Notes of Sears Holding 2007 AGM

Notes prepared by Peter Lindmark of Lindmark Capital, LLC. Peter attended Sears Holdings 2007 AGM. Eddie Lampert answers questions from shareholders and analysts.

This was largely prepared from memory in the car on the way to Omaha and will contain errors; please email me with questions, comments, or reporting of errors at plindmark@lindmarkcapital.com

Presentation by Aylwin Lewis (I was 7 minutes late)

- Goal is to generate a buzz with the customer
- Focus on the customer & How does SHLD make money
- Acknowledged all people who work there, two were absent

2006 in Review
- Profitability up substantially
- 4Q was outstanding
- Lands End set records for itself
- Remodeled 20 Kmarts
- National rollout of Craftsman
- Led by apparel
- Comp’s improved
- Sears Grand – continue to test and learn

Business Investment
- People are their biggest investment
- Direct sourcing & supply chain
- On-line
- New e-commerce center; 4th floor downtown Chicago State store
- IT roadmap

Path Forward
- Leading brands (appliance, tools, lawn & garden)
- New attitude this year by Big brand positioning THIS WAS AYLWIN’S THEME
- Using customer segmentation data

Innovation in Retailing
- Sears Grand important part of the future
- Expanding store within store roll outs of Lands End as well as Dealers being placed in store
- Expand Kenmore in Kmart and Craftsman

Operating with Excellence
- Building management at all levels
- Biggest complaint not enough labor in Kmart stores

Creating Value
- Create value for customers
- Working environment – investing in employees future
- Chairman is the largest shareholder



Maureen

Branding Preview
- Mr. Blue Light
- New commercials on Extreme Home Makeover
- Everything in one commercial was from SHLD

Question and Answer (Mr. Lampert unless otherwise noted)

1) Q: Any ideas on where you will invest your $2 billion in cash?
A: Mainly wants to invest in core retail business “if” it provides decent return.
Background of K-Mart Bankruptcy, and Sears’s merger:
• K-mart’s priority was to demonstrate financial strength out of Bankruptcy; everyone said they would go chapter 22
• Built a cash cushion after (the $2 billion) the bankruptcy
• Built capabilities that didn’t exist (i.e. product design in NY)
• Strong core was in place; sold some assets
• Wanted to figure out how to capitalize on store base & assets
• Terrific capability in their store base; K-mart had stagnated around base of 860 stores
• Were able to pick the best of both companies departments (marketing, IT etc.)
• Successful in bringing both companies together
• 2006 EBITDA $3.6 billion
• Profitability is low and needs to be brought up to “best in class” without giving a specific timetable.
• Need to get into the weeds to operate the companies
• Need to understand the strengths and weaknesses of the whole company
• How to be successful for employees’ future
• They now have significant cash position and cash flow
• They can redeploy this the standard ways: reinvest in the business, dividend, buybacks, etc.
• They must at least spend the minimum on stores to maintain stores (ceilings, parking lots, etc.)
• Very hard to treat 2300 large box stores equally, when they don’t perform equally
• What needs to be done nationally versus local; don’t want to drive people into run down stores
• Must keep an open mind for opportunities and no choices are predetermined
• Maybe more large transformational opportunities or maybe there are just small ones
• Multiple options depend on the opportunity set? Not a set plan (THIS IS A RECURRING THEME FROM MR. LAMPERT, I heard it quite frequently last year as well)
2) Q: by Davis Select Analyst: What is the appropriate amount of leverage (comparison to Autozone and Auto Nation)? Expand on Mr. Lampert’s frustration of their debt rating? Any more information on Securitization of the brands & what they are doing to monetize the real estate? What are they doing with reinsurance subsidiary? Were the swaps for investment purposes? Any sale/leasebacks on properties?

A: Reinsurance sub (captive reinsurance co.) was set up in 2001 for protection and workers comp. After Sear’s sold credit cards their receivables were no longer available as collateral. They replaced it with real estate and IP (the brands) as collateral.

Capital structure: AutoZone has very little to modest leverage with their recurring revenues. His complaint on the credit rating is that the rating agencies are no longer basing this on statistical behavior but more on momentum. SHLD was told that the debt pay downs and the cash balance didn’t matter to the agencies because they SHLD have the ability to do whatever they want with the cash. Mr. Lampert used the example that a company with a ton of leverage with no cash would get the same rating as a Sears Holdings which has low debt, $2 billion in cash and $3.6 billion in EBITDA.

Cap structure: Wanted to have “powder dry” after the transition from bankruptcy, and merger. See’s a lot of uncertainties, and risks of jobs and peoples lives. What level of leverage is appropriate for people’s jobs/lives? He pointed to private equity being in control of so many jobs nos. Twenty highly leveraged investments can lead to trouble. He doesn’t assume the world will be rosy forever and make sure is SHLD is secure in that scenario.

Mr. Lampert left options open on the Sale/Leaseback and the swaps were for investment purposes but were very small in notional value in comparison to EBTIDA.

3) Q: What is your IT roadmap? What is your vision for Sears’s stores? Atlanta prototype store?

A: IT: everything they are doing Mr. Lampert considers a part of ordinary business. He doesn’t understand why Federated and others announce every time they purchase a piece of software, etc.

The head of the IT department mentioned they are 68% complete in combining Sears and K-mart; 90% by year end. They don’t talk about it a lot. Encouraged to go visit the 4th floor of the downtown Chicago store on State Street to see the innovation in their e-commerce.

Aylwin Lewis: Brand positioning of Sears and K-mart; maintain a test and learn culture; Guided by their brand positioning; they want brand activation not just commercials for their brands. “There are two things you can do with a brand build it or destroy it.”

They’ve been happy with the Atlanta store. Some things are working and some aren’t.

4) Q: A five year plan? Another question about leverage? And has Mr. Lampert read any good books?

A: Recommended Black Swan by Nassim Taleb; Referenced Bob Rubin’s Uncertain World. Bob Rubin’s thinking that there are no certainties in life and to maintain optionality in decision making in life seemed to be a cornerstone of Mr. Lampert’s thinking.

• People value certainty highly
• People who speak against uncertainty get no credit i.e. someone wanted to put doors on the cock pits of plans in 1999.
• They doing things to anticipate a variety of factors at SHLD
• There is no perfect answer for leverage in a company

5) Q: Examples of recent retail turnarounds and comparisons? What about SHLD’s marketing demographics?

A: JC Penny was a much more extensive turnaround than SHLD. His financial background brings more criticism than a turnaround with a “retail expert” such as the CEO of JC Penny.

Mr. Lampert’s mother was present at the meeting and he acknowledged her as a “veteran of Saks 5th Avenue.” Anytime someone complains that he knows nothing of retailing he calls his mother and she corroborates it! (laughs)

This turnaround is one of the hardest things he has had to do. Selling stores that generate 200k in profits to competitors who will make 6-7 million is not what he wants to do.

He used an analogy of the Harlem Children’s Zone from a conference a week ago. A 3-4 year old child in the Harlem Children’s Zone knows 500 words versus a higher educated child who knows 1000 words. It takes only one year for Harlem Children’s Zone to close this gap at this age. Five or six years later as the number of words expand the gap widens more and then it takes 3-4 years to close it instead of one, when the child was younger and knew less words.

SHLD needs to change the customer’s perception of the retailer. The biggest challenge is winning back customers with doubts of shopping there. One bad trip to a retailer can end up with a lifetime loss of revenues from a customer.

6) Q: Explain the turnover in the CFO position? What do they do to prevent fraud when managers are trying to meet goals? Is Mr. Lampert going to be there for the long-term?

A: The CFO did not want to move his family, it was that simple.

In regards to fraud: with $53 billion in sales, 360k employees, and 2300 stores there will be fraud. They began with a high shrink rate from internal and external theft, but that has come down. Aylwin Lewis: there is a zero tolerance policy; anonymous reporting; look into everything, and they run routine audits.
The culture needs to start at the top with Mr. Lampert and Aylwin Lewis; no one is exempt. They need to set an example. How you achieve your results is important to fraud prevention.

Mr. Lampert feels like he has been there forever (laughs). As long as he thinks it’s of value he will continue. He has a family and will continue to evaluate his position. The turnaround is in the early stages. SHLD need to become a great place to work and shop.

He is not a believer that an individual is above the system. He receives credit for some things that go right that he shouldn’t and blame for things he deserves. If it is time for him to move on, the company will be in good hands.

7) Q: (Dennis Jean-Jacques, Managing Director, Basso Capital) When do
you know your path for the company isn't working?

A: He cannot predict the future but understands the landscape. He believes competitor’s behavior doesn’t make sense. WorldCom’s competitors actually spent cash flow that WorldCom faked; which was blind imitation.

They are making certain investments that will hopefully move SHLD to the next level. He used the Tribune as an example that if they were able to model the future perfectly they would have put themselves up for sale 5 years ago.

8) Q: Will he split the stock?

A: No

9) Q: Any insight on future working capital management? Explain the total return swaps? Were they investments or hedges? Why is investment grade so important?

A: A lot of low return businesses in SHLD should get better. They will try to improve the working capital management.

The total return swaps were not hedges and had a notional value of $370 million and generated a profit of $100 million. This compares to EBITDA of $3.6 billion, which doesn’t include the $100 million from the swaps. They were tiny; they have $1 billion in sales a week where decisions are much more crucial

Investment grade advantages: he isn’t sure it is worth it for a company given that they have $2 billion in cash, $3.6 billion EBITDA, and $30 billion in assets. A triple A credit rating and a flat stock for 10 years is not successful.

10) Q: Is Kmart really stable? How will what you are learning now in SHLD help you in the future?

A: He feels Kmart is stable, but hedged himself by saying it could be less stable in the future due to a variety of factors. Again throughout the Q&A Mr. Lampert maintained Bob Rubin’s attitude of uncertainty. He said there are real aspirations for the brand names. The passage of time will answer this question.

Companies never are as easy as they look from the outside. Being a longer term investor you can find out five years later you were wrong. When you have your own capital at risk people think differently. The complexity of running a company is missed by many analyzing operations from an outsider’s viewpoint.

11) Q: From Chip Tucker of the Davis Funds again; what’s the upside for SHLD’s gross margins from overseas production with private label products? What is their ability to cut from the $2.2 billion in marketing? What’s the cost of shutting down low profitability stores? How hard will it to be to maintain a 10% EBITDA margin?

A: He doesn’t know how hard it will be to maintain 10% EBTIDA margins since they haven’t achieved it yet. (Laughter)

The cost to shut down unprofitable stores is the jobs it will cost people.

Cost cutting in advertising is a great advantage if you have the same prices at different stores like at AutoZone. You cannot change a customer’s expectations overnight. JC Penny has promotional advertising, Wal-Mart has everyday low prices for advertising, and Target is somewhere in between. The $2.2 billion in advertising needs to be spent dynamically and is complex.

Brands are needed to maintain private label goods, they coexist.

12) Q: What are the primary value drivers? Where are most opportunities for improvement?

A: Inherited a sub optimal mix of stores. The challenge is to drive more customers to the stores. How do you define a customer? Is it one who buys a DVD or who buys the DVD, DVD player and the plasma TV? Autozone’s improvement was the most in their gross margins. But it is not the same at SHLD as there are low return categories, high return categories, and sub-categories beneath.

He has emphasized they are not just cutting costs and this “couldn’t be further from the truth.”

13) Q: What is happening with SHLD grand?

A: None of the stores are up to management’s expectation. They have HIGH ASPIRATIONS. Posed the question: can they become an Apple store or the equivalent of Nike Town?

They need to take risks and try different things. They need to be calculated risk takers.

14) Q: How do you track customer experience improvement?

A: I missed the Sears portion of the question. Kmart performs mystery shops. The results were up for the most part, but flat to down in the 4th quarter. They are “not satisfied” with the level of experience.

15) Q: Was there anything in the 1st quarter results besides weather to extrapolate? What about store evaluations for real estate values? Thoughts on the current investment conditions? Thoughts on buybacks?

A: Weather is a reality not an excuse. They have a long-term focus, nothing to extrapolate from 1st quarter. No comment on the share buybacks.

When the merger was consummated he said no retailer should aspire to have their stores worth more than its business. Most people didn’t believe he was serious.
The divesture of stores depends on facts and circumstances and their aspiration is not to divest their real estate.

He didn’t comment on investment conditions.

16) Q: Ken Feinberg from Davis Advisors questioned: will they take excess free cash flow and invest in other places? Any conflicts with ESL?

A: There are a lot of opportunities. It is hard to be a magnet for talent in retailing if they are disposing of the business. He views them as a start up company with $50 billion in sales. This theme was repeated multiple times last year.

They are trying to transform into a brilliant company. He said that being responsible with their free cash flow stems from being an owner of the business. It is helpful to be an owner and have a significant investment. They are flexible and opportunistic in where they go (another repeated point). He compared Berkshire’s core business as insurance versus SHLD’s core business. They maintain a risk taking culture, but not reckless gambling. Intelligent risk taking is the culture they want!

ESL does not have conflicts. If something is an investment for SHLD then it is not a candidate for ESL. Anything with conflicts goes to the audit committee. Will the internet be a friend or foe in the future? He hopes it will be their friend but it could turn out to be a foe.

17) Q: Article in the New York Times referring to historical exhibit? Would they plan on adding this to stores to get more traffic?

A: They want to tap into their historical heritage. The article was referencing SHLD’s prototype store in Atlanta that used a historical look.

18) Q: Was the decision to bid for Sears Canada after they sold their credit card business a mistake since they didn’t buy it? Is there an investment in Mexico? What is going on with Orchard supply?

A: 15% of Sears Mexico is owned by SHLD and 85% by Carlos Slim. They have no operational control.

Thought the decision was right to wait and bid 2x’s the market value.

No comment on Orchard.

19) Q: Keith Trauner of Fairholme asked if he would behave differently if he expected an extended period of problems for consumer spending? And what were his 2-3 biggest mistakes?

A: The economic environment is very different when there are zero consumers. Not enough time to cover his mistakes.


__________________
Peter Lindmark is the managing partner of Lindmark Capital Fund (www.lindmarkcapital.com) a value based investment fund.  He can be contacted via email at plindmark@lindmarkcapital.com.

Rate This Article:

Currently 3.46/5 1 2 3 4 5 Rating: 3.5/5 (13 votes)

User Comments: