Last week, storied retailer Sears (SHLD +0.00%) whiffed on earnings for the second straight quarter . The company posted an adjusted loss of $1.46 per share, while adjusted EBITDA swung from a gain of $116 million in the second quarter of 2012 to a $55 million loss.
Sears has experienced declining domestic comparable-store sales for more than a decade, as the Sears and Kmart chains have failed to keep pace with the rest of the retail industry. Given this consistently poor performance, it's impressive that the company is still in business. Sears has survived primarily because of a long string of asset sales that have brought in a steady stream of cash.
Still, this trend is clearly unsustainable. Eventually, Sears will run out of assets to sell, and will need to generate cash flow from its operations in order to stay solvent. The odds are stacked against Sears, yet there are some reasons for hope. Unlike fellow department store operator J.C. Penney -- which seems to be entering a death spiral -- some important aspects of Sears' business have stabilized. Moreover, the company's strong liquidity position gives management plenty of time to continue transforming the business.
The bad news
Domestic comparable-store sales declined by 1.5%, with Kmart performing worse than Sears' namesake department stores. Sears' performance was weighed down by poor sales in the appliance department, typically one of the company's strengths. Meanwhile, Kmart's sales were weak across a number of "transactional" categories such as grocery and pharmacy.
Some of Sears' troubles can be explained by macroeconomic factors. Many major retailers have reported worse-than-expected results recently. That said, unlike Sears, Home Depot saw a strong increase in appliance sales last quarter. If Home Depot is taking lots of appliance and home improvement business away from Sears, it bodes ill for Sears' long-term health.
The bright spots
Not everything about Sears' performance was disastrous, though. In fact, Sears showed marked improvement in a few key areas. First, Sears achieved a same-store sales increase in apparel -- typically a high-margin category -- for the eighth consecutive quarter. Second, online revenue grew by 20%. Both of these figures suggest that Sears is benefiting from J.C. Penney's ongoing struggles.
Lastly, Sears saw a significant increase in the number of shoppers using its "Shop Your Way" rewards program, indicating higher customer engagement (although that also created margin headwinds). Sears executives believe that "Shop Your Way" members will become more loyal to Sears and Kmart, eventually leading to higher sales.
A plausible plan
While Sears has been losing money for many years now, the company has a plausible plan for returning to profitability and generating positive cash flow. The company has been working to reduced its fixed cost base for several years, and is also trimming inventory in order to improve cash flow.
However, the biggest change to Sears' philosophy is a focus on personalization. Online retailers like Amazon.com have thrived by personalizing their websites to each customer. Visitors to Amazon's website will see purchase suggestions based on their browsing history and past purchases. By contrast, mass retailers have continued to send the same weekly or monthly promotional flier to all customers.
Sears wants to use the Shop Your Way rewards program to tailor offers to each customer. Management believes that rewarding the most loyal customers and offering individualized deals will ultimately allow the company to cut back on big companywide promotions, which hurt margins. This strategy could ultimately stabilize sales while boosting margins, which would dramatically improve profitability.
Foolish bottom line
Whereas J.C. Penney hopes to recover from Ron Johnson's failed strategy by returning to its previous strategy -- which wasn't working either -- and hoping for the best, Sears is actually trying some new ideas. Management's commitment to reducing fixed costs and the company's emphasis on a rewards program as a substitute for margin-sapping discounts give Sears a fighting chance.
This does not necessarily make Sears a good investment opportunity. Investors should not bet much money on the company unless it can finally return to sales growth while also increasing its profit margin. However, unlike J.C. Penney, Sears has adequate liquidity, a growing e-commerce business, and a credible plan for improving results. Now, the company just has to execute.
