Tuesday, July 24, 2007

Sears: A Look Back At The Merger Announcement

With all the clatter out there about Sears Holdings (SHLD) results and the frustration out there a look back is necessary. I was emailed a copy of the press conference announcing the merger of Kmart and Sears by the blog "Concentrated Value" and it was very revealing given what has transpired since and what may happen down the road.

Lampert on Earnings:

"And given the large ownership that we will have on the Board, we will be able, similar to what Kmart has been able to do for the last couple of years, we will be able to manage the business strategically and for the long-term without having to worry about figuring out how to make monthly same-store sales, hit a specific target, and without giving any type of quarterly earnings guidance and then trying to manage the business to that guidance. We understand the potential for the combination. We're going to manage to the potential, and we're not going to manage to try to generate sort of steady progress. It's going to be probably lumpy progress over time."

Lampert On Real Estate Value
" I don't think any retailer should aspire to have its real estate be worth more than its operating business. There's been a lot of speculation about real estate strategy, real estate value, and I think that there is some truth to the notion that there are certain retailers whose real estate is worth more than its operating business. I think while that may have been true at Kmart at one point in time, we've worked very, very hard to improve the profitability of each of our stores and to make those stores worth a lot more as an operating business than as real estate. The more money the store makes, the more valuable they are as operating businesses, and that's something that I think the combined company can do very, very well.

To the extent that we have stores that can produce the type of profit that we're looking for, we would have to consider other alternatives. I think well-run retailers over time should be able to earn a 10 percent EBITDA to sales ratio. I think when you look at Home Depot, you look at Target, you look at The Gap, they all achieve that metric. And again, that's not something we think that we're going to be able to do anytime soon, but that's something that we're going to work towards. We're going to work towards best-in-class financial metrics and best-in-class customer metrics."

Lewis on Cost Savings
"Savings we expect to be fully realized by the end of the third year. We expect this transaction to be accretive in the first year, excluding some onetime costs"

Lampert responding to the comment: Beyond doubling the synergies here, you are not just doubling the challenges also; taking 2 admittedly weaker retailers and just increasing the challenges that both of them face in one larger perhaps weaker retailer entity?

"You made the sure statement that you're talking about 2 weaker retailers, and I would say that there is probably unanimity of opinion that that's the perception of the 2 companies. My perception of Sears is that in terms of the Sears experience, the Sears service, and certainly the Sears products, they're every bit as good as any of its competition. The problem is they are not where the customers are, and that's the big opportunity. It is not that the retailer per se is weak, but if you have the greatest store and it's not near where the customers are, that's a problem. So I think Sears has a very, very different problem in a sense, or had a different problem than Kmart had. So I think that it's a pretty substantial opportunity to simply bring Sears experience and the Sears product closer where, by the way, Home Depot, Best Buy, Lowe's, Target, Wal-Mart, that is where they are building, that's where they're growing. We're there. We know it because they seem to want to open stores near us, meaning Kmart, because we are perceived as a weak competitor.

In effect, Sears in a Kmart box in that same environment ought to do very, very well. So that's the presumption; we've got to make it happen. So I think that is really the answer to the first question. In terms of cross-merchandising, we're going to try all different types of things, and I think that we have the ability because we have such a large store base to experiment. And we're going to get some things right and we're going to get some things wrong. But we're going to have a flexible culture, and with a flexible culture, we're going to correct our mistakes quickly and move onto something else."

Lampert on Capital Allocation

"I would say that in terms of capital allocation, I mean that is something that I think that this company will do very, very well. It is great to have internal opportunities where you could actually take the free cash flow and invest it in the business. We have a very significant opportunity, whether it is converting the Kmart stores to Sears, whether it is converting the Kmart stores to a better version of a Kmart store. But we are going to have very strict return on capital requirements, and we're going to want to allocate the capital to where the best -- where it is best used. And if the best use is to repurchase shares, we're going to look at that. If it is to build new stores, we're going to look at that.

I think it is important that at least through the transition period, we have a very, very strong balance sheet. And I think that Kmart went through a period where it had a weak balance sheet, and we basically built up sort of undeniable financial strength. I think once Sears sold the credit card business, its balance sheet was very, very significantly strengthened. And I think on a combined basis, you look at the combined cash flow, we feel obviously very comfortable with where we're coming out of the box. But I do think that at different stages of opportunity, you have different capital structures, and it is something that I think we will critically review on an ongoing basis."

So, where are we? Lampert and Lewis are managing the business exactly as they said they would just over two years ago. Lampert anticipated a bumpy earnings ride and it has been, he promised balance sheet improvement as a priority and has accomplished that, they also said they had no set idea as to merchandise and was going to try various ideas and are doing it. Notice no mention of the Land's End expansion currently underway and this illustrates they are flexible and still looking at ways to improve and coming up with new ideas.

All in all, the plan is being executed as initially proposed. It seems the first two years were being spent fixing the financial mess the two separate retailers were in and now we are onto the sales end. That this stage of the plan has coincided with the housing bust and it's corresponding effect on all retailers like Home Depot (HD), Target (TGT), Lowes (LOW) and Macy's (M). It does also mean that other retailers will get cheaper and may mean that Lampert may choose to invest the cash in another retailer rather than build new stores from scratch.

Either way, it will be exciting

Now, the recent stock activity. Take a look at a long term chart of Sears Holdings here. The summers of 2004, 2005 and 2006 all saw large percentage share price declines of 15%, 26% and 15% respectively followed buy large run ups and no, same store sales were not increasing back then either. This current one is a great buying opportunity as shares are off 26% from their all time high, just like 2005. Let's call it the "Annual Sears Summer Stock Sale Event"

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