Five Years Later Sears Finally Licenses One of Its Brands

Long time readers of my blog know that for several years I was a long term investor in Kmart and then Sears Holdings, which was formed after Eddie Lampert orchestrated Kmart’s merger with Sears in early 2005. The bullish reasoning behind the deal, which was largely postulated in the financial media and analyst community given that Lampert keeps his plans close to the vest, was that although Kmart and Sears were eroding brands within the retail sector, they produced strong cash flows which could be harnessed to create shareholder value in ways other than building additional Kmart or Sears locations.

Given his distaste for throwing good money after bad, it was widely thought Lampert would be quick to close money-losing stores, sell the real estate or lease them out to others, push to sell the exclusive Sears brands (Kenmore, Craftsman, DieHard) in other retailing channels, buy back stock, reduce debt, and use excess cash flow to diversify the company into other businesses. Such a holding company structure would be more viable longer term, modeled partly after the model Warren Buffett has perfected within Berkshire Hathaway over many decades. Given that Lampert renamed the Kmart/Sears combination Sears Holdings and repeatedly stressed in his shareholder letters the importance of avoiding unprofitable growth simply for the sake of growing, such a strategy, although not spelled out completely by management, was hardly an outlandish basis for investment.

That was five years ago. Kmart stock was trading at $101 when the Sears merger was announced. Today, despite a share count far lower, the stock fetches only about $90 per share. I have long since given up on Sears as a long term investment after several years of waiting resulted in very little effort on Lampert’s part to truly diversify Sears Holdings. The company has closed dozens of stores, but given their base of nearly 3,500, the closings have not been significant, and many money-losing stores remain open. Real estate sales have been minimal as well.

Rather than buy other businesses or attempt to sell its own brands through other retailers (putting large Craftsman tool sections in Kmart stores was a half-hearted effort on this front), Lampert has been content with paying down debt and buying back enormous amounts of stock. These two value creation techniques are undoubtedly strong uses of excess capital, but their effectiveness is not maximized unless the overall business is, at the very least, stable. However, revenue has fallen every year since the formation of Sears Holdings, from $55 billion a year at the time of the deal to $43 billion annually today. As a result, while the share count has been reduced from 165 million to 125 million (admittedly an impressive 24% decline), earnings per share have fallen off dramatically as declining sales eat into profits (retailing is a very high fixed cost business).

Imagine my surprise then, when on Thursday February 11th, nearly five years after the Kmart/Sears merger closed, Sears Holdings announced that it had reached a licensing agreement to expand distribution of its Diehard brand of automobile batteries and other products into more retailing outlets. It only took five years!

I was certainly interested (at least mildly as a passive observer now) in this sudden shift in strategy, at least until I read the corporate press release announcing the deal. Why the muted excitement? Well, Sears has not signed on any retailers to sell DieHard products, rather they have signed a licensing deal with their own DieHard manufacturer, Schumacher Electric, to distribute them. No wonder I neither have ever heard of Schumacher Electric nor get excited when reading about this licensing deal with them.

While I would never expect a company in Sears’ position to publicly predict how much money a deal like this might bring into the company’s coffers in coming years, I cannot help but be surprised that this is the best they could do after five years. Maybe this deal does actually produce significant incremental cash flow going forward for the company, but I have to think that a deal to sell DieHard products in, say, Target stores nationwide would generate a lot more buzz and investor interest.

While it is good to see Sears Holdings finally making some promising moves to create long term shareholder value, that it took so long for a deal like this to get done, coupled with the fact that it is only with their manufacturer so far and not an actual retailer, is hardly reason to think the lofty goals many investors had for this company will actually come to fruition.

Full Disclosure: No position in Sears Holdings at the time of writing, but positions may change at any time

Steak n Shake Company Quietly Shifting to Berkshire Hathaway Business Model

The Steak n Shake Company (SNS), an operator of 485 burger and shake focused casual dining restaurants in 21 states, has recently been quietly transformed by a new management team into a small Berkshire Hathaway type holding company. The move is very Warren Buffett-esque, with a 1-for-20 reverse stock split aimed at boosting the share price to well above normal levels (above $300 currently) and a bid to buy an insurance company among the noteworthy actions taken thus far.

What I find almost as interesting as the moves made by new CEO Sardar Biglari (a former hedge fund manager who has gained control of the firm and inserted himself into the top management slot) is the fact that this move has largely gone unnoticed by the financial media. Granted, Steak n Shake is a small cap regional restaurant chain ($450 million equity value) but the exact same strategy undertaken by Sears Holdings chairman Eddie Lampert garnered huge amounts of press.

Clearly Sears and Kmart are larger, more well known U.S. brands, but there seems to be a lot of interest from investors for any company trying to mimic the holding company business model that Buffett has perfected for decades. As a result, I would have thought Steak n Shake would have gotten some more attention.

Essentially, Biglari is using similar methods Lampert used when he took control of Kmart and later purchased Sears. Steak n Shake has dramatically cut costs, reduced capital expenditures, and will add to its store base going forward solely via franchising new locations, rather than building them with shareholder capital. The results have been impressive so far. During 2009, the first full year under new management, Steak n Shake's free cash flow soared from negative $20 million to positive $31 million.

Biglari has made it clear that he plans to deploy the company's capital into the best investment opportunities going forward, and that likely does not include heavy investments into the core Steak n Shake business. He has announced plans to rename the company Biglari Holdings (an odd choice if you ask me) and recently offered to acquire a property and casualty insurance company (the Warren Buffett comparison is worth noting here) but was rebuffed by Fremont Michigan InsuraCorp.

In the short term, Biglari and his fellow shareholders have reaped the benefits of his shift from a capital intensive negative free cash flow restaurant business to a more lean and efficient holding company. The stock has more than doubled from the $144 price ($7.20 pre-split) it fetched on the day Biglari took over.

The larger question remains how well this young former hedge fund manager can further deploy Steak n Shake's operating profits in the future. At more than $300 per share, the stock trades for 1.6 times tangible book value of around $196, versus about 1.9 times for Berkshire Hathaway.

In my view, any price over 1.5 times tangible book value for an unproven concept and management team is too much to pay. However, given the results thus far it should come as no surprise that investors are willing to shell out more for the stock than they were previously, despite a lot of uncertainty over Steak n Shake's future. Count me as one who will be interested in monitoring the situation going forward but would only take a flier on Biglari if the price to do so got cheaper.

Full Disclosure: No position in Steak n Shake at the time of writing, but positions may change at any time

Apple iPad is Nice, Probably Not a Game Changer Yet

After seeing Apple's unveiling of the new iPad tablet yesterday my overall conclusion is that the product is very solid and will probably find a niche with certain users, but it hardly seems to be the game changer for old media that many had hoped for.

Essentially the iPad is a thin, light-weight, extremely mobile device that can be described as a supersized iPhone or a thin netbook computer. You can surf the web, check email, play iTunes, and download iPhone-like apps customized for the device.

The real issue I see is that the iPad is not all that different than a netbook or iPhone, other than its physical design. The only unique feature of the iPad seems to be a new e-book store. In addition to buying songs, movies, and television shows from iTunes you will be able to buy e-books from an e-book store, modeled after the iPhone app store and the iTunes media store. Think thin netbook combined with an Amazon Kindle.

The clear loser here is Amazon, whose Kindle overnight gets a strong competitor. The clear winners were supposed to be the content publishers, including magazine and newspaper companies, not just book publishers. On that end, I think the expanded distribution of e-books will be good for those publishers, but the gains for newspapers and magazines is less apparent.

The problem those publishers face today is that most are giving away their content on the web and the advertising revenue they earn from web visitors pales in comparison to the subscription revenue they used to collect. Some have been able to charge for web content (Wall Street Journal) and others are starting to put pay walls on their sites (New York Times) but with so many free news sources on the web, it will be hard for most publishers to convince consumers to pay a monthly fee for their content.

I am not convinced the iPad solves this problem. The content companies will build apps for the iPad, just as they did for the iPhone, but the core issue is the same; will people pay for the content when there are other free options? If the answer is yes, then the publishers will get stronger going forward. If not, nothing will change.

If you put your content on the iPad for free, that is no different than the free web site people are using to access your content. If people are not willing to pay to use your web site today, why would they be willing to pay for an iPhone or iPad app with the same content?

Even after seeing the iPad in action, I think the content game is unchanged. If you truly have valuable content that is unique and in strong demand (Wall Street Journal), you can make good money with online content. If not, people will simply go to free news sites and your profits will evaporate as subscription revenue continues to decline.

Where does this leave Apple stock? They will likely sell a good number of iPads going forward so the product is certainly an incremental positive for the company and the stock. Believe it or not, the shares have been treading water for a while now, and therefore are not overly expensive. At $207 per share Apple sports a P/E ratio of about 18x based on $11-$12 of earnings power this year. Add in the $27 per share ($25 billion) of cash that is wasting away on their balance sheet and you can see that the stock is not super-cheap but is not overly expensive by any means.

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

Glass-Steagal Act Should Not Be Core of Financial Regulatory Reform

There has been a lot of talk lately about the repeal of Glass-Steagal in the 1990's and the potential that such a move contributed greatly to the financial crisis. Glass-Steagal, originally passed in 1933, had many parts to it but it is most widely known to have disallowed commercial banks that gathered customer deposits and gave out loans from also being investment banks that would underwrite securities and trade for their own account.

The logic of Glass-Steagal makes sense; banks should not use depositor or government capital to fund internal hedge funds. Should the enormous risks the trading desks take turn sour, it puts customers' deposits in jeopardy and reduces the amount of lending the firm can do. Not to mention the fact that cheap government funding is given to banks to boost lending and the economy, not to generate trading profits for the firm's partners.

Despite the soundness of the law, those who maintain that the repeal of Glass-Steagal was a leading contributor to the financial crisis are off base. Why? Because most of the casualties of the financial crisis were not banks at the time. Off the top of my head I can name AIG, Fannie Mae, Freddie Mac, Lehman Brothers, Bear Stearns, and Merrill Lynch.

None of those firms were commercial banks but they lost the most money. Those losses came from poor mortgage underwriting, poor insurance underwriting, and extreme leverage ratios of up to 40-to-1. More effective government regulation surely could have helped prevent such monumental downfalls (minimum underwriting standards and leverage limits to name a couple), but a combination business model of commercial and investment banking was not the culprit by any stretch of the imagination.

Now there were commercial banks that failed or nearly did during the recent crisis. Wachovia and Citigroup are the two big ones. But again, Glass-Steagal would not have prevented this. Citigroup was hampered by its leverage and significant holdings in mortgage backed securities, CDOs, and SIVs. Wachovia failed after it acquired a California-based mortgage lender that pioneered interest-only, pick-a-payment, and option ARM mortgage products. Such poor, undocumented, mortgage underwriting doomed them from the start, not investment banking (Wachovia did little, if any).

I am all for better regulation of the financial services sector, but many of the ideas floating around do not really address the core issues the industry faces. Not only that, existing regulators and laws easily allow for better regulation, without further changes, even though modern products such as credit default swaps and futures contracts clearly need to be regulated going forward.

Market Is Pricing In 35% Profit Growth in 2010

A theme of mine in recent weeks, as well as for 2010, is that the stock market has risen 70% from the March lows and has begun to price in the current consensus forecast of $75 in S&P 500 earnings, which would be a 35% increase from 2009. As a result, I think the Wall Street strategist consensus of a 10 -15% market gain this year seems overly optimistic. It is far more likely that earnings come in below $75 than above that level.. not a good risk-reward trade off.

Last evening we got the first big earnings report from the fourth quarter (Intel), they blew away the numbers (40 cents vs 30 cent estimate) and the stock is down this morning. JPM reported a decent number this morning (beat on earnings, light on sales) and it is down too. Whenever you see stocks not go up on good news, it is typically a clear sign that the markets have priced in the good news.

Despite a cautious market outlook short term, there are still good investments out there. I will share a couple in coming weeks to halt the post-holiday lull in postings on this site.