Sears Holdings And ESL Investments: Berkshire Hathaway In Broad Daylight – Sears Holdings Corporation (NASDAQ:SHLD)

I struggled with whether or not to publish this thesis. It’s like I’m watching a world-class magician perform, managing to figure out his finest trick…and then blurting out my discovery to the audience. But ultimately I felt compelled given the blinding amount of misinformation out there. So, here goes…

These days, it is nearly impossible to find an article about Sears that does not include some version of “bankruptcy” in the headline. It’s a buzz word that creates uncertainty, invokes fear and generates clicks. For one reason or another, the majority of journalists, columnists, bloggers and a few former executives of Sears (NASDAQ:SHLD) and Sears Canada (NASDAQ:SRSC) (from over a decade ago) who write about Sears Holdings choose to only look at the brick & mortar retail businesses within Sears Holdings. This recurring cast1 covers Sears and Kmart in an almost obsessively negative light with immediate retorts to any good news, immediate magnification of any bad news, repeated pictures of empty parking lots, barren shelves, crumbling buildings and most often by just paraphrasing a previous obituary and changing the title. Sears and Sears Holdings conveniently share a name, so it is very easy to mistake them for the same thing. But try explaining that distinction to most people, let alone in 140 characters or less.

Sears Holdings is NEVER going to declare bankruptcy (I will explain why below).

But in a world of fierce competition, fast money, volatility, delta hedging, pairs trading, social media, snap judgements and journalism dependent on view count, the “bankruptcy” narrative is the one primed for mass consumption.

Only a select few have taken the time to examine the Sears Holdings story in greater depth, at least in the last couple of years.

SA contributor Eric Moore has done a stellar job comparing the similarities between the current makeup and structure of Sears Holdings with the origins of Berkshire Hathaway, and separately, detailing the strategic transformation underway at Sears Holdings – if you have not already read these, I highly recommend starting here:

I agree with Eric’s analysis and will attempt to add to it by getting into the why and the how.

THE SAGE AND HIS STUDY

Eddie Lampert had a fast rise to prominence in financial circles. He formed ESL Investments in the late 1980’s and began managing capital for some of the wealthiest people in the world. He delivered year after year of impressive gains, nearly doubling the average returns of the S&P 500 from 1988 to 2003. Many noted the similarity between Lampert’s style of value investing with Warren Buffett’s.

In their Bloomberg BusinessWeek cover piece from November 21, 2004, “The Next Warren Buffett?” (subscription required), Robert Berner and Susann Rutledge showed why these similarities were no coincidence:

Lampert has carefully studied Buffett for years. He started reading and rereading Buffett’s writings while working at Goldman after college. He would analyze Buffett’s investments, he says, by “reverse engineering” deals, such as his purchase of insurance company GEICO. Lampert went back and read GEICO’s annual reports in the couple of years preceding Buffett’s initial investment in the 1970s. “Putting myself in his shoes at that time, could I understand why he made the investments?” says Lampert. “That was part of my learning process.” In 1989 he flew out to Omaha and met Buffett for 90 minutes, peppering him with questions about his investing philosophy.

They wrote about how Lampert might use Kmart Holdings (the predecessor to Sears Holdings) as a “launchpad” the same way that Buffett used Berkshire Hathaway, how it would be “a perfect vehicle for bankrolling big acquisitions” and labeled it as “the key to his ambitions.”

And fifteen years before that BusinessWeek cover, Fortune Magazine printed a story called “Are these the new Warren Buffetts?” which included Lampert, among others, like future Mad Money host / The Street founder Jim Cramer (aka “Mr. Aggressive”). In fact, in his 2007 book, “Jim Cramer’s Stay Mad for Life: Get Rich, Stay Rich (Make Your Kids Even Richer),” Cramer wrote the following:

Sears looks a lot like Berkshire Hathaway did in 1981, when you could buy it for $200 a share. The business seemed pretty dowdy; I know I passed on it. But the bet was on the manager, Warren Buffett, who turned a $200 investment into a $100,000 stock twenty-five years later through sheer investing prowess. I believe Eddie Lampert will do the same thing with Sears Holdings.

There were many other instances throughout the years (especially in the aughts) of people comparing Eddie Lampert to Warren Buffett and Sears Holdings to Berkshire Hathaway. Since Buffett & Charlie Munger’s formation of Berkshire Hathaway is the most iconic wealth generation story of the past century, the details are well known and well recognized; Sears Holdings stock price soared while these articles and hypotheses abound.

So here’s a key question… in 2005, how could Lampert truly replicate Buffett and Munger’s famous playbook when the entire world was watching?

How could he recreate Berkshire Hathaway in broad daylight?

TAKING CONTROL

Through his investment vehicle / hedge fund ESL Investments, Lampert acquired Kmart out of bankruptcy by buying up it’s debt. On May 6, 2003, the company emerged from it’s restructuring as Kmart Holdings Corporation and Lampert served as Chairman of the new company. Lampert also controlled a minority interest in Sears around that time. He then used Kmart Holdings to acquire the remainder of Sears through a combination of cash and stock. The new entity became Sears Holdings Corporation – this deal closed on March 24, 2005. Lampert would once again be Chairman.

On May 28, 2005, the first quarterly report as Sears Holdings showed a total of 164,909,735 shares outstanding. ESL held approximately 64.5M shares (this represented approximately 39% of the total shares outstanding).

Then Sears Holdings announced a share repurchase program. Over the next 8 years, the company bought back approximately $6 billion (with a “B”) worth of it’s common stock. For the fiscal year ending on February 3, 2013, the Annual Report states that the company had 106,386,171 common shares outstanding and that ESL beneficially owned approximately 55% of the outstanding common stock. Lampert had shrunk the float and increased his control.

In 2013, Lampert became the CEO and now had formal direct oversight of the day-to-day operations. His annual salary would be only $1 / year, but he would be paid the equivalent of $4.5M per year in SHLD common stock. These shares, more or less, have been the ONLY newly issued shares ever since Lampert gained control of the company2. Lampert was paid 100% in shares and everyone else was paid 100% in cash. That’s strange, right? In instances when C-suite executives were issued stock options, I noticed another pattern – the executives always seemed to sell their shares immediately on vesting. I understand trading plans get filed in advance, but still, everyone?3

Fast forward to the present – as of July 2017, Lampert controls 49% of the outstanding shares (56.5% if you include the December 2019 warrants – SHLDW). He is still the CEO, still the Chairman of the Board, still the largest equity control position and now the largest debt control position as well.

Eddie Lampert is surrounding Sears Holdings on all sides. There is only one way he could lose control of it… bankruptcy. In bankruptcy, Lampert would be ceding control to a court-sanctioned judge and to the PBGC (triggering a springing lien under it’s pension forbearance agreement). Why would someone so focused on control ever give it up?

For nearly a decade, Lampert’s control position as a percentage of the voting stock had basically remained the same, but the company was sustaining (and is continuing to sustain) incredible losses. By all appearances, Lampert has been skippering a sinking ship, throwing away good money after bad through a series of loans and lifelines. Wouldn’t a smart investor have cut his losses and bailed a long time ago? Or just liquidated the company if the remaining real estate and brand assets had so much value?

But if you look below the surface…a big change was slowly taking place.

PARALLEL TRANSFORMATIONS (SEEING DOUBLE)

“We don’t need more customers. We have all the customers we could possibly want.”
– Eddie Lampert, 2017 Sears Holdings Annual Shareholders Meeting

The media suggested Lampert was crazy for saying that. How could Sears survive without more customers? The mainstream brick and mortar retail narrative was clear: customers are fleeing malls, there are many lower cost alternatives, pricing pressure continues, vendors want better terms, younger shoppers shop online or are spending their disposable income on experiences instead of things, etc. By the way, I’m not disagreeing with any of this, these trends are real (though exaggerated).

To combat this changing reality, Sears Holdings is undergoing a strategic transformation. The goal is to return to profitability by becoming a more asset-light organization and by focusing on it’s best stores, it’s best categories and it’s best members. Lampert appears to be taking a Sabermetrics approach to Sears Holdings (note board member Paul DePodesta, of “Moneyball” fame), which I appreciate.

Many of the same trends that are reshaping retail also apply to finance: sophisticated investors want to pay lower fees, younger investors seem to prefer passive ETF-heavy robo-advisors instead of ever seeking “expensive” active management, and even the most well-heeled are spending a higher percentage of their wealth on more tangible and lifestyle items, like their homes, private travel and artwork.

Some people mistakenly assume that hedge fund managers own their funds AND all the assets within them. Hedge funds have customers too, except they’re called investors. In fact, investor flight is the biggest threat to a traditional hedge fund – managers have to either sell out of positions prematurely (at inopportune times) or have to play defense by keeping a disproportionate amount of cash on hand. Many once prominent hedge funds have closed up shop in the last few years due to the downward spiral of redemptions compounding diminishing returns.

It goes without saying that as the share price of Sears Holdings was deteriorating, Lampert was losing investors in his hedge fund (this is well-documented). So how did he keep ESL going while at the same time maintaining his control of Sears Holdings?

I decided to look at Eddie Lampert’s direct ownership of SHLD over time vs. his indirect ownership through his hedge fund.

Here is a snapshot of several Form 4 filings from the past decade:

  • February 16, 2006: 0 shares
  • January 13, 2010: 3,825,147 shares
  • June 30, 2010: 16,906,423 shares
  • September 5, 2012: 23,469,942 shares
  • November 20, 2014: 25,239,546 shares
  • July 5, 2017 (most recent): 32,044,989 shares

It appears that Lampert was methodically accumulating a direct ownership position, which has grown over time to approximately 30% of the company’s total outstanding shares (not including warrants).

It appears that Lampert never sold any of his direct ownership position.

And it appears that Lampert essentially bought (or accumulated) the same shares that his own former hedge fund investors used to hold. From 1964-1978, guess who else once did that.

What if a hedge fund did not need more investors? What if a hedge fund had all the investors it could possibly want?

ENDLESS BEER

Let’s take a break and talk about beer for a minute (I like beer). If I have a six-pack in the fridge, it might last me a few days or a few weeks, but i’ll eventually run out of beer. If i’m having friends over, maybe i’ll buy a case, but again, I’ll run out. If i’m throwing a bigger party, i’ll buy a keg, but that won’t last forever either. I don’t really like asking other people to give me their beer, so how can I have my own supply of beer permanently? Well, I could buy a pub right? Or a beer distributorship? Or maybe even my own brewery? What if there’s a long term electrical outage, or the delivery trucks break down, or the wheat and hops have a bad season, or there’s a drought?

But, if I had control of all these things in vertically integrated perpetuity, I could guarantee that I never run out of my own beer, I would never have to worry about running out of my own beer and I would never have to waste time asking anyone else for theirs.

Henny Sender and Stephen Folly refer to Permanent Capital as “a new holy grail” in their 2015 Financial Times article “Permanent Capital: Perpetual Cash Machines” (subscription required).

In their article “Permanent Capital: The Essentials” Julia D. Corelli and Stephanie Pindyck-Costantino of Pepper Hamilton LLP write:

The permanent capital model avoids the need to harvest investments at artificially created time horizons and to dedicate immense resources to fund formation every several years.

They go on to state:

The most recognised, and perhaps most successful, example of permanent capital may be Berkshire Hathaway. In simple terms, Warren Buffett created a pool of investments where new capital could be added, capital could be withdrawn, management incentivised and the investments within the pool could change. Family offices have been doing this for years, so why don’t more private equity managers adopt permanent capital techniques?

If Warren has endless beer and Eddie wants to be like Warren, then wouldn’t Eddie need endless beer too?

THE PROTAGONIST

Known for her novels “Atlas Shrugged” and “The Fountainhead,” Ayn Rand was a controversial author and philosopher. She is credited as the founder of Objectivism which she described like this:

My philosophy, in essence, is the concept of man as a heroic being, with his own happiness as the moral purpose of his life, with productive achievement as his noblest activity, and reason as his only absolute.

I am by no means suggesting I am an Ayn Rand devotee, nor do I necessarily agree with her writings or philosophies. But you know who is and you know who does?

Eddie Lampert.

Through his charitable vehicle, The Lampert Foundation, he has given to the Ayn Rand Institute. He has also supported the Reason Foundation and The Institute for Justice, organizations that appear similarly focused on laissez-faire economics and are consistent with Lampert’s approach to business. People tend to give to causes and ideals that matter to them.

He also bought a 288-foot mega-yacht estimated to be worth $130M which he named “Fountainhead.”

Pay attention.

If you have not read “The Fountainhead,” the protagonist is an architect named Howard Roark who sticks to his principles and charts his own path despite the incredible societal pressures against him. It is an entire book about individualism triumphing over collectivism.

INFINITE HORIZONS AND SPACE TRAVEL

You don’t have to necessarily be the fastest to cross the finish line first (ask the tortoise). And if all your opponents get tired, distracted or dehydrated, you don’t even have to cross the finish line at all. You can win the race just by being the only one left standing.

Time Arbitrage is the ability to hold on longer than everyone else, to have an unlimited investment horizon. Only a manager with similarly-minded investors has this luxury. Or taking it one step further, only a manager that does not need outside investors at all. Only a manager with… Permanent Capital.

In an article from 2009, Alan Gotthardt described Time Arbitrage as:

The supreme advantage of all the giants, from Warren Buffett to Peter Lynch.

Warren Buffett himself put it another way:

The stock market is a device for transferring money from the impatient to the patient.

But eventually, every skipper needs a boat, and every astronaut needs a rocket ship4. For Buffett, that vessel was an aging textile manufacturer, and it took him money, intelligence, determination, focus and years to build. And when it was finished, it’s where he put everything.

Lampert still needs to optimize Sears Holdings’ capacity before liftoff, but for me, that’s a question of when, not if.

CARGO BIN

But while you’re building a rocket ship and while you’re planning your one-way flight, you also have to decide what to pack.

RBS Partners is the limited partner within ESL that is required to file a 13-F each quarter. Through it’s most recent public filing, RBS holds only 7 positions. Seven.

  1. Sears Holdings
  2. AutoNation (NYSE:AN)
  3. Land’s End (NASDAQ:LE)
  4. Sears Canada
  5. Seritage Growth Properties (NYSE:SRG)
  6. Sears Hometown and Outlet Stores (NASDAQ:SHOS)
  7. Sears Holdings Warrants

One of these holdings is not like the other… for two reasons.

All except AutoNation were once part of Sears Holdings before, under Lampert’s control, being spun off into separate companies. It is important to note that Lampert is not the CEO of the companies that have spun off; like Buffett, Lampert is installing management teams he believes in5. It is also important to note that all shareholders of Sears Holdings have been given the same access to spinoffs and offerings on a pro rata, pari-passu basis. Lampert has always treated shareholders fairly and equally. He has never forced anyone to sell their shares or rights. Neither did Warren Buffett.

Getting back to it, the other thing that currently makes AutoNation different? Per the most recent 10-Q filing, Lampert controls 16% of the company – it is not a Control Position.

The Extended Sears Family companies, as I like to call them, are Control Positions6. And right now they are under the control of ESL Investments.

Now let’s look under the hood of Sears Holdings to see what else is currently under ESL’s control, albeit one step removed. Here is a list of the subsidiaries from the most recent 10-K filing.

POP QUIZ

Adding it all together, within Sears Holdings and the Extended Sears Family, we can start to see what types of businesses will most likely have boarding passes. I believe some Sears and Kmarts will remain as brick & mortar retailers, but I am paying close attention to the subsidiaries and spinoffs that have names other than “Sears” and “Kmart,” especially the ones that have been created or had their names changed in the last few years. See if you can connect the dots by correctly identifying these businesses. Answers are at the bottom of this article:

  1. Real estate investment trust
  2. Intellectual property (ie. brands that collect royalties)
  3. Franchise business
  4. Mail order, catalog and internet clothing retailer
  5. Re-insurance company
  6. Loyalty rewards and data analytics company
  7. Credit card
  8. Logistics, last-mile delivery service
  9. Appliance installation, service, repair and warranty business
  10. Automotive service and repair business
  11. High-end brick and mortar appliance retailer
  12. Internet of things / connected home technology company

While there are some newer growth entries in here, most of these are legacy businesses or tried-and-true models that spin off a ton of cash and generate float in any and all economic conditions. Does this sound familiar?

AN ATMOSPHERIC BUBBLE

In the history of bubbles and their ultimate collapse, there is a theme: you can usually point to the use and (and ultimate abuse) of a seemingly harmless Wall Street creation. Junk bonds, credit default swaps, high-frequency trading, etc. On his podcast Superinvestors and Art of Worldly Wisdom host Jesse Felder recently interviewed Horizon Kinetics founder Steven Bregman on the topic of the ETF Bubble. It is a fascinating conversation, and I recommend listening to the whole thing.

Here’s a brief summary and why it is relevant to my thesis and to companies like the ones ESL controls.

The best active fund managers in the world have not been able to beat the passive ETFs over the last several years, all with different approaches and all at the same time. That’s quite an anomaly.

As the ETF bubble keeps growing, the true valuations of many companies become more and more disconnected from reality. These companies are seeing their valuations distorted based on these passive management algorithms which follow the float adjusted model of the S&P 500 and other indexes to control where the money flows. I believe many individual companies now trade as derivatives to their weighting within the ETFs. Diversification amongst ETFs is not really safe because as money flows into the same places, it will also – eventually – flow out of the same places. The ETF bubble is really about money flows, and that money has to come from somewhere. Bregman believes much of this phenomenon is due to the move from active to passive management (money flowing from left to right). I think the rise of new, accessible and inexpensive forms of passive management like robo-advisors have exacerbated this effect.

But what happens when the money starts flowing out? What happens when the Fed raises rates and the Baby Boomers start drawing down their retirement funds over the next few years?

The only flight to safety is cash or companies that have the lowest correlation to these ETFs.

So what companies are those? Companies with a low public float have the least weighting within the float adjusted model. You know what kinds of companies have low public floats? The ones with a high percentage of insider ownership. And within that class are the owner-operated companies.

These are the companies that should be the MOST aligned with shareholders.

And yet, these are the ones that have been essentially left out of the last bull market cycle.

Let’s take a look at ESL’s ownership again in these 5 positions:

  1. Sears Holdings (56.5% ownership including warrants)
  2. Land’s End6 (64.5% ownership)
  3. Sears Canada (45.3% ESL ownership + Sears Holdings owns 11.7%)
  4. Seritage Growth Properties7
  5. Sears Hometown and Outlet Stores (59% ownership including warrants)

Alarms should be going off.

THE FINEST TRICK

When the ETF bubble eventually pops, value will matter again. And when the market marches south – and it will – who will be best positioned for the long term? The managers with Permanent Capital.

Those are the managers that will be able to buy on the bottom when everyone else is tapped out.

And if things ever get really really bad, like 2009 bad? Those are the managers that will be making sweetheart deals rescuing the Bank of America’s of this world.

Whether or not that happens, I want the same person managing my investments who is most closely following Warren Buffett’s blueprint, the same person who is putting a significant percentage of his own net worth on the line, and the same person whom David Geffen once described, in a February 8, 2006 FORTUNE Magazine article by Patricia Sellers, like this:

I’ve made more money from Eddie than from all the businesses I’ve created and sold.

Because I think that Eddie has been there the whole time.

And his finest trick is persuading you that he doesn’t exist8.

BUCKLE UP, THE DOORS ARE CLOSING

More than anything, I view an investment in Sears Holdings, Sears Hometown and Outlets, Sears Canada, Land’s End, Seritage and Sears Holdings Warrants as an investment in Eddie Lampert9.

Readers, please do your own diligence when deciding whether or not to take a position, but to those of you who do, I would say this: you need to invest with your own Permanent Capital. You need to use correct asset allocation and risk management within your portfolio and maintain adequate liquidity. You need to match your own time horizon to Eddie Lampert’s. After all, he’s the one in control. And it’s going to be a bumpy flight.

So that’s it. Eddie Lampert is the pilot, ESL Investments has the cargo, and Sears Holdings is the rocket ship. Boarding passes are available to those with intelligence, vision and patience. These Class A shares can be found on the public exchanges…for now.

POP QUIZ ANSWERS

  1. Seritage Growth Properties
  2. KCD IP (Kenmore Craftsman DieHard)
  3. Sears Hometown & Outlets (mostly rebranded as America’s Appliance Experts)
  4. Land’s End
  5. Sears Re
  6. Shop Your Way
  7. Shop Your Way 5-3-2-1 Mastercard by Citi
  8. Innovel Solutions
  9. Sears Home Services
  10. Sears Auto Center
  11. Monark Premium Appliance Company
  12. Wally Home

FOOTNOTES

  1. Without going into too much detail, I am considering writing about this topic in a future SA article.
  2. The amount of Sears Holdings shares paid to Lampert as annual compensation is based on the closing price around the last day of the fiscal year (the “Determination Date”) and then issued on a monthly basis. For fiscal 2017, the closing price on the Determination Date was $7.42, so Lampert is currently accumulating 50,539 shares per month. There is one notable exception to shares being issued since Lampert got control: the unsecured 8% convertible notes that mature in December 2019. These were issued in 2014 through a rights offering and came with warrants (SHLDW) attached. All shareholders of record were treated on a pro-rata pari-passu basis in this offering. Eddie Lampert and Bruce Berkowitz exercised their full rights and currently hold approximately 76% of the warrants outstanding.
  3. This is speculation, but perhaps employees of Sears Holdings must follow the same rules as employees of ESL, which states in it’s most recent annual brochure, “ESL prohibits its personnel, except as described below, to trade interests in any securities held by the Funds, or to trade equity or non-government debt securities which could be traded by the Fund, unless specifically approved on a case by case basis in accordance with the Code of Ethics.”
  4. Cheers to “Rocket Sears” from the Yahoo Finance Message Board, whomever you are. It’s not me though, in case you’re wondering.
  5. Sears Canada is the most fluid situation within the group as it is currently in bankruptcy restructuring through the Canadian court system. As of July 27, ESL and Fairholme have terminated their joint legal representation but each individually retains all options. When they were jointly represented, they filed a motion to block the current Sears Canada management from participating in the bidding process.
  6. ESL has actually increased it’s ownership of Land’s End by several percentage points in the last few days leading up to this article.
  7. ESL has a 39.3% interest in the Operating Partnership and approximately 3.7% and 100% of the outstanding Class A common shares and Class B non-economic common shares, respectively. While this is not technically a voting control position, it is the largest ownership position. I believe it is structured this way for legal purposes unique to REITs.
  8. Generously translated from Charles Baudelaire’s quote, “La plus belle des ruses du diable est de vous persuader qu’il n’existe pas.”
  9. Coincidentally, Jim Cramer wrote similarly in his 2007 book, “In the end though, [Sears Holdings] is a play on my friend Eddie, and I am betting on him.” Just because he was over ten years early doesn’t make him wrong. I wonder if they are still friends…

Disclosure: I am/we are long SHLD SHLDW SRG LE SHOS SRSCQ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article was never meant to be a traditional financial analysis of Sears Holdings, Sears Holdings Warrants, Seritage Growth Properties, Land’s End, Sears Canada and / or Sears Hometown and Outlets.

I greatly respect Bruce Berkowitz and agree with him that the real estate and other assets within Sears Holdings still provide a significant margin of safety. I also agree with Berkowitz that Sears Holdings’ NAV will be clearer to the markets once the losses stop. But I wanted to look beyond a return to fair market value at what I believe to be Eddie Lampert’s true longer term intentions, and I have specifically focused my thesis on Lampert because he is the Control Person.

I have a small inverse ETF position (SH, PSQ) as a hedge against the broader markets which, somewhat ironically, happens to be passively managed.

I do not work for, nor am I affiliated professionally with, any of the following: Sears Holdings, Lands End, Seritage Growth Properties, Sears Canada, Sears Hometown and Outlet Stores, Eddie Lampert, ESL Investments, Bruce Berkowitz, Fairholme Funds, Steven Bregman or Horizon Kinetics.

I am a Shop Your Way VIP member and I love it.

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