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Sears' Turnaround Still Going the Wrong Way (Update 2)

Updated to include analyst and management commentary, including added financial detail.

NEW YORK ( TheStreet) -- Adding to an 2012 stock run that lifted battered shares, Sears Holdings (SHLD - Get Report) is selling and spinning off stores in a plan to raise $1 billion in needed cash and add confidence in its financial health, as earnings dim. Investors should focus on the company's continued operating losses, even as the company improves its liquidity.

After reporting weaker than expected fourth quarter earnings, Sears Holdings (SHLD - Get Report) plans to sell 11 stores to General Growth Properties (GGP - Get Report) for $270 million and spin its Sears Hometown, Outlet stores and select hardware stores to shareholders in a rights offering. Those moves and an earnings call clarified Sears' strategy going forward, but it won't help the company stem its biggest problem of falling sales, continued operating losses and declining market share, according to analysts.

Prior to Thursday's announcements, Gary Balter of Credit Suisse highlighted that the retailer's 2012 gain hinged on what it would disclose, after skipping previous quarterly calls. "The most important question for Sears is what is it? Is it a retailer that plans to make it on its execution and turnaround efforts? If that is the case, we believe it is going down the wrong path," wrote Balter in a Feb. 22 note prior to the Thursday's announcement.

In its spin plans and earnings call, Sears clarified how it expects to realize the value of its assets, while attempting a turnaround. But even with those plans laid out, the company's overall problems may be intractible. "Our most important question is if Sears indeed has all that underlying asset value, why does it keep operating?," added Balter in his Wednesday note. That question still lingers.

The spinoff of over a thousand total stores is expected to raise between $400 and $500 million, according to a Thursday statement. Sears Hometown stores carry the company's Craftsman, Diehard and Kenmore brands, which make it a market leader in appliance sales, outpacing competitors like Home Depot (HD). Sears Chairman Edward S. Lampert who's fund ESL Investments is the company's largest shareholder intends to participate "in full" in the spinoff.

But the company's prospects are still cloudy, at best. "Sears has liquidity and the ability to fund negative operating cash flow, but that you can't do that indefinitely. The spin-offs and asset sales provide some offset to the operating losses, but the fundamental problems with the core business isn't a story that we think makes sense at these levels," says Philip Emma an analyst at R.W. Pressprich who is focusing on the company's second lien debt.

"It is important to distinguish between our operating performance and the unrecognized value in our asset portfolio, our substantial liquidity and financial flexibility," said CFO Robert A. Schriesheim in an analyst call. He noted the company's $3 billion in liquidity and minimal debt maturities until 2018.

Of divestitures and earnings figures Sears Chief Executive Lou D'Ambrosio said, "We are further strengthening the balance sheet by approximately $1 billion through the actions we are announcing today regarding Hometown, Outlet, and Hardware stores, a real estate transaction, and inventory reductions."

The comments signal that Sears sees its real estate assets and inventory as providing ample liquidity to complete a turnaround. It also noted that an additional 125 of its stores are held in a "bankruptcy remote subsidiary," giving new insight into its real estate assets. Nevertheless, falling earnings and a high debt load may be the bigger issue.

In fourth quarter earnings, Sears reported weaker than expected adjusted earnings per share of 54 cents, versus an expectation of 68 cents, according to Zacks. Including one-time accounting losses related to tax allowances, the company reported a fourth-quarter net loss of $2.4 billion, or $22.63 a share, compared with net income of $374 million, or $3.43 a year earlier.

Fourth quarter revenue of $12.5 billion slightly beat expectations, but the company still reported a 2011 loss as sales slowed to $43.3 billion.

Moody's keyed in on the company's continued operating losses, giving no reason for a change to its junk ratings and "negative" opinion on Sears. "The rating outlook remains negative, as weak operating performance is expected to persist and it remauins uncertain if the company's strategies taken to improve performance will be effective," wrote Moody's in a Feb. 23 report maintainings its deeply speculative B3 rating. All three ratings agencies hold a "negative" opinion on Sears, signaling potential future downgrades.

The agency said that Sears' rating is a result high debt levels, eroding market share and continued operating losses that outweigh its strong liquidity. Sears's comparable store sales have fallen in every year since the company merged with Kmart in 2005. The $11.9 deal was orchestrated by Lampert of ESL who was then a majority owner of Kmart after it exited bankruptcy in 2003.

Prior to its earnings release and asset sale plans, Sears shares gained nearly 100% in 2012 after the company's shares fell by more than 50% in 2011. On news of earnings and asset sales, Sears rose over 21% to $63.04 in Thursday afternoon trading. That surge made Sears the top 2012 performer in the S&P 500.

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In total, the moves are expected to lower the company's debt by $1.4 billion through capital raises and a reduction in inventory and leasing expense. Currently, Sears total debt stands at over $4.5 billion. As of 2011, Sears has total liquidity of $3.2 billion, which includes $2.2 billion in borrowings via a credit agreement that can be expanded by another $1 billion in cash through an existing "accordion" feature. The company also had $760 million in a second lien credit agreement.
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