Eddie Lampert: Value investor?
Nearly every article I read last week about the merger between Kmart (Nasdaq: KMRT ) and Sears (NYSE: S ) opined that Eddie Lampert is the next Warren Buffett. They talked about how Lampert has studied Buffett's every move, how Lampert is a value investor, and how their records compare favorably even though Buffett's is over a longer period of time.
Frankly, I don't care whether Eddie Lampert is the next Warren Buffett. And I have a feeling he doesn't care either. I would guess that he wants to make his mark as Eddie Lampert. But I do care that Lampert seems to be a value investor because there is something we can all learn from that.
Price is what you pay
The first tenet of value investing is to buy assets at bargain basement prices. Using bankruptcy as a call for a blue-light special, Lampert picked up his 53% stake in Kmart for about $1 billion, and his investment has increased sevenfold since then. Looks like Hidden Gems analyst Rex Moore has company.
To purchase Sears, Lampert offered $50 in cash or half a share of Kmart stock for each share of Sears stock. Take your pick, but either way Sears comes out with a price tag of about $11 billion.
When you add them together, it looks like Lampert will spend about $12 billion to gain control of two retailers that have fallen hard from grace because they did not know how to compete with those "hillbillies" from Bentonville, Ark., and their 800-lb. gorilla, Wal-Mart (NYSE: WMT ) .
But why would someone pay $12 billion for a couple of has-been retailers?
Value is what you get
It all comes down to what you get out of the deal.
Kmart has 1,504 stores. Sears has 1,971 stores, of which 870 are mall-based and 1,101 are stand-alone. After purchasing his controlling interest, Lampert sold 68 Kmart stores for $846 million, or about $12.4 million per store. Now let's assume that he could liquidate the entire portfolio of stand-alone stores, all 2,605, for $6 million per store (this is only a wild guess based on 50% of the $12.4 million Kmart store price tag above). That would value the portfolio of just the standalone stores at $15.6 billion.
But let's not forget a very important piece of a retailer's puzzle that I have not heard much about yet. I'm guessing Lampert picked up two distribution systems quite cheaply. Now I know that my example is based on the $6 million assumption (a wild assumption, remember), but nonetheless, I believe Lampert bought some pretty good assets at bargain prices.
Think of it another way. Target (NYSE: TGT ) has 1,554 stores under its umbrella. According to its balance sheet, Target has $15.4 billion of property and equipment when you add back the accumulated depreciation. Thus, Target seems to have spent an average of $10 million per store, not accounting for distribution system costs.
Could Lampert have built a retailer from the ground up for $10 million per store? No way! It would take far too long and cost far more to do so effectively. Instead, he bought the pieces of two existing ones and will attempt to put them together to set the new company up with enormous economies of scale.
But the really cool thing is what else Sears brings to the table -- the brand-name merchandise. Sears generates $41 billion of sales using household names like Kenmore, Craftsman, and DieHard. Now if only those sales could be used productively to create value.
The role of the CEO
Just because the stores are under one roof now does not guarantee success. In fact, the cards are definitely stacked against the new company. It is going to take a great leader to create value out of the situation.
Warren Buffett, chairman of Berkshire Hathaway (NYSE: BRK.a ) , says he has two roles: motivator and capital allocator. I think the same principle applies to Lampert. For the company to create value for shareholders, Lampert will have to allocate capital and motivate people in such a way to make the business productive. Over the years, Wal-Mart has redefined retailing by using productive systems to lower costs. Costco (Nasdaq: COST ) relies on a similar productivity model but really understands the value of motivated employees.
In my mind, the easy part of the deal is the capital allocation piece. Capital should be spent to upgrade the distribution system as well as others like the point-of-sale system. It should also go to modernizing the stores to give them a fresh, new look. The hard part is going to be creating a culture that strives for low costs in order to make sure that sales create value. Wal-Mart and Target already have this. Lampert does not.
The fruits of his labor
In the press release following the merger announcement, Lampert specifically said that his team would manage the company for the long term and would not worry about bumpy earnings along the way. That's good because this culture thing is going to take time and money.
But if he can pull it off, I think there's a great deal of value to be created along the way. To find out how much, let's look at a peer-group comparison.
|$ in billions|
Enterprise value is equal to market capitalization plus debt minus cash. Comparing the EV/sales ratios for the retailers, we see that the market places considerably less value on the sales of Kmart and Sears. If the new company can achieve Target-type respect, then its value could triple (1.15/0.37 = 3.1). This is the payoff that Lampert is striving for during this journey.
Margin of safety
So what if it doesn't work out? Let's say that Lampert has to liquidate the portfolio and distribute the cash to shareholders. How much could he give back to them?
$ in billions
Cash from store sales $15.6
Plus cash on the balance sheet $5.2
Minus debt on the balance sheet $6.1
Divided by price paid $11.9
Trust me, I know this is an estimate and that actual distributions would be based on all sorts of complicated negotiations with lawyers and such. Plus, in the event of a real liquidation, it's not certain what sort of prices the stores would fetch. But to me, this says that there is some margin of safety built into the strategy.
Eddie Lampert: Value investor
I believe Lampert has one goal in mind -- to create and capture as much value from the assets as possible. He started things off right by buying decent assets at low prices. He has plenty of capital to allocate to those assets to increase their value. And there appears to be some margin of safety built into the plan if he cannot.
Is this merger about synergies? No way. It's about competing effectively against the best retailers in the industry today. That's how he will try to make his mark. But can he lead the turnaround and create a culture that can control costs and create value from those $55 billion worth of sales? Lampert's made a big bet on his ability to do so.
Perhaps one lesson from Buffett that Lampert needs to remember is that Buffett started small. He took lots of smaller swings before he took the big ones. By doing so, Buffett learned how to lead a business along the way. This is an awfully big swing for someone making the same transition from managing a hedge fund to managing a company. Personally, I think the inertia of the current culture will be much harder to turn around than anticipated and I will be more than happy to watch this from the sidelines.
Philip Durell has lots of experience with turnarounds. You can try his Inside Value newsletter free for 30 days to see where he is finding value.