The risky side of Sears

Over its 121-year history, Sears has been a watch seller, a giant mail-order business, a home builder and the nation's favorite retailer. And now, in 2007, it is becoming ... a hedge fund?

As strange as it sounds, this transformation of Sears is now in force. Its retail sales have dropped for five straight years, and managers complain about deteriorating stores. Meanwhile, Sears is pouring its money into risky, esoteric investments to generate huge returns for shareholders.

The man orchestrating this makeover is Edward Lampert, 44, who by many accounts is a brilliant and controversial hedge-fund trader. As chairman of Sears Holdings, which includes Kmart and Sears Canada, Lampert is a startling example of the new avant-garde of Wall Street — alternative investors who have the power and money to acquire and radically transform large traditional businesses.

Lampert's management of Sears Holdings, the nation's third-largest retailer, has been a departure from long-established industry practices — using extra cash to improve stores or earn a small amount of interest. That has stirred anxiety among former executives who fear the iconic brand could be dying. Their concerns are being heightened by retail analysts who predict the company will shed hundreds of stores.

"I do think the company is in a spiral which, if it doesn't pull itself out of, is likely to face at minimum an uncertain future," said Arthur C. Martinez, who led Sears in the 1990s.

But, if Sears the Retailer is ailing, Sears the Hedge Fund has never been healthier. Hedge funds are massive unregulated investment pools typically open to only institutional investors and wealthy individuals. The company's stock soared 45 percent in 2006, driven by high-risk trades that produced $101 million, or a third, of Sears Holding's pretax income in the third quarter. These investments did not perform well in the fourth quarter, and the firm had to sell off properties to cover its losses, according to a Morgan Stanley report.

"It's clearly not your traditional retail business," said William Dreher, a Deutsche Bank retail analyst who dubs the firm the "working man's hedge fund."

Dreher said: "The classically trained retailer focuses on same-store growth, market share, store spending. These are the keys to traditional merchants. They are not the keys for Lampert."

Lampert, through a spokesman, declined comment for this story. Aylwin B. Lewis, Sears Holdings' chief executive, also declined comment. But in a letter to shareholders, Lampert played down the risks to his strategy. Without being specific, he stressed his intention to expand Sears slowly despite falling sales and limited capital spending.

"Some commentators have asserted that we want to shrink the company, but that is simply not so. No great company would aspire to become smaller, and we certainly do not," he wrote.

Insight seen

More than a few Wall Street analysts label Lampert as "the next Warren Buffett," the billionaire investor, for having the insight to buy two troubled retailers, Kmart and Sears, on the cheap and then use their cash flows to fund his investments. In 2003, Lampert gained control over Kmart and helped it out of bankruptcy protection by cutting costs and selling off poor-performing stores. He announced an $11 billion buyout of Sears in 2004.

But some who have crossed Lampert in his dealings say he is ruthless. Traditional retailers add that they doubt whether Lampert's singular focus on profit can work in the long run — he may cut spending so drastically that stores will stop attracting shoppers.

Lampert's detractors point to a worrisome trend: Overall same-store sales for Sears Holdings have dropped for five years, with the Sears component performing particularly poorly. In 2006, sales at Sears stores dropped 6.1 percent, while Kmart sales were down 0.6 percent.

"As those comparable-store sales decline it means you are losing customers and they are finding solutions to their needs elsewhere," said Martinez, the former chief executive who is credited with leading a revival at Sears in the 1990s and retired in 2000. "And it is unlikely once they find those solutions they will ever return."

Under Lampert, Sears has spent far less on its retail business than competitors. Gone are the days of heavy television promotions such as the "softer side of Sears." The Sears Roebuck Foundation, the firm's charitable arm, has dried up in generosity, several Chicago-based institutions such as the Children's Museum report.

Hundreds of poor-performing stores are being allowed to deteriorate, according to analysts and interviews with store managers. A sign of this can be found in the company's financial statements. In 2005, Sears' first full year under Lampert, the firm recorded that its buildings and other assets lost $1.1 billion in value, but it spent only half that maintaining and upgrading its properties.

Meanwhile, Lampert has amassed a war chest worth about $3.3 billion in cash. Some Wall Street analysts speculate this kind of build-up is a prelude to making a huge acquisition. But others say Lampert will use the money for his financial trades.

It's hard to know for sure. Lampert is secretive about his company's direction. He has canceled investor conference calls and rarely grants interviews. He even obtained special permission from federal regulators to delay the reporting of trading activity — a consent granted to a small number of investors.

Defied detractors

Lampert has defied his detractors throughout his career. When he left Goldman Sachs in 1988 to start his own financial firm at age 26, some of his bosses thought he was reckless. But since then, Lampert's hedge funds have averaged close to a 30 percent return every year, a claim few traders can equal. With a net worth of $4.5 billion, he is estimated to be Connecticut's wealthiest man.

Lampert also has shown a steely resolve.

In the middle of negotiating the deal for Kmart in 2003, Lampert was kidnapped in the parking lot of his firm and held for a $5 million ransom. He talked his abductors into releasing him by promising them $40,000 but did not end up paying them a penny. Within days, he was back at work on the Kmart deal.

He tried to strong-arm stockholders of Sears Canada last year to sell their shares to him at a discount. The deal fell through when the Ontario Securities Commission ruled Lampert's tactics, which included an illicit sweetheart deal to institutional investors, violated securities laws.

At Sears, Lampert has been undeterred about cutting costs and focused on selling high-margin products. He has experimented with turning Kmart stores into new formats called Sears Grand, which offer items ranging from milk to appliances and are designed to compete with Target and Wal-Mart.

Ron Culp, a former Sears senior vice president, said drastic moves were needed at Sears because of intense competition from discounters. "Lampert's certainly ruined a lot of lives, but at the same time there was fat in the system that he was allowed to eliminate," he said.

But skeptics point to a downside. On the day after Thanksgiving last year, few customers visited the new Sears Grand outside Cleveland, analysts from Morgan Stanley reported. In his letter, Lampert acknowledged that the company has struggled to find the right product mix in the new stores.

The contrast in declining sales and soaring stock price has left those who devoted their careers to Sears with mixed feelings.

"Lampert is certainly not a merchant," said Ronald Olbrysh, chairman of Sears' 25,000-member retirement association. "He is doing extremely well for the shareholders, but whether or not the retail side survives is another question."