The Best Retail Stock for 2007: Sears Holdings

Sears Holdings (Nasdaq: SHLD  ) -- the parent company of Sears Domestic, Sears Canada, and Kmart -- is still a retail company. Holdings' business is still selling everything from apparel to dinnerware to basketballs to video games to bridal jewelry. The question today, though, is whether it's Holdings' retail operations that make it an attractive stock.

The holding company was formed in 2004 when Kmart, freshly listed after coming out of bankruptcy, announced that it was going to purchase Sears, Roebuck and Co. The man to orchestrate the $11 billion deal was Kmart's chairman, Eddie Lampert, a savvy investor who managed roughly $15 billion in assets through his hedge fund, ESL Investments. Though there was a lot of skepticism at the time of the announcement, shareholders have been rewarded, as the stock has nearly doubled since the end of 2004.

Shedding light on Lampert
In 1984, at the age of 22, Edward S. Lampert interned at finance powerhouse Goldman Sachs, eventually moving to the company's risk arbitrage department a year later. In 1988, preferring to see what he could do on his own, he left Goldman and started his own money management firm, ESL Investments. From its humble beginnings, ESL compiled an impressive record, with some citing returns of nearly 30% per year over the life of the fund.

Lampert's style of taking highly concentrated positions in highly-researched value-oriented investments has drawn many comparisons between him and Warren Buffett. Buffett's firm, Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) started as a textile operation, but used its free cash flow and Buffett's investing acumen to become a holding company and insurance powerhouse. The comparisons between Lampert and Buffett were redoubled when Lampert arranged the Sears-Kmart merger -- many saw the assets and the cash flow of the combined company as an opportunity for Lampert to build a Berkshire-like vehicle.

Sears in the Lampert era
So the question is how this short history of Eddie Lampert, Kmart, and Sears leads to a good investment. Though operations like Target (NYSE: TGT  ) and JC Penney (NYSE: JCP  ) make Holdings' businesses look second-rate at best, and declining comp store sales and overall sales underscore that fact, Lampert has managed to make it worth shareholders' while to hold the stock. Aside from aggressively using cash to buy back stock, Lampert has approval from the board of directors to invest the company's excess cash in whatever way he sees fit. For the nine months ended in October, Lampert managed to bring in $241 million in investing income, using primarily interest-bearing investments and total return swaps (a type of equity derivative investment). This represented over 20% of the company's pre-tax income for the period. Going forward, the operating business' strong cash flow and the potential sale of some of the company's real estate holdings will only add more firepower to Lampert's arsenal.

On the business side, there is also hope. As sales have been declining, cost-conscious management has led to higher gross margins and declining overhead expenses, making the company more profitable. Continuing problems at Wal-Mart, the world's largest retailer, have been good news for Target and others, but could also present a refocused Sears/Kmart with an opportunity to lure former Wal-Mart shoppers. The company also still has a nice set of brands to leverage, including Craftsman, Kenmore, Joe Boxer, Lands' End, and Martha Stewart Everyday.

Is Sears Holdings going to be an eight-bagger over the next few years? Probably not -- it's already a $28 billion company. Well-chosen investments by Eddie and even a modest turnaround in the actual retail business, though, could mean market-trouncing returns in 2007. So do you think Eddie has what it takes? Let the other 20,000 players in The Motley Fool's CAPS service know! Think I'm wrong and Sears is dead money? Well, hop on CAPS and get yourself heard. CAPS is full of great investing insight and is absolutely free to play.

More retail from the Fools:

Go back to the beginning to see what other retail stocks are in the running for our CAPS contest.

Wal-Mart and Berkshire Hathaway are both Inside Value recommendations. If you're passionate about value like Lampert, Buffett, and Inside Value lead analyst Philip Durell, then click here to receive your free 30-day trial.

Fool contributor Matt Koppenheffer is ranked 2,398 out of 20,130 on CAPS, but hasn't benefited much from his position in Sears Holdings -- yet. He also owns shares of Goldman Sachs, but does not own shares of any of the other companies mentioned. The Fool's disclosure policy never needs a hedge.


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