The Merger of Kmart & Sears

As the engineer of the $$11\mathrm{.}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\mathrm{.}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 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 $31,2004$

$($All numbers in thousands$)$

$\backslash$table$[[,$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 $31,2004$

$($All numbers in thousands$)$

$\backslash$table$[[,$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,$97,674,000,5,900,000,25,485,000,30,429,000],[,,,,]]$

What are paper gains? $(5$ points $)$

Why can't you use a simple average to estimate the cost of capital for KMart?