Reflecting on Sears Holdings' (Nasdaq: SHLD) 2007 financials, I'm reminded of a scene in the film Apollo 13. With the status board lit up like a Christmas tree, the head of Houston ground control asks "What have we got on the spaceship that's good?" He knows he's in for a wild ride when his team of rocket scientists (literally) can say only, "We'll have to get back to you on that."

Back in 2005, the combination of Sears and Kmart showed promise. The potential cost savings through overhead reduction, buying synergies, and real estate consolidation all pointed to a revitalization of the two iconic brands. These days, however, it looks more like "Lampert's Lament", referring to Chairman Edward S. Lampert, who engineered the deal.

Yet, we should at least give Lampert credit for a somewhat candid view of the company's difficulties following this past year's dreadful sales performance, which led to a 41% plunge in earnings per share. Here's what the chairman has to say about what's working, what's not, and how he intends to get the company back on track in 2008.

The broken bits
In management's view, last year was a step backward for two reasons:

  • The downturn in housing affected the company more than its competitors thanks to its heavy reliance on big-ticket, home-related items like appliances.
  • Heavier inventory levels to support sales growth backfired when sales growth didn't materialize.

I agree soft sales and aggressive buying are a deadly duo, but these wounds are clearly self-inflicted. Last summer, fellow Fool Rich Duprey noted that the company hadn't delivered positive comparable-store sales in eight quarters. And while hindsight is 20/20, you didn't have to be a super economist to see signs of the housing bubble starting to burst a year ago.

The not-so-broken bits
Sears Canada grew annual sales 8%, on 2% more stores, and improved its adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) margin to 8.8% of sales for the year -- nearly twice the domestic operating margin rate -- on better merchandising and promotion management. Lands' End continued to grow through its direct-to-customer business, posting a 12% increase in earnings during a year when most apparel retailers struggled mightily.  

Both are solid accomplishments, but are they enough to build on?  In the U.S., Sears competes against best-in-class in its major categories; Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) in consumables, Lowe's (NYSE: LOW) and Home Depot (NYSE: HD) in tools and appliances, and Best Buy (NYSE: BBY) in home electronics. None of these retailers is ready to give up an inch of market share.

Abandoning the core?
In an attempt to revitalize its business, the company recently announced a re-organization into a holding company with five components, each held separately accountable for delivering results. The key point is that the new structure will separate the operating (merchandising and stores), online, real estate, support, and brand businesses.

Lampert makes a convincing case for this, using the DieHard brand as an example. While it's a leader in customer recognition, it lags in terms of market share. His point is that wider distribution of the brand could lead to impressive sales gains. In other words, DieHard batteries haven't lived up to their potential since they are distributed only through Sears' auto centers, compared to competing batteries being sold at thousands of locations nationwide, many of which are more conveniently located for customers.

To me, I see this as tacit admission that Sears' primary distribution channel, its stores, are hopelessly broken. This point comes across in Lampert's mea culpa about not investing more in store remodels. All successful retailers use brand and channel extension to grow, but they start with a winning store operating model as the core to build from. Sears' strategies seemed to abandon this core.

The cash flow mantra
Which I think brings Sears back to where it started -- attempting to create value through financial engineering. The company made impressive gains a few years ago by slashing expenses, selling off stores, and squeezing every nickel of cash flow it could find.

However, while cash flow is important, it doesn't make the business more attractive to customers. Last year, Sears deployed $4.3 billion in capital: $3.5 billion went to share repurchases and debt reduction, while only $580 million was reinvested in the business. Meanwhile, Wal-Mart plowed $14.9 billion into its stores last year, so you see the difference in mind-set. Not to mention that Sears paid an average of $135 for its shares, a 40% premium to the current price.

One Fool's opinion
Unless Sears decides to spin off some of its brands, I can't see how financial engineering gets the company much further down the path to healthy growth. Investing in the basics, making the stores and merchandise more appealing to customers, is where the rubber meets the retail road.

It's not flashy, and it certainly won't be quick. The company has the cash flow to hang around for quite a while yet and has a new plan. But does Lampert has the fortitude to solve the real problems that determine the company's fate as a retailer?

Related Foolishness:

Sears, Wal-Mart, and Home Depot are Motley Fool Inside Value selections. Best Buy is a Stock Advisor pick. Try out either service free for 30 days.

Fool contributor Timothy M. Otte surveys the retail scene from Dallas. He welcomes comments on his articles, and owns shares of Wal-Mart, but none of the other companies mentioned in this article. The Fool has a disclosure policy that's always on the straight and narrow.