Jan 23, 2014

Coattailing Sears Canada – $SCC


You don’t have to think of everything, you know. It was Isaac Newton who said I’ve seen a little more of the world than others because I stand on the shoulders of giants. There’s nothing wrong with standing on other people’s shoulders. – Warren Buffett


Sears Canada is an example of what Warren Buffett calls coattailing.  That is, putting other peoples ideas into your own portfolio. I came across this stock when reading the Horizon Kinetics Q4 investor letter.  You can and should read their excellent letter here but essentially – their thesis is that based on recent transactions, the company has leases that could be monetized to the tune of  ~3.00 billion. Given that the company currently has a  ~ 1.3 billion market capitalization this represents a significant asset cushion, and a potentially attractive investment.

That said, intelligent investors will want to know, what are the assumptions going into that ~3 billion of asset? Here’s what the folks at Horizon said:

“So, if the company agreed to vacate six stores for $644 million, how much might the rest be worth? The annual report provides information that the average size of the full-line department stores is a bit over 128,000 square feet. In that case, the $644 million, for those 11 stores amounts to about $450 per square foot. Now some would say, and they’re probably right, that these were among the best-located, most valuable Sears Canada stores, and that the remaining 111 full-line stores are worth far less.

Ok. Our investigations suggest that merely to construct a mall store costs well above $100 per square foot. If we assume that the remaining full-line stores are worth only that much, then 111 stores x $100/sq ft x 128,800 sq ft/store = $3.03 billion, or $29.78 per share. That was over twice the market value of Sears Canada at the time.  Nor does that calculation include the 300-plus other properties. Nor does it include the top four full floors of the Toronto Easton Centre, the premier shopping center/office tower/hotel complex in Toronto, which the company did not vacate as part of the October transaction.”

Cynics might assume that any company selling so cheap must be up to its eyeballs in debt. That’s not the case here. With about ~230 million in cash on the books,  ~700 million in net current assets, ~50 million in debt, and ~412 million in retirement obligations – the company is well capitalized.

As for the operating business, it was cash flow positive for eight years up until 2013. Now however, the business, (like most other big box retailers) is under pressure. Cash from operations over the trailing twelve months has been -33 million. These losses are not devastating to the investment thesis so long as they are constrained to the present level but it is a risk. A mitigating factor is that Sears Canada has Sears Holdings and thereby Edward Lampert as a controlling owner. Bearing in mind that a considerable portion of Mr. Lamperts net worth is invested in Sears Holdings, it seems reasonable to assume he will take steps to maximize shareholder value should the losses mount.

Other Risks

Anything times zero is zero, Buffett said. A total loss is a “zero.” No matter how small the likelihood of a total loss on any given day, if you kept betting and betting, the risk kept stacking up and multiplying. If you kept betting long enough, sooner or later, as long as a zero was not impossible, someday a zero was one hundred percent certain to show up. Long-Term, however, had not even tried to estimate the risk of a loss greater than twenty percent—much less a zero. – Alice Schroder, The Snowball

At first glance SCC seems like a homerun; a well known brand with backed by significant asset coverage and an incentivized owner-operator is probably as much as an investor could wish for. What gives me pause is that this bet has aspects, which to me, make it a derivative of the Canadian real-estate market.

As some may be aware, there has been hypothesizing of a Canadian housing bubble for some time now.  Though skeptics have largely pointed at the residential market, I feel it’s safe to assume that a credit bubble lifts more than one boat.  The most obvious and important being the commercial being real-estate market. Any decline in said market would likely have negative impact on the realizable value of the real estate assets held be SCC. In addition, a declining housing market would likely have a profound impact on an already leveraged consumer base.  Considered together, these vulnerabilities conjure the vision of a declining real-estate market and weakened consumer eroding both the asset coverage and core business at Sears.

Of course, the question is not merely whether the scenario is possible, but rather how likely? The answer is unknowable, at least to me. Nonetheless, it seems likely enough to give any investor second thoughts about about loading up on Sears Canada.

Disclosure: Long SCC