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Hold the Tears for Eddie Lampert


His big bet on Sears looks dicier as profits plunge, but the chairman has a built-in safety net

When Sears Holdings (SHLD) posted a 99% drop in profits last quarter and the stock sank 11% in one day, ESL Investments took another beating. The hedge fund, run by Sears Chairman Edward S. Lampert, owns 45% of the retailer, whose stock has fallen to 111 from a peak of 195 earlier this year. Given its other laggard holdings, such as Citigroup (C) and Home Depot (HD), ESL is on track for losses of 20% to 30%, the worst in its 20 years, according to estimates from one ESL investor.

But don't jump to conclusions. Lampert's well-heeled ESL investors stuck with him through the other dark periods, 1990 and 2002, getting richly rewarded in later years. It can take a while for Lampert's highly concentrated bets to work out, and a five-year lockup period makes it hard for fickle investors to sell. Lampert declined to comment.

Meanwhile, Lampert has cut expenses drastically since he used his controlling stake in Kmart to buy Sears Roebuck in 2005. So the combined company has a hefty pile of cash, which may buy management time to figure out how to fix Sears and survive an extended industry downturn.

Even if the turnaround doesn't pan out, he still can sell the chain's real estate for a tidy profit. "Lampert has far more financial flexibility [than do other retailers]," says Deutsche Bank (DB) analyst Bill Dreher. "He should be appreciated for being so prudent."

Like many retailers, Sears has struggled to attract shoppers in an overcrowded sector and a slumping economy. But compared with other mid-market chains, Sears is in a stronger financial position, giving it more breathing room during these lean times. The company has $1.5 billion in cash, more than J.C. Penney (JCP), Kohl's (KSS), and Macy's (M)—its biggest rivals—combined. Lampert also has been paying down Sears' debt in recent years. As a result, its debt load is only 25% of the total capital on its balance sheet, compared with 46% for Penney's and 53% for Macy's. "There's wisdom in holding back in uncertain times, being cash-rich when your competitors are not," says Charles W. Mulford, an accounting professor at Georgia Institute of Technology, who recently studied retailers' cash flow.

For now, Lampert remains committed to Sears. The value investor, who is not shy about dumping assets if he thinks the money could be more productive elsewhere, has sold few Sears locations since coming on board. He also has been buying back shares aggressively. In the third quarter he spent nearly $1 billion on repurchases, a sign that he thinks the stock is a good deal. He's not the only one. Activist investor William Ackman of Pershing Square Capital Management bought a 3.5% stake in the third quarter, while Steven Munchin, a Sears board member and Lampert's roommate at Yale, picked up 75,000 shares.

The question, though, remains whether Lampert can fix the troubled retailer. Its recent results were especially ominous: the third straight quarter of deteriorating profit margins and sales at stores that have been open more than a year. And after months of slashing headcount and expenses, there's nothing left to cut. Some analysts say Lampert has grossly underspent on store improvements, contributing to the poor results.

Mostly, Lampert has to find the right retail formula. In November, Sears launched a bid to buy Restoration Hardware (RSTO), the home-goods purveyor, which is facing sluggish sales as well. If that deal works out, Sears could decide to create an upscale boutique within stores. It did the same, somewhat successfully, with the once catalog-only brand, Lands' End, says Credit Suisse (CS) analyst Gary Balter.

And if the situation at Sears sours too much, Lampert can always sell off his prized properties. The problems in real estate haven't spilled over much into retail. The reason: supply. Fewer malls are being built, and it's hard to find space for big-box stores in metro areas. That makes Sears' assets attractive to players like Target (TGT). Sears owns 518 of its 816 locations outright, and many of the 1,333 Kmarts are located in strip malls close to big cities. So Lampert can get some juice out of Sears even if the turnaround doesn't materialize.

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A SAFE BET?

In a Nov. 26 report, UBS Securities analyst Jeffrey Spector argues that real estate investment trusts that buy malls are a "safe haven"—since any slowdown in retail sales takes nearly two years to translate into declining rents. In the consumer-led recession of 1990-91, he says, malls proved a defensive play.

HOLIDAY BLUES

European retailers, like their U.S. counterparts, are anxious about the holidays, reported Women's Wear Daily on Dec. 12. Sales have been weak: Strikes hurt stores in France and Italy, while German merchants fret that the recent spike in food costs will dampen spending.


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