1

Find a Zero

Sears the Next Billion Dollar Bankruptcy

The Rogue Traders

Reid Chanon David Henley Joshua Neel

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Company

Date

20 January 2015

Source: 10-K’s

Sector Recommendation

Consumer Discretionary SELL

Industry Current Price 36.57

Department Stores 52-Week Range 22.45 – 48.25

Abstract Summary

In this report, we will make the case that the publicly-traded US equity, Sears

Holdings Corporation (SHLD), will likely file for Chapter 11 bankruptcy within

the next five years. We will discuss various metrics that we believe are strong

indicators of financial insolvency and place those measurements in the context

of the broader department store industry. Next we will analyze current market

trends and the impact they will have on Sears’ market value. Finally, we will

find the true value of Sears and submit our recommendation to short the stock

before the company’s eventual bankruptcy.

Executive Summary

We issue a SELL recommendation on Sears with the expectation that it will file

for bankruptcy by 2020. Sears will be unable to capitalize on their strategic

plans due to their inability to generate the necessary free cash flow to compete

with industry members who have already established the necessary

infrastructure and customer loyalty. These issues will be compounded by an

unsustainable capital structure which will lead to Sears filing for Chapter 11

Protection

For over a decade, Sears Holding Company has been declining despite having a

large market share and numerous stores. This 121-year-old retail giant, though

once thought invincible, is now primed for bankruptcy. Despite an infusion of

$400 billion from its billionaire CEO, Eddie Lampert, and talks of spinning off

stores into REITs, our findings indicate that this company has become obsolete

in a radically changing industry. We will provide evidence of multiple

downward trends found in Sears’ financial statements show that its movement

toward bankruptcy may be accelerated over the next five years.

Investment Overview

Despite trading at a fully diluted market capitalization of approximately $4

billion, Sears’ fundamentals have deteriorated steadily for the past five years or

more. Its earnings per share have declined from $0.39 in 2009 to -$11.97 in

2014. Operating income (EBIT) has dropped similarly from $302 million to -

$927 million over the same 5 years. This loss in earnings creates a high cash

3

Source: Bloomberg

Source: Bloomberg

Source: Bloomberg

Source: Bloomberg

Source: Bloomberg

burn rate, indicating the company’s capacity to continue funding its cash flow

needs with current cash-on-hand is limited. Such a cash shortage could force the

firm to increase its total debt-to-total assets ratio by taking on additional debt,

which has already tripled to 32.6 from 11.5 over the past 5 years. These factors

cast doubt on the company’s solvency, and result in a reduced Altman Z-score to

1.3 down from 2.3.

Negative Earnings

One of the most important indicators of a firm’s growth potential is earnings per

share (EPS). Sears’s EPS have declined a total of -$11.6 over the past 5 years,

worse than the industry decline of -$3.8. To better understand where Sears has

been losing money, we looked at operating margins, which are found by

dividing operating income by total revenue. Operating margins reveal how well

a company is pricing its products, how cheaply it is purchasing input materials,

and how efficiently it is carrying out its core functions. We derived operating

margins by dividing operating income into total revenue and discovered that

Sears’ operating margins have decreased from .65 to -2.56 over the past 5 years.

Because operating expenses have endured a similar decline over the same

period, it appears that Sears has become less efficient with its day-to-day

operations and is losing money as a consequence.

Negative Cash Flow

With 2,249 retail locations across the United States and Canada, Sears controls

roughly 2% of all available retail space. Due to its immense commercial

footprint, Sears’ operating leases comprise a substantial amount of Sears’ future

financial obligations, though they are currently listed off the balance sheet. This

figure should be capitalized to the balance sheet in order to help investors gain

an accurate representation of the firm’s condition. For example, as of 2014,

Sears classified $3,646 million of its leases as “operating”, leaving them out of

long-term liability calculations. In contrast, it has listed only $346 million of

capital lease obligations on the balance sheet. Since operating leases represent

future contractual obligations, we discounted back the value of estimated future

payments using Sears’ appropriate cost of capital (ke). We calculate the

weighted average interest rate on Sears’ outstanding debt to arrive at this figure,

2.7%, and the weighted average interest rate currently being used to calculate its

capitalized lease obligations, 6.4%.

Cash Burn

The cash burn rate (CBR) shows the number of months a company can continue

to operate using only its current levels of cash and cash equivalents and without

4

Source: Bloomberg

securing additional financing. As seen in the graph below, Sears’ CBR has declined over the past

10 years, implying. Even though free cash flows for the department store industry have declined

by an average of 8% per year over the last decade, Sears’ has underperformed with an average

annual decrease of -23%.

In the next graph, we examined the relationship between Sears’ cash flow from

operations and its average current liabilities. This second metric reinforces the

first graph by showing the inability of Sears to meet its current liability

obligations given its current free cash flow from operations. As with first graph,

this metric indicates Sears’ ability to meet its short-term obligations has

deteriorated dramatically over the 10-year period.

Free Cash Flow

Because Sears carries large operating leases that are held outside the balance

sheet, it is important to capitalized them, meaning discounting back the sum of

future lease obligations and placing the present value on the balance sheet. This

makes the firm’s true financial obligations more transparent and helps investors

see a more accurate portrayal of the financial condition of the company. These

leases total $2,929, augmenting both the debt-to-assets and debt service ratios.

With declining cash flows, investors should investigate Sears’ ability to continue

paying its interest requirements over the near future. In its current situation, with

the latest CBR equal showing resilience of -8 months, its clear that Sears is

already pulling money from other sources just to fund its everyday operations.

High Leverage and Declining Credit Rating

High leverage signals an underlying weakness in the firm’s projected ability to

pay back outstanding debt. In Sears’ case, the debt-to-asset ratio has been

increasing for the past 3 years, a result of declining cash flows and the need for

new sources of cash to keep the firm afloat. When comparing Sears to its

competitors, it is apparent that Sears is on the brink of being forced to liquidate

assets in order to continue operations.

Sears’ has suggested it will turn much of its unprofitable store space into a REIT

as a means to generate cash by renting its buildings to other specialty retailers.

27% and 23% of Sears stores are in “weak local trade area demographics,”

however, so pursuing this avenue will only expedite the eventual bankruptcy of

the company. Much of this information, including the declining earnings and

cash flows discussed above, have negatively affected the company’s Altman Z-

score. This score measures Sears’ credit rating has declined dramatically, from

2.32 to 1.33. Since a score below 1.8 means there is a high probability a

company will go bankrupt, Sears’ score of 1.33 is simply one indicator this

company is headed for insolvency.

5

Source: 10-K’s

Source: Bloomberg

Five Year Growth of Revenue

Ticker YoY Growth

SHLD -22.6% JCP -35.9% KSS 16.1% M 12.2%

Industry -7.6% Source: 10-K’s

Source: 10-K’s

Porter’s Five Forces Model

We used Porter’s Five Forces analysis to analyze the level of competition within

the department stores industry (GICS). This framework allowed us to analyze

competition within the industry and revealed what these firms must do to

generate a profit. To analyze the retail industry we used J.C. Penney (JCP),

Kohl’s. These companies are Sear’s closest competitors in terms of revenue,

products, and target-market. The five firms (the representative firms) we chose

are assumed to be indicative of industry trends for our analysis.

Intensity of Competitive Rivalry

High competitive rivalry causes a firm to establish and maintain customer

loyalty, achieve efficient distributions, and minimize its prices. The elements of

interest are the industry growth rate and the concentration of competitors. The

components we selected have a material impact on the profitability of the

industry.

The industry growth was captured using the five year growth of revenue for the

representative firms. The industry had an 8.5% decline in revenue over five

years. We have identified changes in consumer tastes and the growth of E-

commerce as the primary contributors of this decline. Both will be discussed

further in relation to threat of substitutes.

The concentration of competitors has resulted in a saturated market that requires

firms to compete on price and customer loyalty to maintain market share. There

are eight U.S. firms in the department stores industry; however, when we

include industries that compete with Sears’ there are 270 firms, 79 of them have

a market capitalization greater than $1 billion.

Threat of New Entrants

The ability of new firms to enter the retail industry has diminished over the past

10 years. While large department store chains have steadily increased their

number of locations, it has become increasingly difficult for new entrants to find

leasing and supply deals with manufacturers and retail outlets. As seen in the

graph below, the leading department stores have grown their number of stores

by an average of 5% annually over the past seven years. Sears, on the other

hand, has decreased its number of locations by an average of -8%, highlighting

its inability to maintain an aggressive stance in an industry where established

brands should be exhibiting strength (1). Because this industry does not

specialize in high-end products and brand recognition but rather deals in average

goods and has few barriers to entry, E-commerce has the potential to take

significant market share.

Short Name Market Cap Revenue T=0 Revenue T=(5) Geo 5 Yr Growth

Macy's 21.75 27.93 24.89 2.90%

Kohl's 13.81 19.03 16.39 3.80%

Sears Holding 3.86 36.19 46.77 -6.20%

J.C. Penney 2.49 11.86 18.49 -10.50%

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Source: Bloomberg

Source: Company Data

Threat of Substitutes

The department stores industry has a low risk of substitute goods since they are

primarily a retailer of branded merchandise. Since department store retailers

produce very little, their main threat of substitutes are competitors offering

alternative purchase methods. We have identified ecommerce as the retail

industry’s greatest threat.

E-commerce has encroached on the market share of the retail industry by a

substantial margin. In order to demonstrate the magnitude of the effect we

looked at revenue, which is the most appropriate way of isolating the market

share for the retail industry. By comparing the five year geometric growth rates

we identified that the retail industry is trending downwards, while E-commerce

is growing rapidly. Then we looked at the correlation between the two industries

to see how closely the effects vary together. With a correlation of -33% there is

a moderate inverse relationship between the two industries. This historical

growth, along with the 34.8% growth forecasted for the E-commerce firms in

2015, indicates that the retail industry should be expected to diminish by

approximately 11.5%. This will result in the retail industry losing 7% of the

revenues.

The continued loss of revenues is creating a strain on the retail industry to

generate positive cash flows from operations. The firms within the industry are

adopting E-commerce programs to compete, but as we found in their 10-K

reports, their inability to provide free delivery because of differences in their

supply chain is a weakness and since they are dealing in low-end products, there

are many alternatives available.

Bargaining Power of Consumers

We have identified that the consumer has high bargaining power within the

retail industry. Since the consumer is more concerned with the product than the

store, the lowest price will generally prevail. This effect is maximized since

firms in the department store industry predominantly have stores within and

around shopping malls. This results in low switching costs for the consumer,

since there are little to no transportation costs or information barriers.

Furthermore, with the prevalence of the internet consumers are more prone to

checking prices from many retailers. Therefore, the best way for a firm to

succeed within this industry is to minimize their costs.

Bargaining Power of Suppliers

The suppliers for the retail industry have low bargaining power. The average

department store has 170 distinct suppliers; therefore, if a supplier provides an

Short Name Market Cap Revenue T=0 Revenue T=(5) Geo 5 Yr Growth

Macy's 21.75 27.93 24.89 2.90%

Kohl's 13.81 19.03 16.39 3.80%

Sears

Holding3.86 36.19 46.77 -6.20%

J.C. Penney 2.49 11.86 18.49 -10.50%

Short Name Market Cap Revenue T=0 Revenue T=-5 Geo 5 Yr Growth

Amazon 176 88.99 24.51 38.00%

E-Bay 69.76 17.9 8.73 19.70%

Vipshop 14.47 3.77 2.8 7.70%

Asos 2.75 0.98 0.17 55.90%

Mean -2.50% Correlation Mean 30.30%

Variance 0.49% -33.00% Variance 4.46%

Std.

Deviation7.00% Std. Deviation 21.13%

Department Stores E-Commerce

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uncompetitive price, the demand for their product will drop significantly.

Department stores are offered a low price since they have many alternatives and

they don’t depend on few suppliers to provide a product that’s critical to the

retailer’s business.

The suppliers for the retail industry have low bargaining power. The average

department store has 170 distinct suppliers; therefore, if a supplier provides an

uncompetitive price, the demand for their product will drop significantly.

Department stores are offered a low price since they have many alternatives and

they don’t depend on few suppliers to provide a product that’s critical to the

retailer’s business.

The suppliers for the retail industry have low bargaining power. The average

department store has 170 distinct suppliers; therefore, if a supplier provides an

uncompetitive price, the demand for their product will drop significantly. Department

stores are offered a low price since they have many alternatives and they don’t depend

on few suppliers to provide a product that’s critical to the retailer’s business.

Financial Analysis

Based upon our research we conclude that Sears’ is trending towards bankruptcy. Sears

has shown five key shortcomings: negative earnings, negative CFO and a high cash

burn rate, and high leverage with a low credit rating. These issues are making Sears’

continued business operations unfeasible. Compounding the issue of Sears’ deficiencies

is that its industry is performing nearly as bad.

Sears’ Shortcomings

Sears is failing because it isn’t adapting to change in consumer tastes efficiently

enough. Before we look at the macroeconomic conditions contributing to its decline, we

must first look at problems unique to Sears.

Negative earnings – with an earnings growth of -451% over five years, Sears

has become incapable of maintaining its market share or its operating margins,

which have fallen to -2.56 (a 3.21 decline over 5 years).

Negative cash flow from operations –

High cash burn rate (CBR) – Sears has had a negative CBR since 2011,

meaning they have to borrow cash to avoid running out of capital. The CBR

average annual growth of Sears has been -23% during a 10 year period.

High leverage – Sears leverage ratio has been increasing as it borrows capital to

keep afloat. Its leverage is entering the realm where it may have to liquidate

assets to remain in business.

Low credit rating – Sears has a CCC+ (Standard & Poors) Caa (Moody’s)

credit rating, which results in its bonds being considered “not investment

grade.” This is detrimental since Sears is being forced to borrow to maintain an

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adequate cash balance, but it is unable to borrow from most institutional

investors.

Department Stores Industry Decline

The department stores industry is struggling, in large part because the industry is unable

to adapt to changes in consumer preferences quickly enough. Sears has underperformed

the industry in every performance measure we used, often being one of the worst two.

The department stores industry has declined and should continue to decline because:

High rivalry among existing firms – the consumer discretionary sector consists

of 270 firms, this forces existing businesses to compete on price, efficiency,

and consumer loyalty. By competing on efficiency, a firm’s margin will be

adversely affected, causing unprofitable firms to decline faster.

High risk of substitutes – As stated, the key component to being successful in

this sector is to provide goods at a lower cost than the competitors. The

incentive to minimize costs rewards companies with low fixed costs, which

would be an E-commerce firm, not a large square footage department store.

Price takers when selling merchandise – The consumer can choose to forgo one

store for another since there is almost no differentiation between them.

Furthermore, since department stores often compete within the same building

there can be no transportation costs or imperfect information when choosing a

retailer. This harms the profit potential of all firms within the industry.

Recommendation

We believe that Sears will be forced to file for bankruptcy by 2020 because of its

inability to generate an accrual or cash based profit, it not maintaining a reasonable

capital structure, and its industry’s failure to maintain a competitive advantage over

non-traditional department stores.

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-6

-4

-2

0

2

4

6

8

09 10 11 12 13 14

Sears OperatingMargin

Operating Margin

Appendix A: Earnings, Cash Flow,

and Leverage

10

-20

-15

-10

-5

0

5

10

15

09 10 11 12 13 14

SHLD M

KSS JCP

Operating Margin

-8

-6

-4

-2

0

2

4

6

8

10

12

09 10 11 12 13 14

CFO-to-Total Liabilities

CFO/Total Liabilities

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

05 06 07 08 09 10 11 12 13 14

CFO-to-Avg Current Liab CFO/Avg Current Liab

11

(60.00)

(40.00)

(20.00)

-

20.00

40.00

60.00

05 06 07 08 09 10 11 12 13 14

Cash Burn Rate

Cash Burn Rate

-30

-25

-20

-15

-10

-5

0

5

10

09 10 11 12 13 14

SHLD KSS JCP M

Earnings Per Share

12

-2000

-1500

-1000

-500

0

500

1000

1500

09 10 11 12 13 14

Operating Income

SHLD Industry

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Appendix A: Five Forces, Cap. Leases, and Revenue

Five Year Growth of Revenue

Ticker YoY Growth

SHLD -22.6% JCP -35.9% KSS 16.1% M 12.2%

Industry -7.6%

Force Strength

Rivalry Among Existing Firms High Threat of New Entrants Moderately High Threat of Substitutes High Bargaining Power of Buyers High

Bargaining Power of Suppliers Low

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Short Name Market Cap Revenue T=0 Revenue T=(5) Geo 5 Yr Growth

Macy's 21.75 27.93 24.89 2.9%

Kohl's 13.81 19.03 16.39 3.8%

Sears Holding 3.86 36.19 46.77 -6.2%

J.C. Penney 2.49 11.86 18.49 -10.5%

Short Name Market Cap Revenue T=0 Revenue T=-5 Geo 5 Yr Growth

Amazon 176.00 88.99 24.51 38.0%

E-Bay 69.76 17.90 8.73 19.7%

Vipshop 14.47 3.77 2.80 7.7%

Asos 2.75 0.98 0.17 55.9%

Department Stores E-Commerce

Mean -2.5% Correlation Mean 30.3%

Variance 0.49% -33.0% Variance 4.46%

Std. Deviation 7.00% Std. Deviation 21.13%

Regression Statistics

Coefficient _-0.996x + 0.278

Multiple R 33.00%

R Squared 10.90%

Standard Error

24.40%

T Statistic 2.11

Observations 4

E-Commerce Analyst Forecast

2014 Sales F12M Sales Growth

0

1

2

3

4

5

Rivalry AmongExisting Firms

Threat of NewEntrants

Bargaining Power ofSuppliers

Bargaining Power ofBuyers

Threat of Substitutes

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Amazon 88.99 105.24 18%

E-Bay 17.90 19.35 8%

Vipshop 3.77 6.89 83%

Asos 0.98 1.27 30%

Avg. Growth 34.8%

46% 54%

2014 Revenue

Department Stores E-Commerce

39%

61%

2015 Revenue

Department Stores E-Commerce