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Friday, May 31, 2013 - 08:30

Insiders Are Snapping Up These Stocks -- Should You?

Friday, May 31, 2013 8:30 AM

There are many good reasons to look for stocks that the top hedge fund managers like. Activist managers such as Carl Icahn can shake a company up until shareholder value is unlocked. Warren Buffett's best ideas often have great long-term potential.

But some fund managers can actually destroy value for other shareholders.

During the past half decade, fund manager and Sears Holdings (Nasdaq: SHLD) CEO and Chairman Eddie Lampert has taken millions of dollars out of his investment in the faltering retailer through a series of one-time payments to his investment firm, ESL Investments. And while Lampert was giving himself robust paydays, he's virtually ignored the operational trends at Sears and Kmart, the company's two major retail divisions.

Those stores have fared so badly that Standard & Poor's kicked Sears out of its S&P 500 index last year, where Sears had been a fixture since 1957.

You can see Lampert's handiwork in one revealing measure. Sears Holdings generated a free cash flow loss of $311 million in fiscal 2011, $707 million in fiscal 2012 and $681 million in fiscal 2013. For most companies, that kind of performance would suggest that cash is fast disappearing and debt is quickly rising.

Yet Lampert has managed to keep creditors at bay by selling off profitable divisions and prized department store locations. In just the most recent fiscal year, Sears sold off $1.8 billion worth of assets -- good ones -- and the current cash balance still stands at only $471 million.

In Sears' fiscal first quarter, the effects of a shrinking store base showed the damage that Lampert has wrought.

"While these closed stores cost Sears 4% of topline, they reduced profits by 36%, implying some of the best stores are being sold," noted analysts at Credit Suisse.

Shares fell by more than 15% to around $50 upon the release of those earnings last week. And shares could have a lot further to fall before they find a bottom. Investors are scrambling to do the math, and in coming months you can expect to see fairly dim views about Sears' long-term prognosis. By the end of this summer, Sears may be viewed as an eventual bankruptcy candidate.

Let's do the math.

Sears missed first-quarter estimates by a wide margin, losing $1.29 a share, compared with a projected loss of 60 cents a share. It's bad enough that same-store sales fell 3.6% in the quarter from a year ago at a time when most other department store retailers are noting modest sales gains, but Sears' total sales fell 9%.

In the world of retail, falling sales can be quite corrosive as there is less revenue to spread over high fixed costs. And the company's lead buyers have a harder time securing the best pricing from suppliers if they aren't generating sufficiently robust volumes. This kind of negative operating leverage is only starting to play out for Sears.

Looking back over the past nine quarters, Sears has turned a profit just once -- in the fourth quarter of fiscal 2013, which ended in January. During those nine quarters, the retailer has lost a cumulative $3.5 billion. How did Sears post that lone quarterly profit?

"We generate a profit when we close stores and liquidate the merchandise. As such, the first quarter of last year benefited from the closed store activity, as these are profitable events for us," Lampert said on a call with analysts last week.

Sears' response to yet another loss in the first quarter of fiscal 2014? Lampert said last week that the company will likely need to sell its "extended protection" division. These protection plans tend to generate huge margins for Sears and losing this segment would actually deepen the operational losses in the core business. It's kind of like selling off the roof to save the house, which only leaves the house prone to the elements.

As noted earlier, Sears sold off $1.8 billion worth of assets in fiscal 2012, yet has just under $500 million in the bank today. Management noted that Sears has roughly $1.75 billion available on its credit line -- but neglected to mention that lenders require certain levels of cash flow be maintained; otherwise, those lenders have the option to shrink or close those credit lines.

If Lampert is counting on simply borrowing his way out of this mess -- when the company already has $3.7 billion in debt on its books -- he's mistaken.

In fact, those lenders that Lampert has come to increasingly rely upon are probably redigesting Sears' profit path for the years ahead after looking at just-released fiscal first-quarter results. Credit Suisse's Gary Balter now projects losses of $4.24 a share this year, $3.83 a share in fiscal 2015 and $3.77 a share in fiscal 2016, which works out to be more than $1.3 billion.

Balter now thinks this stock will fall to just $20, as "the volumes and productivity of the remaining stores point to margins staying weak or weakening." I share his view over the long term, though I expect shares to start moving in that direction only in the next three to four months.

This stock could move down to $35, a 30% decline from current prices, later this summer as major investors start to head for the exits in what appears to be a looming death spiral for this stock.

Action to Take -->
-- Short SHLD at $45 or above
-- Set stop-loss at $52
-- Set initial price target at $35 for a potential 22% gain in four months

This article was originally published at ProfitableTrading.com:
Looming Cash Crunch Could Cause This Retail Stock to Plummet 30%

P.S. -- Worried about another market crash? They appear to be more common than ever during the past 15 years. Here's how to know when the next one could strike...

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.