Retail Discounters: Hope Their Exotic Investments Excel

Today's Heard on the Street column tells you everything you need to know about the current market.

Sears Holdings (SHLD) may be struggling as a department-store operator, but it is proving an astute hedge fund under billionaire investor Edward S. Lampert.

The retailer, controlled by Mr. Lampert, earned more than half its net income in the fiscal third quarter ended Oct. 28 from investments in exotic derivatives designed to mirror the performance of company stocks. Those investments helped triple net income, to $196 million, or $1.27 a share, despite weak sales at its Sears and Kmart stores....

The company turned an investment in derivatives in other companies' shares into a $101 million after-tax profit during the quarter. A spokesman for the Hoffman Estates, Ill., retailer declined to disclose the company or companies whose shares were represented by the derivatives.

In a statement, the company said the investments involve "substantial risks," adding that future results "may be positively or negatively materially affected based on the timing, magnitude and performance of these investments."

The financial derivatives used by Sears, known as "total-return swaps," are agreements that take on the big risks of highly leveraged investments in equities or other assets without actually buying them or assuming debt to purchase them, said David Krein, president of New York structured-investment adviser DTB Capital Group. Total-return swaps also can boost the liquidity of an investment, carry tax benefits, and have the advantage of gains that can be recorded as profit on a balance sheet, whether realized or unrealized.

Note the analysts falling all over themselves to praise the "strategy." But if Lampert loses the formula, and suddenly the whole thing goes gunnybag, those same analysts will be the ones tsk-tsking from their front row seats, rationalizing their sugar coated strong Buy ratings (of course if it gets really ugly they'll just change firms).

By the way, our nearby Kmart is one of the old style versions... and just a horrid shopping experience. A retail ghost town. For the 4 or 5 people shopping there it is a last resort, like when you just need to whip in there real quick to buy a toothbrush or some batteries.

Beats circling around and around Wal-Mart Stores Inc. (WMT) or Target Corp. (TGT) hoping to find a parking space.

Comments

[Amit Chokshi_:]

Although Lampert has stated he wants to make Kmart and Sears a success from a retailing perspective no investor is in SHLD for the retail story, if one's even possible. The stock's appreciation is baking in expectations that Lampert will turn it into a modern BRK and will use the cash to acquire other businesses, in some cases far outside of the realm of retail. SHLD filed an 8-K about a year and a half ago that basically spelled this out and said that the company's cash would be utilized for investment purposes including controlling stakes in businesses outside of retail. It's basically on Lampert to milk SHLD for as much cash as he can like he did with AZO and Payless and then use any cash flow to invest in other high return businesses.

Total return swaps are derivatives and the fact that those drove the EPS figures for SHLD speaks to the lack of "earnings quality" regarding the retail operations. Still, going back to the previous point, I don't believe most shareholders are buying SHLD for the retail angle at all. It's as a lot of posters/bloggers/write... have said, SHLD is a public investment fund with one of the better fund managers running it. So you're paying a fair to premium price on a retail comp basis for SHLD which makes it seem odd/overvalued but then you factor in that SHLD in 10-15 years, maybe even 5, won't be predominatly a retailer as opposed to a company with a variety of holdings across industries with Lampert picking the investments. That's not a bad opportunity given that access to a lot of managers with Lampert's ability is limited to investors. There are a ton of great mutual funds run by impressive investors but with SHLD you get a manager with virtually no investment restrictions or redemption issues and other technical issues associated with most mutual funds. BTW, I have no position in SHLD.

2006 Nov 18 05:36 PM