By  on January 28, 2008

Does Edward Lampert have a strategy for Sears Holdings Corp.?

If he does, few people appear to know about it, and analysts are growing increasingly impatient. Even as Sears Holdings last week revealed plans to create five types of business units to simplify its operations, analysts remained puzzled and at least one credit analyst reiterated that Sears' retail strategy remains cloudy and slapped the company with a downgrade to its ratings outlook. This follows a report earlier this month from Goldman Sachs analyst Adrianne Shapira that downgraded Sears Holdings to "sell" from "neutral." Shapira said she expects "the retailer to experience accelerated share loss and profit pressures in an increasingly tough macro backdrop."

Meanwhile, Sears' shares, like much of the rest of the retail sector, are trading well below their 52-week high. Last week the stock was around $100, about 48 percent off the 52-week high of $195.18.

The drop is another hit to Lampert's pocket, which already has seen steep declines in the value of the portfolio of his hedge fund, ESL Investments. Although the company does not publish its performance, it is likely the fund has declined more than 20 percent, based on the performance of the stock market. The value of Sears' real estate holdings also is likely to have dropped because of the subprime mortgage crisis.

On Thursday, Fitch Ratings affirmed the ratings of certain Sears debt, but revised its rating outlook for Sears to "negative" from "stable."

Fitch said the revision for Sears "reflects the continued weak sales performance which has pressured operating profit margin and credit metrics....In addition, the longer-term retail strategy remains unclear, particularly given the recently announced changes to [Sears'] organizational structure, which could lead to operational disruption in the near term."

Fitch's retail credit analyst Tiffany Co said one concern over the new organizational structure is that it "doesn't seem like a retail operating strategy. We're not sure how it all fits in at this point. It's not very cohesive and no retailer out there would organize it like these [Sears] units."

There are further signs Sears might be feeling some pressure — and indications of Lampert's financial focus. At Sears Canada, which is 70 percent owned by Sears Holdings and the balance of the shares publicly traded, the retailer is already exacting from vendors a unilateral deduction based on what it deems profits made by suppliers due to the strength of the Canadian dollar.An apparel vendor who sells to Sears, and who requested anonymity, said Sears has deducted from "accounts receivables monies they think they are entitled to, and the average discount is between 9.3 percent and 9.8 percent off the invoices. This is on top of the already negotiated discount of 18 percent. Who can afford to lose 28 percent? This is highway robbery....And with retail not so good last year, requests for markdown money are coming, too."

Bob Kirke, executive director of the Canadian Apparel Federation, said the dispute originated in an August letter from the retailer to its vendors in which, due to currency gains, "Sears said, 'you guys made extra money. Our dollar has gone up, and you got to give it back.'"

A Sears Canada spokesman said, "Our relationships with our suppliers and the various agreements we have with them are not discussed in public."

The Aug. 24 Sears Canada letter said, "Sears Canada has been experiencing increased pressure from its key retail competitors that have been obtaining cost benefits from offshore productivities and the strong Canadian dollar....Sears Canada is now requesting a retroactive lump-sum compensatory adjustment through the period July-August 2007 payments to reflect the entitlement, which has not been provided to Sears during this period of productivity and currency strengthening."

Canadian suppliers have orders from Sears Canada based on the Canadian dollar, but then have contracts with their factories in China using U.S. dollar terms. Hence the perception that, with the U.S. dollar falling in value and the Canadian dollar rising, vendors were getting a windfall.

On behalf of the CAF, Kirke sent a letter relaying concerns over Sears' policy for foreign currency adjustments from vendors, pointing out as well that Canadian apparel firms buy futures contracts to hedge their currency positions to ensure that they can meet their obligations to retail customers.

Also writing a letter on behalf of vendors was David Schacter, director of the Canadian Apparel Credit Bureau, which is affiliated with CAF. Schacter wrote in part: "Sears does not seem to consider that currency exchange rates are but one element in the makeup of a cost...[and] the implication that suppliers are responsible for Sears' profitability is absurd. Only Sears is responsible for its profitability just as our members are responsible for their own financial well-being."Canadian apparel sources said some vendors and buyers had worked out deals after the letter was sent, but those became nonexistent when Sears Canada took a 10 percent deduction from the invoices that were recently paid. Some of those sources also said that, contrary to Sears Canada's position that vendors profited from a currency windfall, most saw their costs rise due to increases in fuel, shipping and raw goods.

Lampert has shown talent at making derivative investments. Before the credit market collapsed, he used Sears Holdings' cash-making ability to make investments, which went straight to the bottom line.

But the adjustable-rate mortgage fiasco and top-line declines at Sears and Kmart made it difficult for Lampert to exercise his wizardry. In the company's most recent quarterly report, profits fell 99 percent.

A day after the report was filed in late November, a clearly frustrated Lampert fired off a letter criticizing coverage of Sears' results, saying that, while he was not pleased with the performance, "much of the commentary in the media and on Wall Street following the results ignores the strength of our company and the progress we have made." The progress includes reducing Sears' debt load, buying back $3 billion of stock and investing in more than $1 billion for capital expenditures.

Lampert also has worked to leverage Sears' stable of brands. In May 2006, Sears transferred ownership of its Kenmore, Craftsman and DieHard brands to KCD, a bankruptcy-remote entity. The entity now charges Sears a royalty fee to license the brands. The $1.8 billion securitization bond deal, backed by the brands' intellectual property, was then sold to a Bermuda-based insurance company that is also a Sears subsidiary, according to a source familiar with the transaction. The royalty fees are used to pay interest on the bonds, which could be sold to outside investors at any time. Other companies that have done similar deals include Dunkin' Brands, Arby's, Quiznos and Days Inn. Of course, in apparel, the notable ones are Bill Blass and Candie's.

An attorney who has advised on numerous securitization deals compared the theory of securitizing with the practice of real estate owners who separate their properties into different companies: "It's a good move from a risk profile standpoint. Why expose assets when you don't need to? Intellectual property is the crown jewel of a company. This is just good asset management."Many view Sears' new operational structure in the same light. In a move seen as a way to shore up its sagging stock and create more of a Warren Buffett-inspired holding company, Sears said last week that it is "implementing an organizational structure and operating model designed to simplify the way its business lines are managed and create greater autonomy and focus for the business unit management teams."

The retailer said there are now five types of business units: operating businesses, support, brands, online and real estate. Sears said the operating business units will consist of the company's current lines of business such as home appliances, electronics and apparel. The support units will focus on functions that provide operational and administrative support to the operating businesses, including marketing, store operations, customer strategy and finance.

From a business perspective, the most intriguing might be the brand units, which Sears said will be responsible for growing the value of the Sears Holdings brand portfolio.

Lastly, both the real estate business unit and an online business unit will focus on "increasing the sales productivity of the company's physical and virtual real estate," the company said.

Sears said each unit will have its own designated leader, as well as its own separate, internal profit and loss statement, supposedly for ease in zeroing in on the core profit opportunities. A Sears spokesman said the company was not providing other details beyond what was in the announcement.

"By creating smaller, focused teams that are clearly responsible for their units, we increase autonomy and accountability, create greater ownership and enable faster, better decisions. Our board...our senior leadership team and I believe this will make Sears Holdings a more responsive and competitive company in the future," Lampert said in a statement.

The chairman added that the delay in switching the structure over was due to the need for a centrally managed structure at the time of the merger to control costs and integrate the two companies. Lampert merged Sears, Roebuck & Co. and Kmart Holding Corp. in March 2005.

"I think it is very risky since it does not consider a uniform image in the stores, and it does not create an innovative [shopping] option," said Walter Loeb of Loeb Associates, a retail consultant and former Wall Street analyst.So far, the Sears game plan has been somewhat haphazard, if only because Lampert has kept the details close to the vest. And that has made him somewhat different from Warren Buffett — if, indeed, Lampert is trying to emulate the billionaire financier, as some investors and media outlets would like to believe.

For example, Buffett's Berkshire Hathaway owns companies that have brands easily recognized by the consumer and top-notch management teams. Buffett's strategy has been to buy and hold, as well as to keep a hands-off approach so their executive teams can manage day-to-day operations.

To be sure, Sears has name brands in Kenmore, Craftsman and DieHard in the hardlines category. It also has Lands' End in softlines, but financial sources question the strength of Jaclyn Smith, Joe Boxer and Martha Stewart Everyday. Moreover, Lampert is known for micromanaging, preferring to find answers to how the company is performing from spreadsheets, according to some reports.

The reorganization has led some to think Sears might consider licensing out the brands. In addition to the much-written-about potential unlocking of real estate values, Sears could potentially license out a Kenmore subbrand appliance for sale at another big-box retailer, and at the same time generate substantial cash flow. Or it could sell the securitized bonds to raise cash and use the funds to make an acquisition or two, said some financial sources.

And could the newly created brand unit, which Sears said will be responsible for growing the value of the Sears Holdings brand portfolio, also be responsible for eyeing licensing opportunities? And what about the new internal profit/loss statements for each unit? Could there be potential conflicts ahead between units as each vies to maximize its own profit-making opportunities?

Despite those options, some analysts aren't willing to buy into Lampert's vision.

"While licensing is a possibility, [that move] could also cannibalize Sears' own existing sales at its stores....Could store operations and the unit that manages the brands compete with each other? This is our own speculation. And, at this point, we're all speculating on the same thing. It is logical speculation. At the end of the day, Sears hasn't actually put forth a strategy for each of the units," said Fitch's Co.

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