Is Sears Holdings Corporation (SHLD) a Screaming Buy?

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Sears Holdings Corp (NASDAQ:SHLD)Sears Holdings Corporation (NASDAQ:SHLD) is one of those companies value investors scream “buy,” while the rest of us sit back and say, “hold on.” Why is the company’s short float at a staggering 10%? Is there something structurally wrong with the company?

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.

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