Last week, Sears Holdings (SHLD +0.00%) released one of its dreaded financial updates. Not surprisingly, the news was ugly. Sears narrowed its loss relative to the prior-year period, but the company still lost a ton of money, while revenue plunged by more than a quarter.
As always, Sears Holdings' management tried to put a positive spin on things, highlighting the smaller loss and a variety of efforts to free up cash. However, investors weren't buying it. Sears Holdings stock fell 6% on Wednesday and has lost about half of its value year to date. Shares of Seritage Growth Properties (SRG 1.34%) -- a Sears real estate spinoff that rents most of its space back to Sears Holdings -- also lost ground on Wednesday.
Sears Holdings Year-to-Date Stock Performance, data by YCharts.
Even though Sears Holdings has reduced its losses for two consecutive quarters, investors should stay away. At this point, bankruptcy seems to be a question of when, not if. On the other hand, the recent dip in Seritage stock makes it a potentially attractive pick for value investors.
Another awful quarter
For the past few years, the third quarter has always been rough for Sears Holdings. This year was no exception. Comparable store sales fell by a staggering 15.3% last quarter, consisting of a 13% drop at Kmart and a 17% plunge at Sears. The closure of money-losing pharmacies at certain Kmart stores and a planned reduction in consumer electronics sales caused part of the decline. But even without those factors, comp sales would have fallen by 13.6%.
Total revenue plummeted to about $3.7 billion in the third quarter from $5.0 billion a year earlier. While Sears Holdings has been closing stores at a phenomenal rate over the past year, it's clear that customers are abandoning Sears and Kmart even faster.
The company also projects that adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) will come in between a $250 million and $300 million loss for the quarter. That's an improvement over Q3 2016, when adjusted EBITDA was negative-$375 million, but it's still a dreadful result, especially when you consider that adjusted EBITDA excludes a lot of expenses.
Bailing out a sinking ship
Meanwhile, Sears' liquidity position is becoming more desperate. At the end of Q3, it had only $200 million of unrestricted cash, plus $39 million available to borrow from its credit facility and $99 million from its general debt basket. By contrast, it had $258 million of unrestricted cash and $174 million available from its credit facility at the same time last year.
Sears Holdings was running low on cash as of late October. Image source: Sears Holdings.
To address these liquidity issues, Sears is going back to a tried and true technique: selling off real estate. The company's asset sales generated cash proceeds of more than $270 million during Q3 and another $167 million since the end of the quarter.
Sears Holdings is also paving the way for more real estate sales in the future. It has reached an agreement with the Pension Benefit Guaranty Corporation to release 140 stores that the latter has been holding as collateral. Sears will be able to sell that real estate in return for contributing a total of $464 million to its pension plans between now and the middle of 2018.
The proceeds from selling these properties will help Sears Holdings fund some of its likely 2018 operating losses. However, the company is running out of real estate, and it could still have trouble refinancing debt that comes due next year or paying for 2018 holiday-season inventory. Sears may have bought itself a little bit more time, but not much.
Good news and bad news for Seritage
Sears Holdings' deepening woes might seem like a big blow to Seritage Growth Properties. After all, Seritage leases 80% of its space to Sears and Kmart.
The truth is a little more complicated. First, Seritage is steadily diversifying its tenant mix. Its master lease with Sears Holdings allows it to recapture space from the Sears and Kmart stores in its portfolio while also giving Sears the right to terminate leases for an upfront payment. The net result of this activity since mid-2015 is that third-party leases (including signed leases that haven't become effective yet) now account for more than 45% of Seritage's annual rent.
To be sure, Seritage is still dependent on Sears Holdings for the bulk of its cash flow. However, most of the redevelopment projects currently underway will be finished by the end of 2018, increasing the proportion of Seritage's cash flow that comes from other tenants.
In addition, Seritage has recently sold joint-venture interests in some properties to mall owners. These moves are raising cash to help fund the redevelopment of other assets. If Sears Holdings were to go bust in the next year or two, Seritage could sell off further properties to tide it over until it completes more redevelopment projects. It could also form additional joint ventures so that it doesn't have to shoulder the full burden of finding replacement tenants for Sears.
In the long run, Seritage could actually benefit if Sears goes out of business. On average, its new tenants pay more than four times as much per square foot as the Sears and Kmart stores they replace. However, Seritage only has contractual rights to recapture about half of the space occupied by Sears Holdings within its portfolio.
The demise of Sears could pave the way for Seritage to eventually lease its entire portfolio at the higher rents associated with new tenants. Thus, Sears' plight could lead to some short-term pain but big long-term gains for Seritage Growth Properties.
