Saving Sears Doesn’t Look Easy Anymore

Date: Monday, January 28, 2008
Author: Gretchen Morgenson, NYTimes.com

This article was reported by Gretchen Morgenson, Michael Barbaro and Geraldine Fabrikant and written by Ms. Morgenson.

BY all accounts, Edward S. Lampert, the billionaire hedge fund manager whose investment savvy earned him renown as “the next Warren Buffett,” is a man not accustomed to rebukes.

But that is precisely what the stock market delivered in mid-January as Sears Holdings, the Kmart and Sears combination engineered by Mr. Lampert in 2005 and his hedge fund’s biggest holding, sank to $86.02 a share. It was a level last seen three years ago, just after the ballyhooed merger was announced, and far below the stock’s peak of $193 in April 2007. In the course of nine months, $14 billion in market value had evaporated.

So it was perhaps not surprising that last week Sears Holdings announced a revamping plan that would divide the company into five units to “simplify the way its business lines are managed.” Although details were scant, the stock rallied 13 percent on the news. It ended the week at $99 a share.

The announcement may also have been timed to precede Mr. Lampert’s annual meeting with his hedge fund investors, scheduled for late next month in New York. After all, investors in his ESL Investments fund saw their holdings fall 26 percent last year. Although it was only the second down year for him since he started his hedge fund in 1988, some of his investors privately acknowledge that they are worried. At 48 percent of the shares outstanding, Mr. Lampert’s stake in Sears is the biggest in his fund, a portfolio recently estimated to be worth $11.5 billion.

Has Mr. Lampert lost his Midas touch? His woes, unlike those of most other investment managers, cannot be attributed solely to market turbulence and wrong-way bets that may soon right themselves. Much of the loss absorbed by his investors last year was a direct result of his hands-on management at Sears Holdings.

Since combining the two retailers, Mr. Lampert, 45, has raised prices even as he has cut capital spending and marketing budgets. The dearth of investment shows up in stores, many of which look shabby next to those of rivals like Target and J. C. Penney. Mr. Lampert’s major use of cash has been to buy back Sears Holdings’ shares.

And in 2008 he faces three problems that were only partly evident last year: belt-tightening by consumers, a falling housing market and a possible recession. “Sears is woefully unprepared to handle this kind of consumer spending slowdown,” said Bill Dreher, an analyst at Deutsche Bank Securities. “The underinvestment in stores has hurt sales, hurt customer good will and will hurt their long-term competitiveness.”

Mr. Lampert, through a spokesman, declined to be interviewed for this article. But a handful of his hedge fund investors, several retailing analysts and a host of people who have worked alongside Mr. Lampert over the years spoke about his operations and results, although some asked not to be identified in order to preserve business relationships with Mr. Lampert.

Just a year ago, shares of Sears Holdings were marching to their all-time high. Other big positions amassed by Mr. Lampert — in Autonation, a car dealership chain, and in Autozone, a car parts retailer — were firing on all cylinders.

Now they’re stalled or moving in reverse. While shares of Autozone rose 3.7 percent last year, Autonation stock ended 2007 down 27 percent. Last spring, Mr. Lampert made another big bet, on shares of Citigroup, which are also down significantly. Some analysts say Mr. Lampert’s misfires at Sears and Kmart may reflect his earlier success at Autozone, where he used the same cost-cutting strategy and generated enviable profit increases. But selling windshield wiper blades and brake hose plugs to do-it-yourself auto enthusiasts is different from creating an inviting shopping experience for home furnishings, jewelry or clothing.

The announcement last week that Sears would simplify its business units did not impress Carol Levenson, a credit analyst at Gimme Credit, an independent research firm in Chicago.

“We just can’t avoid the cliché ‘rearranging the deck chairs on the Titanic’ when considering the proposed new operating structure for Sears,” she wrote in a note to clients. “The goal of making the merged Kmart and Sears into a retailing success has become increasingly less achievable, as same-store sales plunge and excuses abound.”

The stock’s collapse last year — down 40 percent — reflects deteriorating operations at both Sears and Kmart, together the nation’s third-largest retailer, generating $52 billion in sales during the past four quarters. For the first nine months of 2007, the most recent period for which figures are available, sales fell 3.4 percent and operating income declined 31 percent for the combined companies.

Same-store sales, a closely watched measure of financial performance for any retailer, also fell throughout 2007. During the crucial holiday season, same-store sales at Sears — those for stores open at least a year — fell 2.8 percent, while Kmart’s dropped 4.2 percent.

Most rivals of Sears and of Kmart showed similar results during the holiday period. Same-store sales at Macy’s fell 1 percent in November and December, for example, while those at Target dropped 5 percent in December. Wal-Mart was a standout: its same-store sales rose 2.7 percent that month.

Based on figures provided by the company, Mr. Dreher estimates that earnings at Sears before interest, taxes, depreciation and amortization — the figure that Mr. Lampert says best measures the company’s performance — will drop to $1.94 billion in 2008 from $2.49 billion in 2007.

If he is right, it will mean that Mr. Lampert’s combination of Sears and Kmart, after rising for a few years, will have fallen back to the same level of profitability that both companies showed before they got hitched.

SUCH a round trip was not what investors had in mind when Mr. Lampert combined the companies in 2005. Confident in his ability to increase profit for Sears as he had for Autozone, and certain that the Sears real estate holdings alone were worth more than $150 a share, investors bid up Sears Holdings to almost $200 a share last April.

When Mr. Lampert announced the Sears-Kmart merger, his plan for the combined companies seemed simple: Marry the strength of the world-renowned Sears brands, like Kenmore appliances and Craftsman tools, with the attractive locations of Kmart stores. Mr. Lampert had bought Kmart on the cheap in 2003, when it emerged from bankruptcy.

“We’re going to work toward best-in-class financial metrics and best-in-class customer metrics,” Mr. Lampert said when announcing the deal in November 2004. Analysts praised the merger, contending that economies of scale in the combined companies would translate into increased profits.

But three years later, neither financial metrics nor those related to the company’s customers can be considered best in class. The gross margins of Sears Holdings, for example, were expected to expand under Mr. Lampert’s influence just as they had at Autozone when he was its biggest investor. But the gross margin rate of Sears fell during the first nine months of 2007 to 27.7 percent, from 28.2 percent in the period a year earlier.

And in spite of the fact that Sears spent almost $3 billion buying back its own stock and reducing shares outstanding, net income per share fell 38 percent for the first three quarters of last year from the comparable period in 2006.

The problem, analysts say, boils down to this: Customers are avoiding Sears stores in droves. Indeed, at many Sears stores, clerks at times seem to outnumber shoppers.

The Sears Essentials strategy, now called Sears Grand, offers a case in point. This was a plan by Mr. Lampert to compete with the new breed of smaller strip shopping centers, anchored by stores like Best Buy, Home Depot and Target. Sears stores, found mostly in enclosed malls, were losing prized customers to the smaller centers. But by converting Kmart stores, which were near the smaller centers, into Sears Essentials, the company hoped to lure shoppers back to buy Kenmore washers, Craftsman tools and Diehard car batteries.

“I have always believed that Kmart customers had the inclination to buy more valuable products at Kmart if presented with the right value offerings,” Mr. Lampert wrote in a letter to shareholders in late 2005.

But Sears Essentials flopped. It was not because Kmart shoppers rejected Sears products, but because the experiment seemed to consist only of tossing Kenmore stoves and Craftsman hammers into an old Kmart store, rather than creating a vibrant new shopping experience.

The former Kmart in Parsippany, N.J., is typical. Three years ago, it was converted into a Sears Essentials store. By all accounts, the store could have been a success; it sits in a bustling suburban shopping center, surrounded by popular retailers like a ShopRite grocery store and a Bed Bath and Beyond.

But beyond introducing new brands, Sears invested little money in the store. In November, a visitor found mismatched floor tiles in the lobby, Reagan-era beige shelves in the food aisles and a ragged brown carpet in the clothing department.

Near a customer service desk, a broken pipe dripped water from the ceiling into a garbage pail. Workers said the pail, intended as a quick fix, had been in place for two weeks while they awaited repairs. They also said business in the store was terrible.

Burt Flickinger, a longtime retail consultant, said: “Eddie has cut costs and raised prices for two years. But shoppers are not stupid. They figure it out and shop someplace else.”

A Sears spokesman disputed that the stores were down at the heels but acknowledged that the company must work to “improve the customer experience.” He said the company has improved the profitability of the Sears Grand stores and still considers the original concept valid.

Customers who did venture into the Parsippany store found that dozens of products — from contact lens solution to dolls — were sold out. The store did not have enough inventory or employees to replace them on the shelves.

Much of the commodity merchandise that was in stock was more expensive than at nearby competitors. A 32-ounce bottle of Gatorade was $1.59, compared with ShopRite’s price of $1.25. Sears charged $4.19 for a box of Cheerios, compared with $3.29 at ShopRite.

Rita Marra, 69, browsed but said she bought nothing. “Everything here is twice as expensive as anywhere else I shop,” she said. “Even the employees complain: ‘We know, we know our prices are expensive.’ ”

Analysts at Goldman Sachs have found that over the last year, average prices on nationally branded products at Sears Essentials and Kmart stores were 18 percent higher than those at Wal-Mart. “The prices are totally out of whack,” said Adrianne Shapira, an analyst at the firm.

Shoppers and workers are not the only ones complaining. Vendors who sell to Mr. Lampert say his relentless cost-cutting has steadily eroded their business at both Kmart and Sears, giving them little incentive to offer the chains their best new products. A result: a vicious circle of poor sales and second-rate merchandise.

“They are not a priority with anyone,” said the former chief executive of a major clothing manufacturer. “Nobody wants to partner with them on a new project.”

Several months ago, for example, executives from a well-known clothing maker met with Sears buyers to discuss their business for 2008. One executive who participated in the meeting said the Sears buyers praised the clothing company, saying that it was a top performer in its category but warning that sales of the clothing would nevertheless fall by 10 percent over the next year because traffic in the stores was declining. “You are joking, right,” the executive recalled thinking. “We are a top performer and sales are down 10 percent? What is happening to the worst performers?”

SEARS HOLDINGS’ performance has alienated no less a power broker than Martha Stewart, who sells a line of home goods at Kmart. She chose to introduce a new line of furniture last fall at Macy’s, a Sears competitor.

The spokesman for Sears said, “We have thousands of vendors and value them,” adding that the company changes the mix periodically as any retailer does.

Wall Street analysts and former Sears executives also express frustration that Mr. Lampert has not recruited many seasoned retail executives to the company. Only one of the Sears Holdings directors has a retailing background, and Mr. Lampert’s choice for a chief executive, Aylwin B. Lewis, is a former fast food executive who oversaw chains like KFC and Taco Bell.

“Eddie says this is a retail-driven turnaround, but we have not seen marquee retail executives come to the company,” said Ms. Shapira of Goldman Sachs. “Less savvy people than Eddie Lampert realize that retail begins with management. He doesn’t seem to get it.”

According to people with knowledge of the discussions, Mr. Lampert has put out feelers to several top retail executives, including Millard S. Drexler, the former Gap chief executive, and Allen I. Questrom, the man behind the J. C. Penney turnaround. But neither has agreed to join the company.

Mr. Lampert’s prickly personality may be part of the problem. Executives who have made the pilgrimage to his office in Greenwich, Conn. — from where he oversees Sears Holdings, which is based in Illinois — describe their meetings with him as impersonal, if not chilly.

An intensely private man, Mr. Lampert keeps chit-chat to a minimum, rarely asking a personal question or engaging, as most retail and clothing executives do, in industry gossip.

“He is the iceman,” said one clothing company’s chief executive. “There is nothing warm about him.”

The Sears spokesman said the company has executives with significant retail experience and values that diversity.

Mr. Lampert is also decidedly thin-skinned, scolding those who challenge the performance or strategies of Sears. He gets especially riled by those who say that he has starved Sears and Kmart, investing little money in the day-to-day business. “When other companies manage expenses carefully, it is often characterized as a sign of good management and prudence,” he wrote in a late November memo to Sears employees. “In the case of Sears Holdings, meanwhile, expense controls are often cited as a root cause of poor performance.”

STILL the question remains. Would the performance of Sears have improved if Mr. Lampert had not cut the company’s capital investment? In 2004, before the merger, Sears and Kmart managers spent a combined $1.1 billion on investments like new-store openings and renovations. In 2005, Mr. Lampert took that number down to $546 million, and in 2006, capital investment at Sears Holdings fell to $513 million.

Marketing budgets have also been cut. In 2004, the two companies spent $963 million; last year, the amount was $782 million, according to TNS Media Intelligence, a research firm, a decline of almost 20 percent.

But Mr. Lampert has been willing to spend big money on share repurchases. In 2007 and into this month, Sears has bought some 21.3 million shares, or 13.6 percent of its outstanding stock. The company has spent $2.9 billion to retire the shares, paying $105 to $145 a share.

“Poor operating performance can be disguised by aggressive share repurchases, and Lampert is very, very aggressive” in that regard, Mr. Dreher said. He called Mr. Lampert’s reorganization of Sears Holdings “haphazard and spontaneous” and warned that without giving the five new divisions bigger budgets to invest in stores, the changes “could make things even more difficult.”

Mr. Dreher added that the Sears chairman could be moving to take the company private and use the cash generated by Sears Holdings’ retail operation to finance ESL Investments.

Mr. Dreher estimates the liquidation value of Sears Holdings to be about $150 a share, after tax, including the value of its stores and leases and its well-known consumer brands.

Craig Schmidt, an analyst at Merrill Lynch, and Gregory Melich, an analyst at Morgan Stanley, value Sears real estate at around $16 billion. The company’s market capitalization is $14 billion, as of Friday’s close. One investor who has bet against Sears said he believes the real estate may be worth just $10 billion.

Certainly, the commercial real estate market has cooled in recent months. A retail consultant, Howard Davidowitz of Davidowitz & Associates, says he believes that the value of Sears stores is declining, as chains like Rite Aid and Macy’s close stores. “That real estate is worth a lot less than it was a year ago,” Mr. Davidowitz said.

Steven Roth, who heads Vornado Realty Trust, seems also to have lost his enthusiasm for Sears stock. After buying 4.3 percent of Kmart just before the Kmart-Sears marriage, Mr. Roth has sold his stake. He did not return a phone call seeking comment.

If Mr. Lampert finds it difficult to sell in an anemic real estate market, he will have to improve the retail operations to generate shareholder value.

“There is no exit strategy to my knowledge,” said Richard Rainwater, the hedge fund manager and entrepreneur who was an early backer of Mr. Lampert. “He will probably own it forever, and he wants to. My guess is that he has a plan. He is not going to tell you or me. My guess is that it probably makes sense financially.”

WORRIED investors in Mr. Lampert’s fund may soon press him to articulate his plan more clearly. Mr. Lampert’s annual meeting with investors is scheduled for Feb. 28 in New York.

Still, there is no doubt that the Lampert luster has faded; comparisons to Mr. Buffett have quieted in recent months.

“He did really well on Autozone,” said Bruce Greenwald, a professor of finance and economics at Columbia University. “Most of his stocks are retail stocks, and he has done really well with them. So he decided he was a genius at retail, and it didn’t occur to him he could be wrong about it. He believed his own press.”