This Retailer Can Save Itself, But Does It Want To?

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I honestly didn’t know if I would see the day when Sears Holdings (NASDAQ: SHLD) could actually save itself. I've been critical of both the company’s management and their poorly executed merger with Kmart. For a while, it looked like it would only be a matter of time before this company disappeared. However, the company’s current earnings report suggested several ways that Sears Holdings could actually recover.

Some Battles You Just Can’t Win
The first thing that Sears must understand is it has two separate businesses that don’t seem to show any synergies at all. Kmart competes directly with both Target (NYSE: TGT) and Wal-Mart (NYSE: WMT). The biggest problem that Kmart faces today is the fact that customers in large part have forgotten the chain in favor of its two larger competitors.

In the current quarter, Kmart said that it saw the largest declines in grocery, household items, pharmacy, and drugstore. Sears clarified this further by saying that apparel sales at Kmart were less weak, but honestly this is just not a battle that Kmart can win. With same-store sales down 4.5%, clearly Kmart has the wrong strategy. This is particularly true when you realize that Target’s same-store sales declined by 0.60%, and Wal-Mart’s same-store sales declined by 1.4%.

Kmart’s struggles are even more apparent when you compare their gross margin to their peers. In the most recent quarter, Kmart’s gross margin was 24.9%, which was just slightly ahead of Wal-Mart at 24.66%. The difference is, Wal-Mart has been continually stealing grocery market share, which has caused a decline in their gross margin. By comparison, Target has a gross margin north of 30%, and the company’s more upscale store design and higher-end selections allows the company to maintain its higher margin.

The short version is, Kmart needs to be spun off into a separate company that can potentially re-brand itself and hopefully survive. Sears Holdings is doing investors no favors by dragging this process out.

Say Goodbye
If Sears makes the bold decision to spin off Kmart, then the company can focus on redesigning its traditional Sears locations. Unfortunately for Sears, it is clearly losing battles in certain departments, and honestly the company needs to get out of these businesses and let their competition fight it out.

For instance, Sears’ domestic division reported same-store sales down 2.4%. However, the company said that excluding their lawn and garden sales, that same-store sales would have increased 0.3%. Considering that in the lawn and garden area, both Home Depot (NYSE: HD) and Lowe’s have become destination stores for these types of purchases, this decline at Sears is no surprise.

While Lowe’s reported same-store sales down 0.7%, Home Depot reported same-store sales increased by 4.3%. It seems apparent that customers are choosing to walk away from both Sears and Lowe’s, and purchase their lawn and garden supplies at Home Depot instead. With this one department causing Sears domestic business to report negative same-store sales, eliminating or downsizing this area of the store seems to make perfect sense.

What’s Left?
The simple fact is that Sears' strengths are the only place the company can spend its money. With popular brands like Land’s End, Sears can compete directly with both Target and Wal-Mart in clothing. While Target and Wal-Mart might offer cheaper selections, the higher-quality of Sears clothing should command better prices and rightfully so.

Another area that Sears can effectively compete in is their appliance division. Many customers know that Sears carries all of the popular appliances, and some customers are loyal to the company over the home improvement warehouses like Home Depot or Lowes. In fact, you could make the argument that if Sears focuses on its tools and appliances as well as continuing to improve their clothing selection, the company’s gross margin at Sears’ domestic of 29.4% could rise. This is particularly true in light of the fact that both Home Depot and Lowe’s have gross margins of over 34%.

It would be simple to recommend Target or Wal-Mart in the general retail space, as both companies pay a yield of more than 2%, and are expected to grow earnings by 11.6% and 9.3% respectively. Investors looking for a play on the housing market could understandably choose Home Depot and their 2% yield and roughly 14.4% expected growth rate.

However, for investors willing to bet on a turnaround stock, Sears Holdings has the potential to be a good investment. None of the choices that management must make are simple, but the company has the potential to save itself. The question investors have to ask is will management make these hard choices in time to turn the company around?

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Chad Henage owns shares of Target. The Motley Fool recommends Home Depot. 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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