Stuck with Sears

(Removes an incorrect reference in the ninth paragraph to Eddie Lampert selling 4.6 million shares of Sears Holdings. The shares were distributed from Lampert's RBS Partners fund to various partners, including himself.)

Our story begins with a tale of two Buffetts: the real one, of course, and the financier who five years ago was being hailed (by this magazine, among others) as the Next Buffett.

For the real Buffett, business is good these days. Warren Buffett's annual letter to Berkshire Hathaway (BRK.A) shareholders, released in late February, celebrated a triumphant return to form. By seizing opportunities, he wrote, Berkshire had emerged from the Panic of '08 stronger and more profitable. "When it's raining gold," he crowed, "reach for a bucket, not a thimble."

For the Next Buffett—hedge fund guru Edward S. Lampert, 47, who had posted 29% average annual returns since founding his fund in 1988, then created Sears Holdings (SHLD) in 2005 by stitching a deeply wounded Kmart to Sears' once-venerated brand—business is not so good. Lampert's shareholder letter, released around the same time as Buffett's, came out swinging at the critics who now outnumber his fans. Lampert blamed journalists, analysts, and rating agencies for much of the trouble plaguing his retailing empire, arguing that they apply a double standard to Sears Holdings when they blame "our investment choices for our declining sales" while citing the economy for sales declines by rivals like Wal-Mart Stores (WMT) and J. C. Penney (JCP).

Still, Sears Holdings has performed 19 percentage points under the Standard & Poor's 500-stock index since its creation in 2005, and 29 percentage points under Wal-Mart during the same period. Contrast that with Buffett's Berkshire Hathaway. It has posted results that outperformed the S&P 500 in four of the past five years—27 percentage points better than the market in calamitous 2008.

Lampert can point to improvements recently at Kmart. Throughout 2009, Kmart had smaller declines in same-store sales than Target, and it beat Wal-Mart by this metric in the last two quarters, too. He has closed 66 moribund Sears stores, which he says raises cash in most cases, and he has a new effort afoot, applauded by some analysts, to make Sears' signature brands, Craftsman and DieHard, available through other retailers for the first time.

This will create a new revenue stream, but other analysts worry it will also mean there's less reason for customers to walk into a Sears, especially if Lampert begins selling Kenmore appliances outside. "Kenmore is Sears," says Credit Suisse (CS) analyst Gary Balter. "The moment they take that outside the store, they could lose a big, big part of their traffic."

As risky as they may seem, such moves are not likely to turn the tide Lampert's way, according to company watchers. "If he has a strategy other than cutting costs, I haven't seen it," says James E. Schrager, professor of entrepreneurship and strategy at the University of Chicago's Booth School of Business. "What is their concept?"

Tactical retailing decisions of this kind are no doubt necessary, but they're a long way from the bold financial stratagems analysts expected from Lampert when he burst onto the scene five years ago with the creation of Sears Holdings. The Buffett comparisons were based on his approach as much as on his gaudy results. Just as Buffett had turned a listless New England textile maker into one of the most successful investment vehicles in history, Lampert would use a rejuvenated Sears as a Buffett-like holding company with which to mount acquisitions, some to keep and grow, some to be flipped for cash. Sears Holdings would be both a dynamic investment vehicle and a brilliant retailer.

At the moment, Schrager and others say, it is neither. Although downmarket retailers tend to do relatively well in recession, neither Sears nor Kmart has snapped out of its senescence. Sales are down and keep falling. Per-store sales have declined for the past five years, and total revenue has slumped to $44 billion, its lowest level since the 2005 merger. Net income is slipping and, according to its filings, the company has spent more on stock buybacks than it has invested in stores or acquisitions. No one, other than Lampert, who controls 53.1% of the company, seems to have staying power in the C suite. Sears remains without a permanent CEO, having gone through three with Lampert as chairman. An interim CEO, W. Bruce Johnson, has been in place for two years as a protracted head hunt goes on.

Along the way, Lampert has starved the stores of capital spending, according to Balter, while doling out $5.43 billion on those share buybacks to help lift per-share results. This lack of spending, Balter says, has a direct impact on the quality of the shopping experience. And soon the customers won't have to visit Lampert's stores to buy his best products.

Johnson acknowledges the risk that moving Craftsman and DieHard into new retail channels could cannibalize sales at Sears and Kmart. Still, he argues, the gamble is worth it. "We have great potential, unrealized potential to this point, with our major brands," Johnson says. "But we're not going to do that recklessly and without thought."

By the company's own reckoning, however, previous retail restructuring efforts have fizzled. At first, Lampert proposed turning Kmart stores into Sears locations, which would move Sears beyond conventional malls. Before the deal was completed in March 2005, Sears bought 50 sites from Kmart. The post-merger plan was to convert them and hundreds more into freestanding Sears stores.

These new off-the-mall stores were called Sears Essentials and carried goods from both retailers, mixing Kenmore appliances with Martha Stewart housewares. After several stabs at finding the right chemistry, the company pulled back. "We found we just couldn't get the kind of sales and profit lifts to justify the investment in these stores," Johnson says.

Kmart and Martha Stewart parted company in January. Stewart had few kind words for Kmart or Sears as they were breaking up last fall, claiming in a CNBC interview that the retailer had sullied her brand. "The quality is not what I am proud of," Stewart said. "Have you been in a Kmart lately? It is not the nicest place to shop." She now sells her line through Macy's (M).

Sears points to a conciliatory press release that Stewart issued after that interview. "We wish our friends at Kmart and Sears Holdings all the best," it said. Besmirching Kmart "was not my intent."

Sears execs also say that in the years after Lampert acquired the companies, they were bogged down in integrating the two chains, then got walloped by the recession. As for why Lampert never followed the path of his idol into a Berkshire-like acquisition mode, the credit crisis of 2008-09 explains much of it. Some analysts also think Lampert overlooked a major component of the Buffett model. "When Buffett buys a company, he bets on management; that's his No. 1 principle," says Howard Davidowitz, chairman of Davidowitz & Associates, a retail consulting and investment banking firm in New York. "Buffett learned long ago how insane it was to run a fabric mill on his own. So how is Lampert, a guy with a hedge fund in Connecticut, running Sears and Kmart?"

Lampert, who declined to comment for this story, still has his fans. "Profitability, even if done by managing inventory and cutting costs, is good," says Ivan Feinseth, chief investment officer of AlphaWorks, a New York hedge fund bullish on the shares though it has no stake in the company. "Look, are there better places to shop? Absolutely. But Sears is an option on Lampert, not as a retailer, but as a financial engineer."

Lampert's own view, as expressed in his latest chairman's letter, is that Sears Holdings is doing pretty well given the crummy economic environment of the past two years. The real problem, he insisted, is that too many people who follow the company misunderstand how it works. "We hope that those who may have doubted us in the past are willing to keep an open mind," his letter stated. "In our case, it turns out that our performance far exceeded many observers' expectations and we hope to receive credit for this performance in the form of higher credit ratings and more balanced analysis. Simplistic analyses, which automatically prefer capital investment to share repurchases as a use of cash that 'benefits' bondholders, ignore the fact that negative or below market returns on invested capital are as harmful to creditors as to shareholders."

Lampert has a point, but he overlooks another one. His preference for buybacks over capital investment necessarily disadvantages his retail operations—yet he has insisted that he took over Kmart and then Sears because he wanted to operate them as retailing companies. Analysts have just as consistently seen a different motive. They looked at the chains and their combined count of nearly 4,000 stores as a real estate play, hard assets that Lampert bought cheaply and could flip for a fortune.

Consider that in 2004 Lampert sold some 65 Kmart stores and acreage to Home Depot and Sears for $946 million. The analysts' conjecture seemed to be seconded in late 2004 when Vornado Realty Trust (VNO) bought a 4.3% stake in Sears as Lampert was about to merge it with Kmart. (Vornado sold its shares by yearend 2005, for a net gain of $26.5 million.) Since then, though, the Sears chairman has only dabbled in small deals. In 2007 he sold the Sears' Canadian headquarters in Toronto to Ontario for $81 million (Canadian), leasing back the space. That same year he also got a $21 million pretax gain by selling the chain's fashion center in Los Angeles to an undisclosed buyer.

In today's commercial real estate glut, fewer buyers would want Kmart's big boxes or the Sears stores that anchor suburban shopping malls. "The market for this kind of space right now is relatively nonexistent," says Neil Stern, senior partner with McMillan Doolittle, a Chicago retail consulting firm. "There's a flood of vacancies, large-scale bankruptcies, and department-store brand consolidations."

"What Lampert did years back was brilliant," says Stern. "He sold Kmart stores to Sears, got cash, and turned around and bought the whole company. Everyone then extrapolated that he could keep doing that. But times are different." On the other hand, Sears was able to expand deeper into small-city markets with what it calls Hometown stores, which are independently owned and staffed to Sears' specifications. It has more than 1,000 today, after adding 60 last year, and it plans to add 100 more in 2010.

Sears is also testing a new concept at a single location in suburban Chicago. Called Mygofer, it's essentially a huge, well-stocked warehouse where shoppers can pick up goods they've ordered on the Internet at home, on their smart phones, or at kiosks in the store.

Such moves cost Sears little in capital expenditures, which must be attractive to a man who doesn't like to pump money into bricks and mortar. This reticence is why Lampert is often faulted for neglecting the company's stores. Balter, the analyst with Credit Suisse, says too many stores are typically dirty and out of stock. "Customers have a choice every day," he says. "Why are you going to go there? That's the challenge."

That may help explain why the company's same-store sales have declined every year under Lampert's ownership. Sears has consistently underspent its rivals on capital investments. The company committed $361 million in capital spending in the year that ended Jan. 30, less than the $424 million it spent to buy back shares during that period, according to company documents. Compare that with the capital spending by Target ($1.73 billion) and Wal-Mart ($12.2 billion) over the same period.

Lampert has dismissed these comparisons from the start, as does Johnson. Yes, the CEO says, shoppers might happen upon faded outlets, "but most of the stores look pretty good." And capital investment doesn't automatically produce higher sales.

At a Kmart in Chicago, customers say they come for the low prices. Laura McBride, a homemaker shopping with her husband, Richard, a pipefitter, prefers it over Wal-Mart and Target. She shops at Kmart twice a week, after scanning ads for what's on sale. "I love the prices," she says. "Kmart fits my budget. I find more sales here. Things are cheaper."

Those low prices hurt Kmart's performance. Balter thinks it would be better off if Lampert sold Kmart and focused on Sears. He notes that on a per-square-foot basis, Kmart is only a quarter as productive as Wal-Mart, but concedes that a sale or spinoff is highly unlikely in the present retail environment.

Although Sears is smaller than it used to be, it still is a retailing behemoth. It is the nation's fourth-biggest general retailer, behind Wal-Mart, Costco (COST), and Target, with fiscal 2010 sales of $44.04 billion and 3,921 stores. Including Canada, it has more than 300,000 employees. Sears, in 2001, was far and away the biggest vendor of big-ticket household appliances and white goods with a market share of 41%. It's still No. 1, though that share is now 31.7%.

Sears' gross margin came to 27.7% in fiscal 2010, which ended Jan. 30. The margin has ranged from 27.1% to 28.7% since Lampert merged Sears with Kmart in early 2005, according to company Securities & Exchange Commission filings. Target regularly posts margins of 30%, thanks in large part to its greater volume of high-priced consumer electronics. Wal-Mart lags both, with gross margins of 23.5% over the past few years. Wal-Mart, however, relies on food for almost half its revenue and the grocery business is notoriously low margin.

Lampert has always contended that his rivals are spending money on store expansions and updates foolishly, writing in one of his annual letters: "We do not subscribe to the view (seemingly widely held) that more is better, or that there is a certain amount that must be spent on cap-ex every year." With 2,235 full-line stores between Sears and Kmart today, the company has more than Target (1,684), J. C. Penney (1,110), or Kohl's (KSS) (1,060). "The issue for Sears Holdings is therefore not one of building more stores, but rather one of making our existing stores more productive and relevant to our customers," Lampert argued.

Ana Lai, an analyst with Standard & Poor's, says store counts tell only part of the story. "The operating performance has really been below expectations. Its competitive position has really deteriorated against peers such as J. C. Penney, Macy's (M), and Kohl's. Their execution hasn't been all that good either. They need to invest in their stores to make them more attractive and to provide shoppers with a better experience."

Lai is still looking for the promised sales synergies between Kmart and Sears. "The longer this continues, the more their position will weaken." She sees nothing in Sears' strategy that pulls the company out of its "manage-the-decline" slide.

None of these analysts, in fairness, has had to manage two aging retail chains through an epic recession. So it's worth asking: Where would Sears and Kmart be today if this presumptive New Buffett hadn't swooped in five years ago? Probably in worse shape than they are. Other marginal retailers—Circuit City (CCTYQ), Linens 'n Things—have folded. Feinseth of AlphaWorks sees no other hope for once-bankrupt Kmart vs. the duopoly that is Wal Mart-Target.

Indeed, all the tangible goodwill of Sears' many household brands seems to pale in comparison with the intangible premium of Lampert's name. According to Bloomberg data, Sears shares, at their 107 close on Mar. 22, enjoy a $40 premium over analysts' average 12-month price target—tops in the S&P 500.

Managing a business and managing lofty expectations are two very different things.

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