Trouble at Sears Holdings

EVER SINCE 2005, when hedge-fund star Edward Lampert began running Kmart and Sears, many have eagerly waited for him to work his magic.

The veteran investor, whose ESL Investments' RBS Partners Fund now controls 55% of Sears Holdings , the combined operation, espoused cost cuts as a sure-fire way to improve profitability. Redundant stores would be shuttered. Inventories would be carefully calibrated to sales. Only the most profitable products would be nurtured and featured. And if his plans didn't pan out, Lampert would liquidate the old retailers, stores and all, for unimaginable values. At least, that's how the script read. The dream, even in the absence of strong financial results, proved so beguiling that the stock soared, from around $100 a share to more than $190 by April 2007. And even after Sears crashed and burned over the following two years, pulling the stock down to around $30 both last fall and this March, true believers weren't deterred.

This summer, after the stock roared past $75 on a stronger-than-expected first-quarter report, the Lampert claque crowed that the all-important gross margins were on the mend and that Eddie had his mojo back. Thus, Thursday's announcement that Sears Holdings had lost $94 million in the second quarter hit Wall Street like a massive bunker-busting bomb. The stock (SHLD) tanked nearly 12% that day, to 65. It ended the week at about 66.

Analysts scurried to trim their estimates and to heap gratuitous scorn on Lampert. Gary Balter of Credit Suisse, for example, entitled his earnings note "Put A Fork In It," while dropping his estimate for the current fiscal year, which ends next January, to 64 cents from $1.45. And next year's estimate sits at $1.03, making Sears' forward price/earnings ratio an absurd 63.

The second quarter was horrible in any number of respects. Despite heavy cost-cutting, sales dropped even faster. Sales at the old Sears U.S. stores fell a disastrous 12.5%, year over year. Comparable sales at stores open at least a year slid 8.6% when Kmart and Sears Canada (in which Sears has a 73% stake) were included.

The prospective closing of 28 stores cost the company $61 million in severance and various reserves. With at least 400 other poor-performing stores among Sears Holdings' 3,900, a lot more red ink from closings is coming.

LAMPERT AND HIS HEDGE-FUND partners are backed into a blind alley that affords no escape. The cost-cutting has been so extreme at Sears that it can no longer generate the cash flow to mount a turnaround. Nor can the company borrow at the level necessary for a revival. Sears seems faced with the sad prospect of continuing to lose market share to more aggressive rivals such as Wal-Mart Stores (WMT), Lowe's (LOW), Target (TGT), Home Depot (HD) and Kohl's (KSS) -- and watching its earning power dwindle.

Sears' stock could fall by as much as 50% as the problems drag on. Morgan Stanley analyst Gregory Melich has a "base case" number of $35. The breakup scenario, for example, would be difficult if not impossible to pull off. There's no financing for retail-real-estate deals. Mall owners are already choking on vacant space.

The agonies of Sears are of vital importance to the investors in Lampert's hedge fund since the stock, even after falling from its peak, still accounted for more than half the value of the once $14 billion fund. The fund's performance numbers are hard to come by. Several investors tell Barron's that Lampert makes his partners sign stringent confidentiality agreements. But we did learn that some investors who had joined the fund in the summer of 2007 attempted a jail break in November 2008 when Sears had sunk to just 25% or so of its value when they signed on, but Lampert was able to snuff the rebellion. (Lampert failed to return our call seeking an interview.)

Sears likes investors to focus on a number of its own confection called adjusted earnings before interest, taxes, depreciation and amortization. A measure of all the cash the businesses throw off, it not only excludes pesky interest, tax, depreciation and amortization that normal Ebitda does, but eliminates special charges like those related to pensions and store closings. This, of course, represents the profitability of Sears Holdings in an ideal, parallel universe bereft of any frictional costs like those of paying the tax man. By this measure, Sears seems to be spewing cash -- $2.5 billion in fiscal 2007 and $1.6 billion in its latest fiscal year, ended Jan. 31, 2009.

But in the real world according to GAAP, cash generation is starting to dwindle badly at the big retailer. For one thing, the largely ignored special charges now seem to recur each quarter with metronomic regularity, thus punishing earnings. Sears is staring at a pension shortfall of $1.7 billion that has resulted in charge-offs of $42 million in each of the first two quarters of this year; and there are further pension obligations of about $100 million this year and up to $325 million next year. Likewise, future store-closing costs are likely to exceed those that have produced charge-offs totaling $155 million over the past four quarters, given the number of poorly performing stores in the huge Sears empire and the lugubrious environment of retail real estate.

All of this is apparent when one computes another measure of Sears' financial health -- the free cash flow that the retailer has actually generated over the past three years, after deducting capital spending from the net cash provided by operations. It's not a pretty picture, despite the boast of bulls that Sears Holdings, in normal circumstances, is a money machine throwing off a billion bucks a year for Eddie Lampert to do with what he will.

In fact, Sears produced $495 million in free cash flow in 2008, down from $977 million in 2007 and $920 million in 2006. And the company's cash flow is bound to be stunted this year and next, given the U.S. consumer's straitened circumstances. Moreover, of the $1.2 billion in cash and equivalents carried on the Sears balance sheet at year-end 2008 (Jan. 31 of this year), $663 million belonged to its 73%-owned Sears Canada unit, whose shares trade in Toronto under the ticker SCC. Thus, that cash is beyond Lampert's reach.