Wall Street wears the pants at Sears and J.C. Penney

  @FortuneMagazine March 21, 2013: 11:44 AM ET
RET08 retail industry
(Fortune)

Retail disasters come in different forms. Walk into a J.C. Penney store these days, and you're likely to see an appealing work in progress, with lovely signage, spiffy layouts, and popular brand-name merchandise beautifully displayed. It shouts, "I'm soooo trendy." Walk into a Sears or a Kmart, by contrast, and you're likely to see the department store equivalent of tumbleweeds: scuffed floors and indifferent merchandise plopped sloppily onto tables and shelves amid a dingy atmosphere. It wheezes, "Time has passed me by."

But these retailers have several things in common. One, easily visible, is a woeful lack of customers. A second, which you don't see but helps account for the parlous state in which the chains find themselves: They're all heavily influenced by Wall Street guys who convinced themselves -- and, for a while, a whole lot of others -- that they understand what Main Street wants. And they've gotten it wrong.

We're dealing here with two big investors who are polar opposites in personality and approach. There's the flashy Bill Ackman of Pershing Square Capital Management. Two years ago he used his hefty stake in Penney to muscle its board into hiring Ron Johnson, creator of the mega-successful chain of Apple retail stores, who in turn has embarked on a radical, so far disastrous strategy. And there's the reclusive Eddie Lampert of ESL Investments. Earlier this year he appointed himself acting chief executive of Sears Holdings (SHLD, Fortune 500), which owns Sears and Kmart. But the two Wall Streeters, so different in many ways, are alike in thinking that they have the talent and the chops to give a troubled national retail chain what it needs to succeed. So far, at least, they haven't come close.

Both Ackman and Lampert became billionaires by being brilliant investors, bland both got into retailing by amassing big stakes in companies they thought were selling for way less than their assets were worth. Under Ackman's influence, J.C. Penney (JCP, Fortune 500) is spending heavily to upgrade its stores from dowdy to delightful, while Lampert is slowly milking a dwindling asset and revenue base at Sears. Both companies now find themselves in serious trouble.

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By now the Perils of Penney has become a familiar tale. After soaring on the appointment of CEO Johnson, Penney stock has collapsed in recent weeks. It has fallen 30% in less than a month, following a disastrous fourth-quarter earnings report. It's down 60% since Johnson brazenly claimed in January 2012 that he would transform the gradually fading chain into "America's favorite store."

Ackman's ally at JCP (as it now wants to be called), Steve Roth of Vornado Realty Trust, abruptly sold 40% of the company's stake in March; a Macy's lawsuit over plans to open Martha Stewart "stores" inside JCP locations drags on, temporarily leaving a gaping hole in hundreds of Penneys; and on March 14, lender CIT signaled its skepticism about the company's finances by reportedly boosting the cost for vendors to borrow against payments that Penney owes them.

Johnson swept into Penney in November 2011 with the celebratory air of a revolutionary rolling into a vanquished capital. A few months later he hosted a gala relaunch of the brand, a Penneypalooza modeled after the Apple (AAPL, Fortune 500) fests held by his former boss Steve Jobs. (Even Jobs might have considered this one excessive.) Johnson proclaimed that he would reinvent the department store and do so while keeping earnings intact. His most radical moves were to stop running sales, which he said tricked customers, and to try to persuade the bargain addicted to trust that the new "fair and square" JCP would offer lower prices even if its price tags showed no mark-downs. He killed off older brands and signed hipper names like Joe Fresh, announced a new store-within-a-store design, and launched a bold and pricey ad campaign.

The plan aroused a lot of fascination because national department store chains are in such long-term decline that any fresh approach merits consideration. But Johnson talked the board into abandoning decades of practices and changing the whole company at once without testing it first. "You never, ever do a new concept across the board automatically," says Gilbert Harrison, chairman of Financo, an investment bank that specializes in retail companies. "Before [Johnson] could roll it out, he needed to better train his customers."

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Johnson was undaunted by any suggestion that he needed to take some time or that he should refrain from touting JCP's new stores until the company had overhauled more than a handful of them. "The only things that haven't worked for me are when I've held back," he told Fortune during the brand's relaunch. (Johnson declined to be interviewed for this article.) "There's no reason to sell an idea short. The only risk would be to not fulfill the dream."

Johnson's call to arms -- with the enthusiastic support of Ackman, who with Vornado owned about 36% of the stock (some of it through derivatives) before the latter reduced its position -- was based on Apple's approach to retail: Sell must-have products that people line up to buy, helped by a great in-store experience. There was a crucial difference: Apple sells sleek miracles of functionality and glamour. J.C. Penney sells sweatpants and tube socks.

There are always casualties in revolutions. In this case, unfortunately, it was the core customer, who had long trusted J.C. Penney as a great place for a deal on basic, unfussy stuff. Effectively, Johnson fired the old shoppers without first winning over any new ones. Need proof? The past four quarters reveal a breathtaking decline in same-store sales, which plummeted 19% in the company's first quarter and accelerated to 32% in the fourth quarter, which is when stores make most of their money.

Now, after seeing overall sales decline by an astonishing 25% -- $4.3 billion -- in the past year, Johnson & Co. are retrenching (sort of) by bringing back clearance prices and coupons. Ken Hannah, chief financial officer, recently offered a modified mea culpa at an investor presentation: "This is a multi-year journey, and we certainly made our mistakes."

Penney's board clearly blundered by entrusting the company's fate to a leader who was dynamic but had no experience as a chief executive. Although Myron Ullman III, then Penney's CEO, was originally supposed to stay for a while as chairman, confusion about who was running the show led the company to change course. Ullman resigned in January 2012, two months after Johnson's tenure began.

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Hiring Johnson was a classic Street turnaround play: Recruit a hot manager from outside the company, hand him massive financial incentives, and set him loose. The board gave Johnson $50 million of Penney stock to make up for $50 million in Apple shares he left behind. Johnson also shelled out $50 million of his own money to buy a warrant giving him the right to buy 7.3 million shares at $29.92 from mid-2017 through late 2018. Already wealthy from his tenure at Apple, Johnson took that huge flier seeking mega-riches. It also conveyed that he was willing to wager his own money on his audacious revival plan.

At first it seemed like a win: On the June 14, 2011, announcement of his hiring, the stock ran up 17%, putting him ahead more than $30 million on paper. Today, at JCP's recent price of $15.50, the stock has to rise about 150% just for him to get his $50 million back. (You can find the math here.) The guys who hired him are way down too: Ackman is looking at a paper loss of $550 million on his $1.55 billion investment, while Vornado is down about $260 million. Says Ackman: "Retail turnarounds are difficult and take time."

In contrast to Ackman and Roth, who began buying their Penney's stake less than three years ago, Lampert has been dealing with his retail company for more than a decade. He's way, way ahead on his investment; we estimate at least 300%. He started by buying Kmart debt in 2002, at undisclosed prices, while the company was in bankruptcy.

His hedge fund owned more than half of Kmart's stock when it emerged from bankruptcy in 2003. A major attraction was Kmart's real estate, which had far more value then to bricks-and-mortar merchants than it does now, with Amazon (AMZN, Fortune 500) and its online brethren eating physical retailers alive.

Then, in 2005, after Kmart stock had surged from its original post-bankruptcy $15 to triple digits, Lampert got Kmart to buy Sears. That gave Lampert even more real estate and a batch of attractive assets, such as the Craftsman tool line. The bullish story, repeated endlessly at the time, was that Lampert would be the next Warren Buffett, redeploying capital generated by fading stores the way Buffett redeployed capital from Berkshire Hathaway's (BRKA, Fortune 500) original fading (and now closed) textile business.

Lampert didn't discourage this. He took to writing long, discursive letters about the company and his views of life, similar to Buffett's Berkshire reports. He was famously intrusive, saying yay or nay on even relatively minor investments. Lampert ran through three chief executives in eight years before becoming acting CEO in January -- a title he probably should have assumed years before.

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For all his smarts, Lampert failed to hire a strong, topnotch retail CEO to run his company. Time and again, he has been able to articulate a financial strategy for his investors; he has rarely been able to offer more than a cursory nod at a retail strategy -- a reason that customers should shop at Sears or Kmart. That deficiency is evident in the company's results. In 2005, Sears generated $49.1 billion in revenue and $858 million in profits. In 2012 revenue slumped to $39.9 billion and Sears lost $1.1 billion.

You can also argue that Lampert didn't do all that well at his core competency: asset deployment. Rather than put lots of money into new stores and upgrades -- which he said over and over in his annual letters wasn't an efficient use of capital -- he had Sears spend a ton of cash buying back stock. By our count, Sears has spent $6.1 billion to repurchase stock, more than 60% above the $3.7 billion spent on capital expenditures on stores during that period. Shortly after buying Sears, Lampert launched a program called Sears Essentials, rebranding existing Kmarts and stocking them with Sears products in order to compete with smaller-format stores. It bombed. "Had Sears Essentials worked, we would have put much more money into the physical stores," Lampert tells Fortune.

The average cost of the repurchases: a bit over $100 a share, roughly double the recent price. To be fair, some $5 billion of the buybacks occurred before the financial crisis hit and Sears' cash flow began to dry up. But a capital allocator is paid to get it right, and in this case he didn't.

Sears is trying to recover with its latest attempt to mix physical stores with online retailing, shopyourway.com, which combines social media with a loyalty program. But most other national retailers are attempting some version of this. Will Sears get it right? Who knows? But some of the money it spent buying back stock would come in handy right now.

At Sears Holdings' recent price of about $52, Lampert is way less ahead than he was in 2007, when the stock was at $170. There's no reason to believe the stock will be returning to that level anytime soon, if ever.

The idea that if investors make money, everything works out for the best for everyone doesn't hold in all cases. Lampert has made a ton of money, as have some of his early investors. "It's been a better investment than people think," he says, "but the company hasn't been a success yet."

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In both the J.C. Penney and Sears Holdings sagas, there are lots of losers: vendors, communities with abandoned or failing stores, and, above all, employees. Says Ed Cox, a former Penney network engineer whose 32-year career ended abruptly when he was laid off last April: "I was very emotional that day. On those employee-engagement surveys done every year they said, 'Do you see yourself retiring at J.C. Penney?' and I always said yes." Adds his former colleague Lee Stoeckert, who took a buyout: "They always said it was going to take three years, but not that it was going to crash and burn in the meantime."

Today the two American retailing icons look further from revival than they did when Lampert and Ackman entered the picture. The winners so far, in addition to Lampert and his early investors, are the chains' competitors. They include Macy's (M, Fortune 500), Kohl's (KSS, Fortune 500), Target (TGT, Fortune 500), and TJX (TJX, Fortune 500), all of which are run by traditional retailers, not hedge fund guys or their designees.

There's still time for Ackman and Johnson to prove us wrong. Any number of factors could change Penney's momentum. The company could emerge with a favorable result from the Martha Stewart litigation. There are whispers afoot of a significant refinancing, which could remove doubt about its ability to renew its revolving line of credit next year. Customers could come flooding in as the store makeovers are completed. Or not.

Whatever happens, here's the bottom line to this convoluted tale: Retailing is a lot harder than it looks from Wall Street.

Disclosure: Co-author Allan Sloan owns $115,000 of TJX and Target stock, purchased well before this article was conceived.

This story is from the April 08, 2013 issue of Fortune. To top of page



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