In addition to announcing improved fourth-quarter results, it was revealed earlier this week that Sears' (SHLD) Chairman and CEO Eddie Lampert purchased another $55 million worth of stock for his personal ownership. The big question now is whether Lampert, a savvy hedge fund manager, is sinking his entire career into doubling and tripling and quadrupling down on Sears. Or perhaps he is seeing what no one else can, and Sears is the bargain of the lifetime.
We've been fairly critical of his tenure, but it is undeniable that Lampert has done a fantastic job focusing the company on becoming an omni-channel retailer. In his letter to shareholders, Lampert discusses the Shop Your Way rewards program, which now accounts for over 60% of sales, and the endeavor seems to have taken off. Although we feel the company could do a better job advertising its program to new customers, Lampert describes his thoughts on the new social shopping experience, saying:
Shop Your Way is more than just a typical loyalty program. It is a comprehensive platform that transforms customer transactions into relationships and allows us to know our Members better and to serve them better as well. It includes the rewards program, our shopyourway.com social shopping platform, our Shop Your Way Max free shipping platform and a variety of other applications and components. Collectively, these elements change the way we do business both inside and outside the company.
We believe Sears is well aware of how destructive and disruptive Amazon (AMZN) is to its retail experience, and it has subsequently focused on fighting back. In addition to online rewards, the program has partnered with celebrities like Adam Levine and Nicki Minaj, which could be successful in bringing the company's apparel division back to relevancy. We aren't sure exactly how well the Kardashian line has performed, but we believe it could help drive some incremental store traffic.
In addition to highlighting the firm's online strategy, Lampert combated critics that believe the firm hasn't invested enough in its stores. Sears has allocated significant capital investment toward technology infrastructure, while closing underperforming locations. Lampert argues that investing in these stores would have been a waste of money, and the firm has benefited by closing stores, liquidating inventory, and not receiving penalties for lease obligations from credit rating agencies. He estimates the 300 or so stores Sears has closed since peak EBITDA in 2006 contributed $100 million to EBITDA out of $3.2 billion total. Since, the firm has extracted $1 billion in value from these stores vs. what Sears estimates would have been negative $50 million in EBITDA:
While commentators have suggested that we have underinvested in our stores, the data shows that in most cases, stores that were losing money in 2006 or were marginally profitable did not improve over the past six years. Let's assume we had invested $3 million in each of these 300 stores in an attempt to resuscitate them. Had we done this, and had they not improved, we would have thrown $1 billion of good money after bad. Instead, we were able to receive almost $1 billion in proceeds, which is not a bad result given the circumstances.
We have no doubt that Lampert is a skilled financier, so perhaps he's on to something. If the operating performance can improve, investors can look for an actual operating business rather than Bruce Berkowitz's real estate plan.
However, we're not seeing operating performance improve much. Sears Domestic's same-store sales increased only 0.8% year over year, even though the residential real estate market improvements have driven strong appliance sales. Same-store sales at Sears Canada fell 3.8% during the quarter, and sales at Kmart sunk 3.7% year over year. This occurred in spite of JC Penney (JCP) alienating its core customers and Kohl's (KSS) also lacking.
On the profitability side, gross margins were horrendous, coming in at 25.8% during the quarter and 26.7% for the year. However, these figures were up 130 basis points and 90 basis points year over year, respectively, and we believe a mix shift to more appliance sales could be a net benefit for gross margins in 2013. Unfortunately, SG&A expenses remain far too high at the current gross margin run-rate. The firm will need to boost gross margins before it starts generating an operating profit, as there might not be much more to cut from overhead.
Sears doesn't include its statement of cash flows in its initial 8-K filing, so we'll have to wait for the annual report to see how dire the cash burn is. However, taking a simple glance at the balance sheet and reported EBITDA figures suggests it wasn't too bad in 2012.
With Lampert purchasing more shares, positive results from store closures, and a margin tailwind from appliance sales, we think Sears could have upside, but shares look fairly valued at this time. Still, we're warming to the Sears turnaround story, and we think Lampert may know more about the potential to monetize the store base than he's leading on. We're keeping a close eye on the company.