Circle of Competence

Last week, I argued why Eddie Lampert’s current strategy for investing Sears’ capital was rational. This week, I’d like to write a little about why the future is bright as well.

With all the nonsense media hullabaloo over Sears’ awful fiscal first quarter, I thought it might be nice to put the whole situation in context. While the media is talking about how Sears is “ugly,” the company “might go bankrupt,” and other ridiculous scenarios, my view is quite different.

Currently, Sears is having trouble with its stores. Indeed, they probably had the worst quarter of any major retailer out there. This is all true, and I think Eddie Lampert recognizes it to be so.

However, the panic over their cash balances, debt, and decreased cash flow couldn’t be further from the mark. The company ended the quarter with $1.4 billion in cash. In context, their quarterly interest expense comes to $66 million, and the net loss was $56 million. The company is not circling the drain. The fact is, in a bad economy disadvantaged retailers suffer; I’m not sure what is shocking Sears onlookers so much. CEO Bruce Johnson even predicted the company would have higher EBITDA this year than the last. So far, Eddie has been nothing but honest with shareholders, and I see no reason why they would make this prediction unless they believed it to be true.

In essence, people are missing some simple points:

1. Eddie Lampert is heavily incentivized to make the Sears investment work. That doesn’t mean that he is overly concerned with making Sears retail stores work, although I’m sure he’d love to, but that’s not a prerequisite for a successful investment in Sears. ESL has over 60% of their assets invested in Sears, while Lampert has been making 25%+ annualized returns for his partners for 20 years now. Did he turn dum-dum in a year and a half? Do you really think that, from here on out, Lampert is going to permanently lose money on Sears? Me neither.

2. Of course, even the most incentivized owner couldn’t make some investments work (think airlines). However, Sears has the assets to create cash flow and wealth. The big ones? Brands and Real Estate. Brands like Craftsman, Kenmore, and Diehard. Hundreds of owned real estate locations that companies like Target would love to take off their hands.

Think about how a successful restaurant franchiser works. How do they make money? Franchising fees due to their brand strength, and lease payments from owned real estate.

Sears can, for all intents and purposes, have their real estate unit operate like a REIT. They can either choose to lease out the real estate locations or sell them. Either way, they make money. In my view, the market has placed no value on this potential.

Regarding brands, the possibilities are endless. Wal-Mart, Home Depot, Lowe’s, Autozone (Diehard), etc. These are not secondary brands, we’re talking about high quality, easily recognized names embedded in American culture. Actually, I’ll let Eddie tell you about brands:

“One of our most important resources is the great brands we own, in particular DieHard, Craftsman, Kenmore, and Lands’ End. All four of these brands have significant equity with customers and provide tremendous opportunity for value creation. To illustrate, let me discuss one of them, DieHard, in more detail. Based on brand recognition studies, DieHard leads in customer recognition among car battery brands by a wide margin, but it lags dramatically in market share. Why? We believe it is due to fewer points of distribution. As a proprietary brand, DieHard is only available in 900 Sears Auto Centers and 1,400 Kmart stores. Yet it is competing with other batteries that are available in thousands of locations across the country. Further, a car battery purchase is a duress purchase event, in which the customer is looking for the nearest, most convenient solution. Unfortunately, it is not always us, but there is an opportunity for us to rethink our brand distribution strategy to create value. “

Obviously, Eddie is talking about taking Diehard and placing it in other stores: Autozone, Advance Auto Parts, Wal-Mart…these are places that’d love to have a brand like Diehard. Think about similar situations that could arise with Kenmore and Craftsman in appliances and tools.

Problem is, the analysts and journalists can’t see further than their noses right now. 12 months is about as far out as they can imagine. Retail is in trouble! Sears lost money last quarter! Lampert is failing! Thus, the market prices Sears at $11.5B.

On the other hand, when I look at Sears, a few years out, I see a company that is operating a REIT, selling tremendous volume of branded merchandise, operating marginal retail stores, and running a profitable online retail operation, all being run by highly incentivized capital allocating machine. The possibilities are endless.

What I don’t see is the same company that’s been struggling for over a decade. I don’t see the status quo that lead to Sears decline, the very situation that the media is so heavily focused on. Do I think this view is entirely irrational? No. Actually, it is the current reality. Sears retail stores are struggling. Their cash balance is down year over year.

However, these struggles are not being placed in the proper mental framework. As a long term investor with a probabilistic mindset, I see tremendous opportunity in the Sears story. I see an opportunity to take advantage of the auction pricing mechanism of the stock market to pick up a business at prices with very little downside and tremendous, although uncertain, upside.

The story is quickly summed up by Mohnish Pabrai, who to my pleasure, recently disclosed a position in Sears (from the Chicago Tribune)

“Hedge fund investor Mohnish Pabrai has been watching Lampert since he worked his magic at Kmart and until recently viewed Sears shares as too expensive. But last fall—a time when the shares began their decline to below $100—his Irvine, Calif.-based Pabrai Investment Funds began buying and as of March 31 held 517,607 shares, according to Securities and Exchange Commission filings.

“There are two ways to look at Sears,” Pabrai said. “One is as a retailer. The second is as a collection of assets being managed by the greatest capital allocator. And I view it as the latter.”

Remember this: Short-sightedness can be blinding. Those who saw Berkshire Hathaway as a textile maker were trumped by those who saw it as a collection of assets being managed by a brilliant capitalist.

Disclosure: I own shares of Sears.