Tragedy?
There are few storylines in corporate America today that are as intriguing as the last 12 years at Sears Holdings. It has all the makings of a great book. You have a venerable department store that was instrumental in the evolution of shopping and has spawned such iconic spinoffs as Allstate, Dean Witter, Discover card and others. A reclusive billionaire CEO and largest shareholder (Eddie Lampert) who was once thought to be the next Warren Buffett. The Morningstar manager of the last decade (Bruce Berkowitz) who has been the second largest holder for years. Operating results that can be described as nothing short of catastrophic. And stores that are, in many cases, in need of substantial TLC.
What started out as a simple sum of the parts story about real estate value and brands has, on the surface, turned into a cash incinerator! The considerable margin of safety that existed several years ago has largely been spun off or borrowed against to fund operating losses. And the CEO and principal shareholder continues to finance the business (albeit at onerous terms). The question that remains for all that follow the company is…..why?
In his communications, which have been few and far between, Mr. Lampert has been correct about a lot of things. He recognized very early on that Sears Holdings was “overstored”. He also recognized several years ago that the way American’s shopped was on the cusp of profound change. With that type of foresight, you would think Sears Holdings would navigate the retail apocalypse quite nicely. That obviously has not been the case. If Mr. Lampert’s vision of what he would like Sears Holdings ultimately to be was just a smaller version of the legacy Sears and Kmart, I believe the financials over the last several years would have been much better than they’ve been. Think of JC Penney as an example. Once Ron Johnson was gone, JC Penney borrowed against all their real estate and got back to their core strategy and customer using promotional discounts, coupons etc. And the cash bleeding stopped. After all, JCP has ultra- attractive rents and an established core customer base. But with each passing day, JCP’s core customer gets older or finds easier ways to shop. They are stuck in the very competitive business of mass merchant retailing with no clear growth engine. They have figuratively put the ice cube in the refrigerator. It will slow the melting, but that’s it. Is there any future growth driver?
In Sears Holdings case, they were in a pretty similar situation to JCP. Over-stored, low cost of occupancy and an aging core customer. I believe if they had gone the same route as JCP and mortgaged all the stores early on, spent money on capex for stores and reverted to the old print and TV promotional model, results over the last several years would have been far better. The people who rail against the company and the disrepair of stores would certainly have liked to see that! But to what end? They would have put the ice cube in the refrigerator! But the desired state for Sears Holdings is emphatically not a smaller version of its former self.
Instead, Mr. Lampert recognizes big box retailing for the difficult, capital intensive business that it is and he has gone all in on transforming the business of Sears Holdings. Transformation….what a buzz word! But what does it mean in the case of Sears Holdings? It would surely be helpful if Eddie outlined what his ideal end state of the business would look like for investors and included far greater disclosure of different aspects of the business. But that is not going to happen! There is not really any motivation for Eddie to do that now.
The best we can hope to do is look at where Sears Holdings efforts are being channeled and formulate a hypothesis as to why and to what end. When Eddie merged Sears and Kmart, they were the 3rd largest revenue retailer in the country. He was bestowed a vast store network, a portfolio of Real Estate, some highly recognizable brands and millions of customers. He also inherited hundreds of millions in lease obligations, billions in pension obligations and who knows how many legacy contracts with service providers etc. Both the Sears and Kmart formats were not nearly as productive as they needed to be. And, frankly, it was unlikely that they could get there. Many of the early longs in the stock thought the answer was simple enough. Shut it down, sell the Real Estate and the Brands and have Eddie invest the proceeds! It just might be that in hindsight that was the best option! But, there was undoubtedly costs to do that in the form of lease termination, severance, pension etc. that might have left shareholders with less than they believed the NAV was at the time. And a pure liquidation has relatively finite upside.
But what if Sears Holdings could use these thousands of locations as marketing locations to convert a portion of these millions of customers to a new model? One with far better economics than department store retailing? If Sears and Kmart were stuck in these leases for a set period, why not use those points of sale (stores) to try to convert customers to do business with them in a much more profitable way?
If you look at most any broad merchandise retailer, there are aspects of their business that drive their profit. The rest of the operation is largely table stakes to keep the customer. In the case of Costco, it’s been well documented that the profits come from membership fees and their private label credit card. In the case of Best Buy, extended warranties and services are by far their most profitable businesses. Even Macy’s derives much of their profit from credit card originations and the associated revenue share. The millions of square feet, billions of inventory and hundreds of thousands of employees are extremely capital intensive ways to acquire and keep these customers. The evolution of the internet and Amazon has raised the question of how necessary all that infrastructure is. It is clear to me that Sears Holdings is attempting to retain a portion of their customer base within the higher margin, less capital intensive businesses and shed the need for massive amounts of inventory, Real Estate and labor. The pillars of that strategy appear to be credit card relationships, extended warranty and service, affiliate marketing and brand royalties. Let’s look at the economics of each a little closer.
Private Label Credit Cards
Every one of us can relate to being asked if we are interested in a store credit card upon checkout at various retailers. The store network of retailers is an extremely valuable origination network for banks. And it’s great business for retailers. In fact, Macy’s generated 39% of their 2016 operating profit from branded credit cards.^1 The economics to the retailer consist of a one-time origination fee for opening a new card and a revenue share on the profitability of that relationship over time. Most retailer cards have historically been focused on getting customers to use them at their stores only. But the model has changed some, and broader Visa and MasterCard offerings are becoming more commonplace. The Shop Your Way 5-3-2-1 MasterCard is an example of this. As is the Costco Visa. This has two advantages. The first is that the customer is more inclined to use the card more frequently in everyday life and potentially generate bigger balances (gas, groceries, etc.). And the second is the data derived from more frequent transactions is very valuable to the retailer in targeting more impactful promotions. Once active in the credit card ecosystem, there is a recurring revenue stream to the retailer and valuable data insights. It’s no wonder Sears Holdings views the SYW card as a foundational element of the transformation.
Extended Warranty
Many folks could argue whether product warranties are a good deal for consumers. Few could argue that product extended warranty is an extremely good business for the seller. Sears Holdings has a vertically integrated Service business, so its most likely more profitable for them than it is for most. The economics of the warranty business is why Sears Holdings is likely to keep a footprint of several hundred smaller stores for origination of warranties. Sears Holdings also has warranty origination distribution in a less capital intensive way through the Sears Hometown and America’s Appliance Expert model. Sears holdings agreement with Amazon creates a new distribution channel for warranty sales. Importantly, extended warranty contract premiums are much like insurance and do create float to be invested. We know little about the makeup of the reserve portfolio backing warranties at Sears Holdings. But I think few could argue that, at least conceptually, successful investment of those assets could be a value creator over time.
Affiliate Marketing
The internet has fundamentally changed the inventory levels retailers need to keep in stores. In Sears Holdings case, they neither want to carry nor can they get attractive financing on large amounts of inventory. The bread and butter of Sears business is Hardlines. But they want to be able to get their customer (member!) whatever they need. Just like they did in the old days. Enter the Shop Your Way network. The Shop Your way network is an affiliate marketing network. There are agreements with thousands of merchants where if a consumer buys something through the shop your way platform from a given merchant, that merchant pays Shop Your Way a commission for the referral. The commission levels vary from merchant to merchant and over time depending on how promotional the merchant wants to be. The best example of this is the SYW and Uber relationship. If you link your SYW account to Uber, you get $2 per ride in SYW points. Who is paying for this? Logically, if you have taken the time to link your SYW account to Uber, it is Shop Your Way who owns the relationship and it is Uber who should be paying the referral fee. The terms of each deal are private. Maybe it is not $2 a ride, but it is something.
The model of affiliate marketing that is probably most well know is Ebates. Ebates is owned by Rakuten in Japan. Rakuten’s business model is worth studying for anyone who follows Sears Holdings and interested in an example of what Eddie is trying to build. I believe it is the model he is striving for. Ebates is known for its cash back rebates. Shop Your Way is a cash back through points model. For the time being! One negative I have always perceived about Shop Your Way was that points need to be redeemed at Sears or Kmart. Then it occurred to me that if you were conducting a massive liquidation of inventory, you can give people super good deals through points promotions and potentially get something in return for it. A loyal member in your ecosystem. That logic, to me, helps partly explain the ongoing losses at Sears Holdings. They are customer acquisition costs subsidizing membership in the network. Once the stores and inventory are right sized, you can easily change the program to allow points to be redeemed with other merchants. The benefit is that you have a bunch of deferred spending by your members built up in the form of accumulated points. That’s a lot better than just conducting a liquidation sale and having nothing to show for it!
It also bears pointing out that the continued accumulation of points produces a revolving “float” of sorts. A look at Rakuten’s financials and business model will illustrate that. Without getting into too much debate about this point, we can all hopefully agree that float in the right hands is valuable.
It’s also an important distinction that Shop Your Way is part of Sears Brands LLC, which is its own legal entity. Sears Brands LLC is a non-guarantor subsidiary of Sears Holdings. Shop Your Way refers to Sears, Kmart, Uber and Citibank as clients. Sears, Kmart, Lands End, Uber and others pay Shop Your Way for participating in the program. The same way Grocers paid Blue Chip Stamps for Stamps in the 60’s. The non-guarantor subsidiaries then loan money back to Sears and Kmart to support their operating losses. You see this in the financial statements broken out by Guarantor and Non-Guarantor. But it is a loan, not a gift. The non-guarantor entities of Sears Holdings are creditors of Sears and Kmart.
We have a potential catalyst for learning a little more about Shop Your Way in 2018. Effective in 2018, FASB has issued new guidance for accounting for loyalty program points (an area where different methods are used and there has been no standard practice). This guidance will require enhanced disclosure on point programs. The standard was originally published in 2014 as “Revenue from contracts with customers” jointly by FASB and IASB.
Royalties
Frankly, there is not a lot to say here. A royalty business is a great business. To the extent that the Kenmore, Craftsman and Diehard brands can be licensed to others it is a very high margin business, high multiple business. The Stanley Black and Decker deal for Craftsman was structured in a way that certainly implies Eddie intends to be around for a while at Sears Holdings. If cash maximization was the primary objective of that sale, it would have been easier to do an outright sale of the brand with no continued royalty or carve out for Sears sales. But Mr. Lampert understands the power of Stanley Black and Decker’s distribution and elected to participate in future growth.
Other Odds and Ends
The transformation of Sears Holdings is no sure thing, but it comes with a very high payoff if successful. It depends on the SYW ecosystem garnering traction and staying power once the mega discounts run dry. But Mr. Lampert has done some things we are all aware of to de-risk his investment. He has spun off a carefully curated nationwide real estate portfolio, Seritage Growth Properties. He has spun of the Lands End brand, which can clearly exist as a stand-alone entity and was likely held back by association with Sears. And he has spun off the franchise network, Sears Hometown and Outlet Stores.
But what about all the debt? Everything in the form of hard assets left at Sears Holdings is for sale. The remaining Real Estate and inventory. It is all encumbered with debt. It has been borrowed against basically because of a timing mismatch between when it could be efficiently sold and when the money was needed. But it will all ultimately be sold and the secured debt will be repaid. If, for some reason, the proceeds of those asset sales don’t cover the debt load, the corporate structure of Sears Holdings is another layer of security. The four pillars I described above are basically all non-guarantor entities in the corporate structure. Creditors should not be reliant on those businesses for recovery, as it has been disclosed for many years what the holding company structure is. It is my opinion that the equity holders own the non-guarantor entities and great steps have been taken over many years to refute substantive consolidation in the event of bankruptcy of the Sears or Kmart legal entities. Ultimately, if it comes to that, a judge will decide.
How about the cash burn? No question it has been substantial. It can be viewed as customer acquisition costs for the future model. But it is not sustainable long term. We know Sears has taken great steps to cut costs. But the cost cutting cannot outrun the sales declines. So, when will it end? I think there has been a relatively formulaic process to store closings at Sears Holdings. If the store loses less than the rent if it went dark, it stays open to originate more credit card customers and SYW members. If it loses more than the rent, they close. This has been painful on financial results. Lease termination costs, severance, and clearance markdowns on liquidation have absolutely overwhelmed any benefits of the growth of pillars I have outlined above. But the company is 15 years removed from Kmart’s emergence from Bankruptcy. We are likely approaching a lease cliff, where large numbers of stores can be vacated penalty free (I say likely because the 0-5 year bucket in leases reported in financial statements is difficult to triangulate and has been obscured by the Seritage master lease, which has its own out for EBITDAR negative stores). It also appears steps have been taken to move most store employees to hourly and more variable cost. The pension deficit is in the process of healing from higher interest rates, strong equity markets and massive contributions. All this, coupled with the other cost initiatives the company has taken could prove to be the catalyst that stops the losses. It has been a long, painful stretch of financial results. But these types of transformations are usually seen under the protection of Bankruptcy and not in the public markets.
The last bit I’d like to address is dilution and the concept of Eddie taking control of the company via his Secured lending position in Bankruptcy. With respect to dilution, yes, it’s coming. But it doesn’t necessarily have to be a bad thing. The company is currently a ~$4.5 billion enterprise value company with the capital structure 95%+ debt. One could argue equity holders have already been diluted. I offer Sirius XM as an example. In 2009, a large debt for equity deal was done with John Malone and Liberty Media when Sirius XM was on the cusp of Bankruptcy. Existing shareholders were severely diluted. Nine years later it has been a 100 bagger from that time! Regarding Eddie taking the company in Bankruptcy, it is ESL that is the primary lender. Per the last form ADV, Eddie Lampert personally represented 16% of ESL’s capital. Eddie, personally, is the largest common shareholder. And he has been an active buyer of the equity at level much higher than current prices. I can’t see his motivation for wiping out the current equity.
There are many layers to the onion that is Sears Holdings. This piece is intended to describe what I believe Mr. Lampert is referring to when he says, “look to the right”. I’d love to give more numbers to the pillars I’ve described, but we all know that they are not fully disclosed. We do know SYW has had 23 million members redeeming points in the last 12 months, 50 million active members in the last 12 months, and $175 million in outstanding point balances.^2. We also do see the deferred revenue warranty numbers in the 10k. I won’t rehash them here.
As for what the future holds for Sears Holdings, look to the right! But you better have x-ray vision!
^1 https://www.nytimes.com/2017/05/11/business/dealbook/retailer-credit-cards-macys-losses.html
^2 https://www.youtube.com/watch?v=nGIkF6_dP-s