JULY 24, 2003 BusinessWeek online



JULY 24, 2003 BusinessWeek online

STREET WISE

By Robert Berner

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|The Struggle in Store for Sears |

|Selling the credit-card division has lifted the stock and bought time for tackling the retailer's biggest woe: Sales that keep |

|on shrinking |

With the July 15 sale of Sears Roebuck's credit-card business to Citigroup (C ) for $3 million, CEO Alan Lacy bought the struggling retailer some much-needed time and wowed Wall Street, which hadn't expected the operation to fetch anywhere near that price. Now, as Lacy focuses on turning around the outfit's ailing retail unit, the extent of investors' patience remains to be seen.

Just two days after the deal was struck, the news out of the venerable retailer's Hoffman Estates (Ill.) headquarters was sobering: Sears (S ) was reporting a 31% decline in second-quarter profits (excluding one-time gains) and lowering guidance for the year. That announcement underscored the hurdles Lacy must overcome, since falling profits at Sears' retail operations were to blame for the decline. "I don't see signs" of a turnaround, says Dreyfus retail analyst Elaine Rees.

Investors are giving Lacy the benefit of the doubt, at least for now. And the Street clearly found much to cheer in the price Lacy received for the credit business, which has struggled with rising charge-offs since last fall. Since the announcement of the Citigroup deal, expected to close by yearend, Sears' stock has risen by 14%, closing at $40 on July 23.

SWEET PLUSES.  The $3 billion Citigroup is paying for the credit unit, equal to a little more than 10% of the $29 billion in receivables, nearly double analysts' expectations. In addition, disposing the division will free another $3 billion that Sears had dedicated as a reserve on its balance sheet to cover losses on bad credit-card debt. All told, the sale creates $6 billion in pretax proceeds, or $4.5 billion aftertax.

Making the deal sweeter, Sears estimates it will receive $200 million annually from Citigroup in performance payments for opening new accounts and generating sales paid for with those in-house credit cards. Nor will Citigroup charge Sears for short-term, 0% finance offers. That will save Sears' retail operation approximately $200 million annually, since the credit division now charges the retail unit for those consumer promotions and incentives. Combined, the performance payments and finance savings will net retail operations at least $260 million annually after taxes, predicts Joseph Grabowski, an analyst at Strong Capital Management.

That certainly gives Lacy some room to maneuver, Grabowski adds, even if retail profits continue to be sluggish in 2004. He sees Sears' store business posting net income in 2003 of $630 million, which would be flat with 2002. But even if next year's retail profits don't rise, the performance payments and finance savings would boost Sears' net closer to $900 million. Meanwhile, analysts say it's almost certain that Sears will use the bulk of the $4.5 billion proceeds from the sale to buy back stock.

RECOVERY POSTPONED.  Sears spent a mammoth $1 billion on its own shares in the second quarter -- acquiring 11% of those outstanding -- and its board has just authorized another $1 billion buyback. Reducing the number of outstanding shares will put additional lift under the stock and is likely to accelerate earnings-per-share (EPS) growth. Says Grabowski: "I could see Sears' stock trading at $50 in the first couple months of [2004]."

Other analysts are more dubious, questioning why investors would want to reward earnings growth that doesn't stem from increased sales. For each of the past 22 months, same-store sales (those at locations open for at least a year) have declined -- and they have done so despite all efforts to stop the bleeding, such as Sears' acquisition in 2003 of apparel catalog outfit Lands' End. Plus, the retailer has continued pushing back its forecast for when same-store sales will turn positive, with the latest estimate being before yearend.

Further highlighting the importance of reviving sales growth: The performance payments and finance savings will provide a once-only boost to annual earnings, and they'll be built into all comparisons made in subsequent years. In the past, Sears could often count on credit income as a hedge against weak retail profits, as was the case in 2000 and 2001. With that option gone, investors "will be forced to pay more attention to the retail operations," notes Gimme Credit analyst Carol Levenson in a report.

SCANT INFO.  Sears hasn't demonstrated much reason for them to be optimistic. It's losing market share in its appliance business, the retailer's biggest generator of sales and profits. Sears has long been the market leader in that category, but home-improvement retailers Lowe's (LOW ) and Home Depot (HD ) are cutting into that lead, thanks to more convenient locations and easier-to-shop stores. In this year's first quarter, according to research outfit Stevenson Co., Sears' appliance market share fell by 3.2 percentage points, to 38.6%, vs. the same period a year ago.

And despite the introduction of the Lands' End label in 400 of Sears' 870 outlets, same-store apparel sales overall are still down. In its second-quarter conference call, Sears said such sales were between 2 percentage points and 4 percentage points better at stores with Lands' End clothing. But with the scant information Sears has provided on Lands' End, it's hard to analyze whether the improvement is due largely to the higher prices being charged for the brand, notes Levenson. However, the conference call did make clear that the higher gross profit margin Sears is earning on Lands' End is being more than offset by the higher expenses associated with selling the brand.

Furthermore, some analysts contend that Sears' sale of its credit business could ultimately hurt retail revenues. That's because its ability to offer credit to consumers has been integral to boosting sales. In 2002, 44% of total sales were on Sears' plastic -- and the figure was even higher for appliances. Richard Church, managing director of hedge fund Shumway Capital Partners, argues that Citigroup will be focusing on its profits rather than driving Sears' sales -- a contention the retailer staunchly denies.

MINDING THE STORE.  Rivals Lowe's has echoed Church's argument to major investors, contending that Sears' control of its own credit business was the last major strategic advantage it enjoyed in the appliance business, according to one major institutional investor, who declined to be named. Predicts Church: "It will take some time, but Sears will be hurt by this."

Thomas Bergmann, vice-president for finance at Sears, counters that the Citigroup deal will have the opposite effect. His argument: As one of the nation's largest credit-card companies, Citigroup has greater risk-management skills, a wider selection of credit products to offer, and lower costs of funds. All these factors could indirectly spur sales at Sears.

Whatever the case, CEO Lacy insists that the sale is in Sears' best interests because it will put the emphasis on turning around the retail business, an argument some analysts endorse. It also will make the stock -- which trades at a price-earnings ratio of 7, well below the department-store average of 11 to 12 -- a pure retail play. That also could help lift the multiple.

WATCHING CLOSELY.  Lacy is making a big gamble that he can turn around the retail business, a goal that has eluded Sears' management for years. His maneuvers to cut costs in the retail business are running out of steam, no longer able to hold up profits in the face of falling same-store sales. Short term, the aggressive buyback of Sears' shares will certainly increase earnings per share, as will the payments and savings associated with the Citigroup transaction.

But the smart money will be watching the retailer's top line. Excuses are in short supply -- and Lacy has little time left to deliver the goods.

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Berner covers retailing and the markets from BusinessWeek's Chicago bureau

Edited by Beth Belton

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