We’re dealing here with two big investors who are polar opposites in personality and approach. There’s the flashy Bill Ackman of Pershing Square Capital Management. Two years ago, he used his hefty stake in Penney to muscle its board into hiring Ron Johnson, creator of the mega-successful chain of Apple retail stores, who in turn has embarked on a radical, so far disastrous strategy. And there’s the reclusive Eddie Lampert of ESL Investments. This year, he appointed himself acting chief executive of Sears Holdings, which owns Sears and Kmart.
But the two Wall Streeters, so different in many ways, are alike in thinking that they have the talent and the chops to give a troubled national retail chain what it needs to succeed. So far, at least, they haven’t come close.
Ackman and Lampert became billionaires by being brilliant investors, and both got into retailing by amassing big stakes in companies they thought were selling for way less than their assets were worth. Under Ackman’s influence, J.C. Penney is spending heavily to upgrade its stores from dowdy to delightful; Lampert is slowly milking a dwindling asset and revenue base at Sears. Both companies find themselves in serious trouble.
Perils of Penney
By now the Perils of Penney has become a familiar tale. After soaring on the appointment of Johnson as chief executive, Penney stock has collapsed in recent weeks. It has fallen 30 percent in less than a month, after a disastrous fourth-quarter earnings report. It’s down 60 percent since Johnson brazenly claimed in January 2012 that he would transform the fading chain into “America’s favorite store.”
Ackman’s ally at JCP (as it now wants to be called), Steve Roth of Vornado Realty Trust, abruptly sold 40 percent of the company’s stake in March; a Macy’s lawsuit over plans to open Martha Stewart “stores” inside JCP locations drags on, temporarily leaving a gaping hole in hundreds of Penneys; and on March 14, lender CIT reportedly signaled its skepticism about the company’s finances by boosting the cost for vendors to borrow against payments that Penney owes them.
Johnson swept into Penney in November 2011 with the celebratory air of a revolutionary rolling into a vanquished capital. A few months later he hosted a gala relaunch of the brand, a Penney-palooza modeled after the Apple fests held by his former boss Steve Jobs. (Even Jobs might have considered this one excessive.)
Johnson proclaimed that he would reinvent the department store and do so while keeping earnings intact. His most radical moves were to stop running sales, which he said tricked customers, and to try to persuade the bargain-addicted to trust that the new “fair and square” JCP would offer lower prices even if its price tags showed no mark-downs. He killed off older brands and signed hipper names such as Joe Fresh, announced a new store-within-a-store design, and launched a bold and pricey ad campaign.
The plan aroused a lot of fascination because national department store chains are in such long-term decline that any fresh approach merits consideration. But Johnson talked the board into abandoning decades of practices and changing the whole company at once without testing his ideas first.
“You never, ever do a new concept across the board automatically,” says Gilbert Harrison, chairman of Financo, an investment bank that specializes in retail companies. “Before [Johnson] could roll it out, he needed to better train his customers.”
Johnson was undaunted by any suggestion that he needed to take some time or that he should refrain from touting JCP’s new stores until the company had overhauled more than a handful of them. “The only things that haven’t worked for me are when I’ve held back,” he told Fortune during the brand’s relaunch. “There’s no reason to sell an idea short. The only risk would be to not fulfill the dream.”
(Johnson declined to be interviewed for this article.)
Johnson’s call to arms — with the enthusiastic support of Ackman, who with Vornado owned about 36 percent of the stock (some of it through derivatives) before the latter reduced its position — was based on Apple’s approach to retail: Sell must-have products that people line up to buy, with help from a great in-store experience. There was a crucial difference: Apple sells sleek miracles of functionality and glamour. J.C. Penney sells bath towels and tube socks.
There are always casualties in revolutions. In this case, unfortunately, it was the core customer, who had long trusted J.C. Penney as a great place for a deal on basic, unfussy stuff. Effectively, Johnson fired the old shoppers without first winning over any new ones. Need proof? The past four quarters reveal a breathtaking decline in same-store sales, which plummeted 19 percent in the company’s first quarter and accelerated to 32 percent in the fourth quarter, which is when stores make most of their money.
Now, after seeing overall sales decline by an astonishing 25 percent — $4.3 billion — in the past year, Johnson & Co. is retrenching (sort of) by bringing back clearance prices and coupons. Ken Hannah, chief financial officer, recently offered a modified mea culpa at an investor presentation: “This is a multiyear journey, and we certainly made our mistakes.”
Penney’s board clearly blundered by entrusting the company’s fate to a leader who was dynamic but had no experience as a chief executive. Although Myron Ullman III, then Penney’s chief executive, was originally supposed to stay for a while as chairman, confusion about who was running the show led the company to change course. Ullman resigned in January 2012, two months after Johnson’s tenure began.
Hiring Johnson was a classic Street turnaround play: Recruit a hot manager from outside the company, hand him huge financial incentives and set him loose. The board gave Johnson $50 million of Penney stock to make up for $50 million in Apple shares he left behind. Johnson also shelled out $50 million of his own money to buy a warrant giving him the right to buy 7.3 million shares at $29.92 from mid-2017 through late 2018. Already wealthy from his tenure at Apple, Johnson took that huge flier seeking mega-riches. It also conveyed that he was willing to wager his money on his audacious revival plan.
At first it seemed like a win: On the June 14, 2011, announcement of his hiring, the stock ran up 17 percent, putting him ahead more than $30 million on paper. Today, at JCP’s recent price of $15.50, the stock has to rise about 150 percent just for him to get his $50 million back. The guys who hired him are way down, too: Ackman is looking at a paper loss of $550 million on his $1.55 billion investment, and Vornado is down about $260 million. Ackman says: “Retail turnarounds are difficult and take time.”
Bad bets at Sears
In contrast to Ackman and Roth, who began buying their Penney’s stake less than three years ago, Lampert has been dealing with his retail company for more than a decade. He’s way, way ahead on his investment; we estimate at least 300 percent. He started by buying Kmart debt in 2002, at undisclosed prices, while the company was in bankruptcy.
His hedge fund owned more than half of Kmart’s stock when it emerged from bankruptcy in 2003. A major attraction was Kmart’s real estate, which had far more value then to bricks-and-mortar merchants than it does now, with Amazon and its online brethren eating traditional retailers alive.
Then, in 2005, after Kmart stock had surged from its original post-bankruptcy $15 to triple digits, Lampert got Kmart to buy Sears. That gave Lampert even more real estate and a batch of attractive assets, such as the Craftsman tool line. The bullish story, repeated endlessly at the time, was that Lampert would be the next Warren Buffett, redeploying capital generated by fading stores the way Buffett redeployed capital from Berkshire Hathaway’s original fading (and now closed) textile business.
Lampert didn’t discourage this. He took to writing long, discursive letters about the company and his views of life, similar to Buffett’s Berkshire reports. He was famously intrusive, saying yea or nay on even relatively minor investments. Lampert ran through three chief executives in eight years before becoming acting chief executive in January — a title he probably should have assumed years before.
For all his smarts, Lampert failed to hire a strong, top-notch retail chief executive to run his company. Time and again, he has been able to articulate a financial strategy for his investors; he has rarely been able to offer more than a cursory nod at a retail strategy — a reason that customers should shop at Sears or Kmart. That deficiency is evident in the company’s results. In 2005, Sears generated $49.1 billion in revenue and $858 million in profits. In 2012, revenue slumped to $39.9 billion and Sears lost $1.1 billion.
You can also argue that Lampert didn’t do all that well at his core competency: asset deployment. Rather than put lots of money into new stores and upgrades — which he said over and over in his annual letters wasn’t an efficient use of capital — he had Sears spend a ton of cash buying back stock. By our count, Sears has spent $6.1 billion to repurchase stock, about 60 percent more than the $3.7 billion spent on capital improvements at stores during that period. Shortly after buying Sears, Lampert launched a program called Sears Essentials, rebranding existing Kmarts and stocking them with Sears products to compete with smaller-format stores. It bombed. “Had Sears Essentials worked, we would have put much more money into the physical stores,” Lampert tells Fortune.
The average cost of the repurchases: a bit more than $100 a share, roughly double the recent price. To be fair, some $5 billion of the buybacks occurred before the financial crisis hit and Sears’s cash flow began to dry up. But a capital allocator is paid to get it right, and in this case he didn’t.
Sears is trying to recover with its latest attempt to mix traditional stores with online retailing, shopyourway.com, which combines social media and a loyalty program. But most other national retailers are attempting some version of this. Will Sears get it right? Who knows? But some of the money it spent buying back stock would come in handy right now.
At Sears Holdings’ recent price of about $52, Lampert is way less ahead than he was in 2007, when the stock was at $170. There’s no reason to believe the stock will return to that level anytime soon, if ever.
The idea that if investors make money, everything works out for the best for everyone doesn’t hold in all cases. Lampert has made a ton of money, as have some of his early investors. “It’s been a better investment than people think,” he says, “but the company hasn’t been a success yet.”
In both the J.C. Penney and Sears Holdings sagas, there are lots of losers: vendors, communities with abandoned or failing stores, and, above all, employees. Ed Cox, a former Penney network engineer whose 32-year career ended when he was laid off last April, says: “I was very emotional that day. On those employee-engagement surveys done every year, they said, ‘Do you see yourself retiring at J.C. Penney?’ and I always said yes.” Lee Stoeckert, a former colleague who took a buyout, adds, “They always said it was going to take three years, but not that it was going to crash and burn in the meantime.”
Today, the two American retailing icons look further from revival than they did when Lampert and Ackman entered the picture. The winners, so far, in addition to Lampert and his early investors, are the chains’ competitors. They include Macy’s, Kohl’s, Target and TJX, all of which are run by traditional retailers, not hedge fund guys or their designees. (Co-author Allan Sloan owns $115,000 of TJX and Target stock, purchased well before this article was conceived.)
There’s still time for Ackman and Johnson to prove us wrong. Any number of factors could change Penney’s momentum. The company could emerge with a favorable result from the Martha Stewart litigation. There are whispers afoot of a significant refinancing, which could remove doubt about its ability to renew its revolving line of credit next year. Customers could come flooding in as the store makeovers are completed. Or not.
Whatever happens, here’s the bottom line to this convoluted tale: Retailing is a lot harder than it looks from Wall Street.
Sloan is Fortune magazine’s senior editor at large.