Sears: Dysfunctional Operations Suggest Shareholders Bet On Monetization Of Undervalued Real Estate

| About: Sears Holdings (SHLD)

Retailers are getting slammed in recent weeks ahead of the important back-to-school season. Shares of Sears Holdings (NASDAQ:SHLD) are setting fresh lows after its second quarter results didn't reveal any bright points in the company's turnaround efforts.

The lack of urgency in the turnaround continued operating losses combined with large legacy obligations make me hesitant to invest. This is despite the potential upside caused by liquidation of the company's large real estate assets.

As long as Lampert is in place and continues to run the business in a dysfunctional manner, I remain on the sidelines.

Second Quarter Results

Sears generated second quarter revenues of $8.87 billion, down 6.3% on the year.

Net losses attributable to shareholders rose from $132 million last year to $194 million, as losses per share came in at $1.83 per share.

Adjusted losses per share came in at $1.46 per share, greater than last year's losses of $1.06 per share.

Looking Into The Results

Absolute revenues fell by $596 million compared to last year. Some $210 million is attributable to Kmart and Sears full-line store closes, and another $195 million is attributable from the separation of SHO. The remainder is explained by falling comparable store sales in the US operations which fell by 1.5% on the year before.

Notably performance at Kmart was weak as comparable sales fell by 2.1%, while comparable sales at Sears Domestic fell by 0.8%.

Gross margins fell by 210 basis points to just 24.6%. Gross margins were negatively impacted by discounts and Shop Your Way loyalty points.

The negative sales leverage pushed up selling, general and administrative expenses by 10 basis points to 25.8% of total revenues. Consequently, operating losses totaled $51 million compared to $103 million last year.


Sears ended the second quarter with $671 million in cash and equivalents. The company carries along $3.74 billion in short- and long-term debt as well as capital lease obligations, for a net debt position of around $3.1 billion.

Revenues for the first six months of the year came in at $17.32 billion, down 7.6% on the year before. Net losses came in at $473 million. At this pace full year revenues could come in around $36-$38 billion, while Sears will most likely report a large full year loss.

Trading around $40 per share, the market values Sears at $4.2 billion, valuing equity in the business at little over 0.10 times annual revenues.

Given the financial difficulties Sears does not pay a dividend.

Some Historical Perspective

Long-term investors in the stock will most certainly have mixed feelings. Shares rose from merely $15 in 2003 to highs of $190 in 2007 as the US consumer was spending home equity, and investors were optimistic about the mega-merger of 2005.

From there onwards shares have steadily fallen to levels around $40 at the moment, as shares trade at their lowest point in over a decade.

Between the calendar year of 2009 and 2012, Sears has seen its revenues fall by a cumulative 8% to just below the $40 billion mark last year. Modest profits have reversed into losses over the past two years, with losses expected to continue in 2013.

Investment Thesis

All in all there is not too much new to be found in the latest earnings report. Ever since the $11 billion mega-merger between Kmart and Sears, orchestrated by Lambert, revenues have fallen by roughly a third. That does not even adjust for inflation, implying that "real" sales have plunged even more.

Revenues continue to decline organically and on the back of store closings making it even harder to break-even. Even retail mammoths which have much greater execution, like Wal-Mart (NYSE:WMT), are struggling in today's environment. There are few signs of a stabilization, or an improvement in the operations, a major reason why investors are again disappointed.

Back in November of last year I last took a look at Sears' prospects after it released its third quarter results. Shares fell heavily after the report to levels in their mid-forties. Besides missing out on the stock market rally ever since, shares have actually fallen another 10%-15% to their lowest levels in over a decade.

I called the sell-off understandable as the pace of the turnaround is really slow, and now nine months later I have to reiterate that stance. The company remains far removed from reporting operating profits as the business keeps shrinking and cost cuts are not aggressive enough.

The organizational structure implemented by Lampert with 30 separate business units has resulted in so many internal problems that it will be hard to see the company work together, something really crucial in the retail landscape where promotions in one category attract traffic for the other categories.

Key initiatives like data sharing will therefore be difficult, or close to impossible. The only exception and bright spot is the online business of Sears which is quite advanced, as Lampert has high ambitions for the operations.

Given the lack of urgency for a turnaround, or any evidence of that, I remain really cautious and attach a low operating value to the business. For now, as it has been for years, the business is in steady decline and fierce competition makes it even more difficult to turn around the tide.

This means that the business should be valued more on liquidation value terms rather than on a going-concern valuation. Putting a fair value on Sears' great real estate remains tricky, but consensus is that the carried book value and favorable long term leases are undervalued at the balance sheet.

Putting an exact fair value on the real estate is difficult for an outsider. What I do know is that besides supporting the $4.2 billion current equity valuation, the business also has to support $3.1 billion in net debt and has another $2.5 billion in retirement liabilities.

If I want to invest in real estate, I would search for a great REIT and not bet on Sears to liquidate real estate at fair value, if it ever will. The fact that the company has not been able to turn around itself in eight years says it all, while Lampert remains in control.

I would not touch the shares at the moment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.