Is it Time to Bet on a Makeover at Sears Holdings?

Sears has been making itself over into a member-focused retailer with a host of product launches that include in-vehicle pickup. Is it time to bet on this iconic retailer?

Apr 2, 2014 at 3:35PM

Sears Holdings' (NASDAQ:SHLD) management has been pulling a variety of different levers lately in the hopes of finding a winning formula to get the venerable retailer back on the right track. The company has been spinning off units and selling real estate while investing heavily in its Shop Your Way online shopping platform. In its latest gambit, Sears launched in-vehicle pickup at its stores in early February, a service it obviously designed with its online customers in mind. So, is it time to bet on Sears?

What's the value?
Despite the optimism surrounding the 2005 merger of Sears and Kmart, the combined company has generally disappointed investors, which is evidenced by very minimal stock price appreciation over the past five years. Consistent declines in overall sales and less productive stores have culminated in an unending string of operating losses for Sears, which is not a good situation for a company with hefty legacy obligations. While Sears has found some recent sales upside in its online channel, the increase hasn't been enough to offset weakness at its aging physical store base.

In fiscal 2013, Sears held true to the form of the past few years as it reported a 9.2% top-line decline that resulted from a comparable-store sales decline and a further shrinking of its physical store base.  More importantly, the company's merchandise margin hit a new five-year low at 24.2% due to the double-whammy of a highly promotional selling environment and the margin-busting effects of its expanding loyalty rewards program. As a net result Sears posted a larger operating loss and weak cash flow, so it had to use financial engineering in order to fund its necessary capital expenditures.

Could Lampert actually be making the right moves?
While controlling shareholder and CEO Edward Lampert has been criticized for the lack of investment in Sears' physical stores, there are two good reasons why the strategy is probably the right move. First, Sears doesn't have the cash flow to fund a major capital improvement plan because it needs lots of funds to make inventory purchases and meet its annual obligations to pensioners. Second, major store upgrades don't always produce the desired outcomes, as indicated by J.C. Penney's (NYSE:JCP) recent travails.

As is fairly well-known, J. C. Penney installed a new management team and overhauled its stores in 2011 and 2012, which included the addition of branded shop-within-a-shop boutiques, in a bid to catch upscale department store kingpin Macy's. Unfortunately, the strategy failed miserably, and it led to sharp declines in comparable-store sales and the eventual exit of the architects of the strategy. While J.C. Penney's recent results have been better as the company has returned to its traditional private-label product focus and its highly promotional marketing schemes, the debt pile that J.C. Penney has amassed in its bid to get back on track has severely hobbled the company.

A better way to go
Of course, Sears' current makeover into a smaller, omni-channel retailer that primarily sells goods and services to its Shop Your Way loyalty members has no guarantee of long-term success. As such, most investors should avoid the unfavorable risk/reward proposition at Sears in favor of better positioned broad-line retailers, like Dillard's (NYSE:DDS).

While Dillard's has had to wade through the same challenging retail environment as Sears does, it has been more successful in its store operations. This is evidenced by slight gains in both comparable-store sales and revenue growth in Dillard's latest fiscal year after an adjustment for the extra week in 2012. The company's merchandise margin similarly suffered because of a promotional selling environment during the period.

However, Dillard's maintained a stable margin by refocusing its product assortment on in-demand product categories with pricing power, like women's accessories and shoes. More importantly, Dillard's has kept its footprint confined only to areas where it can operate effectively as it has stores in only 29 states, which keeps a lid on its overhead costs and keeps its operating cash flow running at a level far above its necessary capital expenditures.

The bottom line
Sears' makeover is likely the right strategy for the company, but most investors need to avoid this icon until it finds its way back into the black. A better bet would be Dillard's, a retailer with strong insider ownership and a healthy financial profile, which stands ready to pick up stores from its shrinking national competitors.

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Robert Hanley owns shares of Sears Holdings and Dillard's. The Motley Fool owns shares of Dillard's. 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.

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