Drastic Changes Are Needed to Save This One

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It's almost shocking when you see icons of the retailing landscape beginning to lose their way. I remember the first time a big name retailer closed; I couldn't believe the store was really gone.

There are two big-name retailers that are icons in the business, but they are seemingly in a race to the bottom. One company is J. C. Penney (NYSE: JCP) and the other is Sears Holdings (NASDAQ: SHLD). Of these two companies, I'm worried about both, but honestly Sears has a chance to turn their business around. I'm not sure J. C. Penney has that same chance.

Retail Isn't What It Used To Be
Sears needs to make some serious changes to their business if they want to survive. The retailing landscape is different than it used to be. Competitors like Amazon.com (NASDAQ: AMZN) are undercutting traditional stores on pricing and offering the convenience of free shipping.

Sears used to only have to worry about Home Depot (NYSE: HD) and Lowe's for tool and home improvement sales. However, retailers like Target (NYSE: TGT) and Walmart have expanded their selection to compete directly.

Sears clothing sales used to go head to head with J. C. Penney and a few other mall retailers. Today customers buy clothes from Target and Walmart as frequently as they do from the mall.

The bottom line is, Sears is at war with multiple retailers in each of their lines of business, and the company is at a competitive disadvantage by nearly every metric under their current structure.

A Gross Comparison
If you compare Sears to nearly any of their competition, their financials can't match up. For instance, if you look at Sears' gross margin, there is clearly a problem with the company's pricing. In the current quarter, Sears' gross margin was 25.44%. The Sears department stores competes with J. C. Penney, which still has a gross margin of 32.52%.

Target's fashion and housing options go head to head with Sears, yet Target's gross margin is 31.67%. If you look at Home Depot for a tools and appliances comparison, Home Depot's gross margin is 34.56%.

In fact, the only competitor that has a similar margin is Amazon at 25.26%. When you consider that Amazon competes on price and in lower-margin categories, you have to wonder why Sears margins are so low on a relative basis. The most likely culprit in Sears' lower margins is Kmart. Kmart has being playing third string to Walmart and Target for years, and it's likely this unit is a big part of why Sears' overall margins are where they are.

The Company Doesn't Have The Assets To Compete
If you look at Sears on a simple total assets to total liabilities basis, Sears comes up short versus its competition. Sears assets-to-liabilities ratio is currently 1.22. By comparison, Target, J. C. Penney, and Amazon all have asset-to-liability ratios of about 1.49. Home Depot's asset-to-liabilities comes in even better at 1.74. The fact that Sears is currently running free cash flow negative argues that this ratio is going to get worse.

The Cash Is Disappearing
One of the best ways to gauge if a company can survive their troubles is by the strength of their balance sheet and free cash flow. Companies might survive if they have a weak balance sheet and good cash flow, but weak cash flow and a weak balance sheet is a big red flag.

If you compare Sears to any of their competitors except J. C. Penney, they come up short. The two struggling retailers both have negative free cash flow.

While Amazon also reports negative free cash flow, the company is investing for the future. Amazon's capital expenditures are one of the primary reasons the online retailer shows negative free cash flow.

By comparison, Target and Home Depot both generate significant free cash flow to the tune of $0.03 and $0.06 of free cash flow per dollar of sales respectively.

The Solution?
For Sears to survive, the company needs to radically change its structure. Sears Canada seems like a lost cause. The company said that sales were down in women's apparel, electronics, men's apparel, and home décor. The only types of merchandise that saw improved sales were appliances and mattresses. Unless Sears is willing to become an appliance and mattress store, this concept isn't going to work. If I'm a shareholder, I don't care how Sears Canada goes, just get rid of it. 

From the moment that Dustin Hoffman uttered the line “Kmart sucks” in Rain Man, this company has been sliding into oblivion. Kmart and Sears need to split, and Kmart needs to be allowed to compete in whatever way it can.

While Walmart and Target have improved their selections and moved into groceries, Kmart is still playing third string. If the company can't make it as part of Sears Holdings, then it needs to try something drastically different. If a bidder can't be found, then spin this off to shareholders.

The bottom line is, Sears Holdings can't compete the way things are today. Sears is still showing good sales in the area of clothing and appliances, and this needs to be the core focus at the company. Without a split of the Kmart division, I would suggest almost any other retailer is a better investment.

The only exception I might make to that statement is J. C. Penney and its myriad problems. It's crazy to think that two cornerstones of enclosed malls everywhere could disappear, but it's already occurring. If Sears doesn't want to close completely, the company needs to make some hard choices. If management doesn't make these choices now, I'm afraid Sears will be just the latest in a string of big retailers to disappear.

MHenage has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Home Depot. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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