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June 15, 2005

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.

Posted by Steve Birenberg at June 15, 2005 09:00 AM in SHLD