“My first reaction is that the merger is a bad idea,” says Sandy D. Jap, a professor of marketing at Emory University’s Goizueta Business School. “It is doubtful that the marriage of two lackluster companies will make a single great company.”

 

The merger of Kmart and Sears—which was announced on November 17 and is expected to be completed in the first quarter of 2005—was positioned as a way to rejuvenate a pair of tired brands that have lost ground to “big box” retailers like Wal-Mart. A press release announcing the transaction set the tone with Kmart’s 42-year-old chairman Edward S. Lampert noting that, "The combination of Kmart and Sears is extremely compelling for our customers, associates and shareholders as it will create a powerful leader in the retail industry” with “significant opportunities for improved scale and operating efficiencies.” Lampert’s ESL Investments hedge fund controls Kmart and is the largest shareholder of Sears, with a stake reported to be about 15%.

 

In a conference call held on the day of the announcement, Lampert noted that, scale is “very important to compete effectively,” and went on to explain that mergers can offer an opportunity to “service the customer base with products and services, while driving significant efficiencies and productivity out of the back office.”

 

Current Sears Chairman and CEO Alan Lacy has also applauded the merger, noting that Sears will provide Kmart with scale, resource and brand differentiation that will help it to compete more effectively against Wal-Mart and Target. From a combined company standpoint, he adds, “it gives us the opportunity to grow our off-mall locations in areas that are closer and more convenient to the customer. Obviously, there's a significant amount of scale advantage here as well.” Lacy is slated to be the vice chairman of the board and CEO of the merged Sears Holdings company.

 

Can a Financier Run a Retailer?

 

Considered as a case study in competitive advantage, the strategy does appear to offer some strengths—including the potential of achieving $200 million of incremental gross margin by cross-selling Kmart and Sears' proprietary brands and by converting selected off-mall Kmart stores to the Sears nameplate. Further, the retailers hope to achieve annual cost savings of more than $300 million through improved purchasing scale, and by enhancing their supply chain, and administrative and other operational efficiencies.

 

There appears to be little question about Lampert’s track record—the returns on his hedge fund, reported to average 29% a year, have led to favorable comparisons with the legendary investor Warren E. Buffett. Lampert has also impressed the market with his turnaround efforts at AutoZone, a retail car-parts chain, where ESL’s 35% stake has benefited from cost-cutting measures and store expansions that were instituted soon after he starting buying into the company in 1997.

 

But Jap suggests that both Sears and Kmart are struggling in a cutthroat retail environment that demands low prices and high volume, like the Wal-Mart model, or competitive pricing with a cachet, like the Target model. And she says that simply combining two underperformers is not likely to solve the challenges.  “Sears and Kmart each have significant underlying problems with channel structure and with retail skills,” she explains. “The difficulties they’ve had with both merchandising and positioning have meant that neither retailer has been very well received by customers.”

 

A cautionary note was also sounded by Standard & Poor's Ratings Services, which announced on November 17 that its “BBB” corporate ratings on Sears, Roebuck and Co. would “remain on CreditWatch with negative implications.” The notice adds that “It is likely that ratings for Sears and the new holding company parent, Sears Holdings Corp., will be in the 'BB' category” upon completion of the merger, which is scheduled for the end of March 2005.” Despite the company's much greater size, and cost-savings synergies that are estimated by management to occur after the third year, “both companies lag their peers in terms of store productivity and profitability,” notes the S&P announcement.

 

According to the S&P website, an obligation rated BBB exhibits “adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.” A BB rating indicates a company “faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to the obligor's inadequate capacity to meet its financial commitment on the obligation.”

 

Real Estate, Technology Are Decisive Issues

 

One issue is the fact that many Sears stores are positioned in malls, which have fallen out of favor as stand-alone “big box” formats—like Wal-Mart—have expanded their reach. Another factor is Kmart itself, which during the years leading up to its bankruptcy—Kmart filed for Chapter 11 in January 2002 and emerged from bankruptcy protection in May 2003—developed a reputation for dirty stores, empty shelves and poor customer service.

 

While industry watchers give Lampert credit for addressing the worst of Kmart’s shortcomings, a recent article in the information technology trade publication eWeek calls the retailer “one of the least efficient” operators in the business where technology is concerned. The article goes on to note that Kmart’s new partner, Sears, also neglected to keep pace with technology initiatives such as Radio Frequency Identification (RFID) and vendor-managed inventory (VMI)—all of which help Wal-Mart maintain the right level of inventory and minimize expenses; and all of which require significant capital expenditures. Investors who anticipate that kind of investment at Sears and Kmart may be disappointed—at least if Lampert follows the model he used at AutoZone, where cash extracted from operations has been used to repurchase shares instead of to grow sales. Similarly, under his watch Kmart’s capital spending has reportedly been curtailed.

 

But obstacles to a successful Sears-Kmart cross-pollination may in fact stem from the philosophy behind the merger itself, according to Reshma H. Shah, a professor of marketing at Goizueta.

 

“A Kmart-Sears combination could be confusing for the customer base,” she says. “Sears is a department store that is a bit more upscale than Kmart, which is positioned as a discounter. The companies may cannibalize each other’s sales—I’m not sure how they expect to get customers to increase their overall purchases.”

Shah acknowledges the financial clout of the two companies, which will have post-merger annual sales of about $55 billion, but questions the positioning of the Sears and Kmart brands.

 

“Consumers are excited by Wal-Mart’s prices and Target’s image,” she says. “But while they’re attracted to some of the individual Sears lines, particularly the Craftsman tools and Die Hard auto supplies, and to some of Kmart’s designer lines, the draw does not extend to the larger arena of the stores themselves. If they can’t deliver the prices that Wal-Mart offers or the identity of Target, why should shoppers go to a combined Sears-Kmart format?”

 

A Different Kind of Value?

 

Instead, she suggests, Lampert may actually be looking for a different kind of value from the two retailers.

 

“Lampert is smart hedge fund manager, so the acquisition may be a financial move more than anything else,” says Shah. “He could be looking to tap into the real estate holdings of the companies.”

 

In fact, within three to six years the Kmart and Sears retailing brands may both be history, says Howard Davidowitz, chairman of the New York-based consulting and investment banking firm Davidowitz & Associates.

 

“Although the combination of Sears and Kmart is not viable at the retail level, the financial metrics are very good,” he explains. “Kmart has a valuable $3.8 billion tax-loss carry-forward that may be used to offset future income, and both retailers have very attractive real estate holdings that could be sold at a considerable profit, particularly now, when real estate commands such a high premium.”

 

Davidowitz says he was involved in a similar deal some years ago with Alexanders, a longtime New York-based department store chain that closed its retail operations in 1992 and was converted to a real estate investment trust that is now managed and 30% owned by Vornado Realty Trust (Vornado also has holdings in at least two Lampert investments: Sears and AutoZone). The metamorphosis from retail to real estate extends to Vornado itself, which used to operate a retail chain called Two Guys, prior to its re-launch as a real estate investment trust, or REIT.

 

“Alexanders’ stock was about $10 a share when it exited the retail business,” notes Davidowitz. “Today as a REIT it’s more than $100 a share.”

 

Back in 2002 when Sears’ credit card operations generated more than 56% of the company’s net income, analysts asked if Sears was effectively shedding its retailing roots to become a financing organization. Lacy answered them the next year when he sold the credit card business to Citigroup for more than $3 billion. Now however, facing competitors like Wal-Mart and Target—and with Kmart about to dominate the corporate board— the jury is out on what the combined Kmart-Sears entity will look like five years from now.