* "We know we still have a lot of work to do," CEO Lampert says
* Kmart same-store sales drop 3.7 percent
* Total costs fall more sharply than sales; net loss narrows
* Shares down 5.6 percent
By Dhanya Skariachan
Feb 28 (Reuters) - Retailer Sears Holdings Corp reported a higher-than-expected quarterly profit that stemmed mainly from cost cuts, doing little to boost Wall Street's faith in its turnaround and sending its shares down as much as 7 percent on Thursday.
The stakes were high this holiday season for the operator of Sears department stores and the Kmart discount chain. Many on Wall Street were looking at the quarter as a key gauge of progress of the turnaround at the company, which is controlled by hedge fund manager Edward Lampert.
Sears Holdings' sales have fallen every year since 2005, when Lampert merged the Kmart and Sears Roebuck and Co chains in an $11 billion deal.
However, the company has boosted results in recent quarters by closing stores and managing inventory. It has also sold real estate and other assets to pay down debt.
"They live kind of hand-to-mouth," said analyst Evan Mann of independent corporate bond research firm Gimme Credit. "But I don't really see a long-term plan to make them a relevant retailer."
As of Feb. 2, the company had cash balances of $618 million, down from $754 million on Jan. 28, 2012.
On Thursday, Sears reiterated its expectation to generate at least $500 million of liquidity by selling assets over the next 12 months, without specifying what those might be.
The earnings release came just weeks after Chairman and largest shareholder Lampert took over as chief executive after Louis D'Ambrosio left because of a family member's health issue.
Some on Wall Street saw D'Ambrosio's departure adding to Sears' risks, and worried about Lampert's lack of merchandising experience at a time when the retailer was trying to turn around its core Sears and Kmart chains.
"The fact is that they don't have strong leadership that can execute," said Mary Ross Gilbert, managing director of investment bank Imperial Capital LLC. "If you look at the businesses and the execution of the businesses, it's poor, and that hasn't changed."
Lampert, who has faced criticism in the past for not investing enough in stores, defended his strategy on Thursday. "Observers have mistakenly concluded that our issues were primarily related to underinvesting in our stores," he said.
Instead, Lampert tied the company's problems to the changing habits of shoppers, who are increasingly buying their goods online or using their mobile phones to make purchases.
Still, he promised to invest in in-store technology, online business and Sears' loyalty program, in sync with a blueprint he laid out last May to boost results.
"We know we still have a lot of work to do," he told investors in a letter made public in a regulatory filing. "It will not be easy at times, but we will take bold actions to get through it."
But Mann dismissed a lot of Lampert's comments as "boilerplate stuff they have been saying for the longest time" and wondered if the hedge fund manager was the right person to head the retailer.
"He has proven himself to be a very clever financial engineer," Mann said. "But at the end of the day, all the real successful retailers tend to be run by savvy well-known merchants with a fashion background. He doesn't have that."
U.S. sales at stores open at least a year fell 1.6 percent, including a 3.7 percent decline at Kmart that was mostly due to tepid demand for electronic goods.
Same-stores sales rose 0.8 percent at the Sears Domestic unit, helped by demand for apparel.
Rival J.C. Penney Co Inc's woes have helped Sears as the two chains are neighbors in most malls, analysts have said. Penney's sales at stores open at least a year fell 31.7 percent in the latest quarter.
Another competitor, Kohl's Corp, reported a lower quarterly profit on Thursday, hurt by markdowns during the holiday season. It forecast full-year earnings that fell short of Wall Street expectations.
Sears Holdings, home to the iconic Craftsman tool and Kenmore appliance brands, also faces cut-throat competition from the likes of Home Depot Inc, Lowe's Cos Inc, Wal-Mart Stores Inc, Target Corp, Best Buy Co Inc and Macy's Inc.
The company's net loss narrowed to $489 million, or $4.61 a share, in the fourth quarter ended on Feb. 2 from $2.4 billion, or $22.47 a share, a year earlier.
Excluding pension settlements, severance costs, impairment charges and other items, earnings were $1.12 a share. Analysts on average were expecting 98 cents, according to Thomson Reuters I/B/E/S.
Costs fell 2.2 percent to $12.88 billion in the quarter. Sales declined about 1.8 percent to $12.26 billion, but beat the analysts' average estimate of $11.77 billion.
Sears spun off its Orchard Supply Hardware Stores unit in December 2011. Last year, it announced plans to sell some prime real estate and spin off its Sears Hometown and Outlet businesses and certain hardware stores.
In November, the company trimmed its stake in its Sears Canada Inc unit from about 95 percent to 51 percent, distributing the stock to Sears Holdings shareholders.
Earlier this week, Sears Canada reported a revenue decline for the 16th straight quarter. Analysts expect Target's push in Canada to hurt that business.
Shares of Sears Holdings were down 5.6 percent at $44.82 in afternoon trading after falling as low as $44.20 earlier in the session.