Was It a Huge Mistake for Sears to Get Rid of Lands' End?

Source: Lands' End

A lot can change in 12 years. If you don't believe me, just look at Sears Holdings (SHLDQ). In 2002, the company purchased Lands' End (LE 1.30%) in a transaction valued at $2 billion. This purchase was followed by the company's 2005 merger with Kmart, which created one of the largest retailers in the world. With revenue of $53 billion in its first year after Sears and Kmart combined, the company seemed to be heading nowhere but up.

How quickly things turn ugly!
However, the picture quickly turned ugly, with revenue sliding every year since. Today, the company's sales sit at about $36.2 billion, 32% below their all-time high. In an effort to salvage the once high-flying retailer, management has begun spinning off non-core businesses and attempting to stave off the outflow of customers.

Its latest deal, completed on April 4, involved divesting Lands' End. In its first two days of stand-alone trading, shares have fallen 10% from their opening price of $30.46 to $27.34. Sears shares have behaved likewise, likely leaving investors scratching their heads and wondering what value, if any, could be left in either of these retailers.

Source: Sears Holdings

Can Sears be salvaged?
No matter how you dice it, the picture at Sears is anything but pretty. Over the past three years, the company's revenue fell 13% from $41.6 billion to $36.2 billion. According to management, the drop in revenue came from a variety of factors. From 2011 through 2012, revenue fell by about $930 million because of fewer Sears and Kmart stores in operation. Another $740 million hit came about because of a 2.5% decline in comparable-store sales.

In 2013, the situation worsened. Compared to the prior year, revenue fell $1.1 billion from additional store closings, while a 3.8% drop in comparable-store sales negatively affected the business by $1 billion. In addition to these factors, management divested Sears Hometown and Outlet Stores (SHOS). This transaction hit the company's top line by an additional $490 million.

Source: Sears Holdings

While revenue fell over this time frame, profits improved drastically; the company's net loss was narrowed from $3.1 billion to $1.4 billion. However, a reasonable portion of these losses came about because of non-cash impairment charges. Excluding these paper losses, Sears' bottom line was narrowed slightly less, from $2.7 billion to $1.2 billion. In addition to being hit by falling sales, the company booked annual (though shrinking) impairment charges.

Is Lands' End a good prospect?
Instead of investing in Sears, investors have the option to grab hold of an investment in Lands' End. Looking deeper into the company, however, investors might be more inclined to take a pass. In 2002, when Sears acquired the business, it reported revenue of $1.57 billion. At the end of its 2013 fiscal year, the company's top line came in at $1.56 billion, practically unchanged from 12 years earlier. On the other hand, net income has improved over this period, increasing 18% from $66.9 million to $78.8 million.

Source: Lands' End

This level of sales and income, however, is in an apparent downtrend. Since 2011, Lands' End's revenue fell 10% from a three-year high of $1.73 billion to $1.56 billion today; net income ticked up 3% from $76.2 million. Most of the company's sales decline during this period occurred between 2011 and 2012 and was attributed to a drop in orders both domestically and in international markets.

What does losing Lands' End mean for Sears?
Based on the data provided, losing Lands' End will have a significant impact on Sears. While it's possible that the divestiture will allow Lands' End to thrive without interference from Sears, its former parent will be hit even harder on both the top and bottom lines.

Keeping all else equal compared to its 2013 fiscal year, Sears will see its revenue drop by the $1.57 billion Lands' End generated for the business (on a pro-rata basis). This would imply revenue of $34.6 billion for Sears. In the event that Lands' End was losing the company money, it would probably make sense to go this route, but that's not the case. Instead, Sears is ridding itself of a profitable enterprise at a time when the company, in aggregate, is recording significant losses.

However, there is also another way to look at the picture. As part of the transaction, Lands' End is taking out a loan in the amount of $515 million. Once the deal was made official, the company remitted $500 million to Sears in the form of a dividend. So, one way to evaluate the situation is to assume that the $500 million is essentially the price at which Sears is "selling" Lands' End to its shareholders, which equates (pre-tax) to a little more than six times Lands' End's earnings.

Foolish takeaway
As we can see, Sears is continuing its long struggle. In an attempt to salvage profitable enterprises and break up the company in a way deemed most beneficial for shareholders, the company elected to spin off Lands' End. Whether or not the company can stand on its own two feet once again is something only time will tell, but what we do know is how the transaction will both reward and hinder its parent.

At first, the deal will grant Sears some much-needed cash that it hopes to use to make its core operations more attractive. But this comes at the cost of lower revenue and potentially larger losses down the road. However, if management can use its cash to eventually create a net benefit for the retailer, the company's decision might reward investors handsomely.