Tuesday, December 17, 2013

Sears Holdings' Valuation Part Two: Credit Flows For Subsidiaries Inside A Permanently Embedded Capital Structure

Since the publication of Sears Holdings' Valuation: Between Berkshire Hathaway And Bankruptcy on June 18, the tremendous volume of insightful feedback from all of you who read the provisional SOTP analysis of the company has greatly enhanced my depth of understanding regarding Sears Holdings ( SHLD). First, many heartfelt thanks and sincere gratitude to all those who commented, sent direct messages, and emailed to discuss facets of this company raised in the article and share ideas about the future of Sears Holdings. The extensive nature and wide-ranging assortment of questions, additional perspectives, and issues raised in the comments section offered by so many of you has profoundly refined and heightened my knowledge of this company. As a result, this development brought about two extraordinary unintended consequences. Specifically, the first is to transform the lens through which we can view Sears Holdings, a topic we will explore in this report; the second is the product of all of the valuable research discovered since publication of the original SOTP analysis about Sears Holdings, which will be published soon in a forthcoming book. While it is not appropriate for publication in article format, the arrangement of this comprehensive research is nearly complete for availability in book form with detailed analysis of Sears Holdings, its history and future, and revised valuation estimates based on several different scenarios. The ultimate consequence of this phenomenal progress is that a comprehensive tableau of Sears Holdings appears that is accompanied by a more precise valuation of the company in its future-state form.

This report will focus on a relatively concise analysis that differs from both the "Sears Holdings' Valuation: Between Berkshire Hathaway And Bankruptcy" article and the upcoming book in regard to ease of reading. One of the major shortcomings of the original SOTP analysis is in terms of length and readability, which made it challenging for many to finish in one visit. As a result, this report will make use of bullet points for key information related to each topic. There is much more to cover in this report, which makes this technique more manageable to deliver the maximum amount of information in article format. This report is intended to convey the vital aspects of various parts of Sears' balance sheet in digest form and serve as an abridged version of some of the important facets of the company that are synthesized in much greater detail in the new book. Additionally, this format makes for a central user-friendly repository for those of you who may want to retrieve key data about Sears Holdings without digging around the internet searching for it. Please feel free to use this report as a reference anytime you need quick information or links to sources with further relevant data.

Report Summary

In order to fully comprehend the value of Sears Holdings, the fundamental requirements are in-depth research and unraveling the mysteries of its uniquely complex balance sheet. The latter technique is integral to fathoming concealed worth and penetrating the cloak of GAAP-accounting that obscures the spreads between accounting identities and actual market values. As esteemed Wharton Finance Professor Franklin Allen always reminded his MBA students, "In general you have to be very careful of accounting figures since often they don't correspond to the notions that financial economists use." This simple rule is particularly salient in the case of Sears Holdings and to understand the company from the perspective of its Chairman and CEO Eddie Lampert, who clearly makes decisions from a financial economist mindset instead of an accountant's. As a result, the overwhelming quantity of Sears research tends to focus centrally on the possible liquidation value of the company's prodigious real estate portfolio and, to a lesser extent, any potential income streams derived by monetization,. In fact, it is accepted as axiomatic that the true underlying worth of Sears Holdings is found simply by determining the most accurate value of real estate the company owns and leases. This line of reasoning is the trail most analysts follow, including the majority of the analysis in the "Sears Holdings' Valuation: Between Berkshire Hathaway And Bankruptcy" Seeking Alpha article, yet even the most rigorous investigation of the company's real estate portfolio will only yield around 20 percent of the total picture. Real estate is an important facet to understanding Sears Holdings, yet represents an incomplete investment thesis solely on its own.

Transforming Financial Aspects

To comprehensively value Sears Holdings, it becomes necessary to transcend the instinctive appeal of fixating on the asset side of the balance sheet in favor of exacting a cold, hard inspection of the company's seemingly towering liabilities. While this idea seems somewhat obvious, the reality of most Sears Holdings analysis - the "Sears Holdings' Valuation: Between Berkshire Hathaway And Bankruptcy" report included - is that little, if any, attention is given to the composition and trajectory of its immense obligations. By definition, the operative term in the word "Balance Sheet" implies a balance between what an entity possesses and what it owes others, with the elemental goal of determining its intrinsic worth to the owners. It is through a careful review of the liability side of the balance sheet that offers us a counterweight and a new viewpoint from which to synthesize the nature of Sears Holdings' capital structure and true equity value. To put it more simply, if the asset values are the primary random variable - the white rabbit all the analysts are chasing down the rabbit hole - in this equation, without surveying the contour of the landscape that is shaped by the far more definable variable of liabilities then the genuine determination of equity value becomes more elusive. Essentially, we cannot perceive unity without equilibrium, which translates into accounting for the whole in order to achieve the most accurate SOTP valuation of Sears Holdings.

Notably, some of Sears Holdings' liabilities are priced in the capital markets in continuous time, which makes their valuations relatively transparent. Other liabilities rely on GAAP estimates, quantitative models, and evaluations by credit ratings agencies to discern their value. The central component of the company's financial health is actually found in its centerpiece Revolving Credit Facility, which has pricing terms that were negotiated between the company and the syndicate of 34 banks with lending commitments to Sears Holdings.

The Revolver

As the primary borrowing mechanism for Sears Holdings, the $3.275 billion revolving credit facility supplies the company with an ongoing source of credit to purchase inventory and fund operations. The "Revolver" is an ABL facility administered under the terms and conditions set forth in the Second Amended and Restated Credit Agreement, which was finalized on April 8, 2011. This agreement is one of the single most important documents to truly understand the current corporate structure and possible future-state models for both Sears Holdings and its many various subsidiary companies. The Second Amended and Restated Credit Agreement was originally a five-year lending commitment that is scheduled to terminate on April 8, 2016 unless one of the following occurs: an extension is agreed upon; Sears Holdings decides to pay it off and terminate the revolver early; or in the event of a credit default by the company. The revolver offers a low cost funding source without requiring the company to go to the capital markets on a regular basis to seek additional financial resources for its ongoing operations.

Several key factors regarding Sears Holdings' $3.275 billion revolving credit facility and the Second Amended and Restated Credit Agreement that accompanies it are:

  • The Second Amended and Restated Credit Agreement - based on the covenants contained in the Sears Holdings 6.625 percent final bonds prospectus - essentially follows the contractual legal guidelines that segregate of the subsidiary companies of Sears Holdings into two classifications: "Guarantor Subsidiaries" and "Non-Guarantor Subsidiaries." A meticulously detailed and in-depth analysis of this subject is covered extensively in the upcoming book, although the topic is far too lengthy to cover in an article. For now, the important point is to understand that there is a crucial legal distinction between the two classifications of Sears Holdings' subsidiary companies and that the Second Amended and Restated Credit Agreement is one of two legal documents that contain this information.
  • The $3.275 billion credit facility essentially complements most of the former core operations of SRAC - the Sears Roebuck Acceptance Corp. - as the primary short-term funding mechanism for the Sears retail subsidiary.
  • The inventories and receivables of the guarantor subsidiaries are the main source of collateral for the banks offering credit through the revolver.

As you can see in the chart above, Sears Holdings' reliance on the revolver increased steadily YTD in 2013. While Q3 closing is consistently the peak inventory period ahead of the all-important Q4 holiday season, both of the preceding quarters in the first half of 2013 resulted in well over $1.3 billion dollars of revolver borrowings. Compared to the comparable quarters in the first half of 2012, the first half of 2013 quarterly revolver borrowings represent over $500 million of YoY increases. At first take, this circumstance may seem to reflect a necessity for Sears to tap its credit facility as a consequence of the extraordinary operating losses the company has endured throughout 2013. While this condition may in fact be true, and the logic behind the decision will be more apparent later in this report, it also understates the true amount of borrowing this year as Sears Holdings used the accordion feature in the ABL agreement to pay $1 billion of its revolver debt down with its Incremental Term Loan in Q3 2013. 2 Also, notice that letters of credit have steadily declined in the last two quarters as revolver borrowings increased. This condition is made even more interesting by the following note in the SHLD 2012 10-K that reads, "The majority of the letters of credit outstanding are used to provide collateral for our insurance programs." 3 For those who understand the implication of that note, the plot thickens. Included in the ABL agreement is a $1.5 billion sub-limit for letters of credit, which the chart above illustrates Sears Holdings only used roughly 50 percent of that total in any given quarter over the last two years. 3 The primary aspect regarding Sears Holdings' use of its ABL facility is that the trend is increasing for the past three quarters, with both Q2 and the MRQ significantly above the former peak of borrowing in Q3 2012.

Another important set of facts about the revolver is that its credit terms vary, based on the amount of leverage used, in the range of LIBOR plus 2 percent to 2.5 percent. Notably, these terms were successfully renegotiated with the lead banks participating in the revolving credit facility's Second Amended and Restated Credit Agreement to reduce the former terms of LIBOR plus 4 percent with a 1.75 percent LIBOR floor. Sears Holdings was also able to renegotiate commitment fees to a range of 0.375 percent to 0.625 percent, from the former range of 0.75 percent to 1 percent. In total, Sears Holdings reduced the costs associated with its revolving credit facility by more than half with the Second Amended and Restated Credit Agreement in April 2011.

The following is a list of LIBOR rates as of December 15, 2013 from the WSJ Market Data Center:

  • 1 Month LIBOR: 0.16400 percent
  • 3 Month LIBOR: 0.24385 percent
  • 6 Month LIBOR: 0.34540 percent
  • 1 Year LIBOR: 0.58060 percent

Clearly, the revolver and the Second Amended and Restated Credit Agreement are empowering Sears Holdings to fund the transformation of operations to the future-state "Integrated Retail" model at lower credit costs, while the company incurs massive quarterly losses during the restructuring process for its guarantor subsidiaries. The ability to obtain credit at such favorable terms is an essential aspect of Sears Holdings' financial health and vital to achieving Eddie Lampert's vision of Integrated Retail that was detailed in the original "Sears Holdings' Valuation: Between Berkshire Hathaway And Bankruptcy" report.

ABL First Lien Collateral

The inventory and receivables for credit card and pharmacy accounts are the underlying first lien collateral for both the revolver and the new $1 billion term loan. By encumbering the inventory and receivables of the guarantor subsidiaries, Sears Holdings has effectively leveraged some of its most liquid current assets in return for a massive credit line with favorable terms.

In the chart above, you can see the inventory of Sears Holdings in each quarter by the amounts with payables attached and the amounts that the company owns outright. Even during the peak inventory period at the close of Q3, the company retains net equity in 60 percent of its total inventory the last two years. During the other three quarters, this number has risen to around 64 percent. Importantly, in its 2012 10-K filing, Sears Holdings detailed some of the risks to its ability to use the revolver - as well as, at the time prospectively, secure the $1 billion term loan accordion feature that ended up being finalized in early October - by disclosing, "While the Company's domestic revolving credit facility currently provides for up to $3.275 billion of lender commitments, our ability to borrow funds under this facility is limited by a borrowing base determined relative to the value, from time to time, of eligible inventory, accounts receivable and certain other assets. If, through asset sales or other means, the value of these eligible assets is not sufficient to support borrowings of up to the full amount of the commitments under this facility, we will not have full access to the facility, but rather could have access to a lesser amount determined by the borrowing base." 3

Essentially, this translates into the value of Sears Holdings' inventory and receivables for credit cards and pharmacy being vital to the company's ability to continue tapping credit from its ABL facility. Several key considerations arise from this circumstance:

  • Sears Holdings must necessarily either continue holding the lesser of 70 percent of the "net eligible inventory" and 80 percent of the "net orderly liquidation value," along with 85 percent of aggregate outstanding eligible credit card receivables and the same percentage of eligible pharmacy receivables, or otherwise its borrowing capacity under the revolver could be reduced.1
  • Pharmacy receivables are only generated by the Kmart and mygofer guarantor subsidiaries as the only prescriptions that are filled at Sears stores are for sears optical products. An obvious, yet important fact to consider.
  • Pharmacy receivables due from Medicare, Medicaid and other governmental authorities are not considered "eligible pharmacy receivables" under the revolver's credit agreement.1
  • Prescription lists are also considered ABL Priority Collateral under the terms of the Second Amended and Restated Credit Agreement.1
  • Inventory located at a store that is being closed, except during the first four weeks after the store closing sale begins for that particular location and only after the inventory value is marked down by a fair and reasonable "closed store reserve" amount that is established by Sears Holdings, is not considered "eligible inventory" for purposes of the ABL credit agreement.1
  • The spin-off of the guarantor subsidiary Sears Hometown and Outlet Stores (SHOS) significantly reduced Sears Holdings' "eligible inventory" as defined by the Second Amended and Restated Credit Agreement.
  • Any impact on "eligible inventory" of the proposed spin-off of Land's End and potential sale or spin-off of Sears Auto Centers on the revolver's credit line must be taken into account.
  • The partial spin-off of the non-guarantor subsidiary Sears Canada (OTCPK:SEARF) in November 2012 did not have an effect on the ABL agreement's eligible inventory since Sears Canada is not a guarantor subsidiary under the bond indenture, nor a signatory to the credit agreement that only applies to U.S. domestic and territorial subsidiaries.
  • Sears Canada, which is 51 percent owned by Sears Holdings, has no outstanding borrowings and $800 million Canadian dollars worth of credit available under its own revolving credit facility.2
  • Inventory that is being stored in distribution centers for the Shop Your Way online retail business is considered "eligible inventory" until the point at which it sells when an online or mobile transaction is made. It ceases to be eligible inventory at the moment of transaction verification, even prior to receipt of cash or order fulfillment and shipping of the product from the physical inventory.1
  • Inventory that is on layaway is not considered "eligible inventory" under the credit agreement.1 Note that Sears launched a lease-to-own program through a third-party partner in May of this year, which was followed by Kmart starting a similar program in November 2013. The lease-to-own programs are traditionally viewed as an alternative to traditional layaway.
  • Sears Holdings is not allowed to close more than 250 full-line Sears or Kmart stores in any fiscal quarter or 500 full-line stores within four consecutive quarters without receiving permission from the ABL agreement's banks - with Bank of America (BAC) appointed lead over such decisions by its partners Wells Fargo (WFC) and GE Capital (GE) - in order to retain full access to the revolver's $3.275 billion credit line.1
  • The Revolving Credit Facility is scheduled to expire in April 2016, although Sears Holdings' guarantor subsidiaries will still be held to the terms of the Second Amended and Restated Credit Agreement as it will continue to apply to the Incremental Term Loan until June 2018 unless it is paid off before that time.2 By April 2016, Sears Holdings will have to either negotiate a new revolving credit line or find an alternative funding mechanism.

These considerations are only a small assortment of the ways in which the revolver impacts - and could potentially guide - the operational activities of Sears Holdings. Combined with many other covenants in the Second Amended and Restated Credit Agreement, they confute many of the rationalized myths that have emerged in the investment community over the years regarding the intentions of Eddie Lampert and any theoretical strategy of unlocking value through a managed-liquidation business model. Principally, in order to retain full access to the revolver's credit line and abide by the conditions of the ABL agreement, any large-scale sales of real estate and leases for stores currently in operation would be substantially limited by both the eligible inventory requirements and requiring permission from the banks to exceed the caps on store closures. Note that no such provisions necessarily apply to non-guarantor subsidiaries, although these subsidiaries have their own unique set of consequences to consider, which will be fully covered in the upcoming book. Additionally, any notion of spinning-off Kmart, for example, could only be contemplated after either paying the revolver off, allowing it to expire, or renegotiating a third amended credit agreement for a new ABL facility to account for the loss of first lien collateral from inventories and pharmacy receivables. Essentially, this translates into the two main guarantor subsidiaries - Sears and Kmart - being inextricably tied together for the remainder of the period covered by the Second Amended and Restated Credit Agreement, while other guarantor subsidiaries covered by the agreement, such as the former subsidiary Sears Hometown and Outlet Stores, and current subsidiaries Land's End, the Sears Protection Company business, and Sears Auto Centers are, or could be, either spun-off or entirely sold.

As you can see in the chart above, Sears Holdings' working capital in the MRQ is now at the highest level of this year, which is primarily a consequence of the shift of $1 billion of ABL credit from the revolver to the incremental term loan accordion feature that we will detail in the next section of this report. As a result, working capital in the MRQ is $250 million higher than the comparable quarter in 2012, a shade higher than the Q4 2012 amount reported in February, and revolver borrowing capacity has been freed up by essentially stretching a large portion into long-term liability duration with the accordion loan. It is important to consider that this chart does not include the $250 million dividend distribution that Sears Holdings will receive from Sears Canada on January 8, 2014, which will likely provide a substantial boost to the company's working capital amount at the end of Q4 2013. Taken in combination with Sears Holdings' own real estate transactions this year and the incremental term loan, the upcoming Sears Canada distribution will bring the total to around $2 billion of liquidity for the company in the second half of FY 2013 before accounting for any funds from the anticipated Land's End spin-off or possible sale of Sears Auto Centers in early 2014.

With the aforementioned limitations of the ABL credit agreement in mind, CFO Bob Schriesheim clearly stated the company's goal of reducing inventory when he told analysts on the Q1 2013 conference call, "We intend to reduce our expenses by $200 million and did so by $46 million in the first quarter. We plan to reduce our inventory at peak by $500 million, which should generate about $300 million in 2013." 5 As the inventory chart above demonstrates, Sears Holdings actually reduced peak inventory in Q3 2013 by over $650 million from the comparable peak quarter in 2012.

In order to understand one tiny facet of the way Eddie Lampert envisions the role of inventory both operationally and from the perspective of a current asset, consider some of his statements from the Q1 2013 conference call. First, in response to a question about inventory management from analyst Mary Ross Gilbert from Imperial Capital, Lampert remarked, "So I think there are two dimensions to that. Number one, if we don't have the inventory in the store, is that a lost sale? And in the past, was that a customer who would leave and go buy a product elsewhere? Now, we have the ability, you may have seen some of our commercials, but we now have the ability where if you come to the store and we have the product you want, it's not in your size, it's not in the color you want, that we'll ship it to you. And so the ability for us to use store inventory to fulfill online orders, as well as to use non-store inventory to fulfill what effectively are store orders, that's what we're talking about when we talk about integrated retail. It's not that you buy online or you buy in-store, we have, to use an example, if we have a thousand units of a product in one of our DCs, we might have a hundred units of that product or 50 units of that product in a thousand stores. So the idea of having 50,000 units in the stores and 1,000 units in a DC, and if the DC was out of stock to basically not be able to fulfill that, doesn't make sense." 5 This statement alone speaks volumes about Eddie Lampert's vision of the role of the company's inventory distribution and the interplay between brick-and-mortar real-estate and the omni-channel.

Lampert also shared his thoughts on Sears Holdings' retail subs carrying such large amounts of net equity inventory, answering Paul Swinand of Morningstar's question about responsible inventory reduction by stating, "I think it's a combination of store closings, changing the business model to integrated fulfillment, where we carry the inventory and how we fulfill the inventory, whether it's from store or online. And it's also taking a much harder look at inventory turns, return on inventory investment, the aging of inventory where we're taking a much harder look, and a more disciplined look at that, and we think we have some good opportunities to reduce inventory without impacting the business. I think Rob has referenced in the past and in this call that we have $4 billion to $5 billion of inventory with no payables against them. That's fairly unusual for a large retailer. Most retailers have higher inventory turnover and higher return on inventory. So as we get more granular in looking at that, we think we have some opportunities to reduce inventory without impacting the business." 5 Clearly, Lampert is indicating that applying greater leverage to Sears Holdings' inventory might result in higher rates of return if inventory turnover can be materially enhanced by SYW and Integrated Retail.

Incremental Term Loan

In October 2013, Sears Holdings secured a $1 billion term loan under the same terms of the Second Amended and Restated Credit Agreement that matures on June 30, 2018. The term loan was secured by Sears Holdings using the accordion feature in the ABL credit agreement that provided the terms for the additional borrowing capacity. The term loan enjoys the same priority position over the first lien collateral of the company's guarantor subsidiaries. The entire $1 billion of funds from the term loan were used to pay down the company's balance on the $3.275 billion revolving credit facility, ostensibly freeing-up Sears Holdings' credit balance under the revolver and providing access to greater liquidity.

As you can see in the chart above, the total debt of Sears Holdings rose by over $950 million on a sequential quarter basis from Q2 to Q3 of this year. The increase reflects the new debt added by the $1 billion Incremental Term Loan and brings the company's balance of total debt to the highest level in the past two years. It is important to note several key elements of this chart that illustrate the effects on Sears Holdings for 2014. First, as you can see in the chart, Sears Holdings typically experiences a seasonal peak in total debt in Q3 closing, which indicates around an 8 percent drop YoY in total debt for Q3 2013 if we back out the $1 billion added by the term loan. Next, as the chart illustrates, Sears Holdings is capable of paying its debt down rapidly in the final quarter of the year as evidenced by the drop from Q3 to Q4 2012 that reduced total debt by over 20 percent. Lastly, the total debt for Sears Holdings has averaged around $3.75 billion for the first two fiscal quarters of 2013 and would be close to that average sans the $1 billion term loan for Q3. This reflects the fact that the company was beset by huge operating losses thus far in 2013 that required additional financing to turn the corner on the restructuring of Sears Holdings' guarantor subsidiaries.

Some of the key facts to consider about the Incremental Term Loan are the following:

  • Guaranteed by the same subsidiaries of Sears Holdings that guarantee the $3.275 billion Revolving Credit Facility.
  • Secured by the same collateral of the guarantor subsidiaries as described in the Second Amended and Restated Credit Agreement.
  • Interest rate for the loan is determined by either LIBOR - with a floor of one percent - plus a 4.5 percent margin, or a base rate of 3.5 percent plus the highest of either Bank of America's prime rate, the federal funds rate plus 50 basis points, or the one-month LIBOR plus one percent. Sears Holdings determines the most favorable set of rate terms from those options.
  • Quarterly payments on the term loan of $2.5 million begin on February 2, 2014.
  • Mandatory repayments from excess cash flow begin in 2014 under the terms of the Second Amended and Restated Credit Agreement.
  • The term loan can be partially or completely repaid ahead of schedule without any penalty unless Sears Holdings renegotiates the terms of the loan in the first year, which will cause a one percent prepayment premium - roughly $10 million - to be added to the balance.
  • Moody's downgraded the Sears Holdings 6.625 percent secured bonds to a B3 rating from B2 on September 17. The ratings agency further downgraded the SRAC - Sears Roebuck Acceptance Corp. - unsecured notes one notch to Caa2 as a result of the additional first lien collateral claim reducing the assets available to the unsecured creditors.
  • Moody's also assigned a rating of Ba3 to the Incremental Term Loan and noted that the rating outlook remains stable for the company.
  • The term loan matures on June 30, 2018, which will be the fiscal quarter immediately preceding the maturity of the Sears Holdings 6.625 percent bonds.

While Moody's and holders of SRAC bonds may not be thrilled about the term loan, the benefit to Sears Holdings of securing this financing is evident. The ultimate consequence of the Incremental Term Loan is that it effectively stretches the duration of $1 billion of Sears Holdings' previous ABL borrowings at terms much more favorable than an additional offering of secured notes with the same maturity would yield.

ESL and Eddie Lampert

When we contemplate Eddie Lampert's role in Sears Holdings, the common image is that of majority shareholder, Chairman, and, most recently, CEO. Above all of these titles, Eddie Lampert is known first and foremost as the manager of ESL, which is the prominent hedge fund bearing his initials that he formed in 1988. Most do not immediately think of Eddie Lampert or ESL as financial intermediaries with a completely symbiotic interdependent relationship with Sears Holdings as separate and distinct legal entities from the individual subsidiaries of the consolidated holding corporation, yet that it is a vital role they play for the company. In addition to being the largest shareholders and beneficial owners of Sears Holdings, Eddie Lampert and ESL are providing substantial financing to the company through purchases of commercial paper, bonds, and by writing trade receivable puts with certain third-party vendors.

As you can see in the chart above, Eddie Lampert and ESL held a combined $140 million of unsecured commercial paper issued by SRAC - the Sears Roebuck Acceptance Corp. financing subsidiary - as of the 10-Q filing for the MRQ. 2 Additionally, ESL is the counterparty to $90 million worth of participation through an unidentified financial institution in trade receivable put agreements with certain unspecified vendors doing business with Sears Holdings. 2 Essentially, a trade receivable put agreement is a credit derivative that offers the right for a vendor to exchange the outstanding account receivable claim against a company in default for a pre-determined face value. These agreements are a form of insurance for vendors to hedge against the credit risks in carrying trade receivables. Since Sears Holdings has yet to experience any credit events, that suggests that ESL is simply collecting premiums from the agreements in return for providing insurance protection as a counterparty to the company's trade vendors. Notably, ESL's current participation in trade receivable puts in the MRQ is significantly less YoY than Q3 2012 when the hedge fund held a participation interest of $315 million. 2

Similarly, Eddie Lampert held only $88 million and ESL only reported $52 million of unsecured commercial paper in the MRQ, which is substantially lower than the $325 million combined in the comparable quarter in 2012. 2 In the company's Q3 2013 10-Q filing, Sears Holdings disclosed that for the first nine months of 2013 ESL and Eddie Lampert averaged a 2.77 percent annualized interest rate and 29 day maturity with a $237 million average amount of principal outstanding YTD through FY 2013. 2 This rate and duration is in alignment with the estimated term structure for Sears Holdings that we will feature later in this report and demonstrates that Eddie Lampert is willing to provide unsecured credit to the company, acting as a financial intermediary, through the funding mechanism of ESL. Likewise, Eddie Lampert and ESL purchased a total of $95 million of the 6.625 percent Sears Holdings secured bonds with a maturity in 2018 that they continue to report holding as of the MRQ. 2 Additionally, they own a total of $3 million of SRAC unsecured bonds as of the MRQ, which is down from $5 million in Q3 2012 due to the maturity of previously owned Sears DC Corp. subsidiary notes in 2012. 2 Finally, as owners of a 28 percent stake in Sears Canada, ESL will receive around $141 million from the upcoming Sears Canada $5 per share special dividend.

Pension Plan

One of the primary causes of Sears Holdings' operating losses in recent years is the enormous costs related to its pension benefit obligations. These legacy costs have required Sears Holdings to contribute over $1.15 billion to the company's pension plan in the past three years. These outlays reached a temporary peak in FY 2012, yet are projected to rise again in FY 2014. With Sears Holdings in the process of effectively restructuring its guarantor subsidiaries, the timing of these large funding requirements to the defined benefit plan is suboptimal and places an additional burden on the company's financial resources.

In the chart above, you can see that the annual contributions to the Sears Holdings pension plan have grown steadily since 2009 to a peak of $516 million in 2012. Notably, the estimated $352 million contribution required for 2013 is more than double the amount necessary for the company to fund the pension plan in 2009. As of Sears Holdings' Q3 2013 quarterly filing, the company reported that it has already contributed $326 million YTD and anticipates it will contribute another $94 million in combined funds to both the SHC pension plan and Sears Canada postretirement plan. 2 If those estimates hold, pension contributions for 2013 will total around $420 million, which is nearly $70 million higher than the projections in the company's 2012 Annual Report. 3

Over the past three years in particular, the annual funding requirements of the pension plan have materially impacted Sears Holdings' financial position and slowed timetables for completing the transformation of the company. Eddie Lampert stated the importance of the annual contributions and the vital role of stakeholders in Sears Holdings while discussing the way some of its accompanying responsibilities limit the company's progress when he told Reuters, "It is not just in isolation what we want to do. We have got to manage a business with obligations to pensioners, obligations to our employees, obligations to vendors. We have got a lot of people who depend on a pension from Sears, which has hampered our ability to be more aggressive."

As you can see in the chart above, the unfunded balance for the Sears Holdings pension plan has increased significantly in the last three years despite the enormous contributions the company has made during that time period. This condition is primarily a result of the decrease in the applicable discount rate from 5.75 percent in 2010 to 4.25 percent in 2012. The smaller denominator, particularly when discounting the obligations in the out-years, has led to a requirement for the company to make higher annual contributions to ameliorate the rate effects in an effort to bring the plan's balance to a fully funded level. As a result, the company is beleaguered by the impacts on the time value of money associated with historically low long-term interest rates.

When evaluating the impact of future annual contributions on this obligation, the following key facts about Sears Holdings' pension fund are worth considering:

  • For every 1 percent decrease in the discount rate, Sears Holdings' pension fund obligation will increase $814 million.3
  • For every 1 percent increase in the discount rate, Sears Holdings' pension fund obligation will decrease $674 million.3
  • The original Sears, Roebuck and Company pension plan was frozen to new participants on January 1, 2005 under the tenure of former Sears CEO Alan Lacy, more than three months prior to the shareholder vote on the Kmart merger.6
  • The original Kmart pension plan was frozen completely on January 31, 1996, over a half decade before the company declared bankruptcy.6
  • The original Sears pension plan was completely frozen for new accruals of benefits by "grandfathered" participants - employees that met certain eligibility requirements and service tenures - on December 31, 2005, which was approximately 9 months after the merger with Kmart Holdings had been approved.6
  • With both in frozen status, the Sears Pension Plan and Kmart Corporation Employee Pension Plan were merged on January 31, 2008 to form the Sears Holdings Pension Plan.6
  • No assets can be returned to Sears Holdings unless the pension plan is terminated and there are enough assets to pay the entire amount of defined benefits to all of the fund's participants.6
  • Due to its frozen status for the past eight years, actuarial considerations will begin to reduce the size of this obligation over the next decade and a half as the number of participants in the plan declines.
  • Sears Holdings paid out $1.5 billion to former employees who were vested participants in the pension plan in a one-time voluntary lump-sum payment in December 2012 in an effort to reduce total qualified pension fund obligations by approximately $2 billion.3
  • By following GAAP rules, the lump-sum payment, made with funds from the pension plan, had to be expensed as an unrealized non-cash actuarial loss of $452 million in Q4 2012.3
  • The pension plan purchased $250 million worth of the Sears Holdings 6.625 percent bonds with 2018 maturities in a private placement when they were issued in 2011.3
  • The pension plan holds $110 million worth of the 2018 Sears Holdings 6.625 percent senior secured notes as of the MRQ, which, as verified by the Pensions and Investments trade publication, is primarily a consequence of selling the Sears Holdings bonds to fund the lump-sum payments to buy out participants in Q4 2012.2

The important elements to understand about the pension fund is that it is frozen, has been used in the past as a source of capital in a bond offering, is reducing participants through lump-sum buyouts and actuarial rates, and the amount of annual contributions required to fund it in any given year is inextricably tied to long-term interest rates.


While Sears Holdings addresses the legacy costs associated with its pension plan, the company took proactive steps to reduce its long-term debt in 2011 that are significantly reducing its annual interest expense. However, there are greater advantages to the methods Sears Holdings used to undertake this initiative, most notably by establishing the legal distinction between the guarantor subsidiaries and the non-guarantor subsidiaries in the company's bond covenants. This legal distinction is essential to the company's transformation and is a subject that will be fully explored in the forthcoming book on Sears Holdings.

In the chart above, you can see that the annual interest expense incurred by Sears Holdings has declined over the last three years to $267 million in 2012. This condition is improving this year, with interest expense tracking an annual run-rate of around $240 million for 2013 with $181 million YTD. 2 A combination of debt maturities and buybacks have contributed to the reductions in annual interest expense since 2011. In particular, Sears Holdings made significant progress in recapitalizing the company in 2011 with the credit agreement for the current ABL facility and issuance of the SHLD 6.625 percent notes.

Sears Holdings' key recapitalization effort was completed in September 2011 with the successful exchange of SRAC unsecured debt with SHLD 6.625 percent secured bonds at the same interest rates and maturities in 2018. At the time of this debt issuance, Sears Holdings sold $250 million of the $1 billion bond offering to the pension plan in the private placement that we covered in the previous section of this report. 3 Additionally, ESL and Eddie Lampert purchased $95 million of the bonds in 2011 that, according to the 10-Q from the MRQ, they are still holding. 2 The bonds are secured by a second lien on collateral that is identical to the ABL facility: inventory and credit card receivables. 7 Notably, pharmacy receivables are not encumbered by these notes and the liens on the inventory and credit card receivables are classified as junior to the ABL credit security of the banks in the Second Amended and Restated Credit Agreement. Additionally, the notes rank junior to all debt and liabilities of the non-guarantor subsidiaries, which have assets that are not encumbered at all by the bond indenture or credit agreement. 7

Two key items contained in the "Risk Factors" section of the final Sears Holdings 6.625 percent bonds prospectus are particularly salient regarding much of the aforementioned information. First, the role of the bond indenture on the non-guarantor subsidiaries of Sears Holdings and any potential effects of guarantor subsidiary recapitalization and credit guarantees on these subsidiaries:

" We conduct a substantial portion of our business through our subsidiaries. Certain of our subsidiaries will not guarantee the notes, including Orchard Supply Hardware Stores Corporation and Sears Canada Inc. and their respective subsidiaries. Claims of creditors of our non-guarantor subsidiaries, including trade creditors, will generally have priority with respect to the assets and earnings of such subsidiaries over the claims of creditors of Holdings, including holders of the notes. The indenture governing the notes does not prohibit the incurrence of additional indebtedness by our non-guarantor subsidiaries in the future." 7

While the provision specifically cites Orchard Supply Hardware and Sears Canada - at the time entirely or nearly completely owned by Sears Holdings - it does so inclusively and not exclusively. This indicates that these two companies, one now spun-off and bankrupt while the other is only 51 percent owned by the company, are only two out of a long list of non-guarantor subsidiaries that are not encumbered by these notes. This, like so many other subjects, will be comprehensively covered in the upcoming book. Although the second key item from the 2018 6.625 percent bond prospectus has been cited numerous times in many different research reports on Sears Holdings, it is entirely appropriate and vital for purposes of understanding the essential nature of this company to impart this fundamental passage once again:

" Sears Holdings Corporation is a holding company with no material assets other than the equity interests of its subsidiaries. Our subsidiaries conduct substantially all of our operations and own substantially all of our assets. Repayment of our indebtedness, including the notes, is dependent on the generation of cash flow by our subsidiaries and their ability to make such cash available to us, by dividend, debt repayment or otherwise. Unless they are guarantors of the notes, our subsidiaries do not have any obligation to pay amounts due on the notes. Each of our subsidiaries is a distinct legal entity and, under certain circumstances, legal and contractual restrictions may limit our ability to obtain cash from our subsidiaries. Our subsidiaries may not be able, or be permitted, to make distributions to enable us to make payments in respect of our indebtedness, including the notes. The indenture governing the notes does not place any limits on the ability of our subsidiaries to incur consensual restrictions on their ability to pay dividends or make other intercompany payments to us. In the event that we do not receive distributions from our subsidiaries, we may be unable to make required principal and interest payments on our indebtedness, including the notes." 7

Two all-important sentences tell the story from this risk factor: " Sears Holdings Corporation is a holding company with no material assets other than the equity interests of its subsidiaries," and " Unless they are guarantors of the notes, our subsidiaries do not have any obligation to pay amounts due on the notes." 7

In the chart above, you can see that Sears Holdings repaid over $1.3 billion in long-term debt over the past three years. This figure peaked in 2011 when the company repaid $611 million before decreasing to $335 million in 2012. So far in 2013, Sears Holdings has only repaid $65 million in long-term debt YTD according to the company's 10-Q filings for the MRQ. 2

The long-dated end of the maturity curve for the company's debt has some particularly interesting characteristics that seem to be an excellent proxy for the bond market's evaluation of Sears Holdings' credit condition. While the Sears Holdings 6.625 bonds due in 2018 are securitized by second lien collateral, the rest of the outstanding notes are SRAC - Sears Roebuck Acceptance Corp. - debt that was issued before the merger in 2005. These notes are unsecured, although the 2032 SRAC notes are senior debentures in the credit classes, and the long-end of the maturity spectrum includes 30-year debentures that were originally issued by SRAC in 2003 that are now thinly traded on the OTC grey market. These SATURNS - a credit market acronym for Structured Asset Total Unit Repackaging Notes - were originally issued by SRAC through Morgan Stanley ( MS), which was Sears, Roebuck and Co.'s former investment bank by virtue of its Dean Witter connection, and carry coupons ranging from 7 percent to 7.4 percent with $25 principal amounts. These notes from the 2042 and 2043 maturities are essentially "baby bonds" that are unsecured and have many of the same risk characteristics as preferred stock, although they have a defined quarterly coupon and a certain maturity date and therefore cannot be valued as a consol or perpetuity.

These securities are also callable in 2014 and, with around $100 million each outstanding 8 years ago and now with only $55 million each currently outstanding, received considerable attention from Eddie Lampert immediately after the merger was approved in March 2005. In May 2005, the newly created Sears Holdings company issued a tender through SRAC to repurchase these securities and has succeeded in reducing the amounts withstanding of each series by nearly half since that time. The SATURNS were also de-listed by the company from the SEC at that time, which is the reason they are currently only traded in the OTC markets. These securities are currently traded at heavily discounted junk levels and were further downgraded to Caa2 status by Moody's in September when Sears Holdings announced its intention to secure the $1 billion incremental term loan. These securities are an excellent proxy to keep an eye on the credit market's pricing of Sears Holdings' liquidity risks and could provide early indications of either default or turnaround. The relatively unlikely scenario of these notes being called in 2014 offers the most interesting consideration, which could have the potential to ignite a short squeeze in the stock that might exceed the magnitude of some of its previous rallies. Interestingly, there are only $110 million outstanding in the 2042 and 2043 maturities combined and Sears Holdings still has $275 million remaining in its debt repurchase authorization that was approved by the company's board in 2005. 3

In the chart above, you can see that 2018 is set to be the decisive year for Sears Holdings' debt maturities with $1.237 billion coming due that year. For purposes of illustration and to show only the bond maturities, that $1.237 billion figure is only for the notes coming due in 2018 and does not include the $1 billion from the new five-year secured loan that we previously covered in this report. Taken in combination, that adds up to at least $2.237 billion of debt maturities and repayments of remaining principal balances between June and October of 2018, which is 18 fiscal quarters away. The good news for Sears Holdings is that a relatively small $2 million of debt maturities this year and next, with only $3 million each in 2015 and 2016, will provide the company with the opportunity to complete its transformation and return to profitability before making repayment or refinancing decisions regarding the long-term debt due in 2018.

Term Structure

Combining the aforementioned data regarding Sears Holdings' credit facility and debt, we will construct an estimate of the company's term structure to evaluate the effect on various maturities and durations.

As you can see in the chart above, the short-end of Sears Holdings' interest rate curve is extraordinarily flat before a nearly parabolic rise between one and four year maturities. The curve descends into the 2018 maturities as a consequence of the second lien collateral of the guarantor subsidiaries that securitizes these bonds. As a result, the yield on these bonds is 8.58 percent instead of 10.72 percent YTM on the unsecured 6.875 percent 2017 SRAC notes FINRA quotes trading at $88.08 as of December 13, 2013. The curve ascends throughout the remainder of the unsecured maturities of the term structure until it reaches the 7 percent senior notes due 2032 and dips to a YTM of 13.595 percent. At the highest point in the term structure are the SATURNS due 2042 and 2043, which were covered in the previous section of this report, yielding between 16.5 and 19 percent. Although this chart is a snapshot of Sears Holdings' estimated term structure that correspondingly adjusts with price changes in the high-yield debt markets, it stands as a useful illustration of the yields Eddie Lampert and his team, as well as ratings agencies and investors, are closely monitoring on an ongoing basis to make a variety of important decisions regarding the consolidated company and the role of individual subsidiaries within its corporate structure.

Pre-Merger SRAC Capital and Credit Structure

In the years since the 2005 merger, SRAC has transformed its role as the primary financing mechanism for the company to become a principal component in a much more decentralized capital and credit structure that is now utilized by Sears Holdings.

In the Figure 1 chart above, you can see a basic representation of the former capital and credit structure that existed for the pre-merger Sears, Roebuck and Co. with SRAC as the wholly-owned financing subsidiary. Using information obtained from SRAC's FY 2000 SEC 10-K filing and a brief description from the Harvard Business School archives, this chart shows a simple wide-zoom view of the flows of capital and credit between Sears, Roebuck, SRAC, stakeholders, and the markets. Essentially, Sears provided receivable balances and short-term paper to SRAC in return for financing that the subsidiary obtained through the credit markets. While SRAC still plays a meaningful role in support of financing Sears Holdings, it now operates within a much larger system that contains many more components.

Sears Holdings Capital and Credit Structure

With the transformation of Sears, Roebuck and Co. and Kmart Holdings into a consolidated holding company that is nominally owned by an investment fund, the entire financial structure of the company evolved into an interdependent system where capital and credit flow throughout an assortment of subsidiaries and funding mechanisms.

As you can see in the Figure 2 chart above, the flows of capital and credit for Sears Holdings as an evolved post-merger consolidated holding company are far more complex and interdependent. Please note that this chart is a wide zoom perspective of the company's financial structure and much greater detail exists when we zoom in on both the flows between Sears Holdings and ESL and the guarantor and non-guarantor subsidiary level. For purposes of this particular illustration and focusing on the central topic of capital and credit structure, also note that this chart purposely omits the functions of Sears Canada, Sears Hometown and Outlet Stores, and all other spun-off, partially divested, and non-guarantor subsidiaries. Please do not copy, duplicate, or republish this chart without the permission of BR&A or Seeking Alpha and provide a link to this page for source attribution if you cite it in a blog or article. This chart is a snapshot of the consolidated company's financing flows and is intended to be illustrative, not exhaustive. This chart represents the integration of the previously described information contained in this report and the best illustration of the big picture financial structure of Sears Holdings from the perspective of a consolidated holding company.

For a fundamental understanding of Sears Holdings, the Figure 2 chart above provides an excellent structural basis from which to begin synthesizing the information contained in this report. By understanding the very basic ways in which capital and credit flow between the interdependent entities, we can start to understand the vital aspects of the structure Eddie Lampert is creating. When combined with the valuable information contained in the SOTP analysis in the "Sears Holdings' Valuation: Between Berkshire Hathaway And Bankruptcy" report on Seeking Alpha, many of the answers to questions about the valuation of Sears Holdings not only emerge, but become abundantly apparent to those who can integrate the information from these two reports, synthesize the nature of the consolidated company's capital structure, transform the lens through which they view the company, and develop a refined view of the big picture that reflects Eddie Lampert's perceptions of his investment.

For those finding that this information has yet to make sense, the best way to truly put the pieces of this puzzle together to form a complete picture is to read, or re-read, the Seeking Alpha "Sears Holdings' Valuation: Between Berkshire Hathaway And Bankruptcy" report and then re-read this report. The main elements are all laid out in these two reports and it is simply a matter of connecting the dots. The book is a much more detailed analysis with granular data, an in-depth profile of Eddie Lampert, specific timelines, and comprehensive financial and legal options that Sears Holdings has available to it in the coming years. Ultimately, the book will reveal several key aspects of Sears Holdings that are simply too complex to include in article form.

Embedded Capital Structure

When we aggregate all of the aforementioned information with the SOTP analysis from the "Sears Holdings' Valuation: Between Berkshire Hathaway And Bankruptcy" report, we discover that the actionable substance about Sears Holdings leads to several conclusions. First, Sears Holdings is a consolidated collection of subsidiary companies that are distinct legal entities operating with complementary functions. These companies are classified into the two mutually exclusive legal categories of guarantor subsidiaries and non-guarantor subsidiaries. Currently, Eddie Lampert is constructing the consolidated company in such a way that the working capital of the guarantor subsidiaries is being leveraged for future benefit of non-guarantor subsidiaries during a process in which the guarantor subsidiaries are restructured and transformed into a less capital intensive future-state form. Simultaneously, ESL and Eddie Lampert are becoming a significant source of short-term credit for Sears Holdings by financing SRAC-issued unsecured commercial paper each month, holding the company's bonds, and writing participation in trade receivables insurance for some of the company's vendors. ESL is receiving the financial benefits of these funding responsibilities and capturing a nice spread that would have otherwise been paid to a financial institution, thus enabling credit to circulate within the new system.

This entire financial ecosystem is developing as a complex organization of circulating credit flows between distinct categories of current subsidiaries, separated - or nominally independent - former subsidiaries such as Sears Canada and Sears Hometown and Outlet Stores, the domestic pension plan, ESL, and Eddie Lampert to form a permanently embedded structure of capital and credit flows that will provide the foundation for monumental equity appreciation when the value of the company's prodigious unencumbered assets begins to be monetized. It is important to understand that only current assets on the company's balance sheet are specifically encumbered by the bond indenture and credit agreement, while the real estate and all non-guarantor subsidiary assets are not specified, meaning Eddie Lampert has intentionally chosen not to apply leverage or truly begin monetizing these assets on a large scale - yet. Notably, the upcoming book that is near completion will cover many subjects that are far too complex to detail in this report such as leases, DTAs, non-guarantor subs, integrated retail, SYW Rewards, Sears Hometown and Outlet Stores, and Sears Canada. For those who have transformed their perspective and focused their lens on the essential nature of Sears Holdings as a consolidated company with an understanding of a permanently embedded structure of capital and credit, the book will provide greater color and specific strategies available to the company using a comprehensive profile of Eddie Lampert and thought processes he may be considering to realize the value of the company's assets.

Many investors have lost patience with Eddie Lampert in recent years by extracting capital and selling shares of Sears Holdings. In an odd way, this aligns with the capital structure Eddie Lampert is constructing that shakes out the loose longs with unusual volatility, aided by a tiny float, and thereby creates a solid foundation of investors like himself, Thomas Tisch, Bruce Berkowitz, and other lifetime investors. Consider the following three passages from Warren Buffett's " Owner s Manual" for Berkshire Hathaway ( BRK.A) shareholders:

  • "Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets."
  • "In line with Berkshire's owner-orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking."
  • "Because of our two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance. These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them."
Caveat Emptor

In some ways, Eddie Lampert is limited by his own record of success, which has contributed to prolonging the transformation of Sears Holdings. Notably, whenever he wants to divest or spin-off a subsidiary, it becomes increasingly difficult to realize the value he is seeking due to so few investors, banks, or corporate executives being willing to take the other side of the trade against an investment manager with his acumen. This limitation has only intensified since events like the spin-off of Orchard Supply Hardware in 2011, which ended up bankrupt as an independent company in the late spring of 2013. In a counterintuitive way, retail analysts that compare the company's operating strategies to a game of Jenga and the financial media that claims Sears Holdings is selling its most valuable assets to stay afloat are actually helping Eddie Lampert create a market for future spin-offs and monetizations by describing his as desperate. Clearly, as ESL's investments in Safeway ( SWY) and Netflix ( NFLX) in the last two years demonstrate, Eddie Lampert still knows how to pick winners. Being on the other side of Eddie Lampert's trades is often an uncomfortable position, as many SHLD shorts have found out the hard way in the last few years.

Natural System Model

Although Eddie Lampert has a successful investing record, there also is a certain glorified notion among some of his admirers that he has the power to move markets with some sort of mythical invisible iron hand, which is clearly not the case. When he gained control of Kmart in 2003, he was able to achieve things with the company being fresh out of bankruptcy and free of many burdensome financial obligations that simply are not the case with Sears Holdings. The phenomenal stock appreciation and pace of asset sales were aided and accelerated by the unique set of circumstances that surrounded Kmart in the year and half after it emerged from court-administered restructuring. To think that those actions could be replicated with, at a minimum, hundreds of thousands of stakeholders at a bureaucratic corporate juggernaut like Sears, Roebuck and Co. was a fantasy. Following only three and half years after the vote on the merger agreement, there were the dire consequences that befell the macro environment, and particularly Sears Holdings, in the aftermath of the 2008 Financial Crisis. In order to understand the transformation of Sears Holdings in the context of organizational development, consider the following quotes from James D. Thompson's 1967 management classic "Organizations in Action: Social Science Bases of Administrative Theory" about open-system strategy:

"If, instead of assuming closure, we assume that a system contains more variables than we can comprehend at one time, or that some of the variables are subject to influences we cannot control or predict, we must resort to a different sort of logic. We can, if we wish, assume that the system is determinate by nature, but that it is our incomplete understanding which forces us to expect surprise or the intrusion of uncertainty. In this case we can employ a natural-system model."

"Approached as a natural system, the complex organization is a set of interdependent parts which together make up a whole because each contributes something and receives something from the whole, which in turn is interdependent with some larger environment. Survival of the system is taken to be the goal, and the parts and their relationships presumably are determined through evolutionary processes."


In conclusion, Thompson's description of a natural-system model correlates ideally with the organizational model and capital structure Eddie Lampert is laying as the foundation for Sears Holdings. When we consider an investment fund as a portfolio of assets and securities with distinguishing features, unique risk profiles, and varying rates of return that are assembled to outperform the market rate of return, the basic structure and motivations look familiar and are generally understood. With this in mind, hedge funds simply perform the same basic functions of risk management and optimized returns with maximum leverage and by taking 2 and 20 from their accredited investors. When many look at a consolidated income statement of a holding company, which is in fact a portfolio of subsidiary companies with distinguishing features, unique risk profiles, and varying rates of return that are assembled to outperform some benchmark rate of economic return to the owners of the company, they are unable to get past the conventional accounting identities to learn the implications of the de-consolidated subsidiaries and capital structure that supports the system as a whole. These concepts are in clear view for those who approach a holding company from the perspective that Professor Franklin Allen of Wharton calls a "financial economist," which is a title similar to the "financial engineer" label often used in reference to Eddie Lampert. As Dr. Allen always rhetorically asked his MBA students in his smiling and cheerful English accent, "Who wants to make money? Everyone wants to make money, that's right." Financial economists like Eddie Lampert are simply better at making money than their accountants, which explains the division of labor between the two. Yet, everyone in the circulating flow is making money and the equation becomes reduced to orders of magnitude within the framework of the system. Wealth creation is ultimately about capital, not labor, and the multiplier applied to it for growth within a system. The ultimate consequence is that a consolidated holding company that can leverage its guarantor subsidiaries for the benefit of its non-guarantor subsidiaries with a permanently embedded capital structure that enables it to monetize its unencumbered assets to reward long-term partners with their patience by creating financial fortunes without taking 2 and 20, this is an opportunity that only presents itself to investors once in a generation.

Source Attribution Key

1 Second Amended and Restated Credit Agreement, Dated April 8, 2011

2 SHLD Q3 2013 10-Q SEC Edgar Filing

3 SHLD 2012 10-K SEC Edgar Filing

4 SHLD Q3 2013 Investor Presentation

5 Sears Holdings Q1 2013 Management Conference Call - May 23, 2013

6 Sears Holdings Pension Plan - Plan Summary Description for Sears Participants - Plan Summary Description for Kmart Participants

7 Sears Holdings Corporation 6.625 percent $1,000,000,000 Notes Due 2018 Exchange Final Prospectus - SEC Edgar Filing

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