Quick blurbs about SHLD's LE spinoff

LE disclosed the following cost post-spin:

1.       Master lease & sublease agreement that amounts to ~$27 mm in 2014. (Pg 112)

2.       Retail operation agreement, including providing sales and floor support personnel, access to point-of-sale and other information technology systems, logistics and warehousing support and other support services, that amounts to ~$33-36 mm in 2014. (Pg 112)

3.       New Shop Your Way Retail Establishment Agreement that amounts to $33-39 mm over the next 3 years, or ~$11-13 mm in 2014. (Pg 112)

4.       Buying Agency Agreement, including vendor selection and screening, contract negotiation support and quality control, amount to ~$10-11 mm in 2014. (Pg 112)

5.       As a standalone company, LE expects to incur incremental annual operating costs estimated to be approximately $8.0 million to $10.0 million to support the businesses. (Pg 44)

According to the disclosure at pg 44: “The aggregate historical costs of these related party transactions are summarized in Note 11 and Note 5 to our combined financial statements included elsewhere in this information statement, respectively, for the year ended February 1, 2013 and the 39 weeks ended November 1, 2013. The aggregate net costs (which approximate cash payments) were $85.9 million for 2012 and $60.6 million for the 39 weeks ended November 1, 2013. We expect that the existing arrangements, as reflected in the historical financial statements contained therein, are not materially different from the arrangements that will be entered into with Sears Holdings in connection with the spin-off, with the exception of the Shop Your Way program. Net annual costs associated with the Shop Your Way program are estimated to increase by approximately $11 to $13 million in 2014. The additional investment in the Shop Your Way program is anticipated to be offset by increased profits from incremental revenue and reductions in promotions and advertising expense, as we expect to reduce our dependency on other marketing efforts as member engagement through the program continues to grow.”

We expect that only the $11-13 mm incremental cost from SYW and the $8-10 mm standalone operating cost are to be added to the proforma financials. In such a case, assume ~150 mm run-rate EBITDA, LE’s proforma EBITDA should be 150 – 12 – 9 = ~$129 mm per annum. We have trouble getting anything above $25 / LE Share as a fair entry point – maybe in a few years?

We further believe that comping LE vs. VFC, RL, PVH, etc is a bit dangerous – the latter companies enjoy materially more scale, international presence and recognition, better balance sheet, and much higher (>400 bp) EBITDA margin with a consistent track record to grow.

Thus, we hypothesize that 2 likely causes contribute to the current >$30 / LE share price: (1) Original SHLD shorts covering their LEDMV portion and (2) investors extrapolating historical EBITDA margin forward without fully accounting for the added cost disclosed in the fine-prints.

The blue-sky case is tempting though. Assume that in 3 yrs, the management successfully grows the sales to $1.8 Bn and expands EBITDA margin to 9.5%, we get ($1,800 * 9.5% * 11x – 300 mm (w/ FCf paying down debt) ) / 32 mm shares = ~$50 / share. Not bad at all. Maybe it’s worth nibbling as when-issued starts trading. Upside optionality of a take-out remains too. So perhaps I was too tight in my previous valuation case.