Will Sears Holdings Survive 2018?

After years of scrambling, Sears, formerly one of the biggest retailers on the planet, filed for Chapter 11 bankruptcy protection this month. In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Adam Levine-Weinberg consider the fallout from this latest brick-and-mortar casualty.

Can Sears (SHLDQ) survive with its best 400 stores? How did the retailer go from the Amazon (AMZN 1.30%) of its day to decades of decline and debt? And who will benefit from the reduced competition. Click play and find out more.

A full transcript follows the video.

This video was recorded on Oct. 23, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It's Tuesday, October 23rd. We've got bankruptcies on our mind today, Fools, following the official announcement from Sears last week that the company would be entering chapter 11 reorganization proceedings. On tap for this show will be a look at what options Sears has going forward and how this latest retail casualty will affect some of the big peers in the industry. For this discussion, I'm enlisting the help of senior Motley Fool contributor Adam Levine-Weinberg, who's joining us via Skype from Sacramento, California. Hey, Adam! It's been too long, man! How's it going? 

Adam Levine-Weinberg: Good! How are you, Vince?

Shen: Thanks for hopping on today! I'm good. I'm excited for this discussion! I think we have some cool tidbits to discuss. This is a pretty big story in retail. It was also great catching up with you in person earlier this month. I'm glad you reached out to me to cover everything going on with Sears Holdings and the bankruptcy fallout. I think this is news that most investors have been expecting for a few years now. We've certainly seen a lot of coverage and headlines pointing toward the seemingly inevitable bankruptcy for this company. For each sale of assets, each debt restructuring, each round of store closures, or whatever reorganizations we saw, it was pretty much a delay of what we were building toward. 

This is still an over 125-year-old company with a really amazing history in the United States. Even though the current business is just barely a shadow of its former self, Sears was at one point the biggest retailer on the planet, not just in the country. I think that's important context to have in mind as we talk about what's likely to happen to the remaining shell of the Sears empire, which still includes several hundred Sears and Kmart locations. 

Why don't you start us off, Adam? We don't have nearly enough time to go over the full history of the company. For any listeners who haven't been following Sears or its stock closely, can you lay out the path that Sears has taken under its current leadership that resulted in this bankruptcy filing? I think most people would agree that this latest chapter in Sears' history began with the Kmart and Sears merger back in 2005. What's basically happened since then?

Levine-Weinberg: That's right. Sears and Kmart were both struggling prior to that merger, which happened in 2005. Kmart, in fact, had just gone through a bankruptcy of its own. During that bankruptcy, a hedge fund manager named Eddie Lampert took over control of the company, became its chairman, largest shareholder. He used that position to push for their merger with Sears and take over Sears as well. When you combined those two companies back in 2005, they had annual revenue of more than $50 billion. At the time, there were several other retailers that were slightly ahead of Sears Holdings, but Walmart was the only retailer in the world that was significantly larger in terms of total sales. Back then, Amazon was really just a bookstore that also sold some CDs and DVDs and not much else. Sears Holdings was a major force in the U.S. retail industry.

The idea behind the merger was that Lampert first hoped to cut costs for these two struggling retailers by combining them and finding efficiencies. Also, he felt that people were flocking toward these big box stores that were in more convenient locations rather than malls. That's a trend that we actually have continued to see over the past 15 years. Lampert thought that Kmart had these much better, more convenient locations, but it didn't have the products that were going to get people in the door. He thought putting the powerhouse brands from Sears, like Kenmore appliances, Craftsman tools, DieHard batteries, even Land's End for clothing, putting those into Kmart stores would help get more people into Kmart. He even thought about changing some of the Kmart stores' whole name to Sears. The idea was to take the Kmart real estate, the Sears brands and legacy, and create a stronger, more efficient retailer, and thereby hopefully boost profitability. He also actually realized that e-commerce was going to be a big deal before a lot of other people in the industry did. 

The problem wasn't that he was surprised by the growth of Amazon.com, but Lampert didn't have the right strategy for attacking it. He stopped spending a lot of money on store remodels because he didn't see stores as being really important to the future, and he didn't want to invest a lot of money in assets that he didn't think had a very long-term profitable future. On the other hand, he wasn't willing to spend a huge amount of money that you really needed to spend to build up an e-commerce business. 

So, Sears and Kmart got stuck in this limbo where they slowly lost their customer relevance. The stores didn't look very nice, so people started gravitating toward other retailers. Meanwhile, the e-commerce site wasn't compelling enough in terms of functionality, or especially in terms of pricing, to pull customers away from alternatives, particularly from Amazon. 

The result is that you've seen huge revenue losses and customer losses over the past decade. In fact, over the past 12 months, Sears and Kmart combined had revenue of just $14 billion. That's down more than 70% since the merger. The declines are set to continue. Even before the bankruptcy filing, Sears and Kmart were closing stores at a massive rate and seeing comp sales declines that worked together leading to very rapid erosion of the revenue base. 

Shen: I was getting up to speed on everything that has happened to Sears, just trying to get a picture of all the initiatives and everything that's been tried, in terms of these property spin-offs, with the REIT, all these different things that management has tried in this decade-plus long saga. There's one tidbit from a Wall Street Journal article that you shared with me, actually. I think it summed up some of the problems with this whole situation for me. One of the articles highlighted that, back in 2004, Lampert is running this successful hedge fund, has billions of dollars under his management, and a good chunk of that is his own riches. But even at its biggest, the fund, ESL Investments, had an estimated 35 employees. Bringing together Kmart and Sears, as you mentioned, he was now at the head of this giant company, this giant retail force. At the time, it had a workforce of 300,000 people, over 3,500 stores, $55 billion in annual revenue when they first merged. 

Alan Lacy was serving as the CEO for this combined entity back in 2005, but ultimately, Lampert in the chairman role was pulling a lot of the strings. You have here someone with no experience operating a retail business of any kind, let alone one of the largest chains in the country. It was an interesting, very stark contrast there, in terms of that experience and what it led to. What you mentioned, in terms of his ability to predict and see that e-commerce would be a big part of the retail environment in the future, but not pushing in the right ways to pursue that, for example, is telling of his experience and things along those lines.

In my mind, with the state of the stores, I thought that was one of leadership's bigger mistakes in the first years after the deal. They spent over $6 billion from 2005 to 2011 on share purchases. On the other hand, in those same years, Sears spent about $3.3 billion on capital expenditures, reinvesting in the company. This is a time when large parts of the business are in flux, and management is returning capital to shareholders at twice the rate that they're reinvesting in the business. It's hard to justify that kind of move. That was a real head-scratcher for me. 

Before we move on, I want your take, Adam -- what do you think were the biggest mistakes that Sears made after Lampert took over?

Levine-Weinberg: Possibly the biggest mistake was skimping on very basic store maintenance things. There's been stories reported recently about Lampert striking down proposals to spend a few million dollars improving store lighting. He didn't see the return on investment. In the short-term, there may not have been anything to measure. But in the long-term, when stores look bad, people don't like the experience and don't come back. And reacquiring customers is extremely, extremely difficult. That was just a case of penny wise, pound foolish. 

The second thing was not using the opportunity of being one of the biggest retailers in the country to invest in e-commerce. That $6 billion that was spent on share repurchases, if that had been devoted to funding some short-term losses to stand up a really big e-commerce operation, then what we could be seeing today would be a lot different. 

Shen: Sure. On the flip side of that, I'm curious, was there anything that you think management was right about, but it just wasn't enough to turn the tide for the company?

Levine-Weinberg: I would say that management was right in estimating that Sears had a huge number of valuable assets. That's part of why both Lampert and several of his biggest allies invested in the company. We've seen from all of the real estate that's been spun off, other real estate and brands that have been sold, that there really was a ton of value inside Sears. The problem was that Lampert has spent the past 10 years searching for a turnaround in the retail business that never happened. And over that period of time, Sears burned just billions and billions of dollars of cash, to the point where all of those assets were sold, basically, to fund current losses.

Shen: We're going to round out our discussion of Sears' part in the story. This is a chapter 11 bankruptcy. The company wants help dealing with their creditors. But, Lampert does hope to emerge from these proceedings with a leaner, meaner business. He's going to keep the chairman role, but he's going to step down as CEO. There's going to be a three-person committee replacing him in that CEO role. The company has identified about 400 stores that they think are the best ones in the fleet, essentially. I'm curious, what do you think comes next? How optimistic are you that Sears ultimately is able to survive this process?

Levine-Weinberg: Many companies are able to emerge from chapter 11. They use the bankruptcy process to negotiate down their debts and other liabilities, maybe get some extra capital in, and they are able to emerge, and they have a viable long-term business. The problem for Sears is that high debt was not the only problem for the company, although it did have too much debt on its books. The bigger issue was simply that it's been burning so much cash over a period of many years, nearly $2 billion a year. While some of that's related to interest on debt and pension contributions that it probably won't have to be making in the future, some of it's related to closing stores, and losses related to that, I still don't see a realistic path to get from $2 billion of annual cash burn to break even, let alone profitability. 

The fact that there are supposedly 400 profitable stores that Lampert wants to rescue doesn't necessarily mean that, as a collective, they can be profitable. What I mean by that is, each store may be making money inside of its four walls, but you have to have a distribution infrastructure to support all of those stores. If you want to keep sales even at current levels, let alone growing them, you need to invest in marketing on a nationwide basis. That's extremely expensive, and something that Sears in fact has been pulling back on for many years, driving its recent sales declines. 

So, I'm pretty skeptical. I would say, even going from 1,000 stores at the beginning of 2018 to around 700 stores now, 400 stores by the end of the year, I'm pretty skeptical that that's going to eliminate the losses except maybe in the very short-term. The only way to get costs down to the level necessary, as far as I can see, at least, would be to keep marketing spending at very close to zero. And if that happens, you're just going to see sales continue to erode and profitability continue to erode. Any improvements that would be seen in 2019 would probably be gone by 2020. 

Shen: Ultimately, you have here these two chains where same-store sales have declined 9.2%, 7.4%, and 13.5% in the past three years. A lot of the marquee brands that Sears once sold exclusively, attracted a lot of their customers, they've largely been pawned off. As you mentioned, Adam, the reputation for having these older stores, sometimes empty shelves with the way they were managing inventory at very thin levels, service that wasn't what it used to be -- once you've allowed your brand, your image, to deteriorate to these kinds of lows, I think you're going to have a really hard time making the case that any portfolio of even the best-performing locations will be able to survive for very long. That doesn't even include all the financial struggles that they're having, too. 

Adam, despite the poor state of Sears' business recently, you mentioned this earlier in the show, the company still generated over $14 billion of revenue in the trailing 12-month period. Of that, over $11 billion was in merchandise sales. That further breaks down into three categories: hardlines, apparel and soft home, and food and drug. Hardlines is the biggest at about 55% of merchandise sales in the past year. That includes everything from appliances to electronics, tools, sporting goods and toys. Apparel and soft home came in at about 32% of merchandise revenue. Food and drug made up the remaining 13%. 

In that context, what are the biggest opportunities for competitors to come and poach this business that's going to be left open by Sears? And who's best positioned to do that?

Levine-Weinberg: Starting backwards, if you look at the food and drug sales, it's gotten to the point where it's so low and it's such a big category. I don't expect the under $2 billion of sales that Sears did there last year to have any meaningful impact as it gets split up among dozens of other retailers. Even in the apparel and soft home part of the business, I don't see a needle-moving impact. Again, it was $4.3 billion in 2017. Even before the bankruptcy, just based on the rate of sales decline in the first half of 2018, it was on track to decline to around $3 billion. That's also going to get split up among quite a large number of companies. 

The one exception there, I would say, is JC Penney (JCPN.Q), which is arguably Sears' closest competitor in terms of mall-based department stores that cater to moderate-income consumers. I could definitely see JC Penney picking up a good chunk of the sales from Sears in that department. Since JC Penney is also a relatively small company compared to some of the behemoths that the two companies compete with, that could have enough of an impact on JC Penney's sales to be noticeable.

That said, the biggest opportunities for competitors will really be in the hardlines categories where Sears was strongest. Particularly, appliances, tools, and mattresses stand out. Given those categories, Lowe's (LOW 1.49%) definitely seems like it could be the biggest winner here, especially on a pure volume level. First of all, Lowe's is the biggest appliance seller in the country. So, it should naturally be able to get a very good share of the appliance sales that Sears had been getting. Even after all of its recent sales declines, Sears is still the No. 4 appliance retailer in the United States. Additionally, Lowe's began selling Craftsman tools earlier this year. Craftsman is a brand that, for many years, was exclusive to Sears Holdings and was only sold in a few places other than Sears and Kmart, Ace Hardware is one example. Now that it's available in Lowe's, one of the two big home improvement retailers, that should really boost sales of the Craftsman brand. As people have less and less ability to buy Craftsman tools at Sears, because Sears stores are closing, then you're going to see more of that business probably go to Lowe's in particular.

Home Depot (HD 0.86%) obviously is also likely to be a winner here. It's the No. 2 appliance retailer in the country. It's also the biggest tool seller. Even though Home Depot isn't selling Craftsman yet, they certainly might begin carrying a Craftsman line in the near future. Even without Craftsman, they have lots of other tool brands that can potentially take market share in that area from Sears.

Lowe's and Home Depot should also benefit in lawn and garden. That's another area where Sears has done a lot of business. There's a Craftsman line of lawn mowers, snow blowers, things like that, which Lowe's and Home Depot will hopefully be able to capitalize on.

Looking a little further down the list, Best Buy (BBY -0.11%) overtook Sears as the No. 3 appliance retailer in the U.S. a year or two ago, so Best Buy clearly has been profiting from Sears' troubles. I expect that to continue. Best Buy also has an opportunity in electronics. Electronics has not been a big business for Sears and Kmart recently, but they do have some sales there. Best Buy is really the category killer in that merchandise category right now.

Looking at JC Penney, JC Penney added an appliance business in 2016. They've had mixed success there. In the first two years or so, JC Penney did build up a meaningful business by JC Penney standards. About 2% of the company's revenue came from appliances by the end of last year. But that sales growth has stagnated in 2018. The company just got a new CEO. Jill Soltau, the new CEO, is going to have to decide how much to invest in trying to reinvigorate growth in appliances. If JC Penney is willing to offer some big discounts and promotions to try to draw in those lapsed Sears customers that could be another big area of growth for JC Penney. But, it's also very possible that JC Penney will pivot back toward its roots, focusing more on the apparel and home type of goods. 

Shen: Adam, I saw the article that you published last week, where you made the case that Sears' bankruptcy could be one of the better chances that JC Penney has to add a little bit of momentum to its recovery. You had a great data point I saw on how, of the 200-plus Sears locations that are closed or being closed, JC Penney had I think 150 locations of its own stores basically located in the same mall as a Sears closure or close by. 

For these fellow anchor stores -- another one that comes to mind is Macy's (M 1.44%) -- where they share a lot of real estate with Sears in the shopping malls, what do you think comes next for them as these stores close?

Levine-Weinberg: That's a great question. In the short-term, I think it's mixed. On the one hand, having a big, empty anchor space could potentially depress mall traffic a little bit. That said, Sears has been doing so poorly in recent years that I don't think it's really driving very much of the traffic to the mall. On the flip side, you're suddenly losing a competitor. That should allow JC Penney and Macy's to hopefully gain a little bit of market share in each mall and trade area where Sears is closing.

Longer-term, I think the effect is much more positive. You're seeing mall owners become very creative in terms of repurposing the space that has been used by department stores which are now closing, particularly of Sears. A lot of this year's real estate is actually quite good. It's just that Sears didn't have a good way of using it. If you replace a Sears store with a combination of, let's say, a movie theater, an entertainment center, some restaurants, maybe a gym, those are all concepts that aren't competing with department stores, in terms what they're selling. They're more service concepts. They're going to drive a lot more traffic to the mall than Sears has been. That could really help JC Penney and Macy's, in terms of getting more customers nearby. Once people are at the mall, maybe they'll go and shop at the other stores there.

Shen: OK. We've talked about Lowe's and Home Depot with appliances, Best Buy with appliances, the effect in malls with these fellow anchor stores, Macy's and JC Penney. Anybody else, do you think, with the fallout from Sears, all the store closures, might be able to grab a piece of the pie in the void left by Sears and Kmart?

Levine-Weinberg: My sleeper pick for the appliance business is Costco (COST 1.01%). If you look back just three years, Costco had annual appliance sales of $50 million. It was really not a major player there at all. That grew 10X by the 2018 fiscal year, which just ended, according to Costco's CFO. Costco is now up to $500 million of annual appliance sales. That is largely because appliance makers have realized that Costco has this huge base of quite wealthy customers, and it has this captive audience, and they're looking for ways to expand the distribution, with some of their major appliance retailers, particularly Sears, struggling. I don't expect Costco to go from $500 million to $5 billion in three years. But I would certainly expect them to at least double their sales over the next couple of years if Sears continues to shrink or even goes out of business entirely.

In terms of other categories, mattresses is one thing that we didn't really get to talk about. I think that Macy's could be really well-positioned to pick up some of Sears' mattress business. It's already one of the largest mattress retailers in the country. Mattress Firm, which is the top mattress seller in the U.S., had its parent company recently filed for bankruptcy. So, Mattress Firm is going to be closing up to 20% of its stores in the coming months and years. That could definitely lead to a market share opportunity for Macy's. 

Shen: We have another minute or two. I want to close out on this discussion. We've discussed the positives, the tailwinds, that this bankruptcy could have for some of the competitors. We also know that Lampert is closing all these stores, some previously planned and others part of the bankruptcy proceedings. As these Sears and Kmart close their doors, a lot of them are going to have liquidation sales, big promotions to clear out any remaining inventory. I'm curious, given the time of year, since we're about a month out from Black Friday, we're getting into the holiday shopping season -- do you think that this extra promotional activity from the Sears close-outs and Kmart close-outs might end up putting a damper at all on the holiday quarters for companies like Lowe's, Best Buy, Macy's, JC Penney, just because of the timing of all this stuff happening?

Levine-Weinberg: That's a great question. I don't think so. First of all, Sears has been having trouble recently getting inventory. That's reportedly one of the reasons why it filed for bankruptcy when it did. A lot of vendors had stopped shipments to the company. It doesn't have as much inventory to blow through as many companies would after filing for bankruptcy. Also, I should add that at the moment, it's only closing 142 stores by the end of the year. That's about a fifth of its total. The amount of clearance that it's actually doing is really pretty small compared to the total amount of sales you're going to see in the United States over the holiday season, so I would be pretty surprised if it has a measurable effect on any of its competitors. 

Shen: OK. I'm sure it's something that, if there is an effect, especially in more localized areas with certain competitors, that might be something that those management teams bring up in their own earnings calls talking about their results for the holidays.

That wraps up our show for today. Adam, thanks so much for joining us!

Levine-Weinberg: Thanks for having me on the show!

Shen: Fools, thank you for tuning in! People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!