Geoff Dougherty

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Kmart store sites picked over

By Susan Chandler & Geoff Dougherty | Chicago Tribune

It’s one of the most amazing corporate comeback stories in recent history: Only 18 months out of bankruptcy, Kmart Corp. launches an $11 billion takeover offer for Sears, Roebuck and Co.

Where did Kmart get the dough?

Most of it came from the company’s stock, which soared this summer after Kmart announced the sale of fewer than 100 Kmart stores to Home Depot and Sears for as much as $910 million. That amount exceeded the value placed on all the company’s real estate in bankruptcy court.

Investors used that premium price to value the rest of Kmart, giving Kmart Chairman Edward Lampert the purchasing power to pull off the Sears deal.

But a Tribune analysis of Kmart’s remaining 1,400 stores indicates that Kmart’s real estate may be far less valuable than Wall Street thinks.

The Kmart stores sold to Home Depot and Sears weren’t representative of the overall portfolio because they were located in more affluent communities than the average Kmart store, the Tribune analysis shows.

For instance, the stores sold to Home Depot were located in areas with average household incomes of almost $65,000. Kmart’s remaining stores are found in places where the average household income is below $52,000.

In ZIP codes where Kmart stores are situated, 21 percent of households earned less than $20,000 a year and almost 50 percent earned less than $40,000.

“Kmart has the oldest and poorest customers of any discount store,” said Howard Davidowitz, chairman of Davidowitz & Associates, a retail consulting and investment banking firm based in New York.

“They sold the cream [of their stores]. That’s what I tried to tell people. Never in retail history has a retailer who wanted to stay in business sold their good stores.”

A Kmart Corp. spokesman declined to comment on the Tribune’s findings.

Carol Levenson, a debt analyst with Gimme Credit, doesn’t pretend to understand how the stock market is valuing Kmart these days. But she notes that publicly available information about property ownership and lease terms is so sketchy it is almost impossible to put a price on a retailer’s real estate portfolio.

Real estate executives who specialize in retail workouts agree that valuing a portfolio as big as Kmart’s is fraught with the potential for large errors.

It’s not a simple institutional investment, they say, because stores in a single retail chain may vary widely in size and have vastly different lease terms, including landlord rights. Finding new tenants for old retail space is a store-by-store slog that can take years.

Other retail experts say it is highly unlikely Kmart’s remaining stores would fetch anywhere near the premium of those already sold.

At Kmart, more than 90 percent of its stores are leased, far more than most department store chains, which tend to own their real estate.

While Kmart’s long-term leases with below-market rents may have value to others, the leases become less valuable the longer Kmart occupies the properties.

The Tribune’s analysis shows that a third of Kmart’s store leases will expire within the next two years, although it’s unclear what options to extend those leases Kmart holds. A spokesman would not comment on that issue.

“Every day that Kmart is around, the leased stores are all losing value,” said David Neff, a Piper Rudnick attorney who represented Kmart’s creditors in the bankruptcy proceedings.

Besides, not all of Kmart’s leases are at below-market rents, real estate and retail experts say.

“My guess is they already have been looked through pretty aggressively by companies, and there aren’t that many of [the good ones] left,” said Neil Stern, a retail consultant with Chicago’s McMillan/Doolittle. “I don’t know there’s that much gold to tap into there.”

Another hurdle for Kmart is that its stores aren’t a good fit for other retailers.

“A hundred thousand square feet—it’s a ‘tweener size,” said Allen Joffe, principal with Baum Realty Group, a Chicago real estate firm specializing in retail properties. “Home Depot is much bigger and Kohl’s is much smaller.”

Liquidation appeared to be Lampert’s game plan when he began buying up the debt of Kmart for pennies on the dollar while the company was in Chapter 11.

Lampert is a value investor, which means he looks at underperforming companies and out-of-favor industries for bargains. His hedge fund, ESL Investments Inc., has taken large stakes in several retail companies, including AutoZone, which sells auto parts, and AutoNation, which sells new and used cars. In 2002, Lampert became the single largest shareholder in Sears, the nation’s fourth-largest general merchant.

Lampert not averse to risk

His biggest bet by far, however, has been Kmart, the nation’s third-largest discount chain, which filed for bankruptcy court protection from creditors in January 2002.

During bankruptcy, an analysis prepared by its former management and an outside firm estimated its remaining 1,500 stores, 16 distribution centers and fixtures would fetch only between $593.4 million and $879.0 million if they all went on the market at once as part of a Kmart liquidation sale.

That would have been a real Blue Light Special; Kmart had listed more than $6 billion in real estate and fixtures on its balance sheet when it entered bankruptcy.

Spending less than $1 billion, Lampert was able to take a controlling position in Kmart debt during its reorganization. Kmart’s debt was converted into equity when the company emerged in May 2003, leaving Kmart nearly debt-free.

ESL emerged with a 53 percent stake in Kmart’s new equity, and Lampert became Kmart’s chairman. Kmart’s old stock was cancelled and those shareholders got nothing.

“Nobody twisted the previous owners’ arms to sell out on the cheap, but that’s exactly what they did,” said Jeffrey Maillet, a principal with Noble Asset Management in Chicago, which owns both Kmart and Sears shares.

“Lampert went in and saw the immense level of value. Some people have the capability to see the forest for the trees, and Lampert is a master,” Maillet said.

At first, Lampert took steps that looked like he was only interested in keeping the company alive long enough to avoid a fire sale of assets.

He cut back on inventory levels and slashed capital spending on new stores and remodels. By the fiscal fourth quarter of 2003, Kmart was back in the black for the first time in years.

Then, in August, Kmart disclosed that the board had given Lampert permission to invest the company’s cash in non-retail businesses.

Investors who had ridden Lampert’s coattails to big gains in Kmart stock were ecstatic that he would use the company’s cash and tax credits to invest in faster-growing non-retail businesses. Within a few months, Lampert was crowned the new Warren Buffett by BusinessWeek magazine.

Some keep their distance

While Kmart’s stock was soaring, its core business was suffering. Sales at Kmart stores fell by double-digits every quarter this year, a dramatic falloff that shrinks Kmart when powerful rivals Target Corp. and Wal-Mart Stores Inc. continue to expand.

Kmart should have been an ideal investment for George Putnam, editor and founder of “The Turnaround Letter,” a Boston newsletter that analyzes bankruptcies and turnaround situations. Putnam, who specializes in analyzing the hidden value of a company’s assets, does more than give advice. When he finds a promising play, he invests in it.

Putnam looked at Kmart stock when it was $30 a share and then again at $50 a share and took a pass both times.

“It’s the kind of stock we would like to recommend,” Putnam said. “But I could never get comfortable with the valuation even at much lower levels.”

When the store sales to Home Depot and Sears were announced, Putnam got out his financial models again, but the calculations still didn’t make sense.

“We looked at the price per store from the Home Depot deal and the Sears deal. The only way you get anywhere close [to Kmart’s market value] was if you assumed that Home Depot and Sears were buying the worst stores and Lampert was being left with the best,” Putnam said. “And that wasn’t logical.”

The speculation that Lampert intended to diversify out of retailing ended Nov. 17, when Kmart announced it was acquiring Sears for $50 a share in cash and stock, pending regulatory and shareholder approvals.

The speculation about the hidden value of retail real estate only got hotter.

Sears owns or has long-term leases on its 870 department stores around the country, many of which are located in the best shopping malls. The Hoffman Estates-based retailer counts an additional 1,100 U.S. specialty stores among its holdings, as well as department stores in Canada.

Kmart name likely to fade

While the deal helps answer the question of what will become of hundreds of Kmart stores-they will be converted to Sears stores-it doesn’t provide an answer to what will happen to the bulk of Kmart locations, many located in less-than-attractive areas.

Kmart says the new company will operate under both the Kmart and Sears banners, but retail experts say that is extremely inefficient. It’s more likely, they add, that the Sears deal is a way to liquidate Kmart over a longer period of time.

After the Sears deal was unveiled, Kmart’s stock hit an all-time high of $119 a share. Since then, it has drifted down to just over $100.

It doesn’t take a lot of buying to push the stock up, investment experts note, because Kmart’s float isn’t very large and more than half of its stock is held by ESL and Lampert, making it fairly illiquid.

Meanwhile, some top-level Sears executives are bailing out of Sears stock, which now trades in tandem with Kmart’s.

More than $30 million in Sears shares have been sold by at least eight top company executives since the deal was announced in mid-November. Publicity surrounding the sell-off prompted Sears to issue a letter to employees this month saying that the stock sales don’t indicate a lack of confidence in the combined company’s prospects.

Some skeptics compare Kmart’s still lofty valuation to the Internet bubble in the late 1990s. Eventually, though, investors ran out of patience with highfliers such as Webvan, Pets.com and EToys Inc. when significant profits failed to materialize.

For Lampert, investor confidence is critical. If Kmart stock falls below $100 a share before the end of March when the Sears deal closes, Sears shareholders would end up with less than the $50 per share price they expect based on the 2-1 stock ratio laid out in the merger agreement.

A lot of short sellers are still betting that Kmart stock will fall to earth eventually. Almost 25 percent of its shares are sold short in early November, the latest figure available, an usually large amount that means investors are hoping to profit by selling Kmart shares now and buying them back for less at a later date.

But so far, the shorts have been wrong and Lampert has been racking up billions of dollars in profit on his Kmart holdings.

“Investors are always looking for the next hot stock, and sometimes they will buy a story without doing the analysis,” notes Putnam, the turnaround investor. “Their memories are short.”

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h5. How we analyzed Kmart’s real estate

The Tribune’s examination of Kmart real estate is based on a court filing containing the address of each store leased by the retailer when it emerged from bankruptcy in May 2003. The newspaper then combined that information with income data by ZIP code from the 2000 Census.

The analysis does not include stores that are owned, rather than leased, by Kmart. It may also include non-store properties leased by Kmart, and properties Kmart has relinquished since emerging from bankruptcy.

Kmart declined to provide a current list of store locations, but more than 90 percent of Kmart stores are leased, and a spokesman said the retailer has disposed of only a handful of properties since emerging from bankruptcy.

December 19, 2004