Sears-Kmart: Eddie's Master Stroke
Edward S. Lampert has made no secret of wanting to follow in the footsteps of his hero, Warren E. Buffett. Like the Sage of Omaha, Lampert formed a partnership at age 25 and invested in old-line companies that throw off lots of cash. And just as Buffett did with Berkshire Hathaway (BRKA ), Lampert gained control of bankrupt discounter Kmart (KMRT ) last year, hinting he would turn it into a powerful investment vehicle (see BW, 11/22/04, "The Next Warren Buffett?"). Then, on Nov. 17, Lampert swooped in and launched an $11 billion purchase of Sears, Roebuck & Co. (S ).
Most investors loved the deal. Kmart's stock soared 8% the day of the announcement -- instead of falling, as the stocks of acquiring companies usually do -- fetching a huge premium over the value of Kmart's business. The reason is simple: Many investors are buying Lampert, not Kmart, and they see Kmart not as a retailer trying to move product but as a springboard for lucrative deals. "This is the first move of many in the years to come with [the merged company] as [Lampert's] investment vehicle," says John C. Phelan, a former Lampert associate who is now managing partner at MSD Capital, which manages money for Dell (DELL ) founder Michael S. Dell.
Still, Lampert's latest move didn't please everyone. Some fear he will get bogged down for several years trying to turn the two struggling retailers around rather than using the formidable cash pile Kmart is amassing to move more quickly into other, more promising investments. "Kmart shareholders may not appreciate the merger," said UBS analyst Gary Balter in a report. "The hope was that ESL would take a bold move with the cash and start to invest in growth opportunities. This is not the type of move we were looking for to create the next leg of value for shareholders."
Yet for now, that appears to be a minority view. And there's little question that the merger, if it succeeds, will eventually arm Lampert to the teeth to pull off more deals. He's squeezing cash out of every corner of Kmart and has built a $3 billion cash hoard. Sears has its own $2.7 billion cash reserve that will grow as Lampert wrings inefficiencies out of the aging department-store chain.
Lampert says the combination will save $300 million annually in costs and add $200 million to profits by promoting each chain's brands in the other's stores. Kmart also has $3.8 billion in tax credits carried over from previous losses that should shield profits from taxes for several years. UBS estimates that Kmart will book about $885 million of that benefit this year. What's more, if the stock price keeps rising, Lampert may preserve much of his cash pile and instead use his super-rated shares, which now trade around $110, vs. $15 just 18 months ago, as currency for other dealmaking.
A LOT OF UPSIDE?
Sears investors also applauded the deal. Sears surged 17%, to $53 a share. The big winner, of course, is Lampert's private investment fund, ESL Investments in Greenwich, Conn. It holds 52.6% of Kmart and 14.6% of Sears. Analysts estimate that ESL will hold 42% of Sears Holdings Corp., which will own Sears and Kmart after the merger. Sears shareholders have the option of getting half a share of Sears Holdings for each Sears share, or $50 in cash. But with Sears shares trading above $50, investors apparently want to skip the cash and take the new stock. If they all go that way, there won't be enough to go around, so they'll receive up to 45% in cash and 55% in stock.
Either way, Lampert will be forking over a good deal of cash for Sears. Phelan estimates that the combined Kmart-Sears will be down to about $1.5 billion in cash on hand after the transaction. If Lampert improves the combined retailers' performance, he'll rebuild his cash faster. And he will probably also get higher prices when he offloads marginal stores if he can sell them at a measured pace.
Indeed, there may be a lot of upside in Sears Holdings earnings just by squeezing more sales out of Kmart stores. Lampert says Kmart's sales are $80 a square foot below those of Sears. With Kmart's 100 million square feet of real estate, boosting its sales to Sears' level would create $8 billion in annual revenue. Lampert, now Kmart's chairman, will become chairman of Sears Holdings. Sears Chief Executive Alan J. Lacy will become vice-chairman and CEO of the new company, and Kmart CEO Aylwin B. Lewis -- named to the post just last month -- will become president of Sears Holdings and CEO of Sears retail. Combined sales would total $55 billion and rank Sears Holdings as the nation's third-largest retailer behind Wal-Mart Stores (WMT ) and Home Depot (HD ), displacing current No. 3 Target Corp. (TGT ). "We think there is opportunity for a broader customer base and much expanded sales," Lampert says.
Both Kmart, with 1,500 discount stores, and Sears, with 870 mall-based stores, have seen declining sales as shoppers have gravitated to savvier rivals. To counter that trend, Sears has launched its own off-mall concept, called Sears Grand. Kmart helped accelerate that strategy this year when it sold 50 stores to Sears.
In a conference call, Lacy told investors the merger will allow for the conversion of more Kmarts in markets where the stores better fit Sears' demographic of slightly higher-income shoppers. He also said Kmart will benefit from cross-selling Sears' major brands, possibly Kenmore appliances, Craftsman tools, and Diehard batteries.
At Kmart, Lampert has defied skeptics who had left the chain for dead. By converting virtually all of its debt to equity in the reorganization, he bought time to turn the retailer around. He has since posted four successive quarters of profits, sold off marginal stores, and reduced inventories. Kmart helped stoke the surge in its stock by disclosing in securities filings that it could invest its surplus cash elsewhere -- just as Buffett did in the 1960s with Berkshire, then just a declining textile mill in New Bedford, Mass.
Lampert, who always plays his cards close to the vest, isn't saying how he'll use that cash next. Unlike Buffett, he prefers riskier investments that promise a bigger payoff. But he could also place a safer bet by making a play for AutoZone (AZO ) or AutoNation (AN ), in which ESL holds major stakes. Both stocks rose nearly 2% the day of the Sears deal.
FULL OF SURPRISES.
Buying one of them would let ESL cash out of those investments and move the stakes to Sears Holdings. Legendary value investor Martin J. Whitman says that even if Lampert keeps investing in Kmart and Sears, he'll still "have a lot of surplus cash" to invest.
Whatever he does next, Lampert is full of surprises. When he was kidnapped last year, he managed to talk his way out of captivity by offering a small fraction of the $1 million his captors wanted. Investors are betting those dealmaking skills will keep making him -- and them -- lots of money.
By Robert Berner, with Joseph Weber, in Chicago