The Merger of Kmart & Sears As the engineer of the $11.5 billion planned purchase of Sears, Roebuck & Co. by Kmart Holding Corp., Edward Lampert is stepping out of the shadows of Wall Street to make a high‐profile bet that the fortunes of not just one but two retailing giants can be turned around. He keeps his strategy close to the vest, and his fortune is uncertain, though it was estimated at $2 billion ahead of the acquisition news. Mr. Lampert’s hedge‐fund firm, ESL Investments inc., which owns 43 million shares of Kmart, and 31 million shares of Sears, recorded paper gains of nearly $600 million in the wake of the takeover news. He knew that was a spectacular one‐day return given that market interest rates were 6%. Short‐sellers have been wary of Kmart ever since it emerged from bankruptcy in early May 2003. After Mr. Lampert bought up some $1 billion of Kmart’s distressed debt in 2002, he kicked off an aggressive restructuring campaign that included closing stores and selling off real estate to competitors. Investors were so enamored of his results that they helped to double Kmart’s stock price in the past 18 months from $58 per share to the current value of $120 per share. The SEC filing also included a new employment contract for Sears chief executive Alan Lacy, who is slated to be CEO and vice chairman of the combined company, Sears Holdings Corp. Under the employment pact, which runs for 5 years after the merger’s effective date, Lacy is entitled to a minimum base salary of $1.5 million a year and a target annual bonus of 150% of the base salary. An acquirer’s brand typically is the one that goes forward, but companies have been known to flout the rule based on whose brand is stronger in the marketplace. When Nations Bank bought the Bank of America, the merged company took the Bank of America name and re‐branded all the Nations Bank branches. Asked to comment on the Kmart / Sears deal, an analyst said “I don’t think the combined company will be a much more significant challenge to Wal‐Mart. Consumers think that when they want price they go to Wal‐Mart. When they want value – a little fashion – they go to Target.” After hearing this, Mr. Lampert began to wonder if he had made the correct decision. “I wonder,” he thought to himself, “would I have been better off buying Target instead?” Although it was too late, he began to look at the financials for Target to see if he would have been better off buying Target. 

Income Statements – January 31, 2004

Wal-Mart Kmart Sears Target Sales 258,681,000 23,253,000 41,124,000 48,163,000 Cost of Sales 198,747,000 17,846,000 26,231,000 31,790,000 Gross_Profit 59,934,000 5,407,000 14,893,000 16,373,000 Administrative_Expenses 44,909,000 4,998,000 9,111,000 11,534,000 EBIT 15,025,000 409,000 5,782,000 4,839,000 Interest 996,000 162,000 1,025,000 559,000 Taxes (@ 35 %) 4,910,150 86,450 1,664,950 1,498,000 Net Income 9,118,850 160,550 3,092,050 2,782,000 Balance Sheets as at January 31, 2004 Wal-Mart Kmart Sears Target Cash_and_cash_equivalents 5,199,000 2,088,000 9,057,000 816,000 Receivables 1,254,000 301,000 3,397,000 5,776,000 Inventory 26,612,000 3,238,000 5,335,000 5,373,000 Total_Current_Assets 33,065,000 5,627,000 17,789,000 11,965,000 Property,_Plant_&_Equip. 58,530,000 153,000 6,788,000 16,969,000 Other_Assets 6,079,000 120,000 908,000 1,495,000 Total_Assets 97,674,000 5,900,000 25,485,000 30,429,000 Accounts_Payable 31,051,000 1,772,000 7,582,000 7,448,000 Other_current_Liabilities 6,367,000 1,050,000 5,194,000 866,000 Total_current_liabilities 37,418,000 2,822,000 12,776,000 8,314,000 Long_term_Debt 20,099,000 2,297,000 4,718,000 10,217,000 Common_stock 431,000 208,000 823,000 96,000 Retained_Earnings 39,726,000 573,000 7,168,000 11,802,000 Total_Liabilities_&_Equity 97,674,000 5,900,000 25,485,000 30,429,000 

Questions you should consider in reviewing the case:

1. Which firm is most liquid? 

2. What is the return to shareholders?

3. What is the NPV of buying Sears? 

4. What is the PV of Mr. Lacy’s pay package? 

5. How could we find the greatest underperforming area for any of the firms? Please answer all questions and show work