A Former Number One Is Becoming a Has-Been

 | Nov 18, 2011 | 1:30 PM EST
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As chance would have it, I stumbled upon an article on Sears (SHLD) yesterday in Esquire magazine, just as the company's third-quarter loss report was fresh in the minds of investors. Esquire is an odd place to find words such as "sales" and "profitability" married to a jumbled investment thesis, but the story piqued my interest due to these comments in the final paragraph:

"Within a year, Sears will trade for half of what it trades for today."

"Within a year, Sears and Kmart will no longer exist as freestanding stores."

I know that the outlook on Sears stinks, but is it this bad? The author goes onto to admit that he shorts the stock periodically as if to assume as fact that the average Esquire reader understands what that process entails. So, the author has made two powerful comments and has supported them with buzzy numbers from financial statements found on Yahoo! Finance from the past couple of years. However, I don't think this author found his way to the SEC's EDGAR homepage prior to penning the impending demise of America's former number one department store.

While I agree that the fundamental trends at Sears are abysmal, owing to the all too well-known market share loss to Target (TGT), Wal-Mart (WMT), dollar stores, Macy's (M) and Amazon.com (AMZN), Sears is destined to die a slow death instead of having a sudden heart attack that would wipe out those shareholders who continue to buy into the Lampert mystique and intrinsic value of the company's land holdings.

Real Facts for Real Money Investors

  • From the beginning of the year, Sears has burned through $700 million in cash. Retailers typically generate most of their annual cash during the holiday quarter, but Sears has developed an unfortunate trend in this regard. In the fourth quarter of 2008, it brought in $992 million in operating cash flow and $1.5 billion in the fourth quarter of 2009 through improvements in working capital. Last year, that operating cash flow haul only amounted to $103 million since there was less room for productivity from short-term assets and yet another huge net loss. Obviously, management is aware of the worrisome cash flow outlook, and has decided to reign in share repurchases in 2011 and bump up short-term borrowings to $2 billion at the end of the third-quarter 2011 from $360 million in the year-ago quarter. Total liabilities at Sears amount to $17.8 billion. Total equity at Sears is $7.7 billion. It doesn't take my younger brother who's a tax accountant to recognize that Sears has a seriously compromised balance sheet that is normally indicative of a retailer with one foot in the grave.
  • Luckily for Sears, it was able to increase its borrowing capacity pretty significantly in the first quarter of 2011 under its credit agreement, with sufficient access remaining. (For now, this should prevent a supplier run.)
  • Wall Street does not anticipate a return to profitability in the next two years out.
  • Watch the company's accounts payable, which declined in the third quarter. Usually when a retailer is in a weakened financial state, its vendor base demands tighter trade terms. If payables continue to trend lower, essentially sending cash out the back door with no new cash entering the front door, this would be a big-time red flag.

The increased borrowing capacity, backing of Lampert and ability to shave off land at some form of price that brings in money suggests that Sears will be around at least until the 2013 holiday season. One caveat, however, is that if the economy reenters recession, it's likely to speed up the share loss and margin degradation at Sears as consumers flock to one-stop shopping destinations that offer everyday low prices (or, "EDLP" if you want to sound smart at the dinner table on Thanksgiving). The stock now trades below book value, but given the charges being incurred to close stores, I question the value of the portfolio's land holdings, meaning that book value is to be approached with skepticism. Avoid this self-inflicted slow death story.

Friday Fun Fact: Comparable retailers to Sears, namely Target and Wal-Mart, continue to aggressively repurchase their shares and increase their dividend payout ratios. Sears, on the other hand, has restrictions on share repurchases and dividends under its new credit agreement, which enhances the relative value of holding Target and Wal-Mart. (Sears has a poor earnings outlook plus a poor prospect of enacting shareholder-friendly maneuvers; however, its rivals have implemented both of these measures.)

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