The Daily Dose: One Sad Display

 | Jan 10, 2014 | 12:30 PM EST
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Sears (SHLD) and Kmart, a subsidiary thereof, are two iconic American retail institutions. What person over 30 doesn't have fond memories of visiting these retailers as a child for back-to-school supplies or summer lawn games? Nowadays, Sears and Kmart are iconic only by name and Wikipedia searches, and that's basically a byproduct of years of executive turnover and underinvestment in a living beast -- a national retailer with more than $1 billion a year in sales.

Based on some of the Twitter responses I've read of late, the mood on the street is one of deep disappointment in the company. Here's just one example:

But, beyond that, let's drill down to the numbers.

Stateside, as of the end of the fiscal third quarter in October, Sears' capital expenditures came in at 1.28% of the region's sales. While that's up nicely from 0.7% a year earlier, competitors have continued investing more aggressively in order to widen the competitive gap in price and store appearance.

At Macy's, (M) for instance, capex for that period totaled 2.1%, and at Wal-Mart (WMT) it was 2.8%. The number was 5.6% for Target (TGT).

Meanwhile, at Sears Canada, the capex for that period plunged 50.9%. At Kmart, the figure was down 53%.

In the battle for consumer dollars, these years of capex-slashing have figured prominently: Sears and Kmart are badly losing against Wal-Mart and Target, and to a lesser extent fellow mall anchor Macy's.

Quarterly Sales Figures -- Sears, Kmart, Wal-Mart, Target, Macy's
Source: Belus Capital Advisors

Yes, the retail business is pretty brutal, and it's hard to keep individual stores in prime condition. Clothes will sometimes be found on the floor, or a rug may be in tatters near the stockroom. The number of consumers easily overwhelms the minimum-wage-paid workers, and that's worsened in recent years with the advent of technology that allows customers to do their own price comparisons. But when Sears and Kmart string together negative same-store sales for two years solid, when red ink bleeds from their individual profit lines and when stores are being shuttered in rural America, well -- the reality is that things are wrong at the ground level.

First off, the 2004 merger between these two was not implemented correctly when it came to culture, to systems and to processes integration. This failure lives on to this day, mostly inside Kmart stores, I believe.

Second, when you are a humungous retailer like Sears, and have drastically cut your capex commitment, that amounts to stores being starved for dollars. This engenders frustration among managers, which spreads to the teams working for them, causing those folks to tune out -- which, in turn, affects the appearance of the stores and results in a waning flow of goods from the backroom to the shelves.

A winning retailer -- for instance, Starbucks (SBUX) -- succeeds financially in part because its workforce receives the support it needs. The happy Starbucks worker then works way above their pay grade in order to offer exceptional customer service and environment for the brand. Customers repeatedly return to Starbucks, the financials stay strong and the stock price goes up, up and up.

One ripple effect of these capex declines comes in the form of aging computer systems, which stand in stark contrast with the newer machines at Wal-Mart and Target. An investor should care about this because, one, the checkout experience is the final impression a customer has of a retailer. Second, the systems may be unable to handle the initiatives Sears has undertaken to upgrade its online stores, and how people are consuming merchandise via handheld devices. That is an equation for a profit-killer known as "inventory shrinkage."

In Closing

Sears shares have declined some 76% from the April 2007 all-time high. The stock has shed 29.4% since we initiated coverage with a Sell rating in late October. Once-prized assets are being sold to raise liquidity. Yields on Sears' debt have been creeping higher. Sales are in an entrenched downtrend.

All of this is transpiring, moreover, in spite of the company's ongoing "transformation" into a "member-centric model," as management has put it. That transition is apparently underpinned by a good deal of stores that are inviting to shop in -- so inviting that customers would dare not think of driving to competing chains, as Sears' Vice President of Corporate Communications seems to believe:

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