Against the odds, Sears Holdings (OTC:SHLDQ) appears poised to survive its October bankruptcy filing. While Eddie Lampert, the company's chairman, has been trying for months to devise a rescue plan for Sears, the company deemed his proposals insufficient as recently as a few days ago. Yet Lampert sweetened his bid for Sears' assets at the eleventh hour to win the bankruptcy auction earlier this week.

The result still has to be approved by the bankruptcy court, but assuming that happens, more than 400 Sears and Kmart stores will stay in business. That said, the bankruptcy sale may only be a partial fix to Sears Holdings' long-running woes. Barring a miracle, the company is likely to land back in bankruptcy sooner or later.

Lampert wins again

In early December, Lampert's ESL Investments hedge fund revealed a preliminary offer for most of Sears Holdings' assets, which it valued at $4.6 billion. Later in the month, it presented a firm offer worth $4.4 billion.

Creditors weren't impressed. Many believed that they could recover more money through a combination of selling Sears' assets piecemeal and suing ESL over the numerous transactions it has conducted with Sears Holdings in recent years. As a result, Lampert had to raise his bid last week to a little more than $5 billion -- mainly by taking on additional assets and liabilities from the company -- just to get a seat at the table at the bankruptcy auction.

The exterior of a Sears full-line store.

Eddie Lampert's ESL Investments won the Sears bankruptcy auction. Image source: Sears Holdings.

Even that revised bid fell short of covering Sears' highest-priority bankruptcy claims. But in the early morning hours on Wednesday -- when liquidation seemed inevitable -- Lampert finally agreed to increase his offer again. This brought the total value to $5.2 billion or $5.3 billion (sources vary on the exact amount), allowing ESL to prevail in the bankruptcy auction.

Sears is losing scale

Just a year ago, Sears Holdings had a little more than 1,000 stores. The remnant that Lampert's ESL hedge fund is buying will be less than half that size. That doesn't seem like enough to make the company viable in the long run.

Other struggling department store chains like J.C. Penney (NYSE:JCP) have also closed stores in recent years, but Sears has gone way further than its rivals in downsizing. J.C. Penney still has more than 860 stores and annual revenue of about $12 billion. Based on its size, it could make another round of deep cuts in the next year or two while still maintaining plenty of scale -- and yet it is still unprofitable.

Sears Holdings will likely end fiscal 2018 with only slightly less revenue than J.C. Penney. But it had more than 800 stores for most of the year -- roughly double the number it expects to operate going forward. After the bankruptcy-related store closures are completed, revenue will be much lower.

Can a tiny Sears Holdings survive?

Sears Holdings' merchandise sales barely exceeded $2 billion in the third quarter, even though the company ended the period with 766 stores. Just based on the company's planned store closures, full-year merchandise sales will likely fall to around $5 billion in fiscal 2019. Gross margin has consistently been below 20% for merchandise sales in recent years, indicating that Sears' core business might not even produce $1 billion in annual gross profit going forward.

Meanwhile, of the $673 million in services and other revenue that Sears Holdings booked in the third quarter, $157 million came from reselling merchandise at cost to former subsidiary Sears Hometown and Outlet Stores. Another $14 million consisted of amortizing a one-time renewal payment related to its credit card deal with Citi. A substantial chunk of the remainder came from service contracts -- sales of which are plummeting as Sears closes stores.

As a result -- excluding zero-margin sales to Sears Hometown -- annual non-merchandise revenue will likely decline to $1.5 billion or less post-bankruptcy. While this part of Sears Holdings' business is particularly lucrative, it too will generate less than $1 billion of gross profit annually in its shrunken state.

In short, Sears Holdings will have less than $2 billion of annual gross profit to pay for all of its rent, labor, overhead, and interest expense. (That compares to $4.3 billion for J.C. Penney over the past four quarters.) This will leave virtually nothing available to invest in marketing, store upgrades, or improvements to the company's digital sales platform. Sears and Kmart may stagger on for a while, but without the means to make necessary investments, they are still doomed to fail within a few years.

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