By: Susan Chandler, Tribune staff reporter

March 20, 2006, Chicago Tribune

The Sears Essentials store sits forlorn in an old strip mall off Hicks Road in northwest suburban Palatine. A few dozen cars dot the giant parking lot, which is bordered by a former Card & Party Outlet store with a for-rent sign.

More than 150 blue shopping carts are lined up outside, but there are few shoppers inside the cavernous store on a weekday autumn afternoon. An appliance salesman in a white shirt and khaki pants leans back against a dishwasher drumming his fingers on the lookout for customers. A middle-age woman in a yellow windbreaker is frustrated that she can't find a pair of pumps in her size for an upcoming wedding. She leaves empty-handed.

Sears Essentials--the combination of Sears brands in former Kmart stores--was supposed to be the future of Sears Holdings Corp., the $55 billion retail Goliath formed by the March 2005 merger of Sears and Kmart. But as the one-year anniversary of the merger arrives, the outlook for Sears is dismal.

- At Sears' core chain of nearly 900 department stores, sales were down more than 8 percent in 2005 and plunged by 12 percent during the crucial holiday season.

- Sears Holdings' debt is rated "junk" by all three major rating agencies, a far cry from the A credit rating the old Sears earned for decades.

- Sears and Kmart are opening few new stores while competitors such as Wal-Mart unveil more than 300 new locations a year.

The man calling the shots on merchandising and marketing is Sears Holdings Chairman Edward Lampert, a 43-year-old hedge fund operator with no retail experience who gained control of Kmart while it was in Chapter 11 bankruptcy.

By rushing Kmart out of bankruptcy in 2003 and then using the still-struggling discounter to launch a bid for Sears in 2004, Lampert has stretched himself and vastly expanded the borders of his retail empire.

Lampert's supporters, and there are many in the investment community, believe he will be able to hold on to his prize. In a vote of confidence, they bid up Sears Holdings stock to more than $130 a share last week.

His critics wonder if he hasn't overextended himself. They also warn that Lampert's willingness to give up market share to fatten profit margins is shortsighted and self-defeating.

"What has been done is not sustainable," argues Howard Davidowitz, chairman of Davidowitz & Associates, a retail consulting and investment banking firm in New York. "The reason your sales dropped 12 percent is you cut promotions, you've increased prices, you've handed your customers to J.C. Penney, Kohl's, Target and everybody else."

Stuck in the middle

Sears finds itself stuck in the middle, its brand associated with stodgy merchandise and dated stores, despite its repeated attempts to update itself. These days, Sears "doesn't stand for anything," says Tim Calkins, a marketing professor at Northwestern University's Kellogg School of Management. "It's not really cheap and it's not really good."

Where Sears fits in the retail world is the big question, and it goes unanswered partly because Lampert is a bit of a mystery. He rarely gives interviews and declined several interview requests from the Tribune. Stock analysts get the same cold shoulder.

Lampert hates to fly and always goes to bed at 9:30 p.m., even when he is entertaining guests at his home, according to an acquaintance familiar with his routine. He surrounds himself with bodyguards because he was the victim of a kidnapping in 2003. Lampert talked his captors into letting him go by promising to leave $40,000 in a trash can behind a Wendy's. The kidnappers were apprehended and are serving jail terms.

Adding to his air of mystery, Lampert is calling the shots at Sears from Greenwich, Conn., where ESL Investments Inc., a bare-bones 20-person operation, is headquartered. He is addicted to his BlackBerry, and when he messages Sears executives, they stop everything they're doing to tap out a response.

Wearing suits perfectly tailored to his small frame, Lampert could easily be mistaken for a freshly scrubbed MBA graduate. But in a few short years, he has become one of the best-known investors in the country, and few people are willing to bet against him.

Lampert ranks 61st in Forbes' 2005 listing of the 400 richest Americans, with a net worth put at $3.5 billion.

Favoring companies with strong cash flows that had fallen out of favor with Wall Street, Lampert likes to compare himself with the country's most famous investor, Warren Buffett. No surprise. Lampert has studied Buffett--No. 2 on Forbes' list--like a scholar poring over a newly discovered ancient text.

Unlike Buffett, who generally takes a hands-off approach to operations, Lampert has earned a reputation for aggressively managing the companies he invests in. He focuses on reducing overhead and trimming capital investment, and he is unabashed about using cash flow to buy back shares.

He also is skeptical about investing in new stores and store remodeling. Last year, Sears and Kmart cut their capital expenditures in half.

Lampert acknowledges knowing little about retail other than what he gleaned as a teenager when his mother went to work as a clerk for Saks Fifth Avenue after his father died unexpectedly of a heart attack at age 47. His death left the family with little savings.

Lampert's lack of retailing experience hasn't discouraged him from acting as Sears' de facto chief merchant. Since September, managers handling merchandising, product development, advertising, the Internet site and the Lands' End division have been reporting to him. He has fabric samples sent to him in Connecticut, according to former Sears executives.

Some observers are skeptical Lampert has the skills to lead a turnaround at Sears.

"Lampert is a stock picker. Does that make you a good CEO or chairman of the board of a company? Usually no. They are different skills," said James Schrager, professor of entrepreneurship and strategy at the University of Chicago Graduate School of Business.

"If Sears is going to bring in a new line of clothes, the CEO has to pass judgment on the stuff. A finance guy can ask classic finance questions such as, `What are the terms from the vendor?' `How fast will the inventory turn and how attractively can we price it?' `What is the margin?' These are not bad questions.

"But a retail merchant will take a holistic, completely different point of view. Psychologists call it instinct. We now know it is learned behavior, built from years and years of fighting in the trenches," Schrager said.

An outside consultant who has worked at Sears on management issues shares Schrager's concern. "They make the fatal assumption that if you're smart, you can figure it out. People say the same thing about sports, but Michael Jordan didn't make it in baseball, and you don't find much better athletes than him. In business, everybody is a specialized animal, but no one wants to admit it."

Keeping score

In the business world, it's easy to keep score. Increases in revenue, profit or return-on-equity are positive indicators. Decreases are not good.

Retail and restaurant companies have an additional way to measure themselves: same-store sales, the percent change in sales at stores open at least a year. In the retail world, same-store sales are a closely watched indicator of financial health and shopper enthusiasm.

From 2000-2004, Sears, Roebuck and Co.'s same-store sales declined each year. Results have worsened since the merger. In the 2005 holiday season, a make-or-break period for most retail chains, Sears' sales fell 12 percent, the worst showing of any major retailer.

Sears said its fashion offerings flopped with customers, but it also ran fewer promotional events, a deliberate strategy by Lampert to boost gross profit margins. Profit margins did go up and that was reflected in Sears' better-than-expected fourth-quarter earnings.

"We are not focused on sales or sales growth as an end in itself. Nor will we spend capital on stores simply because we have the capital available to invest or because everyone else does it," Lampert wrote in a shareholder letter last week.

Beginning in April 2005, a month after the merger closed, 780 Sears employees were laid off, most of them at Sears' Hoffman Estates headquarters. During private meetings with their managers, they were handed packets with terms of their severance packages, which were less generous than Sears employees had received in previous downsizings.

`We're losing money'

"We're losing money," Sears' communication specialist Rose Bertini told the Tribune last spring. "I don't mind them laying me off, but to not pay me what they said they were going to pay me, I don't understand."

Some departing Sears executives felt the same way.

Beryl Buley had been the executive in charge of managing and opening new stores at Kohl's Corp. when he was wooed away by Sears in 2003. Within a year, he was overseeing operations at Sears' 870 full-line stores and was responsible for the rollout of such new concepts as Sears Grand and Sears Essentials.

After the merger with Kmart, though, Sears Grand and Essentials were taken away from him, and Buley was told his operational team would be cut about 40 percent.

Buley asked for a severance package under the "change in control" provision of his employment contract, which entitled him to a generous payout. The salary and bonus alone would have added up to $1.7 million.

Sears refused to pay him.

Buley sued Sears in Chicago's federal court in June, alleging the company had "engaged in a pattern and practice of using discretion in an arbitrary and capricious manner in failing to provide proper severance benefits to similarly situated executives."

The case has since been settled.

Plenty of other top Sears executives have headed for the exit, too. Mindy Meads, CEO of the Lands'End division, was fired in August; Catherine David, the senior vice president in charge of Sears Essentials, Sears Grand and the Great Indoors, left in September; Luis Padilla, Sears' top merchant, departed in October; and Sears' apparel chief Gwen Manto left in December.

Left at the top are Sears' former CEO Alan Lacy, who was demoted by Lampert in September, and Aylwin Lewis, a former fast-food executive with no retail experience before he was named Kmart's CEO.

"Aylwin would say I'm a quitter, but I'm smart enough to know I didn't want to be on the team," said David, who spent 13 years at Target before joining Sears in 2004. "It would have been harmful to me to stay."

At Sears' headquarters, easy chairs scattered throughout the buildings have been removed. A satellite snack bar has been closed and the cafeteria's hours of operation shortened. When Sears staffers show up for 6 a.m. meetings, coffee is no longer routinely served.

Travel budgets are Spartan. The company will reimburse employees $25 a day for meals: $6 for breakfast, $7 for lunch and $12 for dinner. Hotel costs also are monitored closely, and in at least one case, Sears executives were prohibited from staying at a New York hotel where the company was holding an event because it cost too much.

Lampert's frugality also extends to his retail concepts. A Sears task force concluded it would take about $3 million per store to convert 50 old Kmarts to Sears Essentials. Lampert told them to make a go of it with $2 million per store. Almost three-quarters of that was spent on back-end functions customers don't see, like the information technology systems, leaving only about $500,000 for all the things they do see--new flooring, shelves, lighting and shopping carts, according to sources close to Sears.

Sears recently announced it was dumping the Sears Essentials format because of poor customer response and was changing the name of the stores to Sears Grand.

The real strategy

It's become conventional wisdom that Lampert began buying up the debt of Kmart Corp. because he recognized the underlying value of Kmart's extensive real estate holdings around the country. If Kmart couldn't make money at hundreds of its store locations, maybe somebody else would pay Kmart a premium for its parcels and turn them into retirement villages, office space or another retail chain--one having more cachet with shoppers.

That view appeared to be validated when Kmart sold about 100 stores to Sears, Roebuck and Co. and Home Depot in the summer of 2004 for almost $1 billion, close to what Lampert paid to acquire all of Kmart, which had 1,400 stores remaining.

But in the year since he acquired Sears, Lampert has done little to show that liquidation is, indeed, his strategy.

Lampert has said that Lands' End, the preppy catalog company that Sears acquired in 2002, is not for sale. Rather than selling off the company's majority stake in Sears Canada, Lampert has announced he will buy out the outside shareholders and make the operation wholly owned by Sears Holdings.

Several sources who have spoken with Lampert say it was never his intention to hold a vast real estate auction. From the beginning, he bought into Kmart and later Sears, intending to fix them and run the chains as more efficient and profitable retailers, they say.

Lampert has said the same thing himself, repeatedly.

"I bought Kmart to make money, and I felt the best way to make money was to have it be a viable retailer," he told Tribune reporters the day the merger with Sears closed. "Allen Questrom came out of the retail business, and people gave him four or five years [to turn around J.C. Penney Co.] We've been at this for two years, and people have been selling us short from the beginning. We've accomplished a lot in two years."

Retail consultant Cynthia Cohen, for one, takes Lampert at his word.

"I don't believe the real strategy is liquidation," said Cohen, the president of Strategic Mindshare, a Florida-based retail consulting firm. "If you look at his involvement at AutoZone, he wants to create shareholder value through the operations of the business. I think that's very clear. He wants to win and make it work."

If Lampert has a plan for rejuvenating Sears, he has not unveiled it. One year after the merger deal, he describes Sears Holdings as a "$55 billion revenue, 350,000-person start-up" and characterizes his retail strategy as a work in progress.

"We are a learning company that analyzes, tests and adapts as appropriate," Lampert wrote in a December letter to shareholders. "While we are clear on our vision, we recognize the importance of being flexible and quick to change if the situation warrants. We will not rely on a single grand strategy but will respond to customer desires and market opportunities."