Financial Freedom

Buffett was Right about Sears Stock (SHLD)

The demise of Sears Stock (NASDAQ: SHLD) provides important lessons for every investor.

• Media hype,
• cult of personality,
• overreaching,
• management with different interests,

and other lessons can help investors avoid the next investment disaster.

Going Concern

• After a recent $900 million sale of its Craftsman brand, store closures and other cost cuts, Sears warned late Tuesday that there’s “substantial doubt” that it will survive (via USA TODAY).
• Lampert owns about 48% of Sears stock, according to the company’s annual report, including holdings through his hedge fund, ESL Investments. Besides his stock, Lampert holds about $381 million in unsecured notes issued to Sears.
• USA TODAY estimates that the value of Lampert’s Sears stock has declined by roughly $519 million since the end of 2014.

Closing Stores:

Retailing Is Hard

Warren Buffett  (NYSE:BRK.A)  (NYSE: BRK.B) on why retailing is so hard:

“Retailing is like shooting at a moving target.

In the past, people didn’t like to go excessive distances from the street cars to buy things. People would flock to those retailers that were nearby.

In 1966 we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn’t going to be a winner, long-term, in a very short period of time.

We had an antiquated distribution system. We did everything else right.

We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn’t win.

So we sold it around 1970. That store isn’t there anymore.

It isn’t good enough that there were smart people running it.”   -Warren Buffett (via BI)

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Eddie Lampert:

AutoZone (NYSE:AZO) vs. Sears

This chart speaks for itself. It’s incredible. AutoZone shareholders have had an incredible run while Sears shareholders have suffered huge losses. And Eddie Lampert was running both companies.

Cult of Personality: The One Decision Stock

The pitch for investors via the media and some investors was that Sears was a one-decision stock, i.e. that investing alongside Eddie Lampert was the only decision an investor needed to make. And based on the performance of AutoZone, it was a simple decision.

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Media Infatuation:  The Next Warren Buffett

 Business week hailed Eddie Lampert as the “Next Buffett” in November 2004.

• Under Lampert’s guidance, Kmart has recently posted four consecutive quarterly profits and generated heaps of cash, even as sales have continued to slide. Kmart on Wednesday announced a 13.7 percent drop in third-quarter sales.

• The Next Warren Buffett? (Bloomberg Article)
• Financier Eddie Lampert turned once-bankrupt Kmart into a $3 billion cash cow. Will he build it into a new Berkshire Hathaway? (via Bloomberg)

Past Performance Is No Guarantee

ESL Investments has returned an average of 29 percent a year since its inception, according to a Business week report, generally by building substantial positions in a few highly researched holdings. (via Business week)

Failed Berkshire Strategy

The Sears strategy was a risky strategy that didn’t actually simulate Berkshire Hathaway very much. Warren Buffett has used insurance companies like GEICO, which generate cash, to fuel his investing. Using a struggling retailer to generate cash to fuel an investment company was a risky idea.

Read If I Ran Berkshire Hathaway here

Concentrated Positions

Eddie Lampert made his name in concentrated positions. For an investor, this is always a high-risk/high-reward strategy. For investors in AutoZone, it paid off. But for Sears shareholders, it has been a huge disappointment and learning experience.

Leverage

Retail is a very difficult business, and in the Internet age, even more so. The massive debt load that Sears has makes it that much more challenging.

Leverage is risk. Any business becomes much harder when servicing a huge debt load.

 

Lampert & Buffett

Warren Buffett predicted the fall of Eddie Lampert and Sears over 10 years ago (via Business Insider)

“Eddie is a very smart guy but putting Kmart and Sears together is a tough hand,” said Buffett to the Kansas crowd. “Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around?”

Selling Valuable Assets:

The problem with these transactions is that they reduced risk for Eddie Lampert and not for the average shareholder. The strategy was to sell off choice assets and have the remaining company be a pure-play retailer. And that retailer has been a disaster for shareholders, as losses mounted.

How Lampert  retained assets even as Sears has shriveled:

•Lands’ End (NASDAQ: LE): Sears spun off retailer Lands’ End in 2014, but Lampert’s hedge fund owns 59% of the company. That stake was worth nearly $360 million as of Wednesday morning.

•Real estate: Sears sold 235 store properties and its interest in another 31 properties to a newly formed real estate investment trust (REIT) called Seritage Growth Properties (NYSE :SRG) for $2.7 billion in 2015. The deal gave Seritage control of some of Sears’ best properties in a sale-leaseback transaction.

Lampert’s ESL owns 43.5% of the limited partnership units of Seritage and 7.9% of the REIT’s voting power.

•Real estate collateral: Entities affiliated with Lampert’s hedge fund extended $500 million in credit to Sears in January, secured by at least 46 Sears properties and possibly more. That means that in the event of bankruptcy, the lender may be awarded the property rights, giving Lampert control of those store sites.

•Additional secured financing: ESL lenders provided Sears up to $500 million through a secured letter of credit facility in December, from which Sears has already drawn $200 million. ESL lenders also hold $336 million in secured debt issued to Sears in April through a separate facility and term loan, as well as $300 million in a second lien term loan issued in September. Secured lenders are paid first in bankruptcy.

•Sears Canada (NASDAQ:SRSC): Sears partially spun off its Canadian division in 2012, but Lampert’s ESL owns about 45% of the company. That stake was worth nearly $80 million as of Wednesday morning.

•Sears Hometown and Outlet Stores: Sears spun off the franchise in 2012, but ESL retains 57% ownership of the company. That stake was worth about $45 million as of Wednesday morning.

“Financially he’s moved a lot of levers that have kept this company going longer than some of us thought it could,”  But with “some of those levers you’re setting the furniture on fire to keep the house alive.”

 

Conclusion

The demise of Sears and the cult of Eddie Lampert as the next Warren Buffett provide lessons for every investor:

• beware media infatuation,
• leverage,
• management interests not aligned with shareholders,
• and always pay attention to cash flow.

Merging Two Iconic Brands: American Express And Goldman Sachs

Thesis:

• Combining these two Icnonic brands makes sense for investors for a number of reasons.
• The merged company would be able to achieve true organic growth.
• Cost synergies, especially in the consumer credit and lending businesses would be significant.
• A higher p/e of the combined company would create value for shareholders and a higher share price.
•   The timing is good since both companies are undergoing a major change with the retirement of long-time CEO, Ken Chenault, as well as the announcement that Lloyd Blankfein will be leaving Goldman at the end of the year.
• A combined company would be able to deliver organic growth, which the companies have struggled to create on their own.
• Both companies are expanding into a credit & lending model.  Risks, cross-selling, and synergies are discussed.

Goldman, Sachs: (GS):

Goldman Sachs Group, Inc. is a leading global investment banking, securities and investment management firm that provides financial services to a client base that includes corporations, financial institutions, governments and individuals.

Founded in 1869, the firm is organized in four different business segments: Investment Banking, Institutional Client Services, Investing and Lending, and Investment Management.

American Express: (AXP):

American Express was founded in 1850 and is one of the most valuable and recognizable brands in the world offering financial services, credit cards, and loyalty programs.

“Your margin is my opportunity.” -Jamie Dimon 

The credit card business is an extremely competitive business.  With the addition of the new Sapphire Reserve card from JP Morgan (JPM), costs have been rising for American Express.

The company is now in a battle to retain their high end Platinum Card customers.

“Cost of card member services in the quarter increased 31% reflecting higher engagement levels across our premium travel services including airport lounge access and cobrand benefits such as first bag free on Delta (D) as well as usage of the new Uber benefit on platinum.” -K. Chenault  (Earnings CC)

New threats from companies like Paypal (PYPL) and services like Apple Pay (AAPL) are pressuring American Express to innovate.  In addition, these competitors have hurt revenue and slowed growth.

Charlie Munger was recently quoted as saying AmEx investors are deluded if they think they know the payment industry’s future.

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P/E Expansion:

A combined company would receive a much higher p/e ratio along the lines of competitors like Visa (V) and Mastercard (MA).  The earnings blend of the combined company would be much less volatile and attractive for investors.

The combined company would also be able to take advantage of cost synergies.  Finally, this would be the rare situation where cross-selling would add to organic growth.

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Earnings Volatility:

One of the advantages of the credit card and consumer lending business is that there is less volatility.  Goldman’s recent earnings were quite good and the market responded positively.

However, when we take a closer look, the earnings of each individual business unit were quite volatile which is typical of their current business mix.

• Investment Banking: +17%
• Institutional Client Services: (17%)
• Investment & Lending: +35%
• Investment Management: +3%

Worse, during the first half of this year, Goldman, normally dominant in bond trading, under performed most of its rivals.  Last quarter, its trading revenue fell 40% while competitors gained.

Organic Growth:

Goldman, Sachs is an excellent company.  However, the firm is having trouble creating organic growth.  Headwinds include the lack of volatility in capital markets over the past few years.  The issue for shareholders is how the company can create growth.

In an attempt to create growth, Goldman is expanding lending across the firm, including to smaller clients of its Marcus consumer loan and deposit business, to corporate clients and to private wealth management clients.

The firm is already trying to cut its reliance on volatile trading revenues with a shift to more stable businesses like investment management.

Lending:

In 2016, Goldman launched a new unit, Marcus which is focused on online lending.  And American Express has also recently launched a similar initiative focused on personal loans.

“Of that $5 billion opportunity that we are pursuing over the next three years, $2 billion of it — $2 billion of the revenue opportunity annually relates to lending.”  –Marty Chavez, GS CFO

The issue for investors is whether this new initiative can be successful.  Goldman has capable and talented employees.  However, this is not a traditional focus of the company.  Analysts are mixed on whether this initiative will be successful.  Conversely, American Express has much more experience in consumer credit.

“Goldman’s growth strategy is focused on penetrating new markets or client segments outside of the company’s traditional strengths, so we are somewhat skeptical of the management’s ability to hit these revenue targets,”  -KBW analyst Brian Kleinhanzl

Timing:

Long-time American Express CEO, Ken Chenault is retiring effective Feb 1st. He’s  had a 37 year career with the company and this is going to be a time of change for American Express either way. The timing for this proposed combination seems ideal in my opinion.  In addition, it looks likely that Lloyd Blankfein will be leaving GS as well.

Synergies: 

I believe the overlap in the lending and loans businesses present opportunities for cost reductions.  I imagine cost reductions in the neighborhood of about $1B per year for the first five years of a combined entity.  As stated previously, these are well-run companies.  However, there is considerable overlap in lending and credit.

Risks:

As a large and influential shareholder of both companies, Warren Buffett  (BRK.B) would likely need to approve this pairing.  Obviously, I believe the idea has merit, and I wouldn’t want to speculate on how Buffett would view the benefits and risks.

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Certainly, blending two entrenched corporate cultures could prove to be problematic.  Both companies have long and prestigious histories.  However, both companies are heading in a similar direction: lending.  So, the combination would seem to offer excellent possibilities and the ability offer shareholders organic growth.

Conclusion:

A combination of these two iconic brands makes sense to shareholders of both companies.  Wall street is likely to reward the new company with a higher p/e based on a less volatile earnings profile.  Cost synergies and cross-selling possibilities would be attainable.  Risks include the blending of corporate cultures as well as the view of Warren Buffett.  Overall, the combined companies would be able to generate organic growth and shareholders would be rewarded.