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The Marriage From Hell Why Eddie Lampert's failing Sears-Kmart experiment could mean trouble for dealmakers everywhere.

By Jesse Eisinger

The Great Experiment

Inside a Sears store in the Cincinnati suburbs, Steve Sunderland, the vice president for store initiatives at Sears Holdings, is exuberant as he shows off his company's latest experiment. With his oversize blue blazer and slightly nasal voice, Sunderland bears a passing resemblance to Steve Carell of The Office. Periodically, he interrupts our conversation to race over and hold a door open for a customer or to call out, "Have a great day, ladies!"

At this particular Sears store, Sunderland is point man for the latest test run by hedge fund manager Eddie Lampert, who is using the company as a petri dish to try out his ideas for the retail business. (Read more about Eddie Lampert.) Instead of the usual layout, which groups merchandise by type-clothing, toys, appliances-this two-level store is organized around rooms of the home, including a kitchen, kid's bedroom, garage, and laundry room. The areas are set up, Sunderland says, "holistically." Refrigerators and stoves are in the kitchen area, and washers and dryers are in the laundry zone.

The goal is to create a Cheers atmosphere, referring to the 1980s sitcom in which Boston barflies make up a surrogate family. Sunderland calls this "dwell." Each area has its own pavilion, anchored by a computer kiosk called the Oracle, set up to search out Sears products. Sears has adapted the Willy Wonka, everything-is-edible approach to the mock-up rooms. Everything within them, including the paint on the walls, is for sale. (View slideshow.)

While we are standing in the laundry pavilion, surrounded by cabinetry and Kenmore appliances, a white-haired woman in a blue tracksuit wanders over, looking confused. Sunderland moves in to help. The woman is looking for a belt for her sewing machine, which is 40 years old. Sunderland tells her that Sears has an entire line of new sewing machines on the other side of the pavilion wall, but that doesn't seem to interest her. When he calls a salesperson over to help look for a belt to fit a machine made almost half a century ago, he is met with a slightly terrified look. Do sewing machines today even have belts? Sunderland points to the computer, suggesting that the answer may lie somewhere inside the Oracle.

For Lampert, this particular experiment is part of a methodical approach to running the fourth-largest general retailer in the country. Maybe the Cincinnati store will work. If it doesn't, Lampert will move on, trying and analyzing, desperate to come up with something that will stick. As Lampert fiddles, he's faced with a bigger, perhaps unfixable problem: Sears and its corporate cousin Kmart, which Lampert also owns, are being done in by competitive threats that even the skills of a man widely considered to be one of the most talented financial minds in American business can't fend off. His fetish for data is leaving Sears in a paralysis of analysis, and his micromanaging is driving away executives and alienating suppliers. "Eddie doesn't know what to do. He's not a merchant. He hasn't been a retailer. As a result, he tries a bunch of different ideas because he himself doesn't have a vision," says a former high-level Sears Holdings executive. "In the absence of a vision, what comes out are multiple ideas being tested. On the one hand, that's better than nothing. But there comes a time when the time to test runs out, and you have to lock and load with what's the best answer for the company." Three years after Lampert bought the company, he still hasn't found the answer. Luis Padilla, a Target executive who served as Sears' top buyer for about a year, says, "Eddie had a point of view on retailing, and it doesn't seem to be coming to fruition."

Clearly, elderly women hunting for replacement parts aren't the solution. Sears needs younger shoppers. Upstairs in Cincinnati, two young women have wandered in looking for a down coat. Lori Morsch, a 26-year-old, tells me that the place doesn't feel like a Sears, a comment that would make Sunderland happy-until he hears the followup. She says it has no appeal to women, adding, "I feel like I'm in a wholesaler." The store looks, she says, as if it has received a "make-under." Her friend, 29-year-old Danielle Krull, nods in agreement.

The Warren Buffett of His Generation

Lampert's creation of Sears Holdings had been the seminal investing coup of the decade and a source of inspiration for a generation of financiers. He took control of Kmart in 2003 as it emerged from bankruptcy protection and, in the face of great skepticism, employed massive cost cutting to make it profitable. Kmart's stock increased nearly sevenfold between 2003 and 2004, and Lampert used those shares to buy Sears Roebuck, creating a merged retailing giant with 3,800 stores across the country. Under Lampert's leadership-he's officially the chairman, and his ESL Investments controls about 47 percent of Sears Holdings-the company's sales have been trimmed, intentionally, from what would have been a combined $60 billion in 2003 to about $51 billion in 2007. Operating income initially soared, and Sears Holdings paid down debt and bought back stock.

The deal helped solidify Lampert's place in American business lore. He worked under Robert Rubin at Goldman Sachs, left the bank over Rubin's strong objections, then became a prot�g� of Texas investor Richard Rainwater. He struck out on his own at the age of 27 and made a series of savvy, concentrated bets on undervalued companies. An early win was an investment in I.B.M. at an early point in Lou Gerstner's reign, a storied turnaround that Lampert refers to in letters to shareholders as a model for Sears.

For years, money managers like Lampert have been in the ascendancy, taking over all sorts of companies with the idea that they can manage them better or flip them for a quick profit. Financiers are now running some of the most storied names in American business-Chrysler, Hilton, Hertz, and Reader's Digest. Mostly, private equity firms have been taking over companies through buyouts. But Lampert-style activist investing has also been in vogue, reenergizing people like Carl Icahn and Nelson Peltz, who champion their strategies for companies and sometimes make takeover bids or grab seats on the board.

Many of these financiers insist they are in it for the long term. But in truth, they didn't have to be. Returns came easily. Companies could be flipped back to the public or another buyer in short order, generating huge gains. But now those tricks are played out. Financial markets have seized up. Cheap financing isn't available. For the first time, financiers are being forced-gasp-to manage their companies. They have claimed to have expertise in doing this very thing; now they have to prove it. And if Lampert's experience is any gauge, the challenge is going to be tougher than any of them expect.

This year, the cost cutting and slashing of capital spending caught up with Lampert. Net income at the company cratered, dropping 99 percent in the third quarter to $2 million. Sales at stores open a year or more, a key measure of retail performance, have continued to drop at both Sears and Kmart. And in the all-important holiday shopping season, things probably worsened. Sears stock fell nearly 40 percent in 2007. "We cannot blame our results entirely on the retail and macroeconomic environments," Sears C.E.O. Aylwin Lewis said in a prepared statement. "We have much on which to improve and are working hard to do so."

The problems at Sears and Kmart have also been costly for Lampert's hedge fund and for his status as a canny financier. His main $15 billion fund-made up substantially of Sears stock-was down a stunning 25.7 percent through November, according to a person privy to the results. Once hailed as the Warren Buffett of his generation, Lampert, at 45, now has another turnaround job on his hands: his own reputation.

Lampert runs the $50 billion retailer in much the same way he runs his hedge fund-by overseeing the tiniest details, relying on a small coterie of advisers, and shunning conventional industry wisdom, convinced he knows better. He leans heavily on his No. 2 at the hedge fund, William Crowley, who has an underappreciated yet vital role in managing Sears. Crowley even served temporarily as the chief financial officer, as that position saw a succession of short-timers in recent years. Lampert and Crowley make almost every decision of significance at Sears Holdings, according to former colleagues at the hedge fund and employees of the company. Lampert is "trying to set an example that every penny counts, but no one feels empowered to make any decisions," says an ex-Sears official. "You wind up with a slower, more bureaucratic environment. People are more prone to be second-guessed."

Lampert rarely talks to the media or anyone on Wall Street. (The company declined to make Lampert available for this article.) Sears doesn't hold earnings conference calls, and analysts complain about how little contact they have with the company. Unlike the vast majority of publicly traded retailers, Sears Holdings stopped reporting its chains' monthly sales at stores open at least a year. Instead, Lampert writes letters to shareholders, taking a page from his idol Buffett.

When I ask some of Lampert's former colleagues what he was like, they answer like the brainwashed soldiers in The Manchurian Candidate. To a man, they say he is "intense," but it is a "quiet intensity." He's the "most intense man I've ever known," one says. Several recall receiving emails at all hours of the night. One says he didn't know when Lampert slept. Even after years of working with him, many say they hardly knew him.

Lampert was kidnapped in early 2003 and held over a weekend before talking his way out of captivity. He was back in the office on Monday, according to former hedge fund colleagues, sending emails about arcane filings from companies he owned. "Eddie isn't someone who shares his vision, even internally," says a former analyst at the hedge fund. "He doesn't need to build consensus. He is very self-confident and not one to share. If there is a grand plan, maybe only he knows it."

Lampert's fund is based in Connecticut, and he leaves most of the traveling to Sears' Chicago headquarters to Crowley. "It's very hard to run a big retail company in Chicago out of a conference room in Greenwich," says Paul Charron, the former chief executive of Liz Claiborne, who met with Lampert in the early days of the merger to discuss placement of his company's products. A Sears Holdings spokesperson answered this critique of Lampert with this statement: "Like other senior leaders of the company, Eddie Lampert as chairman gets involved in many aspects of the business and takes the time to visit many different stores and parts of the company. He engages where he believes he can add value or when he is asked for input or advice."

Despite the physical distance, Lampert is ever-present. From the beginning, he wouldn't grant the company's lawyers the authority to settle even minor slip-and-fall lawsuits that amounted to mere thousands of dollars, a former executive recalls. "Operationally, we were grossly inefficient. That's why I left. There were 8 million emails, approvals on everything-simple stuff. All of the contracts had to be reviewed. In general, it was a good thing at the beginning, but it could take forever. Even simple ads. We ran ads every week! At some point you have to let that go," the ex-executive says. "The questions he asked the business people-they were right and legitimate. They were questions we should be asking. The problem was not that we had to talk to him. The problem was you had to talk to him about everything."

Lampert is also prone to lecturing. In spring 2005, he brought five of the company's senior buyers into a room to discuss how and when to mark up Sears goods. "He gave us a retail-math lesson. He was teaching," recalls an attendee. "He felt everybody in retail was stupid like that. We were stunned. A lot of these guys at Sears have been in retailing since they were two. The discussion with them should have been strategic."

Lampert's inability to let go is one reason there has been sizable turnover at Sears Holdings in the past few years. Sears C.E.O. Alan Lacy was pushed out. Luis Padilla left. The chief marketing officer, the Lands' End C.E.O., the general counsel, and Kmart's chief apparel officer departed in the wake of the merger. One of the company's many recent C.F.O.'s, Craig Monaghan, was in the role for only five months.

Under Lampert, Sears has become a tenacious negotiator, which has led to fights with vendors, partners, and even shareholders. Executives say that Lampert works aggressively to wring the very best terms out of the other side, and even after a contract is signed, he won't give up. One former executive claims that he saw Lampert try to renegotiate a contract Lampert himself had negotiated two months earlier. In mid-2005, Sears tried to terminate its I.T. contract with Computer Sciences Corp., accusing the company of not upholding its end of the agreement. In the fall, the two parties settled, with Sears getting slapped down. The company agreed to pay $75 million to C.S.C., more than it had previously reserved.

The thorniest fight was with Martha Stewart Living Omnimedia, a marquee supplier to Kmart. Martha Stewart's company had won generous terms on its contract, negotiated by the previous Kmart management. In early 2003, Lampert assembled Kmart's big vendors, including Stewart, at a New York meeting hosted by Tommy Mottola, a record executive, according to a person who attended. (Thal�a Sodi, Mottola's wife, owns a clothing line sold at Kmart.) At the gathering, Lampert outlined his plans to take Kmart out of bankruptcy quickly. But the suppliers balked, worried that his moves could be premature. As creditors, they were in line and were eager to be paid the full amount they were owed. Stewart was particularly resistant. Lampert, speaking calmly, told her that if she wanted to end their relationship, he had a pen with him and they could sign a deal to end their agreement right there. "Martha didn't say another word," says a person who witnessed the exchange. "It takes a lot to silence Martha." (A spokeswoman for Martha Stewart Living says the company doesn't recall such a meeting.)

Three years later, Stewart made a deal with Macy's. While Martha Stewart towels and dishes still greet Kmart shoppers at most of the stores, some analysts are betting that they won't be there much longer. This fall, Stewart's company sued Sears Canada for failing to pay the paltry sum of $1.8 million (Canadian) in licensing fees. When Sears agreed to pay, it didn't adjust for the falling U.S. dollar. Farcically, Stewart's company amended its complaint to collect the additional money.

Try and Try Again

Retailers experiment all the time. But Sears Holdings celebrates its test-and-learn culture as a matter of corporate pride. Lampert's idea is that he can, using data and good business sense, eventually figure out what's wrong and fix it. "One of the great advantages of having approximately 2,300 large-format that we can test concepts in a few stores before undertaking the risk and capital associated with rolling out the concept to a larger number of stores or to the entire chain," he wrote in a letter to shareholders.

Lampert's tests are peppered throughout the country. In Zephyrhills, Florida, the company put a Sears within a Kmart. In Houston, it's trying out a huge home-appliance showroom. In Rockford, Illinois, Sunderland and his team are testing a new Kmart design that has an outdoor-marketplace feel. Duluth, Georgia, has a retro-themed store. Maureen McGuire, Sears Holdings' chief of marketing, says that testing is now so embedded in the culture that the company put two different covers on its famous Christmas staple, the Sears Wish Book catalog, which it reintroduced this year after a 14-year hiatus. The blue one with stars tested better than the red one with pictures of Christmas cookies in the shapes of power drills and high-heeled shoes, she says.

The problem, though, is that the constant experiments can be redundant, especially when there is such high turnover in the executive ranks. Institutional memory is lost. In late 2004 through early 2005, Padilla came up with a diagnosis for what was wrong with Sears. The result was an experiment in Vernon Hills, Illinois, featuring a store designed around the room concept, emphasizing products for the home. The flow of customers through the store was planned to be more logical, moving them from a garage area to a workroom to an expanded area for backyard products.

But the Vernon Hills model was never rolled out widely. Lampert didn't want to put as much money into the store as the plan called for, and he tended not to embrace initiatives that weren't his own, insiders contend. The result is that, two years later, elements that are awfully similar to the Vernon Hills plan are still being tested just a couple states over, as Sunderland showed me near Cincinnati. It's possible that if Lampert had seen the Vernon Hills plan through, the pavilions and the Oracle might never have been necessary. (Sunderland says Vernon Hills wasn't the inspiration and that he and his team started with a "clean sheet of paper.")

Other times, Lampert appears surprisingly slow moving. Three years after buying the company, he's still searching for ways to expand his Sears stores beyond the mall, which has been dying a slow death for years. One of the ideas behind the merger was that some freestanding Kmart locations could trade up to the slightly spiffier Sears brand and compete more effectively with chains like Target, Wal-Mart, Home Depot, and Best Buy. But years later, Lampert is tweaking and tinkering with different approaches. The latest iteration is in Marietta, Georgia, an affluent white-flight suburb of Atlanta where the first large Kmart has just been converted to a new freestanding Sears. It has the largest Lands' End store-within-a-store in the country (almost a third of the total 72,000 square feet) and emphasizes such Sears-owned brands as Craftsman and Kenmore as well as outside ones like Sony and G.E. Before the Marietta opening-night festivities in November, I approached Carolyn Menzies, a 36-year-old KPMG employee and mother of two, who was shopping there. One of the remarkable things about American consumers is their ability to talk about shopping in perfect advertisement-ready terms. Menzies delivered a message Lampert would love to hear: "I'm thrilled it's a Sears. Kmart had become a much lower-end product." While she told me that Target was her favorite store, she added, "I will come here more frequently."

All good news, except Lampert may be too late. Directly kitty-corner from this store was a towering Target, with a brilliantly lit multilevel parking lot and a giant entrance. It opened in mid-October, weeks before the Kmart was finally converted. The Target was cavernous, about 181,000 square feet. The clothing looked more stylish than the Lands' End merchandise across the street. On offer were fashionable Mossimo bootcut jeans for $22.99, compared with Lands' End jeans that cost anywhere from $39.50 to $49.50, and Levi's jeans for $31.99. Target was selling an Isaac Mizrahi crewneck sweater; the Lands' End sweaters were more expensive. And Target was teeming with people, especially young couples.

Like many of Lampert's initiatives, the Marietta test has a backstory. Even before Kmart took over Sears, Sears executives had contemplated taking over Kmart to accelerate its exit from the mall, according to two ex-Sears executives. But that idea was nixed after Sears realized many Kmart properties were in locations they didn't like.

After the Sears-Kmart deal was unveiled, Sears announced its conversions. In February 2005, the company announced plans to switch some Kmarts over to Sears Essentials, which would emphasize home furnishings. In a press release for the launch, former C.E.O. Lacy said Sears Essentials "will lead the way as we embark on the most aggressive growth initiative in company history." But within a year, a spooked Lampert backed off. Something in the numbers didn't sit well.

Why didn't the plan take off? While the Sears Essentials plan originally called for about $2 million to be spent on each store, Lampert held the line at well under a million, skimping on capital improvements, according to an ex-executive. What little promotion Sears did was limited to advertising around the stores' Saturday-morning grand opening. If you missed those ads, you might not know that the local Kmart was now a Sears.

Today, the same thing may be happening. At a newly refurbished store in Rockford, Illinois, it's almost impossible to tell from the outside that the Kmart is redone. The only indication is a modest sign that reads "Discover a totally transformed Kmart!" hanging at eye level just outside the entrance. Sunderland tells me that neither the new Kmart in Rockford nor the redesigned Cincinnati Sears store will be supported by big local marketing campaigns. The company wants to see if the stores can grab customers mainly through word of mouth. "Flooding the market with more circulars-we're not doing anything like that," Sunderland says, as we walk around the Rockford store. "The goal here was to say, Can we create a buzz off of this, just based upon these customers who shop Kmart?" Because there isn't a store manager in the world who wouldn't want more marketing support, Sunderland concedes, "I think, certainly, you love to see things just explode, which a marketing campaign can help you do."

But he reminds me of past initiatives. Reflecting the uncertainty of the new Sears Holdings, he says, "When we kicked off the Softer Side campaign several years ago, we had some fabulous marketing, fabulous advertising. And I don't know if we delivered on the promise, and that's why it didn't necessarily play. I want to deliver on a promise first, before we sit here and say we want to start shouting to the world what we are."

Plan B

"Once, I asked Eddie, 'What is it that you want? To be the richest? To compound money at the highest rates?'?" recalls Daniel Pike, who worked as an analyst at Lampert's hedge fund before striking out on his own. "He said, 'I just want to wake up in the morning, look at all the available opportunities, and make the best fact-based decisions I can, make the most rational decisions.'?"

So what is the rational decision for Sears? Some investors think Lampert will have to give up on his great retail test and sell the company for scrap. William Ackman, the vocal activist hedge fund manager who has alternated between embracing Lampert and clashing with him over Sears Canada, bought 3 percent of Sears stock in recent months, arguing that Sears Holdings had hidden value as a misunderstood conglomerate. But since then, the results have remained disappointing, and the stock has continued its precipitous decline.

Given the state of the markets, one Lampert exit strategy-selling off some of the company's pieces-doesn't look like much of an option. The commercial-real-estate market has peaked. A recent analysis from Merrill Lynch suggests that Sears stores would sell at a discount to other department stores. "Disposing of its portfolio may not be the best way for Sears' management to extract value for shareholders," it concludes.

Being so concentrated in Sears stock means that Lampert cannot easily sell shares without panicking the market. In the summer, Lampert raised about $3.5 billion for his hedge fund, according to a person familiar with it. Money was flowing freely then, but a side benefit was that raising new money diluted the fund's investment in Sears Holdings. So even as Sears was buying back stock, Lampert's hedge fund was looking elsewhere.

What has gone wrong at Sears is a case study for any investor who has taken over another company. So when they look at the Lampert experiment, how will they judge it?

Maybe they will determine that Lampert skimped on Sears, cutting costs instead of investing. Maybe he didn't pull the trigger fast enough on any one of his numerous experiments. Maybe he hesitated with the asset sales. Any of these might be true. But that would be good news; that would mean a right choice is still out there to be made. The alternative is worse. Perhaps none of the experiments worked because nothing could have worked. This would mean that nothing can stop the decline of Sears and Kmart. And maybe Lampert did consider selling off assets but couldn't get the price he wanted, even in good times. What then? Sears Holdings has little debt and lots of cash. It is still a $50 billion retailer. If anyone can figure out how to make money off this, it should be the best capital allocator of his generation, Edward S. Lampert. Maybe if he just tried one more test...

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