Most investors conceive of and monitor Sears Holdings Corp (NASDAQ:SHLD) as a single unified entity. However, in reality Sears is an accumulation of many pieces, including 1,211 Kmart stores, 851 Sears stores, Lands’ End, Sears Canada, Sears Service, and brands like Kenmore, Craftsman and DieHard notes Credit Suisse in a report this morning. The analysts state ‘over the last few years Eddie Lampert has been slowly dismembering the corporation, taking pieces out much as players pull out pieces of a Jenga game, hoping the overall structure does not collapse’.

Eddie Lampert Sears

Credit Suisse believe what happened this quarter, and what we are likely to see in the future, is that too many pieces have been removed, which in turn is reducing the strength of the core, and suggesting that further actions will weaken it even more. At one point, unfortunately, the volumes and productivity of the remaining stores point to margins staying weak or weakening.

Further details from the Credit Suisse report below:

Eddie Lampert Blames ‘Tax Refunds, Cold weather, etc.’ for Weak Sears Sales

  • Both Sears and Kmart stores suffer from low productivity. Yes it is a large company, but sales are spread out over more than 2,500 stores and productivity is very weak compared to other players. That does not mean that Sears has no strong assets, but to create liquidity Sears Holdings Corp (NASDAQ:SHLD) has been selling these assets, from Sears Hometown and Outlet Stores Inc (NASDAQ:SHOS) to part of Canada to some of its best store locations and now potentially its warranty business, which we believe is another relatively high margin segment.
  • One of the first pillars removed was a portion of the valuable real estate and the sales that went with it. In Q1, 4% of sales were lost because of closed or sold-off stores. While these closed stores cost Sears Holdings Corp (NASDAQ:SHLD) 4% of topline, they reduced profits by 36%, implying some of the best stores are being sold. That is not only a long-term concern but also raises questions about Sears’ remaining real estate value. The second pillar was SHOS, a highly profitable source of about a third of profits two years ago. Canada was levered and now partially spun, inventory is being used as a source of cash, and the next target is the warranty business.

The underlying problem, in our opinion, is that operations are already cash flow negative, but by dismembering the company to fund liquidity that further reduces longterm cash flow. That is what we saw this quarter and our concern is that the trajectory will get worse. Remember, Sears Holdings Corp (NASDAQ:SHLD) has now had seven quarters of positive apparel comps, courtesy of JCP, and we wonder how much longer that will go on.

Sears First Quarter Analysis

  • We return to the question we ask each quarter. If the assets have so much value, why does Sears Holdings Corp (NASDAQ:SHLD) continue to operate? We used to believe that just operating costs the company about five dollars a share in negative cash flow each year, but based on Q1 results we now think that figure could potentially be closer to ten. The problem the company faces is that each time it offsets its liquidity shortfall, it pulls another brick of support to do so. This quarter we saw the costs of that strategy with store closures and the removal of Sears Hometown and Outlet Stores Inc (NASDAQ:SHOS) contributing about half of the ~$205mm y/y EBITDA decline.
  • We are lowering our EBITDA estimate excluding pension expense for this year to $408, which still may turn out to be too optimistic. That would fall lower if Sears Holdings Corp (NASDAQ:SHLD) does sell its warranty business. We believe that we are getting closer to a time where Sears has to decide what its future will be, and it likely wants to do that before J.C. Penney Company, Inc. (NYSE:JCP) has to either close units or improve sales by being more aggressive.
  • We are lowering our 2013, 2014, and 2015 EPS estimates to -$4.24, -$3.83, and -$3.77, respectively, including pension expense as a result of weaker margins from the removal of Sears Hometown and Outlet Stores Inc (NASDAQ:SHOS) and mild topline.
  • Q1 results: Sears Holdings Corp (NASDAQ:SHLD)’s results were weaker than expected with negative low to midsingle digit comps in each division and consolidated EBITDA of -$8mm, down over $200mm y/y. While the results were weak on an absolute basis, parceling out the impact of Sears’ 2012 store closures and removal of the Sears Hometown and Outlet Stores Inc (NASDAQ:SHOS) business, core business performance accounted for roughly half of the $205mm slide in profitability.

As it was for many retailers, we believe the weakness in Q1 was magnified by unfavorable weather and the increase in the payroll tax, with the latter weighing heavily on the Kmart division. While weather headwinds should abate somewhat, the larger issue for Sears Holdings Corp (NASDAQ:SHLD) is the impact that its recent Sears Hometown and Outlet Stores Inc (NASDAQ:SHOS) spinoff is having on margins.

Product is sold to Sears Hometown and Outlet Stores Inc (NASDAQ:SHOS) at cost, which is a substantial drag on gross margin (-160 bps in Q1). The offset, of course, is a modest reduction in SG&A as some expenses are pulled out of the business from the spin. However, Q1 was evidence that the net impact is still negative as the removal of Sears Hometown and Outlet Stores led to a 19% reduction in Sears’ Q1 EBITDA.