Sears' Q1 Surprise Profits May Be Fleeting

Five years ago, the investment world was lauding Eddie Lampert as a “genius” and “the next Warren Buffett.” After taking control of a bankrupt K-Mart and turning it around, he engineered the takeover of the iconic Sears and created what looked to be a potentially dominant new platform for which to execute his investing prowess. Today, with shares having dipped below their price five years ago, the glimmer of Eddie Lampert’s investment prowess has faded a bit and his ability to salvage his investment in K-Mart and Sears (collectively, “Sears Holdings” or SHLD).

SHLD announced a surprise profit of 38 cents per share for the first quarter versus a loss of 88 cents per share expected by analysts. It’s stock is up nearly 14% since Friday and some may be tempted to think that Eddie Lampert and Sears are on their way back from the brink. A closer look at the announcement, however, may tell a different story. Sears achieved its profitability through aggressively managing working capital, closing stores, and drastically cutting advertising and personnel costs. Same store sales at both K-Mart and Sears were down 2.1% and 11.7%, respectively (7.4% overall).

I’ve written before about Eddie Lampert’s age old strategy of managing for cash and using capital to buyback shares - (see: Eddie and Autozone (AZO)). Generally speaking, I believe that paring back investment and returning capital to shareholders is a good way to maximize value to shareholders of mature businesses. The key to this strategy, however, is that the business in question can remain a going concern. Otherwise, siphoning off cash to return to shareholders is merely a glorified run-off of the business.

This is exactly the case with Sears’ most recent Q1 profits. Same store sales have fallen for eight straight years and profitability, despite the recent results, is down over 90%. The Company has yet to find a true successor to its former CEO Aylwin Lewis and its “strategy” of late can be summed up in 4 steps:

1. Close stores
2. Monetize real estate
3. Rationalize the work force
4. Cut discretionary spending (mostly marketing) at all cost

Clearly, this is an unsustainable business strategy. At some point, SHLD will have to prove out its viability. Until then, it’s hard to give much credit to the management team's proclivity to return cash to shareholders through buy backs. Rather than signaling a vote of confidence in the stock, it seems more a tacit acknowledgement that management has no idea what else to do.

For any other company, we might find this a refreshing. This is absolutely not the case with a business where most investors jumped aboard because of their belief in Eddie Lampert and his ability to invest and allocate capital. For Sears Holdings to ever achieve its supposed potential, it will have to do more than manage for cash flow and buy shares back.

Full Disclosure: The author has no position in SHLD at the time of writing.

Comments

[padresfan:]

Thank you for spelling it out. Sears is in trouble, and I am tired of hearing so-called experts trying to defend them. Manipulating the stock seems to be their top priority, rather than try to get shoppers into their stores.

May 27 08:40 AM

[Tricky:]

These were exactly my thoughts as I read thru the last results. I'm not going to short SHLD, as this strategy might ostensibly "succeed" for a little while more. But anyone thinking about going long really ought to visit a few of the stores first -- it's an increasingly gruesome sight and I don't see a platform for turning around revenue growth.

May 27 08:45 AM

[fcharlie:]

No one will mention that Sears Holdings gross margin was the 2nd highest in the history of the merged company. NO ONE will mention that. That's why the earnings blew away expectations. The business may be in decline, but it's being run well given the situation. Also, if they just reported the 2nd highest gross margin in the history of the company, then ask yourself, What happens when housing recovers?

All my life i was told that investing in cigarette companies was a bad idea because they didn't have a sustainable business model, as their customer base is literally dying every day. Smoking has been declining for 40 years straight, yet Philip Morris, i believe, has been the best performing large cap stock at nearly any point of those 40 years. Why? Because the stock has been priced at distressed levels for so long, yet the company keeps churning out cash through cost cuts, consolidation, running the business better, and it keeps sending that cash to shareholders via share buybacks at distressed prices. As long as Sears remains at distressed prices (below net inventory value qualifies), then all they need to do is run the company for cash and buy back stock. That's it. Game over. In a few years, there won't be any float left. Unless you can argue the retail operations won't survive a few more years, the stock is a bargain.

May 27 10:00 AM

[RicK IL:]

"Tricky" is right---Eddie has spent/wasted money on buybacks rather than make even minor improvements at least with KMart---the store near me is a total dump; the check-out counters look like late 50's, with scanners so scratched they can hardly read UPC labels. The KMart clothes would be fine---in the third world! Lampert uses ALL the stockholders' money to increase his own ownership percentage; and this after he's raked off billions. Comp Sales at remaining Sears stores were off 11.7%---what would they have been had the "bad" stores stayed open? Off 30%? I guess that makes Eddie a retail genius these days.

May 27 12:26 PM

[Fighting Yoda:]

Sears is the worst retailer, just one step ahead of K-Mart. Americans may shop at Wal-Mart for prices, but still they are ways from rushing into Sears/K-Mart.

The earlier investment theme on Sears was real estate - that theme is dead and buried. Cutting marketing costs in a super competitive environment would be totally disastrous.

May 27 10:18 PM