Mapping Lampert's next Sears move

NEW YORK (Fortune) -- Billionaire hedge fund manager Eddie Lampert, who controls Sears Holdings (Charts, Fortune 500), has earned a reputation as a boy wonder of retailing by wringing profits from an aging department store chain.

Though that reputation frayed when Sears reported sickly earnings this summer, investors, who have bid up the stock 20 percent from its September lows, are betting Lampert has moves up his sleeve that will soon clear away doubts about the company's future. While there is plenty of speculation as to what Lampert might do next -- including further balance sheet enhancements and real estate sales -- the company's operating weaknesses may be too big to overcome, some analysts say.

Some analysts believe that Sears stock has shot up because investors are awaiting Eddie Lampert's next big move.

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Lampert, 44, controls Sears Holdings through his hedge fund, ESL Investments. The investor gained renown after he took control of bankrupt Kmart Holding Corp. and used the retailer's reorganized shares to buy Sears, Roebuck & Co. in March 2005. The investments in Kmart and Sears were obvious masterstrokes and Lampert is still sitting on huge gains from them. For nearly two years after the purchase of Sears, at least through this year's ugly fiscal second quarter, ended Aug. 4, Lampert impressed investors by consistently reporting improved profitability in his stores. And because of Lampert's track record, there's a growing consensus that it won't be long before he does something big to fully revive confidence in his Sears strategy.

Lampert declined to comment. Sears spokesman Chris Brathwaite said the company is focused on its strategy of reducing costs by implementing more efficient back-office systems and improving sales through national branding campaigns and upgrading the merchandise assortment.

Assuming Lampert does have a trick up his sleeve, what might he do to wrest more value out of the chain? Investors closely track cash flows and some analysts think Lampert could surprise the market by wringing yet more cash out of the balance sheet. Credit Suisse analyst Garry Balter estimates that Sears could free up about $5 billion over the next two years - cash that could be used for further stock repurchases - simply by delaying payments to suppliers. "This is something that retailers have been doing for years," said Balter, adding that Sears has been a laggard here.

However, not everyone agrees that further balance sheet improvements will be easy to achieve. One big problem: Sears inventory has been rising. In the second quarter, it was up 7% from the year-earlier period, despite a 4% percent drop in sales. "It's a classic red flag for a retailer when inventories are rising at the same time as sales are falling," says Gregory Melich, retail analyst at Morgan Stanley.

Hefty markdowns to clear unsold goods, along with lower-than-expected profits, could be on the way. And a period of big markdowns would be a personal defeat for Lampert, whose strategy is based on resisting heavy discounts and going for full-price sales.

Another strategy may involve real estate. Sears has around 3,800 stores worldwide, just over half of which are leased. Analysts generally estimate that Sears' owned and leased properties could be worth between $15 billion and $20 billion. Louis Taylor, a real estate analyst with Deutsche Bank, said mall owners have told him they detect a change of tone on the part of Sears officials, who previously had not been interested in discussing the sale of stores. "Now," Taylor said, "it's no longer a dead end conversation."

And last week, activist investor William Ackman said he had acquired a 3.5% stake in Sears through his fund, Pershing Square Capital Management. News of the purchase, along with an easing of recession fears, helped move the stock higher.

Ackman, who has clashed with Lampert over his attempts to purchase the remaining shares of Sears Canada that he doesn't already own, has, in the past, pointed to Sears' large real estate holdings as a reason to own the stock. "At some point, Sears needs to make a serious revision in the locations they own, and we are at the point where real estate is going to become more of a front burner issue," said Richard Hastings of Bernard Sands.

Though analysts have long expected Sears to trim about 300 stores from a domestic base that numbers 3,400, there are several reasons why Lampert has not rushed to sell. One of the first things Lampert did after rescuing Kmart from bankruptcy was to unload about 67 stores at prices far higher than the amount listed on the company's books, helping to cement his reputation for ferreting out value.

But many of those stores were Kmart's best locations, and divesting made it harder for the retailer to compete. "There is a sense that Eddie was too hasty in selling the Kmart locations, and he doesn't want to make the same mistake with Sears," said one analyst. Moreover, many of the system upgrades that Lampert rolled out after taking control of Sears are only starting to take effect. Lampert would want to evaluate the revised profitability of each location before deciding what to sell, analysts said.

Of course, there's another reason why Lampert might want to hold off on asset sales. The potential value of the company's real estate has served to underpin the stock price. If stores were to fetch less than expected, it could lead the market to ratchet down the overall value of Sears. Also, unloading stores would be harder today than a year ago. Consumer spending has softened, department store consolidation has left fewer buyers and other large stores such as Wal-Mart (Charts, Fortune 500) are scaling back growth. "You may have less demand now," said Morgan Stanley's Melich.

Melich estimates that Sears' real estate is worth $17 billion - less than the $20 billion-plus estimates that have floated around the market recently. And he adds that these sorts of analyses are potentially misleading because they imply most of the real estate can be sold easily, which clearly isn't the case, simply because the company's holdings are so large.

For Sears as a whole, factoring in all assets and liabilities, Melich estimates the underlying value of the company to be between $123 and $145 per share. That's lower than the current share price, $150.79.

If Melich is right, then the market has already recovered its optimism about Sears. But that could be dashed if the company reports another disappointing quarter in November.

How likely is that? After all, retailers can do plenty of things in one quarter to improve results, and the third quarter numbers may well look great. But the specifics of Lampert's approach to retailing profitability make improvement hard to achieve. Lampert has focused solely on driving down costs, while doing little to drive up sales. That's an implicit recognition that Sears - perhaps because of its outmoded department store model - just can't hope for revenue growth. But overdoing cost cutting may have led to even lower sales, as less promotion and dated stores drive shoppers to Sears' competitors.

Burt Flickinger, managing director of Strategic Resource Group, estimates that Sears' seven largest competitors are adding 250 million in combined square footage a year, meaning that Sears, which is not currently opening new stores, is becoming even less relevant.

What metric can investors track to see if this is happening? Very useful is the profit margin that Sears makes on its pretax cash flows from its biggest retail units. In the second quarter, Sears' U.S. operations made $339 million of cash-based operating profits (operating income before depreciation and amortization, a noncash expense), or 5.1% of revenue from that unit. That was way down from $505 million, or 7.2% of revenue in the year-ago quarter. Cash profitability at Kmart, which brings in 35% of revenue, also slipped.

In other words, as revenue fell, Lampert and his managers were unable to cut costs enough to sustain profit margins. It was a personal blow for Lampert, who said in March said that increasing these profit margins was "a significant value-creation opportunity for Sears Holdings shareholders."

And thus, Lampert's methods got Sears into its second quarter mess. The market, by bidding up Sears' stock, is betting he gets the company out. Get ready for a plunge if Eddie doesn't deliver.