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Sears profits on hedge fund tack

Date: Thursday, November 16, 2006
Author: Sandra Jones, Chicago Tribune

Big 3rd-quarter gains despite revenue drop.

Has billionaire investor Edward Lampert finally turned Sears Holdings Corp., one of the nation's oldest retailers, into a hedge fund?

Not quite.

But the prominent investor, who runs his own elite hedge fund in Greenwich, Conn., and is chairman of Hoffman Estates-based Sears, has taken a significant step in that direction.

The nation's largest department store chain generated half of its third-quarter profit on an investment maneuver popular among hedge funds called total return swaps—a derivative that allows an investor to make highly leveraged bets on financial instruments, including stocks.

"They're leaving the world of pure retailer," said Jerome Castellini, president CastleArk Management LLC, a Chicago-based investment firm with $2.1 billion in assets that include hedge fund portfolios. "These total return swaps are traditional hedge fund vehicles designed to get a return for far less capital."

Net income for the quarter ended Oct. 28 more than tripled to $196 million, or $1.27 a share. The increase included $101 million in total return swap income. The profit growth came as same-store sales, a key barometer of a retailer's health, dropped 3 percent. A pick up in apparel sales, helped by a shift away from an experiment with trendy clothing that fell flat with shoppers a year ago, wasn't enough to overcome steep declines in home fashion and lawn and garden goods.

Same-store sales fell 4.8 percent at Sears stores and declined just under 1 percent at Kmart stores, reflecting "increased competition and lower transaction volume," the company said.

Sears shares dropped 5.5 percent, to $169.26, in heavy trading, the biggest decline since August when Lampert first disclosed to investors in Sears' second-quarter earnings report that the company was investing its surplus cash in derivatives. At that time Sears had yet to give details on the types of derivative contracts it held.

Sears warned in its most recent earnings report, "These investments are highly concentrated and involve substantial risks." Sears spokesman Chris Brathwaite declined to comment beyond the report.

Derivatives are financial instruments that can be used to control risk or to speculate in hopes of making a big return. They are common in the hedge fund world but for the most part foreign to retailers.

"It's certainly unusual for a retailer to be using their funds this way, but he warned us," said Philip Zahn, a Chicago-based analyst at Fitch Ratings, a credit rating agency.

Lampert signaled to investors in Sears' second-quarter report that he could also use the extra cash to look for an acquisition outside the retail industry. Since then, speculation about what he would buy has included Home Depot Inc., Gap Inc., Anheuser-Busch Cos. and Safeway, fueling a 22 percent rise in Sears stock in the past three months to as high as $181.

Total return swaps allow Lampert to invest in stocks without having to disclose what he is buying. Like other big-name investors, including Warren Buffett, Lampert's investment moves are so closely watched that buying a stake in a company can almost guarantee that the firm's stock price will rise, making it more expensive for Lampert to build a position.

"The company made investments in derivative contracts that we believe effectively replicate investments in companies without disclosure requirements," wrote Gary Balter, a New York-based Credit Suisse analyst in a report on Thursday. Balter rates Sears an "outperform." Sears is an investment banking client of Credit Suisse.

Sears cash slipped to $2.1 billion at the end of October down from $4.4 billion in January. About $1.1 billion of that decrease reflects cash used to build up inventories for the holidays, particularly in apparel where business has been good.

Many investors like Sears more for its cash and Lampert's investment acumen than for its retail prospects. Indeed, holiday inventory expense is "higher than we would like to see which hurts the cash balance," Balter wrote. " ... We want that cash for other purposes."