Lampert can't reverse Sears' decline

NEW YORK (Fortune) -- Call it the Lampert discount.

Shares of Sears Holdings - controlled by billionaire hedge fund manager Edward Lampert - plunged 15 percent this morning, after the company reported a dismal third quarter and warned that results are unlikely to improve anytime soon.

It wasn't long ago that investors bid shares of Sears to dizzying heights in the belief that Lampert, who is also chairman, would magically unlock value in the beleaguered company. Instead, Sears appears to have badly lost its way. Lampert, who has said he intended to run Sears as a retailer, has so far neither returned the company to its former prowess, nor turned it into a Berkshire Hathaway-like investment vehicle, as some shareholders had hoped.

To be sure, Lampert, who made a fortune rescuing Kmart Holdings from bankruptcy protection and then used its reorganized stock to make an audacious bid for Sears in 2005, may still have some tricks up his sleeve. He could start selling off real estate, for example, although that will become harder if the economy continues to soften. But investors are clearly losing patience. After reaching a high of $195 in April, Sears (Charts, Fortune 500) shares are now trading around $100. Even analysts, who once spoke of Lampert in revered tones, are losing faith. "Eddie Lampert doesn't have a clue how to fix Sears," said Craig Johnson of Customer Growth Partners.

The litany of problems at Sears looks to be getting worse, not better. Sears is neglecting many of the basic strategies that attract shoppers, including renovating stores, stocking the right merchandise and taking timely markdowns. Though a pullback in consumer spending has compounded the company's problems, people who know Sears well say many of the company's troubles are self-inflicted. (Neither Sears nor Lampert's office responded to questions for this story.)

Conversations with several of Sears' suppliers, who spoke on condition they not be named, paint a picture of a company adrift, hobbled by high turnover in the merchandising ranks, and veering from one idea to another. "Sears does everything it can to chase away the customer," said one of its apparel suppliers. Company executives, he said, have become disproportionately focused on the numerical side of retailing, obsessing over profit margins and inventory turns, at the expense of larger merchandising issues - such as stocking products that consumers want to buy.

Yet if Sears is buying the wrong merchandise - as several suppliers contend - it is doing an even worse job of managing that inventory once it hits stores. Sears is routinely out of stock on popular items, but is reticent to take markdowns on goods that don't sell, meaning the retailer's shelves are laden with merchandise that is either out of season or unwanted, these suppliers said.

A case in point: During visits to Sears stores in September, an accessory supplier found the retailer was still selling his summer merchandise. The goods he had shipped for fall remained packed in boxes in the stock room. "I said to them, 'How are you going to sell this stuff? It's out of date by now,'" the supplier said.

Inventory is one of the biggest expenses for retailers and sitting on piles of unsold merchandise can be costly. Lampert, unlike most retail executives, had initially eschewed markdowns. As a result, Sears has built up a pile of unsold inventory, $1.2 billion worth, according to some analyst estimates, over the past two years. Although the company has recently moved to take more aggressive markdowns, merchandise inventories continued to rise in the third quarter, up $500 million compared with a year ago, despite a 4.6 percent decline in sales at stores open at least a year. Overall revenue for the period declined by $400 million to $11.5 billion.

More shocking was a plunge in earnings to $2 million, or 1 cent a share, compared with $196 million, or $1.27 a share, a year ago. The year-ago figure was helped by a 42 cent-a-share gain on investments.

Some analysts are now suggesting that Sears has so badly botched its apparel offerings that it should dramatically scale back the category and focus instead on the areas where it still has credibility: Maytag appliances, Craftsman Tools and Die Hard batteries. Lampert has signaled an interest in boosting Sears presence in so-called hardgoods with a $6.75 a share hostile bid for Restoration Hardware, a small specialty retailer of upscale home furnishings like handcrafted bed frames and leather sofas. The thinking is Sears could use the Restoration Hardware (Charts) brand, which is fancier than its traditional offerings, to add higher margin products to its stores.

But Sears faces challenges in this area, too. Although Sears remains the largest seller of appliances, for instance, it is rapidly losing market share. The company commanded 26.9 percent of the market in 2006, compared with a 28.1 percent share in 2005, according to the most recent data available from TNS Retail Forward. Lowes (Charts, Fortune 500), Home Depot (Charts, Fortune 500) and Best Buy (Charts, Fortune 500) all gained ground over that period, with respective market shares of 12.6 percent, 11.4 percent and 5.3 percent.

Meanwhile, investors who had hoped that Lampert would use Sears' ample cash pile to turn the company into a Warren Buffet-like investment vehicle should think again. As of Nov. 3, Sears' cash stood at $1.5 billion, still hefty, but down from $2.1 billion a year ago. Lampert spent $900 million buying back Sears stock in the third quarter, which suggests that of all the ways to spend that money, Sears is his best idea.

That is heartening for the dwindling few who are still believers in the Sears story. For the rest, it may be time to start shopping elsewhere.