Will Sears Holdings survive in 2018? – The madman

After years of struggle, Sears, one of the largest retailers on the planet, has filed for Chapter 11 protection from bankruptcy this month. In this episode of Sector of activity: consumer goods, Vincent Shen and Adam Levine-Weinberg, senior associate of Motley Fool, look into the fallout of this latest accident in brick and mortar.

can Sears (NASDAQOTH: SHLDQ) survive with its 400 best stores? How did the retailer move from Amazon (NASDAQ: AMZN) from his day to decades of decline and debt? And who will benefit from reduced competition. Click play to learn more.

A full transcript follows the video.

This video was recorded on October 23, 2018.

Vincent Shen: welcome to Focus on the industry, the podcast that plunges every day into a different sector of the stock market. I am your host, Vincent Shen. It's Tuesday, October 23rd. Fools, we have in mind the bankruptcy today, following the official announcement by Sears last week that the company would begin the restructuring process of Chapter 11. This show will be at looking for options for Sears and how this latest incident in the retail sector will affect some of the biggest competitors in the industry. For this discussion, I am seeking the help of Adam Levine-Weinberg, Senior Associate of Motley Fool, who joins us via Skype from Sacramento, California. Hey, Adam! It's been too long, man! How is it going?

Adam Levine-Weinberg: Well! How are you, Vince?

Shen: Thank you for visiting today! I'm fine. I am excited for this discussion! I think we have interesting things to discuss. It's a beautiful story in the retail business. It was also a pleasure to meet you in person earlier this month. I'm glad you got in touch with me to cover everything with Sears Holdings and the fallout from bankruptcy. I think this is news that most investors have been waiting for a few years now. We have certainly seen a lot of coverage and headlines indicating the seemingly inevitable bankruptcy of this company. For each asset sale, each debt restructuring, each series of store closures or any reorganization we found, it was rather a delay in achieving our goals.

It's still a business of more than 125 years with a truly amazing history in the United States. While the current company is a shadow, Sears was at one time the largest retailer in the world, not just the country. I think this is an important context to keep in mind when we talk about what will probably happen to the remaining shell of the Sears empire, which still includes several hundred Sears and Kmart sites. .

Why do not you start, Adam? We have almost no time to browse the entire history of the company. For those auditors who have not followed Sears or its actions closely, can you describe the path that Sears took under its current direction and led to this bankruptcy filing? I think most people would agree that this last chapter of Sears history began with the merger between Kmart and Sears in 2005. What has it basically happened since?

Levine-Weinberg: This is true. Sears and Kmart were both struggling before the merger in 2005. In fact, Kmart had just gone bankrupt. During this bankruptcy, a hedge fund manager, named Eddie Lampert, took control of the company and became its chairman, the largest shareholder. He used this position to lobby for and merge with Sears. When you combined these two companies in 2005, their annual sales exceeded $ 50 billion. At the time, several other retailers were slightly ahead of Sears Holdings, but Walmart was the only retailer in the world whose total sales were significantly higher. At the time, Amazon was actually only a bookstore that also sold CDs and DVDs and not much else. Sears Holdings was a major force in the retail sector in the United States.

The idea behind the merger was that Lampert first hoped to reduce costs for these two distressed retailers by combining them and finding efficiencies. In addition, he felt that people flocked to these big box stores located in more convenient locations than in shopping centers. This is a trend we have been seeing for 15 years. Lampert thought that Kmart had these much better and more convenient locations, but he did not have the products to attract visitors. He thought putting Sears' brands, such as Kenmore appliances, Craftsman tools, DieHard batteries, even Land & End clothes, in Kenmore, putting them in Kmart stores would help more people to stay in business. return there. He even considered changing the full name of Kmart stores to Sears. The idea was to take Kmart real estate, Sears brands and heritage, and create a stronger and more efficient retailer, and thus, hopefully, increase profitability. . He also realized that e-commerce would become a big problem before many other players in the sector.

The problem was not that he was surprised by the growth of Amazon.com, but Lampert did not have the right strategy to tackle it. He stopped spending a lot of money on store renovations because he did not consider that the stores were really important for the future, and he did not want to invest a lot of money in assets that he had. He did not think he had been around for a very long time. future profitable term. On the other hand, he was not ready to spend a huge amount you had to spend to set up an ecommerce business.

Sears and Kmart were thus stuck in these limbo where they slowly lost all relevance for their customers. The stores were not very pretty, so people started to attract other retailers. Meanwhile, the ecommerce site was not convincing enough in terms of features, or especially price, to keep customers away from alternatives, especially Amazon.

The result is that you have seen huge revenue and customer losses over the past decade. In fact, in the last 12 months, the combined revenues of Sears and Kmart were only $ 14 billion. This represents a drop of more than 70% since the merger. The declines will continue. Even before filing for bankruptcy, Sears and Kmart were massively closing their stores and saw their equipment sales decline, resulting in a very rapid erosion of the revenue base.

Shen: I started to understand everything that had happened to Sears, just trying to paint a picture of all the initiatives and all that had been tried, in terms of real estate benefits, with the FPI, all these different things from the direction tried in this decade long saga. There is a treat from a Wall Street Journal article that you share with me, in fact. I think that summarizes some of the problems of this situation for me. One of the articles pointed out that in 2004, Lampert was managing this successful hedge fund, managing billions of dollars and that he owned a good deal of his wealth. Even in its most important form, the fund, ESL Investments, had about 35 employees. By bringing together Kmart and Sears, as you said, he was now at the head of this giant company, this giant retail force. At the time, it had 300,000 employees, more than 3,500 stores and a $ 55 billion annual business turnover when they merged.

Alan Lacy was the CEO of this combined entity in 2005, but in the end, Lampert, as president, pulled a lot of strings. You have here someone who has no experience operating a retail business, let alone one of the largest chains in the country. It was an interesting and very striking contrast there, in terms of this experience and what it led to. What you mentioned, in terms of their ability to predict and see that e-commerce would be important in the retail environment in the future, but not push the right way to continue in this way, for example, is to recount his experience and things in that sense.

In my mind, with the state of the stores, I thought it was one of the biggest mistakes of leadership in the first years following the transaction. They spent more than $ 6 billion between 2005 and 2011 on stock purchases. In the same years, Sears spent approximately $ 3.3 billion on capital expenditures that were reinvested in the company. This is a time when a large part of the business is changing and management is returning capital to its shareholders twice as fast as their investment in the company. It's hard to justify that kind of movement. It was a real headache for me.

Before I continue, I want to know your opinion, Adam. What do you think were the biggest mistakes Sears made after Lampert's arrival?

Levine-Weinberg: Perhaps the biggest mistake has been to skimp on some very basic store maintenance tasks. Lampert recently reported that it was planned to spend a few million dollars to improve the lighting of stores. He did not see the return on investment. In the short term, there may have been nothing to measure. But in the long run, when the stores look bad, people do not like the experience and do not come back. And reacquiring customers is extremely difficult. It was just a case of wise penny, silly pound.

The second thing was not using the opportunity to be one of the biggest retailers in the country to invest in e-commerce. The $ 6 billion spent on the share buyback, if it had been spent on short-term loss financing to support a very large e-commerce operation, what we could see today would be very different.

Shen: Sure. On the other hand, I'm curious if management was right, is there anything you would have said, but that was not enough to reverse the situation for society?

Levine-Weinberg: I would say that management was right in considering that Sears had a considerable number of valuable assets. This is partly why Lampert and several of his biggest allies have invested in the company. We saw in all real estate sold, other real estate and brands sold, that there was really a ton of value in Sears. The problem was that Lampert spent 10 years looking for a retail turnaround that never took place. And during this period, Sears spent only billions and billions of dollars of money, to the point that all these assets were sold, essentially to finance the current losses.

Shen: We will complete our discussion on Sears' part in history. This is a Chapter 11 bankruptcy. The company wants help to deal with its creditors. But Lampert hopes to get out of this procedure with a leaner and more nasty affair. He will retain the role of President, but will step down as CEO. A committee of three will replace him in this position. The company has identified about 400 stores that they believe are the best in its park. I'm curious, what do you think next? Are you optimistic that Sears will finally survive this process?

Levine-Weinberg: Many companies are able to move out of Chapter 11. They use the bankruptcy process to reduce their debts and other liabilities, may eventually obtain additional capital, and they are able to be born and they have a viable business in the long run. The problem for Sears is that the high level of debt was not the only problem in society, even if it had too much. The biggest problem was simply that she spent so much money over a period of several years, almost $ 2 billion a year. Although this is partly related to interest on debts and pension contributions that it will probably not have to pay, but partly to the closing of stores and losses related to that, I do not There is still no realistic way to spend $ 2 billion a year to break even, let alone profitability.

The fact that there are 400 allegedly profitable stores that Lampert wants to save does not necessarily mean that, collectively, they can be profitable. What I mean by that, is that each store can earn money between its four walls, but you must have a distribution infrastructure to support all these stores. If you want to maintain sales, even at the current level, not to mention their growth, you have to invest in marketing nationwide. It's extremely expensive, and Sears has been moving away from it for many years, resulting in a recent drop in sales.

So, I'm pretty skeptical. I would say that even though we went from 1,000 stores in early 2018 to about 700 stores now, that is, 400 stores by the end of the year, I am quite skeptical about the possibility of doing that. eliminate losses, except perhaps in the very short term. The only way to reduce costs to the level needed, as far as I know, at least, would be to keep marketing expenses close to zero. And if that happens, sales will continue to erode, as will profitability. Any improvement seen in 2019 would probably have disappeared by 2020.

Shen: In the end, here you have these two chains where same-store sales have declined 9.2%, 7.4% and 13.5% over the past three years. Many of the leading brands that Sears exclusively sold exclusively attracted many customers and were largely pledged. As you mentioned, Adam, the reputation of having these older stores, sometimes empty shelves with the way they handled inventory at very thin levels, a service that was no longer what it was – once you've allowed your brand, your image, to degrade to this kind of depression, I think you're going to have a hard time asserting that any portfolio, even the more efficient, will survive very long. This does not even include all the financial difficulties they also encounter.

Adam, despite Sears' recent bad business, you've talked about it earlier in the show, but the company has still generated more than $ 14 billion in revenue over the last 12 months. Of this amount, more than $ 11 billion was merchandise sales. The latter is subdivided into three categories: hardlines, soft clothing and clothing, and food and medicine. Hardlines is the biggest market with about 55% of last year's merchandise sales. This includes everything from home appliances to electronics, tools, sporting goods and toys. Clothing and household items accounted for about 32% of the merchandise turnover. Food and drugs accounted for the remaining 13%.

In this context, what are the biggest opportunities for competitors to come and break this business that Sears will leave open? And who is best placed to do it?

Levine-Weinberg: If we look at sales of food and medicine, we come back to the point where they are so low and are such a big category. I do not think that sales of less than $ 2 billion made by Sears last year have a significant impact as they are shared among dozens of other retailers. Even in the clothing and home sector, I see no impact on the movement of the needles. Again, it stood at $ 4.3 billion in 2017. Even before the bankruptcy, just based on the rate of decline in sales in the first half of 2018, it was about to fall to around $ 3 billion. This will also be divided between a fairly large number of companies.

The only exception, I would say, is JC Penney (NYSE: JCP), which is arguably Sears' closest competitor for department stores located in malls and aimed at middle-income consumers. I could certainly see JC Penney pick up a good portion of Sears sales in this department. Given that JC Penney is also a relatively small company compared to some of the giants with which the two companies compete, this could have a sufficient impact on JC Penney's sales to be perceptible.

That said, the biggest opportunities for competitors will really be in the extreme line categories where Sears was the strongest. The devices, the tools and the mattresses are particularly remarkable. Given these categories, Lowe & # 39; s (NYSE: LOW) It certainly looks like it could be the biggest winner here, especially at the pure volume level. First of all, Lowe's is the biggest home appliance salesman in the country. It should, of course, be able to get a very good share of sales of home appliances made by Sears. Even after all recent declines in sales, Sears remains the fourth largest home appliance retailer in the United States. In addition, Lowe started selling Craftsman tools earlier this year. Craftsman is a brand that for many years was exclusive to Sears Holdings and was sold only in a few locations other than Sears and Kmart. Ace Hardware is an example. Now available at Lowe's, one of the two largest home improvement retailers, this should really boost sales of the Craftsman brand. As people are less and less able to buy Craftsman tools at Sears, as Sears stores are shutting down, it is likely that more and more businesses of this type will go to Lowe's.

Home Depot (NYSE: HD) is obviously also likely to be a winner here. It is the second largest home appliance retailer in the country. It is also the biggest seller of tools. Even if Home Depot does not sell Craftsman yet, they could certainly start offering a Craftsman line in the near future. Even without Craftsman, they have a lot of other brands of tools that can potentially take market share in this area of ​​Sears.

Lowe's and Home Depot should also benefit from the lawn and garden. This is another area in which Sears has done a lot of work. There is a range of lawn mowers, snowblowers, etc. from Craftsman, that Lowe and Home Depot can, we hope, exploit.

Looking a little further down the list, Best buy (NYSE: BBY) Sears overtook Sears as the third largest appliance retailer in the US a year or two ago. Best Buy has clearly benefited from Sears' troubles. I expect it to continue. Best Buy also has an opportunity in electronics. Electronics has not been a big deal for Sears and Kmart recently, but they are making some sales there. Best Buy is really the category killer in this merchandise category right now.

As for JC Penney, JC Penney added an appliance business in 2016. They have had mixed success in this country. In the first two years or so, JC Penney created a significant company by JC Penney's standards. About 2% of the company's revenue came from home appliances at the end of last year. But this sales growth has stagnated in 2018. The company has just had a new CEO. Jill Soltau, the new CEO, will have to decide how much to invest to try to revive the growth of the devices. If JC Penney is willing to offer significant discounts and promotions to try to attract expired Sears customers, this could be another important growth area for JC Penney. But it is also possible that JC Penney will return to his roots, focusing more on clothing and household items.

Shen: Adam, I've read the article you published last week, in which you explain that the bankruptcy of Sears could be one of the best chances for JC Penney to add some dynamism to its recovery. You had a good point on how, of the approximately 200 Sears stores that were closed or were being closed, JC Penney had, I think, 150 locations in their own stores, basically in the same shopping center as Sears, or proximity.

For these anchor stores, another that comes to my mind is Macy & # 39; s (NYSE: M) – where they share a lot of real estate with Sears in malls, what do you think they're left after closing those stores?

Levine-Weinberg: It's a great question. In the short term, I think it's mixed. On the one hand, having a large empty docking area could potentially depress a bit the traffic in shopping malls. That said, Sears has done so poorly in recent years that I do not think it really drives much traffic to the mall. On the other hand, you suddenly lose a competitor. This should allow JC Penney and Macy's to secure a small market share in every shopping center and commercial area where Sears is closing.

In the longer term, I think the effect is much more positive. You see shopping center owners becoming very creative with respect to the reuse of space used by department stores that are closing, particularly by Sears. Much of this year's real estate is actually quite good. It's just that Sears did not have a good way to use it. If you're replacing a Sears store with a combination of, say, a movie theater, an entertainment center, restaurants, maybe a gym, these are all concepts that do not compete with department stores, in terms of what they sell. These are more service concepts. They will generate a lot more traffic to the mall than Sears. This could really help JC Penney and Macy's to attract more customers nearby. Once people are at the mall, they may go shopping in other stores.

Shen: D & # 39; AGREEMENT. We talked about Lowe's and Home Depot with Appliances, Best Buy with Appliances, effect in malls with these partner stores, Macy's and JC Penney. Do you think that, given the fallout from Sears, of all store closures, could you grab a piece of the pie in the void left by Sears and Kmart?

Levine-Weinberg: My choice of sleeper for the appliance sector is Costco (NASDAQ: COST). If you look only three years back, Costco has achieved annual appliance sales of $ 50 million. It was really not a major player at all. That rose 10X in 2018, a fiscal year that has just ended, according to Costco's chief financial officer. Costco now accounts for up to $ 500 million in household appliance sales a year. This is largely because appliance manufacturers have realized that Costco has this huge base of wealthy customers, a captive audience, and is looking for ways to increase their distribution. Some of their major appliance retailers, particularly Sears, are struggling. I do not expect Costco to go from $ 500 million to $ 5 billion in three years. But I would certainly expect that they will at least double their sales over the next two years if Sears continues to contract or even shut down completely.

As for other categories, mattresses are something we have not really talked about. I think Macy's could be really well placed to take over some of Sears' mattress business. It's already one of the largest mattress retailers in the country. Mattress cabinet, which is the largest mattress seller in the United States, recently went bankrupt. Thus, Mattress Firm will close up to 20% of its stores in the months and years to come. This could certainly create a market share opportunity for Macy's.

Shen: We still have a minute or two. I want to close this discussion. We discussed the benefits, the favorable winds, that this bankruptcy could have for some competitors. We also know that Lampert is closing all these stores, some already planned and others in the bankruptcy process. When these Sears and Kmart companies close their doors, many of them will hold liquidation sales, big promotions to eliminate any remaining stock. I am curious, given the time of year, since we are about a month away from Black Friday, we are entering the holiday shopping season – do you think this additional promotional activity of the Sears and Kmart balances the Closures could end up putting a brake on vacation quarters for companies like Lowe's, Best Buy, Macy's, JC Penney, just because of the timing of everything that's going on?

Levine-Weinberg: It's a great question. I do not think so. First, Sears recently struggled to get inventory. This is apparently one of the reasons he filed for bankruptcy. A large number of suppliers had stopped shipments to the company. It does not have as large a stock as many companies after filing for bankruptcy. In addition, I must add that, at present, the closure of 142 stores is scheduled for the end of the year. It's about a fifth of its total. The amount of play that it is actually doing is really quite small compared to the total amount of sales you will see in the United States during the holiday season, so I would be very surprised if it has an effect measurable on one of its competitors.

Shen: D & # 39; AGREEMENT. I'm sure it's something that, if there is an effect, especially in more localized areas with some competitors, that might be something that management teams bring in their own calls of income talk about their results for the holidays.

That wraps our show today. Adam, thank you very much for joining us!

Levine-Weinberg: Thank you for having me on the show!

Shen: Fools, thank you for connecting! People on the program may own companies reviewed on the show, and The Motley Fool may have formal recommendations for or against the stocks mentioned, so do not buy or sell anything solely based on what you hear during the program. Wrong!