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August 21, 2006

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.

Posted by Steve Birenberg at August 21, 2006 03:02 PM in SHLD