Last week, a bankruptcy court judge approved ESL Investments' agreement to buy what's left of Sears Holdings (OTC:SHLDQ) out of bankruptcy. The sale will preserve about 45,000 jobs -- at least for the time being. It will also defuse potential crises at key landlords like Sears spinoff Seritage Growth Properties (NYSE:SRG).
Following an ongoing round of store closures, the new company will operate about 425 Sears and Kmart stores. Sears will also have a much better balance sheet, having shed most of its debt through the bankruptcy process. Nevertheless, the new Sears isn't positioned to thrive, and it is unlikely to survive the next U.S. recession.
Recent results haven't been promising
Sears Holdings' results over the past year certainly don't make it seem like a comeback is likely. Through the first nine months of fiscal 2018, revenue plummeted 27% to $8.8 billion and gross margin came in just shy of 20%. This meant that Sears had just $1.7 billion left to pay all of its operating expenses. In fact, selling and administrative expenses totaled $2.6 billion, so the company reported a big loss.
These losses continued over the holidays. In the November fiscal period, Sears Holdings brought in $924 million of revenue at a 17.1% gross margin. Despite deep cost cuts, it posted an operating loss of $50 million.
In December, it generated $1.1 billion of revenue, but gross margin fell to just 14.4%. While Sears Holdings reported an operating profit of $47 million for the month, that included $129 million in asset sale gains. Otherwise, its operating loss would have been $82 million.
To be fair, Sears Holdings has liquidated a huge number of stores over the past year, which has weighed on its gross margin. Once its final round of bankruptcy-related store closures ends next month, gross margin should improve somewhat. That said, gross margin was roughly 21% in both fiscal 2016 and fiscal 2017 and 23.1% in fiscal 2015, so there's only so much improvement Sears can reasonably expect.
Sears lacks scale -- and that problem will get worse
The rationale for saving Sears appears to be that the company has hundreds of profitable stores that have been dragged down by hundreds of unprofitable stores prior to the bankruptcy filing. Yet shrinking the store base to the most profitable locations is not a foolproof plan.
The problem is that Sears Holdings already doesn't have enough scale to be competitive. That problem will get worse, not better, going forward. Sears will have about 425 stores by the end of March and expects to close dozens more in the next few years, either due to underperformance or because it wants to sell the underlying real estate.
The company's business plan relies on deep cuts to overhead spending. That means it will have virtually no marketing budget, which will cause it to continue bleeding market share. (It's also not clear if Sears' projected level of cost cuts is realistic.)
Sears has noted that it may open more small-format stores focused on stronger categories like appliances and mattresses, which could offset further full-line store closures. However, doubling down on these big-ticket items seems like a dubious plan. The current period of economic expansion in the U.S. is already one of the longest on record, so there's a good chance of a recession in the next few years. That would depress demand for expensive items like appliances and mattresses, causing further pain and deeper losses for Sears.
In any case, the stock is practically worthless
Even with deep cost cuts, a modest debt load, and a radically slimmed-down store fleet, Sears Holdings will likely struggle to make money. While the company thinks it has a workable plan, it has a terrible track record for forecasting, having routinely missed its internal projections in recent years. It is planning to sell at least $650 million of real estate over the next three years -- and even that may not be enough to keep the lights on.
Nevertheless, Sears Holdings stock has surged in the past few days, lifting the company's market cap above $100 million. But even if the "new" Sears manages to become profitable, shares of the current Sears Holdings are virtually worthless. ESL Investments is buying nearly all of the company's assets for a little over $5 billion, whereas Sears Holdings' liabilities are more than twice that amount (excluding intercompany claims).
The sale proceeds and any other cash that becomes available will be divided up among creditors. The only money that shareholders can reasonably hope for is a small settlement from ESL to resolve claims that it improperly siphoned off assets from Sears Holdings, primarily through the spinoffs of subsidiaries like Seritage Growth Properties.
Even then, creditors are likely to take the vast majority of any settlement. After all, shareholders had the opportunity to participate in the spinoffs of Seritage, Lands' End, Sears Hometown and Outlet Stores, and Sears Canada. If there was wrongdoing, it was creditors that were harmed, since they could no longer try to recover the assets of those former subsidiaries.
In short, hundreds of Sears and Kmart stores are set to survive bankruptcy, but they may not last long. And even if they do, investors should still steer clear of Sears Holdings stock.
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