What's in Store for Sears and Kmart?

When I heard the news about the Kmart/Sears deal, my first thought was that two dying retailers merging just creates a bigger dying retailer. The day of reckoning gets pushed back, but the story still ends the same way. While I'm still not sure that this story will end happily in a few years' time, there may be more value here than immediately meets the eye. At least, I think that's the case after running through the firms' asset values and speculating on some potential ways to extract value from their brands. Follow my logic and see whether you agree.

First of all, it's clear that in their current forms, Kmart  and  Sears  are suffering the retail version of death by a thousand cuts--bereft of any defined niche or competitive advantage, they've been slowly destroying shareholder value for a while. Despite the recent operational improvements that wunderkind Eddie Lampert has instituted at Kmart, it remains a low-end retailer with shrinking sales, no cost advantage, and just a few decent brands (Martha Stewart and Joe Boxer, for example).

Sears is in marginally better shape, with solid market share in tools and appliances, a stable service business, and some decent apparel brands. However, shrinking same-store sales tell a story that's unlikely to have a pretty end. Moreover, for every reasonably smart decision--such as dumping its credit card business and using the proceeds to buy back stock--Sears has compensated with something less intelligent. For example, the firm's much-hyped Sears Grand concept is a stunning example of poor capital allocation, with massive 180,000 square foot stores aimed squarely at going head-to-head with  Wal-Mart (WMT) and  Target (TGT). One can admire Sears boss Alan Lacy for his pluck, but successfully carving out a niche in between these two giants seems like a low-percentage bet.

So, where does the value in a merged Kmart/Sears come from? Real estate, of course, but I wonder if a more sweeping restructuring of the two retailers' operations isn't also in the cards. Let's examine the asset side first--kudos to Morningstar's financial-services team for working up some of these numbers. (Warning: This is a rough-and-ready analysis, and the devil is always in the details.)

Both Kmart and Sears have a mix of owned and leased stores--Kmart's stores are mainly leased, and Sears has a mix of both. A ton of the two firms' leases are at below-market rates, which means that Sears and Kmart can either sell the leases to other retailers or sublease the spaces for a lot more than they're currently forking out each month. Either way, the market value of the real estate is a lot higher than its value on the firms' books, or (in all likelihood) its value supporting underperforming Kmart and Sears stores.

If you look at the stores that Kmart sold earlier this year to  Home Depot (HD) and (ironically) Sears, you find that the purchasers paid roughly $120 per square foot. Assuming this represents the market value of Kmart's leases, the value of Kmart's leased real estate works out to about double its current book value based on the rates Kmart is currently paying. Call it $14 billion or so, net of debt, and adding in Kmart's owned properties. Similarly, if we mark Sears' real estate--owned and leased--up to market rates, we get a value in the $7 to $8 billion range. (Since many of Sears' properties are in malls, we used a more conservative per-square-foot value for Sears.)

Of course, you can't sell real estate to a buyer and continue running the store that sits on top of it. To realize these values, Sears/Kmart would need to slowly liquidate the whole kit and caboodle, which seems unlikely. Sure, the firm could generate a fair amount of value for shareholders by slowly selling off properties here and there--as Kmart has been doing over the past year--but much of the value would likely still be unrealized.

So, let's try to unlock some of that value by reorganizing the two firms' operations. Start with Sears' "hardline" businesses: appliances (Kenmore), tools (Craftsman) and such. Move these into the Kmart off-mall locations and start competing with Home Depot and  Lowe's  (LOW). Consumers who need hardware, but who don't want to dodge drywall-toting contractors in a cavernous Home Deport or Lowe's, now have another option. Odds are that the Kmart locations will be more convenient for many consumers than the big box home improvement stores, which are located further out where land is cheaper. Heck, at least some of the old Kmart locations must be attractive for hardware/appliance retailing, or Home Depot wouldn't have bought two dozen of them earlier this year.

Next, bring the Martha Stewart, Joe Boxer, and Jaclyn Smith brands from Kmart together with Lands End and Structure from Sears, and set them up in the current Sears mall locations.  J.C. Penney  has done all right recently with a decent apparel selection in mall locations, and with lesser-known brands. Since these "new" Sears stores would only be selling apparel and such--the appliances and tools have been moved off to the old Kmart locations--they wouldn't take up the full 140,000 square foot space of a typical Sears store.

So, carve up the rest of the space into smaller spaces for specialty retailers, charge them a typical $25 per square foot rent, and pocket the difference. Given the huge difference between these rents and the $7 or so per-square-foot value of department-store space--not to mention the low-single-digit rents that Sears is probably actually paying--and the firm wouldn't need to do too many of these carve-ups to generate quite a bit of value. Or, sell the excess space to the mall owner and let them do the same thing. Either way, the higher value accrues to Sears.

Now we have two distinct formats appealing to two distinct consumers--no more trying to sell power tools and fleece vests under the same roof. Apparel is in the mall in a smaller store, while appliances, tools, and the like are in off-mall locations that are likely to be more convenient than a Home Depot or Lowe's. Some of the mall locations get sold or carved up--and before you sniff at the value of mall-based property, I'll note that Target already anchors a number of malls, and Wal-Mart has made noises about doing the same--and some get converted to the softer-side-only Sears format.

Would this happen overnight? Of course not. Are there some holes in this grand plan? Of course there are. But does Kmart/Sears head honcho Eddie Lampert have something in mind other than generating some fairly small cost savings and selling off a few stores here and there? I think that's a pretty good bet. Whether it works or not remains to be seen, but I don't think Lampert has shown all of his cards just yet.

Speaking of cheap real estate, check out newly-minted five-star stock  Lodgian , which owns and operates a number of mid-range hotel properties. If corporate travel keeps rebounding, and the firm stays a couple of steps ahead of its lenders, there could be a lot of value in the shares. Of course, a slowdown in the travel market could take it in the opposite direction just as quickly.