Find a Zero
Sears the Next Billion Dollar Bankruptcy
The Rogue Traders
Reid Chanon
David Henley
Joshua Neel
1
Company
Date
20 January 2015
Sector
Consumer Discretionary
Recommendation
SELL
Industry
Department Stores
Current Price
52-Week Range
36.57
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
Source: 10-K’s
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
2
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.
Source: Bloomberg
Negative Earnings
Source: Bloomberg
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
Source: Bloomberg
Source: Bloomberg
Source: Bloomberg
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
3
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%.
Source: Bloomberg
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 Zscore. 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.
4
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.
Source: 10-K’s
Intensity of Competitive Rivalry
Short Name
Macy's
Kohl's
Sears Holding
J.C. Penney
Market Cap Revenue T=0 Revenue T=(5) Geo 5 Yr Growth
21.75
13.81
3.86
2.49
27.93
19.03
36.19
11.86
24.89
16.39
46.77
18.49
2.90%
3.80%
-6.20%
-10.50%
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
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 Ecommerce 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
Source: 10-K’s
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.
5
Short Name Market Cap Revenue T=0 Revenue T=(5) Geo 5 Yr Growth
Macy's
Kohl's
Sears
Holding
J.C. Penney
21.75
13.81
27.93
19.03
24.89
16.39
2.90%
3.86
36.19
46.77
-6.20%
2.49
11.86
18.49
-10.50%
Short Name Market Cap Revenue T=0 Revenue T=-5 Geo 5 Yr
Amazon
176
88.99
24.51
E-Bay
69.76
17.9
8.73
Vipshop
14.47
3.77
2.8
Asos
2.75
0.98
0.17
Department Stores
E-Commerce
Mean
-2.50% Correlation Mean
Variance
0.49%
-33.00%
Variance
Std.
7.00%
Std. Deviation
Deviation
Source: Bloomberg
3.80%
Growth
38.00%
19.70%
7.70%
55.90%
30.30%
4.46%
21.13%
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
Source: Company Data
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
6
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
7
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.
8
Appendix A: Earnings, Cash Flow,
and Leverage Operating Margin
8
6
4
2
0
-2
Sears Operating
Margin
-4
-6
09
10
11
12
13
14
9
Operating Margin
15
10
5
0
-5
-10
SHLD
M
KSS
JCP
-15
-20
09
10
11
12
13
14
CFO-to-Total Liabilities
12
10
8
6
4
2
0
-2
-4
-6
-8
CFO/Total Liabilities
09
10
11
12
13
14
CFO-to-Avg Current Liab
0.6
CFO/Avg Current Liab
0.5
0.4
0.3
0.2
0.1
0
-0.1
-0.2
05
06
07
08
09
10
11
12
13
14
10
Cash Burn Rate
60.00
Cash Burn Rate
40.00
20.00
(20.00)
(40.00)
(60.00)
05
06
07
08
09
10
11
12
13
14
Earnings Per Share
10
5
0
-5
-10
-15
-20
-25
SHLD
KSS
JCP
M
-30
09
10
11
12
13
14
11
Operating Income
1500
SHLD
Industry
1000
500
0
-500
-1000
-1500
-2000
09
10
11
12
13
14
12
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
Rivalry Among Existing Firms
Threat of New Entrants
Threat of Substitutes
Bargaining Power of Buyers
Bargaining Power of Suppliers
Strength
High
Moderately High
High
High
Low
13
Rivalry Among
Existing Firms
5
4
3
Threat of New
Entrants
2
Threat of Substitutes
1
0
Bargaining Power of
Buyers
Short Name
Market Cap
Bargaining Power of
Suppliers
Revenue T=0
-10.5%
Revenue T=0
Revenue T=-5
Geo 5 Yr Growth
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%
2.75
0.98
0.17
55.9%
Kohl's
Sears Holding
J.C. Penney
Short Name
Amazon
27.93
19.03
36.19
11.86
Geo 5 Yr Growth
24.89
16.39
46.77
18.49
Macy's
21.75
13.81
3.86
2.49
Revenue T=(5)
Market Cap
Asos
Department Stores
2.9%
3.8%
-6.2%
E-Commerce
Mean
-2.5%
Correlation
Variance
0.49%
-33.0%
Std. Deviation
7.00%
Mean
30.3%
Variance
4.46%
Std. Deviation
21.13%
Regression Statistics
Coefficient
_-0.996x + 0.278
Multiple R
33.00%
R Squared
Standard
Error
T Statistic
10.90%
Observations
24.40%
2.11
4
E-Commerce Analyst Forecast
2014 Sales
F12M Sales
Growth
14
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%
2014 Revenue
Department Stores
54%
E-Commerce
46%
2015 Revenue
Department Stores
E-Commerce
39%
61%
15