Bruce Berkowitz thoughts on Sears

In his recent conference call with shareholders and fundholders, Bruce Berkowitz had some thoughts on Sears (transcript here; audio here.) I haven't mentioned Bruce Berkowitz before on this blog--at least I don't think I have--and FYI, he runs the Fairholme family of value mutual funds. His recent record won't show it but he has been quite successful over the years. He is one of the few value investors who avoided overloading on financials. Presently, on top of some legacy positions, he seems to favour healthcare and defense. His core investing strategy seems to rely on looking at free cash flow. He is one of the few bulls on Sears and here are his thoughts on Sears:

Bruce Berkowitz:

What are the – next question, what are the top successes of Eddie Lampert’s
track record as a capital allocator? (Our key) is rather wide. How do you get
comfortable with his ability for much of what he does and his hedge fund is
not public?

Well, we – Eddie Lampert’s overall record is still quite deep and I don’t know
you know that paper trail is important, but what’s most important to us is
studying, see his balance sheet, its liquidation value. I have a whole bunch of
more question on Sears that are coming a little – that – (of to an) answer and
we go into a bit more detail. But we’ve always shares based upon its
liquidation values and always thought that we were buying below liquidation
values and we shall see. I still believe that Sears is quite reminiscent of
Berkshire Hathaway’s days with the – with Warren Buffet’s days, I should
say, with the Berkshire Textile Mills and that inflection point, that point when
we decided it was time to move on and reallocate the cash to more productive
uses. There’s nothing I see at this point which tells me that will not happen at
Sears.

I don't think one should invest in Sears with the expectation that it is going to be like Berkshire Hathaway in the 70's. However, Berkowitz is correct in pointing out that, if Sears is able to produce cash flow anywhere near it has in the last few years, it can re-deploy it into better things. At worst, knowing that Edward Lampert is a good capital allocator, the cash can be used to buy back shares.

Bruce Berkowitz:

Moving on to Sears, could you explain how you have tried to kill Sears and
could not? For example, how long can Sears whether the poor economic
conditions, which may persist for the next two, three more years? When for
the next few years – how can they pay their annual interest payments of 300
million a year, plus meanwhile annual revenues of 50 billion in operating
income off 0.5 billion? Well $50 billion, even of declining revenues, is quite
a significant amount of revenues and so is an operating income of 1.5 billion
with only 120 million shares. Also, when you take a look at the company’s
balance sheet, and we really have truly assessed Sears based upon its balance
sheet, you’ll see over $10 billion of inventories, payables, four-and-a-half
billion – I mean just the inventories alone equal the price of the stock. If you
want, cut it in half. We haven’t even gotten to real estate, Kenmore,
Craftsman, DieHard, Landon, the brands, cash on the balance sheet.

In 2008, Sears had operating cash flow of around $1.5 billion and around $1 billion free cash flow. It is likely to decline for the next few years but it's not clear what would be sustainable long-term cash flow.

On the bullish side, you have the argument that profits are depressed due to the housing bust and the weak economy. Bulls argue that long-term normalized profits will be higher.

On the bearish side, the argument is that, even though the earnings may be depressed, Sears may be underspending on capex. Some claim stores aren't maintained properly and brand value is eroding by the day. If this is true, what seems like fairly high free cash flow is actually an artifically high free cash flow.

Bruce Berkowitz:

Has our evaluations of liquidation value declined in this environment? The
answer is yes. Is it still dramatically above where Sears is trading today? The
answer is yes.

The collapse in commercial real estate, along with tight capital availability, ensures that the liquidation value will be much lower now than at any point in the last 5 years.

Bruce Berkowitz:

Question, can Sears pay off their debt? Can they refinance at reasonable
terms? I think – I think the answer to both questions is yes and if Eddie
Lampert has any difficulties I think he should call Fairholme cause we would
be willing to help him at the right price.

And let’s see. If Sears retires a debt, but stops or curtails stock buybacks,
what happens to the stock price when Sears can’t fend off the short-sellers?
Well, probably if the short-sellers are still there it goes down. And I think – I
hope the stock does go down because it will be to our long-term benefit. I
mean after all, when you take a look at the $500 million chunk of cash he’s
using to buy back stock, that half-a-billion dollars goes an awfully long way at
$40 per share.

I haven't looked deeply but Sears doesn't seem to have much debt maturing for a few years. But it does have a big revolving line of credit which may be cut if Sears doesn't meet creditor requirements. I don't think financing will be a problem--Sears is one of the few retailers with a good balance sheet--but it all comes down to how low earnings will end up being during the worst part of the recession.

I always cringe whenever someone says that collapsing price is good because one can buy more at a cheaper price (Jim Rogers is famous for saying this about commodities.) Unlike fund managers or wealthy investors, small investors like me don't have a continuously flowing fountain of money that can be used to average down. Declining prices also causes psychological issues because newbies like me start doubting the analysis whenever prices decline. I have mostly been a concentrated investor who avoids income producing assets but I'm thinking of pursuing a strategy of investing in income producing assets, so that I can use the income to fund future investments. It won't be much but it will provide the ability to average down.

Bruce Berkowitz:

One other question, how will you know when Eddie Lampert reaches the
point where you have to sell the underlying real estate at distressed prices in
order to prop up the retail side of Sears? Wouldn’t it be wise to meet with
Lampert to get a sense of whether he actually has a turnaround or asset sale
plan? I guess we’ll know when he sells, but even when he starts to sell, we
always say that they’re going to have to be careful. I mean the real estate
probably very much matches up with some type of – and in our opinion is
correct – some type of 80/20 rule, where you have 20 percent of the real estate
is very, very valuable, even today, and 80 percent may not be as valuable as
some might think.

In terms of meeting Eddie Lampert, it’s probably a good time, but it – just like
Buffet though, I think if you – if you – if you read his letters, if you go
through the queues and the news releases, I think he pretty much tells you the
plan. And the plan does match up in my mind, again, with how Warren Buffet
behaved with the Berkshire Textile Mills.

I don't know much about Edward Lampert given how he runs a hedge fund and nothing is public. However, he does seem like a clean character (for the most part) and I think his thinking captures some of the key concepts Buffett has promoted. I don't like the fact that he is so secretive (doesn't even have an investor relations site accessible to investors) but he seems better than many other successful hedge fund managers.