How Sears Holdings makes money with declining sales

Thanks to some financial engineering, Sears Holdings overcame a double digit decline in same store sales to produce a second quarter profit or a less severe loss depending on the arithmetic used.

Making sense of Sears Holding financial performance is an exercise quite unlike any other retailer thanks to the company’s extensive financial maneuvers, real estate transactions and reporting of adjusted results. The moves, undertaken to transform a traditional, store-network based retail business model to something Sears Holdings calls “a more asset-light, member-centric integrated retailer leveraging our Shop Your Way platform,” obscures the underlying performance of the business.

There’s no hiding the fact that same store sales declined 14% at domestic Sears stores and 7.3% at Kmart stores for a blended decline of 10.8% during the second quarter ended Aug. 1. Put another way, shoppers in the United States spent $584 million less at Sears and Kmart stores that had been open at least a year in the second quarter than they did during the second quarter the prior year. That’s a big number and it seems clear that a portion of those dollars in the case of Sears went to the like of Home Depot and Lowe’s where comps at domestic stores increased 5.7% and 4.6%, respectively, and in the case of Kmart, Walmart and Target, where comps increased 1.5% and 2.4%, respectively.

Including the more than half a billion dollar impact of the comp decline, Sears Holdings total revenue declined by $1.8 billion to $6.2 billion during the quarter due to actions taken last year as part of its seemingly endless transformation. There was a $780 million negative impact because Sears Canada results are no longer included in Sears Holdings results and the closing of Sears and Kmart stores added $386 million to the decline. Kmart operated 963 stores and the end of the quarter, compared to 1,077 the prior year, while there were 739 Sears stores in operation, compared to 793 the prior year.

The company would have investors believe the sales declines are part of a master plan that involved an emphasis on highly targeted marketing dollars focused on member of its Shop Your Way loyalty program that accounted for 74% of sales. The shift benefit gross margins rates. Even so, declining categories outpaced gaining categories. For example, at Kmart, same store sales increased in the home appliances and toys categories, but were offset by declines in consumer electronics, grocery and household, apparel and drugstore categories. If the consumer electronics business is excluded, something the company does because it is moving away from the low margin business, the comp decline isn’t quite as bad at a negative 5.4%.

Sears domestic business was also negatively impacted by the consumer electronics category, but only marginally so. Excluding consumer electronics the comp figure improve to “only” a 12.5% decline. Other areas of decline were home appliances, apparel, lawn and garden and Sears Auto Centers. The one bright spot was the mattresses category.

Despite the steep decline in sales, Sears Holdings Chairman and CEO Edward Lampert hailed the quarter as a victory and indication the company, whose share price is near an all-time low, is making progress.

“The second quarter marked our fourth consecutive quarter of improved results,” Lampert said. “During the quarter we completed many of the objectives we laid out to transform Holdings from a traditional, store-network based retail business model to a more asset-light, member-centric integrated retailer leveraging our Shop Your Way platform. The successful completion of these actions has positioned Sears Holdings for long-term success and is consistent with our strategy to focus on our best stores, reward our best members and pursue our best categories as part of our transformation.”

The improvement Lampert referenced is a $200 million adjusted operating loss that is less severe than a $298 million operating loss reported the prior year. When the company doesn’t adjust its financial results and includes several non-recurring benefits, the bottom line profit increase looks downright remarkable. For example, net income increased to $208 million, or $1.84 a share, compared to a staggering second quarter loss the prior year of $573 million, or $5.39 a share. When adjusted to exclude gains from a major real estate deal, Sears Holdings reported a net loss of $256 milllion, or $2.40 a share, that was less worse than a prior year net loss of $293 million, or $2.76 a share.

A lot of retailers report financial results on an adjusted basis to provide a comparable view of the performance of continuing operations. Doing so strips out non-recurring revenues and expenses related to actions such as a closing a large group of stores, selling off a division or a major restructuring. Sears Holdings has elevated the practice of reporting adjusted results to a new level by offering four sets of numbers.

In addition to reporting results that adhere to generally accepted accounting principles, or GAAP, Sears Holdings provides adjusted earnings before interest, taxes, depreciation and amortization (adjusted EBITDA), domestic adjusted EBITDA, domestic adjusted EBITDA excluding Seritage/JV rent and adjusted earnings per share.

The reason for doing so stems from major restructuring actions taken last year, such as divesting ownership of Sears Canada, Land’s End and closing stores, and more recently the establishment of a real estate investment trust to acquire stores and then lease them back to the company.

"In the second quarter of 2015, the company completed its rights offering and sale-leaseback transaction with Seritage Growth Properties and received aggregate gross proceeds from the transaction of $2.7 billion,” explained Rob Schriesheim, Sears Holdings. CFO. “In addition, we completed an amendment and extension of the company's existing asset-based credit facility. With the successful completion of the amendment and extension of the domestic credit facility and the Seritage transaction, we have substantially enhanced our financial flexibility and achieved our objective of reducing our reliance on inventory as a source of financing.”

In addition to the Seritage deal, which provided a $508 million benefit during the second quarter, the company also amended a $3.275 billion domestic credit facility so that $2 billion matures in 2020 and with the remaining approximately $1.3 billion in place until April 2016.

“We intend to continue taking significant actions to alter our capital structure, as circumstances allow, to position Sears Holdings for success and profitability, which could include further reductions in debt or changes in the composition of our debt,” Schriesheim said.

The company contends the moves give it the financial flexibility to execute its transformation. However, sooner or later, as fewer financial rabbits are available for extraction from the Sears Holding hat, the company will need to make money the way other retailers do – by selling stuff to consumers.