The Softer Side of Sears

Sears Holdings, whose 3,800 Sears and Kmart stores make it the nation's fourth-largest broad-line retailer, surprised investors with an earnings announcement yesterday. For the first nine weeks of the current quarter, same-store sales fell 3.9 percent from last year, and quarterly profits could fall by up to 45 percent. CEO Aylwin Lewis noted that the company had been hurt by declining appliance sales (that darned housing market) and needed "to become more relevant to consumers." (That's retail-ese for our merchandise bites.) The stock plummeted about 10 percent on the news.

The declining same-store sales for Kmart and Sears were nothing new, but the negative market reaction was. For the last several years, Sears Holdings, a mini-conglomerate cobbled together by hedge-fund whiz Eddie Lampert, has been a stock market darling. (Here's the stunning five-year chart.) Lampert acquired Kmart, which went bankrupt in January 2002, brought it out of bankruptcy, and used it as a platform to acquire Sears in 2005. Generally, investors have been indifferent to the fact that Sears and Kmart continue to be what they were before Lampert gained control of them—unhip, old retailers whose fortunes rely on middle- to lower-middle-income consumers. The stock soared not because investors believed Lampert would revive the fortunes of these retailers but because they believed he'd perform some of that famed hedge-fund alchemy on the companies—by liberating the value of the firm's real estate, by selling off stores, by turning the company itself into a publicly traded hedge fund, or by using cash flow to buy back stock.

But yesterday's unexpectedly poor financial results have thrown the declining performance of the retailing operations into ugly relief. Most retailers measure their success by same-store sales. At both Sears and Kmart, that metric has been trending in the wrong direction. In fiscal year 2005, according to the company's annual report, same-store sales fell 5.3 percent. Last year, they fell 3.7 percent. In the first quarter of 2007, they slipped another 3.9 percent. For most retailers, such a decline would be a wake-up call—after all, fixed costs like rent, labor, and energy don't fall simply because same-store sales fall. Speaking at the annual meeting in May, Lampert acknowledged the importance of same-store sales but noted, "They just don't matter as much as people have suggested. They're not the be-all and end-all."

Indeed, Sears and Kmart haven't responded to the sales slump by spending heavily on promotion and advertising, or by sprucing up stores. Far from it. In fiscal 2004, when they were independent firms, Kmart and Sears combined invested more than $1 billion in capital expenditures. But in 2005 and 2006, the combined capital expenditures amounted to only $546 million and $474 million, respectively. In the first quarter of 2007, Sears Holdings' capital expenditures were only $113 million. The same quarter, it reported depreciation and amortization—the declining value of property due to wear and tear—of $263 million.

In the last few years, in fact, Sears Holdings has spent more buying back its own stock than it has on making sure its stores are attractive shopping emporiums. Since the third quarter of fiscal 2005, the company has spent $1.9 billion to buy 13.8 million shares—at an average price of $137. With the stock currently at about $155, those purchases still seem like shrewd moves. But Sears reports that in the "nine-week period ended July 7, 2007, the company repurchased 2.8 million common shares at a total cost of $484 million, or an average price of $174.67 per share." Ouch.

It is facile and generally wrong to draw conclusions based on one day of trading. Despite Tuesday's 10 percent plunge, the stock has still far outpaced the broader market in recent years, and long-term investors have made tons of money. (We should all be so lucky as to have Eddie Lampert manage our money.) And Lampert has more to gain than anybody else from Sears' long-term success. The most recent proxy shows he controls 42.5 percent of the shares; yesterday, he (or his fund) lost about a billion dollars.

Yet while the long-term trend for the stock remains positive, the long-term trend for the business that underlies that stock looks rather poor. Sears Holdings is suffering from three factors that have been evident to every investor: 1) the decline in same-store sales and ownership's seeming indifference to Sears' and Kmart's declining appearance and market share; 2) the tenuous competitive position it holds, having to compete with aggressive rivals like Best Buy, Circuit City, Target, Wal-Mart, J.C. Penney, and other big-box retailers and middlebrow department stores; and 3) an unkind macroeconomic climate. As the largest seller of home appliances, Sears is uniquely exposed to the slumping housing market.

Until yesterday, when Sears Holdings was primarily a finance story, none of these ill winds seemed to matter. It's as if Sears stockholders woke up and realized that instead of owning a hedge fund, they own two huge, slipping retailers that happen to be run by a financial genius without much stated interest or demonstrated competency in middle-market retailing.