I want to post a quick commentary regarding Sears Holdings (SHLD), a company I have admired (from the sidelines) for quite a while because of its Chairman and owner of 42% of its stock, Eddie Lampert. The stock was down over 10% yesterday on the heels of a reduced earnings outlook, making the shares more attractive.
Sears is a company that throws off solid free cash flow and continues to buy in shares opportunistically. For any company, what matters should not be size or market share for their own sake but profitability in the markets in which it operates. Lampert is keenly aware of this and is managing for profitability. I would compare this to Warren Buffett not growing premium volume just for the sake of having a larger policy base. There have been 10-year periods for Berkshire where premium volume shrank in every single year, but profitability on those in-force policies remained solid. Lampert is a Buffett disciple, so there is ample reason to believe he looks at Sears in a similar way. I think he’s willing to shrink the total size of the “empire” as long as he, per-share, grows wealthier.
If the Sears (and Kmart) business as a whole shrinks, the stores that are still around will be more profitable in their individual markets. What remains of a smaller, more profitable company will have low reinvestment requirements (since it’s just maintaining what it already has). This will lead to even more robust free cash flow (and proceeds from real estate sales) to use for even more opportunistic buybacks. Using this procedure, Lampert can increase per share business value at a steady clip even while aggregate sales and net income decrease.
As an example of his influence on a company, look at what he’s helped orchestrate at AutoZone (AZO), of which he owns 31%. Since 1997, sales and profits at the company have risen 9.2% and 12.7% annually, but 18% and 22%, respectively, on a per-share basis. They’ve done this by focusing on profitability (net profit margin has gone from an average of around 7% to nearly 10% over that time period) and have used increasing free cash flow to buy back heaps of shares. And the stock has followed, up nearly 20% annually over that time.
Full disclosure: No positions
We discuss a broad range of issues that are often investment-related, but not always so. We call it a 'thought blog'. Sagacious: Having or showing keen discernment, sound judgment, and farsightedness.
A Stock to Go with Those Jeans
A stock that has recently come onto my radar screen is that of American Eagle Outfitters (AEO). I must admit that I do not shop at their stores, but I do walk by them during my infrequent sojourns to the local mall. I find the stores to be clean, well put together, and the fashions to be relevant (as judged by the fact that the teens walking around the mall are wearing what I see in their store). I also know a few teens in the core AEO demographic who provide me with knowledge on what fashion trends are out there (I bought the stock for one of them). The company’s core target is 15-25 years olds, and its new concept store, Martin+OSA, targets 25-40 year olds.
Obviously the most important thing for a teen retailer is to have the knowledge of not just current fashions but what will be fashionable in the near future. Keeping “on-trend” is crucial. AEO management has consistently done this for the past ten years or so, by using focus groups and extensive market research to remain relevant. And its clothes are lower-priced than Abercrombie and Fitch (ANF), one of its main competitors, which bodes well for less heady times for retailers.
AEO shares are just 2% off a 52-week low, and are probably sitting there because of concerns about revised (downward) quarterly guidance. But it is the longer-term that I am concerned with, and there is much to like here. For one, I like the recently announced 23 million share buyback, representing 10%+ of outstanding shares. Its Chairman (and founder) owns about 14% of outstanding shares, so his interests are aligned with minority shareholders. The stock trades with roughly 15% of its market cap in cash and a free cash flow yield of nearly 10% based on its 2006 results. Even with growth slowing (which it inevitably will), the company can throw off lots of cash.
At first glance, it looks like the company has no long-term debt on the balance sheet, but it holds about $975 million (present value) worth of operating leases off-balance sheet. That makes its true debt-to-total capital ratio about 40%. So you’re really getting a 12% return on total capital (20%+ return on equity) at a P/E of 13.5. If the company can continue to grow at 5-10% over the next few years, this works out to a fairly cheap price, even if the growth is lumpy. And if its new Martin+OSA stores take off, the shares could look very cheap in retrospect 5 years from now. At current prices, the market seems to be offering a good price for the core business and what more or less amounts to a call option on the Martin+OSA brand for free. And if Abercrombie continues to fall (down over 4% today), its shares could start to look attractive.
Full disclosure: As mentioned, long AEO.
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