Whatever you do, don't buy Sears
Investor Daily: Betting on the retail sector these days isn't for the faint of heart. But here's one stock to avoid at all costs.
NEW YORK (Fortune) -- Investors who think shares of Sears Holdings are a bargain after plummeting 80% from their peak should think again.
That might sound like a no-brainer after retailers across the board - from Macy's (M, Fortune 500) to Best Buy (BBY, Fortune 500) - have been reporting dismal third quarter results amid one of the worst consumer spending downturns in decades. But there are reasons why Sears (SHLD, Fortune 500) is likely to disappoint more than most when it reports earnings Dec. 2.
A big chunk of the Hoffman Estates, Ill.-based retailer's sales comes from appliances, tools and electronics - categories that have been decimated by the housing collapse. Sears and its sister retailer Kmart have long been getting clobbered by competitors like J.C. Penney (JCP, Fortune 500) and Wal-Mart (WMT, Fortune 500). That drubbing is likely to get worse in an economic downturn.
What's more, Sears provides few clues between earnings reports, such as monthly sales figures or earnings guidance, to help analysts make accurate profit predictions. Analysts expect Sears to lose 50 cents a share in the third quarter ended Nov. 1 and earn $2.51 for the year. That compares with break-even for the year-ago quarter and $5.70 in earnings per share for fiscal 2007.
Credit Suisse analyst Gary Balter cut his 2008 earnings estimates last week, to $1.19 a share, but concedes that his revision may be too high. Meanwhile, Richard Hastings, a consumer strategist at the investment bank Global Hunter Securities, says he's concerned that Sears' sales of big-ticket items were impacted in the third quarter "greater than is generally understood."
Another bearish sign: Hedge fund Pershing Square Capital, run by activist investor William Ackman, recently sold all but 500,000 shares of what had previously been a 6.7 million share stake in Sears.
Sears' stock, which traded above $190 back in April 2007, is now changing hands around $34. Some analysts say the shares have further to fall. Balter thinks the stock could trade as low as $20. At is current level, Sears' trailing price to earnings ratio, at 9.7, is more expensive than most of its major competitors, including J.C. Penney, Macy's and Kohl's (KSS, Fortune 500).
"It's the most expensive stock we cover," Balter said.
Much of that premium is predicated on the expectation that Eddie Lampert, the billionaire hedge fund manager who controls Sears, will live up to his boy wonder status and magically turn Sears' lemons to lemonade.
The company owns valuable brands, including Kenmore appliances, Craftsmen tools and Lands End apparel, as well as a pile of real estate. But those assets are worth less than they were in November 2004, when Lampert, after rescuing Kmart from bankruptcy, used its shares to buy Sears, Roebuck & Co. and create what is now called Sears Holdings.
So what does the future hold for Sears, one of the oldest names in American retailing? Despite a brief revival in the 1990s, Sears long ago lost its way. The company's problems, including a lack of focus and eroding customer service, predate Lampert's involvement. But Sears' slow decline doesn't mean it can limp along indefinitely.
While Sears is sitting on a $1.3 billion cushion - the difference between the cash it brings in from operations and what it owes in rent and interest payments - that safety net is expected to shrink in coming years as sales continue to decline.
"Sears is about as badly positioned as anyone we cover," said Morgan Stanley analyst Gregory Melich.
Also key to its survival is maintaining the confidence of suppliers. Electronics retailer Circuit City, which filed last week for Chapter 11 bankruptcy protection, was pushed to the edge when vendors stopped shipping goods. One important difference in Sears' case: collateral - essentially its inventory - is more than double its credit line, which should reassure vendors.
Sears spokesman Chris Brathwaite denies that the retailer is in dire straits. "Sears Holdings has consistently maintained a strong capital structure with more than adequate liquidity," he said. At the end of the second quarter, Sears had $1.5 billion in cash and a $4 billion revolving credit facility in place, which doesn't expire until 2010.
Still, it's not clear that Lampert wants Sears to survive. He has not made the usual store upgrades necessary to keep Sears competitive with peers, which suggests he is running the company for the cash it generates. Lampert has used some of the cash for buybacks, which typically boost a company's share price.
But you can only milk a cow for so long before it runs dry - one reason why investors should steer clear of this stock.
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