Michael Santoli

As Sears cuts Lands' End loose, investors should hold fast

Michael Santoli
Sears to spin off Lands' End business
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FILE - In this Monday, May 14, 2012, file photo, shoppers walk into Sears in Peabody, Mass. Sears Holdings Corp. said Friday, Dec. 6, 2013, that it will spin off its Lands' End clothing business as a separate company by distributing stock to the retailer's shareholders. (AP Photo/Elise Amendola, File)

Like emails pushing discounted polo shirts and beach totes, shares of Lands' End Inc. will arrive unbidden in the accounts of Sears Holdings Inc. (SHLD) shareholders Friday evening.

Such investors should welcome the gift and hang on to Lands' End stock, given its sturdy brand, prospects for financial improvement and the broadly favorable track record of investing in corporate spinoffs.

The deal is good news for Sears, too, representing further progress in chairman and principal shareholder Edward Lampert’s long effort to realize the value of the company's better business assets and store real estate as the core Sears and Kmart retail operations continue to erode.

Before liberating Lands' End, which Sears bought in 2002 for $1.9 billion, Lampert had hived off most of Sears Canada Ltd., Sears Hardware and Outdoor Stores Inc. (SHOS) and Orchard Supply (which later filed for bankruptcy), and the company has also said it might look for ways to separate or sell its automotive-service unit and a warranty business. All the while, Sears is actively marketing many of its 2,000 stores (of which it owns 700) for sale, re-lease or redevelopment.

Sears shareholders of record as of March 24 will receive 0.300795 shares of Lands' End for each Sears Holdings share they own. Lampert, importantly, will own 48.4% of Lands' End upon the distribution of shares, matching his ownership of Sears.

Lands' End shares, which will begin trading formally Monday on the Nasdaq under the symbol “LE,” have already been trading on a “when-issued” basis for the past couple of weeks, under the ticker "LEDMV". At a recent share price of $32, Lands' End carried a market value of $1 billion – near the upper end of the anticipated range based on several comparable companies.

In February, I suggested Joseph A. Bank Clothiers Inc.'s (JOSB) deal to buy Eddie Bauer (which was later  terminated when Men's Wearhouse made a $1.8 billion cash deal to buy Jos. A Bank) offered a rough gauge of Lands' End potential value, and arrived at $1 billion as the higher end of fair value.

Horizon Kinetics, a money manager often cited as a pioneer in evaluating and buying into spinoffs, crunched the numbers and arrived at $31 a share as a plausible high estimate of fair value based on the valuations placed on Eddie Bauer, J. Crew and Lands' End itself the last time each was sold.

Should Lands' End continue to trade in the low-$30s once the spinoff is official, it would be at close to a 50% premium to what bargain-hunters were looking to pay for it based on the company’s sales, cash flow and the multiples the market now pays for somewhat comparable clothing retailers.

A record of outperformance

One reason Lands' End is being well-received in the early going is that it embodies much of what is attractive about spinoffs, which themselves have become a popular hunting ground for hedge funds and various value investors given their long record of outperformance as a group.

Horizon Kinetics, in fact, just recast one of its longstanding mutual funds as a specialist in this market segment, calling it the Horizon Spin-Off & Corporate Restructuring Fund (LSHAX). There is an exchange-traded fund that tries to track the sector, too, the Guggenheim Spin-Off ETF (CSD), which lacks flexibility in capturing the full value of spins but nonetheless has dramatically outperformed the market in recent years.

Spinoffs tend to be underappreciated by Wall Street out of the gate, with no research coverage. The stocks are the only kind that ever shows up in a portfolio without the investor having decided to buy it, so they often come under initial selling pressure before finding their audience.

Lands' End, begun in 1963 as a yachting-gear supplier, has a durable brand, and was under-exploited and not well integrated by Sears, a common theme in spinoffs. As an independent company, management will have the incentives and freedom to pursue a more rapid growth strategy.

While Lands' End sells its wares through some 275 “stores within a store” at Sears locations along with 16 standalone venues, more than 80% of its sales come direct, either online or via the catalog business where its roots lie. Lands' End’s revenue and cash flow has been flat-to-down in the past few years, so investing in it now is less about riding a proven growth story than banking on the idea that a strong direct seller with no terrestrial-retail corporate parent can gain market share.

[Sears Hardware & Outdoor, incidentally, looks rather cheap itself, having declined to the mid-$20s from above $50 last year. Its franchised, smaller-format stores tend to pick up appliance and other hard-good sales surrendered by closed big Sears stores, and the company throws off a nice stream of free cash flow while trading at a big discount to other hardware retailers.]

Illustrating how the spinoff maneuver can surface value the market has been overlooking, Lands' End’s current $1 billion stock-market value now represents 19% of Sears Holdings’ equity market value, even though last year it accounted for just over 4% of Sears’ revenue.

A corporate financier

Lampert is also having Lands' End take on $500 million in debt and hand the cash to Sears, yet another way Lampert treats Sears as a corporate financier, rather than a merchant, would. He has created complex structures for housing the prized Kenmore, Die Hard and Craftsman brands to isolate their value and licensing streams, and placed 125 of the most attractive store buildings in a separate unit walled off from creditors that could deliver outsized value over time. It’s all pretty hard to track, but the Horizon analysts calculate an eventual sum-of-parts value based on some success monetizing chunks of real estate in excess of $80 a share for Sears Holdings.

Too many investors fixate on the truly lousy performance of the core retail business and desultory appearance of the stores and determine that the corporate entity is doomed. It is among the most heavily shorted stocks in the market, with short interest at 64.2% of the float, according to Yahoo Finance data.

For sure, declining sales and Sears’ considerable debt and pension burdens mean Lampert doesn’t have forever to make his math work. But he does seem to have enough time and levers to pull to continue confounding the doomsday crowd for a while longer.

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