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K-Mart an Albatross for Sears?

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By howardroark
March 3, 2008

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While I am not invested here, I strongly disagree with this notion. I think brands like LandsEnd, Craftsman, Sears Canada, and DieHard have quite a bit of room for expansion and rev growth. LE direct biz increased their earnings by 12%, in quite a bad year for apparel guys.

I would agree with DrWhiskey, that it may be...difficult to execute the correct strategy, but I think there is boundless room for say, DieHard or Kenmore to increase market share and profitability over time.

The captive brand expansion seems kind of interesting, some more than others. I wouldn't get too excited about Diehard as a boundless opportunity, for example. The aftermarket battery business in the US is pretty small, if I had to guess maybe $2.5b - $3b at retail. Even in a total homerun scenario where Diehard increases market share by 1000 points to around 30%, it wouldn't add enough incremental EBIT to move the needle. You'd be talking about at something like $25m in incremental EBITDA on a $2.5b EBITDA base. And unless you think Lampert is going to strong-arm AZO into replacing Duralast with Diehard altogether (you'd be wrong) or that consumers will prefer Diehard like it was Snickers versus Sam's Choice, the process seems like it might be even slower than that. Not to say it isn't a good idea, but it's unlikely to be meaningful. I would say similar things about Land's End. It's nice that they are performing well, but is Land's End really an important growth engine to the enterprise? I mean, maybe $15m-$20m in incremental EBIT for a few years, but again I don't think you're going to move the needle here.

Craftsman especially seems like it might be a different story, with more potential to really matter if it works in, say, HD and LOW and TGT and WMT. And maybe Kenmore, too, though whether Kenmore could gain substantial market share at profitable levels in this tough business without running into significant problems with Whirlpool and GE seems like a thorny question.

Often it's tough to tell exactly how much economic value is embedded in a captive brand. I hope that Sears will report its segments according to its new operating structure (five business units). It will be interesting to see whether retail is shown as profitable after overhead once you (1) Charge it for SHLD's estimate of fair market rent to its real estate division (2) Charge it estimated arms-length markup for its vertical brands (3) extract the Lands' End direct business and other online business from retail profitability.

Over 5 years, SHLD+KM has reduced Debt by $4.6 Billion according to ESL. The chart in his letter is quite illuminating in showing what other mega-retailers have done over that time frame

I thought this chart was less than illuminating. Where did the starting figure of $8.6 billion come from? I can't recreate this unless you are completely ignoring a large chunk of offsetting cash, which would be bizarre. And if we are judging major acquirers like CVS and SUPERVALU based on their preexisting debt compared to their post-acquisition debt, why does K-Mart's comparison start with combined debt of K-Mart and Sears and not the $3.5b of net cash that K-Mart actually had before the acquisition closed 2.8 years ago? Because of the technical holding-company legal structure of the acquisition? Really? Some people are way too smart to provide ridiculously provincial tables in the name of being explanatory but the spirit of being defensive. If Safeway is going to show me a chart of comp and EBITDA growth versus other retailers without mentioning Capex, at least I expected it. But not from a track star. The idea that leverage can be viewed abstractly like that -- without respect to changes in operating earnings and shares outstanding -- seemed totally anathema to Lampert's usual intensely rational discourse.

It seems like the state of the Sears Holdings story is that K-Mart is in deep trouble and Sears is still holding in. K-Mart did maybe $300m in EBITDA less Capex (guessing on capex) last year despite all the Craftsman and Diehard stuff it could eat. That comes to around $2.30 per square foot, or $3.80 in EBITDA terms, with adjusted EBIT down about 2/3 from the post bankruptcy peak. Wal-Mart's EBITDA and EBIT psft in the US (excluding Sam's) were around $37 and $29. For Target, the numbers were (ex credit card earnings) $29 and $21. Both are essentially in line with recent years' performance This allocates about $8 psf in maintenance capex to TGT and WMT versus $1.50 to K-Mart. The sales psf number come to about $425 for WMT, $300 for TGT and $125 for K-Mart.

I would imagine this is pretty close to the precipice for K-Mart, at least the informational precipice. By that I mean that despite the admirable test-and-experiment with patience and thrift management style SHLD espouses, I can't imagine that Lampert will allow K-Mart to last long at these levels of profitability if its RE is worth even a fraction of what some believe. If you really believed that K-Mart was not a highly likely bet to improve markedly from its most recent appearance as a declining business with $300m in pretax earnings power, then you'd be willing to sell the RE and leases for $10 or $15 psft (cf. Home Depot paying $150 psf for its cherry-picked locations a few year back).

My guess is that either K-Mart improves by the end of 2008 from 2007 or dramatic changes are made to the size of the chain. And by informational precipice, I meant that without operational improvement we might see significant monetization or simply find out that the some of the real is less saleable than expected.

But I don't think any of that -- the brand expansion, the ultimate value of K-Mart's Real Estate, or whether it reverses its profit decline -- are the most interesting part of the story right now, except maybe when it comes to trying to figure out your downside. Sears is what's interesting. Unlike KMRT, Sears did experience a truly miserable year in industry conditions, such as appliance and home furnishing demand. It isn't nearly the competitive disaster that K-Mart is with the radical productivity disparities (such as sales per square foot), though it isn't exactly a gem. Like K-Mart, Lampert dramatically improved Sears' profitability in the first couple of years in reasonably good times. Now it had one somewhat off -- but not catastrophic -- year amid very tough conditions. Is it possible that Sears is following a pattern similar to K-Mart where the cumulative effect of reduced spending shows up with a lag (that is, if you believe K-Mart has followed this pattern)? I mean, there is another version of the example in Lampert's letter where he explains the wealth destroying capex investment that produces no increase in profitability. It's the one where that capex investment which seems to produce no improvement actually prevented what would otherwise have been a natural decline in profitability, producing a real but disguised return on investment.

It still seems like a wide open question whether 2007 for Sears reflects the beginning of a lagged downturn stemming from a combination of Sears' existing competitive position and recent years' reinvestment rates, or a mere hiccup due to heavy inventory buying before a temporary industry downturn in an overall profitability improvement story. The questions are not nearly this academic in real life, as it's possible the future of Sears is actually determined by some well tested idea produced by a powerful culture with intelligent incentives that is wholly separate from any backward looking results. This kind of productivity Eureka could also happen at K-Mart (or at least use K-Mart's real estate), though that seems pretty unlikely at this point, at least to me. For Sears, it seems more possible but still unlikely. JCP was also possible but unlikely, as were Ames and Caldor and Bradlees before them.

If any of this sounds like another lemming criticizing Lampert in a bad year, I'm humiliated. My best guess is that the vast majority of retail executives atop KMRT post-bankruptcy would have invested enough in price and capex to produce zero free cash flow, better comps, and far less value. Even if Sears ends up in permanent decline, the same might be said for it. And I never believed that Lampert could have sold 1400 K-Mart's for $150 or even $100 psf, so I don't think you can benchmark opportunity cost from that point -- even if the retail business never turns around. The only things that seemed odd to me was the confidence that they could get to 10% EBITDA margins at retail at very low levels of reinvestment. But Lampert's smarter than me, so maybe they get there in 2010. Right now to get very excited by the downside I still believe you need a confidence level in the net real estate values for Sears and K-Mart that are not beneath the wide range of reasonable possibilities, which I don't have. But I wouldn't bet against Lampert, either.