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Taking Note of Sears Holdings
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By gocanucks
June 13, 2007

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There are many people posting notes/transcripts taken at BRK shareholder meetings. I went to the SHLD meeting this year instead, and thought people on this board may be interested in what Eddie Lampert had to say. Unfortunately, Eddie was not as forthcoming as Buffett on many questions. Still makes a very interesting read. It was obvious how big an impact Bob Rubin had on Lampert (cited Rubin at least 3-4 times).

All notes were taken by hand, and may not be entirely accurate.

Recap of KMRT/Sears.
� Year 1: There were many things that make it hard for retailers to emerge. Back in bankruptcy days, priority was viability of the business, keep vendors happy -- many restrictions in 1st year and retain store associates.
� Year 2: continue to build cash. Sold some stores, but don't want to sell all. It will be a shame if the competitors took the same locations and be successful. In the mean time, Sears had 800 stores that were stagnating and needed off-mall locations to grow, but would have cost $billions with no guarantee on good return. So (made some sense strategically) to combine the two companies. Could also eliminate duplicative functions, mostly in the back end. Integration took place in '05 and '06, creating new culture and brining in new people.
� Did $3.6B in EBITDA in '06. Profit margin still well below best-of-class, but have no strict time table to catch the comps. Bad practice at both companies will take many years to fix. Spent last 2 years removing weeds.

How will you allocate capital?
� Philosophically, will invest in core business provided it will return decent returns with priority
� Confusion is sequencing/prioritizing: when/how to make investments
� Going forward, all options (buyback, acquisition, reinvestment) are on the table.
� At the minimum, will maintain the stores. With 2300 large-box stores, will be hard to treat them equally when it comes to reinvesting. Online shopping could provide consistent shopping experience, but hard to do with physical stores. A common challenge for all big retailers (GPS?)
� No pre-determined mindset, will depend on economic conditions, operations. Will not rule out more transformational external opportunities (HD?)
� Good companies all have excellent operation capability and capital allocation
� Actual capital allocation will depend entirely on opportunities presented in the year.
� Key is to be flexible, given multiple scenarios and multiple possible outcomes.

What's the right amount of leverage for SHLD given the history of recap at AZO?
� AZO went from little debt to carrying modest debt. still investment grade, stable business throwing lots of CF.
� Very frustrated with the debt rating of SHLD.
� For the last 4 years, debt is down, cash is up, have a new mgmt team showing more discipline with capital. This is what would matter to me if I were the rating agency.
� Yet cash balance apparently does not matter to agencies, as "it can be used in anything", which was true with previous mgmt team.
� Feels credit agencies had shifted to more of a approach based on momentum (past performance). Should be more statistics driven. Companies undergoing transformations are often misunderstood.
� The fact that SHLD is not investment grade is a "joke". Feels many AA rated companies do not deserve that rating. What good does it do if a company keeps AAA rating but stock stagnates for 10 years?
� AZO went from no debt to $1.8B of debt. But it did not happen overnight
� Still want to keep powder dry for options.
� See lots of uncertainties. Want to take care of employees/jobs, doing the right things.
� Do not want to pass judgment on the amount of leverage many companies are taking on these days, but think it could lead to problems in downturns, especially when it comes to customers/employees.
� Thinks PE funds should be responsible for beyond shareholder value, like jobs.
� Sustainability is the key. We don't assume future is always rosy. Roads will be bumpy and we will never be as aggressive as others with leverage.

Is SHLD falling behind in IT system (cited JCP/KSS getting benefits from systems like markdown optimization, new POS, etc).
� We are implementing the same systems, but just not doing press releases.
� Part of the running the business for a promotion driven business, don't understand why others make a fuss out of it.
� KMRT actually spent millions of $ in IT before bankrupcy.
� IT integration between Sears and Kmart should be 90% complete by year end (68% now).

Why not borrow money when it is cheap like Buffett?
� No right answer with "right amount of leverage"
� Not best predictors of future interest rate

Books you are reading?
� "Black swan", by the same author who wrote "fooled by randomness". Explains low probability event that has big impact on eventual outcomes. Applicable in business and politics, and explains why many big 5-year plans fail.
� We are in an uncertain world, and need to deal with probabilities.
� Most people value certainty and want to know everything is ok. Those that assume uncertainty are often not taken seriously but proved right eventually.
� Will make mistakes at SHLD, given the size of the company.
� Last year's recommendation is "Crazy Busy".

What's the implication of the reinsurance subsidiary and recent securitization of brands?
� Media read too much into the events. Not wrong about possibilities, but wrong about intentions.
� Reinsurance subsidiary was set up in 2001, sells lot of protection, like many other big companies. Used credit card receivables as collateral, but that asset was no longer available after selling the CC biz in 2003. So put in real estate instead. All of this happened before the merger (so not Eddie's decision, but he was a big shareholder then)
� Reinsurance is all about risk management. Real estate and brands are all assets and have value. So chose to replace real estate with brands as the collateral.

What are the success factors in retail turnarounds?
� Most recent significant turnaround was JCP.
� New guy coming in with long history in retail. Had a 5 year plan. Sold underperforming divisions (Eckerd chain), and took more dramatic actions than at SHLD.
� Sears actually had similar attempts 2 CEOs ago. Success as a leader is often equally dependent on circumstances.
� Frustrated that retail world still dismisses him with no retail experience, despite past success at AZO/AN. Call his mother (a Saks veteran) with questions on retail. (His mom was in attendance)
� FD-May merger are taking more extreme action also, but since they were done by people from retail world, they get benefit of doubt.
� Big companies have more staying power, but also much more complex.
� It is a shame that Kmart sold stores that were doing $200K EBITDA to competitors that are now doing $7-8M EBITDA on the same site.
� Turn-around is challenging. Cited a study that illiterate children can close the gap within 1 year at 5-6 years old, but will take 3 years at 12 years. Kmart and Sears had both been mismanaged for a long time.
� KMart has gotten a lot better, but the problem is that competitors don't just stand still. Getting better is necessary, but still need to close the gap and win back customers who give benefit of doubt to successful companies.

Given the lack of communication with outside investor base, how do you know when an approach/path is not working?
� Could see competitors that are doing things that just do not make sense. An entire industry got off track by blindly following one rogue company in WorldCom.
� Like to create options. What can we do if one approach does not work? Always have plans for alternatives.
� Timing of decision is important. Tribune could have sold the company 3 years ago for twice as much as they could get now.
� We do not "wish" reality, while many other companies have wishes.
� We constantly ask/challenge ourselves whether the path is right.

A gentleman asked whether Eddie's attire was from Sears or Sachs (they showed a cheesy TV ad where everything in the ad from appliance to apparel was in Sears). Eddie smiled and said "neither" (crowd laughed. BW article described Eddie dressed in tailor made suits. Surprise surprise)

Any plan for a stock split?
� Want to create a long-term oriented share holder base. This position is reinforced by more and more companies, like BRK, Washington Post, GOOG. (Then the person who asked the question proudly claimed he owns shares in all those companies mentioned and will go to Omaha tomorrow. Eddie replied "now you know who to talk to about stock picks at break-out sessions)

Source of cash in WC improvement (ala AZO)?
� Lots of moving parts. This year will have $100-200M extra inventory in pharmacy categories after ending arrangement with CAH.
� Will choose to pay a lower price to take inventory sooner.
� Still not happy with WC and see many LT opportunities.

Was total return swap used to build value or hedge?
� Again, this was blown out of proportion - swap produced $100M profit vs. $3.6B EBITDA. Need to be put into context. Notional value of the swap was not that big compared to $30B balance sheet. Even if lose $300M, it wont be that big a deal, as we do sales of $1B every week.
� There may be things going forward that are non-traditional.
� On Swaps, have to say they are risky because lawyers insisted, even thought they are not really risky (interesting)
� Disclosure was to make sure people know we are doing it, but not signal that we will be a hedge fund.

Is Kmart really stable given weak results in Q1?
� Yes, it is stable. Even with problems (weather), made lots of money, but not Circuit City (ouch).

Difference between investing and managing companies?
� As investors, may think of strategies that sound great but hard to execute. Many of these grand strategies have very low probability of success.
� People may trade in/out stocks often, but uncomfortable taking LT view of business unless with own money at stake.
� Our board holds lots of stocks. Opportunity looks difference depending on whether own money is at stake.

Margin opportunities for SHLD compared to peers. WMT spending $650M in marketing, and SHLD spends $2B.
� Cost of closing weaker stores is mostly people costs (landlords happy to take back leases?)
� Difference is SHLD is very promotionally driven. Efforts on managing markdowns, sending circulars have taken away focus on customers.
� Have and plan to cut back mkting and lower prices.
� JCP/KSS very promotional. WMT everyday low price. TGT is somewhere in middle.
� WMT has great advantage of single low price everyday. Same is AZO.
� But SHLD inherited a legacy of promotion driven business.
� Land's End is different.
� As for marketing, key is to get bang for the buck. With online ads, newspaper decline, traditional ways of doing things have changed. Also need to remove inefficiencies such as sending appliance catalogs to customers who just bought appliance recently. Not matter how good the deal, they will not bite.
� Gross Margin: private label (apparel) has higher margin than brands, so mix shift will create lots of opportunities. Key is to be flexible and serve customers better (give them brands if they desire so).
� Exclusive brands matter a lot and are valuable. Need certain brands (crest/colgate) to keep customers, but won't differentiate business.

Big drivers of value? Sales? Margins?
� Inherited mix of sales that was not optimal.
� Taken time to understand how each category is priced, promoted, mattered to customers.
� Intentionally lost sales
� Key is to drive more customers, and drive existing customers to buy more - if they are buying tools, drive them to buy electronics. So big opp of converting/upselling.
� Customers are not equal - buying a DVD is a lot different from buying a plasma TV.
� Still in the process of testing/tweaking product categories.

Looking back to AZO's GM improvement, what are similarities and differences?
� AZO was a single category business. Some products turn very slow, maybe once every 2 years, so knowledge of customers and products (how often they break down) is crucial, and means AZO can carry fewer inventory and charge higher price and higher margin on those products.
� SHLD sells a big range of categories, both branded and private label.
� Biggest misunderstanding of improving margin is to "juts cut costs". "Cannot be further from the truth".
� $500 sales at 2% margin is a lot different from $500 sales at 40% margin.
� Mix is crucial. Where we invest in inventory/shelf space.

Operational Metrics: Are there stores that are way below chain average?
� No store is at aspirational 10% margin level.
� Home service could get to that level.
� Emotional attraction of customers like Nike and Apple just not in SHLD's DNA
� Wide variance in store metrics. Not all are making money.
� (IMPORTANT) Don't like to close stores just because they lose money. Take LT approach. For money losing stores, question is can/when/what kind of effort? Will not hesitate to reinvest if expect marked improvement, whether the store is very profitable or not making money at all. Stores that are marginally profitable and not projected to improve much, will not re-invest, and re-evaluate for possible closure
� Would have liked to keep more stores open during bankruptcy even though they were losing money.

What to make of real estate opportunities?
� No retailer should aspire to have underlying real estate worth more than operational business. SHLD is no different.
� However, will not rule out opportunities of selling more stores.

Is SHLD turning into another BRK? Conflict of interest with ESL?
� Company of this size provides lots of opportunities. SHLD is a $50B start-up, and could provide variety of opps/career paths that could be magnet to talents.
� Just stock options or pay packages are not enough.
� Large shareholders often make the company overly conservative. KO did not buy Quaker Oats, which look to be a mistake.
� Future direction is flexible but core biz will be retail. BRK core business is insurance, despite headlines of stock investing.
� Companies are about taking risks. Both BRK and SHLD have the base/balance sheet to take risks. Want employees to take calculated risks. Some losses are expected and ok.
� Will not rule out possibility of investing in stocks like buffet did.
� Think P/E firms have more conflict of interest with various portfolio companies. Have checks/balances in place to make sure conflict of interest. (2/20 sure doesn't hurt either)

Sears Canada:
Felt we did the right thing - unlocked the value first (selling the CC portfolio) before making the offer. Could have made a bid and kept all profits for ourselves.

Consumer slowdown?
� Economic environment is soft. Sub-prime issue was created in a low interest environment. Good part was getting more people to buy houses, bad part is that some of them should never be owners to start with.
� Interesting that Sears comp'd better than HD/LOW in Q4, despite many overlaps
� Need to control costs better in down times. Do not want to spend money when there is no customer.

How do you create right incentives? What metrics to use for employees at different levels?
� Compensation is partly performance driven, and partly legally driven -- certain discrimination is ok, but others are not.
� SBUX does a much better job getting more out of its employees despite similar compensation schedules, so key is to go beyond compensation.
� As a metric, SSS is important, but does not matter as much as people think.


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