There's Huge Upside in the Worst Retail Disaster in History

Editor's Note: Michael's Zenith Trading Circle readers got a special holiday profit play recommendation on this retail dead-ender, but he thinks the gains here could be so big that he asked us to get another recommendation out to everyone, early in the shopping season, because the window for maximum profits won't be open long. Here's Michael...

By all accounts, 2016's "Black Friday" was a success, surpassing $3 billion in sales for the first time in history. That might be welcome news for a retail industry that is now unambiguously in crisis, but most of the record spending was done online.

That's just another nail in the coffin for an industry that's seen a raft of bankruptcies lately, with mall-based fixtures like Sports Authority, RadioShack, Aéropostale, American Apparel, and PacSun all going belly-up.

I'm not trying to spoil anyone's festive mood, but it's my job to call it as I see it: This trend for these traditional retailers points straight down. No matter how much you personally spend this shopping season (and I do hope you get some good deals), the explosion of ecommerce, along with weak and/or increasingly selective consumers, makes traditional retailers' destruction inevitable.

But hardly anyone is falling faster or harder than this turkey, which means we have to move quickly...

No One Can Stop the Collapse This Man Started

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I've been recommending Sears Holdings Corp. (Nasdaq: SHLD) as a short since Chairman Eddie Lampert was having the company buy back stock at $190 a share a few years ago - one of the grossest misuses of corporate funds in business history.

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By now, the stock has lost 90% of its value, and I see significant upside in the retailer's "last gasp."

The truth is, no short portfolio is complete without this train wreck - one of the biggest in recent years. 2016 could well be the company's final Christmas season because at the rate it is going, by this time next year the stock could be trading at zero.

But you're not likely to find anyone that publicly shares my view: The financial press set a new standard in stupidity and sycophancy in its treatment of Sears' majority shareholder, hedge fund manager Eddie Lampert.

A decade ago, Mr. Lampert was heralded as a "young Warren Buffett." Since then, he presided over the collapse of not one but two of the greatest names in American retailing, Sears and K-Mart, while managing to enrich himself and impoverish the investors in his hedge fund and Sears shareholders.

Now, it's one thing to define investment genius down, but Mr. Lampert's performance is nothing short of a disgrace. Not only did this investment collapse, but it swallowed Mr. Lampert's hedge fund along with it. As I've said many times, beware of investing with celebrity managers. Once they get famous, their best days are behind them.

Lampert has presided over some of the biggest losses in American business history. Sears lost $1 billion, $2.6 billion, and $1 billion in 2015, 2014, and 2013, respectively. Cash flow from operations in those years was -$2.2 billion in 2015, -$1.4 billion in 2014, and -$1.1 billion in 2013. For the six months ended July 23, 2016, the company lost another $866 million and had cash flow of -$640 million.

Revenue and same-store sales collapsed sequentially during all of these periods, with some minor variations. In fact, losses are increasing, despite Lampert's best efforts (which are obviously not very good).

Remember, Lampert is supposed to be a "hedge fund genius," and his genius has unfortunately spread like a virus to many of his peers, including Bill Ackman, John Paulson, and others.

The company has also been hurt by serial management failures. Like the destruction wrought by Bill Ackman at J.C. Penney Co. Inc. (NYSE: JCP) before he had the decency to leave the scene of his crime, Mr. Lampert has left a trail of losses and destruction behind him at Sears.

But Lampert is not alone in this investment. Another so-called investment genius, Bruce Berkowitz, manager of the once-successful and now woefully underperforming Fairholme Fund (MUTF: FAIRX), is up to his eyeballs in this disaster.

Mr. Berkowitz has been pushing the narrative that investors will be bailed out by Sears' "hidden" real estate value.

Think again!

Sears has been selling off its prime real estate assets for years, but the proceeds of these sales are being consumed by billions of dollars of operating losses in its retailing operations.

As desperately as Lampert is trying to shrink the retail operations, he can't do so quickly enough to stem the bleeding that is sucking up the value of the real estate.

The so-called "smart money" (and believe me, anyone who calls himself "smart" is compensating for something) thinks that the real estate value will outrun the losses, but a hard look at Sears' numbers and the collapse of Sears' stock price tells a different story.

Sears and Lampert Tried to Bury the Truth

Just take a look at the July 2015 spinoff of 235 Sears and K-Mart stores into a real estate investment trust (REIT), the oxymoronically named Seritage Growth Properties (NYSE: SRG). It perfectly illustrates the folly of relying on Sears' real estate to save the company.

At the time, Wall Street hyperventilated over the deal, but it was really hyperventilating over the fees it generated. That's because its underlying premise is patently absurd: A REIT whose main tenant is going bankrupt will never be a good investment.

The deal generated $2.7 billion of proceeds for the company but added roughly $170 million of annual lease payments to the company's expenses - which increase by 2% annually thereafter.

Now, the official press releases all tried to make it sound like the company received $2.7 billion in cash. But if you read the fine print buried in Sears' annual reports, you can see where this cash actually comes from. And it's eye-opening: $745 million came from Lampert, $297 came from Berkowitz's Fairholme Fund, and $1.2 billion was borrowed.

In other words, only $458 million of new equity capital was raised from non-insiders!

That $1.5 billion of equity won't last long for a company burning $1 billion of cash every year - two-thirds of it has already been burned up and thrown down the garbage chute.

The problem with this transaction is that it only took about a year for the company to eat up the cash it generated from this deal, and all it has are added lease expenses to show for it; the company no longer has those stores to sell.

The situation was spelled out pretty plainly when the company reported a paltry $218 million of cash on its balance sheet at the end of 2016 even after completing the Seritage and other financing transactions a mere five months earlier. Sears stock has lost roughly 50% of its value since the Seritage deal as investors wake up to the fact that, to quote Gertrude Stein, "there is no there there" - if there ever was.

Sears Digs a Deeper Hole (and There's Our Upside)

As of the end of August 2016, the company's debt has risen to $5 billion and the company had to enter an agreement with the Pension Benefit Guaranty Corporation, the government agency that is left holding the bag when companies go bust, to protect beneficiaries of its $2 billion pension fund. After years of losses and financial engineering that have destroyed the company, the government doesn't want to be left to clean up Mr. Lampert's mess.

It is also, unsurprisingly, running low on cash again. Sears had only $238 million in cash at the end of August and was again promising more financing transactions to keep itself afloat. But it is increasingly relying on borrowing money from Lampert and Berkowitz (and its own pension plan) since outsiders want no part of this mess.

The company remains cash-starved and in constant need of raising more money to fund its incessant operating losses. I expect to hear that vendors and factors will be reluctant to extend credit for holiday sales as they did last year. Nobody wants to get caught holding the bag.

Many stores are in terrible shape, falling apart, and sporting bare shelves.

People only shop at Sears if they have to, not because they want to. Have you heard anybody talk about wanting to shop at Sears? That's like saying they want to go to the dentist, or they want to have a colonoscopy. Sears is a shopper's last choice. And that's why it's heading for the bone yard.

But there's a lot of money for us to make on the way down. I've put my Zenith Trading Circle members in a very specific high-profit trade to ride this for profits.

Otherwise, savvy investors should consider buying out-of-the-money puts, dated to 2017, on SHLD shares. But do it before Christmas. This stock isn't long for this world.

You probably won't hear much from the media about Sears' steep drop, and that's OK: There's more profit potential for the rest of us. It's also likely the media isn't paying attention to these 43 other stocks, all headed toward zero, that Michael is watching right now. To learn about a highly controversial way to play these dying dinosaurs, and turn a small stake into $100,000, click here.

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About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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