Sears Holdings ( SHLD) mastermind Ed Lampert copped to missteps in his fashion department Tuesday but warned critics that their "so-called expert" opinions about his company usually have been wrong. In a wide-ranging letter to shareholders that was filed with the Securities and Exchange Commission, Lampert, the usually taciturn hedge fund manager who merged Sears and Kmart last year, lampooned media critics who question his long-term strategy. "I will not dwell here on the many instances where the 'conventional wisdom' -- for example, the view that Kmart would neither emerge from bankruptcy nor survive its first Christmas as a new company in 2003 -- has turned out to be only 'conventional' and not at all 'wisdom,'" Lampert wrote. "I will simply say that I am pleased with the progress we are making at Sears Holdings." The comments accompanied a third-quarter financial report that showed same-store sales falling at both Sears and Kmart. Lampert conceded that "customers have not yet embraced the new, more fashion-forward brands" Sears rolled out in the quarter, and promised to fix the problem. "Being a learning company also means appreciating frankness and being willing to recognize where our ideas have not played out as expected -- so that we can refine and change course," he wrote. Sears and Lampert have received increasingly hostile press in recent months as the stock has retreated from above $160 in July to a recent quote of around $120. Pundits, keying on Lampert's billion-dollar paycheck as manager of ESL Investments, have wondered whether his grand ambition of merging two struggling discount chains makes economic sense. "Although all the attention Sears Holdings is receiving is, in some fashion, flattering, I would caution you to approach much of what is written and said about us with an appropriate amount of healthy skepticism," Lampert wrote. "This is particularly so with respect to the loudest views, the most widely held views, or the so-called 'expert' views. For many commentators, analysts, and reporters, their success is dependent on the excitement or controversy generated by their articles -- not on the accuracy of their writing or of their predictions."
Lampert sounded ominous when he said some of his critics "cloak themselves in anonymity or do not disclose the true motives that are driving their comments." Earlier, Sears said third-quarter earnings were $58 million, or 35 cents a share, including a net charge of 7 cents a share from restructuring and divestiture items. Sales were $12.2 billion. Analysts surveyed by Thomson First Call were forecasting earnings of 28 cents a share on sales of $12.95 billion. The better-than-expected earnings gave the shares traction Tuesday morning. The stock was recently up $6.92, or 5.9%, to $123.63. Still, bears are sure to pick up on the sales miss and a line in the earnings release showing that Sears spent $153 million on capital expenditures in the latest quarter compared with $55 million and $264 million spent by Kmart and Sears, respectively, a year ago. In his letter, Lampert defended Sears' capital spending strategy. In an increasingly competitive retail landscape, Lampert has consistently kept a lid on investing cash back into stores, a strategy he employed with success at AutoZone ( AZO). Critics have maintained that the strategy may enrich shareholders in the short term, but could damage the long-term viability of the company as customers flock to Wal-Mart ( WMT) and Target ( TGT). Lampert rejected that "more is better, or that there is a certain amount that must be spent on cap ex every year." He said reinvesting in stores is not always the most productive way to spend a retailer's cash, noting that sometimes acquisitions or stock repurchases produce better returns. In these cases, he said, "it would be a mistake to plow money into capital expenditures merely because that is the 'accepted practice' or 'expected.'" During the quarter, Sears repurchased $434 million of its common stock, reducing its share count and boosting its earnings per share. It also paid down $700 million in debt, contributed $270 million into its pension plans and funded the $1.4 billion seasonal build in its inventories for the holiday selling season. By year's end, Lampert expects the company to have $3 billion in cash on its balance sheet.
"We believe these resources give us ample ability to invest in our business and pursue attractive investment opportunities," he said. An ability to raise cash to find attractive investment opportunities has been the cornerstone of Wall Street's enthusiasm for Lampert, leading to a quintupling of Kmart's shares in 2004. Analysts have pointed to Sears' real estate portfolio and its Lands' End catalog business as assets the company could sell to raise cash and return value to shareholders -- even if its retail operations continue to underperform. During the third quarter, Sears completed the sale of the credit card operations at Sears Canada, its 54%-owned subsidiary that is publicly traded in Toronto, to J.P. Morgan Chase ( JPM). The deal raised $2 billion after taxes, of which $820 million will go to Sears Holdings in mid-December. On Monday, the company announced it would buy up the remainder of Sears Canada. "We believe that Sears Canada will best be able to compete if it is owned 100% by Sears Holdings," Lampert said. "The benefits will include an ability to reduce costs and counteract some of the scale advantages of the US competitors as well as the ability to focus on long-term challenges rather than having to meet short-term expectations as a public company." Also during the quarter, Sears completed the sale of part of its Orchard Supply Hardware chain, a chain of hardware stores in California. Ares Management LLC, a private equity firm, bought a 19.9% stake in the chain with a three-year option to buy another 30.2% stake. "We hope that if Ares exercises its option, the value of Orchard is then substantially above the exercise price, because the ownership interest we would continue to own after exercise of the option would allow us to share in the additional value creation," Lampert said.
Due to a weak junk bond market, Sears had to accept a note, with an initial 10% interest rate that increases over time, for $230 million in the transaction instead of getting a $450 million cash dividend from the recapitalization, as originally expected. Lampert said the structure of the transaction "allows us to share in additional value creation, when we concluded that potential buyers did not recognize what we believe to be the true value of the business." Aside from asset transactions, top-line pain was still apparent at Sears Holdings in its third quarter. Kmart, the formerly bankrupt discount chain refurbished by hedge fund manager Lampert, third-quarter sales fell by $300 million, year-over-year, while sales in U.S. stores open more than a year dipped 2.8%. At Sears, which Lampert acquired via Kmart a year ago, domestic sales fell 6.3% from a year ago on a 10.8% same-store sales decline. "While Kmart's overall comparable store sales declined as a result of lower transaction volumes across most businesses, most notably home products and electronics, the apparel business outperformed other businesses and had positive comparable store sales during the period," the retailer said. "The decline in Sears domestic comparable store sales reflects efforts initiated in 2005 to improve gross margin by reducing reliance on certain promotional events and weak apparel sales resulting from weaker than anticipated customer response to fashion offerings within the full-line stores," the company said. On the bright side, Sears reported pro forma gross margin of 27.5% in the latest quarter, up from 26.8% a year ago, and said it has bought back $434 million of stock since March. Sears' pro forma earnings before interest, taxes, depreciation and amortization was $426 million in the latest quarter, excluding a restructuring charge, or 3.5% of revenue. The number was $396 million, or 3.1% of revenue, a year ago.
Overall, Lampert stressed the company's determination to focus on creating shareholder value over the long term rather than focusing on the short-term whims of Wall Street and the media. "Most observers and financial pundits missed the turnaround at IBM ( IBM), missed the turnaround at American Express ( AXP), missed the turnaround at J.C. Penney ( JCP), missed the emergence of Google ( GOOG), and missed the resurrection of Kmart -- until it was abundantly clear that those companies had succeeded," he said.