Sears' Hole Gets Deeper

Updated from 10:14 a.m. EDT

Sears ( S) is having a harder time than many on Wall Street believed, as overhanging inventory issues continue to plague sell-through, especially in apparel.

The department store chain reported a greater-than-expected drop in second-quarter earnings and lowered its full-year earnings guidance to below consensus early Thursday.

But shares of Sears regained some losses -- though still at a 52-week low in afternoon trading -- after the company asserted on a subsequent conference call that its sales and inventory management outlook is improved for the all-important holiday fourth quarter as it continues work on resetting several business units.

Including charges, the company earned $53 million, or 24 cents a share, in the quarter ended July 3, down from $309 million, or $1.04 a share, in the year-ago period. Charges totaling 24 cents a share included severance costs from a restructuring of the company's home office and additional depreciation expense from assets sold to Computer Sciences Corp. ( CSC). Computer Sciences will be providing Sears with desktop and server computer systems and support for the retailer's Web site and voice and data networks.

Excluding charges, the company would have earned 48 cents a share. On that basis, analysts had been calling for a profit of 71 cents a share.

Shares were lately down $1.03, or 3%, to $33.90, after earlier dropping about 8%.

"We lacked a sufficient amount of fashion-oriented spring merchandise in what has been a strong fashion-oriented spring season," said Chief Executive Alan J. Lacy on the call.

Total sales dropped to $8.78 billion, from $10.2 billion a year ago. Domestic same-store sales decreased 2.9%. Home appliance sales were negatively impacted because cooler, wetter weather in much of the country led to decreased sales of air conditioners, negatively impacting overall home appliance same-store sales by 130 basis points.

In terms of apparel, the company's plan is to update fashions with several new brands to be rolled out this fall, including the A line brand, a partnership with Jones New York ( JNY) announced in the first quarter, expected to be in 450 stores in August. Another new brand, Structure for men, will be rolled out to 100 stores in early September.

The Structure and A line brands will be supplemented by two new lines, Sears said, one of which will be from designer Harve Bernard. Meanwhile, Sears' own proprietary brands, such as U.S. Polo, will offer coordinating accessories.

"As we move into fall, we'll continue be have a negatively impacted top line until the seasonal transition is complete," Lacy said. The company is generally cautious on the third quarter but said a recovery could materialize late in the period.

Third-quarter EPS is expected to be flat to 10 cents, including a carrying cost of 3 cents to 5 cents for legacy debt. Same-store sales are expected to be down in the low-single-digits.

In terms of its Lands' End line, where same-store sales were flat in the first half of the year due to inventory issues, the company is redistributing its overall allocation of the line to match customer preferences. For example, the line is more popular at the company's upper scale shopping areas and, as such, its offerings will be increased at those locations and decreased ? but not eliminated - at locations where demand is weak.

"We have had some price value issues, most notably in the kids area, where Lands' End did not deliver the price value we wanted to see in our stores," Lacy said.

In order to better manage its apparel offerings, the company said it has a new supply chain management system, which includes inventory management and replenishment as well as a new assortment and allocation process. In other words, rather than receiving a huge shipment of inventory at the beginning of a season, individual stores will get a smaller shipment and then subsequent inventory shipments tailored to specific customer demand levels.

Gross margins in the quarter expanded to 27.9% as a percentage of sales, from 27.5% in the year-earlier period. Sears cited $38 million income and revenue gained from its alliance with Citigroup ( C). Sears sold its credit card business to Citigroup's subsidiary Citibank in October 2003 but retained a 10-year agreement whereby it will receive $200 million annually from new accounts.

At its Canadian operation, Sears Canada, operating income was $11 million in the quarter, down from $23 million last year. Revenue rose 4.6% to $1.1 billion, helped by foreign exchange benefits.

The company improved its debt position during the quarter, however. Partly because of the sale of the credit card business to Citibank, its domestic term debt position is now $2.9 billion, down from $23.9 billion in the prior year.

The company's full-year earnings guidance was reduced to $2.66 to $2.68 a share and includes special charges as well as a debt carrying cost of 20 cents to 25 cents a share. Before items, EPS in the full year is seen at $2.90 to $3.10.

Analysts' consensus is a profit of 44 cents a share for the third quarter and $3.63 a share for the year.

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