Sears, Kmart stores ailing as CEO Eddie Lampert's hedge fund gets hundreds of millions

When he became CEO of Sears Holdings, Eddie Lampert declared he was on a mission to restore the iconic retailer to its former glory. Since then he's extended billions of dollars in loans from his hedge fund to Sears and Kmart.

But the difference between what Sears has invested in its stores — and therefore what customers experience when they shop — is stark compared with many of its peers, a USA TODAY review of public filings and analyst research shows. And if the chain ever sinks into bankruptcy, the records show Lampert's hedge fund will be positioned at the front of the line when loans are repaid.

While Sears has spent less to spruce up stores, competitors have taken the opposite approach. Best Buy, for instance, was left for dead five years ago, Since then, CEO Hubert Joly has plunged hundreds of millions of dollars into store upgrades and critical information technology systems. Today, the electronics retailer is back on its feet, having remade itself as a vibrant physical retailer immersed in the digital age.

Sears stores, on the other hand, have fallen into disrepair. Stained carpeting, broken fixtures and dim lighting are commonplace. Analysts, industry watchers and even shoppers predict the iconic retailer doesn't have much time left.

“If you go into any Sears, physically they look like 1982,” said Stacey Widlitz, president of SW Retail Advisors. “So as a customer you’re thinking, ‘This is not a place I’m coming back to.’”

USA TODAY's examination of public capital spending data and research compiled by Susquehanna International Group found Sears and Kmart spent 91 cents in capital expenditures per square foot in the fiscal year that ended in February. In contrast, Best Buy invested $15.36 per square foot in its most recent fiscal year.

Lampert declined to be interviewed for this story and a representative for Lampert’s hedge fund, ESL Investments, declined to comment or to make him available.

In an emailed response to questions, Sears told USA TODAY, “we strongly disagree with your assertion” that the company has not used a sufficient percentage of its resources to reinvest in stores. The company pointed out that its recent investments have included several new smaller-format locations, including Sears Appliance & Mattress locations in Texas, Pennsylvania and Hawaii.

While Sears has steadily lowered its investment in store upgrades over the last five years, the company has loaded up on loans due to Lampert himself.

By extending almost exclusively secured loans to the company, Lampert's hedge fund has racked up more than $2.4 billion in Sears debt, according to a USA TODAY review of public filings and research by Debtwire, which provides news and analysis of corporate and municipal debt.

Lampert-owned investment funds, including ESL and a related fund called JPP, are getting roughly $200 million to $220 million per year in interest payments from Sears, according to separate estimates from Susquehanna and Debtwire.

As the company bleeds cash and puts prized brands up for sale, some industry watchers question whether a greater focus on its stores — or even a declaration of bankruptcy some years ago — could have put it on the path to profitability. Now, instead, the company's demise may be inevitable.

"Two or three years ago, in a bankruptcy ... you probably had a chance to execute reorganization,'' said Van Conway, CEO of Van Conway & Partners, a financial advisory firm specializing in distressed situations. Now, "I've got to believe when they head into a bankruptcy ... you're going to see a Toys R Us outcome, which will be just a liquidation.''

If that happens, Lampert has put the hedge fund in position to snap up some of the company's prime assets, analysts said. This would come after the CEO orchestrated a series of complex financial deals in which he effectively has played the unusual role of both seller and buyer or lender and borrower.

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Lampert has previously said he does not believe in pouring money into stores that would not provide sufficient return on the investment.

Instead, he has pursued partnerships, including recent deals with Amazon.com and Citi that have earned praise from investors, and made loans to the company that have been personally lucrative.

“My conclusion is he’s trying to take the whole thing for himself,” said Susquehanna International Group analyst Bill Dreher, a retail stock analyst who has tracked Sears for two decades and recently estimated that the retailer needs $1.4 billion in fresh capital to make it through the year. Dreher recommends that investors sell the stock. Susquehanna is a market maker in the stock, meaning it buys and sells shares to help investors execute trades.

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Lender, borrower and cost cutter

Under Lampert’s reign, Sears has implemented a relentless cost-cutting campaign — $1.25 billion in 2017 alone, including hundreds of store closures — while making priority payments to Lampert the lender.

Cost cuts and loans have extended the retailer’s lifespan and kept 89,000 employees at work. The loans were authorized by the board of the company, which may have faced difficulty in securing other financing without Lampert’s help.

“He clearly understands the value of the assets that are in the company and is looking to maximize the value of those assets,” said Philip Emma, senior analyst at Debtwire.

Most of Lampert’s loans likely would be paid in full if Sears goes bankrupt, since it’s nearly all secured debt, which typically takes precedent in court over unsecured creditors such as vendors and landlords.

To be sure, Lampert has a lot to lose if he can't turn Sears around. That includes his 49% equity stake, which was valued at $115 million as of June 4

“He’s been cutting most of the checks,’’ said Noel Hebert, a Bloomberg analyst who noted that a spin-off of outdoor apparel retailer Lands' End in 2014 was one of the few occasions when Lampert earned equity without paying for it up front. "It’s not like he’s just totally stripping it and just harvesting all of the value for himself. He is paying for it.’’

The question is “whether he’s paying the right value,’’ Hebert said. “If they ever file for bankruptcy, I suspect that will come up in court if he doesn’t by that point own all of everything.’’

Falling into disrepair

Many of the retail sector's challenges, including declining mall traffic and Amazon's rise, were already intense by the time Lampert became CEO.

Lampert signaled his reluctance to heavily invest in stores in a letter to shareholders in 2006 — roughly a year after he engineered the merger of Sears and Kmart to create the new parent company, Sears Holdings.

The business would not invest money in “stores simply because we have the capital available to invest or because everyone else does it,'' Lampert wrote. "Rather we are investing in our stores where the investment makes sense — in other words, where it improves the experience for our customers and associates and leads to attractive returns."

That philosophy may have led to Lampert's decision to scuttle a pilot project to renovate dreary stores within weeks of his appointment as CEO in early 2013.

The plan had involved fresh paint, new carpeting, replacement fixtures, updated lighting, additional staffing and new products for about five locations to prove the business case for upgrading other stores, said a former Sears executive who revealed details about the plan on the condition of anonymity.

“We do and will continue to invest in our stores — and open new stores, too,” Sears said in its statement to USA TODAY. “As we look at investing in our business we think about how we improve the overall customer experience, including anticipating how we will be interacting with the customer as an integrated retailer.

“Customers want stores that look nice so we are investing in fixtures, paint and designs, but a store’s appearance, by itself, is necessary but insufficient. We plan to make our stores more inviting by using technology and information in a different way. In today's society, information trumps most assets, so we are also deliberately investing in digital and integrated retail.”

Lampert has insisted in blog posts that Sears is “fighting like hell” to survive, saying that the company’s upgraded Shop Your Way loyalty program will pay off and that it is hoping to shrink the company to a sustainable size.

“Put it this way, if I consider all the other alternatives, they’re not great for a lot of people, and I just want to be responsible,” Lampert told Vanity Fair recently. “If I didn’t believe that this company could be transformed still — the window is definitely shrinking — but if I didn’t believe that, I would try to take a different path. But I don’t know what that path exactly would be. It’s not a question of giving up or not giving up.”

Dreher views Lampert’s description of his efforts to inject new life into the company as a distraction.

“It’s all just lip service to obfuscate the true issues,” he said. “It’s terrible for the employees, for the communities, for the shareholders.”

Key moves since Lampert came on board have included:

• Selling the Craftsman brand in 2017 to Stanley Black & Decker for roughly $900 million.

• Transferring 235 of the most valuable Sears store properties in 2015 to a new real estate investment trust, Seritage Growth Properties, where Lampert is the largest shareholder and chairman, for $2.7 billion. Sears paid Seritage $109 million in rent in 2017, $43 million in expenses such as property taxes, insurance and utilities, and $35 million in lease termination fees, according to a public filing.

• Spinning off retailer Lands’ End in 2014. Lampert's ESL owned roughly 67% as of Jan. 24, according to a filing, a stake worth nearly $430 million as of May 17, and roughly $578 million as of Friday afternoon.

Now, Lampert is taking his strategy a step further.

In April, Lampert, in his role as hedge fund manager, wrote a letter to the Sears board — which he chairs — asking that the company consider selling ESL its Kenmore appliance brand and other assets. A month later, Sears set up a special committee to explore the possibility.

On May 25, Lampert's hedge fund, ESL, wrote to the committee saying that it had "received numerous . . . inquiries from potential partners,'' and asking for the go-ahead to talk to them and others in preparation for offering Sears "a definitive proposal.''

Sears has said Lampert will not be involved in the decision process, "except to the extent specifically requested by that committee." And the special committee has previously put limits on ESL working with partners as it aims to buy key Sears assets.

“He’s basically been sawing off the legs of this thing almost from the very beginning of his engagement,” said Lampert critic Mark Cohen, former CEO of Sears' Canadian division, who was fired in 2004 over what Sears described as “strategic differences” regarding a unit that was ultimately spun off in 2012 and then liquidated in 2017.

“How can the board allow him to do these things? The board is basically meaningless. The board is a group of puppets who do what Lampert requires of them," Cohen said.

The five Sears board members other than Lampert either declined to comment through their representatives or did not respond to requests.

Sears said in a statement: "Sears Holdings prides itself on having a strong board of independent and experienced business leaders who put the best interests of our members, associates and shareholders at the forefront. Any suggestion to the contrary is unjustified."

Competitors keep investing

While Sears has offloaded assets, borrowed and cut store spending, its competitors have taken another approach.

Archrival J.C. Penney, facing many of the same challenges, has continued to reinvest. The company spent about $4.13 per square foot on capital improvements during its most recent fiscal year, data shows.

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Strategically, the company broadened in-store sales of popular Sephora beauty items, which has helped sales, though J.C. Penney continues to face hurdles of its own.

“They’re bringing new product in and trying new things in the store,” Bloomberg analyst Hebert said. “But they’re also investing enough to make sure all the light bulbs work and the floors are clean, and there’s enough people actually working in the store.’’

Others have invested even more. Kohl’s, for example, spent $8.12 per square foot. Sears and Kmart, by contrast, collectively spent 91 cents per square foot.

Even when measured as a percentage of the company’s declining business, the disinvestment is evident. Sears’ capital expenditures, or "capex," as a slice of revenue have plunged 47% since 2013, when Lampert became CEO.

Sears now spends less than one-half of 1% of its annual revenue on upgrades at stores and online operations.

The company told USA TODAY it’s not fair to use that metric. The company did not respond to a question about Lampert’s 2013 cancellation of the store renovation plan.

“We believe that traditional measures of capex in a store do not apply to our evolving, member-centric and integrated business model,” Sears said. “We feel that you have to look at all investments and expenditures that potentially touch the customer experience, whether they be in-store, online, in the home or via our mobile platform.”

Retailers typically spend between 2% and 4% of their annual revenue on store upgrades and other improvements, Hebert said, “because you want people to come to the store and enjoy that experience.’’

Sears was struggling financially long before Lampert came on the scene.

"The only time for Sears to have turned itself around would have been in the late 1980s,'' said Robin Lewis, CEO of The Robin Report, which chronicles major trends in the retail industry.

That was the moment when Sears had an opening to emphasize the sale of appliances, tools and other home categories it was known for. "If they had discarded all other merchandise and focused on the home . .. they could have been the Home Depot of today," Lewis said.

Decades later, Sears continues to face challenges, including declining mall traffic, major pension obligations and nimble physical competitors such as fashion deal destinations T.J. Maxx and Marshall’s.

But Lewis doubts that saving Sears as a retail business was ever really Lampert's priority. "From day one,'' Lewis said, "he was cutting costs.''

"He initially announces to the world that he’s going to turn around these two iconic American brands and bring them back to their greatness,'' Lewis said of Lampert. But while "he probably thought 'we'll give this the old college try' . . . he saw those assets were worth more than the operating retail business and that he personally could make a lot of money.’’

Retail consultant Widlitz made note of some promising Sears moves, including the company’s recent deal to allow Amazon shoppers to buy tires for installation at Sears locations.

“That’s great. That’s traffic driving,” Widlitz said. “But we are in the 11th hour here. It’s too little, too late.’’

Signs of decay

On a recent Wednesday afternoon at the Sears store in the Coastland Center mall in Naples, Fla., signs of neglect were impossible to miss.

Although employees kept the store as tidy as possible, the tattered carpet looked like it hadn’t been replaced in ages. Gum stains and splotches from unidentifiable sources were plainly obvious.

A bathroom sign was broken in half, labeling looked outdated and paint was faded. Product placement also seemed off. Air mattresses were being sold next to garden hoses and swim toys next to exercise equipment.

Most of the kiosks were empty, even when a customer seemed to need help.

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“I’ve been coming here for quite a few years, but more and more lately, I’m hardly seeing anybody in the store,” said Hilda Aguilar, a Naples resident who often shops at the store for activewear. “I’ve seen the amount of employees drop quite drastically. My husband had to search in the hardware department when we were here like two weeks ago and couldn’t find anybody.”

She said there always used to be a pleasant employee at the jewelry counter. Now the employee is gone, and no one has been there to help her the last four times she has been to the store.

At a Sears store in the Oakland Mall in southeast Michigan, Louise Johnson, 76, of Detroit said she has noticed the retailer’s decline over the years. The stores and their customer service are not as great as they once were, she said.

“Everything seems to be going down instead of coming up,” Johnson said.

That descent could yet deepen before the company comes to what many analysts predict is its destiny: going out of business.

“The company is essentially insolvent, although not legally insolvent,” said Cohen, who now teaches at Columbia Business School. Lampert will keep it alive “as long as he has to, to enable him to pull assets out.”

Lampert told Vanity Fair that “we’re doing things that are necessary to keep the company going,” and “I feel like I can make a contribution by (being) involved, OK?”

Loan payments pile up

If Sears liquidates, the company’s employees will be thrown out of work while hundreds of American communities will be left with gaping vacancies in local malls. Sears still operates 88 million square feet of selling space in about 899 stores, which includes ailing Kmart, according to Susquehanna estimates. On May 31, the company announced plans to close more than 60 additional locations.

But for the investment portfolio of Lampert, liquidation may not be particularly damaging. Less than one-tenth of Lampert's remaining Sears debt is unsecured, according to Debtwire.

Meanwhile, the company’s attempts to sell assets and a series of deals with Amazon to sell products and services on the rival’s site have given some investors new confidence in recent months. Citi also agreed in May to give Sears $425 million in a Shop Your Way credit-card deal that provides upgraded points-for-merchandise deals for customers.

The company’s stock is trading slightly above its low of $1.99 hit on Feb. 12.

Dreher thinks Sears stock is likely still “on its way to zero.”

Sears customers such as Brian Jarquin, 26, of Phoenix, would have to find another place to shop.

Other than a few customers, the Sears at the Paradise Valley Mall in Phoenix was mostly empty on an early Tuesday afternoon in May. Vacant parking spaces surrounded the store.

Jarquin was there to find underwear for his young child. What he was looking for wasn’t in stock, though.

During his youth, his father shopped at the chain for nearly everything. Now, the store rarely touches his life.

"Dang,” he said. “Sears has become one of those stores.”

Contributing: Katherine Hamilton of the Naples Daily News; JC Reindl of the Detroit Free Press; Perry Vandell and Robert Gundran of the Arizona Republic.

Follow USA TODAY reporter Nathan Bomey on Twitter @NathanBomey.