Sears Holdings Has Squandered An Opportunity

The last four years or so for Sears Holdings (SHLD) and its shareholders would make for quite an interesting Harvard Business School case study. I have been writing about the company since 2005 and was an early investor in Kmart, even before Eddie Lampert used it as a vehicle to buy Sears.

The early success was very impressive. Lampert bought loads of Kmart debt as it filed bankruptcy and gained control of the company’s equity when it reemerged in 2004. In 2006 Sears Holdings earned a profit of $1.5 billion, or $9.58 per share, quite a turnaround for a retailer that had been bleeding red ink.

Lampert accomplished this not by turning Sears and Kmart into strong retailers like Wal-Mart (WMT) and Target (TGT) (sales and profit margins still lagged those competitors), but rather simply by running the companies very efficiently and milking them for cash flow. Even if you earn a 3% margin instead of 6%, that is big money when you bring in $50 billion of sales annually.

The Wall Street community was sold on the idea that Lampert would use the cash flow from Sears Holdings to diversify its business away from ailing retail brands. Maybe he would close down stores and sell the real estate, or lease it back to other retailers who wanted the space. Maybe Kenmore and Craftsman products, which are owned by Sears, would show up on other retailers’ shelves. Maybe Land’s End, also owned by Sears, would be expanded as an independent retail brand. Maybe Lampert would buy other companies outside of retail altogether. The possibilities seemed, were, and still are, endless.

And yet none of this has materialized. Sears continues to operate as a sub-par retailer and uses excess cash flow to repurchase stock. As the economy has faltered, so has cash flow. Adjusted EBITDA year-to-date has fallen to $700 million, from $1.5 billion last year. The only positive has been the reduction in share count. Sears earned $1.5 billion in 2006, or $9.58 per share. If they somehow are able to earn that much again when the retail environment improves, earnings per share would be nearly $12 per share because of the lower share count. With the stock at $31 today, you can see that the stock would trade back above $100 in that scenario.

But how will that happen anytime soon if Sears continues as is has? It won’t, which is why Peridot Capital has been steadily selling Sears stock over the last year. It used to be a very large holding, but is now one of our smallest. Eddie Lampert evidently was convinced he could do more with the retailer’s operations even after the low hanging fruit had been picked. That was a bad decision.

As long as the economy remains weak, Sears will likely use it as an excuse for its poor operating results. That is a shame, because they had a perfect opportunity to diversify out of retail and they chose not to, even when it was widely accepted as the right strategy for investors. The truth is, however, that Sears and Kmart are not strong retailers and likely never will be, at least not in their current form.

To me, Sears is in the same exact position as General Motors (GM) right now. They are operationally inferior to their competitors, but refuse to dramatically alter their business plans to adapt to the market. Today the Big 3 CEOs will testify in front of Congress and explain that the economy is the source of their problems. They need annual auto sales of 13 million units to earn a profit, far from the 10 to 11 million run rate we are now facing.

I don’t need to tell you that GM’s business model is the problem, not the economy. If the U.S. auto market shrinks due to higher job losses and tighter credit standards, managers need to make changes to ensure they can survive in such an environment. In that case, a stronger economy would mean higher profits, not just survival.

I heard a GM dealer on television complaining that he can finance customers with credit scores of 650 or higher today, whereas last year someone with a 550 could get a loan. He implied that the banks were at fault for cutting credit for people with bad credit (the average credit score in the U.S. is 680). Was it not the fact that 550 credit scores qualified for car loans in the first place that got us into this kind of financial crisis? We should give loans to low quality borrowers to save the Detroit auto industry? I think not.

The bottom line is, if your company adapts you will likely be a survivor. When times are bad the weak die out and the strong not only survive, but they come out of the downturn even stronger than they were before. In today’s market, when nearly every stock is down tremendously, there are fewer reasons to invest in Sears or GM when you can buy a stronger company like Target or Toyota on sale. When Target fetched a 20 P/E I preferred to buy the more undervalued Sears. Combine disappointing execution by Sears and a 50% drop in Target stock, and given the same choice I will take Target at a 10 P/E, which is what I plan to do.

Full Disclosure: At the time of writing Peridot Capital was long shares of Sears and Target and had no position in GM or Wal-Mart, but positions may change at any time