By Leah McGrath Goodman
| (Illustration by Andy Martin) |
Does Edward Lampert know something about Sears that no one else does? This question has been whispered up and down Wall Street as Lampert, Sears’ beleaguered chairman and the founder of a $13 billion hedge fund firm, ESL Investments, has steadfastly clung to his vast position in the struggling retailer. Awash in negative ratings outlooks, liquidity concerns and dire warnings that cash flow may dry up during the next 12 months, Sears shares have taken a beating. The stock price has plummeted to as low as $29 a share earlier this year from just above $90 a year ago, trending steadily downward from more than $190 in 2007, leaving investors in ESL and Sears flummoxed by Lampert’s seemingly unshakable confidence in the ailing retailer.
Lampert, who took the helm of Sears when it merged with Kmart in 2005 to form Sears Holdings Corp., is well aware of the problems. Since becoming chairman, he’s witnessed 19 consecutive quarters of declining sales on the back of a lasting financial downturn that has left middle-class shoppers — Sears’ bread and butter — especially hard-hit. Analysts have roundly junked the stock, while investors, who once prized Sears for its “Lampert premium,” are abandoning ship.
“The quickest and cleanest way to optimize the business appears to be the bankruptcy process,” says analyst Jason Alper, managing director at Tejas Securities in New York. “Sears needs to improve its gross margins by increasing revenue and cutting expenses.” Revenue increases will need to include improved sales at Sears and Kmart stores at a time when the economy remains in a slump. That Sears and Kmart devote an inordinate amount of their floor space to less-than-stellar clothing lines when they might instead focus on Sears’ core products — such as appliances, hardware, and a broad range of home and auto services — only points up areas that could use an overhaul, Alper says.
Even as Sears struggles to stay afloat, rather than distancing himself from his monster investment, Lampert appears to be doubling down. This year in his annual letter to Sears shareholders, Lampert conceded the company’s performance was “very poor.” Yet at the start of the year, he purchased $145.7 million of Sears stock on the open market, as well as from his hedge fund for his personal portfolio — this, after dismal holiday sales in December and the announcement that Sears plans to shutter 100 to 120 of its Sears and Kmart stores as online sales continue to hobble its brick-and-mortar locations.
Lampert also raised eyebrows for accepting an additional 573,184 Sears shares from his fund just after the new year as part of his annual management fee. To top it off, Lampert and ESL together plan to pay up to an estimated $300 million as part of a proposed rights offering that would spin off some of the Outlet, Hometown and hardware stores of Sears, transferring direct ownership to the shareholders (including Lampert and ESL) in exchange for up to $500 million cash. Given that Lampert’s personal stake in Sears now comes to about 23 million shares and ESL holds roughly 38 million more, even as Sears rids itself of dead weight, Lampert will effectively retain 61 percent control.
“Does Eddie have an ace up his sleeve, or is the stock of Sears simply held by a sick man who continues to prop up the price?” asks one New York–based portfolio manager who has been closely watching the stock. “That is my greatest concern about investing in Sears. You could be short, only Eddie’s almost singlehandedly holding up the stock price. You could be long, only this is not a company anyone in his right mind would want to be long in.”
Fund managers have scoured the Sears balance sheet for any sign that Lampert has squirreled away the best nuggets of Sears in a capital structure that might favor him in the event of a bankruptcy (people close to the fund say he has not). Those familiar with the situation say the turmoil over Sears has been a source of frustration not just for Lampert’s investors but also for the fund itself as market observers attempt to come up with increasingly outlandish reasons for Lampert’s latest moves. “Everyone is trying to figure out why Eddie wants to buy a bunch of Sears stock,” one of these people says. “Guess what? He wants it for the same reason anybody wants to buy stock in a company. It’s because he thinks it’s a good investment.”
Surely, Lampert could clear up some of the confusion. But his legendary penchant for privacy, abiding distrust of the press and reluctance to speak as an insider in detail about his investing decisions — especially when it comes to Sears — makes this an unlikely prospect. Those familiar with the fund’s thinking say bankruptcy is off the table and there is little interest in a buyout for the foreseeable future, contrary to market jabber. “There is almost zero chance Eddie will want to file for bankruptcy,” says a second person familiar with the situation. “Frankly, he can probably buy the entire company if he wanted to.”
Lampert was first drawn to Sears by way of Kmart, a company with sales of more than $30 billion when he bought it for less than $1 billion in bankruptcy court in 2003. Kmart’s major lure was its ability to throw off billions of dollars of cash, which helped it to snap up Sears, prompting many Lampert admirers to conclude the fund manager wanted to use the merged company as an acquisition vehicle. Lampert has made no secret of his respect for Warren Buffett’s value investing style; Buffett has successfully used his company, Berkshire Hathaway, as a launch pad for profitable acquisitions. What is forgotten is that for much of his career, Buffett did not achieve his feats under a media microscope as Lampert seeks to do now. And Buffett took more than 20 years to fully shed Berkshire of its troubled roots in the form of a failing textile business, which he never did get off life support.
Considering what Sears is up against today, it may be facing the same kind of painful and protracted metamorphosis. Sears is bracing for negative earnings before interest, taxes, depreciation and amortization that only a full-on restructuring or Buffett-like transformation may be able to remedy. The company’s chief executive, Lou D’Ambrosio, on the job only a year, is the fourth CEO to preside over Sears since Lampert took over. Considering the company’s dire straits and Lampert’s long shadow, some shareholders wonder whether the measure of a good CEO at Sears may be the degree to which he takes his marching orders from Lampert.
Some of this criticism is understandable. Until recently, Sears was able to generate enough cash to keep itself humming, but it’s now fighting to stay alive. Detractors contend Lampert is more interested in share buybacks (which appear to have done little to put a floor under the stock price) than in crucial capital expenditures that could have made Sears a much fiercer foe if applied earlier in his tenure. Store upkeep, in particular, has been a bone of contention, as competitors Wal-Mart Stores and Target Corp. — which have actively invested in their stores and breadth of inventory — erode Sears’ market share. “In my opinion, Sears Holdings has a profit problem, not a liquidity nor an asset problem,” Lampert wrote in his annual letter.
The situation highlights the perils of being a fund manager who decides to serve as chairman of the company in which he’s heavily invested. If Lampert did file for bankruptcy, he would potentially lose control of Sears and the roughly $3 billion of equity he’s patiently been building in the company for almost a decade. He also would not be able to liquidate the company’s assets in a strategic manner, leading to a poor recovery of potential future winnings. If anything, those close to the fund say, he would rather take Sears private. Certainly he has the capacity do so, as a sizable chunk of ESL sits in cash and bonds.
So why doesn’t he? Because, sources familiar with the situation say, by allowing Sears stock to continue to trade publicly, Lampert arms himself with yet another weapon: access to an additional form of liquid currency that’s more flexible than a private security. Although Sears’ once-formidable market capitalization has now shrunk to just over $5 billion (compare this to Wal-Mart at $205.7 billion and Target at $35.3 billion), a small pool of liquid currency in the form of stock is better than none at all. And at this point, Lampert largely gets to control just how liquid it is. In short, he has every intention of protecting and defending Sears, say sources close to the fund, even to the extent that he may own it in its entirety one day.
Lampert, who trained as a risk arbitrageur under future Treasury secretary Robert Rubin at Goldman Sachs, is primarily interested in deeply undervalued American corporations. His tendency is to go long, not short (although the fund is allowed to do both), and invest in debt or stock. Lampert does not have a particular bias on the length or size of an investment — some of his event-driven plays have a fast turnaround, spanning just months or days — but neither does he shy away from the prospect of holding an investment for a decade or longer, says the second source familiar with the fund.
ESL’s investing methodology has been compared with that of private equity firms, but unlike the latter, Lampert does not always have an exit plan when first dipping into a stock, nor does he feel the imperative. The fund believes its edge — and its luxury — is the ability to invest for long periods of time, unencumbered by the requisite institutional drive for short-term liquidity events. Lampert’s preference, as is the case with Sears, is to remain open-minded about his options for the lifetime of the investment, with an emphasis on not limiting those options unnecessarily.
From Lampert’s perspective, there is no magic formula for saving Sears, the people close to the fund say, but he is very comfortable with the levers he has at his fingertips. In truth, Sears does not run a real risk of insolvency for at least another year, according to most analysts tracking the stock. Total assets are valued at more than $21 billion, while the company’s debt clocks in at about $3.5 billion. Some of the company’s most salable assets include its immense swaths of real estate, as well as its coveted Lands’ End clothing line and its Craftsman, DieHard and Kenmore brands. In fact, in February, Sears agreed to sell 11 stores for $270 million in a show of how easily it can turn some select holdings into cash.
In the meantime, Sears is capitalizing on its assets wherever it can by leasing out space in its cavernous stores and licensing a clutch of its most popular brands for a fee. Though some see this as a shortcut to undermining Sears’ core businesses in the long run, it may be enough for now just to live to die another day. In a sign Lampert sees the writing on the wall, he took pains to emphasize last year that a major reason for hiring D’Ambrosio as his new CEO was D’Ambrosio’s 16-year career at IBM and his intimate knowledge of how companies transform old businesses for new technology platforms. Perhaps this is the real reason for Lampert’s reluctance to invest hard-earned revenue in store upgrades.
Sears’ second-biggest shareholder, $8 billion Fairholme Capital Management — whose performance took a drubbing in 2011, in part due to its loyalty to Sears — is unflinching in its devotion, noting that Sears can make up for some of its lost business through its online sales. If necessary, Lampert can also sell off more Sears assets to combat cash declines and divest what it doesn’t want to keep, just as Buffett did in the 1960s with Berkshire Hathaway before turning it into an insurance powerhouse, says Fairholme founder and portfolio manager Bruce Berkowitz in a video he posted on his fund’s web site in February.
While it’s clear Lampert still believes he has plenty of room to turn Sears around, he may find, like Buffett, that the only way to save the company is to abandon its old model completely. A lot is at stake — not just financially but also politically — as Sears employs more than 300,000 people, many highly reliant on the long-term prosperity of the company, especially in rural areas of the country. Lampert is “trying to fix the entire system and . . . it all can’t be fixed, so that which can’t be fixed will be sold,” Berkowitz said in the video. He added that he believes the Sears brands and real estate amount to “a pretty big number, and the number is many multiples of what we think the current stock price is.” Berkowitz declined to comment directly for this article.
The jury is still out on whether Lampert’s fund clients agree with that assessment. “Lampert’s investors are going ballistic,” says the New York–based portfolio manager. “They think they are on the Titanic with this guy and they can’t get off.” Investors in ESL must agree to an unusually lengthy five-year lockup to get into the fund. Among them, as the Wall Street Journal has reported, is a smattering of Goldman clients who invested $3.5 billion in Lampert’s fund in 2007. Goldman also invested $75 million in ESL the same year. If Lampert was looking for a perfect time to take Sears private, it might be after the possible changing of the guard of Goldman’s investors, whose pullout could trigger a steep drop in the Sears stock price. These investors, who bought into ESL across a six-month period in 2007, will begin seeing their lockup periods expire this August.
Chief among Lampert’s priorities, say those familiar with the situation, is to ensure that the investors who piled into ESL several years ago reap a sizable return, which is affected by fluctuations in the Sears stock price. As ESL’s largest stakeholder, Lampert also stands to lose. (According to a person close to the fund, Lampert owns less than 50 percent of the fund but holds the plurality.) As of the end of January, those familiar with the situation said ESL had received no notices of redemption within the prior 60 days and had performed no divestments of Sears stock to any fundholders.
Other funds piggybacking on ESL’s Sears investment last year but which appear to have more recently jumped ship include Adage Capital Management and quantitative shops D.E. Shaw and Hutchin Hill Capital, most likely due to the stock’s volatility. During the second half of last year, Millennium Management slashed its holdings in Sears, and Citadel similarly turned bearish, dumping $13 million of Sears calls in favor of nearly the same amount of puts.
Lampert, whose average annual return since opening ESL at age 25 in 1988 stands at just above 21 percent, is well aware his long-standing bet on Sears could go south. His fund’s annualized average return in late 2004, on the eve of the Sears-Kmart merger, stood at 29 percent. Still, this would do more damage to his rock star reputation than to ESL, which shelled out about $15 each for the combined shares of Sears Holdings, well below the current market price.
All told, there is some reason to believe that Lampert’s style of running Sears may be a great deal riskier than his more conservative handling of ESL. While his fund vehemently eschews leverage, the financial risk profile of Sears, as assessed by Standard & Poor’s, is “highly leveraged.” According to S&P, if Sears cannot turn around its business by 2013 or execute “substantial asset sales,” it faces liquidity constraints.
Many believe the concern about liquidity is the most immediate threat to Sears. “A major retailer is not that much different from a bank: Confidence is everything,” says Alper. “If a major retailer does not demonstrate strength, just like with a large financial institution, there can be a run on the bank.” When CIT Group ceased lending to vendors of Sears earlier this year, fearing a possible liquidity problem on the back of the company’s weak holiday sales, that action may have affected only a small fraction of Sears’ business, but it created an instant ruckus in the market. The stock of Sears tumbled 6 percent as investors ran for the exits, worrying that one hiccup could lead to a fatal blow. After all, it is not usually the investors who initiate a retailer’s downward spiral, but the vendors that deliver the inventory and those, such as CIT, who finance them. Since then there have been indications that CIT might approve lending to Sears vendors again, so long as they provide letters of credit for their orders. CIT declined to comment.
With the market still jittery, there’s been a sharp spike in the number of funds betting against Sears in recent months. Short interest, which hovered at 11 million shares for the past 12 months, hit a 52-week high at the start of this year, climbing in January to top 15.4 million shares. Sears stock has become such a popular short, it’s now prohibitively expensive to borrow, notes a portfolio manager at a West Coast short-only hedge fund. As a result, many investors are fleeing to long-dated Sears bonds and even credit default swaps, which have become more expensive this year. Although information about most of the bondholders is confidential, Fairholme has disclosed it owns $60 million of Sears’ second-lien bonds due in 2018. ESL declined to comment on the fund’s own bond holdings of Sears.
Even with the cost — and risk — incumbent in investing in Sears on the rise, funds from established New York stalwarts to fledgling Australian start-ups are getting in. “If you’re on the right side of these bets, you can make a lot of short-term money,” Alper says. The New York long-short equity firm Fine Capital Partners sank millions into Sears in the second half of last year, snapping up more than 200,000 shares just as the company commenced its nosedive. Reached by phone, Debra Fine declined to comment. By contrast, Bronte Capital, a fund in Bondi Junction, Australia, “did ferociously well” after placing a short bet on Sears during the stock’s holiday plummet from $80 to $30, where the fund covered just before the new year, says Bronte’s chief investment officer, John Hempton. “It was a lucky cover,” he says. “We did it because the borrowing cost for the stock was too high, not because we have any enthusiasm for the company — a company we believe will file for bankruptcy.”
While Lampert’s own Sears bet may be so perilous as to depart from his typical conservatism, if he can extract another round of profit from a company as crippled as Sears, he may yet reinforce the moniker bestowed on him several years ago as the “next Warren Buffett.”
That said, it could be a very long time before he gets Sears back to resembling any kind of acquisition vehicle.
