Eddie Lampert On Sears: Transformations Of This Size, Scale Are Not Easy

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Eddie Lampert provides an update on Sears Holdings Corp (NASDAQ:SHLD) transformation from the second quarter CC and talks about action to create long-term value for shareholders.

Eddie Lampert on Sears’s transformation

Thanks, Rob. I also would like to thank all of you for joining us today.

Beginning on Slide 4, I will provide an update on the progress we are making in our transformation, review key highlights from the second quarter and briefly review some of the actions we are taking to simplify and focus our Company while creating long-term value for our shareholders. Rob will then review our financial results for the quarter and update you on our asset redeployment efforts in more detail.

Following Rob’s remarks, I’ll provide an update on the framework for profit that I introduced on our last earnings call, outlining our efforts to restore Sears Holdings Corp (NASDAQ:SHLD) to profitability. This framework is not meant to give guidance as to our future results or to predict that we will be successful in executing every aspect of this framework, but rather to highlight some of the different levers we’re utilizing that could restore profitability.

As the CEO and the largest individual shareholder of Sears Holdings Corp (NASDAQ:SHLD), I am personally committed to driving our transformation, improving our profit performance and ensuring our financial flexibility, all while creating shareholder value.

Slide 6 illustrates our transformation to move from a traditional retail operating model to a member-centric operating model. While retailers continue to be impacted by the same external factors, we are moving aggressively to address what we can control. We have a number of different levers at our disposal that will enable us to return a company of our size and scope to profitability and deliver value to our many stakeholders.

A key component for transforming our business is to move towards a structure that focuses on providing benefits to our members by combining technology, people and stores to form more personalized relationships with them. Our new business model is intended to be less asset-intensive and our new cost structure is intended to be more variable in nature.

Moving now to Slide 7. I will direct my opening summary comments on five key areas of focus: first, while we’ve continued to show progress on our transformation, as demonstrated by growth in our Shop Your Way penetration rates and our online sales growth, our second quarter earnings are unacceptable.

We are taking steps to address our performance on several levels including reducing costs, investing in the acceleration of our transformation, rationalizing our physical footprint to focus on our better performing stores and markets, and improving our pricing and promotional design to yield higher gross margins.

Given our scale, small changes can have a big impact on our results. For example, a 100 basis point increase in margin rate in the second quarter would have increased EBITDA by approximately $80 million for the quarter and over $300 million on an annualized basis.

Second, our transformation continues through Shop Your Way and Integrated Retail. We continue to see increasing engagement from our Shop Your Way members who drove 73% of eligible sales in the quarter. In addition, our Integrated Retail initiatives drove our online and multi-channel sales, up 18% in the quarter and 22% in the first half.

The success of these two platforms is allowing us to maintain relationships with our members as we rationalize our store footprint and place an increased focus on supporting our better performing stores. Despite the fact that adjusting our footprint has resulted in store closures, we continue to have a substantial nationwide footprint with a presence in many of the top malls in the country.

Third, we plan to take short and long-term actions to enhance our financial flexibility. We reduced our inventory by $1.7 billion over the past three years as we closed stores and improved productivity. As a result, in the future we will be less reliant on inventory as the primary form of collateral in our financing arrangements. In the next six to 12 months, we intend to work with our lenders and others to evaluate our capital structure with a goal of achieving more long-term flexibility.

Fourth, we have a proven record of funding our transformation and our business model. We have a large, valuable, diverse and unencumbered set of assets and businesses. In the first half of 2014, we generated $665 million in proceeds towards our initial stated goal of $1 billion for the year.

We also continue to reduce our liabilities by: one, decreasing lease obligations by over $1 billion over the past three years; two, reducing our underfunded pension status by over $600 million in the past year; and three, reducing our overall pension liability, including making $1.5 billion lump sum payment in 2012 to our pension plan participants, which reduced our exposure to the market risk associated with managing pension plan assets.

Fifth, we continue to add to the talent pool of the company. We have brought in new leaders, and elevated others within the company, as we change our culture to be more accountable and focused on driving performance. We currently expect the combination of these actions to improve our operating results.

We will continue to take actions that we believe will create value and provide us with the financial flexibility to invest in the strategic priorities of the company. As changes occur in and around retail, we intend to be actively involved, focused on investments and acquisitions that we believe will accelerate and enhance our transformation.

I will now hand the call over to Rob who will take you through our second quarter results and financial position followed by a more detailed update of our asset redeployment and reconfiguration activities.

Eddie Lampert: Restoring profitability to Sears

Transitioning to this section on Slide 24, I mentioned that I want to use this opportunity to provide an update on the levers we are using to restore profitability to Sears Holdings Corp (NASDAQ:SHLD). As I have said before, the framework I am outlining is not intended to provide guidance as to our future results or predict that we will be successful in executing any aspect of this framework. It is intended to describe the opportunities we are focused on to increase profitability.

Slide 25 highlights that we believe that fostering deep and lasting relationships with our members will drive sustainable and profitable growth. As we pursue this fundamental objective, we will remain disciplined stewards of capital, with an overriding focus on creating value for our shareholders. A transformation of this size and scale is difficult, but our entire management team is committed to its execution.

Slide 26 we outlines the framework of our new model, which leverages our scale and the investments that we continue to make in the Shop Your Way program and Integrated Retail capabilities. These include, optimizing store network and square footage, accelerating Shop Your Way and Integrated Retail as the foundation of our business. Transforming select business models and reducing selling and administrative expenses.

Turning to Slide 27, we’ve announced plans to close about 130 stores in 2014, having closed about 95 to date. In fiscal 2013, these stores generated almost $1B in sales; however, they generated an EBITDA loss of about $26 million. Due to the flexibility in our real estate portfolio we believe we will be able to close these underperforming locations efficiently. So, by closing these locations, we would expect to generate approximately $26 million of incremental EBITDA on an annualized basis by avoiding the losses they currently produce. Furthermore, closing these locations is expected to reduce our working capital requirements by about $160 million in 2014.

Additionally, we believe that there is opportunity to retain a portion of the sales associated with the closed locations by maintaining a relationship with the members who shopped those stores. This belief is based on experience we have had to date in stores that we have closed over the last year. As is shown on the slide, we believe that the annualized EBITDA value of retaining these members could be about $50 million, resulting in a total annualized EBITDA benefit of about $73M. As our ability to retain members improves, we believe that the potential annualized impact of optimizing our store network could be about $300 million to $400 million.

Eddie Lampert: Integrated Retail capabilities in Sears

Turning to Slide 28, we have made substantial investments in Integrated Retail capabilities in our stores. We are seeing these investments drive very good results, and we will continue to roll out these capabilities to additional stores throughout the remainder of the year. For example, these abilities include more flexible technology, like the ShopSears app utilized by associates in stores, digital signs, which enable dynamic pricing and marketing, and RFID technology, which enables our associates to do inventory counts in a fraction of the time giving them more time to focus on serving our members.

This has resulted in improved sales and margins in the stores where we have enabled this technology. Based upon this experience, which we have introduced at hundreds of locations, we believe there is the potential to generate about $500 million in incremental annual revenues and between $150 million to $200 million of incremental annual EBITDA for these initiatives alone.

On Slide 29 we wanted to highlight that our In Vehicle Pickup has received very positive feedback from our members. We launched this member benefit in the first half of the year at our Sears Full-Line Stores to make pickup of online orders easier. This is one of the many ways we demonstrate our industry leadership in leveraging online channel and physical stores to enhance the integrated shopping experience. Based on that positive feedback we are looking to expand this capability to Kmart and are piloting it in 115 Kmart stores.

On the bottom half of this slide, we show that during the second quarter we announced new functionality that allows our members and customers to order from sears.com and kmart.com and pick up in either format stores, all over the United States. This will allow members and customers to shop their favorite brands and pickup at the location most convenient to them, with no charge for shipping.

On Slide 30, we show that the difference in annual spend between an average engaged Shop Your Way member and a very engaged Shop Your Way member continues to be significant, with our most actively engaged members spending 75% more than our average active member.

We are focused on targeted actions that will convert more of our average active members to more engaged members and we continue to see positive signs that these actions are working. Both the number of members that have redeemed points in the last 12 months and the number of contactable members have increased meaningfully. To put this in perspective, moving one million members from average to most engaged status represents $50M in EBITDA.

We are focused on enhancing margins and reducing our overall cost of goods through a number of initiatives. On Slide 31 we show that cost of goods annual spend is $23.6B. We have invested in our pricing capabilities, both in people and technology, which will enable us to be more targeted and real-time, responding to our members’ needs and the competitive environment. We are also focused on shifting our promotional design to be less dependent on promotional markdowns and replacing them with Shop Your Way points, where it makes sense.

There will always be a level of promotional markdowns as part of our go to market promotional design, but our intent is to replace a portion of our existing promotional markdowns with Shop Your Way points. Also, we are focused on optimizing our supply chain to right-size our network, and leveraging our real estate portfolio by partnering with other retailers to lease out valuable but unproductive space.

Strategic sourcing is one specific area I would like to call out where we have made some progress since our last call. In the first half of the year, we have executed a number of strategic sourcing initiatives that we expect will improve profitability for the company in the future by $80 million on an annualized basis. We will continue to utilize the strategic sourcing framework to continue to identify and go after additional savings across both merchandise and non-merchandise sourcing.

Through these actions, you can see that with revenue held constant, each 1% reduction in our cost of goods, which would include the impact of sub-lease income, would generate an incremental $230 million of annual EBITDA.

Eddie Lampert: Sears’ selling and administrative expense

On Slide 32, selling and administrative expense is also an area of focus. As we have discussed in the past, we have reduced our fixed expense structure by about $800 million annually over the past three years, though this is a mix of costs included in both cost of goods sold and selling and administrative expense. Through the first half of the year, we have reduced our fixed expenses by $30M, and we believe there is still significantly more opportunity.

Our areas of focus are re-engineering processes, leveraging technology and shifting our marketing mix. In the first half of the year, we shifted more of our marketing dollars from fixed marketing assets to more variable-based, targeted digital assets, reducing our marketing expenses by $42 million while maintaining similar levels of marketing productivity. I would point out that the impact of these initiatives can be substantial. With revenue held constant, each 2% reduction in selling and administrative expenses translates into $150 million of incremental EBITDA.

On Slide 33 we aim to clearly show both the challenge and the opportunity represented by Apparel. Our revenue per square foot in our apparel business is about one third of the industry average. Each $10 improvement in our sales productivity per square foot represents $100 million in incremental annual EBITDA.

To that end, we are aggressively transforming our apparel business with a focus on refreshed brands and product assortments and are reducing lead times to better meet our members’ needs. We are excited about our brand

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