Does This Retail Icon Have Value?

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

Shares of Sears Holdings (NASDAQ: SHLD) perked up over 10% this week, after it disclosed additional stock purchases by majority owner and company chairman Edward Lampert.  The hedge fund manager has controlled the company since 2005, when he engineered the high-profile merger between K-Mart and Sears.  Despite a common belief that the post-merger Sears would undergo a major transformation, management has only made gradual changes over the years, including recent spin offs of its outlet and hardware chains.  Investors who are hoping for a buyout of the company may be similarly disappointed, since the company's publicly traded shares provide valuable currency for future transactions.

What’s the value?

While Sears has substantial asset value in its brands, net operating losses, and heavily depreciated property, it also has an under-funded pension plan and relatively high debt levels.  The past five years have been a rough road, with Sears’ stock price down roughly 55% as the domestic housing market contraction has negatively impacted its large tool and appliance segments.  In addition, the company’s home services unit, the industry’s largest service network with 8,800 technicians, has been similarly affected by lower demand from the nation’s homeowners.

In its latest fiscal year, Sears reported revenue and adjusted EBITDA of $41.6 billion and $277 million, decreases of 2.6% and 80.0%, respectively, versus the prior year.  While online sales rose 16% during the period, comparable sales in the core domestic store segment declined 2.2%.  Sales growth in apparel and appliance categories were more than offset by declines in the electronics and pharmacy areas.  Despite an advertising strategy that extolls the company’s "softer side," apparel still accounts for less than 30% of total sales in Sears' stores.  On the upside, Sears’ apparel category has enjoyed multiple quarters of same store sales increases, as customers have gravitated to the company’s celeb-inspired clothing lines that include offerings from Jaclyn Smith and Sofia Vergara.

In FY2012, Sears’ has improved both its gross and operating margins, due to the spin-off of underperforming stores and better management of its inventory costs.  However, its consolidated store base still operates at approximately a breakeven level and the pension plan continues to require large contributions, with almost $500 million in payments in 2012.  Barring a recovery of the U.S. housing market back to pre-crisis levels, Sears needs to keep shrinking its store base to a level that allows it to generate an operating margin that is in line with its competitors.  Until then, investors need to keep this retail icon on their watchlist as a work in progress.

Focus on the competition

Instead of taking a speculative position in Sears, investors should focus on the retail competitors that have taken market share from the company over the years.  In the apparel business, one of the best-run broadline companies is Kohl’s (NYSE: KSS).  The Wisconsin-based retail powerhouse offers a wide assortment of branded and private label merchandise, including men’s and women’s apparel, footwear, and home accessories.

In FY2012, Kohl’s has reported flat growth in revenue, while operating income declined 11.1% to $1.2 billion.  Despite the lack of current growth opportunities, the company delivered a 41% increase in sales through its e-commerce channel and maintained operating margins above 9% during the period.  In addition, Kohl’s has focused its capital investments on remodeling stores and driving more customers to its celeb-inspired, proprietary brands, including its Jennifer Lopez and Marc Anthony clothing lines.  Operating cash flow also remains strong, with $703 million generated in 2012, which the company is returning to shareholders through dividends and stock repurchases.  At a 10 P/E multiple based on recent prices, Kohl’s is one cheap retailer.

Meanwhile, Home Depot (NYSE: HD) has passed Sears in the tools category by offering almost 40,000 products through its 2,200 warehouse-like stores.  Despite weakness during the financial crisis, the company’s results continue to improve, in line with the rebounding U.S. housing market.  In FY2012, Home Depot has reported increases in revenues and operating income of 3.9% and 12.9%, respectively, compared to the prior year period.  After having built a national network of stores over the past 30 years, the company is increasingly turning its attention to the services market, including the acquisition of remodeling services provider U.S. Home Systems earlier this year.  Similar to Kohl’s, Home Depot has also been returning excess cash flow to shareholders with dividends and large stock repurchases.  Despite a big run in its stock price over the past year, Home Depot is a good long-term bet.

The bottom line

Sears has tremendous operating leverage with a national base of stores, leading brands, and a strong home services unit.  However, the company’s long term debt and legacy pension costs continue to present potentially lethal challenges.  Until Sears finds a way to profitably deal with its uncompetitive cost structure, investors should steer clear of this icon.

rghanley owns shares of Sears Holdings. 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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