Berk's Blog

Word Of Sears Holding’s Demise Proves To Be Extremely Premature

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Sears Holdings Corporation, the publicly traded (NASDAQ: SHLD) parent of Kmart and Sears, Roebuck and Co., is the nation’s fourth largest broad-line retailer with over $50 billion in annual revenues and approximately 3,800 full-line and specialty retail stores in the United States and Canada.

And it seems everyone knows that it is just a matter of time before SHLD folds up and hands famed value investor Eddie Lampert a humiliating defeat. We’ve been waiting ever since for the company to liquidate.

Not just yet. Today, SHLD released operating results for its most recent fiscal year. The results? If you go by the traditional metrics that have only a tangential relationships to the drive for shareowner value, like same store sales, hot merchandise and increasing traffic, oh yeah, and really hip modern day “shopper experience”, Sears failed again!

But what about profits and cash flow and the balance sheet in this once in a lifetime consumer recession and housing bust. Remember Sears is the largest seller of home appliances in the nation. No home sales. No new refrigerators. No new washing machines. And it’s be going on for three years.

The critics have consistently called for Lampert to spend more money because JC Penney and WalMart and others were updating their stores, expensive remodeling and expanding right into the teeth of the worst consumer recession in a generation. Fortune summed up the critics’ arguments in an article in December 2007 this way:

Take the $1 billion in capital investment that Lampert refers to in his letter. Sure, this sounds like a lot of money, but it pales in comparison to what other retailers spend on store upkeep and expansion. Over the past 12 months, Sears spent 1.2 percent of its overall sales on capital expenditures. That compares with 7.1 percent for Target(Charts, Fortune 500), 4.4 percent for Wal-Mart(Charts, Fortune 500), and 2.2 percent for Costco(Charts, Fortune 500), according to Credit Intel, a credit research firm.

Analysts expect Sears to spend no more than $700 million on capital expenditures this year, a slight increase from the $513 million spent in 2006 — paltry sums for a retailer with $30 billion in annual sales.

Plus, it’s taken Sears nearly two years to get to that $1 billion mark. Consider that over the same period, Lampert has spent $3 billion buying back Sears’ stock.

On the question of inventory, Lampert blamed Sears’ bloated merchandise levels on a slowing economy that has caused consumers to delay purchases of items like appliances, tools and lawn and garden equipment, which account for a large chunk of Sears’ sales.

Mr. Lampert’s answer to his critics: “Spending lots of money doesn’t always lead to the results people expect.” And that in a nutshell is the EVA Company’s mantra – growth is good for the analysts, for some employees, for some customers and good for the short-term stock price – but willy nilly spending does not necessarily lead to the creation of value.

The stock price has certainly suffered, but the question should always be whether the per share intrinsic value is less than or greater than the current stock price. And then we must ask whether the company has the social technology, the DNA, to understand what to do in the face of the pressure to expand at any cost. We think Sears with Lampert at the helm has that internal social technology.

The stock price of Sears Holdings (SHLD) rose about 780% from May 2003 through the end of April 2007, where the stock peaked at $195. JC Penney went up 210%; Home Depot went up only 11%; Kohl’s went up nearly 70%; Target up 56%; while WalMart actually declined -8% during that time. (It was this under-performance by WalMart’s stock that led the company to rethink its international and US expansion plans by implementing a capital efficiency plan that aimed to increase returns on capital spent and increase free cash flow.) Of course, that summer was the beginning of the financial crisis and was the beginning of the end of the consumer led boom.

The retailers stocks have suffered since. Sears and JC Penney have dropped -80% since then; Home Depot fell -47%; Kohl’s and Target both fell more than -50%. WalMart is flat since then, and if it wasn’t for the under-performance of the market in the last month or so, WalMart would have increased since it initiated its EVA-like Capital Efficiency program.

Which brings us to Eddie Lampert’s interesting, must read annual letter released this morning.

This following excerpt explains how and why a $50 billion retailer that most critics suggest is a “dead company walking” pays down debt, buys back stock and remains cash flow positive during the death of the American consumer.

This past year was a very difficult year for the world economies and for retail in the United States, and 2009 needs to be the year of restoring confidence and trust in our financial system. We have witnessed the weeding out process that inevitably accompanies difficult economic times, with retail companies like Circuit City, Mervyn’s, Linens ’n Things, and Fortunoff not just filing for bankruptcy, but undertaking complete liquidation. Other retail companies, many of whom are highly regarded, have seen their plans and expectations thwarted by events ranging from consumer distress and the tightening of credit markets to rating agency concerns, all of which have upset normal expectations about how a retail business should be run.

As discussed at the 2008 Annual Shareholder Meeting, there has been significant expansion over the past five years in big box retail square footage and significant capital expenditures by our competitors, primarily for opening new stores, but also to refresh and expand their existing store base and infrastructure. At Sears Holdings, our investment principle is guided by the belief that capital invested in any area of our business deserves a reasonable return on that investment. If that return is not forthcoming, significant investments in the business will destroy value rather than create value for shareholders.

Over the past several months, many of our competitors have announced dramatic reductions in their capital expenditure budgets for 2009 and beyond. Perhaps they too are recognizing that unbridled expansion and investment rarely yield the types of returns forecasted by analysts and industry experts.(My emphasis) The dramatic increases in capital investment in the retail industry that took place in recent years are being reversed, and investment levels are being reevaluated. I think that ultimately this is a healthy dynamic for the entire industry. Retail is not immune from the economics of overexpansion experienced in other industries. At Sears Holdings, we will continue to evaluate opportunities based upon our expectations for returns and continue to experiment with a variety of options where the returns could justify higher levels of investment.

We couldn’t agree with you more Mr. Lampert. You were once named by some rag as the “worst” CEO in America. On the contrary, we suspect you are one of the best Value-Aligned CEOs in the world. Thanks.

Disclosure: Berk Advisory and/or its clients own or have owned SHLD in the recent past.