Tag: SHLD

“What we’ve got here………is a failure to communicate. Some men you just can’t reach….” Strother Martin in “Cool Hand Luke”

Yesterday I was doing my reading on Seeking Alpha and came across Chad Brand’s blog The Peridot Capitalist and his post pertaining to RadioShack (RSH). Since he was the first to recommend it as far as I know, I will direct you to his site when my posts reference them (got to give credit where it is due). Moody’s investment rating services recently downgraded the debt of The Shack saying:

“Moody’s Investor Services downgraded RadioShack Corp.’s long-term senior unsecured rating and short-term commercial paper Monday on lackluster sales and operations. The ratings agency lowered the electronics retailer’s senior unsecured rating to “Ba1” from “Baa3.” The move means the company’s senior unsecured rating is no longer investment grade. Moody’s also cut RadioShack’s commercial paper rating to “Not Prime” from “Prime-3.”

After reading it, the first thing that came to my mind was Sears Holdings (SHLD ) as the similarities are stunning. In his annual shareholder missive, Chairman Eddie Lampert lamented:

“We ended the year with more cash on hand than debt. On a combined basis (including Sears Canada) we have $4.0 billion of cash and only $2.8 billion of debt (excluding capital lease obligations of $0.8 billion). Domestically, our $3.3 billion of cash exceeds our debt balance of $2.3 billion (excluding $0.7 billion of capital lease obligations). Furthermore, approximately $350 million of the outstanding domestic debt represents borrowings by our Orchard Supply Hardware subsidiary, which is non-recourse to Sears Holdings. Despite the conservative nature of our capital structure and our improved profitability, the rating agencies have not upgraded us and continue to hold a non-investment grade rating on our debt. We believe Sears Holdings is an investment-grade company; the lack of response by the agencies is puzzling and is certainly something we continue to hope will change.”

Luke: Yeah, well, sometimes nothin’ can be a real cool hand.

Why is this a big deal? The downgrade, aside from being a negative in the eyes of potential investors means that when Sears and Radioshack do borrow money, it will cost them more. What did Radioshack due to deserve the downgrade? They had lower sales (it should be noted this was inevitable to fix The Shack). When CEO Julian Day, an Eddie Lampert U graduate took over Radioshack, it was stuck in the dead end loop of growing sales and decreasing profits. In an attempt to “just get bigger”, Radioshack fell into the “sales at all cost” mentality. It worked. Sales increase but the unfortunate cost of those sales was decreased profits. This apparently is fine with Moody’s as Radioshack had an “investment grade” rating on its debt (memo to Moody’s: This is bad). Day recognized that this was an unsustainable business model and that unprofitable locations had to be closed and the system wide discounting that was crushing margins and profits had to stop. The result of this would be lower sales initially but if done properly, increased profits. It worked as 4th quarter profits jumped 55% (Day took over in June) and crushed “analyst” expectations. In almost a year now, Day has decreased debt at Radioshack by 30% and increased cash on hand by a whopping 110%. According to Moody’s this was bad?

Boss: Sorry, Luke. I’m just doing my job. You gotta appreciate that.
Luke:: Nah – calling it your job don’t make it right, Boss.

Both Sears and Radioshack have business model that Moody’s clearly just does not understand. Here is the really odd part, they both have the ability at this second, to write a check and pay off all their debt and, have plenty left over! How can any reasonable person consider this a negative? This is even more bizarre when you consider that when both Day and Lampert took over their prospective companies, neither had the ability to pay off even 1/2 their debt and Radioshack was then considered “investment grade.” Let’s pretend you are applying for a mortgage. You have $250,000 in the bank , no other debt and are asking for a mortgage of $175,000. What would you say to the loan officer if he claimed you were a “bad credit risk” because as a sales person you only made $95,000 vs the $100,000 you made the year before (Radioshack had a 5% sales decline in 2006 vs 2005)? Personally, I would resist my initial urge to assault them and then inquire as to what they had drank or smoked for breakfast that morning.

What is Moody’s communicating to retailers? Sales are what count. Annoying things like profits, debt levels and cash levels are secondary. Lampert and Day are both saying by their actions that they have this cute little idea that profits and increasing shareholder value are what really count. Both Sears and Radioshack are in the best financial condition in years yet Moody’s just can’t seem to grasp (or refuses to) the Lampert U concept. Thank god for us shareholders that Lampert and Day ignore Moody’s and do not manage their business’s to appease them..

Maybe a “night in the box” will help Moody’s see the light…..Don’t get it? Watch the movie

Last weekend I listed what I thought were the notable comments from Warren’s letter to the Berkshire Hathaway shareholders. Since I have entrusted the largest portion of my personal portfolio to Eddie Lampert at Sears Holdings, I ought to post the important “notables” from his.

Retail Operations
“Lands’ End had a record year in profitability in its traditional business (i.e., catalog, online, and inlet stores). In addition, we saw a significant improvement in the profit performance of Lands’ End merchandise in our Sears stores. With a new leadership team and a more integrated approach to working across Sears Holdings, the business is moving in the right direction. Our customers are embracing the opportunity to buy Lands’ End quality merchandise in our stores, on the phone, and on the Internet, and we are working hard to make Lands’ End available across more of the chain.”

If anyone has seen the Land’s End “store in a store” concept in Sears, it is a real winner. I am fast becoming convinced that the future direction of Sears apparel will predominately be Land’s End merchandise.

“Home Services is another business that achieved a record year of profitability in 2006. Home Services is not only a highly profitable business for us, but also an important strategic asset as it provides a point of differentiation from many of our competitors.”

“The apparel businesses at both Kmart and Sears also showed continued improvement. Kmart is further along in partnering with our sourcing and design groups, and we believe that we have improved our offering for our customers with higher quality, better fit, and appropriate fashion at great value. Sears apparel has turned around the decline that occurred in 2005 when it moved away from the styles our customers wanted to buy. The team has made significant progress this year, and is focused on creating the kind of breakthrough improvement that would return Sears to its previous levels of profitability in this area.”

On Cash flow

While we like to think of ourselves as a start-up, we are different from most start-ups in our cash flow generation. Since the merger closed in 2005, we have demonstrated a consistent ability to generate cash flow. This strong source of cash provides us the flexibility to deploy capital in the manner that we believe is best calculated to create long-term shareholder value. (Emphasis mine).

Ratings Agencies

We ended the year with more cash on hand than debt. On a combined basis (including Sears Canada) we have $4.0 billion of cash and only $2.8 billion of debt (excluding capital lease obligations of $0.8 billion). Domestically, our $3.3 billion of cash exceeds our debt balance of $2.3 billion (excluding $0.7 billion of capital lease obligations). Furthermore, approximately $350 million of the outstanding domestic debt represents borrowings by our Orchard Supply Hardware subsidiary, which is non-recourse to Sears Holdings. Despite the conservative nature of our capital structure and our improved profitability, the rating agencies have not upgraded us and continue to hold a non-investment grade rating on our debt. We believe Sears Holdings is an investment-grade company; the lack of response by the agencies is puzzling and is certainly something we continue to hope will change. Then again, we have taken these measures not out of a desire to please the rating agencies, but rather because we believe they are the right moves for our Company at this time.

Derivative Instruments

Our disclosure in 2006 that we had entered into total return swap transactions generated a fair bit of media attention and speculation. Perhaps this was prompted by the disclosures that we provided relating to the risk of the investments. As we disclosed in our filings, these total return swaps are derivatives, a term used broadly to describe a vast spectrum of financial instruments, which often have very different characteristics and purposes. Derivatives are so labeled because their value is tied to, or “derived” from, the value of one or more defined underlying indices, prices, or other variables. But it is important to remember that derivatives come in a myriad of forms and carry various levels of risk.

In our case, we entered into total return swaps, whose value is directly derived from changes in the value of the underlying securities. We could have purchased the underlying securities directly, but we elected to make our investments in the form of total return swaps because it can be a more efficient and cost-effective means of managing capital. As of February 3, 2007, the notional value of these derivatives was less than $400 million.

While we chose to include risk disclosures to make clear that, as with all investments, there is risk associated with the total return swaps, it is also the case that every company takes risks every day. Indeed, business is about managing risk. When these risks come in other forms, they are not always accompanied by the same level of detailed disclosure in public filings. Doing business in California will always carry “earthquake risk” and doing apparel business in winter clothing will carry “weather risk.” Investors and executives focus on some of these risks and tend to overlook others. If a company’s risk-management process is a robust one, the level of focus will be proportionate to the amount of risk and the probability of the risk occurring, as well as whether or not the risk can be effectively managed. At Sears Holdings, we try to manage risk in an effective way – whether it is in our investment decisions, our real estate decisions, or our product line decisions – and we are prepared to take risks where we believe the probability of success justifies the investment. We will not always be successful, but if we do a good job of evaluating opportunities and executing on them, we believe that our shareholders will be well rewarded.

A Strategy of Disciplined Growth

As we look ahead, I want there to be no doubt about one thing: It is certainly our intention to grow Sears Holdings. Some commentators have asserted that we want to shrink the Company, but that is simply not so. No great company would aspire to become smaller, and we certainly do not. But before embarking on a growth plan, it is critical to provide a sound base from which to grow. To this end, we have set out to improve the profitability of our business model. Our objective is disciplined growth. We do not want to grow simply for the sake of becoming bigger. Rather, our aim is to become more profitable, and as such we need to ensure that any revenue growth occurs at an appropriate level of profitability.

As we have said before, we do not want to spend $1 too much or $50,000 too little on our stores. Unless we believe we will receive an adequate return on investment, we will not spend money on capital expenditures to build new stores or upgrade our existing base simply because our competitors do. If share repurchases or acquisitions appear to be more productive, then we will allocate capital to those options appropriately. We will seek superior returns, wherever they may be found.

Many of our largest competitors, on the other hand, are primarily focused on growing their top line. To that end, and consistent with the conventional wisdom, they are quickly building new stores. This is a highly capital-intensive way to try to drive returns for shareholders, but provided the return on their investment in new stores is more attractive than their alternatives, it may be the best use of capital for them. Over the past three years, by contrast, we have shown that there are other ways to create value for shareholders. Sears Holdings’ stock has been one of the top retail performers for each of the past two years, as was its predecessor Kmart in 2004, in spite of this non-traditional approach.

We believe we have managed to create a lot of value for shareholders without excessive spending partly because of our disciplined stewardship of our shareholders’ capital. For Sears Holdings, in the near term we believe the greatest value will come not from increasing our store base, but primarily from better utilizing our existing assets to deliver more value to our customers and ultimately our shareholders.

Compensation

I believe one of the causes of the many well-known accounting abuses was this myopic focus on moving share price by driving short-term earnings. As we have explained, we do not attempt to manage earnings or expectations, we generally do not meet with Wall Street analysts, and, except in a few select cases, we have not provided options to our associates. Stock options can play an important role in compensation arrangements if handled correctly, and many companies have used them to motivate and compensate their executives and employees appropriately. The requirement that companies account for stock options as an expense is helpful in highlighting to investors and directors the cost of these programs.

At Sears Holdings, we have linked a very significant part of our executives’ variable compensation to the EBITDA of Sears Holdings or one of its businesses, adjusted for certain items that are not within the control of our associates. We consider EBITDA a superior measure of operational performance, as it provides a clearer picture of operating results and cash flows by eliminating expenses that are not reflective of underlying business performance. We have both a one-year EBITDA goal used for annual bonuses and a longer-term goal that is generally based on EBITDA performance that we have used for our Long Term Incentive Plans (LTIPs). Unlike some companies, which set targets at levels that are difficult to miss, we set targets that are achievable but require us to perform – it is important to set goals that challenge and stretch us.

Members Of The Military

One aspect of Sears Holdings’ commitment to the military – our Military Service pay differential and benefits continuation program – has received a fair bit of grassroots attention in the past couple of years. I have seen a number of emails and blog entries about this program, most of which ask whether it’s true or an urban legend. The initial skepticism is understandable, given the unfounded rumors and exaggerations that can circulate on the Internet, but in this case the program is real. For associates of Sears Holdings (other than certain part-time and seasonal associates) who are called to duty in the National Guard or Reserve, we make up any difference between the associate’s pay at Sears Holdings and his or her military pay – for up to five years. We will also hold a comparable position for an eligible deployed employee for up to five years, and allow those employees to continue most benefits while deployed. Since 2001, we have had over 3,500 associates participate in our military leave program; at present, there are about 400 Sears Holdings associates in the program. We are proud to support these individuals as they serve our Nation.

Having mention Gap (GPS) as a possible investment in a previous post , we must revisit the most recent conference call to see if any of the goals we set for it are being met.

Gap earnings call highlights (at least the ones that matter to me)

–2006 Earnings down and 2007 does not look much better- No surprise

-Closing Forth & Towne. Given the sales, productivity levels, and the traffic momentum we had seen to date, they felt that the probability of achieving an acceptable return on investment from a full rollout of the brand was too low. As a result, they will close 19 Forth & Towne stores by the end of June, 2007.

– Converting Old Navy outlet stores to Old Navy stores. Given the change in competitive environment, there is no longer a clear distinction between the two businesses. They expect to convert the 45 outlet stores by October of this year. This decision has no impact on Gap Outlet and Banana Republic factory stores.

– In addition to gaining cost efficiencies in management structure, this decision also allows them to close one of our Northern Kentucky distribution centers. The expenses associated with converting the Old Navy outlet stores and closing the distribution center will be about $6 million in 2007. However, annual savings from these measures are estimated to be $12 million.

– Regarding share repurchases, they plan to continue to use excess cash to opportunistically repurchase shares. At the end of the fourth quarter, they still had $200 million available under the current authorization. Gap has plenty of cash and still generates enough to buy much more back. My guess is that it will be left for the new CEO to announce the new amount to get him (her) off to a good start with shareholders.

– The real estate strategy for 2007. At this time, they expect to open about 230 new stores and to close about 200. The openings are weighted towards Old Navy as they continue to believe there is additional real estate opportunity and the returns remain attractive, and the closures are weighted to Gap and include the impact of the 19 Forth & Towne store closures. Please also note the 45 Old Navy outlet conversions will be recorded as both a closure and opening to reflect the reassignment. Full year net square footage is expected to be up about 1%.

Gap is off to a decent albeit anemic start. The Forth & Towne closing was a no brainer because it should have never been attempted in the first place. As for the other closings, there will be net gain of 49 stores at year end, mostly Old Navy. Of the 135 stores to close, most will be Gap. Here is my issue, they are only scratching the surface here. Gap does not need to get bigger, it needs to get more profitable and when you are not performing well given the present scale of your company, what make you think being bigger will magically fix that? In 2006, Banana Republic sales were up 14%. Old Navy’s were flat and Gap was down 6%, so we aren’t in a situation where the whole company is struggling, just Gap brands. The move to convert a few of them to Old Navy stores again is a good one but still not enough. What was not discussed was Banana Republic, why not convert some Gap’s into them? Currently Gap is a retailer with an excellent premium brand (Banana Republic), a good value brand (Old Navy) and a John Candy like bloated mid-level brand (Gap). I need somebody to come in a say “we need to be more profitable, not bigger” because the two are not always directly related.

The CEO search continues and I cannot even think about investing until I know the who’s and what’s of what they plan to do. If they are of the Julian Day of Radioshack (RSK) or Eddie Lampert of Sears Holdings, (SHLD ) mold then I will be racing to buy Gap shares (for more on Radioshack, visit Chad Brand’s blog The Peridot Capitalist ). Can you imagine what somebody like them could do with the Gap? What do I mean? Sears Holdings shares are up over 1000% since Lampert took over almost 3 years ago when both Sears and Kmart were left for dead by everybody. Radioshack has gone from one foot in the grave to seeing its shares up almost 80% since Day took over last summer. How did they do it? They have this novel approach that the most important thing they can do is grow profits, not just sell merchandise. Somewhere along the way, retailers got the “bigger at all cost is better” mantra ingrained in them and began to chase sales over profits. Lampert and Day have said, profits matter most, not just sales. This has lead them to close under performing locations, sell off unnecessary assets, keep closer tabs on inventory and not just discount merchandise to drive unprofitable revenue growth. They then take this extra money and begin massive share buybacks, pay off debt and to re-invest in the current locations that are performing satisfactorily. The potential here for a CEO like this to make shareholders very wealthy is just waiting to be had as Gap has $2 billion in the bank, produces another $1.5 billion of operating cash flow per year and is virtually debt free. If they would stop investing in trying to just get bigger and got smart, they could return a ton to investors via buybacks (I estimate 15%-20% in year one at current prices). Currently Gap (GPS) shares are trading over 10% below their early year buyout rumor highs.

If they new guy (gal) has more store growth aspirations or a “new product mix” goal, I will be watching from the sidelines. Gap has a lot to like about it and I think there is a ton of hidden value there, it just remains to be seen what the new CEO will do with it. Think of it this way, if both you and Emeril Lagasse have the same ingredients in your kitchens, my guess is his final results cooking dinner with them will be far superior. Thus is the dilemma with a CEO-less Gap, are we going to get Emeril or Norm Peterson’s dinner from the “Hungry Heifer”? Please don’t tell me you do not know who he is…….

In the past month I had had more than a few email conversations with readers who want to know what to look for before they buy a stock. Rather than keep saying the same thing to you individually, I will try to put it down here. Please continue to email me your investment ideas though, I do so enjoy the process. I need you to remember my mantra “successful investing does not need to be difficult”. Here is where I start:

How far back to I look into a company’s financials? Easy, as long as current management has been there. If the new CEO and his team have been there 2 years, who cares what the previous guy did 5 years ago? The new guy is making the decisions, what is done is done. The only reason to look back is to get an idea of the future and of what the priorities and strategies are. The guy that is gone cannot effect that, why look at what he did? In the same vein, I tend to avoid companies with new CEO’s for that very reason, I have no idea what they are going to do. In full disclosure, one of my portfolio picks ADM, does have a new CEO. Patricia Woertz took over in November last year. I have looked past this because my vision for the company is for it to be the Exxon of biofuels. Woertz came to ADM from Chevron and was hired specifically with this goal in mind so in this case, I know her direction for ADM and mine are the same. You also have to consider that former CEO G. Allen Andreas remained on as Chairman of the Board until recently for continuity. This is a rare exception to the rule. I even avoid new CEO’s that have “risen through the ranks” as there tends to be a desire on their part to “leave their mark” on the company. This leads them to at time create change just for the sake of change and the results are seldom good. GE’s Jeffery Immelt is the rare exception to this rule. For this reason, two of the stocks we are watching now, Gap and Home Depot are not buys at any price until we know what the plans of the new CEO’s are. If your new CEO came from another company, it would behoove you to look at what they did there. Tigers cannot change their stripes and managers do not usually change their methods, especially if they worked before.

Shares Outstanding: This should always be shrinking. If this number is going up your share of the company is going down, bad news. If the company uses stock for acquisitions or issues new stock for operations, it is you who are funding those uses. Here is how. Our company has 100 shares outstanding, they earn $100 ($1 a share) and you own 1 share (for easy math). In this scenario you essentially have ownership of $1 a share in earnings. Now, the company decides to buy a small supplier but does not have the cash so they issue 50 more shares to fund it and because of the acquisition, earning jump 25% to $125. Great news right? No. Because of the dilution of the shares (the extra shares out there issued for the purchase) you only earn 83 cents a share for the shares you own ($125 divided the 150 shares). In this case the extra stock issued for the purchase that caused the 25% increase in overall profits resulted in a 17% drop in your earnings per share. Put another way, you (and the other shareholders) gave up 17 cents to fund the total $25 increase.

Price Earnings Ratio & Growth Rate: These two important metrics are seldom talked about together but I can’t see how they can be separated. Let’s walk through this. The price you pay per share for a stock is neither cheap or expensive because it’s price is $1 or $100. It is only cheap or expensive depending how that price relates to its earnings. For instance, lets say the $1 stock earns 1 cent per share. That means it has a price earnings ratio (PE) of 100 ($1 price divided by the 1 cent per share in earnings). Put another way, the premium you are paying for the stock is 100 times its earnings, you are paying $100 for every $1 in earnings. Now, the $100 stock earns $5 a share. That gives this stock a PE of 20 ($100 divided by$5). In this case the $1 stock is actually 5 times more expensive than the $100 stock (100 PE vs. 20 PE). Does that mean we should run out and buy any low PE stock because it is cheap? Not exactly.

Now we need to talk about the growth rate. This is the rate of growth in earnings per share, not net income. This is another very important distinction. In the first section, our company grew net income but earnings per share dropped because of the extra shares outstanding. The opposite could also be true that net income is flat and because the company bought back shares, the total number of the outstanding shrunk therefore the amount available per share (earnings per share) actually increases. This is why share buybacks help, they provide a cushion. Our new company earned $1 last year and $1.10 this year so they grew earnings 10% (10 cent increase divided by $1 prior year earnings). You want the premium you pay to be as close to or below the growth rate as possible for stocks with steady or increasing growth rates. If the stock has had an abnormally high growth rate and it is falling you must pay far less than the growth rate (I would avoid these stocks until they settle into a sustainable rate). As a rule, I will never pay more than 25 times earnings unless there are unusual extenuating circumstances.

Why is the PE ratio to growth rate so important? It gives you your payoff on the stock or, how long it will take until the total earnings have paid off your initial investment. Our company is growing at 10% and has $1 per share in earnings. We have two investors, (A) pays a premium for the shares (PE ratio) equal to the growth rate (10) and the other (B) pays twice that (20). Now, the question is how long will it take for the earnings we receive each year to equal the purchase price when they grow at 10%? Investor (A) would have to wait just under 7 years while (B) would have to wait 11 years or almost 60% longer!

Going further, let’s assume that both investors bought 100 shares. (A) paid $1000 (100 x$10) and (B) paid twice that $2000. Here is the important part. We are now 10 years down the road and the market is pricing the shares at a PE ratio of 15, or 1.5 times the growth rate (I split the difference). At year 10 earnings per share would be $2.56 and the 15 PE would give the shares a price of $38 per share. Investor (A) has almost quadrupled his money ($1000 to $3800) while (B)’s has not even doubled ($2000 to $3800)! Let’s reverse the scenario and say earnings growth slows to 5% in year 10 and the market decides it will only pay twice that for the shares (PE of 10) at the same $2.56 in earnings the price of the stock would be $25. That means (A) has more than doubled his money ($1000 to $2500) and (B) has only made 25% ($2000 to $2500).

When you pay a premium for shares equal to or only slightly higher than the growth rate, you do two things, you limit your downside risk and maximize your upside potential.

The caveat here is that earning growth rates have to be stable or increasing, not decreasing. If you pay a premium equal to the growth for a stock with decreasing earning growth, the shares will keep falling to the growth rate which means a smaller premium and share price each year. See my Google post for more on this scenario.

Cash Flow From Operations: This tells us the health of the business operations. It gives the amount of money left over after operating expenses are paid. That extra cash can be used for dividends, paying off debt, building new plants, buying other businesses or my favorite thing, buying back shares. It also tells you what management is doing with the extra $$. They may be approved by the board to buy back shares but did they? Here is where you find out. Caveat: Avoid the Net Cash line until later and I will give you a real life example of why. In 2005 Eddie Lampert purchased Sears and formed Sears Holdings (this is a stock I own and you must also). Cash flow from operation in Jan 2005 before he took over was $1 billion and the net cash was $1.3 billion, great job. In Jan. 2006, the year after he took over cash from operations was $2.3 billion but net cash was only $1 billion. If you are only following the net # you would think that things deteriorated. But, by starting at the cash from operations # we see that Eddie did two things we love. He spent $455 million buying back shares and $800 million paying off debt, both of which are actions that benefit shareholders. It should be noted that the first 9 months of fy2007 saw another $800 million in stock buybacks and $500 million in debt payoffs. By starting at the cash from operations line and working your way down you can determine the health of the business and what management is doing with the extra money.

Now, as Deep Throat said in the movie All The President’s Men, “follow the money”. Once you have cash flow from operation you have to determine where it goes. If it goes to Capital Expenditures (new plants, repairs on them etc) pay close attention. If this number is regularly larger than Flow From Operations, that means the cost of maintaining or expanding the business is greater than the cash it generates. The only way this works is to either use more debt or issue more shares. This will occasionally happen in a certain years but if it is a regular occurrence, alarms & whistles should go off.

Skin In The Game: This isn’t an old John Holmes movie. It simply concerns the stake management has in the company. Not only do we care if they own shares but more importantly “are they buying them on them on the market”. I am going to avoid the insider selling issue here. There are dozens of reason insiders may sell stock and most of them are not bad. Some executives are compensated mostly in stock, in order to receive income they must sell some, many sell stock at regular intervals to diversify their holdings, retiring CEO’s often sell chunks to fund retirement and management sells the options (options are a “use them or lose them” proposition) they receive to get the cash. All of these scenarios do not necessarily mean anything negative about the company and all companies see insider selling from time to time. Can anyone think of a reason management would go into the open market and buy shares of the company they work for? The only thing I can think of is they are excited about it future prospects. In the Value Plays Portfolio, OC, SHLD, and DOW have all experienced heavy insider buying. SHLD director Richard Perry recently plopped down $5.3 million of his own money buying SHLD shares when they hit an all time high, clearly he sees a bright future and Eddie Lampert owns 65 million shares. Do you think he will do anything he thinks will wreck the stock price?

To review, while insider selling can be a bad sign, it quite often is not. Insider buying however, in my opinion is almost never bad news.

In Review: If you find a company with stable management, decreasing shares outstanding, increasing cash flow from operations, increasing earnings, with management buying shares and the premium you have to pay is close to or below the earnings per share growth rate, stop and take a closer look. They have the key elements in place for success and warrant a much closer look.

All these figures can easily be found online, I personally use Google Finance but most of the online finance sites will give you the same info.

If you want me to expand on a particular area, comment and I will do my best to accommodate.

All investments have risk. No matter how safe they look and feel, there are risks involved. Let me get that out of the way first. You can never eliminate the risk you assume when you plop down your money on an investment. The question then becomes, how do we minimize that risk? There are many alleged ways, do exhaustive research, only buy bonds or CD’s, avoid tech stocks, etc, etc, etc. Many of these “risk avoidance” options also come with the “return avoidance” result. Yes, you can almost totally eliminate all risk by buying a cd at your local bank but in today’s low interest rate environment you are barely making a return in excess of the inflation that is eating away at those dollars. Also, you have now locked those funds away and can only get YOUR money back should you need it by paying the bank a hefty penalty. There is risk.

This discussion will focus on stocks. While the reasoning I will illustrate does apply to most investments, the discussion will focus on the effect on common stocks and their investors. Let’s look a two charts and try to decide which looks like the better investment:

A quick look would have us saying chart #1 is the far superior investment. Here is the thing though, both charts are of Sears Holdings (SHLD). Chart #1 is SHLD since its inception and chart #2 is its chart for the past 3 months. Same investment and depending on your time frame, two very different results.

When you have a very short time frame, your attention to every minutia of information that may effect the stock is mandatory. Let’s use the 3 month chart above. This investor bought SHLD in October hoping to capitalize on the typical holiday bounce retailers seem to enjoy. What “risks” are there to his investment? Off the top of my head I can think of same store sales at Kmart fall, same store sales at Sears fall, warm weather keeps people out of the mall, snow keeps them from getting there, an “analyst” downgrades the stock out of the blue, the Fed decides to raise interest rates, Iran cuts off oil and it spikes to $80 a barrel and the whole market falls while investors sort it out, Lampert loses money that quarter in his investments (it is bound to happen) or a fire at the Land’s End factory destroys the winter line and quarterly results are adversely effected etc, etc. There are dozens more but those are just a few I came up with without really thinking about it. All of these have no long term effect on SHLD but in the short term would be negatives to the price of the stock (not the value of the company). What should he do? If he reads news articles on SHLD he becomes more confused, one says buy, on says sell and a third chastises him for even buying it in the first place! This investor has probably become frustrated and sold for either a loss or no gain.

Now, investor #2 has held the stock for 2 years now. He sat back and watched during the summer and fall of 2005 when the stock fell from $160 to $120. As he looked at the company he could see no fundamental reason for the dip. Nothing had changed with SHLD and the reasons he bought it were still valid. This being said he decided people were wrong for selling and bought more during this drop (many smart Berkshire Hathaway (BRKA) shareholders did the same during the tech bubble in the late 90’s and have been richly rewarded). The stock has since rebounded and broke through the $160 level up to the near $180 it stands at today. Why was he so confident? He bought SHLD not as a trade but as an investment. He saw SHLD as an investment in Eddie Lampert. He saw increasing profitability in retail operations and a growing cash hoard for Lampert to invest. Based on the 16 year track record Eddie has, that cash is in excellent hands. During the summer of 2005 none of these parameters changed and in fact he had good company as Lampert was in the market buying the stock with him!! The only risks to his investment are a fundamental change in the company’s prospects (retail operations cease to be profitable) or Lampert leaving (unlikely since he owns 60% of the stock). In this investors mind, bad news or an “analyst” downgrade that causes the stock to dip are no big deal since it then allows him to buy more at cheaper prices. All of the risks that investor #1 has are meaningless to #2. They make no difference to the long term prospects of SHLD only the price the stock trades at today. If he plans on holding this investment until one of those fundamental factors changes, the weather this winter which is negatively effecting investor #1, will be meaningless to him.

The shorter your time frame of any investment, the increased risk you face that elements having nothing to do with the fundamentals of that investment will adversely effect the value of it. As you lengthen your time frame you diminish the importance of these short term events (risk).

OK, so we expect SHLD to have about $3.5 billion in its piggy bank at the end of the quarter. time to go shopping? I think so. If we are, what makes sense?

• Invest More In Current Locations: NO!! the current program is working just fine. Lets not forget when Eddy bought Kmart it was fresh out of bankruptcy with bleak prospects and Sears was heading there when he bought it. Now the combined entity is throwing off almost a billion a year in profits. What is the problem? As an investor, the number of sweaters they sell does me no good, the money they make from those sweaters does. Eddy talks of the same store sale fallacy retail metric here: http://www.searsholdings.com/invest/ . Read it carefully to get an idea of the direction he is taking both Sears and Kmart. He has no vision of either of them growing into a colossus. What he wants is for them to become as profitable as possible to provide him $$ to grow Sears Holdings. It is a subtle but very important difference. If you have been to a Sears that has the Land’s End “store in a store” concept, it is a great change.
• Buy Home Depot: NO!! HD was a great value play 2 years ago. Not anymore. Add to this the current hostility towards the board of shareholders (they would almost certainly reject any recommended offer from the board, forcing a hostile bid) and you have the making of a very long, expensive process, nothing Eddy wants
• Buy BJ’S: Dare to dream? This would wonderful. At its current valuation Eddy could write a check for it. It would add almost a dollar a share to next years earnings (adding another 10% growth) without making any assumptions on the financial benefits of synergies. The synergies there are exciting. We would be able to sell more Craftsmen and Kenmore items in BJ’s. Think also of the Sears / Kmart apparel line that could also be sold through BJ’s. Picture a Land’s End closeout section in BJ’s. BJ’s also sells home heating oil in the northeast. The purchase of this would go nicely with Sears service agreements on home heating and cooling systems. Once in the door, sell windows, siding etc. Same with BJ’s auto service locations, picture all the extra Die Hard batteries we could sell . The increase in assets due to BJ’S real estate holding would be a plus for us in a leveraged play later on if he wished. Another oft overlooked plus: we could instead of selling the under performing Kmart and Sears locations, convert them to BJ’s and in one fell swoop preserve the asset base and increase profits. The conversion from a Kmart or Sears to BJ’s would be dirt cheap. Just gut it and stock it… they are warehouses for crying out loud!! Eddy are you listening? I have a real hard time finding any negatives to this scenario.
• Buy Radio Shack: Until last night I though this was just a desperate idea being floated out there, then we scooped John Warren from Best Buy. The knock on The Shack has always been a disconnect between it and its customers. I had not seen anyone at SHLD capable of effectively fixing that (since its own electronics dept. is no world beater). Mr. Warren is arguably the best out there today in the electronics world at??? Consumer Relations … HMMMMMM. That does get the wheels turning. Why would would you raid the #1 electronics retailer for their #1 consumer guy? It must have cost a pretty penny. I am sure that you want to improve your own operations but electronics is only a portion or our business, can he really make that much of a difference? Unless maybe you are planning on buying an electronics retailer with a troubled history defining itself. If you look at the Shack currently Julian Day is turning the books around there. Cash is growing ($225 million to $450 million, profits look to go from 30 cents a share to almost 90 cents next year, but same store sales are falling (does any of this sound familiar?) Did I mention Mr. Day is a former SHLD exec? It would appear that maybe you at SHLD are preparing to make a purchase in this area and want your ducks in a row first. This purchase would vault us to the #2 electronics retailer over night. Might Mr. Warren’s desire be to the then make us #1 over his old friends at Best Buy? This is yet another purchase Eddy could do with a check and would have friends in management there to make it happen. It would add 30 to 40 cents a share to next years earnings again assuming no financial benefits to the obvious synergies. This one is starting to excite me now..