Sears is dying for completely understandable reasons

Sears is dying for completely understandable reasons
Courtesy Library of Congress

Sears is dying. And it’s happening for completely understandable reasons.

It’s managers are managing by the book. They’re doing exactly what you’d expect high-profile executives to do in this situation. Unfortunately, Sears is up against two forces that it almost certainly won’t be able to overcome: investor expectations and its self-identity.

Sears’ financial performance is on a decade-long downward trajectory

We learned last week that Sears sold its iconic Craftsman brand to Stanley Black & Decker for about $900 million. Zooming out a bit, Sears has lost about 50% of its stock price over the last year. In its most recent quarterly report, the company revealed two more data points that support a broader trend:

  1. Quarterly revenues fell over 12%, from $5,750 to $5,029 million.
  2. Quarterly losses grew 65%, from $454 to $758 million.

The next two bar charts show Sears’ struggles over the past decade. First, we can look at Sears’ annual revenue over the last 10 years. It’s easy to see the steady decline, in which 2015 revenue ($25.1 billion) was less than half of 2006 revenue ($53.0 billion).

Sears annual revenue, 2006 through 2015

Second, we can look at Sears’ net income over the last 10 years. The trend here is a little messier. We see net incomes near, or above, $1 billon from 2006 through 2009. Then we see considerable erosion from 2010 through 2012, with net incomes between $50 and $250 million. Then, we see a massive loss in 2013 of $3.1 billion, followed by a jump in 2014 to $0.9 billion, followed by another loss in 2015 of $1.0 billion.

Sears annual net income, 2006 through 2015

 

Finally, Sears CEO Eddie Lampert has given his company two loans in the past week. (It helps that Mr. Lampert is a billionaire, and is also CEO of a hedge fund. He’s able to throw a few bucks Sears’ way.) With the financial performance we saw in the charts above, I’m not surprised Sears has needed a few lifelines.

But why does Sears have to die?

It doesn’t. I’m certain that the best-performing Sears stores would make an attractive business. And that’s what Sears is trying to do. It’s trying to whittle its way down to a sustainably profitable business.

In fact, that’s exactly the recipe you’d find in business school. What do you do with an over-extended retail chain? You close the least profitable locations, and you cut fixed costs to match. You shrink the footprint of the business, until you arrive at the profitable core.

Great. So Sears is in good shape, right? Wrong. Let’s move along to the two forces I mentioned at the top of this post: investor expectations and Sears’ self-identity.

Companies seek outside investors to accelerate their growth

Why do companies go public? Because it’s a great way to capture the capital they need to grow. (There are tons of reasons businesses go public. For Silicon Valley startups, it might be to allow your private investors and employees to liquidate their ownership interests. But let’s focus on growth capital for a moment.)

Every business has to get its seed capital from somewhere. In the case of small mom and pop shops, it might be from the owners themselves. Or maybe the owners take out a loan at the community bank. Or maybe a wealthy family member is the source of funds.

There are tons of businesses that take surprisingly little money to get off the ground. And that’s great. There are two problems. First, there’s no guarantee the business succeeds. Whoever supplied the seed capital is at risk of losing everything. Second, even if the business does succeed, growth might be a long, slow grind.

If the business isn’t generating tons of cash flow, there won’t be much to reinvest in the business. You’ll have to be patient, letting the force of time work in your favor. That isn’t a problem, per se. But most people aren’t terribly patient, especially when it comes to business.

What can you do then? You can ask for more money. You can use that money to invest in your business. Open another retail location. Buy another piece of manufacturing equipment. Hire another engineer. You can use that money to attack the most limiting bottleneck you can find in your business.

Investors in publicly-traded stocks have unique expectations

If the point is to grow quickly, you need a lot of money. And you need a compelling story. You need to convince investors that money is the only thing holding you back from reaching breathtaking new heights.

The quickest way to access a large amount of capital is via the public markets. You don’t have to go pitch individual investors. You put your business on public display, and hope that with enough investor confidence, you’ll sell your shares at a high enough price to collect the capital you need.

Now, we get into an important difference between public and private ownership of companies. With publicly-traded companies, you often get to the point where your owners aren’t involved in the business at all. They didn’t help start the business. They didn’t consult with the executives about early strategy. They simply supplied capital with the expectation of earning an attractive return.

Yes, all investors are looking for a return on their invested capital. The difference with privately-owned companies is that owners typically have more than a financial stake in the business. They might have been a partner from the very beginning. They might have helped the executives make key hires that helped the business grow. They typically have a longer-term commitment to the business, something more than just a calendar quarter or two.

The owners of publicly-traded companies are looking for steady, predictable growth. They’re not interested in trading away near-term results to gamble on a longer-term payoff. They want a calm, quarter by quarter walk to better and better financial results. And that’s a huge problem for a dying retailer.

Why investor expectations are problematic for Sears

The problem for Sears is that the only path to viability is for them to shrink. That’s not what public investors want to hear. It’s not that you can’t shrink. It’s just that if you do shrink, you need to show incredible jumps in profitability.

When valuing a company, many investors are looking at forecasts of future cash flows. That’s ultimately what the investor is buying…a claim on future cash flows. It’s fine if you get smaller, but getting smaller needs to allow for even greater cash flows. In other words, you need to cut costs faster than you’re ceding revenue.

It’s easy, as a business academic, to say that Sears should drop its worst performing stores. It should keep the best performing ones, and eliminate various inefficiencies. Great. The problem is, given the state of the retail game, keeping only the healthy stores will make Sears a much smaller company.

That’s how you get to the headline for this ABC News article: “Sears and Macy’s Set to Close Hundreds of Stores Across the US”. And this isn’t the first time Sears has closed stores. Here’s a press release from last April announcing a wave of summer store closings. It’s a drip, drip, drip story.

Sears is trying to close absolutely as few stores as possible. The more stores it closes, the smaller its future cash flows will be. But if it keeps too many poorly performing stores open, it’s profitability will suffer. It’s stuck. There’s no realistic way it can be a flagship retailer and meet the expectations of its investors. That brings me to the second force that will overwhelm Sears: it’s self-identity.

Sears doesn’t see itself as anything but a flagship retailer

It’s hard to overstate the significance of Sears to American business culture. Over the last 100 years or so, Sears was probably one of five or so corporations that exemplified American business excellence. It had a dominant run through the middle of the 20th century. The strength of that success has carried them through decades of decline and multiple attempts at reinvention.

I’m not connected to Sears. I’ve never worked there. I’ve only shopped there a handful of times. I don’t know anyone who owes their livelihood to Sears. To me, it’s a dark, cold, dying behemoth.

But that’s not the case for people a generation or two older than me. Sears was THE retailer. It was the only place that most people bought most of their day to day stuff. It sold everything, at reasonable prices in conveniently located stores.

Further, I belong to a generation of people that are supremely comfortable with online shopping. Retail chains aren’t the focal point they once were with American consumers. That’s not something that surprises or saddens me.

It’s easy for me, then, to say that Sears should completely change its own game. I’m not invested in the current version of Sears. With little to no connection to its business, I can dream up all kinds of scenarios for how Sears might emerge from the land of the dead.

Imagine, though, that you’re a Sears executive. Imagine you speak with shareholders every day. They’re constantly on your case about steady, predictable cash flows. You know that some retail chains are still thriving (e.g. Walmart and Home Depot).

There’s enormous incentive to convince yourself that you’re one operating trick away from success. You just over-expanded. Once you rationalize your footprint, you’ll be in good shape again. Or you’re not carrying the right inventory. Or your web presence is too outdated and inconvenient.

The sale of the Craftsman brand landed hard with me

The reason I decided to write this post was Sears’ sale of the Craftsman brand. For whatever reason, in my head, I always imagined an alternative reality for Sears built around Craftsman. They’d give up on their dreams of returning to retail glory and focus on tools.

Craftsman is a highly visible, and highly respected, brand. Its products serve a space that’s having some success (home improvement). My thoughts were admittedly underdeveloped. But I thought if Sears was going to save itself, it would leave the retail game behind and focus on making high-quality products that you could buy from all kinds of retailers.

I know, Sears isn’t a hardware company. They’re a retailer. That’s their bread and butter. Why would they try to become a product company? Because as they are, they’re toast. Because they’re marching down a path to bankruptcy and liquidation. Because the Craftsman brand, specifically, is so highly regarded that you could build a small, lucrative business around it.

When Sears sold the Craftsman brand as a desperate attempt to raise more capital, I guess I knew they were committed to marching off the retail plank. They’ve ditched an asset they could have used to reinvent themselves.

I’m not surprised. In fact, it’s completely understandable. Sears is dying because investor expectations, and the way that Sears’ most influential employees see the company, align in that direction. Investors and executives don’t have an interest in making the enormous gamble of exiting retail to compete in a different way.

They’d rather a slow, methodical demise, rather than risking a fast, fiery one. And while I understand why it’s happening, it still makes me just a little sad.

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