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We maintain our long term ‘Neutral’ recommendation on leading U.S. broad line retailer, Sears Holdings Corporation (SHLD - Analyst Report), as the company continues to narrow down year-over-year losses in every quarter since the beginning of fiscal 2012. However, we remain cautious regarding the company’s Kmart stores’ performances, which were significantly hit by Wal-Mart Inc. (WMT - Analyst Report) and dollar stores’ aggressive pricing and expansion strategies.

Sears Holdings is one of the largest broad line retailers in the U.S. The company operates a strong network of over 2,600 full-line and specialty stores across the U.S. and Canada to compete effectively against rivals, such as Wal-Mart and Target Corp. (TGT - Analyst Report). Furthermore, in order to boost customer footfall, the company is continuously taking prudent steps to improve its merchandise and realign its inventory with sales trend.

Sears Holdings reported third-quarter 2012 adjusted loss of $1.99 per share, narrower than the loss per share of $2.55 reported in the prior-year quarter. The robust bottom-line comparisons from last year resulted from the company’s ongoing cost reduction initiatives, which helped lower selling and administrative expenses during the quarter, offset by a decline in sales that pulled down gross profits. Additionally, the company has managed to effectively reduce merchandise inventory levels to $9.6 billion at the end of the quarter compared with $10.9 billion at the end of third-quarter 2011.

Revenue for the quarter decreased 5.8% to $8,857 million compared with $9,405 million in the prior-year quarter, driven by the reduction in the number of Kmart and Sears full-line stores in operation during the quarter as well as lower domestic comparable store sales.

Over a reasonable span of time, Sears Holdings has successfully revamped its organizational structure and operating model in an effort to simplify its business lines. The new structure is based on five business units - operating businesses, support, brands, online and real estate. Each unit operates separately to facilitate greater focus on profitability and rapid decision-making to capitalize on opportunities and mitigate risks. We believe that the company’s strategy of capitalizing on opportunities, while increasing profitability through its revamped organizational structure and new operating model, will boost its top and bottom lines.

Further, the cash-strapped Sears Holdings announced a string of measures to enhance its growth prospects by reducing investments in those sections, which no longer contribute significantly to its growth. These measures are mainly focused on optimizing the company’s financial performance.

As a major step in this direction, Sears Holdings completed the partial spin-off of 45% of Sears Canada’s common shares to the company’s shareholders on November 13, 2012. The company also successfully completed the separation of Sears Hometown and Outlet Stores Inc. on October 11, 2012, raising $446.5 million in gross proceeds.

Apart from this, the company has been focusing on cost containment, inventory management, and merchandise initiatives to improve margins through leveraging buying and occupancy expenses.

Though the above mentioned traits project an overwhelming picture of the company positioning itself for incremental future growth, we remain a little concerned about the performance of the company’s divisions – Kmart stores and Sears Canada. These divisions have been posting significant comps decline over the past few quarters. The business at Kmart stores have been severely hit by Wal-Mart and dollar stores’ aggressive pricing and expansion strategies as these players are significantly increasing their store count in the Kmart’s market.

Moreover, intense competition, macroeconomic issues and exposure to adverse foreign currency translations may undermine Sears’ future operating performance.

While our recommendation on Sears Holdings rides on the company’s improving earnings performance driven by its cost containment measures, weakness in Kmart and Sears Canada, threats of competition and foreign currency translation, keep us on the side lines. The company retains a Zacks #3 Rank, implying a short-term Hold rating. This is also consistent with our long-term Neutral view on the stock.

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