Sears Feels Heat from the Street

Analysts have cut their earnings outlooks and price targets on the retailer, noting its reluctance to sell unprofitable stores

It would appear that Eddie Lampert's timing couldn't be worse. The man who masterminded the $11 billion merger of Sears and Kmart three years ago is trying to engineer a turnaround at Sears Holdings (SHLD) at a time when consumers are shopping less amid increasing fears the U.S. may be slipping into a recession. And the real estate market is in its worst slump in more than 40 years, making it that much harder to sell underperforming stores without incurring losses.

Unlike Allen Questrom, who initiated a makeover at J.C. Penney (JCP) seven years ago, Lampert, Sears' chairman, hasn't been willing to sell off some of the firm's impaired stores or to bring in the latest technology in order to better manage inventories and profitability, said Bill Dreher, an analyst at Deutsche Bank Securities in New York.

"I have no conviction that the company has the operational controls or systems implemented well enough to handle this continued slowdown in the consumer spending environment," he said. On Jan. 14, he cut his rating on Sears to buy from sell.

Sears' latest sales figures came in just slightly below his own estimates, but "what's shocking is its inability to control profitability," he said, pointing to the 2% drop in gross margin during the nine weeks ending Jan. 5. (Deutsche Bank Securities does and seeks to do business with the companies it covers in its research reports, and Dreher owns one share of Sears Holdings.)

On Jan. 14, Sears reported weaker sales for the November-December period at stores open at least one year, citing stiffer competition and a pullback by customers who are tightening their purse strings amid further deterioration in home prices and consumer credit concerns.

The company, based in Hoffman Estates, Ill., said that same-store sales at its Sears Domestic stores fell 2.8%, while Kmart's comparable store sales dropped 4.2%. Declines in Sears apparel and tools, as well as Kmart seasonal product lines stood out, and these were partly offset by higher home electronics sales at both Sears and Kmart stores.

An increase in promotions during the holiday season contributed to the 2% slide in gross margin, as stores took bigger markdowns in order to clear seasonal merchandise. The relatively high proportion of sales of home electronics, which have a lower margin rate than other products, also ate into profits, the company said.

That prompted Sears to sheer its profit forecast for the fourth quarter to between $2.59 and $3.48 per share, vs. $5.33 per share a year ago. For the full year ending Feb. 2, 2008, the company reduced its outlook to between $744 million and $864 million, or $5.13 to $5.96 per share, vs. $9.00 in fiscal 2006.

The average forecast among Wall Street analysts was for earnings of $4.43 per share for the fourth quarter, vs. $5.36 a year ago, on revenue of $15.36 billion. For the full year, analysts were projecting a profit of $6.64 per share, compared with $9.00 in the prior-year period, on $51.07 billion in revenue.

On Jan. 14, shares closed 5% lower at $91.38, after rebounding from a low of $86.04 earlier in the day.

Like a host of other budget retailers who reported disappointing holiday sales last week, Sears is having a hard time attracting customers who are increasingly worried about the value of their homes, reduced credit availability and now their jobs, after a dismal December nonfarm payrolls report.

"It was clear during the summer that apparel retailers were having a tough time," said Dreher. "Now it's clear that even food and drug retailers are having a difficult time in this environment."

That was plain last Friday in the selloff in the stocks of consumer staples companies such as Costco Wholesale (COST), Kroger (KR) and Procter & Gamble (PG), a sector that until now has been viewed as virtually recession-proof.

If leaders in the retail industry such as Target (TGT) and Walgreen (WAG) -- companies that "already have their act together" -- aren't able to thrive in the current environment, it's that much tougher for Sears to be able to buck the downtrend, Dreher said.

Credit Suisse analyst Gary Balter downgraded the stock to underperform from outperform due to a dramatic decline in recent months in the value of Sears' assets, chiefly its real estate holdings, but also its brand value. The negative value in the Sears and Kmart properties makes "a breakup type analysis much less valuable than in the more bullish real estate market of a few months ago," Balter wrote in his Jan. 14 note. That means the company's only remaining value is as an ongoing retailer.

In view of the lack of investments, competitive conditions, the slowing consumer and, most importantly, the relative valuation of rivals, "one has to ask oneself why not invest in better positioned retailers rather than take a chance on a company with declining market share," Balter wrote.

Standard & Poor's reaffirmed its sell rating on the stock.

Lampert made it clear a little over a year ago at a Financial Leadership Forum in New York that he believes he can potentially create much more value by turning around a struggling retailer rather than by just liquidating stores, given that Sears' net asset value is well above what's reflected in it stock price, said Deutsche Bank’s Dreher.

"He's publicly saying, 'We're not going to shrink our way to profitability.' Then we believe over the next 12 months, we're unlikely to see any jettisoning of any underperforming assets from Sears as the company tries to turn around its profitability," he said. "If that's not going to be realized, we're not willing to include that in our valuation."

Based on the company's revised outlook, he cut his fourth-quarter profit estimate to $3.02 from $4.67 per share, and pared his fiscal 2007 forecast to $5.15 from $6.77 per share. For fiscal 2008, he now expects Sears to earn $2.73 per share, down from his prior estimate of $7.47. He slashed his 12-month price target by more than two-thirds to $53 from $161, which included asset sales.

Last week, analyst Robert Drbul at Lehman Brothers cut his earnings forecasts for the fourth quarter and the full year, pointing to the additional pressure on consumers. Despite the options open to Sears by virtue of its $1.5 billion in cash and equivalents, Drbul predicted it would take years to achieve management's goal of becoming a best-in-class retailer, which will require further analysis and work to understand this complex business.

In a Jan. 14 report for Goldman Sachs, retail sector analyst Adrianne Shapira recommended shorting shares of Sears and Dillard's (DDS) in the first half of 2008, pointing to potential for negative economic events, the probability of lower earnings and the absence of positive catalysts. Even if sales pick up in the latter part of this year, along with signs of more stability in labor markets and realigned inventories, Goldman excluded Sears from the handful of stocks it suggested as ways to profit from a rebound. (Goldman Sachs has provided investment banking services to Sears within the past 12 months and expects to receive or plans to seek compensation for investment banking within the next three months.)

In a Dec. 3 note for Bear Stearns & Co., analyst Christine Augustine advised investors to stay away from Sears on a bet that economic headwinds would persist through at least the first half of this year. But in fiscal 2009 and beyond, she said she expects the company's sharper focus on managing its inventory, improving its merchandise and shoring up its marketing to deliver "meaningful benefits." Augustine reaffirmed her peer perform rating and said intrinsic value of the shares was $110 based on a discounted cash flow analysis. (Bear Stearns does and seeks to do business with the companies it covers in its research reports.)

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