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Sears Profits by Paring Advertising Expense

Some of its success has come from cutting ads, not from advances in retail.

Editor's note: This column by Jeff Bagley is a special bonus for TheStreet.com and RealMoney readers. It first appeared on Street Insight on Aug. 17 at 10:18 a.m. EDT. To sign up for Street Insight, where you can read Bagley's commentary in real time, please click here.

The conventional wisdom is that the expense management at

Sears Holdings

(SHLD)

has been nothing short of fantastic.

But what if a large portion of the earnings gains actually stemmed from slashing advertising expense? That wouldn't really be a good thing, would it, if same-store sales continue to plummet?

The reduction in advertising expense isn't mentioned, as far as I can see, in this morning's press release. But a look at last quarter's 10-Q indicates that reduced advertising expense accounted for a whopping 29 cents a share, or about a third of the company's year-over-year pro-forma earnings gains.

I'm not entirely down on Sears, because I believe there was a great deal of fat to begin with, and management has been able to stem the sales declines pretty well at

Kmart

. As a financial engineering story -- which is what this is -- it's been a pretty good experience for shareholders.

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From a retailing perspective, however, it looks as if current profits are being boosted at the expense of brand equity. I never liked Sears as a stand-alone: It's been a terribly run chain for years and the stores -- mostly empty save for the hardlines -- continue to lose customers. Same-store sales at Sears Domestic fell 6.3% in the most recent quarter, following a 8.4% decline in the first quarter of the year. This is no surprise, however -- these sales have been in a long, almost secularlike decline.

Advertising expenses at Sears have been declining for some time now, but there was a marked decrease in the first quarter. Although the reduction in advertising expense wasn't explicitly stated in the most recent 10-Q filing, management indicated that lower advertising expense was responsible for 100 basis points of the improvement in the SG&A rate for Sears Domestic; for Kmart, lower advertising expense accounted for 20 basis points of the decline.

That equates to a reduction of $67 million and $8.5 million at Sears and Kmart, respectively. Adjusted for taxes, the combined savings comes to almost 29 cents a share. That's substantial.

Perhaps too much was spent on advertising to begin with. And, after all, this isn't a retailing story, right? I can't help but be a bit cynical, because one of the first things I learned when studying retail is that advertising spending is discretionary, and managers who need to make the numbers will resort to slashing advertising.

This might please investors in the short term, but it brings up serious earnings-quality issues. We'll have to wait until the 10-Q comes out in September to see just how much of the expense savings in the just-reported quarter was a result of lower advertising expense.

Can investors rely on the current run rate of profits if a future increase in advertising expense will be necessary to increase customer traffic? Judging from the continued decline in Sears same-store sales, such an investment could well be necessary sooner rather than later.

At the time of publication, Bagley had no positions in stock mentioned, although holdings can change at any time.

Jeffrey Bagley, CFA, is a portfolio manager for McCabe Capital Managers, Ltd. Bagley received a master's of business administration in finance from Fordham University and a bachelor's of science in business economics from the State University of New York at Oneonta. Disclosed holdings may change at any time without notice. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. Bagley appreciates your feedback;

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