(FORTUNE Magazine) – CAN WE RETAIN our position as the world's premier retailer?'' asks Edward A. Brennan. Then Sears' cheery chief executive goes on to answer his own rhetorical question. ''Absolutely.'' But the chairman of the world's largest merchandiser faces worldclass problems. Three years ago K mart shot past Sears to become the biggest retailer in the U.S. (see chart), and many believe that K mart and Wal-Mart will outrank Sears' worldwide merchandising business by 1990. Compared with these fleet-footed competitors, Sears is a 2,000-pound centipede. The antennae work poorly, so the creature is directionless. When some of the 101 legs try to move ahead, others interfere and even move backward. Brennan -- broad of face, wide of girth, and 6 feet 1 inch tall -- seemed oblivious to his company's enormous problems when he talked with FORTUNE in a rare two-hour interview recently. But the picture that emerges from conversations with 70 other people -- Brennan's associates, former Sears executives, consultants, and competitors -- is of a century-old, muscle-bound behemoth crushed by its lumbering corporate culture, needing new strategy and probably new management. Sears' half-hearted, clumsy efforts to adapt to a competitive retailing environment reveal an American institution in decline, a textbook example of what happens to any company that settles too comfortably into its market. Consider the numbers. Last year Sears had revenues of more than $48 billion. Net earnings of $1.65 billion represented a 12.1% return on equity in an industry where the average is 15.5%. The financial services businesses that were supposed to make up for any shortfall in retailing earnings -- Allstate insurance, Coldwell Banker real estate, and the Dean Witter stockbrokerage -- have not been able to do so (see box). In this year's first nine months, - Sears' earnings tumbled 18%. And the future isn't bright either. Retail analyst Walter Loeb at Morgan Stanley expects that during the next five years Sears' profit growth will lag behind that of every one of the other 22 companies he follows. Costs in the U.S. merchandising division, the heart of Sears' business, are out of line. Selling and administrative expenses are a bloated 30% of sales, vs. 24% at J.C. Penney and K mart and 17% at Wal-Mart. Prices are way too high, as much as 50% more than competitors charge for the same goods. Sears' share of general merchandise sales in the U.S. has dropped to 13%, from 18% ten years ago. That's $8.4 billion lost to competitors. THE BUREAUCRACY in a company that employs 526,000 people is elephantine, out of touch with the consumer, and too unwieldy to coordinate change. Yet Brennan doesn't think Sears' size hurts the company much. ''Bigness has disadvantages and it has advantages,'' he says. ''How does it all weigh out? Over the years, in general, bigness has served Sears well.'' Until recently bigness did serve Sears well by making it too huge to be acquired. Now the wildest shopping spree in Wall Street history has destroyed that logic. Sears is no longer safe from the auction block because security analysts estimate that its breakup value -- the amount of money that could be raised if the company were sold off in parts -- is as high as $94 per share, more than twice the recent selling price of the stock. Brennan's announcement on Halloween that Sears would downsize was designed to scare away the takeover goblins and reassure impatient institutional investors that the company was doing something to improve shareholder value. But Wall Street was unenthusiastic about plans to sell off parts of Sears' financial services empire along with the Sears Tower -- the world's tallest building and once a fitting symbol for the biggest retailer. SEARS has not been knocking them dead either with the new merchandising strategy that it announced. Everyday low pricing, as it is called, is a departure from Sears' longtime promotional tactic of marking up some merchandise as much as 60% and then ultimately selling half the goods at reduced prices. The stores inadvertently trained their customers to wait for the sales, but even then Sears could be undersold by competitors because the markup was so generous. Now Sears is cutting prices on almost every item it sells. Says Brennan: ''Sometimes we'll compete with discounters, other times with department stores.'' Everyday low pricing, which dispenses with special clearances in favor of what its name implies, is nothing new to Wal-Mart, K mart, and Penney shoppers. But Sears' conversion would be the most sweeping shift in pricing strategy that any retailer has ever attempted, and it is bound to confuse customers. During the next few months, before they convert to selling at regular prices, the 825 stores will stage the largest price-off sales in Sears history to clear the the shelves of some $250 million worth of goods, about 7% of Sears' total inventory. To stem the consumer exodus, the selling floor will be replenished with nationally branded merchandise that will sell alongside Sears' own Craftsman tools, Diehard batteries, Weatherbeater paints, and Kenmore appliances. A prototype name-brand appliance and consumer electronics department called Brand Central is already operating in 17 Indiana and Kentucky stores. Says Michael Bozic, whom Brennan appointed two years ago to head the Sears Merchandise Group: ''Some of the Brand Centrals are running 50% to 60% ahead of sales in the same departments before the conversion.'' The company figures that lower operating costs will result from more predictable sales, leading in turn to more controllable and smaller inventories, and ultimately to lower interest charges and warehousing costs. But competitors are not quaking over their cash registers. Said a senior executive at one large retailer the day after Sears' announcement of everyday low pricing: ''We had a board meeting today and just laughed. They can't compete on price.'' WALL STREET is also not convinced the new merchandising strategy will succeed. Says L. Wayne Hood, an analyst at Prudential-Bache: ''It's a step in the right direction, but I don't know if Sears can get its costs down quick enough.'' Takeover rumors are surfacing, with everyone from Ronald Perelman to Donald Trump said to be after Sears. But Brennan remains serene. The past few weeks have been ''stimulating'' and not difficult, he says. ''It's very appropriate and very healthy for me to be challenged.'' Symbolic of the challenges facing Brennan is Sears' listless $6 billion apparel business. ''Presentation and assortment are the driving forces of retailing,'' he says. Yet Sears displays its apparel poorly. FORTUNE reporters visited several Sears stores in New Jersey and found a great disparity in quality of presentation. A typical store on the trip -- neither the best nor the worst -- was the large Sears at the Paramus Park Mall. Every female mannequin seen -- at least ten -- had torn stockings. In the maternity department the pillows beneath the mannequins' clothes had slipped -- above the belly, below the belly -- everywhere a baby is not. The jewelry department had been the cosmetics department ''about six months ago,'' said a salesperson, which accounted for the empty cosmetic racks and huge photos of heavily made-up models that were still on the walls. Known to be meticulous, Brennan, now 54, joined Sears at 22 as a salesman in men's furnishings. Helped by energy, merchandising knowledge, and a near- photographic memory, he became CEO in 1986. (The Brennans are a family act: Brother Bernard is the CEO of Sears' cross-town rival, Montgomery Ward.) Early in his career Ed Brennan considered leaving Sears to open a McDonald's franchise because he was and still is an admirer of McDonald's quality control. ''I really don't think consistency is a problem in our stores,'' he says. Before he or other Sears executives from Chicago descend on an out-of- town store, they give the managers a courtesy call. But one reason McDonald's keeps its 7,715 U.S. restaurants so neat and clean is that the brass visit unannounced. HE HAS BEEN ineffective in attacking the problems. Consider the Sears ''store of the future'' program. Brennan launched it with lots of fanfare in 1983, when he ran the merchandise group. He was going to put new sparkle in 600 Sears stores by giving them a clean, uniform look and a more exciting selection of merchandise. But instead of investing the $1.7 billion that was budgeted for the program, Sears spent only $1.2 billion. ''We found much more economical ways of doing changeovers,'' Brennan says. Many of the lights and other fixtures bought for the ''store of the future'' are finally being used in other Sears outlets. Though store sales jumped 15% initially as customers heard the public relations hoopla, the increases did not last. Says Carol Farmer, a New York retail consultant: ''The store of the future is the store of the past.'' The retailer has had trouble making other changes too. One of the more exciting ideas, the ''neighborhood store,'' was supposed to include only ''soft lines'' -- apparel and home furnishings, both high-margin categories. Sears executives who represented ''hard lines'' -- appliances, electronics, and home improvement and automotive products -- argued that they % couldn't be left out of the store, because they drive Sears' business. No one could resolve what Bozic calls ''creative confrontation,'' and the stores never opened.

The neighborhood store became the ''intercept store'' -- scaled-down multiline Sears stores with a merchandise mix targeted at a specific community. In hopes of intercepting customers before they head to the competition, Sears plans to locate these stores in urban and highly populated suburban areas where it typically has not had outlets. Specialty retailing is another Sears wrinkle. The most promising project is McKids, a chain of clothing shops for children up to age 10 that has grown out of a joint venture with McDonald's. Sears operates McKids departments in its stores and plans to build up to 40 free-standing McKids shops in the next two years. But Edward Weller, an analyst at Montgomery Securities in San Francisco, points out that even if Sears opens 650 McKids stores and each one does as well as an average Gap store, Sears' annual sales would increase only 2%. The company has been shopping for specialty retail acquisitions but has yet to find any big enough to make a difference in the bottom line. In cost cutting, the centipede legs get in the way of each other too. Bozic says he wants to avoid a ''monolithic'' approach to cost reduction, so he has set no targets and has empowered his six merchandising vice presidents to ''design the kind of organization they need for their business.'' Sears just recently developed an accounting system to determine net profits in each merchandise line, so Bozic is holding managers accountable for the businesses that they oversee. The idea is to become a low-cost operator like the discounters. Burdened by an antiquated catalogue operation and labor-intensive warehouses, Sears has the highest distribution costs in retailing -- about 8% of sales vs. 3% at Wal-Mart and K mart. A recent experiment to cut costs was botched by the bureaucratic culture. Last year, in a line of men's apparel in five stores, Sears agreed to reduce inventories from the usual 22-week supply to eight. The stores packed up the leftover 14 weeks of goods to ship back to the supplier. The merchandise was never sent. It sat in boxes for five months until it was unpacked this past summer and placed -- ironed -- back on store shelves. An exasperated consultant who worked on the test blames turf battles: ''There was disagreement about who would decide what to send back. It's not a cohesive organization.'' ^ Apparel, Sears' most troublesome area in retailing, is essential to fix. Brennan seems to lack the urgency or know-how to do it. Would he ever consider leasing out the front of the store -- the women's apparel section -- to a specialty retailer such as the Gap or the Limited? He declines to comment. If Sears acquired a major apparel retailer, it could move those goods into its own stores. Sears sells some branded apparel, but wooing national manufacturers is difficult. Vendors don't like Sears' sloppy presentation and say the stores don't treat their goods with respect. Nike was considering leaving Sears because it wanted to spiff up its image by selling in more prestigious stores. It pulled its $40 million worth of business out last year after the retailer, without telling Nike, decided to run a price-off coupon for its sneakers on the back of Kellogg's cereal boxes. SEARS MUST CHANGE or it will lose what may be its most valuable asset -- a reputation that has held up remarkably well with consumers. In October the Gallup Organization asked 1,005 Americans to think of companies that they associate with high quality. Sears came in fifth, behind GE, General Motors, Ford, and IBM. Sears' own studies show that 75% of Americans still visit a Sears store at least once a year, and consumers trust the company as much as ever. What the company needs, says retailing expert Louis W. Stern, a marketing professor at Northwestern University, ''is someone with Wal-Mart mentality and the Limited's flair.'' Adds Ann C. Hunt, a partner at the Korn/Ferry International search firm: ''Someone like John Sculley.'' She thinks the Apple Computer chairman could charge up product development, woo branded suppliers, and apply the financial discipline that Sears needs. Alas, whoever the right person is, he or she does not appear to be Ed Brennan. When asked what is the biggest problem he faces next year, Brennan replied, ''I don't see any huge problems. I feel very good about how we're positioned strategically.''

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: HOW SEARS GETS CLOBBERED AT HOME Three years ago K mart snatched the U.S. retailing lead. Since 1983 Sears' sales have grown only 12%, vs. K mart's 39% and Wal-Mart's 242%. Sears' earnings have declined 25%, the worst performance among the big four.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: Sears' sales add up to more than 1% of GNP; net income (above) is for its businesses before corporate and miscellaneous losses.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: INVESTOR'S SNAPSHOT SEARS ROEBUCK