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) 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) plans to sell 11 stores to General Growth Properties ( GGP) 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.

In December, Sears said it would close 120 Kmart Stores after the company's same store sales fell 5.2% during the eight weeks of the holiday retail season.

That move is expected to generate as much as $170 million in cash from inventory and lease sales. In 2011, operating income at Kmart stores rose to $353 million, while it fell nearly 80% to $121 million at the company's Sears branded stores. In January, the company brought in Ron Biore to lead a turnaround of its merchandising and retail stores.

Sears' liquidity is set to continue to improve, with the company also providing added insight into how it views the value of its inventory and real estate. The company also indicated that it may fund a turnaround through asset sales.

"Sears consists of many disparate businesses and the valuation of Sears in the marketplace is not necessarily reflective of the value of the independent components and obviously Sears also is valued in the marketplace based upon perceptions - accurate perceptions in some cases, inaccurate perceptions in other cases - of the value of the portfolio of assets, said CFO Schriesheim.

"The real value is in the accelerated transformation of our company. The activities we spoke about today are additional ways to unlock unrecognized value and those two sets of activities are very complementary as we play out our strategy going forward."

Sears' focus on its liquidity may help alleviate previous reports that its suppliers might cease doing business with the company, putting its operations in peril.

" The company's initiatives to bring cash into the business by asset salesremoves an overhang on operations for 2012, which is suppliers weregoing to stop shipping products to them for fear they wouldn't getpaid back (they were envisioning Borders)," wrote Realmoney analyst Brian Sozzi, in a Thursday note.

The Hoffman Estates, Ill.,- based company's shares surged in 2012 as concerns of a liquidity squeeze eased with reports that CIT Group ( CIT) would continue to finance the company's retail vendors, commonly known as "factoring." Without such financing, Sears would have trouble maintaining and financing its in-store inventories of retail goods.

While earnings have fallen at Sears, competitors like Target ( TGT) and Wal Mart ( WMT) have grown sales, picking up market share.

In fourth quarter earnings released on Thursday, Target reported a 2.2% rise in comparable store sales and a 3.3% rise in overall revenue to $20.9 billion. That sales rise contrasted with Sears and competitor Kohls ( KSS), which reported a 2.1% comparable store drop and a small quarterly revenue slowdown that led to a less than expected 60 cents in earnings.

Overall, Sears U.S. comparable store sales fell 4.1% in the fourth quarter and 3.0% for 2011, while Kmart's comparable store sales declined 2.7% in the fourth quarter and 1.4% in 2011.

The fall in sales and operating income has been a hit to the company's cash on hand, which fell nearly 50% to $754 million, as of its fiscal year ended in Jan. 2011.

For Sears's largest shareholder and Chairman Lampert, asset spins and sales may be a way for the company to improve its balance sheet and lower an over $4 billion debt stock as earnings fall. Other large Sears shareholders include Bruce Berkowitz run - Fairholme Capital, with an over 15% stake in the company according to Securities and Exchange Commission filings compiled by Bloomberg.

For more on Sears, see 10 best performing S&P 500 stocks in 2012 and Fairholme Capital's portfolio

-- Written by Antoine Gara in New York

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