What is Sear’s (SHLD) Orchard (OSH) spin-off worth?
Please note this is only a preliminary valuation, intended as a guide and to encourage a bit of discussion. Also note I wrote this post on December 19th and have scheduled it to post December 28th, 2 days before OSH shares start trading. Markets may have rallied or fallen a bit by then, so the Lowe’s and HD valuation may have changed slightly. Baring a complete collapse or leveraged buyout, the conclusions reached in this article will not have changed. Also note that this was written before OSH filed their 10-Q, though I went through it and found nothing that would change this article. Finally, Sears reported some pretty disastrous results, which could result in a bit more frustrated selling pressure on OSH.
Let’s start by thinking about what the company’s EV should look like. TTM sales come in ~$665m, while EBITDA (after adjusting for some spin items and some additional cost they will incur as a public company) will come in between $70-80m, depending on how you calculate it. The two big publicly traded competitors are Lowe’s (LOW) and Home Depot (HD). Lowe’s trades for 7x EV / EBITDA and ~0.75x EV / Sales. HD trades for 8.6x and 1x, respectively. Both of those valuations point to an EV range of $490m-665m. Yes, a pretty big range, but we’re just thinking broadly here, and I think it shows you something- Orchard is so leveraged that it will be very, very sensitive to the multiple you apply to it.
Orchard will have $337m in debt and capital leases. Backing those out of the EV would give us an implied equity value of $161m-328m. Equity consists of preferreds with a liquidation value of $20m in total and 3 classes of shares. The three classes are basically economically equivalent. In total, there will be 6m shares outstanding.
Now, it’s tough to argue the preferreds should be worth liquidation value. They’re basically entitled to nothing unless the company is taken over or the board of directors decides they want to liquidate them. Let’s assume their worth 50% of liquidation to be conservative. This would give us a value of the common between $150m and $315m. With the 6m shares outstanding, this would imply a share price between $25 on the low end and $52.5 on the high end.
Personally, I think you can throw the high end out. Considering the geographic concentration (exclusively California), the fact Orchard has much, much more leverage than HD and Lowe’s, and that they will be a controlled company with low float, I doubt OSH deserves a premium valuation like HD. Maybe even using LOW’s valuation is too aggressive, though morningstar appears to be assigning a much higher multiple to get their valuation…..
Of course, leverage works both ways. Orchard is very levered to the California market, and past results do show that a more normalized market would yield significantly higher revenues and EBITDA- EBITDA and rev in 2008 was $85m and $761m respectively, and even higher in the prior years. If the California market starts to turn around in the near future, OSH would likely prove a bargain in the low $20s, as both operating and financial leverage could drive huge gains in the equity value.
So where do I think you can find a margin of safety here? Again, tough question. Orchard is just so sensitive to the multiple. What if you think it deserves to trade at a bit of a discount to Lowe’s??? Assuming the preferred is worth 50% of liquidation, applying 0.6x EV/sales or ~5.5x EV / EBITDA multiples would result in a target share price of just $8.60. In other words, flexing the EBITDA multiple by just 1.5x can result in almost 3x swings in share price!
I think the company would be interesting in the low teens, around $12-13 per share. This would imply EV / EBITDA of 6x and EV / Sales of ~0.63x. At that price, your downside would be relatively limited (assuming, of course, no further drops in earnings and sales) while you would have huge, huge upside to multiple improvements or earnings improvements from a more normalized housing market or the spin-off serving as a catalyst to focus management and drive operational improvement. I’ll be on the side lines at the start, but if shares get crushed when trading starts I certainly will be tempted to start buying.
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