SERITAGE GROWTH PROPERTIES SRG
February 03, 2017 - 8:39am EST by
rickey824
2017 2018
Price: 41.87 EPS 0 0
Shares Out. (in M): 56 P/E 0 0
Market Cap (in $M): 2,334 P/FCF 0 0
Net Debt (in $M): 994 EBIT 0 0
TEV ($): 3,328 TEV/EBIT 0 0

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Description

Disclaimer: The Author of this post and related persons or entities (“Author”) may hold a position in this issuer’s or related securities. The Author makes no representation that it will continue to hold such positions. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that the Author will inform the reader or anyone else prior to or after engaging in such transactions. While the Author has tried to present facts that it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note or subsequent comments. The views expressed in this note and in subsequent comments are only the opinion of the Author. The reader agrees not to make investments based on this note and to perform his or her own due diligence and research prior to taking a position in this issuer’s or related securities. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the below note and associated comments.

 

Summary

 

Seritage Growth Properties (“SRG” or “Seritage”) has been written up previously on VIC as both a long (8/5/15 by thecafe, 2/9/16 by Woodrow) and a short (8/25/16 by Den1200). While there is a wealth of information and discussion in those threads, recent developments at Seritage as well as a selloff precipitated by the ongoing stream of bad news coming out of Sears warrant, in our view, a renewed look at the Company. We will cover some of the basics of the Seritage value proposition below but, in the interest of advancing the conversation, will attempt to focus the majority of our discussion on developments since the previous write-ups and some of the common misconceptions we encounter in discussing Seritage with others. In particular, we believe that many people view Seritage simply as a less expensive (lower cost of borrow) way to short Sears without focusing explicitly on the valuation of Seritage. We had responded at some length to Den’s post, which advanced a similar argument, this past August but felt it would be worthwhile to address some of the most common short arguments directly. As we stated in our reply to Den last August: “SRG will likely trade down if Sears files for bankruptcy, but we don’t believe in letting short-term technicals dictate our long-term capital allocation decisions. This is Value Investors Club after all.”

 

Value Proposition

 

Seritage is a real estate investment trust (“REIT”) that was formed on June 11, 2015 to purchase a portion of the Sears Holdings (“Sears” or “SHLD”) real estate portfolio. The Company purchased 235 wholly-owned properties and 31 partially-owned properties (via joint ventures with General Growth Properties, Simon Property Group and Macerich) comprising a total of roughly 40.0 million in owned square feet of gross leasable area (“GLA”). The real estate was principally leased back to Sears pursuant to two master lease agreements (each an “MLA”), one of which governed the wholly-owned properties and another substantially similar agreement that governed the JV properties. The important detail to understand with respect to the MLAs is that they designate each of the properties in the portfolio as Type I, II or III. Under the lease agreements, SRG has the right to ‘recapture’ 50% of the Sears GLA at all Type I properties and 100% of the GLA at the Type II properties (subject to a notice period, and certain termination payments tied to store-level EBITDA which are likely to end up being fairly negligible). The Type III properties do not feature Sears as a tenant and therefore are not subject to ‘recapture’ provisions. We estimate that at the time of the original transaction, Seritage had the ability to recapture almost 19.0 million in GLA from the wholly-owned properties and an incremental 1.4mm from the JV properties (all of which are Type II). Sears also has the right to terminate certain of its leases (subject to a notice period, certain pacing restrictions and the obligation to pay Seritage one year’s worth of foregone rent). Sears has exercised this right at 36 properties to-date, all of which were Type II, and we believe that these terminations have increased the GLA available to Seritage by approximately 1.8 million today.

 

At the time of the Seritage sale-leaseback transaction, SRG was receiving roughly $185 million in rental income (including its share of rental income from the unconsolidated JVs), roughly 83% of which was derived from Sears at a rate of slightly less than $4.30 per square foot (“PSF”). On a GLA basis, Sears accounted for 91% of the space in the wholly-owned properties and 94% of the space in the JV properties (slightly more in each case if you consider space occupied by Land’s End, which was spun out of Sears in 2014). The disconnect is explained by the fact that third parties other than Land’s End generally pay multiples of what Sears is paying ($15-20+ PSF). This is partly a result of the fact that smaller tenants pay more than anchors (and occupy smaller spaces) but largely a result of the fact that the Sears rent under the MLAs was set substantially below market comparables for anchor and junior anchor tenants (in many cases 50+%, in our estimate). Therein lies the fundamental Seritage value proposition: SRG shares are trading at roughly 17x trailing AFFO, roughly in line with high quality REIT peers, but the Company is under-earning in the vast majority of its space. SRG will therefore have the ability to deploy large amounts of capital at what we estimate will be low double-digit unlevered (25%ish levered) returns in the process of recapturing, redeveloping and re-tenanting much of its GLA. This value proposition has been validated to-date by the company having replaced, in just 5 quarters, over 2 million in Sears GLA that had originally been earning $4.20 PSF with dozens of new tenants that are paying an average rate of $18.62 PSF on a same-space basis.

 

Modeling this business is not particularly challenging. While there are a variety of approaches to valuing a REIT, in this case we prefer a simple discounted cash flow approach. The operative assumptions are (i) the pace at which SRG recaptures space from Sears, (ii) the time required to redevelop a property, (iii) the associated redevelopment economics, (iv) the Company’s anticipated cost of capital and capital structure and (v) the appropriate discount rate. At an average quarterly recapture rate of 500,000 square feet (a significantly slower pace than was achieved in Q4), an average one year redevelopment period, redevelopment costs in-line with what Seritage has realized to-date and a cost of capital and capital structure similar to other mall REITs, we think that SRG shares offer considerable upside. Rather than specify a price target based on a chosen discount rate and set of re-development economics, we think it is more instructive to provide a stratification of valuations (per share) that will both illustrate the margin of safety as well as provide a framework for the reader when considering the points we raise in the remainder of this note, which will broadly be an attempt to respond to the most common concerns we hear raised about the Seritage value proposition.

 

 

The foregoing is principally intended as a brief summary of the Seritage value proposition and we believe that our valuation conclusions are generally consistent with previous long write-ups here on VIC. We encourage others to lay the numbers out themselves as it is a relatively quick process. A wealth of information is available both in the Company’s filings as well in connection with the CMBS offering that was part of the Seritage acquisition financing (J.P. Morgan Chase Commercial Mortgage Securities Trust 2015-SGP, CUSIP 46645CAA5). A publicly available annex to the CMBS offering document contains property-level information including basic property characteristics, appraisal data, store-level EBITDA, rent and tenant information, in-line sales data and much more. Additional information (including demographic data at the property level) is also available on the Seritage website.

 

Recent Developments & Alternative Views

 

We believe that the principle risks to the investment thesis in SRG derive from (i) developments in the broader retail environment and the associated impact on SRG redevelopment pace/economics and (ii) exposure to Sears. The Sears risk can be further split into risks associated with a loss of rental income resulting from a Sears bankruptcy and the risk associated with potential fraudulent transfer litigation brought by creditors following a Sears bankruptcy. While we believe that these are legitimate risks, our opinion is that the severity of the risk is likely being overestimated by market participants based on the present valuation of SRG shares. We’ll address these concerns in turn as well as what we believe are the mitigants.

 

Retail Environment & Development Economics

 

With the continued growth of e-commerce and recent high profile store closures announced by big names such as Macy’s, Gap and The Limited, the health of brick and mortar retail remains a subject of significant concern. As department store closures accelerate, we’re frequently told that there is a strong possibility that the pace of SRG redevelopments will slow and the economics will deteriorate. While we agree that various threats to brick and mortar retail are real, we question both the immediacy and the scope of the threat, particularly as it pertains to Seritage. Through the third quarter in 2016, Cushman & Wakefield recorded over 4,000 retail closures, up from a record 3,600 for the comparable period in 2010. Despite this, retail vacancy rates actually declined year-over-year from 7.8% to 7.4%. Leasing rates were flattish year-over-year ($20.43 PSF in 2016 compared to $20.67 PSF in 2015) and remain substantially above the ~$18.00 PSF average in 2010. Net absorption rates remain positive, as do broad economic indicators correlated with retail activity. While different data providers (REIS, CBRE and CoStar) will provide slightly different numbers, they all broadly paint the same picture. Traffic data remains concerning, but at a high level conceal the underlying dynamic where performance at A-malls is diverging significantly from lower-quality malls. Indeed, much of the data suggests that some of the recent stability in key indicators is largely a result of significant declines at low-quality properties being offset by strength at marquee and other high-quality properties, which is why it is important to look at the individual properties in the Seritage portfolio and the Company’s growing redevelopment track record.

 

Developments at Seritage over the past several quarters are exactly the opposite of what one would expect if the retail environment was presenting a serious challenge to the Company’s redevelopment efforts. On January 17, Seritage put out an update covering its redevelopment activity through the fourth quarter of 2016. The tables below summarize leasing and development activity :

 

 

Seritage announced that it had signed 29 new leases in the fourth quarter for 890,350 in GLA at an average rate of $16.77 PSF, representing nearly $15.0 million in new signed but not operating (“SNO”) rent and a significant increase in the pace of activity over both the prior quarter and the comparable period in the prior year. The Company also announced 8 new development projects with their highest anticipated unlevered return prospects to-date (14.1%). As the Company does not usually have all of a site’s GLA leased before submitting a recapture notice, it is difficult to map the leasing activity to the individual projects and the projected returns rely on undisclosed stabilized rent assumptions for the not-yet-signed space. Nonetheless, we’ve observed several quarters of broadly stable projected returns and releasing spreads as well as a meaningful increase in the pace of re-development activity. This is again at odds with the narrative of a supply glut reducing demand for SRG’s real estate.

 

A remaining question, then, is whether we should be concerned that our somewhat small sample size reflects a selection bias or, rather, that the Company has simply elected to go after the low-hanging fruit first. Using data from the publicly available CMBS annex, we find little evidence that this is the case. Though Sears is paying an average of roughly $4.30 PSF in rent, the dispersion around that average is large (ranging at the time of the SRG spinoff from as little as ~$1.20 PSF to as much as $19.37 PSF) and a property’s rental rate within that range is generally correlated with quality (Aventura is likely the highest quality property in the portfolio and also has the highest rent). Of the 24 redevelopment projects announced through the end of 3Q16 (excluding King of Prussia, a Type III property) for which we have project data, 75% of the projects are locations paying at or below the average rental rate. For 15 of those 24 properties we have in-line sales data and can similarly use that data as a proxy for property quality. On this metric the evidence is more balanced with 6 of the properties below the portfolio average, 4 slightly above the portfolio average and 5 meaningfully above the portfolio average. We would highlight that, with the lone exception of Santa Monica (recaptured in 4Q16), Seritage has not yet issued recapture notices for its most valuable ‘trophy’ properties including Aventura, Boca Raton and Hicksville. These projects are likely to be more complicated than the projects announced to-date and will likely involve a complete re-imagining of the space. To use Aventura as an example, Seritage recently settled a legal dispute with Aventura Mall Venture (owned by Turnberry Associates) and is proceeding with approvals for a mixed-use redevelopment that will likely incorporate an entirely new open-air retail space and residential or hotel space as well. We expect that both the capital intensity and return potential of these trophy projects will be higher than in the rest of the portfolio.

 

The data and track record are, of course, lagging indicators but there are several reasons to be sanguine about the prospects for brick and mortar retail, particularly for higher-quality malls and properties. There are a large number of innovative retail concepts and prospective tenants that are growing rapidly and looking for attractive real estate. Certain retailers that had previously focused exclusively on the online channel (Warby Parker, Bonobos, Athleta and even Amazon, among others) have begun expanding their brick and mortar presence in recognition of the fact that online sales are frequently won in-store. The ability to return or exchange items in-store is attractive to consumers who appear to favor omni-channel retailing and surveys show that consumers remain attracted to well-maintained community and lifestyle centers. Importantly, Seritage is not signing new department store anchors but rather dozens of tenants spanning categories including luxury retail, dining, entertainment and lifestyle. The outlook for department store chains may be bleaker than it was a decade ago, but it seems unlikely that these stores will all disappear overnight. In our view, we’re less likely to see an immediate wave of mass closures and more likely to see a managed reduction of the department store footprint over the coming years with much of the space transitioning to a slate of tenants more suited to a younger generation that will increasingly make up the retail consumer base. Very poor properties are unlikely to find much use, but we don’t believe that this is a significant problem for Seritage given the composition of its portfolio.

 

As has been detailed extensively in previous write-ups, the real estate in the Seritage portfolio most closely resembles the type of property in A-mall portfolios. The GLA-weighted 10-mile average household income for Seritage (excluding the JV properties) is slightly over $76,000, which is well above the national average and compares favorably with companies like GGP, MAC and SPG for which 10-mile household incomes average roughly $75,000, $79,000 and $83,000, respectively. The population density around the Seritage properties also compares favorably with these operators at an average of 700,000 in a 10-mile radius, only modestly lower than for GGP, MAC and SPG. Much of this is the result of Sears’ long history in the development of America’s urban and suburban landscape. As an early mover in department store retail, Sears frequently finds itself owning land well situated in communities that have grown around its locations over the past several decades with favorable access characteristics and high visibility. We have visited a number of properties in the portfolio and would encourage others to do so. Failing that, a Google Earth tour is surprisingly illuminating. While we have all seen the pictures of empty parking lots and the brutalist architecture of the generic Sears box, it’s often surprising to see the stark contrast with the quality of the communities immediately surrounding some of these locations. There are unquestionably locations in the portfolio that will be poorly suited to retail redevelopment, but we believe the real estate itself is still quite valuable and the Company has been clear that in finding the highest and best uses for its properties it will, regulation permitting, redevelop properties for other industrial, commercial and residential uses. Some of the lower quality properties may not be a great home for a trendy bistro or luxury retailer but might be a great fit for storage facilities, office space or data centers. The rents will likely be lower, but the redevelopment costs will similarly be less burdensome and we believe that, on balance, the unlevered return prospects will remain attractive.

 

Sears Bankruptcy – Loss of Rental Income

 

Another common argument that we encounter in discussing the Seritage thesis is that the Company’s largest tenant, Sears, is on the verge of bankruptcy and the imminent loss of a majority of SRG’s rental income would be a disaster. We think there are a number of problems with this argument. To begin with, the idea that Sears is going to file for bankruptcy is a consensus view and, while we do not have a particularly differentiated view, this information should not be a surprise to Seritage shareholders or the market generally. Like others, we have spent a non-trivial amount of time speculating as to why Eddie Lampert continues to sell assets to fund operating losses at Sears when the future looks so obviously bleak and, one day, this will all likely make for a fascinating case study. However, determining the timing and probability of a Sears filing ultimately falls into our “too hard” bucket. Fortunately, we believe that the relevant question for SRG shareholders does not require a judgment call here. The real question involves determining what happens to SRG’s real estate in the event of a SHLD bankruptcy. In other words, we need to make some determination as to what the real estate is worth. This most-important question seems to be ignored by the shorts.

 

To begin with, it is apparent that a number of market participants assume that a Sears bankruptcy necessarily results in the loss of 100% of the Sears/Kmart locations as paying tenants. For example, Den wrote in August:

 

“…if SHLD files for Chapter 7 tomorrow morning it would have a huge impact on SRG. Today the $38.8 million it gets in rents from Third Party Leases would be all that is left in rental income and that is before expenses.”

 

We think it is unfairly punitive to assume that Seritage will have to replace the entirety of the Sears rental income stream if SHLD files and do not think that this conclusion is supported by the evidence. If we look at the data in the publicly available CMBS annex, we have store-level TTM revenue, EBITDAR and rent coverage information on a TTM basis as of July 2015. Something that will jump out immediately to those looking at the data is that, on a GLA basis, just 15% of the stores in the Sears portfolio were not covering their rent (EBITDAR/Rent < 1.0x). Another 20% of the stores covered their rent by between 1.0x and 1.5x. Said differently, the overwhelming majority of the portfolio was cash-flowing at the store level at the time the portfolio was transferred to Seritage. This is a positive fact in itself, but also supports our view that SRG’s properties leased to Sears are generally stronger than the broader Sears portfolio given their higher EBITDA.

 

Of course, these stores have likely suffered a decline in performance alongside all the other Sears stores. One can adjust the annex data to exclude properties we know to have been recaptured or terminated and shock revenue and EBITDAR margins to approximate the declines we’ve seen at Sears’ other properties (20% and 25% would be rough approximations of the declines that have taken place in the broader Sears portfolio). We can also adjust rent upward to capture the 2% annual escalator in the MLA. The result from stressing the data still suggests that over 50% of the portfolio are able to cover rental payments today. This is an oversimplification and we understand that store closures elsewhere likely have an impact on supply chains and that there are other effects. Our point is that we have concrete evidence that a large number of Sears/Kmart stores are profitable at the store level (and likely still are), which suggests that a Sears filing is likely to be a Chapter 11 and not a Chapter 7. Because each MLA is an all-or-none agreement (meaning that Sears cannot selectively terminate the leases for individual stores), Seritage will have some leverage in the inevitable bankruptcy negotiation which likely will result in Seritage keeping a significant portion of its rental income stream from Sears. Interestingly, some of the most valuable properties in the Seritage portfolio are also some of the worst performing. High quality properties in affluent and densely populated areas such as Aventura, Hicksville and Santa Monica all had rent coverage below 1.0x at the time of the Seritage spinoff. Indeed, for the subset of properties not covering their rent we find that in-line sales are 19% higher than the portfolio average.

 

Compounding this error, we believe that many people then look at the 34.6 million square feet Seritage currently leases to Sears and erroneously assume that all of that space has to be dealt with in some capacity before Sears files. For example, Den wrote in August:

 

“If you look at the development cost in Q2 2016, I get to an estimated number of $171 per sq. foot. $171 per sq. foot times 33 million is $5.64 billion. I am quite sure SRG does not have access to this amount of money on short notice.”

 

We think this is the wrong way of framing the problem principally because Seritage does not need to concern itself with replacing the Sears GLA but rather the Sears rental income. Sears is paying 4.0x – 5.0x less than new third party tenants which means that: (i) Seritage could replace the entirety of the Sears rental income stream by redeveloping just a fraction of the square footage that Sears occupies and (ii) it could do so by spending vastly less than the amount of capital it will ultimately need to redevelop the full portfolio. Said differently, the mix of income derived from Sears should decline rapidly in coming quarters.

 

At the end of the third quarter, Sears was paying Seritage $151.8 million in rental income. In-place third party tenants were paying roughly $40.6 million, bringing the total annualized rent for in-place tenants to $192.4 million. However, the Company reported an incremental $28.8 million in SNO leases at the end of the third quarter and we know, per the 4Q16 operational update, that the Company signed an additional $14.9 million in SNO leases through the end of the year. This means that the Company already has tenants lined up to pay $43.7 million in rent once the existing slate of projects is complete (generally within a year). This SNO rent represents nearly 30% of what Sears is presently paying Seritage and should roll online over the coming quarters. Even if you believe that Sears will permanently stop paying all of its rent when it files, this leaves just $108.1 million in Sears revenue that would have to be replaced by new tenants in order to maintain cashflow at Q3 levels in the unrealistic event that all Sears rent disappeared immediately. At the 4Q16 rate of $14.9 million, this would take just 7 quarters. The important point is that the Company could line up tenants to replace the entirety of the Sears rental stream in under 2 years without a material acceleration in its present recapture rate.

 

Assuming redevelopment economics comparable to what we’ve seen in past quarters, we believe such an effort to replace the Sears rental stream would cost somewhere between $1.1 and $1.3 billion over the next few years (including the cost of already-announced projects) or about 20% of what Den estimated in his short thesis. We estimate that between the balance of the Company’s Future Funding Facility ($80 million at 3Q16), the proposed $200 million ESL loan (announced in December) and cash on hand that Seritage should have roughly $400 million in current liquidity. This is to say nothing of the roughly $100 million (post-dividend) in annual operating cash we expect Seritage to earn in the short-term while Sears remains a paying tenant or the termination payments due to Seritage for the 36 terminated properties (we estimate roughly $15 million). All-in, we expect that Seritage would likely need to raise an incremental $500.0 - $750.0 million over the next few years to facilitate a replacement of the Sears rental income. This is no small task, but we believe that the Company will be able to find willing lenders, particularly if it continues to produce slates of projects with a majority of lessees for the space already signed up. ESL and Fairholme have shown no lack of willingness to invest in these businesses and other deep-pocketed shareholders like Warren Buffett are likely to take a similar long-term view in considering lending to Seritage. This also ignores the Company’s ability to simply sell certain of its properties to bridge any short-term liquidity shortfalls.

 

The end result of all of this is that even in the draconian scenario where all Sears rental payments disappear immediately, Seritage could replace the entirety of the Sears rental income stream by redeveloping just 20% of its total GLA (at just 20% of the cost it would spend redeveloping the entire portfolio). Importantly, if you buy our argument that not all of the stores will be immediately liquidated (i.e. that a Sears filing will not be a Chapter 7), you can cut those numbers substantially. We believe in a more realistic bankruptcy scenario Sears would continue to operate at least half of its stores, meaning Seritage only needs to redevelop 10% of Sears GLA to maintain its current cashflow.

 

Lastly, we would highlight that although the headlines regarding Sears and retail generally have been overwhelmingly negative, there have been a number of headlines recently that would suggest Sears may not, in fact, be filing imminently:

 

December 29, 2016 – Sears Holdings Announces $200 Million Secured Standby Letter of Credit Facility (Expandable to $500 Million)

January 4, 2017 – Sears Holdings Obtains $500 Million Secured Loan Facility ($321 Million Funded)

January 5, 2017 – Stanley Black & Decker Reaches Agreement to Purchase Craftsman Brand From Sears Holdings for $525 Million at Closing and $250 Million at End of Year Three

January 30, 2017 – CBL & Associates Acquires Five Sears Stores Through Sale-Leaseback for $72.5 Million

 

In the last month, Sears has obtained nearly $1.0 billion in short-term funding, another $250 Million payable in three years (against which they can likely borrow) and a $200 million standby letter of credit facility. The Company further announced that they were exploring the strategic sale of up to $1.0 billion in real estate assets and the Kenmore and Diehard brands remain on the market. Even in its dour downgrade note last week, Fitch acknowledged that the Company still had a number of unencumbered assets that could be sold to provide liquidity. We reiterate that we have no strong view as to when or how likely Sears is to file for bankruptcy. But if you think Sears can make it another year (we encourage you to make your own assumptions) then you can cut the 10% from above in half yet again, given that Seritage will have signed enough SNO leases at its current pace to fully replace the Sears rental income stream in just 2 years. Simply put, the current pace and economics of SRG’s redevelopment activity make it much easier to replace the entirety of the Sears rental income stream than shorts appreciate.

 

One final point that is often neglected is that, at some point, it will be highly accretive to Seritage if Sears vacates all of the space in the SRG portfolio (either voluntarily or in bankruptcy). In the very short term, the loss of operating income might prove challenging. In the long run, however, if you believe in the redevelopment proposition and the value of the underlying real estate, it would be far more valuable to be able to reclaim 100% of the Sears GLA than just 50% at most locations where Sears is paying rent that is meaningfully below market rates. Seritage is rapidly displacing Sears as a tenant and we believe that this inflection point is much closer than most people realize.

 

Sears Bankruptcy – Fraudulent Transfer

 

An additional risk that has been raised but not fulsomely addressed in the previous write-ups is the possibility of creditors bringing fraudulent transfer litigation in the event of a SHLD bankruptcy. Under state and federal law, there are protections for creditors that provide recourse against equity owners that would attempt to move assets outside the company and beyond the reach of creditors at off-market prices ahead of a bankruptcy. An example would be a debtor facing imminent insolvency selling an asset to a controlled affiliate substantially below fair market value in order to shield that asset from creditors in a bankruptcy. Such transactions can generally be unwound outright or creditors can win a verdict for money damages.

 

Generally speaking, fraudulent transfer can either be argued as (i) actual fraud or (ii) constructive fraud. Actual fraud requires the plaintiffs to demonstrate that the defendants acted with willful intent to defraud creditors and requires either explicit evidence of intent to defraud or a significant amount of circumstantial evidence pointing to intent to defraud. As you might imagine, it is not common for the management teams at large companies to circulate emails about asset protection schemes or other strategies outside the usual course of business that would be construed as a discussion of defrauding creditors. There are a number of common ‘badges of fraud’ that are used in such cases to establish a fact pattern pointing to intent to defraud, but our understanding is that such cases are generally uncommon and difficult to win. Constructive fraud, by contrast, is a much more common type of fraudulent transfer litigation and requires a plaintiff to demonstrate both (i) that the debtor sold assets for insufficient consideration and also (ii) that the debtor was either insolvent at the time of the transfer or became insolvent as a result of the transfer.

 

Our view is that it will be difficult for Sears creditors to satisfactorily demonstrate either condition necessary to prove constructive fraudulent transfer. To begin with, the hurdle for creditors to demonstrate that Sears either was insolvent or became insolvent as a result of this transaction will be incredibly high. Immediately following the Seritage transaction, Sears had a public market capitalization of nearly $3.0 billion. Its publicly traded bonds had single digit yields (the 6.625s of ’18 traded at just 7.5% and today trade at a 10.5% yield). In a bankruptcy proceeding, creditors will have to demonstrate that both equity and debt investors were wrong in their assessment of SHLD’s solvency.

 

If creditors were somehow successful in proving Sear’s insolvency at the time of the spin, they would then have to also show that were harmed. SRG shares have appreciated by just 33% since the time of the IPO. While the shares have outperformed the Dow Jones REIT Total Return Index (which has returned roughly 13% over the same period), that 13% annualized outperformance does not strike us as the type of eye-popping return that would result from fraud. Meanwhile, ongoing monetization of real estate and intellectual property supports the proposition that asset value more than covered outstanding debt obligations at the time of the transfer.

 

We think it will be similarly difficult for creditors to prove damages for more subjective reasons. At the time of the transaction, Sears received independent appraisals from nationally-recognized firms Cushman & Wakefield and Hilco. Further, Sears received an independent opinion from Duff & Phelps, a nationally-recognized financial advisor, that it had received adequate consideration from Seritage in exchange for the transferred real estate and that the rental rates and other terms set pursuant to the MLA constituted fair market value. In its CMBS offering documents, Sears further disclosed that its Board of Directors had received an opinion from an additional, unnamed fourth financial advisor as to the solvency and adequacy of capital of Sears Holdings following the transfer of the real estate portfolio to Sears. Moreover, CMBS investors were not bending over backward to lend to Seritage on attractive terms. The LTV at close was just 51.6% through the mezzanine debt and 41.1% through the senior debt. The terms and rates SRG received were not unusually favorable and, taken together with the previous points, suggest to us that it will be extremely difficult for creditors to argue that the transaction was materially off market.

 

Finally, a court will also consider the strategic nature/value of the transaction in effecting the Sears business plan in the context of determining whether Sears received adequate consideration. Regardless of the outcome, a cornerstone of the Sears business plan in recent years has been to rationalize the Sears and Kmart footprint within its existing spaces in order to improve profitability. The MLA signed with Seritage (and other similar sale-leaseback transactions) were uniquely structured to enable this business plan and the ability to effectuate a managed reduction of the Sears/Kmart footprint under the MLA was of strategic value to Sears. Sears received real value in the discounted rents it pays to Seritage and the right to retain some of its space to continue to operate its retail business. That value is something experts will debate at length and is something that will be very difficult to quantify. In short, we believe the evidence points toward solvency at the time of the Seritage transaction and, although we have constructive views on the value of the real estate, we nonetheless believe that it will be difficult for creditors to present a case that consideration received was insufficient in the context of the third party opinions received, the amount of time and capital that must be invested (under uncertainty) to realize a higher value for the property and the unique strategic value of the MLA to Sears.

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

 

Seritage continues to recapture GLA from Sears at a rapid pace and with favorable development economics

Sears continues to find ways of avoiding a bankruptcy filing, allowing Seritage to shift to a mix of third party tenants and de-risk its income stream

 

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    Description

    Disclaimer: The Author of this post and related persons or entities (“Author”) may hold a position in this issuer’s or related securities. The Author makes no representation that it will continue to hold such positions. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that the Author will inform the reader or anyone else prior to or after engaging in such transactions. While the Author has tried to present facts that it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note or subsequent comments. The views expressed in this note and in subsequent comments are only the opinion of the Author. The reader agrees not to make investments based on this note and to perform his or her own due diligence and research prior to taking a position in this issuer’s or related securities. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the below note and associated comments.

     

    Summary

     

    Seritage Growth Properties (“SRG” or “Seritage”) has been written up previously on VIC as both a long (8/5/15 by thecafe, 2/9/16 by Woodrow) and a short (8/25/16 by Den1200). While there is a wealth of information and discussion in those threads, recent developments at Seritage as well as a selloff precipitated by the ongoing stream of bad news coming out of Sears warrant, in our view, a renewed look at the Company. We will cover some of the basics of the Seritage value proposition below but, in the interest of advancing the conversation, will attempt to focus the majority of our discussion on developments since the previous write-ups and some of the common misconceptions we encounter in discussing Seritage with others. In particular, we believe that many people view Seritage simply as a less expensive (lower cost of borrow) way to short Sears without focusing explicitly on the valuation of Seritage. We had responded at some length to Den’s post, which advanced a similar argument, this past August but felt it would be worthwhile to address some of the most common short arguments directly. As we stated in our reply to Den last August: “SRG will likely trade down if Sears files for bankruptcy, but we don’t believe in letting short-term technicals dictate our long-term capital allocation decisions. This is Value Investors Club after all.”

     

    Value Proposition

     

    Seritage is a real estate investment trust (“REIT”) that was formed on June 11, 2015 to purchase a portion of the Sears Holdings (“Sears” or “SHLD”) real estate portfolio. The Company purchased 235 wholly-owned properties and 31 partially-owned properties (via joint ventures with General Growth Properties, Simon Property Group and Macerich) comprising a total of roughly 40.0 million in owned square feet of gross leasable area (“GLA”). The real estate was principally leased back to Sears pursuant to two master lease agreements (each an “MLA”), one of which governed the wholly-owned properties and another substantially similar agreement that governed the JV properties. The important detail to understand with respect to the MLAs is that they designate each of the properties in the portfolio as Type I, II or III. Under the lease agreements, SRG has the right to ‘recapture’ 50% of the Sears GLA at all Type I properties and 100% of the GLA at the Type II properties (subject to a notice period, and certain termination payments tied to store-level EBITDA which are likely to end up being fairly negligible). The Type III properties do not feature Sears as a tenant and therefore are not subject to ‘recapture’ provisions. We estimate that at the time of the original transaction, Seritage had the ability to recapture almost 19.0 million in GLA from the wholly-owned properties and an incremental 1.4mm from the JV properties (all of which are Type II). Sears also has the right to terminate certain of its leases (subject to a notice period, certain pacing restrictions and the obligation to pay Seritage one year’s worth of foregone rent). Sears has exercised this right at 36 properties to-date, all of which were Type II, and we believe that these terminations have increased the GLA available to Seritage by approximately 1.8 million today.

     

    At the time of the Seritage sale-leaseback transaction, SRG was receiving roughly $185 million in rental income (including its share of rental income from the unconsolidated JVs), roughly 83% of which was derived from Sears at a rate of slightly less than $4.30 per square foot (“PSF”). On a GLA basis, Sears accounted for 91% of the space in the wholly-owned properties and 94% of the space in the JV properties (slightly more in each case if you consider space occupied by Land’s End, which was spun out of Sears in 2014). The disconnect is explained by the fact that third parties other than Land’s End generally pay multiples of what Sears is paying ($15-20+ PSF). This is partly a result of the fact that smaller tenants pay more than anchors (and occupy smaller spaces) but largely a result of the fact that the Sears rent under the MLAs was set substantially below market comparables for anchor and junior anchor tenants (in many cases 50+%, in our estimate). Therein lies the fundamental Seritage value proposition: SRG shares are trading at roughly 17x trailing AFFO, roughly in line with high quality REIT peers, but the Company is under-earning in the vast majority of its space. SRG will therefore have the ability to deploy large amounts of capital at what we estimate will be low double-digit unlevered (25%ish levered) returns in the process of recapturing, redeveloping and re-tenanting much of its GLA. This value proposition has been validated to-date by the company having replaced, in just 5 quarters, over 2 million in Sears GLA that had originally been earning $4.20 PSF with dozens of new tenants that are paying an average rate of $18.62 PSF on a same-space basis.

     

    Modeling this business is not particularly challenging. While there are a variety of approaches to valuing a REIT, in this case we prefer a simple discounted cash flow approach. The operative assumptions are (i) the pace at which SRG recaptures space from Sears, (ii) the time required to redevelop a property, (iii) the associated redevelopment economics, (iv) the Company’s anticipated cost of capital and capital structure and (v) the appropriate discount rate. At an average quarterly recapture rate of 500,000 square feet (a significantly slower pace than was achieved in Q4), an average one year redevelopment period, redevelopment costs in-line with what Seritage has realized to-date and a cost of capital and capital structure similar to other mall REITs, we think that SRG shares offer considerable upside. Rather than specify a price target based on a chosen discount rate and set of re-development economics, we think it is more instructive to provide a stratification of valuations (per share) that will both illustrate the margin of safety as well as provide a framework for the reader when considering the points we raise in the remainder of this note, which will broadly be an attempt to respond to the most common concerns we hear raised about the Seritage value proposition.

     

     

    The foregoing is principally intended as a brief summary of the Seritage value proposition and we believe that our valuation conclusions are generally consistent with previous long write-ups here on VIC. We encourage others to lay the numbers out themselves as it is a relatively quick process. A wealth of information is available both in the Company’s filings as well in connection with the CMBS offering that was part of the Seritage acquisition financing (J.P. Morgan Chase Commercial Mortgage Securities Trust 2015-SGP, CUSIP 46645CAA5). A publicly available annex to the CMBS offering document contains property-level information including basic property characteristics, appraisal data, store-level EBITDA, rent and tenant information, in-line sales data and much more. Additional information (including demographic data at the property level) is also available on the Seritage website.

     

    Recent Developments & Alternative Views

     

    We believe that the principle risks to the investment thesis in SRG derive from (i) developments in the broader retail environment and the associated impact on SRG redevelopment pace/economics and (ii) exposure to Sears. The Sears risk can be further split into risks associated with a loss of rental income resulting from a Sears bankruptcy and the risk associated with potential fraudulent transfer litigation brought by creditors following a Sears bankruptcy. While we believe that these are legitimate risks, our opinion is that the severity of the risk is likely being overestimated by market participants based on the present valuation of SRG shares. We’ll address these concerns in turn as well as what we believe are the mitigants.

     

    Retail Environment & Development Economics

     

    With the continued growth of e-commerce and recent high profile store closures announced by big names such as Macy’s, Gap and The Limited, the health of brick and mortar retail remains a subject of significant concern. As department store closures accelerate, we’re frequently told that there is a strong possibility that the pace of SRG redevelopments will slow and the economics will deteriorate. While we agree that various threats to brick and mortar retail are real, we question both the immediacy and the scope of the threat, particularly as it pertains to Seritage. Through the third quarter in 2016, Cushman & Wakefield recorded over 4,000 retail closures, up from a record 3,600 for the comparable period in 2010. Despite this, retail vacancy rates actually declined year-over-year from 7.8% to 7.4%. Leasing rates were flattish year-over-year ($20.43 PSF in 2016 compared to $20.67 PSF in 2015) and remain substantially above the ~$18.00 PSF average in 2010. Net absorption rates remain positive, as do broad economic indicators correlated with retail activity. While different data providers (REIS, CBRE and CoStar) will provide slightly different numbers, they all broadly paint the same picture. Traffic data remains concerning, but at a high level conceal the underlying dynamic where performance at A-malls is diverging significantly from lower-quality malls. Indeed, much of the data suggests that some of the recent stability in key indicators is largely a result of significant declines at low-quality properties being offset by strength at marquee and other high-quality properties, which is why it is important to look at the individual properties in the Seritage portfolio and the Company’s growing redevelopment track record.

     

    Developments at Seritage over the past several quarters are exactly the opposite of what one would expect if the retail environment was presenting a serious challenge to the Company’s redevelopment efforts. On January 17, Seritage put out an update covering its redevelopment activity through the fourth quarter of 2016. The tables below summarize leasing and development activity :

     

     

    Seritage announced that it had signed 29 new leases in the fourth quarter for 890,350 in GLA at an average rate of $16.77 PSF, representing nearly $15.0 million in new signed but not operating (“SNO”) rent and a significant increase in the pace of activity over both the prior quarter and the comparable period in the prior year. The Company also announced 8 new development projects with their highest anticipated unlevered return prospects to-date (14.1%). As the Company does not usually have all of a site’s GLA leased before submitting a recapture notice, it is difficult to map the leasing activity to the individual projects and the projected returns rely on undisclosed stabilized rent assumptions for the not-yet-signed space. Nonetheless, we’ve observed several quarters of broadly stable projected returns and releasing spreads as well as a meaningful increase in the pace of re-development activity. This is again at odds with the narrative of a supply glut reducing demand for SRG’s real estate.

     

    A remaining question, then, is whether we should be concerned that our somewhat small sample size reflects a selection bias or, rather, that the Company has simply elected to go after the low-hanging fruit first. Using data from the publicly available CMBS annex, we find little evidence that this is the case. Though Sears is paying an average of roughly $4.30 PSF in rent, the dispersion around that average is large (ranging at the time of the SRG spinoff from as little as ~$1.20 PSF to as much as $19.37 PSF) and a property’s rental rate within that range is generally correlated with quality (Aventura is likely the highest quality property in the portfolio and also has the highest rent). Of the 24 redevelopment projects announced through the end of 3Q16 (excluding King of Prussia, a Type III property) for which we have project data, 75% of the projects are locations paying at or below the average rental rate. For 15 of those 24 properties we have in-line sales data and can similarly use that data as a proxy for property quality. On this metric the evidence is more balanced with 6 of the properties below the portfolio average, 4 slightly above the portfolio average and 5 meaningfully above the portfolio average. We would highlight that, with the lone exception of Santa Monica (recaptured in 4Q16), Seritage has not yet issued recapture notices for its most valuable ‘trophy’ properties including Aventura, Boca Raton and Hicksville. These projects are likely to be more complicated than the projects announced to-date and will likely involve a complete re-imagining of the space. To use Aventura as an example, Seritage recently settled a legal dispute with Aventura Mall Venture (owned by Turnberry Associates) and is proceeding with approvals for a mixed-use redevelopment that will likely incorporate an entirely new open-air retail space and residential or hotel space as well. We expect that both the capital intensity and return potential of these trophy projects will be higher than in the rest of the portfolio.

     

    The data and track record are, of course, lagging indicators but there are several reasons to be sanguine about the prospects for brick and mortar retail, particularly for higher-quality malls and properties. There are a large number of innovative retail concepts and prospective tenants that are growing rapidly and looking for attractive real estate. Certain retailers that had previously focused exclusively on the online channel (Warby Parker, Bonobos, Athleta and even Amazon, among others) have begun expanding their brick and mortar presence in recognition of the fact that online sales are frequently won in-store. The ability to return or exchange items in-store is attractive to consumers who appear to favor omni-channel retailing and surveys show that consumers remain attracted to well-maintained community and lifestyle centers. Importantly, Seritage is not signing new department store anchors but rather dozens of tenants spanning categories including luxury retail, dining, entertainment and lifestyle. The outlook for department store chains may be bleaker than it was a decade ago, but it seems unlikely that these stores will all disappear overnight. In our view, we’re less likely to see an immediate wave of mass closures and more likely to see a managed reduction of the department store footprint over the coming years with much of the space transitioning to a slate of tenants more suited to a younger generation that will increasingly make up the retail consumer base. Very poor properties are unlikely to find much use, but we don’t believe that this is a significant problem for Seritage given the composition of its portfolio.

     

    As has been detailed extensively in previous write-ups, the real estate in the Seritage portfolio most closely resembles the type of property in A-mall portfolios. The GLA-weighted 10-mile average household income for Seritage (excluding the JV properties) is slightly over $76,000, which is well above the national average and compares favorably with companies like GGP, MAC and SPG for which 10-mile household incomes average roughly $75,000, $79,000 and $83,000, respectively. The population density around the Seritage properties also compares favorably with these operators at an average of 700,000 in a 10-mile radius, only modestly lower than for GGP, MAC and SPG. Much of this is the result of Sears’ long history in the development of America’s urban and suburban landscape. As an early mover in department store retail, Sears frequently finds itself owning land well situated in communities that have grown around its locations over the past several decades with favorable access characteristics and high visibility. We have visited a number of properties in the portfolio and would encourage others to do so. Failing that, a Google Earth tour is surprisingly illuminating. While we have all seen the pictures of empty parking lots and the brutalist architecture of the generic Sears box, it’s often surprising to see the stark contrast with the quality of the communities immediately surrounding some of these locations. There are unquestionably locations in the portfolio that will be poorly suited to retail redevelopment, but we believe the real estate itself is still quite valuable and the Company has been clear that in finding the highest and best uses for its properties it will, regulation permitting, redevelop properties for other industrial, commercial and residential uses. Some of the lower quality properties may not be a great home for a trendy bistro or luxury retailer but might be a great fit for storage facilities, office space or data centers. The rents will likely be lower, but the redevelopment costs will similarly be less burdensome and we believe that, on balance, the unlevered return prospects will remain attractive.

     

    Sears Bankruptcy – Loss of Rental Income

     

    Another common argument that we encounter in discussing the Seritage thesis is that the Company’s largest tenant, Sears, is on the verge of bankruptcy and the imminent loss of a majority of SRG’s rental income would be a disaster. We think there are a number of problems with this argument. To begin with, the idea that Sears is going to file for bankruptcy is a consensus view and, while we do not have a particularly differentiated view, this information should not be a surprise to Seritage shareholders or the market generally. Like others, we have spent a non-trivial amount of time speculating as to why Eddie Lampert continues to sell assets to fund operating losses at Sears when the future looks so obviously bleak and, one day, this will all likely make for a fascinating case study. However, determining the timing and probability of a Sears filing ultimately falls into our “too hard” bucket. Fortunately, we believe that the relevant question for SRG shareholders does not require a judgment call here. The real question involves determining what happens to SRG’s real estate in the event of a SHLD bankruptcy. In other words, we need to make some determination as to what the real estate is worth. This most-important question seems to be ignored by the shorts.

     

    To begin with, it is apparent that a number of market participants assume that a Sears bankruptcy necessarily results in the loss of 100% of the Sears/Kmart locations as paying tenants. For example, Den wrote in August:

     

    “…if SHLD files for Chapter 7 tomorrow morning it would have a huge impact on SRG. Today the $38.8 million it gets in rents from Third Party Leases would be all that is left in rental income and that is before expenses.”

     

    We think it is unfairly punitive to assume that Seritage will have to replace the entirety of the Sears rental income stream if SHLD files and do not think that this conclusion is supported by the evidence. If we look at the data in the publicly available CMBS annex, we have store-level TTM revenue, EBITDAR and rent coverage information on a TTM basis as of July 2015. Something that will jump out immediately to those looking at the data is that, on a GLA basis, just 15% of the stores in the Sears portfolio were not covering their rent (EBITDAR/Rent < 1.0x). Another 20% of the stores covered their rent by between 1.0x and 1.5x. Said differently, the overwhelming majority of the portfolio was cash-flowing at the store level at the time the portfolio was transferred to Seritage. This is a positive fact in itself, but also supports our view that SRG’s properties leased to Sears are generally stronger than the broader Sears portfolio given their higher EBITDA.

     

    Of course, these stores have likely suffered a decline in performance alongside all the other Sears stores. One can adjust the annex data to exclude properties we know to have been recaptured or terminated and shock revenue and EBITDAR margins to approximate the declines we’ve seen at Sears’ other properties (20% and 25% would be rough approximations of the declines that have taken place in the broader Sears portfolio). We can also adjust rent upward to capture the 2% annual escalator in the MLA. The result from stressing the data still suggests that over 50% of the portfolio are able to cover rental payments today. This is an oversimplification and we understand that store closures elsewhere likely have an impact on supply chains and that there are other effects. Our point is that we have concrete evidence that a large number of Sears/Kmart stores are profitable at the store level (and likely still are), which suggests that a Sears filing is likely to be a Chapter 11 and not a Chapter 7. Because each MLA is an all-or-none agreement (meaning that Sears cannot selectively terminate the leases for individual stores), Seritage will have some leverage in the inevitable bankruptcy negotiation which likely will result in Seritage keeping a significant portion of its rental income stream from Sears. Interestingly, some of the most valuable properties in the Seritage portfolio are also some of the worst performing. High quality properties in affluent and densely populated areas such as Aventura, Hicksville and Santa Monica all had rent coverage below 1.0x at the time of the Seritage spinoff. Indeed, for the subset of properties not covering their rent we find that in-line sales are 19% higher than the portfolio average.

     

    Compounding this error, we believe that many people then look at the 34.6 million square feet Seritage currently leases to Sears and erroneously assume that all of that space has to be dealt with in some capacity before Sears files. For example, Den wrote in August:

     

    “If you look at the development cost in Q2 2016, I get to an estimated number of $171 per sq. foot. $171 per sq. foot times 33 million is $5.64 billion. I am quite sure SRG does not have access to this amount of money on short notice.”

     

    We think this is the wrong way of framing the problem principally because Seritage does not need to concern itself with replacing the Sears GLA but rather the Sears rental income. Sears is paying 4.0x – 5.0x less than new third party tenants which means that: (i) Seritage could replace the entirety of the Sears rental income stream by redeveloping just a fraction of the square footage that Sears occupies and (ii) it could do so by spending vastly less than the amount of capital it will ultimately need to redevelop the full portfolio. Said differently, the mix of income derived from Sears should decline rapidly in coming quarters.

     

    At the end of the third quarter, Sears was paying Seritage $151.8 million in rental income. In-place third party tenants were paying roughly $40.6 million, bringing the total annualized rent for in-place tenants to $192.4 million. However, the Company reported an incremental $28.8 million in SNO leases at the end of the third quarter and we know, per the 4Q16 operational update, that the Company signed an additional $14.9 million in SNO leases through the end of the year. This means that the Company already has tenants lined up to pay $43.7 million in rent once the existing slate of projects is complete (generally within a year). This SNO rent represents nearly 30% of what Sears is presently paying Seritage and should roll online over the coming quarters. Even if you believe that Sears will permanently stop paying all of its rent when it files, this leaves just $108.1 million in Sears revenue that would have to be replaced by new tenants in order to maintain cashflow at Q3 levels in the unrealistic event that all Sears rent disappeared immediately. At the 4Q16 rate of $14.9 million, this would take just 7 quarters. The important point is that the Company could line up tenants to replace the entirety of the Sears rental stream in under 2 years without a material acceleration in its present recapture rate.

     

    Assuming redevelopment economics comparable to what we’ve seen in past quarters, we believe such an effort to replace the Sears rental stream would cost somewhere between $1.1 and $1.3 billion over the next few years (including the cost of already-announced projects) or about 20% of what Den estimated in his short thesis. We estimate that between the balance of the Company’s Future Funding Facility ($80 million at 3Q16), the proposed $200 million ESL loan (announced in December) and cash on hand that Seritage should have roughly $400 million in current liquidity. This is to say nothing of the roughly $100 million (post-dividend) in annual operating cash we expect Seritage to earn in the short-term while Sears remains a paying tenant or the termination payments due to Seritage for the 36 terminated properties (we estimate roughly $15 million). All-in, we expect that Seritage would likely need to raise an incremental $500.0 - $750.0 million over the next few years to facilitate a replacement of the Sears rental income. This is no small task, but we believe that the Company will be able to find willing lenders, particularly if it continues to produce slates of projects with a majority of lessees for the space already signed up. ESL and Fairholme have shown no lack of willingness to invest in these businesses and other deep-pocketed shareholders like Warren Buffett are likely to take a similar long-term view in considering lending to Seritage. This also ignores the Company’s ability to simply sell certain of its properties to bridge any short-term liquidity shortfalls.

     

    The end result of all of this is that even in the draconian scenario where all Sears rental payments disappear immediately, Seritage could replace the entirety of the Sears rental income stream by redeveloping just 20% of its total GLA (at just 20% of the cost it would spend redeveloping the entire portfolio). Importantly, if you buy our argument that not all of the stores will be immediately liquidated (i.e. that a Sears filing will not be a Chapter 7), you can cut those numbers substantially. We believe in a more realistic bankruptcy scenario Sears would continue to operate at least half of its stores, meaning Seritage only needs to redevelop 10% of Sears GLA to maintain its current cashflow.

     

    Lastly, we would highlight that although the headlines regarding Sears and retail generally have been overwhelmingly negative, there have been a number of headlines recently that would suggest Sears may not, in fact, be filing imminently:

     

    December 29, 2016 – Sears Holdings Announces $200 Million Secured Standby Letter of Credit Facility (Expandable to $500 Million)

    January 4, 2017 – Sears Holdings Obtains $500 Million Secured Loan Facility ($321 Million Funded)

    January 5, 2017 – Stanley Black & Decker Reaches Agreement to Purchase Craftsman Brand From Sears Holdings for $525 Million at Closing and $250 Million at End of Year Three

    January 30, 2017 – CBL & Associates Acquires Five Sears Stores Through Sale-Leaseback for $72.5 Million

     

    In the last month, Sears has obtained nearly $1.0 billion in short-term funding, another $250 Million payable in three years (against which they can likely borrow) and a $200 million standby letter of credit facility. The Company further announced that they were exploring the strategic sale of up to $1.0 billion in real estate assets and the Kenmore and Diehard brands remain on the market. Even in its dour downgrade note last week, Fitch acknowledged that the Company still had a number of unencumbered assets that could be sold to provide liquidity. We reiterate that we have no strong view as to when or how likely Sears is to file for bankruptcy. But if you think Sears can make it another year (we encourage you to make your own assumptions) then you can cut the 10% from above in half yet again, given that Seritage will have signed enough SNO leases at its current pace to fully replace the Sears rental income stream in just 2 years. Simply put, the current pace and economics of SRG’s redevelopment activity make it much easier to replace the entirety of the Sears rental income stream than shorts appreciate.

     

    One final point that is often neglected is that, at some point, it will be highly accretive to Seritage if Sears vacates all of the space in the SRG portfolio (either voluntarily or in bankruptcy). In the very short term, the loss of operating income might prove challenging. In the long run, however, if you believe in the redevelopment proposition and the value of the underlying real estate, it would be far more valuable to be able to reclaim 100% of the Sears GLA than just 50% at most locations where Sears is paying rent that is meaningfully below market rates. Seritage is rapidly displacing Sears as a tenant and we believe that this inflection point is much closer than most people realize.

     

    Sears Bankruptcy – Fraudulent Transfer

     

    An additional risk that has been raised but not fulsomely addressed in the previous write-ups is the possibility of creditors bringing fraudulent transfer litigation in the event of a SHLD bankruptcy. Under state and federal law, there are protections for creditors that provide recourse against equity owners that would attempt to move assets outside the company and beyond the reach of creditors at off-market prices ahead of a bankruptcy. An example would be a debtor facing imminent insolvency selling an asset to a controlled affiliate substantially below fair market value in order to shield that asset from creditors in a bankruptcy. Such transactions can generally be unwound outright or creditors can win a verdict for money damages.

     

    Generally speaking, fraudulent transfer can either be argued as (i) actual fraud or (ii) constructive fraud. Actual fraud requires the plaintiffs to demonstrate that the defendants acted with willful intent to defraud creditors and requires either explicit evidence of intent to defraud or a significant amount of circumstantial evidence pointing to intent to defraud. As you might imagine, it is not common for the management teams at large companies to circulate emails about asset protection schemes or other strategies outside the usual course of business that would be construed as a discussion of defrauding creditors. There are a number of common ‘badges of fraud’ that are used in such cases to establish a fact pattern pointing to intent to defraud, but our understanding is that such cases are generally uncommon and difficult to win. Constructive fraud, by contrast, is a much more common type of fraudulent transfer litigation and requires a plaintiff to demonstrate both (i) that the debtor sold assets for insufficient consideration and also (ii) that the debtor was either insolvent at the time of the transfer or became insolvent as a result of the transfer.

     

    Our view is that it will be difficult for Sears creditors to satisfactorily demonstrate either condition necessary to prove constructive fraudulent transfer. To begin with, the hurdle for creditors to demonstrate that Sears either was insolvent or became insolvent as a result of this transaction will be incredibly high. Immediately following the Seritage transaction, Sears had a public market capitalization of nearly $3.0 billion. Its publicly traded bonds had single digit yields (the 6.625s of ’18 traded at just 7.5% and today trade at a 10.5% yield). In a bankruptcy proceeding, creditors will have to demonstrate that both equity and debt investors were wrong in their assessment of SHLD’s solvency.

     

    If creditors were somehow successful in proving Sear’s insolvency at the time of the spin, they would then have to also show that were harmed. SRG shares have appreciated by just 33% since the time of the IPO. While the shares have outperformed the Dow Jones REIT Total Return Index (which has returned roughly 13% over the same period), that 13% annualized outperformance does not strike us as the type of eye-popping return that would result from fraud. Meanwhile, ongoing monetization of real estate and intellectual property supports the proposition that asset value more than covered outstanding debt obligations at the time of the transfer.

     

    We think it will be similarly difficult for creditors to prove damages for more subjective reasons. At the time of the transaction, Sears received independent appraisals from nationally-recognized firms Cushman & Wakefield and Hilco. Further, Sears received an independent opinion from Duff & Phelps, a nationally-recognized financial advisor, that it had received adequate consideration from Seritage in exchange for the transferred real estate and that the rental rates and other terms set pursuant to the MLA constituted fair market value. In its CMBS offering documents, Sears further disclosed that its Board of Directors had received an opinion from an additional, unnamed fourth financial advisor as to the solvency and adequacy of capital of Sears Holdings following the transfer of the real estate portfolio to Sears. Moreover, CMBS investors were not bending over backward to lend to Seritage on attractive terms. The LTV at close was just 51.6% through the mezzanine debt and 41.1% through the senior debt. The terms and rates SRG received were not unusually favorable and, taken together with the previous points, suggest to us that it will be extremely difficult for creditors to argue that the transaction was materially off market.

     

    Finally, a court will also consider the strategic nature/value of the transaction in effecting the Sears business plan in the context of determining whether Sears received adequate consideration. Regardless of the outcome, a cornerstone of the Sears business plan in recent years has been to rationalize the Sears and Kmart footprint within its existing spaces in order to improve profitability. The MLA signed with Seritage (and other similar sale-leaseback transactions) were uniquely structured to enable this business plan and the ability to effectuate a managed reduction of the Sears/Kmart footprint under the MLA was of strategic value to Sears. Sears received real value in the discounted rents it pays to Seritage and the right to retain some of its space to continue to operate its retail business. That value is something experts will debate at length and is something that will be very difficult to quantify. In short, we believe the evidence points toward solvency at the time of the Seritage transaction and, although we have constructive views on the value of the real estate, we nonetheless believe that it will be difficult for creditors to present a case that consideration received was insufficient in the context of the third party opinions received, the amount of time and capital that must be invested (under uncertainty) to realize a higher value for the property and the unique strategic value of the MLA to Sears.

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

     

    Seritage continues to recapture GLA from Sears at a rapid pace and with favorable development economics

    Sears continues to find ways of avoiding a bankruptcy filing, allowing Seritage to shift to a mix of third party tenants and de-risk its income stream

     

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