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Sears Holdings: The Pension Is Not the Problem

Adam Levine-Weinberg, The Motley Fool

Last Thursday, Sears Holdings (NASDAQ: SHLD) released another dreadful quarterly earnings report. While comparable-store sales dropped just 3.9% -- following several quarters of double-digit percentage declines -- profitability plunged again. Sears' net loss more than doubled to $508 million, while adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) fell to -$112 million from -$66 million a year earlier.

Sadly, the poor results may not have been the most disturbing news out of Sears Holdings last week. In conjunction with the earnings report, CEO Eddie Lampert posted a commentary on the company blog that blamed Sears Holdings' problems in large part on its pension liabilities.

While Sears Holdings has allocated billions of dollars to its pension plans over the past decade, this has been a minor annoyance rather than a major cause of the company's problems. The fact that Lampert seems to blame everyone but himself for Sears' problems is yet another warning sign for investors who put their trust in his leadership.

Bad financial choices

In his blog post, Lampert noted that Sears Holdings has contributed more than $4.5 billion to its pension plans since 2005. Low interest rates and changing mortality assumptions have increased pension costs relative to what Sears would have had to contribute otherwise.

The exterior of a Sears full-line store

Image source: Sears Holdings.

Lampert laments, "Had the Company been able to employ those billions of dollars in its operations, we would have been in a better position to compete with other large retail companies, many of which don't have large pension plans, and thus have not been required to allocate billions of dollars to these liabilities."

However, Sears Holdings could have spent far less shoring up its pension plan if it had made better financial decisions. The company's pension deficit was less than $1 billion at the end of 2007 and less than $2 billion even after the 2008 stock market crash. Sears Holdings could have gotten rid of its pension liability a decade ago for $2 billion or less by paying to transfer the liability to an insurance company.

Additionally, if Sears had contributed money to its pension plan earlier, it would have had more assets available to capitalize on the ongoing equity bull market. Macy's (NYSE: M) is another major retailer with a substantial pension plan, but it hasn't needed to make contributions in recent years, because its pension has been well funded. (Sears' pension funds were also hurt by subpar investment returns in 2014 and 2015, both on an absolute basis and relative to Macy's.)

How much money is $4.5 billion, anyway?

Thus, Lampert himself deserves some of the blame for Sears' need to spend over $4.5 billion on pension funding. But in any case, this was not as much of a calamity as he would make it appear.

Spread over 13 years, $4.5 billion of contributions would amount to around $350 million per year. For comparison, in the immediate aftermath of the 2005 Sears-Kmart merger, the combined company generated more than $50 billion of revenue annually. (That total has since plunged to $14 billion due to spinoffs, comp sales declines, and wave after wave of store closures.)

SHLD Revenue (TTM) Chart

Sears Holdings TTM Revenue, data by YCharts. TTM = trailing 12 months.

In other words, the pension burden should have been easily manageable. The real problem has been Sears Holdings' dreadful profitability in recent years. This can be traced to management's failed strategy to transform Sears into a "member-centric" retailer that wouldn't have to spend much on traditional advertising or renovations to keep stores in state-of-the-art condition.

Furthermore, lower pension contributions wouldn't have necessarily paved the way for higher investments in the business. Indeed, Sears Holdings spent more than $5 billion on share repurchases between 2005 and 2010. That included $2.9 billion spent on buybacks in fiscal 2007 at an average price of $134.65, more than 100 times Sears Holdings' current stock price.

SHLD Stock Buyback (Annual) Chart

Sears Holdings Annual Stock Buybacks vs. Share Price, data by YCharts.

Macy's capital allocation strategy hasn't been ideal, either. But at least Macy's has prioritized investing in its stores and technology capabilities above share buybacks. Capex has averaged about 3% of revenue over the past decade -- and that figure doesn't fully account for Macy's spending on software.

By contrast, even a decade ago -- when Sears Holdings was generating positive free cash flow and spending plenty of money on share buybacks -- the company was investing no more than 1% of its revenue on capex. That has since fallen to a small fraction of 1% as Sears has cut spending to the bone to preserve cash.

SHLD CAPEX to Revenue (Annual) Chart

Sears Holdings CAPEX to Revenue (Annual), data by YCharts.

Sears Holdings is spinning out of control

Some investors may see Lampert's blog post as an example of misleading but harmless corporate spin. However, as the primary architect of the company's strategy over the past decade and a half, Lampert should accept most of the blame for Sears Holdings' current problems.

Also, this isn't the only example of Lampert being out of touch with reality. On multiple occasions over the past year, he expressed a commitment to returning Sears Holdings to positive EBITDA this year, up from -$562 million in fiscal 2017. Instead, adjusted EBITDA deteriorated to -$337 million in the first half of fiscal 2018, compared to -$286 million in the year-ago period.

Sears Holdings consistently burns more than $1 billion of cash annually and is running low on assets that can be sold to fund its losses. Meanwhile, it has billions of dollars of debt maturing between now and July 2020. In short, the company is on a path that will almost inevitably end in bankruptcy within a couple of years. A lower pension burden wouldn't have saved Sears. At most, it would have dragged out the company's slow death by a few more years.

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