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November 17, 2006

Is Sears Holdings Really a Hedge Fund?

posted by MR WAVETHEORY at 11/17/2006 12:30:00 AM
You have to love Eddy Lampert. He buys Sears Holdings Corporation (Nasdaq SHLD) whose core business was formerly known as retail, and proceeds to turn it into a hedge fund. According to Sears' earnings report, Lampert threw Sears' excess cash into $387 million of total return swaps during the quarter. Under the setup, Sears is paying a floating rate tied to LIBOR and receiving a return tied to several company stocks.

Sears earned more than half its net income in the fiscal third quarter ended Oct. 28 from investments in exotic derivatives designed to mirror the performance of company stocks. Net income tripled to $196 million, or $1.27 a share, despite weak sales at its Sears and Kmart stores. Of that amount, $101 million attributable to total return swaps. In the year-earlier quarter, the company earned $58 million, or 35 cents a share.

In Sears' earnings press release, under interest and investment income, Sear's devoted a full section to the swaps that it bought during the quarter. Sears did not describe the basket or index that the total return swap is linked to.

Eddie Lampert has managed to make the job of consumer retail analysts around the world truly interesting. Forget about doing channel checks and store visits during earnings season . Forget about building same store sales models. Figure out the swaps that Eddie Lampert is buying, and nail the earnings estimates.

Interest and Investment Income

The following table sets forth the components of interest and investment income as reported on the Company's condensed consolidated income statement. Amounts from prior periods have been reclassified to interest and investment income to conform to current period presentation. The Company previously reported interest income on cash and cash equivalents as a component of net interest expense, and reported other investment income as a component of other income.

13 Weeks Ended 39 Weeks Ended
October 28, October 29, October 28, October 29,
millions 2006 2005 2006 2005

Interest and investment
Interest income on cash
and cash equivalents $36 $16 $112 $51
Total return swap income 101 -- 101 --
Other investment income 3 24 28 35
Total $140 $40 $241 $86

The Company, from time to time, invests its surplus cash in various securities and financial instruments, including total return swaps, which are derivative contracts that synthetically replicate the economic return characteristics of one or more underlying marketable equity securities. In exchange for receiving the return tied to the position underlying a total return swap, the Company pays a floating rate of interest tied to LIBOR on the notional amount of the contract. The fair value of a total return swap is based on the quoted market price of the underlying position and changes in fair value of the total return swaps are recognized currently in earnings. During the third quarter of fiscal 2006, the Company entered into total return swaps and recognized $101 million of investment income consisting of realized gains of $66 million and unrealized gains of $38 million less $3 million of interest cost. As of October 28, 2006, the total return swaps had an aggregate notional amount of $387 million and a fair value of $38 million. These investments are highly concentrated and involve substantial risks. Accordingly, the Company's financial position and quarterly and annual results of operations may be positively or negatively materially affected based on the timing, magnitude and performance of these investments.

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