Profit Plunge Slams Sears

A disastrous third quarter raises questions about the company's ability to continue as a retailer.
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Updated from 11:09 a.m. EST

Shares of

Sears Holdings

(SHLD)

dropped below the $100 mark on Thursday for the first time in their two-and-a-half year existence after the company reported disastrous third-quarter results that suggest its days as a retailer could be numbered.

Fans of the company's chairman, Greenwich, Conn., hedge fund manager Ed Lampert, say that Sears may be a dying retailer, but it's cash can be invested elsewhere by a value-investing genius. Others say the path to riches at Sears lies in the hidden value of its real estate, which guarantees upside in the stock -- even in the event of a liquidation.

With shares of Sears down nearly 50% from their April all-time highs, such convictions are looking increasingly precarious as the U.S. housing bust threatens to plunge the economy into a recession. The company's cash flow is dwindling as its profitability sinks, and real estate values are mired in a cloud of uncertainty.

Meanwhile, there's no sign that Lampert has another blockbuster acquisition in store for the company that could get its shares moving again the way his 2005 purchase of

Sears Roebuck

with

Kmart

stoked exuberance on Wall Street back in his high-flying days at the height of the housing bubble. Currently, he's making a

bid to buy

Restoration Hardware

(RSTO)

, a floundering retail chain with just $713 million in annual revenue.

"It should be clear to investors that if Sears continues to try to make it as a retailer, it will likely not happen," said Credit Suisse analyst and longtime Sears bull Gary Balter in a research note.

The company eked out a profit for the quarter of $2 million, or 1 cent a share, down sharply from year-earlier earnings of $196 million, or $1.27 a share. That missed expectations on Wall Street by a long shot. Analysts projected earnings 50 cents a share, according to consensus estimates reported by Thomson First Call.

Sears Holdings' revenue dropped 3.2% to $11.55 billion from $11.94 billion a year earlier, missing Wall Street's estimate of $11.61 billion.

Shares of Sears fell to as low as $98.25 before climbing back slightly. The stock recently was trading at $101.28, down $15.01, or 13%.

"We are very disappointed in our performance for the third quarter," said Aylwin Lewis, Sears Holdings' chief executive and president. "We cannot blame our results entirely on the retail and macro-economic environments. We have much on which to improve and are working hard to do so."

Same-store sales -- a key gauge of retailing health that measures sales at stores open for at least a year -- were down 4.2% at the Sears chain and 5% at Kmart. Moreover, the start of the holiday season has yet to provide a lift -- the company said its same-store sales are down 0.4% so far in November.

"Unfortunately, visits to the stores show very little evidence that Mr. Lampert has figured out the magic sauce that makes good retailers profitable and we doubt that we will see that in the near and medium term," said Balter. "While it is easy to blame management, one should also remember that Sears' mix leaves it exposed to the worst current trends. Home-related goods are a large bulk of sales, with apparel, which has been weak for everyone due to weather, another large chunk."

Sales have long been in decline at Sears and Kmart, but in the past the holding company has been able to hold up profits through cost cuts and expense controls. In the most recent quarter, however, operating income plunged $230 million to $46 million. Gross margins slid 90 basis points to 27.4% as the company marked down merchandise.

"Given that we do not expect any significant near-term improvement in the overall retail environment, we believe that our sales and gross margin for the balance of fiscal 2007 will likely continue to be pressured by the above-noted unfavorable economic factors," the company said.

Perhaps most alarming to the Lampert faithful, the company's adjusted earnings before income taxes, depreciation and amortization dropped 45% in the quarter. That signals that its retail operations are generating less cash, giving Lampert less wiggle room with which to invest in other businesses that could raise the company's prospects.

At the end of the quarter, Sears Holdings had cash and equivalents of $1.5 billion, down from $2.1 billion at the same time last year and below the $4 billion it had at the beginning of the fiscal year. Much of the cash decline stems from the company's aggressive share repurchasing -- an effort that signals Lampert's belief that even at $180, the stock was cheap. But with the market now valuing the stock below $100, it doesn't look like such a good investment.

Balter said that if one assumes Sears generates $2.5 billion in earnings before income taxes, depreciation and amortization next year, then the stock is trading at 7 times earnings at $105.

"The hope and value for investors is that Mr. Lampert recognizes this and sells the pieces that have value," said Balter. "Unfortunately the longer he waits, the lower the value for two reasons. First, the credit markets are not supportive of a leveraged transaction and second potential real estate and asset buyers would recognize that Sears has very little leverage to push prices higher."

Balter sees three options for Sears. First, he said, it can continue to try to operate as a retailer in an environment that is not conducive to merchandising turnarounds. Second, Lampert can keep buying back shares until he eventually takes the company private. In this scenario, Sears' public shareholders could lose out while Lampert's hedge fund clients benefit from whatever value he sees.

The legendary investor Warren Buffett -- to whom Lampert has compared himself -- has historically refused to buy back shares of his holding company,

Berkshire Hathaway

, when he felt it was undervalued because he didn't want to buy out his shareholders at a discount.

Lastly, the company could sell assets like Sears Canada and Land's End -- a move that could that amount to a strange turnabout considering that Lampert is in the process of trying to buy Restoration Hardware.

"Ironically, the Sears story may be more dependent on the credit markets than the consumer markets," said Balter. "While flying in the face of all our analysis, while lowering our estimates and price target, we are keeping our outperform rating as we still believe this very strong

board of directors recognizes its options and will make the decisions that add value at this price."