Finding Value in This Recent Spinoff

On April 4, the spinoff of Lands' End (NASDAQ: LE  )  from Sears Holdings Corporation (NASDAQ: SHLD  ) was consummated, continuing Eddie Lampert's strategy to divest Sears Holdings and unlock value for shareholders. Foolish investors should dig deeper into this special situation, as it may have huge upside potential.

Spinoff
Sears Holdings spun off Lands' End, a retailer of casual clothing, accessories and footwear, as part of a multi-year strategy to narrow the focus of it's operations. Sears' stockholders were given approximately three shares of the new Lands' End for every ten shares held.

Sears has completed several spinoffs in recent years, includingOrchard Supply Hardware, 44% of Sears Canada, and Sears Hometown/Outlet Stores, with the latter creating a permanent buyer of Kenmore and Craftsman products. Why has Sears been divesting so many assets?

Real estate and breakup value
Sears CEO and majority shareholder Eddie Lampert has been on a mission to unlock value in the struggling business, as he believes the market is pricing the stock improperly. His thesis is that the market is overly focused on recent earnings, and missing the value of the company's assets, especially the real estate. This can be explained because property and equipment is recorded on the books at cost minus depreciation. For property that was acquired years ago, it is likely that true value differs substantially from its historical cost.

According to a value-focused hedge fund, the real estate portfolio is conservatively worth over $8.6 billion, with $7.3 billion of value in the top 350 owned and 50 leased locations. Whats more is that the company can redevelop the locations by sub-dividing or releasing, which could increase the value to over $12 billion. This value was approximated by a property-to-property appraisal from 3rd party real estate consultants. Furthermore, real estate is only part of Sears.

Source: Baker Street Capital

The breakup value for the above assets are estimated at $85, $122, and $158 per share for worst, average, and best case scenarios, respectively. It appears that Mr. Lampert is spinning off Lands' End to capture some of this value.

Lands' End potential
Lands End' was purchased by Sears in 2002 for $1.2 billion and generated approximately $1.6 billion in sales last year. Revenue is made from Direct sales (Internet/catalog) and Retail stores. Last year, sales through the Internet/catalog were 83% of the company's total sales, while retail sales accounted for 17%. With the majority of sales unrelated to Sears, it was a natural spinoff candidate.

What makes Lands' End a special situation is that it's sales have fallen recently while it's administrative and selling expenses have remained high. Selling and administrative costs for direct sales alone were approximately $437 million.

 

2010

2011

2012

2013

Sales

$1.655 billion

$1.725 billion

$1.585 billion

$1.562 billion

Selling & Admin Cost

n/a

$621 million

$498 million

$560 million

Net income

$121 million

$76 million

$49 million

$78 million

Source: Lands' End 10-K

I speculate that Lands' End will be able to get back to sales levels it had in 2011, especially as Lands' End taps into Shop Your Way members, which is one of the largest membership rewards programs around, with approximately 70% of Sears and Kmart sales running through the program. Furthermore, since Lands' End is now a separate entity, it may seek other avenues to generate sales.

Selling and administrative expenses are comprised of payroll for direct, retail, and corporate employees, advertising, occupancy of retail stores and corporate facilities. Prior to the spinoff, expenses allocated to Lands' End Shops by Sears were $68.4 million, $75.4 million and $80.4 million in 2013, 2012 and 2011, respectively. Now that the spinoff is complete, selling and administrative costs allocated from Sears will likely decrease.

 

2009

2010

2011

2012

2013

Diluted EPS

$4.02

$3.79

$2.39

$1.56

$2.47

Price

$26

$26

$26

$26

$26

P/E

6.46

6.86

10.88

16.67

10.53

If Land's End is able to revamp its sales and decrease its expenses, it will likely meet, if not beat, EPS levels from previous years. In the depths of the recession in 2009, the company had an EPS of $4.00, which is approximately 60% higher than its EPS in 2013. With the spinoff now consummated, management has a tighter focus and is directly rewarded for Land's End's success.

Foolish Takeaway
The spinoff of Lands' End should create value for both Sears and Lands' End shareholders. As Mr. Lampert continues his strategy to unlock value from Sear's assortment of assets, the market should focus less on the poor earnings performance in recent years and more on its breakup value. Foolish investors interested in special situations should dig deeper into Lands' End, as it may achieve EPS that is similar to the recession years.

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