2015 was an eventful year for Sears Holdings (SHLD). The company took steps to prune its product lines in order to focus on its most profitable products. This led to a 9.2% drop in comparable store sales. With the drop in comp store sales and previous spin-offs and store closures, sales fell nearly 20% to $25.1 billion. Sears also formed three store joint ventures with major mall operators and sold its interests in those ventures along with 235 stores to Seritage Growth Properties (SRG), a recently formed, independent REIT that it created. These transactions should allow Sears to reduce its store footprint and much of the associated operating costs over time.
For fiscal 2015, which ended on January 30, 2016, Sears posted a modestly lower loss of $1.1 billion or $10.59 per share. That compares with a loss of $1.7 billion or $15.82 per share in fiscal 2014.
On a non-GAAP basis, Sears lost $8.94 per share in fiscal 2015, wider than fiscal 2014’s $7.81 per share loss. The company had been showing steady improvement (i.e. lower non-GAAP losses) in the first three quarters of the year; but warm weather and a competitive Christmas selling season widened its loss in the fourth quarter and for the full fiscal year. Sears has now posted wider non-GAAP losses for the past three consecutive years.
The 19.4% drop in merchandise sales and services in fiscal 2015 was due mostly to efforts by Mr. Lampert and his management team to remake the company. Sears has been trying to shrink its geographic footprint, focus its efforts on its best product lines and grow its social shopping platform, Shop Your Way, and its integrated retail capabilities. $3.8 billion of the $6.1 billion decline in 2015 revenues was due to the deconsolidation of Sears Canada, the spinoff of Lands’ End and the closing of certain Kmart and Sears stores.
The largest portion (about $2.0 billion) of the remaining decline was due to a 9.2% drop in comparable store sales. Sears has been losing market share in many product categories. In 2015, the company deliberately scaled down its offerings in low margin categories like electronics. However, a significant portion of the drop in same store sales was due to declines in other key categories, such as apparel, home appliances, lawn & garden and Sears Auto Centers.
Sears also reported that its online sales from sears.com and kmart.com, shipped directly to customers, accounted for 0.1% of the 9.2% decline in comparable store sales. That’s only a small drop, but it is still disappointing because the company has staked much of its future on growing its online and integrated retail business.
A quick look at key financial metrics from Sears and a few of its competitors illustrates the company’s disadvantageous market position. The average Sears store had $15 million of sales in 2015. By comparison, most of its peers reported average sales of more than $20 million per store and the most profitable chains had sales per store above $30 million.
There is typically a strong correlation between store sales volume and profit margins. Sears’s operating margin was ‑5.8% in 2015, while its peers’ operating margins were positive, ranging mostly in the mid- to high-single digits. All of the difference between Sears and its peers appears to be in gross margin. Sears’s gross margin was 23.1% in 2015, more than 12 full percentage points below its peers. It should be noted that Sears includes occupancy costs (i.e. rent) in cost of sales, while its peers generally do not.
Consequently, Sears is not getting sufficient merchandise sales throughput in its store base. (I also suspect that the company may have to address supply chain and distribution inefficiencies, which may be due in part to low sales volumes.) In the eleven or so years that Mr. Lampert has been at the helm, Sears has made insufficient progress in tackling this problem.
The company has been seeking to address its excess capacity problem in several ways: mostly by selling and closing stores at a steady pace, but also in 2015 through the formation of Seritage and the real estate joint ventures with mall owners. The company has reduced its Kmart and Sears domestic store count by 38% over the past four years, but non-GAAP losses have continued to climb. Since 2011, Sears has funded those losses by using its financial strength and asset base. The additional planned store closures and the implementation of Seritage’s plan to lease out to third parties a portion of the space in larger Sears stores should help to reduce losses in 2016 and beyond
The steady but slow rolling restructuring has taken a toll on shareholders. Those who bought the stock at the peak of $141.29 in April 2007 have seen the value of their investment decline by 80%. Investors who bought at the average price of around $40 in recent years are down 55%; but the spin-offs and rights offerings could have added as much as $50 per share, according to my estimates, if share sales were timed perfectly.
As the company’s largest shareholder with a 54.6% stake, ESL Investments and related entities, the investment vehicles controlled by CEO Edward S. Lampert, have suffered similar losses on their equity positions. Yet, as evidenced by the purchase of an additional 2.1 million shares in 2015, Mr. Lampert and ESL remain committed to the company. Besides that $1.1 billion equity stake, Mr. Lampert continues to hold $200 million of SHLD’s unsecured senior notes and recently agreed to lend the company an additional $250 million (as discussed below).
Fairholme Capital, another long-time shareholder, also increased its equity stake in SHLD in 2015 by 0.3% to 25.0%. Bruce Berkowitz, the founder and CIO of Fairholme was recently appointed to the Board of Directors of Sears Holdings.
Despite those commitments, each major financing move by Sears Holding raises the concern about whether the company is reaching the limit of its ability to squeeze cash out of its assets. The $2.7 billion Seritage rights offering in 2015 seemed to be pushing near the limits, but earlier this month Sears announced the closing of two loan agreements: a $500 million term loan from Mr. Lampert and Cascade Investments (which is controlled by Bill Gates) and a $750 million secured term loan entered into by Sears Roebuck Acceptance Corp. and Kmart, which will be used mostly to pay down debt on another asset-based loan. Sears also expects to raise another $300 million from asset sales in 2016.
Mr. Lampert may have other ways of raising cash if need be, but Sears Holdings’ ratio of debt (including the value of capitalized store leases)-to-market capitalization ratio is now near 80%, according to my estimates. Sears’s auditors did not qualify their opinion based upon the company’s ability to continue as a going concern; but the company’s remaining CCC-rated bonds trade at yield spreads in excess of 1000 basis points, which qualifies them as distressed.
Obviously, Sears cannot continue to lose money indefinitely. Its performance over the past few years has been a disaster, but management has taken decisive steps to close unprofitable stores, exit marginal product lines and shrink its store footprint. As Sears laps the one-year anniversary of those product moves, the rate of decline in its comparable store sales should begin to ease. The company has set a return to profitability as its primary goal this year.
In its fourth quarter earnings report, the company said that comparable store sales fell 4.5% during the month of January. That is a noticeable improvement from 2015’s full year decline of 9.2%, but it would be disappointing if the rate of decline in comp store sales did not fall further in the remaining months of the first quarter and for the balance of the year.
Last week, Sears announced that it would be closing 78 stores this summer: 68 Kmarts and 10 Sears stores. The move will reduce its annual sales run rate by an estimated $800 million, but it should help to improve profitability (excluding associated closing costs) in 2016 and beyond. Investors welcomed the news.
So far this year, SHLD has fallen 17.9%, worse than the S&P 500’s 0.6% price gain; but the stock rallied 36% from its April 7 low of $14.05 to a peak of $19.12 on April 22. It has since fallen back, probably on profit taking.
The company’s stock price is still cheap on at least one measure: price-to-sales. By my calculations, SHLD trades at a price-to-sales ratio of 0.09, well below its peer group average of 0.43. The discount, of course, reflects the company’s ongoing operating losses and expectations that sales will fall further as the company closes more stores. If Sears is able to move towards profitability, however, the peer group average price-to-sales ratio provides an estimate of SHLD’s upside potential.
At the average industry price-to-sale multiple of 0.43, SHLD would be valued at about $80. Of course, the stock would rally back to that level only if and when the market began to anticipate that Sears was on a clear path to sustainable profitability, at or near average industry profit margins. An $80 target price is probably a stretch at this time; but it is not inconceivable that the stock could rally back to $40 with better comparable store sales data and a substantial narrowing of its quarterly net loss.
Without a quick turnaround, Sears will eventually (probably within the next two years) be forced to file for bankruptcy and begin a more radical downsizing of its store base.
April 29, 2016
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036
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