Should You Bet Against This Famous Value Investor?

It’s pretty safe to say hedge-fund manager Edward “Eddie” Lampert has gotten far more headaches than he bargained for in 2005 when he bought a major stake in what has since become Sears Holdings (Nasdaq: SHLD).

Back then, he promised a more profitable company and more growth. He’s subsequently delivered 18 consecutive quarters of declining year-over-year sales and managed to turn a reasonably profitable company into one with growing losses.

Oh, and there’s no end in sight to the widening losing streak.

What happened to this American retail icon? To answer the question meaningfully, we have to go back to Lampert’s beginnings.

Hedge fund pro turns retail wizard… or maybe it was just luck
By most accounts, 49-year-old Eddie Lampert started on the right foot. He formed his hedge fund, ESL Investments, in 1988 with the intention of following in the value footsteps of Warren Buffett. And for a while, he did it quite well, using Buffett’s model and boasting of average annual gains of nearly 30% for the first several years of the fund’s existence.

It wasn’t until 2003, however, that Lampert forever cemented his name into investors’ memories with an amazing retailer turnaround story.

Though K-Mart was technically coming out of bankruptcy proceedings at the time, the market had pretty much assumed the worst, even if there was still going to be a semblance of a company left when it was all said and done.

But contrary to what most thought, Lampert didn’t see the remainder of K-Mart in a pessimistic light. He saw a company with an established name in the discount retail business that had 1,500 stores. Most important, he saw an opportunity to acquire a cheap stock that owned 1,500 pieces of prime real estate.

He paid just under $1 billion for a big chunk of the reorganized outfit — real estate and all — worked some magic, and ended up selling 68 of the company’s stores to Home Depot (NYSE: HD) for $850 million… almost what he had paid for the entire company just a few months earlier.

His stake in the remaining 1,400-plus stores was valued at $2.5 billion by the end of 2004.

The revamped K-Mart became such a reliable cash flow producer ($17.1 billion in revenue in 2003 alone), it largely funded the acquisition of a majority stake in Sears in late 2004. The combined companies became the Sears Holdings we know today.

Unfortunately, the magic Lampert worked with K-Mart hasn’t worked with Sears at all.

This isn’t a K-Mart redux
Despite promises of synergy between the two companies, few have been realized. And despite promises of cost-cutting its way to greater profits, Lampert’s stinginess with capital expenditures has ultimately led to falling sales and increasingly-frequent dips into the red ink. Per-share earnings of $9.00 in fiscal 2007 have turned into a per-share loss of $4.69 in fiscal 2012. The company is expected to lose $4.56 per share this fiscal year.

Lampert has been burning through the company’s cash, too. Sears had $1.36 billion in the war chest a year ago, and now it’s got $747 million. To put these numbers into perspective, the retailer took a $2.44 billion loss last quarter — despite the busy holiday shopping season — on $12.5 billion in sales.

Lampert’s response?

He says the company “has a profit problem, not a liquidity nor an asset problem.”

Few would argue the lack of profits isn’t a problem. But, with the company aiming to divest 11 Sears stores as well as its Sears Hometown and Sears Outlet stores to put a much-needed $1 billion back in the bank, it’s difficult to say the retailer isn’t also in a liquidity crunch.

It all begs the question, what happened to this seemingly-brilliant guy who unlocked so much value with K-Mart? The answer is, K-Mart was a real estate and balance-sheet driven decision.

Sears wasn’t.

From the outside, retailing looks like a relatively simple business. But it’s fiercely competitive and it can’t be managed from a balance sheet perspective. Retail has to be managed at the store/customer level, which isn’t something most value-hunters embrace until it’s too late.

Lampert saw what he thought was excessive capital spending and a chance to go toe-to-toe with Wal-Mart (NYSE: WMT) and other discount retailers. He hired veterans with no retail experience to run stores like they’d previously ran technology companies. Case in point: Lou D’Ambrosio — former executive at IBM (NYSE: IBM) and CEO of privately-held Avaya, an IT firm. D’Ambrosio had never been involved in retail before — but now he’s the top man at Sears.

He and Lampert appear to be learning the hard way that retail is as much of an art as it is a science.

Risks to Consider: Investors love to get in on turnaround stories. Whether one is actually happening or not with Sears is irrelevant. Some traders say it’s happening, and this alone is often enough to prod a stock upward. As such, it’s possible that not owning shares — or even shorting them — could leave you on the wrong side of the near-term trade. On the other hand…

Action to Take –> I think Sears Holdings is a name best avoided by true long-term investors until all the liquidity and profit kinks are clearly worked out.

This doesn’t necessarily mean it’s a short (bearish) trade, but things are apt to get worse before they get better, even with a successful liquidation of some of the company’s parts. Sure, the market may temporarily love it while it’s happening, but as Lampert has said, this is ultimately a profit problem. And selling stores doesn’t actually solve the profit problem.