Why Sears' first profit in 3 years doesn't matter

Like a scrappy boxer that keeps getting up no matter how many punches he takes, Sears on Monday defied critics when it said it would earn its first profit in three years during the second quarter.

Or did it?

The department store's shares fell nearly 8 percent after it issued a second-quarter performance update indicating it would report net income between $155 million and $205 million for the period ended Aug. 1, or $1.46 to $1.92 per diluted share.

How Sears got there, however, signals that the core business in its current state is unsustainable. Although the retailer was able to squeeze out $3 billion in proceeds from clever real estate transactions and the extension of a credit facility, its same-store sales plunged 10.6 percent for the quarter, highlighting just how troubled its Sears and Kmart stores remain.

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"I don't think [Sears' turning a profit is] very significant at all, particularly given the reason that they're actually turning a profit," said Ken Perkins, president of Retail Metrics.

"I don't really think it changes the story longer term at all in terms of the core business."

AP

A shopper at Sears

During the quarter, Sears closed on its anticipated real estate investment trust transaction with Seritage Growth Properties, through which Sears sold off 235 of its properties.

In addition to this deal, Sears struck up joint ventures with real estate firms General Growth Properties, Simon Property Group and Macerich, which apply to 31 additional properties.

Along with these moves, Sears executed an amendment and extension of a $3.275 billion domestic credit facility. As a result, the retailer said it expects that at the end of the quarter, it will have about $1.2 billion available under its domestic credit facility and $1.8 billion in cash. That compares to $200 million and $600 million a year ago, respectively.

"We have substantially enhanced our financial flexibility and achieved our objective of reducing our reliance on inventory as a source of financing," Sears said.

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The problem, however, is that performance at retail—which, in theory, should be the company's primary focus—continues to suffer. According to Retail Metrics data, Sears has not posted positive same-store sales results since first quarter 2010. Aside from that one reporting period, it hasn't happened in a decade.

Perkins said it looked as if the department store was starting to gain some traction at retail last year. In the third quarter, domestic same-store sales for its Sears and Kmart units fell just 0.1 percent. That followed a 0.8 percent decline in the second quarter, and a 1 percent drop in the first quarter.

In the fourth quarter, however, they slipped a more substantial 4.4 percent.

"Given the easy comparisons and the closures of underperforming stores..., which should make everything easier, they're still not able to generate a positive comp," Perkins said.

For its part, Sears said in its first-quarter earnings call that looking solely at its same-store sales does not provide the full picture.

"First, we are focused on restoring profitability to our Company and we have taken deliberate actions with respect to our promotional design and marketing spend in pursuit of this objective," the company said. "The result of these actions was that, in many categories, we saw an increase in profitability despite experiencing comparable store sales declines"

Standard & Poor's last month revised its liquidity assessment for Sears to "adequate" from "less than adequate," following the REIT transaction and the extension of its lending facility.

But the firm maintained its "negative" outlook on Sears, cautioning that although it "retains significant unencumbered real estate it can use to generate liquidity," it predicts "weak operating performance will persist."

"A turnaround depends on the company's progress with its integrated retail strategy to reverse the lack of profitability and substantial cash use," S&P said.

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In a separate note issued earlier in July, the ratings agency said that Sears had sufficient liquidity to fund losses from its retail business into at least late 2016. That analysis took into account the expected proceeds from the pending REIT transaction.

Although Perkins said it's essential for Sears to revamp its merchandise and stores to execute a real turnaround—two areas where it hasn't shown a willingness to invest—the extra cash it has on hand should quell any potential fears vendors might have about supplying Sears for the crucial holiday season.

Still, he cautioned, "Things are getting more and more competitive every day in retail."

"If they do these comps in Q3, Q4, that just is not going to be good for long-term viability."

Sears said it will report its results on or about Aug. 20.

Update: This story has been updated with additional comment from Sears