How Can TheStreet.com Publish This Story?

In a piece written by Glenn Hall, TheStreet.com published an article today entitled "Today's Outrage: Sears Isn't Worth $4 Billion." I had to check my calendar to make sure it wasn't April 1st because I can't believe the editors at a prominent site would publish this nonsense.

Here is how the article begins:

"How can Sears be worth $31.84 a share? Target fetches only $29.54, and JC Penney is down to $16.55. At the other end of the retail spectrum, investors are only paying $6.41 for Macy's, and at the low end, Family Dollar Stores are only trading at $26. Wal-Mart is one of the few higher-valued competitors, with its shares at $53. So I have to ask: Who thinks Sears is better than Target or even JC Penney for that matter?"

I would expect this from a market novice who does not understand that share prices themselves do not indicate which companies are "better" than others (the number of shares outstanding, and therefore the equity market values, are different). But from TheStreet.com? I think Jim Cramer needs to have a talk with his editors over there.

I was planning on writing about Sears today, and will still do so later, but I just had to point this out for those of you who are often a little too quick to act on something you read online. It has become very easy to reach the online masses with one's views these days, given technological advances, but as a result the quality of the content is diluted, and perhaps even more so than I thought.

Full Disclosure: Peridot was long a small position in SHLD at the time of writing, but has been selling the stock steadily over the last couple of years, for reasons which will be explained in an upcoming blog post. Positions may change at any time.

Analyzing Stock Valuations During Recessions

Now that third quarter earnings reports have largely been released, I thought I would write a bit about valuing stocks during a recession. Having seen all of the numbers and listened to all of the conference calls, I am beginning the process of going through my client accounts and making adjustments, if necessary, based on what information has come out during earnings season.

Drastic business model shifts are rare, so this analysis largely involves looking at management's execution of a company's particular strategy (are they doing what an investor would expect) coupled with valuation analysis (what price is the market assigning to the business and what assumptions are embedded in those assumptions).

Valuation analysis is a bit trickier during a recession because earnings are at depressed levels. The key is to understand that a stock price is supposed to equate to the present value of expected future cash flows in perpetuity. As a result, corporate profits for any given single year are not always indicative of value, meaning that valuations using earnings during a recession will likely underestimate a company's fair market value and vice versa during boom times.

A lot of people these days remain negative on stocks, despite the recent crash in prices, because they are assigning a low multiple to depressed earnings and are concluding that stocks aren't very cheap, when in fact, they have not been this cheap since the early 1980's. For instance, many expect earnings for the S&P 500 to dip to $60 in 2009. Market bears will assign a "bear market" P/E of 10 to those earnings and insist the S&P 500 should be at 600 (versus 865 today). More aggressive projections might use a P/E of 15 (the historical average) and conclude that the market is about fairly valued right now (15 x 60 = 900).

The problem with this analysis, of course, is that it assumes the economy is normally in a recession and a $60 earnings target for the S&P 500 is a reasonable and sustainable estimate for the future. In fact, it represents a trough level of earnings, which is not very helpful in determining the present value of all future cash flows a firm will generate, unless of course the economy never expands again.

Consider an entrepreneur who sells winter coats, gloves, and hats in an area that has normal seasonal weather patterns. If this person wanted to sell their business and a potential buyer offered a price based on the company's profits during the month of June (rather than the entire year as a whole), the offer price would be absurdly low.

Because of that, you will often hear the term "normalized" earnings power. In other words, when valuing a stock investors should focus on what the company might earn in normal times, rather than at the extremes.

Take Goldman Sachs (GS) for example. Wall Street expects GS to earn $0.28 per share in the current quarter, whereas in the same quarter last year they earned $7.01 per share. Just as one should not use a $7 per quarter run rate to determine fair value for GS (the stars were aligned perfectly for them last year), one should also not use a $0.28 per share run rate either, because today represents close to the worst of times for the company's business.

Investors need to value stocks using a reasonable estimate of normalized earnings power and apply a reasonable multiple to those earnings. With cyclical stocks, oftentimes you will see share prices trading at elevated P/E multiples during the down leg of the cycle because earnings are temporarily depressed. Investors are willing to pay a higher price for each dollar of earnings (as shown by high P/E's) because they don't expect earnings to remain at trough levels longer term.

One of the reasons stocks are so cheap today in historical terms is because many firms are trading at single digit P/E multiples based on recessionary profit levels. Buying trough earnings streams for trough valuations has always been a winning investment strategy throughout history, which is why so many long time bears are finally stepping up and starting to buy stocks again.

Take a very recent purchase of mine, Abercrombie & Fitch (ANF), as an example. The stock is trading at $16, down from $84. ANF typically trades for between 10 and 15 times earnings. They earned $5.20 per share last year but profits are expected to drop to $3.30 this year and to below $3 in 2009. The 2007 level of profitability is not what I would consider a "normalized" number, but earnings could drop 50% from the peak by 2009 (to $2.60) and that would not be normalized either.

The great thing about today's market for long term value investors is that we can buy a company like ANF for only 6 times earnings, even after taking their 2007 profits and slicing that number by 50% to account for the recession! When the economy recovers, isn't ANF going to earn more than $2.60 per share and trade at more than 6 times earnings? If one believes that, then ANF is a steal (as is any other stock that is trading at a similar price) as long as one is willing to be a long term investor and wait out the full economic cycle.

Full Disclosure: Peridot was long shares of ANF at the time of writing, but positions may change any time

Circuit City Bankruptcy Is Great News For Competitors

A week after announcing it would close 20% of its stores, electronics retailer Circuit City (CC) has announced it will file for Chapter 11 bankruptcy protection. While that really is no surprise (retailers can't operate in the red forever), investors should consider who wins from this development.

The most obvious choice is Best Buy (BBY), the leader in the space. Although CC is a weak player, there are many places where Best Buy and Circuit City locations are very close to each other. Given the store closings, plus the stigma of Chapter 11 with the stores that will remain open, BBY should see some incremental benefit. BBY trades at 8-9 times earnings, quite a low price for the best managed consumer electronics retailer.

Full Disclosure: Peridot Capital was long BBY at the time of writing, but positions may change at any time

Slightly Lower Gas Prices Do Not Spark Huge Increases in Consumer Spending

Oil is down a couple of bucks and retailers are on fire. Sears Holdings (SHLD) jumps $9 per share today? Remember everyone, rising gas prices did not result in plummeting retail sales and this subsequent drop does not mean Sears is all of the sudden going to see an influx of shoppers or its average ticket rise meaningfully.

These small incremental changes in the price per gallon does not materially change behavior. If national gas prices drop from the peak around $4.10 per gallon to, let's say, $3.50, how much does the average consumer save? Well, let's say you fill up once a week and have an 16 gallon tank. We are talking about less than $10 per week, or about $500 per year.

Now, I am not saying that extra $500 does not have an economic impact, because it definitely does. That said, it will not translate into incremental earnings at the retail level that would justify a 5%-10% jump in share prices of the nation's leading retailers. As much as I would love to say otherwise, Sears should not be up $9 in today's market.

Full Disclosure: Long shares of Sears at the time of writing

Sears Needs To Do More

A couple people have asked about Sears, including a comment on my last post, so I decided to copy my reply here for all to view:

"As for Sears. my last comment was after they decided to split the management of the company into a holding company structure. My take home message was that such a move would hopefully allow for faster decision making and unlocking some shareholder value, but we would have to wait and see if that actually was the result.

Since then, very little has changed. The retail environment remains very weak and yet the company has made no meaningful moves to unlock value or diversify its business. They just keep buying back stock, which is fine with me, but more needs to be done with the core business.

I have not been adding shares of SHLD and in some cases have actually been cutting back the position. With the weak retail market, stocks like TGT have gotten cheap enough that new money might be better served going there until SHLD shows signs they really are more than just a sub-par retailer.

Until they show some life in that regard, I likely will not become more bullish on the stock. There is value there, but if management does not unlock it adequately, Wall Street won't take notice."

Full Disclosure: Long shares of SHLD (just in less quantity than previously) at the time of writing

Blockbuster Bid for Circuit City Makes Little Sense

The Wachovia (WB) news is garnering all the headlines today, but an interesting story is developing in the retail space; Blockbuster (BBI) is making a bid for Circuit City (CC) and taking the offer directly to shareholders after CC ignored the video rental giant's repeated attempts to negotiate a deal.

A couple of different reasons come to mind as to why this deal is a bad idea. First, we have too many retailers in this country, which is why so many of them are marginally profitable, if profitable at all. The credit bubble we have experienced in recent years has led to more retail stores than can be supported in a typical economic environment. These excesses can only be corrected by bad retailers going away.

We have already started to see bankruptcies in the retail space (Sharper Image, Bombay, etc), which is a good thing. Blockbuster and Circuit City have thousands of poor performing locations. The solution to make these companies more stable financially is to shrink them, not keep them open. However, a merger proposal is a clear sign that Blockbuster thinks the synergies from a deal (if there are any, which is debatable) would slow the progress of their eventual demise, which is doubtful.

Secondly, why should we have any confidence that Blockbuster and Circuit City would do any better together than apart? There is no evidence that either retailer has any idea what they are doing. As a result, there can be little confidence from shareholders that either party would be successful in combining the two firms and seeing any benefit from such a move.

All in all, it is certainly a positive development that Blockbuster feels it needs to do something to improve its competitive position, but a deal with Circuit City likely isn't a very viable solution.

Full Disclosure: No positions in the companies mentioned

Are All Consumers in the Same Boat?

Last weekend I attended some festivities for a friend's birthday that included dinner at the Landmark Buffet at the Ameristar Casino and Hotel (ASCA) in St. Charles, Missouri. Along with spending some time with good friends, I was also especially interested to see how busy the casino was on a Friday night. If you simply looked at the stock prices of the major casino companies in the United States, you would have predicted the place would be empty. Gaming stocks have been crushed lately on consumer spending worries. ASCA stock, for example, is down about 45%, from a high of $38 to the current quote of $21 per share.

Such large drops are fairly surprising given that gaming stocks are widely believed to be fairly recession-proof. Rather than take lavish vacations, or even hop on a plane heading to Vegas, people tend to scale back and just drive to a local riverboat casino instead. Despite the typical feeling that gaming holds up okay in recession, the casino stocks this time around have really taken it on the chin, so investors are clearly betting that this time is different.

Surprisingly, the Ameristar Casino was as crowded last Friday as I have ever seen it. At the buffet, for example, people are still standing in line for at least an hour for a $21.99 crab leg, steak, and shrimp dinner. After seeing such a large crowd, I came to the conclusion that the health of the consumer likely depends largely on where the person lives. Here in the Midwest, the housing market downturn has been less severe because it never really got crazy to start with. Compared with hot areas like California, Nevada, Arizona, and Florida, states like Missouri had much more subdued housing speculation.

The result of that is that things aren't that bad here. You don't hear about huge numbers of foreclosures or see evidence that the consumer is largely tapped out. The main problem here with respect to housing is simply a supply-demand imbalance. There is still a decent amount of building going on, in the face of high levels of for-sale signs out already, so houses aren't selling. However, people are simply sitting on them, reluctant to lower prices to motivate buyers, much like other places across the country. But without extreme speculative activity, the negative impact on consumer spending does not appear to be as drastic as other places across the nation.

How can we make investment decisions based on this? Well, my opinion is that many consumer related stocks have been beaten down way too much. Companies focused on the roughest housing markets will likely see the brunt of the negative impact. Other areas such as the Midwest will likely hold up well on a relative basis. For a company like Ameristar, which owns properties in Missouri, Nebraska, and Mississippi, things might wind up being okay.

Additionally, the upscale consumer sector should still do relatively well. Sure, things will slow down, but the high end of the market will drop off less than the lower end, and likely will rebound faster once things turn around. After all, rich people probably aren't scaling back too much due to elevated inflation levels.

One other area I think is poised to hold up well is the restaurant sector. Wall Street is bracing for people to stop eating out during the current economic downturn, but I would argue that eating out is due more to a secular shift in behavior than a bi-product of easy credit. People nowadays work longer hours than they used to and have less time to make dinner every night. I'm not saying dining spending won't drop when things get tough, but I think if you look at the hits the stocks have taken and what that implies about business expectations, things won't be nearly as bad as investors are pricing into the stock prices of restaurant chains.

All in all, I think investors should differentiate between the varying degrees of consumer stocks. A lower end company operating in California or Florida is going to fare differently than a high end company in the Midwest. A Vegas casino might not do as well as one based in St. Charles, MO in uncertain economic times. Traffic declines at a clothing retailer will likely be more dramatic than at a restaurant chain, if indeed eating out is a decision made for convenience more than monetary reasons. A new wardrobe is much easier to postpone than making time to prepare dinner at home.

As we allocate money to the consumer discretionary sector, it might serve us well to think about these things.

Full Disclosure: No position in ASCA at the time of writing

Sears to Split Up Businesses, Adopt Holding Company Structure

Sears Holdings (SHLD) Chairman Eddie Lampert has decided to move the company one step closer to a Berkshire Hathaway model, according to a story by the Wall Street Journal yesterday. The new holding company structure will split up Sears into as many as three dozen separate businesses, each with its own operating executive. The move is seen as an admittance that the current structure was not working to boost the company's retailing operations, and therefore focusing on each aspect of the company's assets individually will allow for greater control and change. This is similar to the Buffett model, where he has someone running each business and has little say in day-to-day decision making.

Many followers of Lampert have been saying that his plan all along was to emulate Berkshire Hathaway, but initial moves after the Sears/Kmart merger were more focused on cost cutting (which has been successful) and introducing brands like Lands End, Kenmore, and Craftsman into both Sears and Kmart stores (which has done little to stop same store sales declines).

Separating Sears into various business units, each with an experienced executive, makes a lot of sense in terms of ultimately getting Sears to diversify its profit base, rather than simply relying on retail operations in this difficult economic environment. Possible business groupings (the plan has not been publicly announced) could include real estate management (bulls on the stock will be happy about that one), all of the company's individual brands, individual business lines, and the online divisions. That way, rather than just throwing every product they own into Sears and Kmart locations, they could strike distribution deals with other retailers for Lands End, Kenmore, Craftsman, and Diehard products, in addition to possibly opening smaller stores for each business line (Lands End clothing might not sell well in Kmart, but it might do very well in its own branded store, for instance).

This overhaul was probably a bit overdue, but I can understand Lampert not wanting to hurry into revamping the $50 billion company. However, given the retailing environment right now, he obviously could not afford to wait too much longer to make inevitable changes. This reorganization itself, although positive on its face, does not mean Sears is out of the woods. I don't expect a huge upward move overnight.

This is because while a reorganization is nice, shareholders will need to see results before the stock rebounds meaningfully. Does the real estate management group do anything to monetize the real estate holdings? Do the individual brands outline a licensing, distribution, or expansion strategy and show progress? Are meaningful changes going to result from this new holding company structure? It is one thing to move people around (anybody can do that) but unless successful changes result from it, shareholders won't be any better off.

Bulls on the stock, myself included, have long expected that Lampert would use a holding company structure to maximize the value of the company's wide array (and often under appreciated) assets. After all, why would Lampert have named the company Sears Holdings? The speed of these changes has been less than I and many others had hoped for, but since Lampert owns 50% of this company (worth $6 billion), he has the incentive to make bold changes now that the stock has taken a huge hit. As you can see from the chart above, things were working well for a while, but now that the low hanging fruit has been picked, it is good to see he is willing to shake things up. Hopefully it produces positive results.

Full Disclosure: Long shares of Sears Holdings at the time of writing

The Consumer is Far From Dead...

If you believe Best Buy to be a good proxy for retail:

Best Buy 3Q Profit Rises, Boosts Outlook

Tuesday December 18, 9:03 am ET

Best Buy Earnings Rise 52 Pct in 3Q on Sales of Flat-Panel TVs, Boosts Full-Year Outlook

MINNEAPOLIS (AP) -- Best Buy Co., the nation's biggest consumer electronics retailer, said Tuesday its third-quarter profit jumped 52 percent, boosted by holiday shopping and sales of higher-ticket items such as flat-panel TVs.

The results beat Wall Street expectations and the company boosted its outlook for the year.

Its shares rose more than 2 percent in pre-market trading.

Profit for the quarter ended Dec. 1 rose to $228 million, or 53 cents per share, from $150 million, or 31 cents per share in the prior-year period.

Revenue rose 17 percent to $9.93 billion, from $8.47 billion last year.

Analysts polled by Thomson Financial predicted a profit of 41 cents per share on revenue of $9.44 billion. The earnings estimates typically exclude one-time items.

Same-store sales rose 6.7 percent, helped by higher average selling price and a calendar shift that added an extra week of holiday shopping to the quarter. Same-store sales, or sales at stores open at least fourteen months, is a key indicator of retail performance since it measures growth at existing stores rather than newly opened ones.

Results were helped by a shift toward higher-ticket items such as video-game consoles, notebook computers, flat-panel TVs and GPS devices.

The company boosted its fiscal 2008 earnings outlook to between $3.10 and $3.20 per share, from a previous range of $3 to $3.15 per share. The company expects revenue of about $40 billion for the year.

Lampert, Sears Make Play for Restoration Hardware

Just days after I wrote about the focus at Sears (SHLD) being store redesigns, not non-core asset sales, we get a timely SEC filing from the company announcing its interest in bidding for home furnishings retailer Restoration Hardware (RSTO). The comments from Sears are very interesting. Chairman Eddie Lampert has been eyeing the company since June, and this month alone has increased his stake by 3.4 million shares, bringing SHLD's total ownership to 5.3 million shares, or 14%.

In case you didn't read the filing, here is what we know. Lampert indicated his interest in acquiring or partnering with RSTO in June, but he did not meet with management to discuss a deal until October. At that point he offered $4.00 per share for RSTO, which was 40% above where the stock was trading. RSTO indicated that price was too low, but Lampert insisted on conducting due diligence before raising his bid.

On November 8th, RSTO announced a management led buyout (along with private equity firm Catterton Partners) in a deal worth $6.70 per share in cash. However, RSTO stated publicly that it will consider other offers until December 13th, and that it plans to actively solicit such alternative deals during that time. Lampert appears eager to sign a confidentiality agreement in order to look under the hood and perhaps make a revised offer.

Obviously, a lot is going on here. The market's reaction has been largely negative, but it appears that is mainly based on the short term retail environment being bad for home furnishings. Lampert is clearly not concerned with how well RSTO will do in Q4 or 2008. He is likely looking long term, trying to come up with ways to strengthen the product and profitability of Sears merchandise in a more normal retail environment.

So what is the rationale for an interest in RSTO? To me, it's not that complicated. Lampert has said repeatedly since he took over Kmart, and subsequently bought Sears, that his first priority was not growing the company, but increasing profits. Retail experts and many investors have complained about lack of store growth and negative same store sales growth, but they are missing Lampert's point.

See, Lampert doesn't think the problem is lack of sales or not enough customers. Sears has thousands of stores and more than $50 billion in annual revenue. The problem is, despite such a strong retail presence, the company makes very little money. In his mind, he can do one of two things. One, open more stores that hardly turn a profit, or two, maximize profits from the existing store base and then figure out how best to grow the business. Not surprisingly, he prefers the latter because he is an investor in the business. Remember, long term stock prices are dictated by profits, not sales.

How would RSTO fit into this model? First, Lampert is buying a cheap retailer during a time when home furnishing sales are weak, so he has upside with the current strore base (100 plus locations). More importantly, he can add better merchandise to thousands of his existing stores. Not only could those products potentially sell better than the ones they have now (RSTO's product is a very high quality), but they are far more profitable because Sears would own the suppler.

Lampert seems to be focused on building store redesigns around promoting certain well known brands, many of which Sears actually owns (think Kenmore, Land's End, etc). If the goal is to maximize profits, this model makes the most sense. Consumers have multiple avenues to purchase company-owned products. You can buy Land's End clothing through the catalog or in Sears stores. There is tremendous potential to boost sales and have the cost structure lower at the same time. The same could be done with Restoration Hardware.

So, although the reaction to this news has hardly been positive, I think that is simply because people don't believe in Lampert's strategy. However, if you are investing in Sears alongside him, you have to be pleased that he has done exactly what he said he would do. Either investors want in to the plan, or they don't. That's what makes a market.

Whether or not the plan works remains to be seen, but Lampert's track record to date has been pretty impressive. Although the stock is down significantly from its highs, along with all other retail stocks, investors need to keep in mind it was $15 per share when he started this whole retail endeavor. As for the most recengt news, we should know the fate of RSTO shortly, as the company has about three more weeks to field competing offers.

For those who were wondering if Lampert was up to anything on the acquisition front, it was very interesting to learn that he has been eyeing RSTO since June. Not only that, but he likely first bought shares back then at prices below $3, versus the $7 price tag today (the SEC filing noted that SHLD has owned 1.9 million shares for longer than 60 days). That kind of return is exactly the type of thing Lampert fans have been hoping for and RSTO might just be the beginning.

Full Disclosure: Long shares of Sears Holdings at the time of writing