By: Susan Chandler and Geoff Dougherty, Tribune staff reporters

February 16, 2005, Chicago Tribune

When Kmart Holding Corp. Chairman Edward Lampert was heralded last year as the next Warren Buffett, the parallels were obvious.

Buffett, one of the country's most successful value investors, began his run by buying struggling companies with loads of losses and using their tax-loss carryforwards to offset income at his healthy companies.

Similarly, hedge fund operator Lampert picked up a controlling share in Kmart for less than $1 billion in bankruptcy court and walked away with $3.8 billion in net operating loss carryforwards, also known as NOLs.

Or did he?

Kmart's NOLs were wiped out when the company exited Chapter 11, a fact that has been widely overlooked or misunderstood by the media, several Wall Street analysts and an unknown number of investors.

"There are tax credits, but they were offset by cancellation of indebtedness," confirmed Jon Gieselman, Kmart's vice president of advertising and public relations.

Here's the math.

In January 2004, almost nine months after Kmart exited bankruptcy, the company reported it had $3.8 billion in net operating losses, according to its 10-K filing. Given Kmart's tax bracket, that translates into a $1.41 billion tax benefit.

But that tax credit was more than offset by $1.65 billion in debt canceled by Kmart's creditors.

"There's no free lunch," said Haresh Sapra, associate professor of accounting at the University of Chicago Graduate School of Business.

The comparison between Kmart and Berkshire Hathaway was never really apt, accounting experts say. Tax laws that allowed Buffett to put NOLs to such profitable use were tightened in the 1980s, restricting their utility.

So how did the idea get started that Kmart had nearly $4 billion in NOLs at its disposal?

Kmart points to an April 2 report by brokerage firm UBS that trumpeted the importance of the company's NOLs and estimated they represented almost $11 of Kmart's share price, which then was about $41.50.

Kmart was seriously undervalued, wrote UBS retail analyst Gary Balter, who was initiating coverage of the Troy, Mich.-based retailer with a "buy" rating and target price of $54 a share.

"This reflects what we believe is a stellar cash flow and asset story, currently masquerading as a market share-losing discount store retailer," Balter wrote.

Gieselman, Kmart's spokesman, says the company did call UBS and point out there was a problem with the report, which was updated by the brokerage. But the corrected April 5 report shows that UBS only changed "NOLs" to "DTAs," or deferred tax assets. UBS' estimates of their value to Kmart remained the same.

UBS said it stands by the information in its April 5 report.

Other tax credits held

Even without NOLs, Kmart does have about $2 billion in other tax credits held in a reserve, its filings show. But how quickly they can be used is unclear because they depend on varying rates of depreciation for property and equipment.

"They're not as good as an NOL," said Thomas Lys, a professor of mergers and acquisitions at Northwestern University's Kellogg School of Management.

Under certain circumstances, Kmart might be able to use all $2 billion in tax credits in one year, Lys explained. Under other scenarios, the tax benefit might be as little as $80 million annually.

The perception that Kmart had billions in tax assets was one reason that its stock had risen to more than $100 a share in mid-November when Kmart announced an $11 billion takeover of Sears, Roebuck and Co.

Lampert, Kmart's chief, did nothing to clear up the confusion about the company's tax situation in a conference call with analysts Nov. 17, the day the deal was announced.

In response to a question about whether the combined company could use its NOLs to offset gains from potential sales of Sears' real estate, Lampert responded: "In terms of NOLs, I think the NOLs are available. I think that we've described the limitations on the NOLs in our SEC filings. So I think that there are some use of the NOLs and some limitations of the NOLs."

Lampert did not misspeak, Kmart says, because the NOLs do exist even if they are being offset by the cancellation of indebtedness.

But his remarks reinforced the misperception about Kmart's NOLs. A cover story in BusinessWeek magazine comparing Lampert to Buffett a week after the merger announcement cited the company's $3.8 billion in NOLs. So did a Street.com story in November and a Forbes magazine story in December. (The Chicago Tribune mentioned Kmart's NOLs last July).

Kmart said it hasn't been calling media outlets and asking for corrections or clarifications.

"If we responded to every single misstatement and inaccurate report, we'd be doing nothing but doing that all day," Gieselman said.