Hedge Fund Key to Sears Holding’s Success.

Implications: Clearly the Sears’ Chairman is now conflicted. He has to either invest heavily to turnaround Sears Roebuck or figure out how to monetize the assets of Sears Holding to ensure the continuity of his other concern, the hedge fund.

Analysis: If Sears Holding could be broken up for a big profit, then Lampert would have already sold the assets and moved on to the next deal. However, notwithstanding the asset value spin, Sears Roebuck and K-mart will most likely go the way of Allied Stores and Montgomery Ward that were either consolidated or liquidated; usually at a substantial discount to book value.

Analysts and pundits alike have touted the real estate value, mix changes, and IT investments as reasons why Sears Holding share price should be higher than its current trading price. That’s an old argument that can be misleading when taken out of context. Historically, Campeau, better than most, proffered the same argument that there was some intangible value in mall real estate that bolstered his high valuations of both Allied and Federated deals in the late 1980’s. Later, hardly a quarter went buy when Bernie Brennan didn’t declare Montgomery Ward’s revised product mix would not only stimulate sales, but improve profit margins too.

However, Montgomery Ward was eventually shutdown and Allied Stores absorbed into Federated before it filled Chapter 11 in the early 1990’s. Federated was eventually reorganized as its brands had a strong customer franchise, while Montgomery Ward was liquidated since its core customers were insufficient to support a turnaround. Two decades later, Lampert finds himself in both Brennan’s and Campaeau’s position with Sears Holding. He has one brand name, K-mart, that is strategically unviable and another, Sears Roebuck, in need of a lot of cash to make the changes necessary to rebuild its consumer franchise.

Unfortunately, Lampert needs the cash to shore up his hedge fund too. Notwithstanding the Fed’s recent rate cut, it's problematic just how much lower Bernanke can allow interest rates to fall before a depreciated dollar rekindles late 1970’s like inflation. Alan Greenspan, the former Fed Chairman, recently noted, the appetite for US debt has probably peaked; as illustrated by last weeks largest overseas sell off of US bonds in recent history. This means more pressure on Lampert’s $3.5 billion hedge fund, ESF Investment, to increase its liquidity; putting a future turnaround of Sears in jeopardy

Some pundits have suggested Lampert prefers to turn Sears around the old fashion way; in part, because his reputation is at stake. They point to investments in infrastructure like improved systems that have made the company operationally more efficient. But that argument ignores the magnitude of stock that the company has bought back. Since the merger in 2005, Sears has spent more than $3.0 billion on stock buy backs and has indicated its intention to buy back another $1.5 billion during the last half of 2007 and 2008; devaluing the company in the process.

Lampert could have reinvested that cash in Sears in any number of ways. For instance, Craftsman, Kenmore, and Diehard brands could have been extended and new apparel brands like JC Penny’s “American Living” could have been developed. Sears could have become a supply chain leader by introducing comprehensive RFID tagging systems to improve operating margins. As the second largest US retailer, Lampert could have invested in any number of businesses that were appropriate for Sears and K-Mart brands. For instance with one of the largest credit card data bases, he could have followed Wal-Mart’s lead to develop highly profitable and franchise building financial services.

But the fact remains that he has chosen to buy back the company’s equity instead. From a financial point of view, the only reason to do that is if Holding’s cost of equity is higher than the return Sears could get buy reinvesting it in the business. That suggests that Lampert either doesn’t know how to turn the company around or his short term interests are best served by extracting as much cash as possible from the company.  But, that may not be the best strategy for many shareholders.

Clearly the Sears’ Chairman is now conflicted. He has to either invest heavily to turnaround Sears Roebuck or figure out how to monetize the assets of Sears Holding to ensure the continuity of his other concern, the hedge fund. He may not be able to do both and given the degree at which the US financial markets are stumbling it remains to be certain whether he can save either Sears Holding or ESF Investments.