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March 20, 2006

Sears Holdings Moves Higher on Good Earnings Report

(SHLD) responded very positively last week to a better than expected quarterly earnings report. Since Northlake clients all own SHLD, I am obviously quite pleased with the stock action, even if much of its was driven by short-covering when many bears threw in the towel. I am also quite pleased with quarterly results and with Eddie Lampert's letter to shareholders. Bears and retailing experts have noted that SHLD can’t shrink its way to success. However, I'd qualify that statement by saying that SHLD can have shrinking sales for another year or so without offsetting the upside for SHLD stock. I see the stock as a race between expense savings and gross margin expansion on one side and softening sales on the other side. Eventually, expense savings and gross margin opportunities will run out. At that point, without top line growth, EBITDA will flatten out or decline. But, over the next year, EBITDA should expand as the "shrink sales to grow profits" strategy continues to work.

Take a look at 4Q05 operating numbers. Revenues fell 5% on a pro forma basis but operating income rose almost $300 million, or 30%, because gross margins rose 130 basis points and SG&A as a percentage of sales fell 90 basis points. Lampert's shareholder letter spent a lot of time explaining how profits can rise when same store sales decline. Along with a comment that merger integration was largely complete, I think the unwritten message is that the financial model in 4Q is sustainable at least through 2006....

If this is the case, then analyst estimates of a $1 billion increase in 2006 EBITDA seem plausible. In that case, the stock trades at less than 5 times EBITDA and with a free cash flow yield near 10%. This is enough to drive the shares back to at least the 2006 highs at $160.

Some may say "so what, after 2006 there is no operating income growth, so why pay up now?" My response would be that if growth does disappear the company could then accelerate the share buyback and look to be more aggressive about selling some real estate. For now, those are secondary priorities as management maximizes profitability of the current store base and searches for a store concept that might work for Sears. That is not an impossibility as similarly beleaguered Kmart is growing same store sales again after several years under Eddie Lampert's management team.

I see this scenario as creating a window for outperformance in the shares and providing a backstop for shareholders as the cash on the balance sheet builds from its already healthy level.

I'd strongly encourage any investor with an interest in retailing to read Eddie Lampert's letter. His discussion of same store sales and profitability is interesting. Some will call it self-serving, but I think he raises some real interesting points, especially as it relates to the ongoing growth in retail square footage across America.

Posted by Steve Birenberg at March 20, 2006 10:44 AM in SHLD