Turning Kmart Into A Cash Cow

Its Sears deal shows how it can serve as Eddie Lampert's investment vehicle

Could Kmart, the discount retailer once left for dead, become investor Edward S. Lampert's Berkshire Hathaway Inc. (BRK )? The possibility that it will turn into an investment vehicle like Warren Buffett's is looking increasingly likely after a June 30 announcement that Kmart Holding Corp. (KMRT ) will sell 54 stores to Sears, Roebuck & Co. (S ). The sale, which Troy (Mich.)-based Kmart said would reap up to $621 million, will add to the $2.2 billion cash hoard the retailer has built up since it emerged from bankruptcy last year under Lampert's leadership. In Securities & Exchange Commission filings, Kmart said it could use its cash to acquire securities or unrelated businesses -- just as Buffett did with Berkshire. Sears, meanwhile, will use some Kmart locations to jump-start its new Sears Grand stores, which aren't located in malls. Sears is trying to stanch drooping sales, though many experts are skeptical of the strategy because of fierce competition from rivals such as Best Buy (BBY ), Lowe's (LOW ), and Home Depot (HD ).

The transaction is an artful move by Lampert, a low-key billionaire who once worked for former Treasury Secretary Robert S. Rubin while he was still at Goldman Sachs & Co. (GS ). His private investment fund, Greenwich (Conn.)-based ESL Investments Inc., has a stake in both sides of the deal: It's the largest shareholder in both retailers. The sale shifts a bundle of cash to Kmart, where Lampert thinks he can make better use of it. He bought heavily into Sears when its huge credit-card operations ran into trouble with bad debts and its stock tanked in late 2002. He now holds a 13.5% stake, but doesn't have a seat on the board. Under pressure from Lampert, Sears ultimately sold the credit business to Citigroup for $3 billion.

Lampert swooped on Kmart when the nation's third-largest discounter filed for Chapter 11 protection in January, 2002, buying up the majority of its debt at a big discount from creditors. He changed management, closed 599 of Kmart's 2,100 stores, and hustled the retailer out of Chapter 11 early, in May last year. He also emerged as Kmart's chairman and owner of 51.4% of its new stock, issued to replace most of the company's debt.

ERODING SALES

Kmart's earnings have rebounded since Lampert imposed tighter management and cleaned most of the debt off the balance sheet. In the first quarter through April 28, net profits totaled $93 million, vs. a $862 million loss the previous year. Kmart's new stock, now around $72 a share, has quintupled from its first-day close of $13.55. Still, Kmart's sales at stores open at least a year continue to erode, leading analysts to question its chances of long-term survival against Wal-Mart Stores Inc. (WMT ) and Target Corp. (TGT ).

Some observers contend that Lampert doesn't have to turn Kmart's existing business into a winner to make his investment a success. Just look at Buffett, who acquired Berkshire in the 1960s. Although the textile maker was under siege from foreign competition, Buffett used its cash to make investments with higher returns in unrelated businesses. Bruce Van Kooten, a portfolio manager at Wells Fargo & Co. (WFO ), sees the potential for a similar play with Kmart. "What [Lampert] ended up with [at Kmart] is a lot of cash flow for a minimal amount of money," he says.

Lampert, who declined to comment for this article, is a longtime student and admirer of Buffett, former colleagues say. Like him, he has taken concentrated, longer-term positions in a handful of companies. But with Kmart, he has another advantage: It's sitting on $3.8 billion worth of tax losses that could be used to shield income from future acquisitions. Such buys, says UBS (UBS ) analyst Gary Balter, could become "new cash flow vehicles as Kmart's prospects dim."

With all the cash he now controls -- up to an additional $365 million is coming from an earlier sale of Kmart stores to Home Depot -- Lampert has plenty of options. Now, like his hero Buffett, he has to find something worth investing in.

By Robert Berner in Chicago

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