Sears Holding Follow-Up

Late last year, I sold my position in Sears Holding (SHLD) on the basis that I no longer had an edge in analyzing the shares. I am willing to buy back the shares if I feel my edge returns, so I was especially interested when Credit Suisse analyst Gary Balter, the clear axe in the stock, came out with a really interesting new report on SHLD last week.

What I like about Balter's latest post is that it cuts against the conventional wisdom coming from the retailing experts who are usually quoted whenever SHLD is in the news. Here is some of what Balter had to say in his latest report:

Chief among the many criticisms of Sears is the argument that they are not investing to build a long term sustainable retailer but are milking the business. That argument ignores among other items the investments in Sears Grand and Sears Essential, Lisa Schultz and the apparel effort, Maureen McGuire and her marketing changeover and of course Alwyn Lewis. In the latest sign that Sears is serious about its business, last night the company announced its highest profile higher since Mr. Lampert took control.

Balter goes on to discuss the hiring of a highly regarded Best Buy executive to the position of Chief Customer Officer and the Office of the Chairman. Retailing experts will no doubt argue that no amount of management talent can save Sears and Kmart but maybe what these experts are really admitting is that they don’t understand Lampert's strategy. Speaking of the retail strategy, Balter says:

Our view is that they do care, but that they care in a way that brings better service to the customer and better bottom line cash flow to the retailer. That is not the way the way many retailers drive their business, where comps is the primary factory, but is the way the better ones it….

Time will tell if the retailing strategy Lampert is using will prove successful. Depending on what strategic direction the company takes, the retail results may not even drive long-term stock performance. In the meantime, the lesson of SHLD, which has gone from less than $20 to $180, is that we should question conventional wisdom and remember that there is often more than one way to analyze a company.

Sold Sears Holdings

I decided to step to the sidelines on Sears Holdings (SHLD). I sold all shares held by clients and personally last Thursday and Friday.

I don’t really see anything in the SHLD that has changed much as a result of last week's earnings report. However, I do think the falling gross margin and EBITDA at Kmart provides some useful ammunition to the bears that will linger through the holiday season. Pitching the line that Sears will similarly run out of margin expansion in the next year or two could prove an effective argument....

I really don’t think that matters all much, just as I don’t think the obsession over same store sales really matters much. This story is about Eddie Lampert and his ability to create value. To create value requires astute decision-making on his part and no backtracking in the retail turnaround story. With Sears still on the mend, I expect 2007 to offer similar quarterly results to what we have seen recently and that is good enough on the retail story.

The primary reason behind my decision to sell is that for the first time since I bought the shares in late 2004 (I've added it to new client portfolios regularly since then) I don’t feel like I have an analytical edge. Northlake's investment strategy is primarily ETF based through a sector rotation among small, mid, and large cap indices and growth and value indices. Consequently, I limit individual stock holdings to only those companies where I feel like I have a real edge. This explains my focus on media stocks --- that is my area of expertise and I think I can analyze and trade those stocks better than the average investor.

Additionally, I had a long standing target of $160 for SHLD based on the work of Credit Suisse analyst Gary Balter. Balter subsequently raised his target to $180. At $173, I feel like I am close enough. I could have sold at $180 a few weeks ago but I made what turned out to the incorrect decision to wait out the quarterly report. Put together my loss of an analytical edge and reaching my target and sale seemed like the disciplined play.

SHLD CEO Eddie Lampert is probably a much better investor than I and he has greater resources and access to investment opportunities that I will never be fortunate enough to receive. I like the idea of letting Mr. Lampert invest a portion of my own and my clients money and that is almost enough to make me hold the shares. But in the end, I decided that wasn't a good enough reason if my confidence in my analytical abilities was not 100%.

I can always go back in and buy SLD again. In fact, based on what I know now, I think I would re-enter around $160. That would provide enough upside to my $180 target to compensate for my lower confidence level.

Sears Holdings Gives The Bears Some Ammo

Below are two comments I wrote for StreetInsight.com in the hours following Sears Holdings (SHLD) earnings report. Overall, the quarter was OK but left some room for those bearish on the story due to the weak positioning of both Sears and KMart. THe pullback is understandable and reasonable in this context.

Initial Comment, 8:08AM Central

Sears Holdings (SHLD) reported 83 cents against consensus of 98 cents. The stock is down $8 on the news. Revenues were slightly above expectations and same store sales declines moderated to -3.8% with Sears providing all the improvement. The fact that sales are better than expected and EPS fell short implies that margins did not expand as much as expected. The press release lacks a full income statement but states that margins improved at Sears. Thus it appears that Kmart might be the source of the EPS shortfall. If so, this gives the bears something to chew on as they will state that Kmart shows there is a limited life to the ability to drive financial results based solely on margins.

I think this brief comment captures why the stock is trading off but I'd like to learn more and I wouldn't sell my long position or add to it based on what I know so far.

Follow-Up Comment, 8:32 AM Central

I found Sears Holdings' (SHLD) financial statements in the SEC filings. The figures at Sears look fine. Kmart saw a 90-basis-point decline in the gross margin vs. a year ago. Although SG&A leverage improved by 30 basis points, that was not enough to overcome the lower gross margins, and earnings before interest, taxes, depreciation and amortization fell from $85 million to $57 million.

Gary Balter is out with a comment. He says that the quarter was basically in line but notes that Kmart fell short as outlined above. He also says he thinks that investors were expecting slightly better same-store sales performance. He also noted another quarter of inventory investment. While this is to be expected with the holiday season just ahead, the increase was a little higher than he expected.

One positive noted in the press release is that apparel sales at Sears showed progress. This has long been a weak area for the company, offsetting the core strength in home-related hard and soft goods.

The stock has recovered a bit off its lows in pre-market trading. I still haven't decided what, if anything, to do with my long position.

Sears Holdings 3Q06 Earnings Preview

Sears Holdings (SHLD) reports before the open tomorrow. In fact, it will probably have reported by the time you read this. The company doesn’t host a conference call. All we get is the financials and a press release with some commentary. The limited information flow, the stocks high price and high volatility, and the ongoing controversy over the company's same store sales performance, will likely produce some fireworks in the stock. According to a note I read yesterday on theflyonthewall.com, SHLD options imply a potential move over $9. Big move for sure, but keep in mind that is just 5%.

After the company reported its last quarter, the shares fell sharply from $160 a few days before the report to $135 a week or two after the report. The stock has since recovered and is trading just under its 52 week high. The recovery is due to some signs that same store sales are trending OK (which means better than last quarter's -3.8%), less fears about Lampert making a big new acquisition, renewed share buyback activity in 3Q which was not evident in the 2Q report, and expansion of the share buyback by $500 million....

There are six earnings estimates on First Call averaging 98 cents. The estimates vary widely with a low estimate of 83 cents and a high estimate of $1.05. The axe is SHLD, Credit Suisse analyst Gary Balter, is at 98 cents. There are only two revenue estimates, $11.67 billion and $11.94 billion. Reuters is reporting a consensus revenue estimate of $11.82 billion.

Last quarter, same stores sales fell 3.8% with Sears down 6.3% and Kmart down 0.6%. Sears same store sales, while deeply negative have improved for two consecutive quarters following a double digit decline last holiday season. Kmart has had several consecutive quarters of flat to -1% same store sales. While I still believe that SHLD has another year at least where same store sales should not matter to the stock price, I think investors will be looking for a number less negative than last quarter. I have seen a couple of reports suggesting that SHLD's comps might show improvement based on sales performance at Danaher and Martha Stewart, two important suppliers to SHLD.

The real story at SHLD, for the time being, is margins. Last quarter, gross margins rose 120 basis points and EBITDA margins rose 100 basis points. I think further margin expansion is required for the stock to continue to work higher. Look for performance at least as good as last quarter in the 3Q report. Some improvement in SG&A leverage would nice as well.

Also, look for improvement in inventory management. That is part of the reason for the expectation of continuing increases in gross margins. Last quarter, inventories were a little higher than expected so improvement this quarter would be a positive and might be necessary to keep the stock on an uptrend.

Finally, an update on share repurchase activity to see the pace since the authorization was increased in mid-September. However, the press release maybe silent on activity since the quarter ended.

SHLD shares are close to Gary Balter's long standing $180 target, a target I have adopted in deference to the analyst who clearly knows this story the best. I've been willing to hold the stock with limited upside because I like the idea of letting Eddie Lampert manage part of my clients money. After all, he might be better at money management than me!

Insider Buying at Sears Holdings

On Friday, theflyonthewall.com, citing a report in Barron’s Online, noted that there was some meaningful insider buying at Sears Holding (SHLD) recently:

A director at Sears Holding (SHLD) recently bought $5.5M worth of the company's stock just as it was climbing to an all-time high. Richard C. Perry, the co-founder and president of Perry Capital, bought a total of 33,000 shares for his New York-based hedge fund on Oct. 9 and 10. The purchases, which were made for prices ranging from $165.02 to $168.95 a share, came as the stock was soaring to an all-time high of $171.96 on Thursday. The run-up began after Sears Holdings reported Q2 earnings on August 18 that handily beat the consensus estimate. Since then, reports have speculated that Edward Lampert, a superstar hedge-fund manager who doubles as chairman of Sears, may be targeting Anheuser-Busch (BUD), Gap Inc. (GPS) or Home Depot (HD) for a buyout. Perry Capital's transactions in Sears Holdings shares have accurately predicted the stock's movement in the past, says Ben Silverman, director of research at InsiderScore.com. According to SEC filings, Perry Capital sold about 857,400 of the company's shares in Q2 2005, bringing its total holdings down to 2M shares by June 30. During that period, the share price rose to a high of about $155. In 2H 2005, however, the stock price tumbled and was range-bound between about $115 and $125. Perry Capital took advantage of the lower prices to purchase 683,200 shares during Q3. With this week's purchase, Perry Capital now holds about 2.7M shares of Sears Holdings, or 1.7% of total outstanding shares.

You got to love that revisionist history about the run-up in SHLD that began after 2Q earnings “handily beat the consensus estimate....."

In reality, SHLD sold off hard following the earnings, which supposedly missed the consensus. The fact that the consensus was formed by a very few analysts that had a very wide range of estimates with no input from management didn’t really matter when the stock went from $160 to the low $140s. Further pressuring the shares at that time was new language in the press release that indicated that share buybacks might cease in favor of new acquisitions determined solely by Lampert.

I have stuck with the shares using Credit Suisse analyst Gary Balter’s long running target of $180. We are getting close to that level now so I will have to decide whether to hold to my discipline. One other aspect to my holding in SHLD is that I am turning over a portion of my clients to Eddie Lampert’s care. There are plenty of great money managers out there, including Lampert, and my pride won’t let me get in the way of letting someone else help me out. If I decide to hold Northlake's position in SHLD, gaining access to Lampert’s expertise will be one of the major reasons.

Sears Ups Share Buyback

Sears Holding (SHLD) announced that it is increasing its share repurchase authorization by $500 million. About $118 million remains on the prior $1.5 billion authorization. So far, the company has repurchased 11 million shares at an average price of $126.14. As of August 29, the company had 154 million shares outstanding. At current prices, the new authorization plus the remaining $118 million can buy almost 4 million additional shares.

SHLD sold off following the most recent quarterly earnings, partly because I and many others noted that share repurchases seemed to have slowed and that the press release contained language that could be interpreted as a signal they would remain slow. Apparently, we were all wrong.

I suspect the investors will like this news, and that the recent positive momentum in the shares will continue.

Is Eddie Lampert Using Sears To Make A Run At Home Depot?

Tuesday's rumor has it that Eddie Lampert is putting Sears Holding (SHLD) cash to work buying Home Depot (HD) shares.

SHLD traded up on the news, and the stock has now recovered pretty much all the losses immediately post earnings. Those losses were due to either fears that (1) the share buyback would slow and Eddie would invest in something new, or that (2) earnings were below expectations.

I never felt the earnings were a miss, although they were below the high estimate on the Street, which happened to be posted by a bearish analyst. The share buyback fears were put to rest when the 10Q indicated that August saw lots of new activity. Now we get a rumored target, and the Street seems accepting. This strikes me as all pretty bullish for further gains in SHLD.

Clarification On Sears Holdings

Looking back at my recent posts on Sears Holdings (SHLD), I may have left the impression that improving same store sales trends are necessary to drive the stock higher. Just to be clear, Northlake's long position in (SHLD) has never been about sales. It has been about free cash flow generation over the 2006 and 2007 time frame. Over this period, sales merely need to be what they have been: terrible but with comps getting slightly less negative.

For 2006 and 2007, combined comps of negative low to mid-single digits should allow the company to produce the expected cash flow, and it is that cash flow will drive the stock price via share repurchases or acquisitions.

Sure, you have to trust Eddie Lampert to wisely spend the money. I am willing to do that given his stellar track record.

Is Sears Cutting Its Advertisng Expenditures Too Much?

I am no expert in retailing despite Northlake's long position in Sears Holding (SHLD) so when my colleague at StreetInsight.com, Jeff Bagley, wrote a scathing post noting that most of the earnings upside at SHLD over the past few quarters had come from large cuts in advertising expenditures, I was very interested in learning more. Jeff’s basic thesis is that SHLD has not hope to stabilize its same store sales if advertising expenditures continue to be cut and without further cuts, upside to earnings may be limited.

Jeff and I debated his post via instant messages after his post went up with me assuming that prior advertising budgets were too high. As I thought about it further, I realized that even if I was right, eventually those savings would run out and the company would be challenged to find another source of earnings growth.

Given this concern, to help me better understand the issue, I spoke with a street analyst who covers SHLD. I learned that last year SHLD spent about $2 billion on advertising, equal to around 4% of sales. This is similar to the range of spending at other department stores like JC Penney or Federated and substantially more than WalMart, which spends around 1% of sales. Breaking it down further, the analyst told me that $1.7 billion of the spending was at Sears, which put it over 5% of sales, while Kmart’s spending was more in line with WalMart.

Given these numbers, particularly at Sears, it seems that there was room to cut advertising. The question though is what is the right amount?....

I suppose it really goes deeper than that and Eddie Lampert and his team are trying to figure out how to get the best return on its advertising investment. After all, you could argue that no amount of ad spending could drive sales of Sears and Kmart.

That said, Jeff does have a point. At a minimum, the ad budget can’t be cut forever. And it has been a source of earnings growth this fiscal year. I asked the analyst if they were assuming further cuts next year and the answer was yes, but less. Using my terms, the analyst said that to “right-size” the ad budget was a two step process. First, this fiscal year there are absolute cuts from a bloated budget. Next year, as the ad budget of Sears and Kmart are brought under a single ad agency, there would be additional rationalization. Overall, this analyst’s model calls for a 50 basis point improvement in SG&A, where advertising expenditures lie this year and a 40 basis point improvement next year.

I am not sure what conclusions to draw from this debate. Clearly, advertising can’t be cut forever. On the other hand, given the apparently high ad expenditures pre-Lampert at Sears and the fact that many retailing experts long complained about how Sears was being managed, it seems that some significant level of cuts was always part of the plan.

Jeff is right that eventually Sears and Kmart have to figure out a way to get people in the stores and stop the same store sales declines. He is also right that you can’t drive earnings forever by cutting ad expenditures without risking an even worse sales performance. However, I don’t think it is fair to call the cuts in advertising to date an “earnings quality issue.” It was probably always part of the plan, and it ignores the fact that Kmart’s comps have stabilized over the past year and Sears are improving with very easy comparisons against double digit declines in the next two quarters. Finally, as I have noted for some time, the story at SHLD for at least one more year is not driven by sales but cost cutting, gross margin expansion, and free cash flow generation.

Then again, we may one day wake up to something completely different to analyze now that the company has reminded us that Lampert is free to invest in whatever he wants and, coincidentally, the share repurchase activity has slowed to a crawl. On this front, I am willing to commit a small part of my client’s money to Lampert’s care in a blind trust. He’s done pretty well so far.

Sears Results Better Than Stock Price

Sears Holdings (SHLD) earnings reports was largely in line. However, the stock traded sharply lower, giving up most of its gains so far in August. The decline can be attributed primarily to two things. First, SHLD is owned by a lot of aggressive investors and they wanted another big positive surprise like the company delivered the last two quarters. Second, as described further below, the press release indicates that investment of the company’s substantial cash balance in new ventures might be likely. The uncertainty related to what these investments might be concerns some people. I think that the retailing part of the story including the massive cash generation is on track and I like the idea of Eddie Lampert, one of the most successful investors in the last decade, investing that cash on behalf of shareholders. SHLD remains a unique investment and small positions fit nicely in the portfolios of most investors.

EPS of $1.74 exceeded consensus of $1.67 but given the lack of estimates and any guidance form the company, I’d call the number within the margin of error. Revenues of $12.8 billion were above expectations. Gross margins expanded by 120 basis points and EBITDA margins grew by 110 basis points. Same store sales fell by 3.8%, an improvement over the 1Q decline of 4.8%. Sears had a same store sales decline of 6.3%, while Kmart had a decline of 0.6%. Sears results improved from a 1Q decline of 8.4% and a 4Q decline of 12%. Kmart has been at plus or minus 1% for the last several quarters. Inventories rose slightly, which might be a concern on declining sales, but management explicitly noted that it was planned increase due to earlier deliveries of fall merchandise and a desire to add to merchandise displays in certain categories....

The shares were very strong in the few days leading up to the earnings report so it is hard to read too much into the initial sell-off following the results. If I had to guess why the shares might be trading lower on a generally good report it would be the inclusion in the press release of a section titled “Investment of Available Capital.” This section did not appear in the 1Q report. Management notes that the company has plenty of excess capital and indicates that it could be used to invest in the stores, buyback stock, invest in other public companies, or “fund investments that it believes offer the Company attractive return opportunities, whether or not related to its ongoing business activities.”

Combined with a low level of share repurchase activity in the quarter, less than 1 million shares, for just $91 million, at an average price of $137, this new section might have some investors concerned that Eddie Lampert may have something new up his sleeve. This is pure speculation on my part and I may be way overanalyzing and looking for conclusions where none exist.

I plan to hold all my SHLD, which I own across the Northlake client base. Regardless of the reaction to the earnings, this report largely leaves the long-term story intact. Little has changed based on the new information so my opinion remains unchanged and bullish.

The shares were very strong in the few days leading up to the earnings report so it is hard to read too much into the initial sell-off following the results. If I had to guess why the shares might be trading lower on a generally good report it would be the inclusion in the press release of a section titled “Investment of Available Capital.” This section did not appear in the 1Q report. Management notes that the company has plenty of excess capital and indicates that it could be used to invest in the stores, buyback stock, invest in other public companies, or “fund investments that it believes offer the Company attractive return opportunities, whether or not related to its ongoing business activities.”

Combined with a low level of share repurchase activity in the quarter, less than 1 million shares, for just $91 million, at an average price of $137, this new section might have some investors concerned that Eddie Lampert may have something new up his sleeve. This is pure speculation on my part and I may be way overanalyzing and looking for conclusions where none exist.

I plan to hold all my SHLD, which I own across the Northlake client base. Regardless of the reaction to the earnings, this report largely leaves the long-term story intact. Little has changed based on the new information so my opinion remains unchanged and bullish.

Sears Holdings Earnings Preview

While fireworks are likely in the shares of Sears Holdings (SHLD) after the company reports earnings before the open today, there has been a virtual blackout as far as research is concerned ahead of the report. There are only five EPS estimates creating the First Call consensus of $1.69. The estimates range from $1.46 to $1.90, with Gary Balter of Credit Suisse, the axe in the stock, sitting at $1.69. Only one of these estimates has been adjusted since mid-June and three were in place in May. Revenue estimates are also scarce, with First Call carrying just two, $12.4 billion and $12.6 billion. EBITDA estimates are also limited to two, $690 million and $760 million.

By the time you read this, SHLD will have reported and the shares are likely to have moved significantly from their Wednesday close of $150. Besides the headline numbers, investors will be very interested in same store sales results. The outlook here is not good but I think that is expected and accounts for the pullback in the shares over the last month. Investors jumped on indications from suppliers like Martha Stewart who indicated that sales at Kmart were not strong. Overall, the trend has been for Kmart to see flat to very low single digit declines in same store sales and Sears to see double digit declines. Most investors will not pay up for the cash flow produced by SHLD as long as same store sales remain under such severe pressure. That is understandable given it is hard to have confidence in future cash flows if sales are declining.

However, the real story at SHLD surrounds margins and working capital management....

...and on those fronts the last couple of quarters have been solid. This is where investors should be looking most carefully in the earnings report. If the company looks like it can meet cash flow estimates for 2007, even on continuing sales declines, the shares will move up at least to old highs in the low $160s.

There is only a couple of other news items of note surrounding SHLD since the last quarterly earnings report. First, the company hired Craig T. Monaghan as its new CFO. Monaghan previously worked as CFO at another Eddie Lampert company, Autozone. Based on limited information I could dig up, he appears to be well regarded by analysts. Second, a few weeks ago, SHLD lost a Court ruling in Canada in its attempt to buy out the minority shareholders in Sears Canada.

SHLD doesn’t hold a conference call, so don’t expect updates on either of these topics or any plans to enhance shareholder value through real estate sales. The company may post an update letter from Lampert on its website and more information should be available in the 10Q, which the company says will be filed “on or before” September 7th.

Sears Holdings 1Q06 Earnings Preview

Sears Holdings (SHLD) will have reported earnings by the time you read this. Since I get a lot out of writing previews by setting my own expectations and understanding the setup in the shares, I am posting a preview anyhow. Hopefully, this note will help you put the reported figures in perspective.

SHLD accelerated its earnings report from early June but noted that no 10_q would be filed in conjunction with the press release. This might mean limited or no comments from Eddie Lampert and/or lack of detail in the press release. The company is very tight lipped and analyst coverage is sparse so there is no way to know why the earnings report was pushed forward.

Consensus calls for 64 cents on sales of over $12 billion. Beware that consensus is composed of just five analysts and there is wide dispersion in the estimates which range from 48 cents to 82 cents. Comp store sales will also be closely watched. Both Sears and Kmart face year ago store sales of -3% to -4%. In 4Q05, Sears had a -12% comp, while Kmart eked out a small positive gain. As far as I can tell, analysts are expecting comps at Sears of -10% with Kmart coming in around flat. Margins are expected to rise due to cost savings and gross margin expansion due to fewer promotions at Sears. With the lack of asset sales so far, the key to the SHLD story is operating leverage, so some combination of good expense control and in line or better than expected sales is what the bulls need. My 2 cents on the company's 4Q04 report discusses this in some detail and is worth a read as you analyze this morning's numbers.

There have been a couple of hints that have supported the shares. First, Whirlpool (WHR) noted in its earnings report that appliance sales at Sears were up in 1Q. According to Gary Balter of Credit Suisse, appliances were 17% of sales at Sears in 2005 and WHR represented 25% of the total. Second, Martha Stewart Omnimedia (MSO) noted on its conference call that sales at Kmart were up 4.4% in the first quarter. Finally, Bear Stearns found the 1Q06 earnings from Sears Canada to be better than expected.

A last thing to look at is the state of share repurchases. The company has bumped up its authorization and is buying back stock. This provides good support for the shares in a supply-demand sense but it also steadily increases the ownership stake of a well respected insider.

SHLD shares soared in March following better than expected 4Q05 results. The shares have added another 3-5% since then ahead of today's earnings report. The shares are bound to volatile today given the usual activity surrounding this stock and the added market volatility. I am optimistic that the street will like the numbers. We shall see.

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.

Sears Holdings: Recent News Articles Provide Insights

The Chicago Tribune took another shot at Sears Holdings (SHLD) this weekend with an article (free registration required) recapping a contractual dispute between the retailer and long-time Sears spokesperson Bob Vila. Noting that SHLD is in "demolition mode," the article recaps CEO Eddie Lampert's strategy to de-emphasize celebrity endorsers, focusing on the company's attempt to terminate its contract with Vila. Of course, given the Tribune's consistently negative reporting on SHLD over the past year, referring to Lampert the headline notes that "the moves may cost him."

I noted in a piece in a January that much of the analysis from journalists and retailing experts was failing to distinguish between SHLD the stock and Sears and Kmart the retailers. I suppose this is understandable given their differing perspective from Wall Street analysts and portfolio managers. In the case of the Tribune, there is a focus on the job loss and decline of a long-time Chicago icon. Retailing experts are more concerned with the shopping experience and the long-term competitive positioning of the stores....

Wall Street, of course, is interested in short-term results and focused on profits, cash generation, and asset value. On these fronts, I remain optimistic that SHLD will produce the goods and the stock will rally. SHLD shares have traded in a tight range between $115 and $125 since culminating a sharp and steady two-month decline from July high's over $160. The company is reporting in mid-March and after pre-announcing a good quarter from a profit and cash generation perspective, I don’t see much downside risk in the shares. Gary Balter of CSFB, the ax in the stock, was out last week with a brief comment noting a positive profile on Lampert that appeared in Fortune. Balter re-iterated his buy and noted the shares are cheap if they hit his 2006 estimates at under 5 times EBITDA and around a 10% cash flow yield. I agree and I remain long. I continue to add shares to new client accounts.

Two quotes from the Fortune give me comfort. The first is from Bill Crowley, CFO and Chief Administrative Officer of Sears.

"We don't use discounted cash flows out five years and weigh it against the cost of capital. We talk about how much money we are making right now, and how that can change."

The second is from Lampert. "The notion of spending money on the business--I'm not opposed to it. I just want a return for it."

These quotes tell me that decision-making at SHLD is being done with shareholders in mind. As I shareholder I can exit my position at any time, even if those decisions might hurt Sears and Kmart in its long run battle to remain competitive as retailers.

Sears Holding: It's The Stock, Stupid!

"Sears Sees Stingier the Side of Holiday Sales"

"Dismal Christmas Puts Heat on Sears Chairman"

"Retail Experts Doubt Lampert's Strategies"

The headlines in a front page story from last Friday in the Chicago Tribune scream of the demise of Sears Holdings (SHLD). And the Trib is not alone. Virtually every retail expert quoted anywhere thinks SHLD is doomed.

I guess the journalists at the Trib forgot to read that press release the company issued before the open last Thursday. OK, sales in the Sears division were awful, declining 11.9% in December on a same store basis. Worse than expected? Barely. But wait a minute, Kmart had a positive comp of 1%. Losing market share? Sure. A decent performance compared to the 2% comp put by WalMart (WMT)? Definitely. Better than expected? Certainly.

And look at that EPS guidance…$3.55 to $3.95 against a current consensus of $3.52. And how about that cash balance? $3.5 billion, a full $500 million ahead of expectations. Share buybacks? 826,000 shares at an average price of $115.43.

I wonder if the Trib writers and all those retailing experts have checked the stock price lately. SHLD closed at $116.01 the night before the press release was issued. Yesterday, the stock closed at $122.70 for a gain 5.8% in three days. Read through the Trib article and it takes until well past halfway before they note that the stock might not care about the holiday sales. As I noted back in September, the obsession with sales is totally missing the story at SHLD. Quoting Gary Balter of CSFB, " The Sears story is one of negative comps, 500 basis points of margin expansion over three years and asset sales. This done right, and Sears would be currently trading at 3 times our 2007 EBITDA."

It seems to me that Jim Cramer and a couple of Wall Street analysts are the only ones who get what it is going on: SHLD the stock is a far different animal than SHLD the retailer. And guess what, Eddie Lampert's primary interest in and fiduciary responsibility to is SHLD the stock. As for the recent action in the stock, I think Cramer nailed it when he said yesterday on Real Money, "Now that Christmas is over and Sears didn't blow up – and Kmart accelerated – I would have to cover if I were short because there are no more data points for months to come that could knock it back down again."

I added SHLD to two new Northlake accounts last Friday morning because I figured we got the all clear with the press release. Think about the setup now. No news we know of for certain until the earnings release in early March. We already know the numbers will be OK. This means the news we are uncertain if we will hear takes center stage. And that news is far more likely to be good for SHLD the stock: closure of the Sears Canada deal, more share buybacks under the current authorization (providing downside support since we know the company was a buyer at $115), a larger share buyback announcement, maybe a few store sales, maybe those rumors of a leveraged buyout are true, though I am not counting on it. And I'm no technician, but the base on the stock since mid mid-September looks pretty powerful if it can break out to the upside.

If your time horizon is long enough that you are worried whether or not Sears and Kmart will survive the brutal competitive environment this stock is not for you. If your time horizon is 2006, then the sales don’t matter and this stock is for you. Northlake's time horizon is 2006.

Sticking With Sears Holdings Despite Mixed Earnings Report

Sears Holdings (SHLD) 2Q06 earnings for the quarter ending July 30, 2005 disappointed investors leading to a decline of 5.2% in the shares on Thursday. To get a sense of what the Street was expecting please take a look at my preview note posted yesterday.

The main disappointment in the quarter was on the top line where the company reported $13.1 billion against a consensus of $13.7 billion. The culprit in the quarter was the old Sears stores which had a same stores sales decline of over 7% despite an easy comparison. The old Kmart stores actually performed OK with same store sales declining just 0.3%....

....Management attributed the weak sales at Sears to a decreased and different approach to promotions and a reduction in inventory. I have to believe that sales were worse than internal budgets but it is worth noting that despite the lower sales, gross margins at Sears expanded sharply from 26.7% to 29.4%. This suggests there is a strategy in place designed to boost profitability and cash flow at the expense of sales. However, as the Kmart results discussed below make clear, there is only so much room for sales declines before gains in profitability are overwhelmed. Sales were weak across all categories at Sears with apparel the worst and hardlines, including appliances, faring the best.

Another disappointment at Sears was lack of SG&A leverage. SG&A as a % of sales was 23.4%, down just 10 basis points against year ago levels. Cost savings are a key aspect of the investment story for SHLD and this quarter was supposed to show more operating leverage. Is it the lousy sales? Is it poor management? I'm not sure but I still think the cost savings will come and here is why: in the latest quarter, Kmart had SG&A as a % of sales of 20.6% almost 300 basis points less than Sears. The two retailers aren't identical but this gives some sense of the cost savings potential that can drive earnings and cash flow for SHLD in the next few years given the revenue base at Sears exceeds $30 billion annually.

One thing completely overlooked in the reporting so far on SHLD is that despite the sales shortfall and less than expected SG&A savings, Sears still reported an increase in EBITDA of almost $200 million to $439 million against $242 million a year ago. This is the type of performance investors want to see from the entire SHLD entity and is where management can drive shareholder value via free cash flow leading to debt reduction, share buybacks, dividends, and acquisitions. Asset sales will also contribute to financial flexibility for creation of shareholder value.

As mentioned above, Kmart had a decent sales performance but with many cost savings and gross margin expansion opportunities already realized prior to the merger, flat sales won�t drive EBITDA. In fact, in the quarter, EBITDA at Kmart fell by over $60 million on a year over year basis to $141 million. This comparison is probably not apples to apples due to Kmart store closings but it does suggest that merely stabilizing sales across SHLD is not enough in the long-term (three to five years).

Of course, as an investor I am interested in results over the next year or two. In that time frame, stability in same store sales is fine as far as the shareholder value creation story goes. Sears will enjoy higher gross margins and eventually the SG&A savings will multiply to the $500 million to $1 billion management and analysts expect. Kmart also has the potential to improve gross margins as many of Sears better brands take up more shelf space. Kmart also is showing improved results in apparel of late which is a high gross margin product.

Finally, in his quarterly management letter Eddie Lampert mentioned the company is on track to open 50 Sears Essentials stores this year and over 400 in the next two to three years. Analysts who have visited some of the Sears Essentials stores seem impressed and if these stores are well run, over time they will operate at significantly higher margins than the remaining base of legacy stores.

The bottom line is that this quarter did not meet expectations for bullish investors. However, the results are not as bad as the media is reporting and many money managers are claiming. Signs of the potential for a big uptick in earnings and cash over the next one to two years were evident in the quarter. Hopefully, the management restructuring announced in the quarter will lead to cost savings being realized over the next two quarters. I think that is enough to drive the stock to its old highs, which now represents a gain of about 25%. I am comfortable holding looking my position in the stock and would look to add to my holdings if the shares pull back toward $115.

Sears Holdings Earnings Preview

Northlake clients remain long Sears Holding (SHLD) ahead of second quarter earnings due to be reported before the open tomorrow. The company is not expected to host a conference call but will release a 10Q and probably a note from Eddie Lampert along with the earnings. Current client positions in SHLD are on the small side as half of the original positions were sold in July when the stock was at $160. With the weak performance since then the holding is now below average and I decided to wait on the earnings report to decide if I want to rebuild to a full position.

Consensus estimates call for EPS of $1.36 on revenue of $13.7 billion. Investors will probably focus on same store sales trends, gross margins and operating margins....

....The second quarter marks the first of two very easy same store sales comparisons as 2Q/3Q04 both saw same store sales decline slightly over 7%. Consequently, investors will want to see a big improvement with analyst estimates ranging from -1% to 1%. Gross margins are supposed to be up slightly due to some initial benefits from the merger in terms of buying and product mix on the shelves. Operating margins should expand more robustly. First, last year had some one-time items that depressed the margin by 60 basis points. Second, this quarter should see the first significant benefits from the cost reductions on the SG&A line that are the key driver to the earnings story over the next two years. When the company reported 1Q05 investors were disappointed in the margins which caused the shares to fall about 8%.

Besides the financial statements, investors will also be hoping to hear news on the opening and performance of Sears Essential stores, possible uses of the company's cash and balance sheet to enhance shareholder value, and an update on asset sales. Each of these items has the potential to impact the stock price as much as the earnings report.

SHLD shares have been poor performers against a weak retail group since peaking at $163 on July 20th. The 18% decline in the shares compares to a loss of 7% for the Merrill Lynch Retail HOLDRs (RTH). Both securities have been down for all but a handful of days since the end of July.

Normally, I'd consider this a good setup for a long side trade as the pessimism on SHLD seems severe. However, I think SHLD is a tough stock to trade as the story is designed to develop over a multi-year time frame as shareholder value is realized through a combination of cost savings, improved same store sales, asset sales, and possibly acquisitions. Furthermore, the stock has gained analyst coverage since the 1Q05 report with at least four major firms now providing research. Lack of coverage was a positive in 1H05 but additional coverage now works as a negative since most analysts are bullish and the investment story is a work in progress.

A good quarter will certainly be well received as it will take the pressure off the asset/cash flow story which is longer term in nature. I don�t feel that I have an edge off which to trade the quarter so I am sitting tight and will do any trades, at potentially significantly higher or lower prices, after analyzing the results.

Sold Half of Sears Holdings

Just a brief note to let everyone know that I sold half of client and personal holdings in Sears Holdings as the stock crossed $160 on Tuesday afternoon. I still think this momentum stock can go nicely higher as traders react to news flow including asset sales, better same store sales against easy comps and margin expansion due to better-than-expected cost savings. However, since I had an initial target of $160, I want to show discpline and ring the register given the huge gains in the shares since they were purchased. The stock is still held by all clients including in my own accounts (just like everything clients' own) so we still want it to go higher. If the shares were to pullback sharply, buying back the positions sold will be considered. The new lower commission structure at Schwab makes these sort of trades easier.

Buying More Sears Holdings

I bought shares in Sears Holdings (SHLD) (formerly KMart) on Monday for the first time in six months following the sharp pullback in the stock after the company reported first-quarter earnings. Current holdings were maintained as the new shares were placed in client accounts who had not previously owned SHLD.

When it was issued, I thought the $160 target by UBS analyst Gary Balter was realistic based on cost savings, asset sales, and gross margin expansion. The sharp pullback since first quarter earnings were reported is the first buying opportunity since Gary's report was issued. With the shares offering about 20% upside to the $160 target, there is enough potential to get me interested again....

Not Worried About Achieving SG&A Savings

I think the stock has pulled back as momentum traders exited on the excuse of a sloppy quarter. In reality, the quarter was OK with gross margins actually expanding. As far as I can tell given the limited estimates, the shortfall appeared to be higher than expected SG&A. If there is one thing in the SHLD story I am not worried about it is achievement of SG&A savings. Eddie Lampert easily met SG&A goals at Autozone (AZO) and as Balter noted in his March upgrade, Autozone is still seeing SG&A leverage five years after the deal. SHLD has $1 billion in potential SG&A savings if it could drive expenses towards the levels of competing soft-line and hard-line retailers. Management has guided to savings of $500-$800 million. If the high end is achieved, more than $3.00 in EPS would be added to a pro forma 2004 base of $5.00.

Gross Margins Expanded in the First Quarter

The sharp decline in SHLD shares since the earnings were reported has led investors to overlook the fact that despite negative comp store sales, gross margins expanded in the first quarter. Autozone achieved significant gross margin expansion early in Lampert's ownership. While Autozone faced much lesser competitors, it did not have the benefit of $55 billion in run rate sales to leverage. SHLD is the third largest broadline retailer in the United States.

Positive News Flow Expected Over Next Six Months

I think the current weakness is a buying opportunity because news flow is likely to be positive over the next six months. First, comps are easy in the next two quarters facing year-ago declines of 14.9% and 12.8%, respectively. Second, asset sales are possible with Orchard Supply, Land's End, Sears Canada, and excess real estate creating a pool of $4 billion to draw upon. Third, the next couple of quarters are more likely to show the SG&A savings investors expect as new management will have had complete control of the combined operation for a period long enough to make a difference. Finally, initial swaps of Kmart stores to the Sears Essential nameplate will occur. This represents the riskiest part of the story but also the most upside. From what I have read, retail analysts on and off Wall Street are reasonably impressed by Sears Grand stores and a few redesigned Kmart stores.

Lack of Wall Street Coverage A Plus

If several items in that list of potential catalysts break positively, investors will get quickly get excited again about the earnings power, asset value, and cash flow of SHLD. Even better, Wall Street might stop ignoring the company, which currently has only two analysts actively following it. Two analysts for the third largest retailer is absurd (#2 retailer Target (TGT) has 24 analysts) . Any new coverage is going occur because an analyst wants to make a splash and the tough call on SHLD is be bullish in the face of near-universal skepticism that two hurting retailers can be put together in a rewarding way for shareholders. The bottom line is that the setup of skepticism, catalysts, and lack of coverage will provide nice profits for shareholders.