The company’s recent earnings results were a mixed bag, but what should keep investors upbeat about the company is the cheap valuations and the enormous upside potential the company could have.
Earnings highlights
Sears Holdings Corporation (NASDAQ:SHLD) reported an 8.4% decline year-over-year in revenue. The decline in revenue was primarily attributable to the company closing stores. When there are fewer stores, there is less revenue. The company also reported a decline in its gross margin rate from 27.7% to 25.5%. The decline in the gross margin was driven by increased clearance markdowns and bad timing when it came to vendor allowances. Overall, the company had to clear a lot of its inventory when closing stores, which led to a lot of discounting.
The company’s financial condition seems to be stabilizing, though. It reported a loss of $279 million for the first quarter versus a $189 million profit from the year-ago period. The loss was tough, but had to be felt in order for the company to restructure its operations.
Investment thesis in Sears Holdings
The company has a negative 2.6% profit margin. If it were to cut costs and boost its profit margin to 5% while maintaining revenue at around $35 billion (currently the company has $39.8 billion in revenue), Sears Holdings Corporation (NASDAQ:SHLD) could generate $1.7 billion in profits for the full year (the company’s current market capitalization is $6.2 billion).
Sears Holdings Corporation (NASDAQ:SHLD) is focused heavily on cutting costs, and may at some point generate a profit margin in the 5% range. If the company were to do this, the stock could trade at a much higher valuation. It’s a matter of figuring out what to keep, and what to scrap.
Currently the company is sitting on top of an unconventional gold mine. Sears Holdings Corporation (NASDAQ:SHLD)’ chairman, Eddie Lampert, states that the company’s real estate portfolio is easily worth more than $20 billion. The company’s property portfolio includes approximately 250 million square feet (which is why Sears was able to borrow so much money to remain solvent; collateral goes a long way).
To put this in perspective, the company has more mall square footage than some of the largest mall owners like Simon Property Group, and Macerich. To be fair, both Simon Property Group and Macerich trade at higher earnings multiples when compared to Sears Holding because these two real estate operators tend to use a lot of leverage, which allows these companies to generate higher rates of return.
Nonetheless, it doesn’t change the fact that Sears Holdings is undervalued. GAAP accounting standards don’t report the fair market value of these properties, but rather the value of the property at acquisition less depreciation expenses. This is why Sears Holdings Corporation (NASDAQ:SHLD) reports a meager $25.89 in tangible book value per share (stock trades at $58.16 per share). The stock is undervalued, and assuming the company’s assets are worth $20 billion, the company’s current $6.2 billion market capitalization is a bargain.
Other opportunities in retail
While Sears Holdings Corporation (NASDAQ:SHLD) merits a much higher valuation, there are other companies in the space that have been able to grow earnings consistently.
These days, smaller retail stores like L Brands Inc (NYSE:LTD) and Abercrombie & Fitch Co. (NYSE:ANF) tend to outperform larger department stores like Sears. Smaller stores carry a lower risk, optimize profitability, are easier to expand, and are easier to close. Smaller retail stores are also better at target marketing and appeal to a specific demographic, which leads to higher sales per square feet.
L Brands Inc (NYSE:LTD) operates both Victoria’s Secret and Bath & Body Works. The company is heavily focused on expanding its brand internationally, returning cash to shareholders through share buybacks, along with store remodelings and expansion efforts. The company was able to grow earnings by 17% year-over-year in its most recent quarter. The growth in earnings was driven by effective cost management.
The favorable economic environment should help to boost L Brands Inc (NYSE:LTD)’ earnings toward the end of the year. Analysts anticipate the company to grow earnings by 7.5%. The low earnings growth is driven by capital expenditure spending, which will lower profitability for the full-year. Ignoring the spending for the year, the company still merits an investment. The company also offers a compelling 2.3% dividend yield.
Abercrombie & Fitch Co. (NYSE:ANF), a fashion retailer, similarly merits your attention. Unlike Sears Holdings, Abercrombie & Fitch Co. (NYSE:ANF) has been able to cut costs effectively and grow the business in fiscal year 2012. The company’s iconic preppy brand is being heavily built upon through international expansion. The company recently opened a flagship store in Singapore, and continues to focus heavily on opening its Hollister brand in Europe.
The company’s trailing 12-month growth is a staggering 82%, and it is likely to continue as analysts on a consensus basis anticipate the company to grow earnings by 16.7% on average over the next five-years. The company also comes with a 1.5% dividend yield at the time of writing.
The CEO Mike Jeffries’ commentary of selling products to only “cool” people recently brought media controversy that had negatively affected the company’s stock. Some even speculate that it was the CEO’s statement that led to the decline in the recent same-store sales performance year-over-year.
The company’s decline in revenue was attributable to the decline in inventory levels due to the strong winter sales season. The CEO stated in the latest quarterly earnings announcement that the decline in inventory accounted for 10% of the decline in comparable-store sales. Therefore, the 8.9% year-over-year decline in revenue will be addressed with stronger inventory levels in the following fiscal year.
Conclusion
I am highly optimistic about Sears Holdings Corporation (NASDAQ:SHLD). The company will continue to cut costs, sell real estate, and decrease its level of inventory. The effects will continue to hurt shareholders over the short term, but going into the holiday season, the company should be able to record some record profits per share. Assuming a positive holiday shopping season and continued cost cuts, the company will be on track to operate profitably again.
This is just one of those contrarian stories you can’t help but want to buy into. After all, Sears is a classic name. If you’re too classy for Sears, both L Brands Inc (NYSE:LTD) and Abercrombie & Fitch Co. (NYSE:ANF) should be in touch with your investment and fashion senses.
The article Is Sears a Screaming Buy? originally appeared on Fool.com.
Alexander is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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