Sears Holdings (Ticker: SHLD)

The testing of long-term Eddie

Eddie Lampert has endured worse days than these. After all, it is only five years since the billionaire investor was kidnapped in the garage of his office in leafy Greenwich, Connecticut, and spent a weekend tied up in a motel bath-tub before somehow talking his way to freedom. But as far as his investments are concerned, things have never been tougher for a man who has prompted comparisons to no less an investor than the “Sage of Omaha”, Warren Buffett.

Take Sears Holdings (Ticker: SHLD), where Mr. Lampert is chairman and his much-feted hedge fund, ESL Investments, owns half the company. The unthinkable has happened. American consumers are losing their urge to shop. Maybe it is because they have been scared into prudence, maybe it is because they can no longer get the credit to which they have long been addicted, but they are spending less. Every single retailer is hurting from the drop in demand, but the weakest are in grave trouble. 

Against this industry backdrop, and with a bravura touch, the management of Sears on Tuesday announced both the 10th consecutive quarter of sales declines and a $500 million share buyback. Credit, at least, is not a pressing problem. Provided that suppliers continue to extend normal payment terms, the retail group has a line of credit in place until 2010 and $1.2 billion of cash on hand. The downturn may even provide some relief by halting the expansion plans of competitors – a significant contributor to losses in market share since Mr. Lampert decided to merge discounter Kmart together with department store chain Sears back in 2005.

Yet comparable-store sales dropped by 9% in the third quarter. The consensus of the six analysts who still cover the stock is that revenues, which totaled $53 billion in 2007, will have dropped to $45 billion by 2010. Earnings are expected to fall by three-quarters next year, similar in magnitude to the fall in the shares from their peak.

The fundamental problem is that it is hard to see what Sears is for. General retailers work when they become destinations in their own right. Either because they are cheap and all encompassing, such as Wal-Mart (Ticker: WMT), or offer superior service and convenience. A city centre department store can prosper because high rents discourage cut-price competitors and there is a large pool of customers close by. But good locations are rare and specialist stores such as Best Buy (Ticker: BBY) or Home Depot (Ticker: HD) proliferate. But closing any of the 3,800 North American stores is costly and any serious attempt at a turnaround needs a large investment.

Judging by the steady stream of bad news about the American economy, things may get a lot worse for Sears before they get better. Yet, as a long-term investor, Mr. Lampert has time on his side – and it is his money, more than anyone else’s, that is on the line. “Adversity has made me stronger in my business and personal life”, he says. “I don’t doubt what we are trying to do”.

Lining up for profits

Bill D’Alonzo’s Brandywine Blue has been adding to its stake in Southwest Airlines (Ticker: LUV). At the last count, 3.49% of his fund was invested in the low-cost operator. Why?

Mention the airline industry in polite company and a few truisms invariably come trundling out: airlines are loss making, inefficient, prone to extreme cycles and vulnerable to fickle consumers. Why, most of America’s airlines have at one time or another in recent years flown on only thanks to the Chapter 11 bankruptcy cushion. The trouble with truisms is that they can obscure big changes as they start to happen. In fact, while most consumer-facing businesses contemplate a recession, there is a good chance that the US airlines are about to make record profits.

The reason is fuel, but not just because the oil price has dropped to $50 a barrel. Prices almost three times that level in the summer threatened the industry with oblivion. With those kinds of inputs it was simply not possible to raise prices by enough to cover costs. So the airlines responded by cutting capacity. Seat numbers are down by 14% in the fourth quarter. Even Southwest (Ticker: LUV), the famously lean operator, intends to cut back early next year – the first time in its 37-year history. The North American industry will shortly be back to its 1998 size.

Meanwhile, charges have appeared for things that used to be free. Passengers may feel like their pocket is being repeatedly picked, but the industry has discovered $3 billion of new revenues. And rafts of Chapter 11 proceedings mean healthcare and pension liabilities have been addressed, while the steady rise of fuel costs forced all manner of efficiency improvements.

The sector rallied as the oil price dropped, but has collapsed again as demand worries rose to the fore – the Bloomberg index of US airlines has dropped 31% since Lehman Brothers collapsed. Yet JPMorgan calculates that, should crude average, say, $70 a barrel next year, sales would have to fall by a fifth to wipe out the benefit of that cost reduction. Assume sales decline by 2% – typical in past recessions – and the industry makes a record $9 billion of operating profit.

Ultimately the grim cyclicality of the industry will prevail, and fresh demands from labor remain a worry. But, with airline debt yielding up to 20%, and with deleveraging in prospect next year, it could be time to get in the game.

Deal or bust?

While the Great Gatsby believed he could lie his way from mid-western obscurity into Long Island society, Walter Chrysler, a railway mechanic from Ellis, Kansas, earned his 23-room house, complete with swimming pool and 450-foot waterfront on Long Island Sound, through single-minded application.

By 1923, when he was only 47, Chrysler was the first American manager with a $1million salary. Yet Chrysler’s real life’s work was only beginning: he was about to found his car company and finish the then biggest and most beautiful skyscraper in New York, the Chrysler Building. While Chrysler would never be the Ford Motor Company or General Motors, both man and company were to occupy a prime position in American motor history. Chrysler’s original workman’s toolbox, with the tools he crafted himself, is still stored in the company’s Detroit offices, like some sacred ark of the covenant.

Can today’s American automakers recapture this pioneering, can-do spirit? In a sense, General Motors’ Buick, the 105-year-old marque, long positioned as an entry-level luxury car behind Cadillac, epitomizes both the challenges and opportunities of its parent. The automakers will soon return to Congress with plans to use billions in government loans to restructure without declaring bankruptcy. Congressmen mulling this request might want to visit their local Buick dealership. They should have no trouble finding one with 2,751 nationwide (the last time the National Automobile Dealers Association counted), over double those selling Toyotas. As a result, only 88 Buicks a year are sold per dealer versus 1,821 for Toyota, whose sales are spread across fewer brands. Barring Chapter 11, multiple brands and excess dealerships can only be remedied with billions in dealer buy-outs due to state protection, as seen with Oldsmobile, that dowdy brand where GM pulled the plug eight years ago.

On the other hand, Buick epitomizes much that GM has done right lately. For one, it is a leading brand in China, its big growth market, where it outsells the US and earned cachet from being driven by the last emperor and the first car to enter the Forbidden City. Back at home, it recently won awards for quality and has begun luring slightly younger drivers with its Enclave crossover, while consolidating four sedan models into two new ones. Buick has even considered introducing a model designed for China to the US. Cash constraints today make it hard for GM to realize this global vision or to cull its bloated line-up. Buick may be worth keeping, but bankruptcy would allow it to weigh the costs and benefits properly.

Yes, there is a role for the federal government in aiding Detroit, but not the one the industry has requested in its lobbying and public relations blitz. This option is not being considered because interested parties such as the powerful United Auto Workers union and large shareholders such as Cerberus would have to take a hit, as would the personal wealth of management and state coffers in Michigan and elsewhere.

The ill-considered $25 billion lifeline being debated might merely buy a few extra months for the most distressed manufacturers such as General Motors and Chrysler at their recent rate of cash burn. But a lasting turnaround could be achieved in the bankruptcy courts. The only hitch is the dysfunctional state of financial markets. Normally, a bankrupt company can attract low-cost “debtor-in-possession” financing senior to existing claims. Such loans are in short supply today, as some retailers are discovering. But the federal government could guarantee this funding to the Big Three and their key suppliers at little taxpayer risk.

Under Chapter 11, unionized autoworkers that receive the equivalent of more than $70 an hour in wages and benefits could see contracts torn up. So would dealerships currently protected by state franchise laws. Shareholders would be wiped out. Lenders would suffer haircuts in exchange for equity in the reorganized companies. Managers would see their wealth and careers evaporate.

Arguments such as the UAW’s that consumers would never buy a car from a bankrupt manufacturer or that of industry-funded studies showing that 3 million or even 14 million jobs would be lost are nonsensical. Similarly, anti-bail-out politicians crying for the scalps of senior executives ignore their impressive cost-cutting efforts even before this unforeseen financial crisis. The US auto industry is viable with much lower costs, capacity and debts. But taxpayer cash should only be spent after existing stakeholders swallow some bitter medicine.

Electronic Arts (Ticker: ERTS) / GameStop (Ticker: GME)

Playing a long game

Videogames and the future have been locked together from the beginning. The father of them all was “Space War”, which was written in 1961 on one of the first interactive computers, the Digital PDP-1, as an exercise in finding something interesting for a computer to do. The answer: move two little outline rocket ships against a background of stars. It seemed only natural to allow them to shoot torpedoes at each other. Thus was born the videogame. Why were the spaceships shooting at each other? Because that is what future spaceships do. But “Space War”, in a sense the first videogame, was also one of the last to arrive without a bit of hokey sci-fi plot explaining why, exactly, you need to blow away everything that moves on the screen.

Today, as economic storms rock the ship of the typical American household, luxuries have been thrown swiftly overboard. But while new cars, designer handbags and exotic holidays are sinking, it seems that the kids are still shooting up aliens and pretending to be rock stars. Data from the research company NPD shows that US sales of computer games software in October were a third higher than the year before. While most retailers were wondering what happened to their customers, games players carried on regardless.

Gaming companies, such as Electronic Arts (Ticker: ERTS), claim that that this reflects the good value entertainment on offer. For the cost of taking a family to the cinema, a computer game provides many more hours of fun. That deserves skepticism – a product costing $50-60 is rarely an impulse purchase. Tighter budgets should still mean fewer games bought, with more from the second-hand market actively encouraged by such retailers as GameStop (Ticker: GME), whose management believes it will end this year with sales up more than 20% year over year and profits up a robust 30% or better.

The hardware cycle is at work. Morgan Stanley points out that during the last recession US video game sales (excluding those for PCs), grew by 10% in 2001 and 21% the year after. Stagnation came between 2004 and 2006. The three new games machines launched since – Nintendo’s Wii, Microsoft’s Xbox 360, and Sony’s PS3 – have reinvigorated the market. Nintendo, in particular, has attracted new players, including women and families – claiming 12% of Wii buyers are first-time console owners.

For game developers, the growing customer base should mean improving margins as development costs are spread across more units. The profile for game sales is changing too. Online gaming is both prolonging the life of successful games in an industry that has tended to move rapidly from one hit to the next, while also developing new revenue streams – music downloads for instance. Developers though have largely tracked the market downwards, trading on low teens earnings multiples.

Electronic Arts, at $19.41, is on a forward p/e of just 10.85, while GameStop at $21.35 sells at 7.60 times prospective earnings. Both look an ideal way to avoid the gloom.

Citigroup's rescue

Citi never sleeps, advertisements from the US bank reminded customers at the weekend. Nor did anyone else as bail-out negotiations ran late into Sunday night. The result was a convoluted package to ring fence $306 billion of Citigroup’s (Ticker: C) problem assets, with loss-sharing and guarantees from a trio of government backers, some of whom receive preferred stock and warrants in the bank. Then there is an injection of another $20 billion in preferred equity under the Treasury’s Troubled Asset Relief Program (TARP), plus $16 billion in capital released thanks to lower-risk weighting.

The complexity diminishes the punch from this solution. There is no “bad bank” as the assets stay with Citi, revalued as part of the deal. Including some $8 billion of existing reserves, Citi is on the hook for about the first 12%, or $37 billion, of losses, plus a share of the remaining losses. But it is giving away remarkably little for its protection, which includes a promise from the Federal Reserve to lend up to $227.1 billion. The interest rate on the preference shares at 8% is moderately higher than the original TARP but below that demanded by the UK government to rescue its beleaguered banks. Common stockholders lose their dividend but no management heads will (yet) roll. No evidence either of renewed pressure to slim down Citi’s bloated balance sheet.

Citi is too big to fail. Its problems are not as acute as were those of Lehman Brothers, which failed in September: with access to central-bank loans and the government already backing its debt and deposits, it is not about to seize up. But thanks to its vastness, any crisis of confidence has systemic ramifications. Indeed, Citi’s shares slumped over the past few weeks to a level at which some pension funds were barred from holding them and trading partners and customers were growing twitchy. Officials would have taken little time to decide to shore up the bank, given the fragile state of all markets for risk assets. 

But the impression here of a favorable deal is unfortunate, especially as this model may be extended to other institutions. The market, with Citi’s shares down 60% last week, had utterly lost confidence in the bank’s top brass and its ability to deal with losses from the $3,000 billion-plus in total assets (about a third off balance sheet). In such an instance, public control at the expense of common shareholders would be a cleaner and more definitive course of action. Citi’s shares soared on Monday but languished 45% below the price at which the government is receiving warrants. That reflects lingering fears that Citi may well cause sleepless nights once again. Though its huge losses from residential mortgages have peaked, Citi faces a second wave of write-downs on credit cards, commercial property and corporate loans as the recession deepens.