Sears Mangement, Berkowitz At Odds Over Retail Losses

| About: Sears Holdings (SHLD)

Summary

Bruce Berkowitz mentioned that he considered Sears's retail losses to be voluntary. Sears's own comments indicated that it was actually trying to make money though.

The transformation resulted in an additional $787 million drop in adjusted EBITDA for 2015 compared to if it had just maintained -2.5% comps and cut costs in the same way.

Retail profitability appears a long way away in 2016 despite additional cost cutting.

Sears needs +9% comps with its current gross margins just to reach zero adjusted EBITDA or +4% comps if it can improve gross margins by 1%.

Sears has delivered negative comps every year for over a decade.

Bruce Berkowitz made some interesting comments during Fairholme Capital Management's 2016 public conference call when discussing Sears Holdings (NASDAQ:SHLD). He mentioned that the "retail losses, is, in our opinion, voluntary, and is expected to stop this year" and that "A considerable portion of the past cash burn is voluntary based on the transformation of the retail businesses."

To me, a voluntary loss may entail lower gross margins or perhaps a temporary hit to sales as a new turnaround strategy is executed. Thus, the losses incurred soon after it unveiled its transformation roadmap in 2012 could be considered voluntary. However, if nearly four years after that sales and EBITDA are becoming worse than ever, it would be proper to attribute the losses to failing business strategies and not a voluntary move. Certainly one can't believe that Sears's retail transformation was intended to produce worse profitability year after year. Indeed, Sears's own comments indicate that it wasn't planning on generating large losses as part of the transformation plan.

Profitability Was Supposed To Be Part Of The Plan

Although Berkowitz mentions that the retail losses were voluntary in his opinion, Sears's statements offer a different perspective.

In Q1 2013, Eddie Lampert mentioned that "first quarter 2013 financial performance is not acceptable." and that "We have a clear vision and strategy, and in order to execute on it, we have to generate acceptable profits."

In Q4 2013, Lampert said, "I am not pleased with our profit performance."

In Q2 2014, Lampert mentioned that "We are committed to driving profitability."

In Q1 2015, Rob Schriesheim indicated that Sears's primary focus was "improved profitability."

Those statements do not appear to support the idea that several years of declining adjusted EBITDA was part of the master plan.

Additional Losses Caused By The Transformation

Here's a look at the comparable store sales for Sears Domestic and Kmart in the three years since Eddie Lampert became CEO. Between 2010 and 2012, Sears Domestic averaged -2.5% comparable store sales, while Kmart averaged -1.4% comparable store sales. By comparison, 2013 was a weak year, 2014 was consistent with previous trends and 2015 was quite atrocious.

2013

2014

2015

Kmart

-3.6%

-1.4%

-7.3%

Sears Domestic

-4.1%

-2.1%

-11.1%

Click to enlarge

If Sears had averaged -2.5% comps per year since 2012 (roughly in line with previous trends), it would have ended up with approximately $27.3 billion in net sales during 2015 rather than the $25.1 billion that it actually ended up doing. If Sears had just managed to maintain that relatively weak level of performance, it would have $2.2 billion in additional sales now.

In addition, gross margins have fallen significantly for Sears as well. Kmart's gross margin was down from 23.4% in 2012 to 21.3% in 2015. The comparison between 2012 and 2015 for Sears Domestic is a bit trickier to figure out due to the spinoffs of Lands' End and Sears Hometown and Outlet Stores, but I estimate that excluding the companies that were spun off, Sears Domestic would have had around 25.3% gross margin in 2012. This has declined to 23.3% in 2015. Gross margins have been challenging for department stores over the past few years, so it is probably reasonable to assume that gross margins would have gone down by 1% anyway with the previous strategy. This means that the retail transformation has resulted in an additional 1% decline in gross margins.

Between the worsening comparable store sales and the greater decline in gross margins, it is estimated that the retail transformation has resulted in adjusted EBITDA being $787 million lower in 2015 than it would have been based on previous trends. Even allowing for a budget of couple of hundred million extra for capital expenditures to upkeep and refresh stores would leave Sears significantly better off than in the current scenario.

All Sears needed to do was to maintain mediocre performance (-2.5% comps per year and a modest decline in gross margins) while closing unprofitable stores and cutting costs where it could, and adjusted EBITDA would have been approximately $787 million higher in 2015. This would still leave it with slightly negative adjusted EBITDA (around negative $49 million), but still substantially better than before.

Retail Profitability In 2016

Berkowitz mentioned that he expects Sears's retail losses to stop in 2016, but that's going to be a very tough thing to do. Sears has mentioned improving profitability as a goal for many years now, but retail results continue to get worse.

Sears indicated that it intends to reduce expenses by $550 million to $650 million in 2016. Assuming that Sears reduces expenses by around $600 million, that still leaves around a $310 million improvement required from sales and gross margin just to get adjusted EBITDA to zero. Sears would still be unprofitable on retail operations including capital expenditures in this case, but we'll consider zero adjusted EBITDA the target here.

Sears is also expected to close more than 50 stores as part of the expense reduction. Assuming that store closures result in a 3% decrease in net sales, that means that Sears would need +9% comps in 2016 to improve adjusted EBITDA by an additional $310 million at 2015's gross margin. If Sears can increase gross margins by 1% (such as from 22.5% to 23.5%), then it would need +4% comps in 2016 to improve adjusted EBITDA by the required amount. Given that Sears hasn't recorded positive same-store comps in over a decade, it seems quite unlikely that it can do the mid-to-high single-digit comps required to reach zero adjusted EBITDA.

Conclusion

Berkowitz's opinion that Sears's retail losses were voluntary appears to be contradicted by Sears's own comments about the financial performance being unacceptable and that its primary focus was on improving profitability.

The attempt at transforming Sears appears to have resulted in 2015's adjusted EBITDA being $787 million lower than if it had just managed mediocre -2.5% comparable store sales while cutting costs. By simultaneously driving comparable store sales and gross margins down considerably, Sears has managed to increase its losses in 2015 by a significantly greater amount than it received from the Lands' End dividend.

Sears may be able to improve its adjusted EBITDA from 2015 levels as it continues to close stores and cut costs. However, getting to zero adjusted EBITDA in 2016 appears quite unlikely, as it would require +9% comps with current margins or +4% comps along with gross margin improvement.

Disclosure: I/we 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.