Sears Holdings (NASDAQ: SHLD) reported a 3.9% decline in comparable store sales for the second quarter. That's not a good result by any means, but it is a vast improvement compared to recent quarters. During the fourth quarter of 2017, for example, comparable-store sales plunged 15.6%.
In July and August, Sears managed to post comparable store sales growth of 3% and 2.5%, respectively. It would seem that the strong consumer environment that has been buoying sales at retailers like Walmart and Target is benefiting Sears as well.
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While sales trends are improving for the retailer, its too little and far too late. Losses are exploding, gross margin is plunging, and the balance sheet is becoming increasingly precarious. The company is aggressively closing unprofitable stores, which is helping with its comparable numbers. But it's also underinvesting in its remaining stores, a strategy that's good for short-term cash preservation but terrible for long-term sustainability.
Sears had $4.95 billion in total debt and capital lease obligations at the end of the second quarter, up from $4.0 billion one year ago. That debt comes with quarterly interest to the tune of $188 million. In the second quarter, interest expense ate up 5.9% of sales and more than one-quarter of gross profit.
This debt explosion is happening while gross margin is in decline. Sears managed an overall gross margin of 22.1% in the second quarter, down 0.6 percentage points year over year. Merchandise gross margin, which exclude services, was just 15.4%, down nearly two percentage points. Total gross profit plunged 28% from the second quarter of last year, while interest payments shot up 53%. Sears' net loss was $508 million, twice as big compared to the prior-year period.
In other words, Sears doesn't sell nearly enough stuff to support its debt. And it isn't able to realize acceptable margins on the stuff it does sell. Even Walmart, known for its rock-bottom prices, operates on gross margins around 25%.
Even if Sears is able to consistently produce comparable sales growth going forward, the hole it finds itself in is deep. For the first six months of the year, Sears' free cash flow, excluding proceeds from asset sales, was a loss of more than $1 billion. Cash is streaming out the door.
A retailer that doesn't maintain its stores is a retailer that doesn't survive. Sears spent just $32 million on capital expenditures during the first half of 2018, spread across its 866 remaining stores.
To put that in perspective, J.C. Penney, another struggling department store, invested $221 million in its 860 stores during the first half of the year. Best Buy, with its 1,035 stores, spent $375 million on property and equipment in the first half.
Sears is spending so little partly because it can't afford to do anything else. There's simply no money available to maintain its stores. This underspending actually inflates Sears' free cash flow. If the company invested at a rate in line with its peers, it would be burning through cash even faster.
This neglect isn't new -- Sears has been underinvesting for years. The company spent $432 million on capital expenditures in 2011 when it had more than 4,000 stores -- that's about $110,000 per store. In 2017, Sears spent $80 million on capital expenditures, with an ending store count of about 1,000 stores. That's just $80,000 per store. For comparison, J.C. Penney's expected $375 million of capital spending for 2018 comes out to about $430,000 for each of its locations.
Years of underinvestment all but guarantees Sears' fate. There's just no coming back from this, no matter how much consumers loosen their purse strings.
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