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The $55B Baby: Retail Landscape Shifts as Kmart Buys Sears

Kmart Corp.’s purchase of Sears makes it the second-largest U.S. apparel retailer and puts its new chairman, Edward Lampert, in the spotlight.

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NEW YORK — Retail has a new big player, and its name is Sears Holdings Corp.

In a deal that reshapes America’s retail scene, Kmart Holding Co. said Wednesday that it will buy Sears, Roebuck & Co. for $11 billion, creating the nation’s third-largest retailer with $55 billion in sales. The company will be based in Hoffman Estates, Ill., and operate 2,350 full-line and off-the-mall stores, and 1,100 specialty stores.

The deal also turns Edward Lampert, the financier behind it, into one of the industry’s major powerbrokers. Lampert — who took Kmart out of bankruptcy in 2003 with an investment of less than $1 billion and owns 15 percent of Sears — will become chairman of the new group and his firm, ESL Investments, will end up with a 42 percent stake in Sears Holdings. Lampert alone made an estimated $1 billion on the deal by breakfast time on Wednesday.

Sears’ top brands are Kenmore, Craftsman and DieHard. Kmart’s proprietary brands include Martha Stewart Everyday, Joe Boxer, Thalia Sodi, Jaclyn Smith, Route 66 and Sesame Street.

The merger will generate $500 million of annualized cost and revenue synergies, but will create a company that is still only a fifth the size of Wal-Mart Stores. Observers also were skeptical Wednesday as to the logic behind the purchase and the long-term future of the merged entity. Some described it simply as a real-estate deal benefiting Lampert, while others pointed out that both Kmart and Sears have struggled in recent years to carve out strong niches in the mass and moderate department store sectors. They questioned whether the combination will, in the end, create a viable retailer.

Lampert said the merger was the taking of the “best of both the Kmart team as well as the Sears team, converting Kmart stores to Sears where appropriate and bringing Sears product to Kmart.” He described the merger as a blending of the two “into one culture, an operation under one culture [with] two brand names,” and a retail operation that is very “customer-focused.”

As for converting the store base from one nameplate to another, Lampert said: “This is a great opportunity to explore commutations and permutations.”
Part of the plan is for Kmart stores in big-box locations to be possibly converted to Sears Grand stores, and maybe have Sears merchandise in Kmart stores, according to Alan J. Lacy, chairman and chief executive officer of Sears Roebuck who will be the vice chairman and ceo of Sears Holdings.

Lacy said during the call, “The savings will be fully realized by the end of the third year, and be accretive in the first year excluding one-time costs. [We are] taking the best from both cultures.” Lacy added that the merger, with cross-selling of proprietary brands, can help Kmart “be even more differentiated.”

But even Lampert appeared to recognize the challenges. In a conference call Wednesday, he said the merger is an “enormous undertaking” and the path ahead as a “lumpy progress over time.”

“Scale is very important to compete effectively….We need to have a very low-cost structure to compete with competitors, with the reputation and quality of service that we at Kmart aspire to achieve,” he added.

Kmart shareholders will receive one share of new Sears Holdings common stock for each Kmart share. Sears stockholders can elect either $50 in cash or 0.5 shares of the new entity for each Sears, Roebuck share. The transaction is expected to be tax-free to Kmart shareholders, and to Sears stockholders to the extent that they receive stock. Sears Holdings is valued at $50.61, the price of Sears stock at its close at the end of trading on Tuesday.

On paper, the deal appears to be a gamble for Lampert. The value of his holdings in Kmart and Sears prior to the merger, calculated from the most recent Securities and Exchange Commission filings, is about $8.79 billion. Converting his existing shares of the new company leaves Lampert with a stake in the merged company worth $4.49 billion. Analysts did not speculate yet on the share value of Sears Holdings, or whether it would reach Kmart Holding levels of more than $100. Analysts’ reactions were mostly critical, although there were some praises.

“Putting aside the question of whether the combination of Sears and Kmart will be a successful investment, the retail underpinnings of putting these two chains together appear challenging,” said George Strachan and Adrianne Shapira, analysts at Goldman Sachs, in a research note after the market closed.
Emanuel Weintraub, of the consulting firm that bears his name, said if this deal “isn’t a long-haul, retail consolidation, but a platform for a real estate play, then the move is brilliant, and Lampert is a true genius.”

Investment banker Gilbert Harrison of Financo cautioned, “This is a very interesting merger because it creates a retail giant, but one where the downside is protected by its real estate. Whether you call it a real estate investment trust using their own real estate or whatever rationale you want to call it, if Sears and Kmart are going to be in business 10 or 20 years from now, there still has to be a retail rationale that continues.”

Under the new structure anticipated following the merger, Lacy will be vice chairman and ceo of Sears Holdings. Aylwin B. Lewis, the newly appointed president and ceo of Kmart, will become president of Sears Holdings and ceo of Sears Retail. Glenn Richter, executive vice president and chief financial officer of Sears, Roebuck, will retain those titles in the new Sears Holdings.

Meanwhile, Standard & Poor’s Ratings Services issued an update of its ratings of Sears, which was placed on CreditWatch last month, and said that Sears’ ratings would likely fall to “BB” category following the Kmart merger.

Gerald Hirschberg, S&P analyst, said that that “BB” rating is the “first full category of below-investment grade.” According to S&P, the merger represents an opportunity for Sears to accelerate its off-the-mall initiative by converting existing Kmart stores into Sears Grand units, but the strategy is still in its infancy and had yet to demonstrate success.

“The business risk in both companies is that neither is doing well, nor had done well for quite a long time, despite efforts by management at both firms. When we look at the business of each company, and then put them together, we don’t get to investment grade,” the S&P analyst said.

Fitch Ratings placed Sears on Rating Watch Negative, noting that after the merger the ratings could be downgraded two notches from where they are currently.
“The Rating Watch reflects the risks associated with combining two underperforming retailers; uncertainty as to the new company’s operating, financial and real estate strategies, and reduced financial flexibility as a result of the cash outlay required to complete the merger,” the Fitch report said.

Danielle Fox, analyst at Merrill Lynch, noted in her report, “In our view, neither management team brings a significant track record of operating success to the transaction. Still, better real estate locations will give them access to greater customer traffic, so we think it would be rash to discount the deal entirely.”

She also noted that long term, the combined entity’s success will hinge on execution, although neither retailer has a good track record on that front.

“I think this a marriage made in heaven by nonmerchants. I can visualize that this can take several years to sort out and that the identity of both retailers will be blurred in the customers’ minds,” observed Walter Loeb, retail consultant of the firm that bears his name.

Adam Rogoff, bankruptcy attorney at Cadwalader, Wickersham & Taft, saw the merger as a good one for Kmart creditors. “Many were impressed that Kmart even emerged from Chapter 11. Bankruptcy professionals were expecting that at some point in 2005 or 2006, Kmart was ripe for a second bankruptcy filing. Vendors we talked to were waiting for the second shoe to drop. This merger, with a transaction of this size, creates enough momentum at least to push off that talk. It also gives creditors in the Kmart bankruptcy who received stock another 12 to 36 months to take some value from the deal.”

Kmart shares have been trading in the $100 range in the last week. They shot up as high as $119.69 in intraday trading on Wednesday, before closing at $109, up $7.78, or 7.7 percent, on the New York Stock Exchange. Sears’ stock gained 17.2 percent, or $7.79, to close at $52.99 in trading on the Big Board.

Rogoff added that the merger of two struggling retailers doesn’t necessarily create a stronger one even where there are synergies. He pointed out, “There is a tremendous amount of debt layered on top of the two entities.”
One of the pluses, according to Rick Darling, president of Li & Fung USA, is that the merged retailing operation could create huge leverage on the sourcing side, “but only if they were to cross-use the brands in the stores. That could create pretty significant synergies and increase buying clout. Still, that would be a big assumption as the two are historically different and sell to different customer bases.”

Investment banker Peter Solomon said that a number of years ago he had approached then ceo of Sears Arthur Martinez with the same suggestion, only to be told that there were too many overlapping stores. With Kmart shutting 600 stores during its bankruptcy days and the need to rationalize the department store segment, the banker said it was just a question of time of when a merger would take place. He added, “Sears was at the end of the line. Fifteen years ago Sears almost merged with [now defunct] Montgomery Ward. Sears for the last several years has known it was in the position of having to do something.”

Solomon said he wouldn’t be surprised if the Kmart nameplate fades into the sunset, since Sears is the stronger brand. Sears also hasn’t been too successful in integrating its Lands’ End acquisition, a point noted by Solomon, who helped to broker the transaction.

As for the merger of the two cultures, “that would be the $64,000 question,” Solomon said, noting the past history of the two operations and lack of success on execution.

Edward Nakfoor, a consultant in Michigan, observed, “This makes sense because of Sears Grand. It is the best strategy to compete with Wal-Mart and Target, and the nimble Kohl’s and Meijer’s, as well as the growth of lifestyle centers vis-à-vis regional malls. It would be unprecedented and grossly expensive for Sears to build hundreds of new Grand locations from the ground up, and more economical to step into an infrastructure of stand-alone stores available through Kmart.”

Abe Chehebar, Accessory Network’s chairman and ceo, said: “Combining the resources can definitely be a help to both chains, because each one has strengths and weaknesses in different areas. Sears is stronger in hard lines like electronics. Kmart has made tremendous strides in the past two years in its apparel and accessories presentations. We are seeing a Kmart that’s a lot more aggressive in so far as the timing of when they launch new products.
“I think Sears’ strength in hardline can be a help to Kmart and Kmart’s strength in softlines can be a big help to Sears,” Chehebar continued. “I think the two combined are going to be powerhouse retailers,” he added.

Accessory Network Group supplies Kmart with private label handbags, jewelry, headwear and cold-weather accessories, as well as licensed children’s and teen merchandise such as Batman, “Star Wars” and Bratz.

The Sears and Kmart merger could provide opportunity for a multicultural consumer focus, according to Jennifer Pritchard, senior manager, retail specialist for Atlanta-based Kurt Salmon Associates.

“This could create synergy for Sears, with its strong multicultural target demographic to combine with Kmart’s ethnic consumer focus, to help them drive traffic, and compete with Wal-Mart, which is primarily driven by low-cost, rather than any specific consumer channel,” she said.

Pritchard said that, while the merger should help cut costs and overhead, Kmart will probably continue to close stores for some time. But Sears, which has many underperforming mall stores, could benefit from Kmart’s off-the-mall locations.

“In soft goods, brand positioning will probably take some time, while the two combined companies decide who they want to be,” she said. “Sears has a stronger cachet in soft goods, but Kmart has the Martha Stewart brand, which will probably still do well.”

Pritchard also predicted that the merger would increase the likelihood that Sears would sell or spin off the Lands’ End brand, as has been rumored.

Merrill Lehrer, president, Retail Samurai, a retail-manufacturing consulting firm in San Diego, said the two stores should build up a soft-goods strategy, to compete with Wal-Mart, which has yet to flex its muscle in apparel.

“They need to raise the bar in discount apparel,” he said. “Neither store is as respected in soft goods as they should be. They need to capitalize and build on a few strong brands in both chains, including Lands’ End, which Sears has done little with since buying it.”

And then there are more immediate challenges ahead as the firms try to take advantage of potential synergies.
Sears, which has been undergoing a major information technology transformation, including a $1.9 billion outsourcing contract inked earlier this year, faces a considerable data management task in its merger with Kmart, whose logistics systems are described by one industry source as “not the best in the world.”

“I’m sure that they know that they will have to go through the mechanics of converting data, cleansing data and migrating data,” said Dan Staresinic, senior manager, Deloitte Consulting. “But they will also face the challenge of developing a common data model for the combined organization, and that is where things begin to get trickier.”

It’s important for the new entity to develop an enterprise data management strategy, he said. “It would be possible for this new entity to execute their data evolution on a project-by-project basis, but what they really need to do is bring together three things: the business strategies of the new entity, the supply chain needs of the new entity and the collaboration needs of the new entity.

Technology strategy already in place at Sears may take a leading role.

“They will evaluate each technology group — supply chain, merchandising systems, stores — and probably pick a best-of-breed strategy,” said Michael Jones, senior vice president and chief information officer at $3 billion Michaels Stores and a former technology executive at Kmart. “I have to believe it will lean toward the Sears side at this point.”

— With contributions from Marc Karimzadeh, New York; Georgia Lee, Atlanta, and Denise Power, Chicago

Kmart-Sears

Merged Company Name: Sears Holdings Corp.

Value of Deal: $11 billion

Total Number of Stores: 3,500

Total Number of Employees: 394,000

Total Revenue: $55 billion

Through the Years

Sears

1886: Richard Sears sells watches to supplement his income as a station agent in North Redwood, Minn.
1887: Sears opens Chicago store, hires watchmaker Alvah C. Roebuck.

1888: Catalogue features only watches and jewelry.

1893: Corporate name becomes Sears, Roebuck and Co.

1896: First general catalogue released.

1925: First Sears store opens in catalogue center on Chicago’s West Side.

1931: Allstate Insurance Co. established.

1945: Sears sales exceed $1 billion.

1973: Sears moves headquarters to Sears Tower.

1981: Sears acquires Dean Witter Reynolds Organization and Coldwell, Banker & Co.

1985: Discover Card introduced.

1993: Sears sells 20 percent of Dean Witter shares in initial public offering, spins off remaining shares to shareholders. New company called Dean Witter, Discover & Co.

1995: Sears appoints Arthur C. Martinez as chairman and chief executive officer.

1997: Sears opens The Great Indoors stores.

1999: Sears launches Sears.com.

2000: Sears appoints Alan Lacy as chairman and ceo.

Kmart

1899: S.S. Kresge Co. founded by Sebastian S. Kresge.

1912: S.S. Kresge Co. incorporated in Delaware. Sales at its 85 stores are $10.3 million.

1918: S.S. Kresge becomes a publicly traded company, and is listed on the New York Stock Exchange.

1952: S.S. Kresge adds checkouts to stores and becomes one of the first retailers to open stores in shopping centers.

1962: Harry B. Cunningham, president of the retailer, opens the first Kmart discount department store in a suburb of Detroit.

1966: Founder Sebastian S. Kresge dies at 99.

1966: Sales top the $1 billion mark while number of stores swells to 915, including 162 Kmart stores.
1977: Company changes name from S.S. Kresge Co. to Kmart Corp.

1994: Kmart sets IPO of its interests in The Sports Authority, OfficeMax and Borders Group Inc.

1997: Kmart introduces Big Kmart store format and logo.

2002: Kmart files Chapter 11 bankruptcy, closes 283 stores.

2003: Chuck Conaway resigns as chairman and ceo. Board member James B. Adamson is appointed chairman and ceo. Julian C. Day is appointed president and chief operating officer. Kmart files reorganization plan, which includes investment agreement with the Plan Investors, ESL Investments Inc. and Third Avenue Value Fund. Kmart emerges from bankruptcy, Edward S. Lampert is named chairman of Kmart Holding Corp.