Eddie Lampert's Letter to Shareholders

I would like to start off this letter in a rather unconventional way by congratulating the New York Giants, led by their young quarterback Eli Manning and by head coach Tom Coughlin, for winning the Super Bowl earlier this month. This was quite an upset victory. Throughout the regular season, fans and the media were quick to criticize Manning every time he had a bad game, and to question his leadership. As recently as late November, after a particularly disappointing loss to Minnesota in which Manning threw four interceptions, many pundits were declaring him a bust. Manning, however, did not give up or lose heart. He remained focused, continued to work hard on his game and on improving his skills, ultimately leading the Giants to the NFL Championship and being named the Super Bowl MVP.

-

I mention this not because I am a Giants fan (I am actually a lifelong fan of the New York Jets) but rather because the Giants’ story reminds me of what we went through a few years ago with Kmart. When I first became involved with Kmart in 2002, during its bankruptcy, the company had been given up for dead by most industry analysts and media commentators. Kmart was like an undrafted free agent who nobody thought had a chance to play in the big leagues. Its more than 150,000 employees and its investors had an uncertain future. Despite intense criticism of and skepticism about the company and its prospects, we were able to rally Kmart’s various constituents and turn an unprofitable, failing company into a profitable company with hope for the future. Like Eli Manning, we know what it’s like to be underestimated and questioned, but we intend to keep working on our game to achieve our full potential.

...

All of these are legitimate questions. What we have tried to do is improve our operations in the near term while positioning ourselves for long-term success. After the merger, we initially worked to improve our operations by focusing on the basics, like markdown disciplines and expense management. At the same time, we have been prioritizing our resources to rebuild many of the company’s systems and processes by taking a longer-term view than most investors and business managers.

-
Looking forward, I continue to be excited about the prospects for Sears Holdings. In 2008, we need to reverse much of the profit erosion we experienced in 2007. It won’t be easy, especially if the economy stays soft. The environment surrounding U.S. retail has been very difficult; we were not alone in experiencing disappointing performance this past year. Many retail companies lost significant market value. As illustrated in the table below, while the recent correction has brought Sears Holdings’ stock price down from an increase of nearly 20 times since Kmart emerged from bankruptcy to around ten times, it remains one of the top-performing retail stocks over the past five years. In addition, it is not clear that heavy expenditures of capital guarantee either short or long term success. Like any investment of capital, the return on that capital over time will determine its wisdom.

...

During the year we increased our buyback activity and reduced our shares outstanding by nearly 15% as we repurchased approximately 22 million shares at an average price of $135 per share. In hindsight, although we believe it was a prudent use of cash, it would have been better if we had exercised more patience in the buyback as our share price continued to decline as the year progressed. However, my experience is that it is difficult to predict short-term stock price performance and that one should make the best decisions one can with the available information and a long-term perspective.

...

Some have wondered why we haven’t invested more money in our stores. This is a legitimate question. In theory, a company can always invest more money in its operations, but, when we make an investment we expect to earn an appropriate return. Since we have invested a significant amount of capital in hundreds of stores, we have some good data to work with to better understand what works and what does not. In some cases, our investments have led to higher earnings in the stores in which we invested and we continue to make investments like those today. In other cases, however, the investment has not led to acceptably improved performance.

-
Let’s look at a hypothetical example. Imagine that we invested $200 million to remodel or improve 100 stores, or $2 million per store. If the store profitability after that investment is exactly the same as before, then the $200 million investment generates 0% in return. By simply keeping our money in cash, we could have earned anywhere from 3-5% over the past several years, which is better than the 0% return in this case.

-
The related question then becomes: why can’t you find ways to invest in your stores that generate an acceptable return? That’s exactly the problem we have been working to solve and we will continue to work until we solve it. Until then, we will seek to be responsible with our shareholders’ capital and to make decisions based on the results of the portfolio of tests that we have in process at any point in time.

-
Pressing this point even further, some might ask, if you can’t justify investing in your stores, then how are you going to grow your business? To be clear, we are not saying that we can’t justify investing in our stores. The issue is more about the size and type of investment as well as the timing and sequencing of an investment. There are many things that a retailer can do to improve its business without the significant amounts of capital that a major remodel would require. Improving the assortment of products and services, mix of inventory, visual presentation, recruitment and training of employees, and marketing and communications to customers are all ways to generate improved performance. They all require significant investments, but we already invest a significant amount of capital and expense in all of these areas. The key is to improve the productivity of these investments. Our marketing and labor spend is in the billions of dollars each and we need to work diligently to get the most from these significant investments. Fundamentally, our capital allocation decisions are influenced by the alignment of management and owners with the goal of creating value for the shareholders of the business.