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Why Sears Is Not Too Big to Fall
Posted by: Patricio Kehoe (IP Logged)
Date: October 8, 2013 04:50PM

Negative macroeconomic trends, such as consumer credit contraction, housing market downturn, and increases in commodity costs, have negatively affected the retail industry. Yet the economic downturn, which followed the 2008 financial crisis, has not hit all retailers equally. Whereas Sears Holdings Corporation (SHLD) has struggled to grow, Kohl’s Corp (KSS) is expected to continue on its positive growth trajectory.

A Solid Business Model

Targeting middle-income customers and offering moderately priced brands, Kohl’s now operates over 1,155 department stores in the U.S. The firm not only offers national brand merchandise, but also exclusive label goods, which comprise more than 50% of total sales. This company, which generates near double-digit operating margins, is one of John Hussman’s recent purchases.

Unlike its rival retailers, Kohl’s is located at off-mall locations, with only 80 stores being mall-based. This not only gives the firm cost advantages, but by improving access to consumer demographics, sales have increased. Also, the company boasts newer stores, with 75% being less than 15 years old and 50% either new, or remodelled sometime in the past six years. Kohl’s offers solid returns on investments and has a narrow economic moat, which stems from its low cost structure and its ability to generate high gross margins from its exclusive brands.

Raising gross margin has been the focus of the latest merchandise efforts. Adding new brands over the past years has been highly beneficial and is expected to continue driving sales. The addition of new brands such as Ralph Lauren’s Chaps, Simply Vera, and Rock and Republic, demonstrates Kohl’s ability to continually update its product offerings. This attracts new customers and is a key for repeating past business experiences.

John Hussman of Hussman Economtrics Advisors seems to have picked out a good stock. Kohl’s not only has enough operating cash flow to open stores and remodel others, but has maintained target debt levels and a good dividend growth rate. While currently trading at a price discount relative to industry peers’ average, the firm offers a solid 2.61% dividend yield. As sales are expected to continue rising, shareholders returns are bound to increase in the process.

Lack of Investment and Loss of Market Share

Sears Holdings Corporation was formed in 2005 after the merger with Kmart. The traditional retailer operates more than 2,000 stores, catering to lower income customers and as of late, aims to become an online focused retailer. However, the company has not yet improved its profitability and is suffering from declining revenue. Bruce Berkowitz of Fairholme Capital Management is the only investment guru to buy shares of Sears in the past month, which is indicative of the company’s downward trend.

Although Sears is considerably large in terms of stores and has a long history in the retail business, the firm has not reported top-line growth in eight consecutive years. The company was hit disproportionately hard by the economic downturn of recent years, mainly due to the reduced purchasing power of its working-class customers. These consumers are highly sensitive to commodity cost increases and have less money to spend on appliances than they used to. Since Sears’ historical strength lies in home appliances, there will be room for improvement in this sector once the market rebounds. However, competitors are already nagging at the firm’s market share in this segment, which is currently at 30%, down from 40% in 2000.

Looking forward, the closing of stores and a low investment rate in shop maintenance only favors rival retailers. Large-format store closings are expected to continue under the current economic conditions, while Sear’s online business continues to grow steadily. Positive returns on investments, winning awards and increasing customers, depict a favorable outlook for the firm’s e-commerce. If the company manages to reinvent itself into an online based retailer, many growth opportunities could arise.

Although Sears is currently trading at a significant price discount and has the backing of Bruce Berkowitz, I feel bearish regarding this stock. Continuously declining income and cash flow, the loss of market share in the appliance segment and poor attention to store remodelling, are not signs of improvement.

Outperforming a Historical Retailer

After comparing these two stocks, Kohl’s comes out as the clear winner. Not only due to its current performance, but also looking at its growth possibilities, the retailer has an edge over competitor Sears. The traditional retailer seems stuck, without any real ideas to get out of its current situation except for its online business. Kohl’s on the other hand has benefited from its increasingly lucrative off-mall locations, its new and remodeled stores, and its updated product offerings, which have resulted in solid sales growth.

Disclosure: Patricio Kehoe holds no position in any stocks mentioned.

Guru Discussed: Bruce Berkowitz: Current Portfolio, Stock Picks
Stocks Discussed: SHLD, KSS,
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