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Sears: Auto Centers Reveal Big Picture Problems For Company

Summary

Sears Auto Centers aren't being sold to a 3rd party.

Seritage has the right to recapture 100% of the Sears Auto Centers.

The Sears Auto Center real estate doesn't appear to be moving.

We decided to write an article on Sears Auto Centers because we believe it exemplifies one of the major flaws in the long thesis on Sears (NASDAQ:SHLD). Sears Auto Center represents a tiny portion of Sears' overall revenue, but the flaw we will discuss permeates a large portion of the investment valuation for Sears. It also demonstrates when reasoning can go bad.

What is the flaw? We believe that many investors have artificially inflated the value of Sears by valuing the real estate of Sears independent of the underlying retail business. Because Sears continues to lose money the net asset valuation calculations used by investors fail to account for these ongoing losses, and thus their calculations might be artificially high. Also, some have suggested that combined with the real estate, that the businesses owned by Sears have hidden values in of themselves that can be monetized outside of Sears (for example, KCD brands). Hence, they get the value of the real estate plus the value assigned to the different operating businesses. We believe that this represents a form of double dipping. Either you value the operating businesses or you value the real estate with no operating businesses. And the experience with Sears Auto Centers offers one example of why this might be important.

The Market Cap Myth

First we wanted to take a brief moment to address one issue. We hope that this helps educate the average investor on how to think about property valuations, as it offers a cautionary tale. Also, we think it demonstrates how investors need to be skeptical in their reliance on other people's work (including ours). In the Fairholme presentation on Sears, Fairholme offered the following slide.

When this presentation appeared we were extremely disappointed with this particular slide. It is factually correct, but it offers at best minimal relevant information for investors. And in our opinion it does more harm than good. By comparing Sears' real estate portfolio and market cap to other REIT portfolios and market capitalizations it assumes that you are comparing apples-to-apples. However, Sears and the REITs listed are nothing alike. Sears makes money by selling goods and services to customers, and at the time of the presentation made little to no money from 3rd party leases. The REITs make money by renting stores to 3rd parties. The slide above assumes that Sears can transition into a similar portfolio over night. It doesn't account for costs to do so, or the burn over the same period. It also fails to account for the fact that in general anchor tenants pay less in rent than inline stores even when released at current market rates. Sears (excluding freestanding) has primarily anchor store locations. So what does this have to do with Sears Auto Centers?

Sears Auto Center & Valuation

Attached to the 2013 10-K is a letter from Eddie Lampert, in which he says the following,

We also are considering strategic alternatives for our Sears Auto Center business, subject to board approval and other...


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