(The Wall Street Journal) — Sears Holdings may be struggling as a department-store operator, but it is proving an astute hedge fund under billionaire investor Edward S. Lampert.The retailer, controlled by Mr. Lampert, earned more than half its net income in the fiscal third quarter ended October 28 from investments in exotic derivatives designed to mirror the performance of company stocks.

Those investments helped triple net income, to $196 million, or $1.27 a share, despite weak sales at its Sears and Kmart stores.

In the year-earlier quarter, the company earned $58 million, or 35 cents a share.

Investors, counting on a turnaround on the retail floor, fled the stock, sending shares down more than 5.5 percent, or $9.89, to $169. 26 in Thursday trading on Nasdaq.

The drop in its shares, which have been up nearly 50 percent in the past 12 months, also came as the company cut back last quarter on share repurchases.

Sears Holdings shares are no less costly than those of its peers.

Analysts expect Sears to earn $10.39 in its next fiscal year, which ends January, 2008, and $11.41 in the following year.

That means the stock is trading at 16 times next year's estimated earnings and almost 15 times the following year's earnings.

By way of comparison, retailers such as J.C. Penney, Target and Federated Department Stores trade at 14 to 16 times next year's estimated earnings.

The company turned an investment in derivatives in other companies' shares into a $101 million after-tax profit during the quarter.

A spokesman for the Hoffman Estates, Illinois retailer declined to disclose the company or companies whose shares were represented by the derivatives.

In a statement, the company said the investments involve "substantial risks," adding that future results "may be positively or negatively materially affected based on the timing, magnitude and performance of these investments".

The financial derivatives used by Sears, known as "total-return swaps," are agreements that take on the big risks of highly leveraged investments in equities or other assets without actually buying them or assuming debt to purchase them, said David Krein, president of New York structured-investment adviser DTB Capital Group.

Total-return swaps also can boost the liquidity of an investment, carry tax benefits, and have the advantage of gains that can be recorded as profit on a balance sheet, whether realised or unrealised.

This isn't the first time Sears has used financial swaps. For the quarter ended July 2005, the retailer reported $60 million in proceeds from swaps it made around $600 million in variable-rate debt.

The third quarter's swaps, which had an aggregate notional amount of $387 million, weren't linked to a specific debt offering.

Sears has authorised Mr. Lampert, who plays an active role in overseeing the company's operations from his chairman's perch, to throw excess cash into investments that are unrelated to the retail operations, and Thursday's news is a sign that Sears is no longer merely a retail company, industry observers said.

Last August, after Sears Holdings' cash flow improved, Mr. Lampert told investors that he planned to consider nonretail "acquisitions, joint ventures and partnerships".

As his company's stock price has risen, Mr. Lampert has cut back on repurchases of Sears shares.

In the third quarter, Sears spent $289 million on repurchases, down from $413 million in the first quarter.

Goldman Sachs analyst Adrienne Shapira said the retailer's continued sales drops remain a concern, but that the derivatives trading gain is "another sign that this management team knows how to make money and is building a war chest for potential acquisitions".

There has been recent speculation that Sears might acquire companies as diverse as Anheuser-Busch, Home Depot and Radio Shack, whose chief executive formerly headed the Kmart stores.

The company said most products performed poorly at Sears and Kmart, and a $1.1 billion ramp-up in holiday inventory sapped its cash.

Revenue fell 1.5 percent to $11.94 billion from $12.12 billion.

Sales at stores open at least a year, a measure called same-store sales, fell three percent overall, with a 4.8 percent drop at Sears stores.

Sales of home fashions at Sears stores saw steep drops amid a weak housing market despite revamped furniture, kitchenware and bedding, as well as its sponsorship of ABC's hit home-improvement show, "Extreme Makeover".

Kmart's 0.7 percent same-store sales drop was spurred by declines in food and hard goods including electronics and toys.

Apparel sales were one of the few bright spots for Sears and Kmart, which for years have been plagued by dowdy fashions.

As of October 28, Sears Holdings had cash and cash equivalents of $2.1 billion, up from $1.2 billion a year earlier, but down sharply from the second quarter as it ramped up inventory.

Richard Hastings, an analyst at New York retail consultant Bernard Sands, said Sears looks at inventory "in a brutally realistic way".

The company slashes investments in poor-performing categories, rather than just ordering products to fill shelves, and that has helped boost gross margins, he said.