Thursday, June 30, 2005

Wal-Mart 9, Sears Holdings Corp 2


Yogi Berra might have said “you can observe a lot just by looking,” or he might not. But it’s still a wise notion.

Which is why yesterday I found myself in a newly re-merchandised K-Mart store—sorry, a “Big K”—a few towns away from home, just looking.

Visiting stores is the fun part of investing in retail stocks. Unlike a lot of businesses that do things nobody can possibly get a handle on even by visiting the field operations—oil companies, for example, which I used to follow—when you study retailers, you can actually see with your own eyes whether the company is doing what the management says they’re doing.

The trick, however, is to see a lot of stores, at different times of the day and in different parts of the country, if possible.

Stores can be as empty as an Art Garfunkel concert or packed like they’re giving away shares of Google, just depending on the time of day and the day of the week and the season of the year.

Also, talking to employees is not always the best way to find out what’s really going on, because store clerks don’t think in terms of year-over-year-change-in-comparable-store-sales the way Wall Street types do.

When you ask the kid behind the counter, “How’s business?” and he says “Really slow,” he’s talking about the previous half hour. And, since employee turnover at that level averages probably 50% a year, it's likely he's only worked there a few months anyway.

So you go to stores and look at what people are actually buying, and try to talk to the store manager or someone who runs a department to find out what’s selling and what’s not, and see if anyone in a position to know can tell you how business has been for that store in recent weeks. And you do it as often as you can.

All that said, it’s usually pretty easy to see when a retail concept really works—and when it doesn’t—without a whole lot of effort.

For instance, I was having dinner in Chicago last week, taking my sister-in-law and her husband to check out a restaurant spin-off from the Cheesecake Factory called the Grand Lux Café.

(If you’ve never been to a Cheesecake Factory, you ought to try it, if only to see a restaurant concept so successful the menus carry advertisements. In fact, I know some former National Hockey League players who looked forward to playing in certain cities where they could follow up a hockey game—probably the most physically demanding sport on earth—by heading to the local Cheesecake Factory for a few million carbs.)

This particular Grand Lux Café is three years old, and just off Michigan Avenue. While we ate, my brother-in-law asked me what I looked for in a restaurant. I told him I look at what people order, how quickly the tables turn, the cleanliness and the ambiance and service and yadda yadda yadda. “But actually,” I told him, “before we got here I knew all I needed to know when I saw the line out on the sidewalk.”

Grand Lux Café is a retail concept that works.

As for one that doesn’t, check out your local K-Mart.

After watching from the sidelines while Eddie Lampert built his own version of Berkshire-Hathaway buying up the remnants of two once-great retail chains and combining them into a single once-great retail chain, I was interested in seeing how the nearest "Big K" was faring.

This particular “Big K” is off Route One, in a C+ location next to an Ocean State Job Lot, a Dollar Tree and a Fashion Bug, and it looks a lot better than it looked during the the K-Mart Chapter 11 when the vendors weren’t shipping: the shelves are full, the signs are cheery, the lighting is good and the floors are clean.

And that’s about it.

“Big K” had that curiously soul-less feel of a decent-looking place with no particular franchise, nothing driving people in and little to keep them there. One ancient clerk moved slowly around the racetrack, putting up signage from a shopping cart when he wasn’t stopping to chat with other clerks. A few customers lurked in the aisles, but the only crowd was at the service desk.

Registers open? Two.

I then drove a few miles down Route One to the nearest Wal-Mart, which is in an A+ location next to a supermarket and a Home Depot. It was a typical Wal-Mart, bustling even at 11:30 on a Wednesday morning. The demographics of the shoppers were probably thirty years younger than the “Big K,” with mothers dragging children through the apparel section, kids roaming the DVD aisles and men in the tool area. Overall, it had the energy of a store doing a lot of business.

Registers open? Nine.

Now, Eddie Lampert is smarter, and richer, than 99.9% of the money managers on the planet. He found value in AutoZone and Sears and K-Mart, and extracted billions. A couple of other big investments didn’t work out so well, but that’s still a remarkable batting average for anyone in any line of work—and right up there with his role model, Warren Buffett.

But people forget that the original Berkshire Hathaway—the New England textile company Buffett acquired and turned into the conglomerate we all know and admire—failed.

Even Warren Buffett couldn’t make a New England-based textile company successful in a world of cheap southern mills and, later, offshore producers; so he liquidated that business, put the money into insurance, and used the float from the insurance business to buy high-return businesses with “moats,” as he calls their competitive advantages.

I have no doubt Sears Holdings Corp will be an even more successful investment vehicle for Eddie Lampert than it already has been.

But in its base business, with Wal-Mart adding more sales every two years than the combined annual sales of Sears and K-Mart together, I also have no doubt that whatever Sears Holdings Corp is making money at twenty years from now, it will not be making money from its motley collection of stores without billions of dollars of newly invested capital.

Yes, I know the “story” of Sears Holdings—just shut down a few hundred more lousy locations, start selling Sears appliances in the K-Mart locations, and get store productivity up to the level of Target. Voila! The incremental EBITDA and earnings are mind-boggling.

But there are no moats around those Sears stores and K-Mart stores with their lousy merchandising and old clerks and the ratty fixtures and 1980’s-era technology—only streets leading to better-looking, better-run, lower-priced Wal-Marts and Targets and Costcos and Sam’s Clubs.

And to get the customers back will require more than bright signs and Kenmore dishwashers.

From what I saw, the score right now stands at Wal-Mart 9, Sears Holdings Corp 2.

If Yogi were watching, he might just say “it’s deja-vu all over again.”


Jeff Matthews
I Am Not Making This Up



The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

17 comments:

DaleW said...

But people forget that the original Berkshire Hathaway—the New England textile company Buffett acquired and turned into the conglomerate we all know and admire—failed.

Who forgets this? Mad Money viewers? Journalists? I doubt any serious investor has forgotten this point.

Jeff Bagley said...

Excellent piece, Jeff.

Slash said...

Its HP and Compaq all over again. Nothing fundamental has changed, you can't combine two lousy companies and make a better company. That's not how Dell was built neither was Walmart. Eddie has made out like a bandit and he will continue to extract cash from operations and real estate but the underlying business is not going to be the driver for the stock.

DaleW said...

Its HP and Compaq all over again.

Eddie Lampert is not Carly Fiorina. How is it a guy that has compounded money at 35% per year for 15 years is suddenly Carly Fiorina?

Nothing fundamental has changed, you can't combine two lousy companies and make a better company.

Sure you can. You say this like it's a law of physics. There are lots of things that can be done to improve the combined company. And in any case, this is a matter of increasing shareholder value, not necessarily making a better retail experience. These are not mutually exlusive goals.

That's not how Dell was built neither was Walmart.

So there are to ways to build a successful company? This IS how the modern Berkshire was built.

Jeff Matthews said...

"DaleW" needs to read the Berkshire annual reports.

While he is certainly more knowledgable than the "Mad Money" viewers and journalists he appears to distain when it comes to understanding Berkshire's failed roots in textile manufacturing, he seems not to know what Buffett looks for in acquisition candidates: high return on capital, low capital expenditures, a competitive "moat" around the business, and, above all, A+ management.

None of which Compaq or Sears, or K-Mart, possessed.

Buffett credits Charlie Munger with moving Buffett beyond the strict Graham & Dodd "50 cents on the dollar" investment style of his early days--of which Berkshire textiles was a prime example of how that can go wrong--to a focus on buying quality that sustains itself over the long run.

Buffett's own retail investments are spectacularly well-run franchises.

DaleW said...

Jeff,
Anyone who knows me would hardly suggest I need to read Berkshire's reports or get to know Buffett better. The acquisition criteria you suggest did not pertain to Berkshire when Buffett originally acquired it. This was a net/net job, pure and simple. If you're looking for the rationale behind the investment, I would suggest supplementing your education on the matter by going beyond the Berkshire letters and reading the Buffett Partnership letter from the era.

"Low capital expenditures" is not a Berkshire acquisition criterion per se, by the way. Take a look at FlightSafety, NetJets, or the utility investments. "High return on capital" is also not a criterion per se. It's high returns on incremental invested capital he's most interested in.

Charlie Munger disclaims much of the credit for moving Buffett beyond the 50 cent days, by the way. Berkshire is not a prime example of how net/nets go wrong, because in the end it did not go wrong. It helped them buy Diversified Retailing, Blue Chip Stamps, and See's. The IRR on the investment was great. If anything, it's a prime example of "margin of safety."

As for "A+" management, this is where you are missing the boat on Sears. Lacy was an excellent capital allocator when that was his chief function at Sears and he has only been superceded by a guy who has compounded capital at a spectacularly good rate for 15 years. Sears has some very good merchants and operating people and they are thinning out the dead wood that contribute nothing to the organization.

All I claim was that not everything has to follow one model that Slash believes is some sort of universal law. I guess I'm just a little less deterministic than others.

As to my original point, I think your assertion on people forgetting Berkshire's origins is a bit of a straw man. It's basic history. I would be surprised if many of the major Sears Holdings investors don't know the history and would not be very surprised if the vast majority of Mad Money viewers did not know the story. Where I am surprised is on your slightly superficial knowledge of Berkshire, which I would not otherwise point out, but I will lay the claim since you did the same in reference to me.

dcm1023 said...

Dale- Compared to you I think we might all be accused of having only "superficial knowledge" of Buffett/Munger.

Jeff- I bet you didnt know you were picking a fight with a guy whose hobby is researching Berkshire... see the link below.... i'd say you have about as much chance debating this guy on buffet as you would in a bikini contest with pam anderson....

http://www.fool.com/About/staff/dalew.htm

To both of you….. The debate is fantastic- too bad it is more of an argument than an intellectual give and take.

Its_strange said...

Our pal Pat Byrne is going to be on CNBC's Kudlow and Company today

DaleW said...

I have no arguments with Jeff. I am here to learn. When challenged, I will probably respond, but I would prefer to keep it gentlemanly and amicable. I have the utmost respect for Jeff's work and abilities -- again, I am the student here.

Jeff Matthews said...

"DaleW": very well put on all accounts.

However.

Munger may disclaim credit for moving Buffett beyond the 50-cents-for-a-dollar days, but Buffett gives Munger the full credit, as you know. Since Munger's job is not to take the spotlight away from Buffett, I take Munger's claim with a grain of salt and I take Buffett at face value.

Second, "high incremental returns on capital" versus "high absolute returns on capital" is a "distinction without a difference," as Buffett likes to say, in my view--since you rarely have one without the other.

However, you are right that Buffett owns several capital intensive businesses. My guess is that given the choice between a high-return, capital intensive business and a high-return, non-capital intensive business, Buffett would choose the latter every time. But that's only my guess.

As for Lacy as an "A+" asset allocator at Sears, you are, I think, dead wrong. Lacy was dreadful. Look at his record. He bought Lands End for $1.8 billion and they could probably sell it for a third of that three years later. He spent nearly $600 million buying K-Mart stores, and will now be closing stores in the wake of the merger with K-Mart. He oversaw a retail business with negative same-store sales during the lowest interest rate environment of a generation. He got lucky when a great asset allocator came along and bought the company out from under him; but based on his own track record, he is a C- at best.

As for Berkshire textiles being a good investment, despite being a bad business...well, yes--that was precisely my point: Berkshire did not make its money in textiles.

And Sears Holding Corp, I believe--and everybody in the world may disagree, and that's fine--will not make its money in retailing without billions of dollars of new capital investment.

But I would love to hear from people who have visited the new Sears "Essentials" stores to see how the turnaround is succeeding with the people who matter--customers.

Thanks.

coolbreeze_23 said...

Dear All,

I wonder what you might think of Timothy Vick's contention, in 'How to Invest Like Warren Buffett', that Buffett made a tremendous amount of his money on leveraged merger arbitrage situations. Since 1989 he's gotten too big to compete in that arena, but until that point a large portion of Berkshire's profits reportedly came from leveraged bets on mergers.

I could never figure out how he managed a 24% to 26% return for so many years when the constituent stocks: Washington Post, etcetera, were just returning 16% to 17% a year. Vick's book outlines the most rational argument I've seen for how he made up the difference.

Its_strange said...

Don't know if Sears or others offer a employee discount program but i gotta figure with GM's results people have to be looking .. Maybe a BBY offering a employee discount program on widescreen TV or any high priced toy....I think GM has has everyone talking and thinking...

DaleW said...

Jeff, There is a vital difference between high high incremental returns vs high absolute returns. A company may lose money today or make very small amounts of money while investing in hopes of realizing a higher return business model as the fruit of that investment. NetJets is an absolutely perfect example of that. Berkshire was a fine investment -- why does it matter where the cash flows were reinvested? The important thing is they had a capital allocator who diverted the cash to something other than textiles. I'm not too interestede in the fact that a business is failing -- I am always interested in what is priced in today and what happens on the margin. Lacy being a capital allocator. First, "perfect track record" shouldn't disqualify one on this score. Lands' End was probably a mistake, but it certainly won't be sold for one-third of the purchase price. I think the news flow indicates that pretty clearly. The sale of the credit card unit at a fine price was a much bigger impact move. Buying back 30% of the company's stock was also a good move and very narrowly paralled in its scale. As far as the Kmart store purchase goes, why do you ding him for actually addressing a structural problem that led to the negative comps? Selling 300 full-line stores (which is where they were heading), reinvesting off-mall, and continuing to return cash to shareholders was a good plan, in my opinion. Lacy wasn't rescued -- a number of parties, smart parties, were interested. Lacy was already starting the process of monetizing what those smart parties wanted. I agree Sears will need additional cap ex to improve things. They'll get the cash from operations as well as from asset sales. What's important before doing that is to get the right people in place. I don't think Lampert wants to just throw capital at the problem. There is one thing I think investors can count on with Lampert, and that is that he will allocate capital to its highest and best use. If they can't make it work in retail, the capital will be withdrawn. If they can, great. He's a rational manager with some good assets in hand. You can't ask for too much more in investing.

DaleW said...

Jeff,
There is a vital difference between high high incremental returns vs high absolute returns. A company may lose money today or make very small amounts of money while investing in hopes of realizing a higher return business model as the fruit of that investment. NetJets is an absolutely perfect example of that.

Berkshire was a fine investment -- why does it matter where the cash flows were reinvested? The important thing is they had a capital allocator who diverted the cash to something other than textiles. I'm not too interestede in the fact that a business is failing -- I am always interested in what is priced in today and what happens on the margin.

Lacy being a capital allocator. First, "perfect track record" shouldn't disqualify one on this score. Lands' End was probably a mistake, but it certainly won't be sold for one-third of the purchase price. I think the news flow indicates that pretty clearly.

The sale of the credit card unit at a fine price was a much bigger impact move. Buying back 30% of the company's stock was also a good move and very narrowly paralled in its scale.

As far as the Kmart store purchase goes, why do you ding him for actually addressing a structural problem that led to the negative comps? Selling 300 full-line stores (which is where they were heading), reinvesting off-mall, and continuing to return cash to shareholders was a good plan, in my opinion. Lacy wasn't rescued -- a number of parties, smart parties, were interested. Lacy was already starting the process of monetizing what those smart parties wanted.

I agree Sears will need additional cap ex to improve things. They'll get the cash from operations as well as from asset sales. What's important before doing that is to get the right people in place. I don't think Lampert wants to just throw capital at the problem. There is one thing I think investors can count on with Lampert, and that is that he will allocate capital to its highest and best use. If they can't make it work in retail, the capital will be withdrawn. If they can, great. He's a rational manager with some good assets in hand. You can't ask for too much more in investing.

david bennett said...

Kkimming the celebrity journalism K-mart was able to extract nearly as much money from selling a few stores as the entire real estate holdings were valued in the bankruptcy proceedings. The goal doesn't seem to make the remaining stores into long term competitors, but to generate some profit and skim it into other investment. So far it seems to be mostly working.

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judy said...

Has anyone heard how sears holdings is doing with their other sidline stores, the are called The Great Indoors. Anyone have any info on these stores and what sears plans to do with them, keep them open or close them.
Thanks