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Sears Holdings' Profit Keeps Plunging Despite Better Revenue Trends

Adam Levine-Weinberg, The Motley Fool

Sears Holdings (NASDAQ: SHLD) has been struggling for a decade, but it has taken a turn for the worse in the past few years. Despite efforts to close underperforming stores and drive customer traffic through a robust loyalty program, comparable store sales fell 7.4% in fiscal 2016 and plunged 15.3% in fiscal 2017. This has caused losses to spiral out of control, pushing Sears Holdings to the brink of bankruptcy.

On Thursday afternoon, Sears Holdings reported a dramatic improvement in its comp sales trend for the second quarter of fiscal 2018. Nevertheless, its profitability continued to deteriorate, providing further evidence that the company is in the midst of a death spiral.

The sales trend changes for the better

In the first quarter of fiscal 2018, Sears Holdings remained on last year's dreadful sales trajectory, with comp sales down 11.9% year over year.

By contrast, comp sales declined just 3.9% year over year in the second quarter, consisting of a 3.7% decline at Kmart and a 4% decline for the Sears chain. Furthermore, comp sales increased 3% year over year in July (the last month of the second fiscal quarter) and 2.5% in August (the first month of the third fiscal quarter). Total revenue still declined 26% year over year, though, due to the impact of hundreds of store closures over the past year.

The exterior of a Sears full-line store.

Store closures are driving big revenue declines at Sears Holdings. Image source: Sears.

Two months don't make a trend. Nevertheless, Sears Holdings' recent performance provides some hope that the company has finally closed most of its worst stores and is on a path to more stable comp sales results.

There's a catch

Unfortunately, while sales trends improved significantly last quarter, profitability went in the wrong direction. Sears Holdings' net loss more than doubled to $508 million from $250 million in the year-ago quarter.

Adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) -- which is management's preferred earnings metric -- moved further into negative territory, plunging to -$112 million from -$66 million in Q2 2017. While Sears Holdings has touted deep cost cuts, it hasn't been able to reduce expenses as fast as revenue has declined. In the second quarter, operating expenses increased modestly as a percentage of revenue.

Furthermore, gross margin declined to 22.1% from 22.7% a year earlier. For merchandise sales specifically (as opposed to non-merchandise revenue), gross margin fell to just 15.4% last quarter from 17.5% in the year-ago period.

Part of this decline was driven by efforts to clear out stale inventory. However, management also highlighted "an increase in our Shop Your Way promotional offerings" during the quarter. This suggests that Sears' improved sales trend may have been driven by discounting (in the form of more generous points offers) more than a real improvement in demand.

Liquidity improves -- but for how long?

Given that Sears Holdings' improved sales trend may have been driven by increased promotional activity, the only truly positive development in the second quarter was an improvement in its liquidity. At the end of the first quarter, the company had just $457 million of liquidity, including $186 million of cash and equivalents. By the end of last quarter, liquidity had increased to $941 million, including $193 million of cash and equivalents.

Indeed, Sears Holdings actually produced positive free cash flow of almost $100 million last quarter, after burning more than $1 billion in the first quarter of fiscal 2018. The second quarter tends to be a seasonally stronger quarter for Sears Holdings, and its cash flow was boosted last quarter by a $425 million payment from Citigroup related to extending its credit card deal. Asset sales and new debt financing also contributed to the liquidity improvement last quarter.

However, the third quarter tends to be seasonally weak in terms of earnings and cash flow. Last year, Sears Holdings' liquidity declined by $472 million between the end of the second quarter and the end of the third quarter.

This year, Sears Holdings' liquidity could be further pinched during the third quarter due to an upcoming debt maturity. Moreover, the company is already at risk of violating some of its debt covenants, which could trigger additional mandatory debt repayments.

Sears Holdings stock surged more than 20% in after-hours trading, presumably due to its improved sales trend. However, with losses growing and the balance sheet steadily deteriorating, investors should continue to steer clear of this failing company.

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Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.