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Wednesday, September 06, 2006

Slight of Hand at Sears?

From The Average Joe Investor

As I've mentioned before here, I'm a fan of Cramer. I unfortunately do not make it home most nights in time to watch his TV show, but I usually listen to his radio show Podcast on my commute home, and also will catch an article on every so often. While I don't know that I agree with his investing timeframe for most individual investors and I don't tend to follow any of his suggestions because of the "Cramer Effect," I do think that he knows a lot about investing and he is very entertaining to boot.

Sometimes, though, I do disagree and tonight was one of those times. On his show I was listening to him talk through his take on Sears Holdings Corp (Nasdaq:SHLD), his largest holding for his charitable trust. On the show Cramer walked through the seemingly simple idea of how Sears, currently the third largest diversified retailer, is valued at a market cap of $24 billion versus $42 billion and $190 billion, respectively for Target Corp (NYSE:TGT) and Wal-Mart Stores Inc (NYSE:WMT), and how the company is currently buying back some of what small amount of stock is outstanding and not in the hands of Eddie Lampert (or his "friends"). At the rate that the company is buying back stock, Cramer estimated that they could retire up to half of the outstanding non-insider controlled stock (he approximated 60 million of these shares) in the next twelve months or so.

With the stock trading at $150/share, that amount of buyback action would lop a cool $4.5 billion off the market cap. Surely, Cramer argued, the company isn't worth $4.5 billion less, so the stock price will have to come up to keep the market cap around where it is now. Now I certainly may be unintentionally misconstruing Cramer's words, but will the company be worth $4.5 billion less? In a word, yes. The buyback and retiring of the stock isn't going to happen out of thin air, it's going to be bought using the cash that the company has on it's balance sheet - $3.7 billion as of the most recent 10-Q. And as cash disappears off the balance sheet, whoosh, you magically have a company that's worth less.

Certainly if revenue and profits grow the value of the company should go up, or at least stay steady as shares disappear, but getting a stock to rise consistently by simply taking out shares would be a tough trick. Think about it this way: if you look at Sears right now, it's trading at about 17.8x expected 2006 earnings. If you keep the market cap the same and pull out 30 million shares you're now looking at roughly a $188 share price - now a 22.0x multiple of '06 earnings, and for what? No additional value was created, you just retired a bunch of shares.

As we all know, stock prices are determined by supply and demand - when more people want to buy the stock than want to sell it, prices go up, and when more people want to sell than to buy it, the price falls. So when a company goes to market with an aggressive stock buyback the way Sears is, it creates greater demand for the stock and can push the price higher if there aren't enough sellers in the market. As the price starts to creep up, though, more and more holders are going to start to see the new, higher price as a nice time to make an exit. Generally, when a stock is undervalued, you'll be able to see the stock climb more before too many new sellers come into the market, while when the stock is fairly valued or overvalued, you're more likely to see new sellers come to the market quickly as the price starts to rise.

Which brings me to my last point on Sears, especially with regard to Cramer's comments. Cramer likes to concentrate on finding the "best of breed" company in each different industry - you know the Microsoft's and the Best Buy's of the world. But is Sears really best of breed? It certainly is valued like it is - while it's currently trading at 17.8x forward earnings both Target and Walmart are down around 15x. In part of his comments tonight Cramer quipped "There is more to a store than just how it looks. There are the profits, and at Sears the profits are immense." While I agree that profits are key, if the store can't continue to compete with what I consider to be better-of-breed stores like Target and Walmart it's sure going to be tough to keep those profits growing. And more to the point, it's more than likely that Sears will not be able to support a valuation much above its current level, aggressive buyback or not.

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