A Retail Turnaround? Don’t Bet on These Two Fallen Angels

retail-turnaroundI’m a contrarian value investor at heart.  My curiosity is more aroused by the stock that plunges 50% than the one that surges 50%.  I love trolling the bargain bins.
That said, I troll carefully. Some sectors tend to produce damaged goods that are even too dinged and dented for my liking.  Through experience, I’ve learned to avoid betting on a turnaround in an airline (most of the major airlines have been bankrupt at least once), a sit-down casual restaurant, a niche software developer. Once dinged and dented, no amount of putty and burnishing restores the luster.
I also generally avoid retail turnarounds. I’ve been asked a few times for my opinion on J.C. Penney (NYSE: JCP) and Sears Holdings (NASDAQ: SHLD).  I understand a contrarian’s interest. J.C. Penney’s share price is down 85% in the past two years; Sears’ share price is down 55%. Both are iconic retail names whose history can be measured in centuries.
Contrarian interest is further piqued because of celebrity-investor interest. George Soros owns a 6.6% stake in Penney. Sears is run by investor Edward Lampert, who owns 25 million shares, nearly 25% of the retailer’s outstanding shares.
I’m still not on board.  In 2007, Penney recorded $19.9 billion in revenue. That same year, Sears recorded $53 billion.  Over the trailing 12 months, Penney recorded $11.9 billion in revenue; Sears recorded $37.6 billion.  Each successive year brings in fewer dollars.
But what about the iconic names? Everyone is familiar with J.C. Penney and Sears.
Fair enough, but at one time everyone was familiar with W.T. Grant, Caldor, Woolworth, Foley’s, Service Merchandise, and Montgomery Ward.  A recognizable retailing brand simply doesn’t ensure a high level of customer loyalty. Should a retailer fail to anticipate consumer trends or to price competitively, consumers have no qualms about patronizing the competition.
A turnaround is further hindered by plentiful, fierce competition. The retail sector is easy to enter, and many do. Within a five-mile radius of most suburban homes, a consumer will find a plethora of retail outlet to satisfy nearly all his needs.
Plentiful, fierce competition means retailers must continually evolve.  Older retailers like Penney and Sears are rarely thought leaders, and hence always behind the evolutionary curve.
Retailing also allows any investor to easily kick the tires. When I walk into Sears, I see an antiquated retailing concept. When I walk into Sears’ subsidiary K-Mart, I see dilapidation.  J.C. Penney, to me, is a poor imitation of Kohl’s (NYSE: KSS).
Time is another obstacle. Even if energetic, progressive managers take the reins, time works against them. Customers are quick to leave, but slow to return. And when customers are quick to leave, vendors are usually quick to demand more immediate payment terms.
Fewer dollars flowing in and more dollars flowing out is a forbidding combination. Returning to 2007, Sears generated $1.4 billion in cash flow from operations. Over the trailing 12 months, Sears’ operations generated a negative $694 million. Penney offers a similar cash-burning tale: Operating cash flows were a positive $1.3 billion in 2007 and a negative $1.6 billion over the trailing 12 months.
When a retailer hemorrhages cash, the ensuing bloodbath frequently leads to irreparably damaged goods. In my opinion, J.C. Penney and Sears are irreparably damaged.

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