The chairman's letter I've been waiting for finally arrived.
I'm not talking about the one from Berkshire Hathaway Chairman Warren Buffett (although I read that, too). I refer instead to the letter from Sears Holdings' (NASDAQ:SHLD) Eddie Lampert, whom some consider the "next" Warren Buffett.
Why the anticipation? Lampert has much to teach about being a better businessman and a better investor.
Value creation 101
Mr. Lampert clearly has value creation on the brain. There are four ways to create value, so I'll briefly explain each, then point out how Lampert uses that principle to create value for himself -- he owns tons of Sears Holdings shares through his ESL Investments vehicle -- and his fellow shareholders.
Reduce the cost of financing
The least sexy method merely requires reducing a company's cost of capital, whether by issuing debt at lower interest rates or reducing the risk associated with equity capital. I don't think this is Lampert's main focus, but he's not ignoring it.
Lampert took a shot at credit ratings agencies in the letter. Given its huge cash hoard, reduced debt, and more stable operations, Lampert openly questioned why Sears Holdings' debt rating hasn't improved. An upgrade would allow the company to pay lower interest rates and reduce future costs of financing.
Increase cash flows from the assets in place
This is Lampert's No. 1 goal. Kmart and Sears weren't managed well in the past, but Lampert aims to improve the company's profitability. He's especially focused on improving "adjusted EBITDA margins."
Admittedly, I cringed when I read this. I'm not a huge fan of EBITDA (earnings before interest, taxes, depreciation, and amortization), more commonly known as "earnings before all of the bad stuff." Fortunately, this is not the company's sole focus, and Lampert also provided the amount of maintenance capital expenditures required to sustain the business. That lets me compare the company's required maintenance capital expenditures against its depreciation and amortization charges, giving me an even better measure of performance.
Last year, the adjusted EBITDA margin increased 140 basis points to 6.9%. That's no small feat. In his letter, Lampert focused on the following ways to make current improvements and sow future ones: rational capital allocation, better inventory control, innovating ways to improve customer service, and creating a culture of accountability.
Culture changes and rational capital allocation are very broad topics that can be difficult for individual investors to measure. In my opinion, customer service and inventory management are the respective levers we should observe for those metrics -- the lifeblood of retailing. Retailers must not only know what customers want, but also when they want it, how they want to buy it, and what price they're willing to pay. All the while, employees must have the freedom and flexibility to carry out these tasks in the face of continually changing customer needs. If retailers can meet these steep challenges, they should be rewarded with greater sales, margins, and inventory turnover, creating value for shareholders.
Increase the expected growth rate and lengthen the period of high growth
These two points are Lampert's future goals, the building blocks that will help Sears Holdings reach its ultimate goal of profitable long-term growth.
The financial press has criticized Lampert's "whining" regarding the incompleteness of same-store sales as a measure of a company's worth, especially since Sears Holdings' same-store sales have been declining. But in this case, Lampert's got it right; Kmart and Sears need to be stable and profitable before they can grow again. Without both of those qualities, capital allocation becomes a fruitless exercise in value destruction.
Before you condemn Lampert for the declining sales caused by closing non-performing stores and selling assets, look at how his company's profitability has changed. Sales are beginning to produce higher margins, which create better returns, which in turn attract the capital necessary to grow. Lampert clearly grasps this process.
Performance comparisons
Lampert specifically mentioned a number of Sears Holdings' competitors in the letter, including Kohl's (NYSE:KSS), Target (NYSE:TGT), Lowe's (NYSE:LOW), Home Depot (NYSE:HD), and J.C. Penney (NYSE:JCP). (Should I be surprised that Wal-Mart (NYSE:WMT) was not mentioned?) Lampert conceded that Sears' adjusted EBITDA margin still trails margins at the companies he cited. But if you don't think he's got value creation on the brain, consider this quote: "Narrowing these gaps in margins and space productivity represents a significant value-creation opportunity for Sears Holdings shareholders."
Is Sears a bargain?
To answer this question, I'll start with some relative valuation metrics. Fools, beware: These are shortcuts to valuation, not an estimate of value. Valuation requires a discounted cash flow analysis or an economic-value-added analysis. Don't make buying decisions based on metrics alone, or you'll find me on your doorstep in a lecturin' mood.
The companies above, excluding Wal-Mart, have an average EV/EBITDA multiple of 9. If Sears' sales decline 2% next year as store rationalization continues, adjusted EBITDA margin increases to 8% from 6.9%, and, for some reason, debt, cash, and shares outstanding remain constant, then the company could sell for $251 a share. That's 42% higher than Friday's closing price.
Can it happen? It all depends on whether you believe Lampert has the right value-creation strategy in place.
The Foolish bottom line
I recently wrote that I based my investment philosophy on value creation. That's why I waited with bated breath for Lampert's letter, to learn more about how he's leading his business. Ignore all of the rumors that Lampert's buying this or that. He's not simply going to give you a fish; instead, he'll teach you how to catch your own. That's why, for Foolish reading, I find Lampert's letter even better than Buffett's.
Value creation is at the core of the Motley Fool Inside Value newsletter. That's why lead analyst Philip Durell recommended Wal-Mart and Home Depot. To follow in the footsteps of greatness, try Inside Value free for 30 days.
Retail editor and Inside Value team member David Meier learned about value creation at Wake Forest. He does not own shares in any of the other companies mentioned. He is ranked 298 out of 23,710 investors in Motley Fool CAPS. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.
