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This article attempts to analyze or break apart Lampert's Letter to Shareholders dated 2/23/2012, published almost a year ago. Although the letter is almost a year old, little has changed and Lampert still finds himself addressing almost the exact same issues today, as they still concern shareholders. Edward Lampert is Chairman and recently also CEO of Sears Holdings (SHLD). Examining the rationales in the letter can help one determine whether the shares are a buy, hold, short, or avoid. In the author's opinion, for reasons stated later in this article, they are the last.

The letter is interesting for a number of reasons:

(1) it addresses concerns still present among shareholders today (such as the company possibly running out of funding);

(2) offers a glimpse into Lampert's long thesis and the rationale for his sizeable investment in the company. I will consider these two in opposite order.

1) Lampert's Long Thesis - "The Five Pillars"

In the letter, Lampert shares his five-pillar business strategy, essentially his long thesis.

  1. Creating lasting relationships with our customers by empowering them to manage their lives
  2. Attaining best in class productivity and efficiency
  3. Building our brands
  4. Reinventing the company continuously through technology and innovation
  5. Reinforcing "The SHC Way" by living our values every day

Lampert himself admits that SHLD has been able to make progress on some of these pillars, yet has failed miserably in others.

For instance, as to pillar one, he cites a major success being the Shop Your Way Rewards program - essentially a loyalty program that as of time of the letter, numbered "tens of millions" of members. Of course Lampert does not disclose how this program has added to the sales or profitability of the company. Nevertheless, a group of "tens of millions" of loyal customers is probably an impressive accomplishment, although in my opinion these customers may not be as loyal as it may seem initially - in other words, they'll be loyal only if their loyalty is rewarded with perks, good prices, etc. Still a commendable accomplishment, probably.

Pillar two, according to Lampert, has been a miserable failure. Despite hiring talented retail veterans, no one has been able to transform any significant number of Sears stores into the sort of high-efficiency (whether measured in terms of EBITDA margin, inventory turn, etc.) stalwarts that are Lampert's ultimate goal.

Lampert states that his goal for Sears ideally would be a 10% EBITDA margin - the closest the chain has ever come is 6+% in 2006.

The next logical questions anyone would ask, then, is:

(1) WHY haven't these efficiency goals been reached;

(2) what gives you confidence that you will EVER reach them?

I know the dangers of relying on first hand, anecdotal evidence, but in my view Sears stores appear to be over-stocked, have a poor (untidy) appearance; they look more like warehouses for inventory rather than inventory-turn centers. Whatever the reasons, considering the abysmal failure in changing the nature of Sears stores,

what gives Lampert confidence that he will EVER be able to make the stores more efficient?

Lampert has never sought to address or answer this question. Not in conferences, not in filings, and not in his letters to shareholders. At this point, he wants shareholders to invest based on blind faith that somehow this turnaround will occur.

In pillar three, Lampert compares the Kenmore and Craftsman brands to brands like Nike and Apple. His ultimate goal is "to have Kenmore and Craftsman be the Nike and Apple of the appliances, tools, and lawn and garden industries."

Anything is possible - look at how Apple transformed its brand in a mere decade from Microsoft's poor cousin to the most respected brand in tech. But Nike and Apple are so well regarded for a reason - namely they have the products to back up the brand.

Lampert fails to explain how Kenmore and Craftsman can create the sort of products that will create as much excitement as Apple or Nike. Because of this logical leap -another leap of faith, essentially - Lampert's comparison is comical. And again, in my opinion it represents a failure of communication with shareholders.

As to pillar four, Lampert claims that "we have made great strides driven by significant investments in building the tools and processes to become a truly integrated retailer." By "integrated," I think Lampert means a sort of amazon.com type, one-stop shopping experience that people can access online or in person at stores.

I think self-praise is premature here, because (1) anyone who's visited Sears' websites (especially Sears.com and Kmart.com) knows that these websites are nowhere near as user-friendly as almost any other retailer's; (2) almost every other retailer has done this already; therefore this is an example of Sears merely playing catch-up with competitors, not innovating ahead of the pack.

As to pillar five, Lampert gives lip service to managements across Sears sharing information with one another, and praises this sort of activity.

From reading Lampert's discussion of the five pillars, it appears that the greatest value creation can come from pillar two - in-store efficiency, yet this has been the least successful of the five pillars. In other words, if Lampert gives no indication of a light at the end of the tunnel, must investors merely dream up of a reason on their own?

In the end, to the author, Lampert's thesis appears to have a 'pie-in-the-sky' feeling. Sure, any retailer, from the corner five and dime, to Sears and everyone in between may want to transform their store into Wal-Mart, but for one reason or another, it does not happen often (or at all). Is there a backup plan, operationally (other than asset sales)? For instance, is EBITDA abnormally low due to the economy? If there is a back up plan, it so far has not been communicated to shareholders.

(2) Funding / Asset Sales:

Essentially, Lampert responds to funding concerns by citing the asset side of the company's balance sheet, and throws in a 'trust me', on the basis that the real estate is understated on the balance sheet, due to below market leases and the like.

Additionally, he points to the company's $3+billion revolver (maturing in 2016) borrowing capacity, as well as its ownership of inventory less payables of roughly $5+ billion, as well as its ownership of Sears Canada (95%) and Lands End (100%).

So Lampert believes that, even if the company were to operate unprofitably, it could fund its operations (not from earnings as is usually the case) but from revolver capacity, and, absent that, ultimately asset sales.

Such an explanation is both exciting and troubling.

First, it is exciting because Lampert begins to divulge some of the untapped assets of the organization. Sears Canada trades at a valuation of roughly $1 billion; Lands End might fetch a similar or higher sum.

However, the ultimate goal cannot be to fund a losing retail operation through the sale of valuable or profitable assets; this is turning value investing on its head. A more common-sense approach would be to realize value from asset sales and terminate non profitable operations. For Lampert to even suggest that he would do the former literally makes no sense, as it is a classic example of throwing good money after bad.

This leads one to wonder: (1) whether Lampert would seriously consider doing this (i.e., he has such a strong belief that he can turn the stores around such that he's willing to sell off the entire rest of the company and invest that into the stores; (2) if not, why is he not more forthcoming about the true purpose of the assets? Surely it will not be to take the place of the revolver, as he suggests.

Conclusion:

Sears has always been a sort of black-box investment, with the promise of valuable assets hidden behind an under-performing retail operation. Until true progress, or at the least, improved shareholder communication, is made on either the asset front or the operations front, shareholders are unlikely to see a significant change in their investments.

Source: Analyzing Lampert's Sears Letter: An Unconvincing Long Thesis