Sears, Roebuck & Co

G5 Investment Group
Matt Nutsch Renis Kacani Melody Seely Ashley Green Wiley Eagle
.

G5 Investment Group

December 4, 2004 Retail Broadline

Buy
Stock Data
Price (52 weeks) Symbol/Exchange Beta Fully Diluted Shrs Average Daily Vol Current market cap Book Value / Share Current ratio $31.21 - $55.90 S / NYSE 1.3 230.4 million 5,028,000 shrs 10.82B $28.3 1.32

Valuation (per share)

Current Price Comparables DCF Analysis Residual Income DD Analysis Abnormal Earnings $34.78 $36.60 $36.94 $38.38 $27.97 $46.49

Summary Financials (in millions) for 2004

Revenue Earnings $36.6 billion $550 million

Executive Summary
Sears is following a differentiated approach in a competitive industry. Consequently, Sears has lagged behind other broadline retailers such as K-Mart, Target, and Wal-Mart. Should Sears adjust its marketing approach, it would have great potential for success. Growth prospects for Sears include continuation and growth of sales and expansion. The development of subsidiary brands such as Lands End and the acquiring of 61 of-mall stores from K-Mart and Wal-Mart. of new stores abroad will fuel this growth. Financing the acquisitions should not be overly burdensome for Sears, given the companys large cash. Also, the companys Z-Score of 5.9 will provide easy access to financing if needed Sears has began to shift to an off-mall emphasis for its stores as it acquired stores from K-Mart and Wal-Mart. It has named this process Sears Grand and it is progressing well for the company. This shift in emphasis will also sustain Sears growth. Sears performance is highly correlated to market factors. It is subject cycles in the industry as well as economic fluctuation in the system as a whole. Sears sales are highly seasonal and the company heavily depends on holiday season performance. Sears financial statements are reasonably transparent and more or less free from error. They report information on a quarterly basis. Sears fiscal year ends on December 31st. As a publicly held corporation they publish 10Q quarterly statements and 10K annual statements are in accordance with SEC regulations. We have analyzed Sears using three categories of ratios: liquidity, profitability, and capital structure. In the liquidity section we calculated the current ratio, quick asset ratio, receivables turnover, inventory turnover, and working capital. In the profitability section we calculated gross profit margin, operating expense ratio, net profit margin, asset turnover ratio, return on assets, and return on equity. In the capital structure section we calculated debt to equity ratio, times interest earned, and debt service margin.

We valuated the company based upon five valuation models. Those models were the Method of Comparables approach, the Residual Income Method, the Discounted Dividends Model, the Free Cash Flows Model, and the Abnormal Earnings Growth. Based upon all of these valuation methods except the Discounted Dividends Model, we have determined that the company is undervalued. Thus we recommend Sears as a buy as current price is undervalued to our predictions based on the valuation methods. These valuations methods were performed using data from November 1st of 2004. On November 17th K-Mart, one Sears main competitors, announced that it is going to buy Sears Roebuck & Co. for $11 billion. Immediately prior to this announcement, Sears stock was selling for $45.20 per share. The day of the merger, Sears stock jumped $7.79 per share. We estimate that K-Mart believes that it can justify this additional $7.79 per share due to synergies from the merging of the two companies. In this evaluation we learned that Sears uses a differentiated strategy. We also learned that the industry that Sears operates in is more competitive than differentiated. This could explain why Sears has not been performing extremely well in recent years. After the merger we can expect to see a more competitive K-Mart strategy integrated into the traditional Sears, differentiated strategy. We can also expect that many previously closed, freestanding K-Mart stores reopened as Sears, as the new company plans to shift its focus away from the mall model.

Business and Industry Analysis

Business Analysis
Sears Roebuck & Co., founded by R. W. Sears in 1886, is a multi-line retailer that offers a variety of merchandise and related services. It operates primarily in the United States, Puerto Rico, and Canada. Sears, Roebuck, & Co. is ranked fifth in

the retail market, behind: Wal-mart Stores Inc., Target Corp., Kohls Corp, and JC Penney Company Inc. In 2003, the company was divided into three domestic segments: Retail and Related Services, Credit and Financial Products, and Corporate and Other. In addition the company has one international segment, Sears Canada. The Retail and Related Services segment focuses principally on merchandise sales and supporting activities, such as: service contracts, product installation, and product repair. The Credit and Financial Products segment manages the domestic portfolio of MasterCard and Sears Card receivables. This segment was sold in November of 2003. The Corporate and Other Segment includes the operations of Sears Home Improvement Services. Sears Canada includes its own retail, credit and corporate operations. Sears competitors have similarly segmented company structures (http://finance.yahoo.com, 2004). Sears operates both specialty and full-line stores. Its customer operations include major sales from online and catalog marketing. Sears 871 full-line stores offer a wide range of products for the home. These include appliances, clothing, jewelry, automotive supplies, power tools, and garden equipment. Sears.com is Sears implementation of internet marketing and offers a limited assortment of home and accessories merchandise. In addition to its full-line stores, Sears operates 1,100 specialty stores, 792 primarily independently owned stores, 245 Sears Hardware Stores, 8 furniture stores, 18 The Great Indoors stores, 45 Sears Outlet Stores, and a commercial sales division (http://finance.yahoo.com, 2004).

Five Factor Model

Rivalry Among Existing Firms
Sears Roebuck and Co. is in an industry that is growing fast in our nation today. The retail industry is an industry that people will turn to time and time again, and with Sears becoming more diverse with their products and services it has helped them grow in this ever growing industry. Their concentration is based on service to the customer. Sears is the largest product service provider, with 14

million service calls made annually (http://www.marketresearch.com, 2004). Along with being a high service provider Sears also keeps it products versatile by offering differentiation with their product line. Sears Roebuck and Co. is a leading U.S. retailer in apparel, automotive, home products, and service. As well as offering a wide range of products, they are also able to compete on the fact that they are a low-pricing retailer. Although, there are existing competitors in this same industry, they are doing a great job differentiating their company, which is helping them to continue growing in this industry.

Threats of New Entrants

As mentioned in the previous section Sears is doing a great job to continue its growth in this industry. As we look at economies of scale we see that in this industry they are large. The threat of new entry in the retail industry of this magnitude is very low. New entrants would have a hard time breaking into the industry, because of the time and money needed. A competitor would have to invest a large portion of money and time and then still it would take a lot of growing and expanding to ever be a strong competitor to Sears. Here we see that Sears has the first mover advantage, which has enabled them to be stronger by already having things like good relationships within their distribution channels, which might be hard for new entrants. Although, there arent many legal barriers to stop new entrants it would still be very hard for one to jump into the industry and be competitive with a large corporation like Sears.

Threat of Substitute Products

Within the Sears retailing store there are products that could be in threat of substitution. The retail industry always has the threat of substitute products. For example, there are many producers for all kinds of apparel and home products. The one thing that Sears does to keep their customers willingness to switch down is providing the lowest possible price and giving the greatest service available. Sears again uses their customer service to deter customers from switching over to a competitors product. Even though, there is an existing threat there, Sears tries to do everything possible to avoid it. 5

Bargaining Power of Buyers

In this company this could go both ways, for instance like the apparel and small home products would be more price sensitive, but things like in the automotive section could become more costly because of higher switching cost. Although, things could be a little different in terms of bargaining power from product to product, Sears still has an inside hand with relative bargaining power. They have been working with their suppliers so long that they have developed strong relationship that help them lower their prices by increasing their buying volume, which in turn lets them buy for less.

Bargaining Power of Suppliers

On the suppliers side things would be about the same, because of the many different products they sell it could be a little different from supplier to supplier. Then again Sears has been working with its suppliers so long that it has gained barging power over them to allow them to insure low prices when it comes to their supplies.

Conclusion
Sears Industry is differentiated. This is evident due to many factors. First, it offers a wide range of products, is a low-price retailer, and provides a huge magnitude of services. These differentiate Sears from other low cost retailers. Second, Sears is a company of gigantic proportions and the barriers to entry into its business are immense. Third, Sears uses great customer service to deter customers from switching to competitors products, this focus on customer service acts to mitigate the effects of substitute products. Fourth, the company has forged strong ties with its suppliers, giving Sears a competitive advantage. Finally, Sears has developed a robust and loyal customer base, thus giving it power as their supplier of consumer goods.

Competitive Advantage Analysis

Based upon its key success factors we can conclude that Sears competitive advantage is centered on its ability to differentiate itself from its competitors. To achieve this end, the company has incorporated the following success factors into its competitive strategy:
Investment

in Brand Image. Sears, Roebuck, & Co. has a rich, long history

that dates back more than a century to when R. W. Sears sold his first batch of watches. Since its founding in 1886, Sears has endeavored to foster a brand image of strength, reliability, and good customer service (http://www.searsarchives.com, 2004). This image persists today not only in connection with the stores retail chain, but also in many of the companys subsidiaries.
Superior

Customer Service. Sears has repeatedly been the source of

innovation and has focused on customer service as a core competency. It has continually sought to differentiate itself from its competitors through customeroriented practices. Such practices range from designing its stores around merchandise placement to staffing the most experienced associates during the peak hours of evenings and weekends, thereby allowing it to turn superior customer service into a competitive advantage (http://www.searsarchives.com, 2004).
Superior

Product Quality. Sears has expanded and integrated vertically by

establishing its own suppliers. In doing so it has afforded itself not only the opportunity to provide a higher quality of products, but also greater control over the merchandise that it sells. Brands owned by Sears include Diehard, Craftsman, Kenmore, and Lands End. Sears also implements 1,100 specialty stores that are dedicated to serving the specific needs of their customers (http://finance.yahoo.com, 2004).

More Flexible Delivery. Sears enhanced focus on internet sales represents a

traditional shift away from its historically famous catalog series. Internet sales

have grown and offer customers the opportunity to pick their products up at a store location or have their purchases delivered to their doorstep. As a result of these key success factors, Sears, Roebuck, & Co has managed to persevere for more than a century. These translate into advantages that when paired with devout customer loyalty, have allowed Sears to grow, develop a firm customer base, and force out smaller competitors. While Sears tradition and long history have been boons when it comes to maintaining customer loyalty, the companys rigidity and unwillingness to change have allowed low cost multi-line retailers, such as Wal-Mart and Target, to capture a significant share of the market. Slowly these low cost retailers are forcing Sears out of the Department & Discount Retail industry into the peripheral Specialty Retailing and Catalog/Online Retailing industries (http://www.marketresearch.com, 2004).

SWOT Analysis
Sears Roebuck and Co. held the #1 position among retailers for 40 years (Prentice-Hall 2003). The company is organized into four major segments: retail and related services; credit and financial products; corporate and other and Sears Canada (Multex Investor, 2003). In June 2002, Sears acquired Lands' End, Inc, a company specializing in traditionally-styled casual clothing for the entire family, footwear, accessories, soft luggage and home products (Multex Investor, 2003). This acquisition seems to be a win-win deal. Lands' End became a wholly owned subsidiary of Sears and will gain an even larger direct sales customer database while Sears will gain a brand that is known for quality and service. Lands' End has traditionally sold its products through a flagship and specialty catalogs and it has gained a wide presence on the Web (Hoover's, 2002). Besides gaining a respected brand, Sears also gains the direct marketing expertise and experience a company that has a reputation of being one of the most efficiently run direct marketers in the world (Scheraga, 2002). All of Sears direct marketing efforts are now handled by Lands' End (Scheraga, 2002).

Internal and external environment scans can begin with a SWOT analysis. (SWOT - Internal Strengths and Weaknesses; External Opportunities and Threats).

Internal Strengths:
The marriage of Sears and Lands' End gives Sears a much-needed boost in expertise in the arena of direct marketing and sales and also of gaining a strong presence on the Internet (Halligan, 2002). This merger has strengthened Sears key success factors of superior product quality and more flexible delivery. This marriage also gives Lands' End face-to-face consumer exposure wherein consumers can try on the clothes in their Sears store before buying (Scheraga, 2002). Sears now has several known brand goods, e.g., Craftsman, Lands' End, Kenmore and all of their merchandise that carries their own brands, such as Lands' End Oxford Express brand of shirts (Halligan, 2002). Sears has an extensive customer database (Prentice-Hall, 2003). This is due to the companys key success factor of superior customer service.

Internal Weaknesses:
Sears has allowed their reputation and sales volume to plummet because they did not keep up with the changing market environment. Too much diversification within the company; the focus was moved away from retail services to providing all sorts of other services, such as investment and banking (Prentice-Hall, 2003). Many of the retail stores are in disrepair and not reflective of the needs of today's consumer (Prentice-Hall, 2003). Operating expenses are higher than competitors (Prentice-Hall, 2003).

Opportunities:
The acquisition of Lands' End represents an enormous opportunity to the Sears Corporation. It is a brand that has a repatriation of quality and service. Halligan (2002) advises Sears' executives to find the 'silver bullet brands in the brands offered by Lands' End and to capitalize on these to increase revenues. 9

Some possibilities are the Lands' End Custom and Lands End Swim Finder. They should also capitalize in Lands' End Guaranteed Period service (Halligan, 2002). The reputation of the Lands End brand contributes to Sears brand name, thus bolstering its key success factor: investment in brand image.

External Threats:
The retail industry is highly competitive with both old names, like Wal-Mart and K-Mart taking the lead above Sears and with new companies opening both on the Internet and in physical buildings (Prentice-Hall, 2003). Departments, like women's apparel are constantly under siege from other stores who capitalize on the notion of quality clothing and sales, such as Liz Claiborne (Prentice-Hall, 2003). More and more discount stores are opening, further driving sales in certain departments at Sears lower, such as all apparel departments (Prentice-Hall, 2003). There are two levels in the external environment: the macro-environment, which incorporates all of the major sectors, such as political aspects, sociopolitical aspects, technological aspects, socio-cultural aspects and economical aspects, and the micro-environment, which includes all the stakeholders relative to a specific organization to include shareholders, partners, financial institutions, regulators, customers and competitors. The major issue at this writing is the economic condition of the country. We are in an economic downturn, still. This means the company must take steps to reduce costs but increase revenue. There are no political issues that would have a dramatic impact at this time. Social values, however, have changed. Consumers are looking for convenience and value-added products and services. Lands' End Guarantee Period is a value-added service and should be emphasized. In fact, Sears could initiate the very same guarantee; it offers this on Craftsman tools but not for any other product. Technology continues to change and Sears has made good use of it, often spending more on technology

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than competitors. New laws and regulations are always a possibility. The company must simply deal with them as they emerge.

Accounting Analysis
I. Identify Key Accounting Policies
Sears and Roebuck is a very broad company that has the opportunity to be very versatile when it comes to accounting choices. It is a full line retail store that consists of appliances, electronics, home improvement and home fashions. This broad base includes apparel and accessories, Sears Auto Centers, and online sales from Sears.com. A couple activities that need to be taken into account are activities that overall hold the companies nature are, one that consists of administrative activities, the costs of which are not allocated to the companys business. The other is the home improvement services (primarily siding and windows through Sears Home Improvement Services. (http://biz.yahoo.com, 2004) In the retail industry the management of inventory is a key success factor. This is something that Sears has over the years learned to estimate very well, which has allowed it to turn over increasing numbers. Total Revenues for the 13 and 39 weeks ended September 27, 2003 were 9.8 billon and 28.9 billion compared to the previous year that was at 9.7 billion and 28.8 billion. (http://biz.yahoo.com, 2004) Within the accounting practices of inventory and also revenues and expenses, there are not a lot of ways that Sears can manipulate the numbers; everything is pretty much straight forward within there accounting procedures. Now on the flip side there are some ways that Sears is able to estimate numbers, which makes them able to manage the numbers to look better. For one example, selling and administrative expenses as a percentage of total revenue were 22.8% for 13 week ending period September 27, 2003, compared to 24.2% the prior period. There is a certain amount of expense that cannot be avoided from administrative activities but there are some like their marketing research, which they include in administrative expenses. In

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2003, selling and administrative expenses for Sears totaled $9,111,000,000. Another way that Sears is able to adjust numbers the numbers for good or bad is the allowance for uncollectible accounts, these estimates can effect the company for the good or the bad depending if they are underestimates or overestimated. Sears allowance for uncollectible accounts in 2003 was $1,747,000,000. Overall Sears does and good job in their accounting procedures. Hypothetically, there are ways that they are able to manipulate numbers. However, the companys financial statements do a good job giving accurate information that represents the truth about Sears and Roebuck. It does this by providing timely and relevant accounting numbers to current and potential shareholders.

II. Assess the Degree of Potential Accounting Flexibility

As previously discussed, there are ways that Sears and Roebuck are able to be flexible with their accounting numbers. Generally speaking, business inventory cannot be manipulated, it is just what it is, but there are other ways to be flexible. For example, during 2002, the company adopted Statement of Financial Accounting Standards (SFAS) No. 142 Goodwill and Other Intangible Assets. (http://biz.yahoo.com, 2004) That change caused a $208,000,000 loss on Sears income statement. This is a way that Sears can be flexible with their estimates of numbers, because in reality goodwill cant be measured. Another way that the accounting numbers could be distorted is by deferring the amount paid to pensions. These are evidence that Sears can be flexible in some areas of accounting yet inflexible in others.

III. Evaluate Actual Accounting Strategy

Sears Roebucks critical estimates of the companys significant accounting policies are the following:

Inventory valuation
Approximately 88% of merchandise inventories are valued at the lower of cost or market, with cost determined using the retail inventory method (Rim) under the LIFO cost flow assumption (Sears 10K Filing, 2004). Management judgment

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and estimates for the calculation of RIM include merchandise markon, markups, markdowns, shrinkage, and vendor allowances. These judgments and estimates have an impact not only on the ending inventory but also on gross margins.

Self-insurance reserves
The Company uses a combination of third-party insurance and/or self-insurance for a number of risks including workers compensation, automobile, product and general liability claims (Sears 10K Filing, 2004). The companys liability reflected on the consolidated balance sheet represents an estimate of the ultimate cost of uninsured claims incurred as of the 2003 10K balance sheet date (Sears 10K Filing, 2004).

Defined benefit retirement plans

The fundamental components of accounting of accounting for defined benefit retirement plans consist of the compensation cost of the benefits earned, the interest cost from deferring payment of those benefits in to the future and the results of investing any assets set aside to fund the obligation (Sears 10K Filing, 2004). These retirement benefits are earned by Sears associates over the time of their work at Sears. As a result the amounts reported in the Income Statement for these retirement plans have historically followed the same pattern. This systematic and gradual recognition of changes has been accomplished by amortizing experience gains/losses in excess of the 10% corridor into expense over the associate service period and by recognizing the difference between actual and expected asset returns over a five year period (Sears 10K Filing, 2003)

Allowance for uncollectible accounts

Sears records an allowance for uncollectible accounts to reflect managements best estimate of losses in the account of credit card receivables. This allowance is established through a charge to the provision for uncollectible accounts and represents amounts of current and past due credit card receivable balances that management estimates will not be collected (Sears 10K Filing, 2003). The company calculates the allowance for uncollectible accounts using a model that 13

considers the current condition of the portfolio and factors such as bankruptcy filings, historical charge off patterns and other portfolio data (Sears 10K Filing, 2003). The management reviews these calculation to decide if additional analysis are required, based on economic events. In 2003 Sears earmarked $1,747,000,000 for uncollectible accounts (Sears 10K Filing, 2003).

Valuation of long-lived assets

Sears Roebuck evaluates the carrying value of long-lived assets whenever events or changes in circumstances indicate that a potential has occurred (Sears 10K Filing, 2003). When a potential impairment has occurred, an impairment writedown is recorded if the carrying value of the long lived asset exceeds its fair value. Fair value is measured based on a projected discounted cash flow model using a discount rate the company feels is commensurate with the risk inherent in the companys business (Sears 10K Filing, 2003).

Income taxes
The company provides deferred income tax assets and liabilities based on the estimated future tax effects of differences between the financial and tax bases of assets and liabilities based on currently enacted tax laws (Sears 10K Filing, 2003). The tax balances and income tax expense recognized by the company are based on managements interpretation of the tax laws of multiple jurisdictions (Sears 10K Filing, 2003). Income tax expense also reflects Sears best estimates and assumptions regarding the level of future taxable income, interpretation of the tax laws, and tax planning. Comments on Sears Accounting Strategy: Sears accounting policies are similar to the norms in the retail industry. The only major difference between Sears accounting policies and other firms in the retail industry is the treatment of Allowance for uncollectible accounts. This is because not all the firms in retail industry have issued their own credit cards. However, similarities for the treatment of Allowance for uncollectible accounts exist between Sears, Wal-Mart, Target and JC-Penney. The reason for these similarities is that while not all of these retailers offer financing on their products 14

via store credit cards, they do provide financing from external companies. Sears Roebucks managements estimates of the financial statements have in the past reflected and do reflect its best judgment based on the consideration of available facts and circumstances. The company has tried to maintain its accounting policies and keep its estimates realistic and similar to the norms of the retail industry. However, these policies and estimates have required and may require adjustment as additional facts have become known or as circumstances change. For example, past and future changes in tax laws, changes in projected levels of taxable income, and tax planning could affect the tax rate and tax balances recorded by the company. Sears has changed some of its accounting policies. The company changed its method of accounting for goodwill in 2002 and its methods of accounting for credit card securitizations, derivative instruments and hedging activities in 2001. (These changes were required by new accounting standards.) Under the provisions of SFAS No. 142, Goodwill and Other Intangible Assets, goodwill is no longer amortized. This change showed as a negative $208,000,000 on the 2002 balance sheet (Sears 10K Filing, 2003). Prior to the start of 2002, the company followed the provisions of Accounting Principles Board Opinion (APB) No. 17, which required that goodwill be amortized by systematic charges to income over the period expected to be benefited (Sears 10K Filing, 2003). That period ranged from 5 to years. In addition, on March 31, 2001, Sears adopted the requirements of Statement of Financial Accounting Standards (SFAS) No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which superseded SFAS No.125. (Sears 10K Filing, 2003). Under SFAS No. 125, the companys securitization transactions were accounted for as sales of receivables, and SFAS No. 140 established new conditions for a securitization to be accounted for as a sale of receivables. Moreover, in the first quarter of 2001, sears adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The adoption of this new accounting standard did not affect Sears net income. In 2001, the cumulative 15

effect of the change in accounting principle reduced other comprehensive income by 262 million dollars. This included the reclassification of other comprehensive income of a 228 million dollars deferred loss on an interest rate swap that was terminated in 1997 and the recognition in other comprehensive income of 34 million dollars related to a cash flow hedge (Sears 10K Filing, 2003). Also, sears plans to change its method of accounting for its domestic defined benefit (explained above) plans to immediately recognize any experience gains or loss in excess of the 10% corridor and to value plan assets at fair value. This method of accounting in contrast with the above accounting methods is not required to be changed by any new accounting standard. The reason for change is because the company believes that the new method is preferable in regard to changes made to its domestic benefit plans to discontinue providing pension and retiree medical benefits to associates under the age of 40 as the new policy accelerates recognition of events which have already occurred. (Sears 10K Filing, 2003). But under this new accounting method, Sears pension expense in future periods may be more volatile as this method accelerates recognition of actual experience.

IV. Evaluation of the Quality of Disclosure

Sears Roebuck & Co. discloses sufficient information for the public through their 10-K and 10-Q reports. These disclosures are present in the footnotes of the financial statements, and they give light on certain policies that might have been misunderstood. In their most recent 10-K filing on January 3, 2004, they disclose a special category of information in the body of their financial statements concerning market risk affecting their company. They show that their primary market risk is interest rate risk that mainly stems from their amount of variable rate debt. They went from variable rate funding of $24.2 billion in 2002 to $4.3 billion in 2003. This dramatic decrease in variable rate debt is explained through the sale of the companys credit and financial products business to Citicorp in November

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of 2003. Even though this might decrease the amount of variable rate risk, Sears still felt it necessary to pass this information along in hopes of making their company more attractive to investors. Sears also discloses information about their accounting policies and procedures to the public. The SEC deems it necessary to disclose significant accounting policies. They explain the sale of their credit and financial products business as mentioned above. They also give explanations as to how the fiscal year is realized. Sears has a different way of figuring the fiscal year by ending the fiscal year as the Saturday nearest to December 31. Also disclosed are estimates for the year including inventory valuation, allowance for bad debt, depreciation, etc. Sears explains in detail the borrowing practices. They disclose the interest rates and maturities of their long-term debt securities listed and separated by their own companies. This disclosure helps with the transparency of the companys liability section on their balance sheet. Their total liabilities decreased significantly from $43,656 in 2002 to $21,322 in 2003. This decrease is shown through the amount of long-term debt and capitalized lease obligations, which is stated as $4,218 in 2003 from 2002 being $21,304. From the sale of the business previously mentioned they were able to decrease their amount of longterm debt. Another key disclosure seen in the notes section on the 10-K is earning per share ratio:
(Millions, except per share data) Net Income (1) Average Common Shares Outstanding Dilutive Effect of Stock Options Total Average Common Shares Outstanding Earnings per Share: Basic Diluted $11.95 $11.86 $4.34 $4.29 $2.25 $2.24 286.3 320.7 328.5 2003 $3,397 284.3 2 2002 $1,376 317.4 3.3 2001 $735

326.4
2.1

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The disclosure of the earnings per share ratio sheds light as to why the ratio for this year is almost three times as it was the year before. With an increase of $3,000 in Treasury Stock in 2003, this leads us to conclude that the buyback of the common stock led to the decrease in shares outstanding from 320.7 in 2002 to 286.3 in 2003. In the year of 2003 there was an increase in Net Income due to the gain on sale of the credit and financing business. With the increase in Net Income and the decrease of shares out standing, this ratio is then justified with the significant increase. Overall Sears Roebuck & Co. discloses information very well. Not only do they show the calculation they made and the numbers that got them there, but they also explain in words what is going on within their company and try to allow investors to make educated opinions about their company.

V. Identifying Potential Red Flags

At Sears Roebuck & Co. the identification of potential red flags is important in keeping a high standard of accounting quality. Sears identifies these red flags in hopes of reducing or eliminating all accounting errors that would lead to incorrect financial statements. When Sears looks for theses red flags there are certain indicators that show where our accounting analysis may need to be checked. Asset Write-offs is one of these red flag indicators. Sears is very varied in the types of products it sells, such as: Clothing, jewelry, appliances, automotive supplies, and many more. Because of the amounts of inventory held by Sears is rather large this variance is also. Since Sears is mainly retail, the type of assets that could be written-off would be inventory. If Sears has a large inventory of clothing or jewelry that are out of style they should not be written off to enhance the financial statements. If this is seen the statements will be checked and Sears Roebuck & Co. will make sure the assets written-off were done legitimately.

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Another red flag is many fourth quarter adjustments. Sears Roebuck & Co. should not have a large number of 4th quarter adjustments to increase the value of there company to its customers and investors. This red flag can be found by looking at quarterly statements and making sure that Sears did not fix the numbers on there statements in the 4th Quarter to make there year-end totals look better than they should. The types of adjustments that should be looked for are large number changes in current and non-current assets or liabilities on the balance sheet. The adjusting of these numbers in the last quarter is a key red flag, and this ensures the quality of Sears accounting. A third red flag is called a related party transaction. Transactions of this type are when another company or a branch of Sears purchase or sell in large amounts, and in doing this, gets rid of unwanted or outdated products or services. In doing these transactions it allows Sears to rid themselves of items not wanted on there statements, once again enhancing their statements. These are some potential red flags of Sears Roebuck & Co. The identification of these red flags is necessary to maintain a high quality of accounting to the public. The high quality of Sears accounting keeps there name out of the public eye for the wrong reasons. Sears has been around for over a century, but with new accounting rules and changes in standards, it still must maintain the correct principles and the high standard it is held to.

VI. Undo Accounting Distortions

Asset Write-offs
In Sears July 2004 10-Q report, there is a significant anomaly in its allowance for uncollectible accounts. On June 28, 2003 the allowance for uncollectible accounts was $1,953 (in millions). However on July 3, 2004 this number has plummeted to $31. This may show that Sears is sugar coating its uncollectible accounts. Management appears to be overly optimistic on how much accounts receivable that it can collect upon. To undo this distortion, management should

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either give a more realistic number or explain in the notes why this number has changed so greatly (Sears 10Q Filing, 2003-09). To adjust for this anomaly we have taken the average of the two allowances for uncollectible accounts and inserted it, $992 into the balance sheet. This has reduced the total current assets to $17,235,000,000, which in turn reduced total assets to $26,762,000,000. Retained earnings were reduced to $10,675,000,000 and total shareholders equity became $5,440,000,000.

Fourth Quarter Adjustments

In the fourth quarterly report of 2003, Sears announces a refinement of the business strategy for The Great Indoors line of stores. This refinement includes a $99 million impairments charge including a $60 million write-down of property and equipment to be held and used as well as a $39 million write-down of property and equipment to fair value. The timing of this announcement raises questions about the credibility of Sears financial reporting. While this distortion cannot be undone, Sears needs to take a more proactive approach to informing the shareholders of financial changes (Sears 10Q Filing 2003-09).

Related party transactions

Sears reorganized in 2004. Prior to this reorganization, Sears consisted of the following segments: Retail and Related Services, Credit and Financial Products and Corporate and Other; and one international segment: Sears Canada. During this reorganization the Credit and Financial Products segment was separated from Sears, Roebuck, and Co. This sale may have been intended to hide losses by the Credit and Financial Products segment. Correcting this distortion would require calculating data from the Credit segment into the Sears, Roebuck, and Co. reports. Financial information from the Credit segment is no longer publicly available due to its sale and cannot be factored into our analysis. The only adjustments made were on the balance sheet. (See Table 1)

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Preliminary Ratio Analysis (Screening Ratios)

2003

Sales Manipulation Diagnostics

Net Sales/Cash from sales Net Sales/Net Accounts Receivable Net Sales/Unearned Revenues Net Sales/Inventory 12.11 3.22 33.06 7.71

Core Expense Manipulation Diagnostics

Declining Asset Turnover (sales/assets) Changes in CFFO/OI Changes in CFFO/NOA 1.48 2.53 2.53

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Exhibit 1
SEARS ROEBUCK & CO 10-K 2004-01-03: Original Adjusted

Balance Sheet
2003/01/03 ASSETS Current assets Cash and cash equivalents Credit card receivables Less allowance for uncollectible accounts Net credit card receivables Other receivables Merchandise inventories, net Prepaid expenses and deferred charges Deferred income taxes Total current assets Property and equipment Land Buildings and improvements Furniture, fixtures and equipment Capitalized leases Gross property and equipment Less accumulated depreciation Total property and equipment, net Deferred income taxes Goodwill Tradenames and other intangible assets Other assets TOTAL ASSETS LIABILITIES Current liabilities Short-term borrowings Current portion of long-term debt and capitalized lease obligations Merchandise payables Income taxes payable Other liabilities Unearned revenues Other taxes Total current liabilities Long-term debt and capitalized lease obligations Pension and postretirement benefits Minority interest and other liabilities $1,956,000,000 $1,389,000,000 $1,956,000,000 $1,389,000,000 $3,106,000,000 $1,867,000,000 $2,950,000,000 $1,244,000,000 $609,000,000 $13,759,000,000 $4,218,000,000 $3,106,000,000 $1,867,000,000 $2,950,000,000 $1,244,000,000 $609,000,000 $13,759,000,000 $4,218,000,000 $1,033,000,000 $2,950,000,000 $1,033,000,000 $2,950,000,000 $392,000,000 $7,151,000,000 $4,972,000,000 $609,000,000 $13,124,000,000 $6,336,000,000 $6,788,000,000 $378,000,000 $943,000,000 $710,000,000 $708,000,000 $27,723,000,000 $392,000,000 $7,151,000,000 $4,972,000,000 $609,000,000 $13,124,000,000 $6,336,000,000 $6,788,000,000 $378,000,000 $943,000,000 $710,000,000 $708,000,000 $26,762,000,000 $9,057,000,000 $1,998,000,000 $31,000,000 $1,956,000,000 $733,000,000 $5,335,000,000 $407,000,000 $708,000,000 $18,196,000,000 $9,057,000,000 $1,998,000,000 $992,000,000 $1,956,000,000 $733,000,000 $5,335,000,000 $407,000,000 $708,000,000 $17,235,000,000 2003/01/03

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Total Liabilities COMMITMENTS AND CONTINGENT LIABILITIES SHAREHOLDERS EQUITY Common shares issued ($.75 par value per share, 1,000 shares authorized, 230.4 and 316.7 shares outstanding, respectively) Capital in excess of par value Retained earnings Treasury stock - at cost Deferred ESOP expense Accumulated other comprehensive loss Total Shareholders Equity TOTAL LIABILITIES AND SHAREHOLDERS EQUITY

$21,322,000,000

$21,322,000,000

$323,000,000

$323,000,000

$3,519,000,000 $11,636,000,000 ($7,945,000,000) ($26,000,000) ($1,106,000,000) $6,401,000,000 $27,723,000,000

$3,519,000,000 $10,675,000,000 ($7,945,000,000) ($26,000,000) ($1,106,000,000) $5,440,000,000 $26,762,000,000

Ratio Analysis & Forecasting Financials

In the performance of the Financial Forecasting and also a look at the companies standing through the ratio analysis we come to learn a lot about the company. We will do analysis of Sears profitability, liquidity and capital structure ratios. At the same time we will compare these ratios with those of the companys competitors, and also we will compare Sears ratios with retail industrys ratios. These comparisons will help us see where Sears stands in the retail industry as far as profitability and liquidity. In most peoples eyes they would see Sears to be one to the leading companies in the retail industry. Now, what we found through this process is that even though Sears seems to look good through the cash flow area, we have to take a look at the fact that they have so much in credit card sales.

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Sears & Roebucks Ratio Analysis

Level I Ratios
Liquidity Ratios
12/31/03 12/31/02 12/31/01 12/31/00 12/31/99

Current Ratio (T) Quick Asset Ratio (T) Receivables Turnover (T) Inventory Turnover (T) Working Capital T/O (T)

1.32 0.85 2.43 5.01 9.88

2.15 1.81 1.39 5.12 5

2.32 1.92 1.67 5.06 4.8

1.95 1.48 1.95 5.1 4.97

2.09 1.63 1.88 5.58 5.14

Profitability Ratios

12/31/03 12/31/02 12/31/01 12/31/00 12/31/99

Gross Profit Margin (%) Operating Expense Ratio(%) Net Profit Margin (%) Asset Turnover (T) Return on Assets (%) Return on Equity (%)

34.07 26.9 8.26 1.5 8.2 57.36

35.89 27 3.33 0.83 4.85 21.36

33.82 24.9 1.79 0.94 4.54 11.49

32.31 23.27 3.28 1.11 5.92 19.74

31.68 22.6 3.54 1.12 6.17 22.61

Capital Structure Ratios

Debt to Equity Ratio (T) Times Interest Earned(T) Debt Service Margin (T)

12/31/03 12/31/02 12/31/01 12/31/00 12/31/99

3.33 5.32 0.52

6.46 2.15 N/A

6.24 0.86 1.34

4.45 1.78 N/A

4.4 1.9 2.38

Level II Ratios
12/31/03 12/31/02 12/31/01 12/31/00 12/31/99 Dividend Payout Ratio (%) SGR (%)

9.63 51.83

21.29 16.81

41.09 6.77

23.98 15

24.43 17

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Analysis of Sears Ratios:

Level I Sears current ratio has been decreasing since 2001. The only time it increased was from 2000 to 2001. The decline of the current ratio has a negative impact on the company. It shows that in 2003 Sears current assets covered its current liabilities by 1.32 times compared to 2.15 times in 2002 and 2.32 times in 2003. Sears quick ratio has also dropped from 2001 to 2003. This ratio shows that in 2003 Sears cash and other current assets one step removed from cash that is, marketable securities and accounts receivable - are equal to 85% of the current liabilities. Sears inventory turnover has been going up and down from 1999 to 2003. It decreased from 5.12 in 2002 to 5.01 in 2003, and this decline indicates that Sears in 2003 had a larger investment in inventory relative to the sales being generated than in 2002. This decline in inventory turnover caused Sears days to inventory to increase from 70.38 in 2002 to 71.79 in 2003. This is a negative impact on sears because in 2003 it took the company 71.79 days to sell its entire inventory compared to 70.38 days in 2002. Sears days to receivables increased from 2000 to 2002, and then decreased sharply from 2002 to 2003. This sharp decrease has a positive impact on the company. It means that in 2003 took Sears 150 days to collect its money compared to 263 days in 2002. This large decline in days to receivables was due to the sale of the companys domestic credit segment where most of Sears receivables and uncollected receivables came from. Sears working capital turnover increased from 4.8 in 2001 to 5.0 in 2002 and to 9.88 in 2003. This increase has a negative impact on the company. Sears gross profit margin increased from 1999 to 2002 which is a good indicator for the company. However, gross profit margin dropped from 35.89% in 2002 to 34.07% in 2003 (negative impact). This percentage decline in 2003 shows that Sears pricing policies and/or its production methods were not as effective as the previous years. Sears net profit margin sharply increased from

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3.33 in 2002 to 8.26% in 2003, and this is a very good indicator for the company. This shows that in 2003 Sears earned 4.93% more on each dollar of sales than in 2002. In other words, in 2003, 8.26 cents of every sales dollar was retained as profit, whereas only 3.33 cents of every sales dollar was retained as profit in 2002. Sears asset turnover increased from 2002 to 2003 {positive impact} after a decrease each year from 1999 to 2002 (negative impact). This increase in asset turnover shows that each dollar of assets produced 1.5 dollars of sales in 2003 compared to 83 cents in 2002. Sears return on assets has been increasing since 2001. It sharply increased from 4.85% in 2002 to 8.2% in 2003 (positive impact). This increase of return on assets ratio has been due to Sears high profit margins, and is also attributable to the improvement in asset turnover. The increase in net profit margin and asset turnover have caused Sears return on equity to increase, which is positive factor, from 11.49% in 2001 to 21.36% in 2002 and to 57.36% in 2003 Sears experienced a big decline in debt-to-equity in 2003 from 2002, which is a very good indicator for the company. It dropped from 6.46 in 2002 to 3.33 in 2003.The debt-to-equity ratio for 2003 indicates that the firm has 3.33 dollars of liabilities for every 1.00 dollar of owners equity, compared to 6.46 dollars of liabilities for every 1.00 dollar in 2002. This decrease indicates that debt has become a smaller proportion of total financing. The increase in times interest earned ratio from 0.86 in 2001 to 2.15 in 2002 and to 5.32 in 2003 indicates that Sears income from operations is more adequate to cover required interest charges. It jumped from 2.15 times in 2002 to 5.32 times in 2003. Level II Sears dividend payout ratio decreased from 41.09% in 2001 to 21.29% in 2002 and finally to 9.63% in 2003. We can say this is a negative impact for the company because companies with stable earnings are more likely to pay out a greater proportion of their earnings as dividends than are companies with more volatile earnings. However, companies with a large, continuing number of highreturn investment projects are less likely to pay out a high proportion of earnings 26

as dividends because of their need for the capital to finance these projects. As a matter of fact, Sears has expanded its stores in Canada and Puerto Rico the last 2 years, and just recently Sears bought a few discount stores from K-Mart. These expanding projects that Sears has undertaken the last years might have forced the company to cut its dividends. Sears sustainable growth rate (ROE * [1 Dividend payout ratio]) for the years 1999 2003 is as follows: 2003 51.83% 2002 16.81% 2001 6.77% 2000 15% 1999 17%

Sears sustainable growth rate declined from 1999 to 2001, and then it started to improve, noticeably from 2002 to 2003. Sears improved its sustainable growth rate because of its improved ROE (from 2001 to 2003) and a marginal decline in its dividend payout ratio (from 2001 to 2003). Sears & Roebuck vs. Competitors
Liquidity Ratios
5-Year Averages Current Ratio (T) Quick Asset Ratio (T) Receivables Turnover (T) Inventory Turnover (T) Working Capital T/O (T) Sears Wal-Mart JC-Penney Target

1.97 1.54 1.86 5.17 5.96

0.83 0.14 229.44 7.5 6.2

2.31 1.58 65.43 3.23 5.2

1.64 0.77 28.4 4.2 4.3

Profitability Ratios
5-Year Averages Gross Profit Margin (%) Operating Expense Ratio (%) Net Profit Margin (%)

33.55 24.93 4.04

21.94 15.6 3.39

33.03 27.23 0.69

31.25 22.15 3.59

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Asset Turnover (T) Return on Assets (%) Return on Equity (%)

1.1 5.94 26.51

2.6 8.89 21.5

1.02 0.51 1.13

0.98 6.56 19.58

Capital Structure Ratios

5-Year Averages Debt to Equity Ratio (T) Times Interest Earned (T) Debt Service Margin (T)

4.98 2.4 1.41

1.36 15.85 2.09

2.02 4.51 3.34

1.98 3.2 2.64

Comparison between Sears and Competitors: We are comparing Sears ratios with Wal-Marts, JC-Penneys, and Targets. They are Sears main competitors and the only ones that Sears competes in all divisions. We calculated the ratios for Sears and its competitors for each year from 1999 to 2003 and then we took the average of the 5 years in order to compare them with each other. Sears has a higher current ratio than Wal-Mart and Target but a lower one compared to JC-Penney. Sears has a current ratio of 1.97, which means that Sears must be able to convert each dollar of current assets into at least 0.5 dollars (1/1.97) of cash to meet short-term obligations. Sears competitors on the other hand must be able to convert each dollar of current assets into at least 1.2 dollars of cash (Wal-Mart), 0.43 dollars of cash (JC-Penney), and 0.6 dollars of cash (Target) to meet their short-term obligations. As a result Sears current ratio compares favorably with Wal-Mart and Target but not with JC-Penney. Sears quick ratio compares favorably with JC-Penney and Target but is unsatisfactory compared to Wal-Mart. The company has a quick ratio of 1.54, which shows that Sears current assets are equal to 154% of the current liabilities. On the other hand Sears competitors current assets are equal to 14% of the current liabilities for Wal-Mart, 158% of the current liabilities JC-Penney,

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and 77% of the current liabilities for Target. Sears days to receivables ratio is 196 days, which compares unfavorably with Wal-Marts 1.6 days, JC-Penneys 5.6 days, and Targets 0 days. Sears inventory turnover ratio compares favorably with JC-Penney and Target but not with Wal-Mart. This indicates that Sears has larger investment in inventory relative to the sales being generated compared to Wal-Mart, and a smaller investment in inventory compared to JC-Penney and Target. Sears asset turnover ratio of 1.1 compares favorably with JC-Penneys 1.02 and Targets 0.98 but is lower than Wal-Marts 2.6. This shows that each dollar of Sears assets produces 1.1 dollars of sales, compared to 1.02 dollars of sales for JC-Penney, 98 cents for target, and 2.6 dollars of sales for Wal-Mart. Sears gross profit margin of 33.55 is higher that its competitors gross profit margins (Wal-Mart: 21.94, JC-Penney: 33.03, Target: 31.25). This higher ratio indicates that either Sears pricing policies and/or its production methods are more effective than those of the competitors. Also, Sears net profit margin compares favorably with its competitors net profit margins. In other words, Sears is earning 0.65% more on each dollar of sales than Wal-Mart, 3.35% more than JC-Penney and 0.45% more than Target. Sears return on assets compares favorably with JC-Penney, and this is due Sears higher asset turnover compared to JC-Penney. However, Sears has a lower return on assets compared to Wal-Mart and Target because of its lower asset turnover compared to WalMart and Target. Sears has a higher return on equity ratio (26.51) compared to its competitors (Wal-Mart: 21.50, JC-Penney: 1.13, Target: 19.58). This is due to Sears higher profit margins, which have resulted in profitability ratios higher than its competitors. Sears debt to equity (4.98) is higher than its competitors debt to equity ratios. This indicates that Sears uses more than the usual amount of borrowed funds to finance its activities compared to its competitors. Sears times interest earned ratio (2.4 times) is less than its competitors ratio (Wal Mart: 15.85, JC Penney: 4.51; Target: 3.2). This shows that Sears competitors income from operations is more adequate to cover required interest charges than Sears. 29

Gross Profit Margin Year

Wal-Mart
20.14 19.72 20.68 21.42 21.94

Target
28.87 28.99 28.91 29.13 31.02

JC-Penney
30.02 28.42 27.3 25.08 32.06

Sears
34.07 35.89 33.82 32.31 31.68

12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999

40 35 30 25 20 15 10 5 0 1999 2000 2001 2002 2003 Wal-Mart Target JC-Penny Sears

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Net Profit Margin Year

Wal-Mart
3.29 3.06 3.29 3.26 3.21

Target
3.77 3.43 3.43 3.39 3.41

JC-Penney
1.25 .31 -2.21 1.03 1.11

Sears
8.26 3.33 1.79 3.28 3.54

12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999

10 8 6 4 2 0 -2 -4 1999 2000 2001 2002 2003 Wal-Mart Target JC-Penny Sears

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Return on Assets (ROA)

Year 12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999

Wal-Mart
10.47 9.66 10.24 12.10 11.19

Target
8.45 8.59 9.01 8.96 8.88

JC-Penney
3.81 1.95 -1.87 3.3 2.12

Sears
8.2 4.85 4.54 5.92 6.17

14 12 10 8 6 4 2 0 -2 1999 2000 2001 2002 2003 Wal-Mart Target JC-Penny Sears

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Return on Equity (ROE)

Year 12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999

Wal-Mart
15.02 13.77 14.64 18.05 17.65

Target
12.12 12.87 14.19 13.97 13.12

JC-Penney
5.62 3.23 -2.78 4.66 4.02

Sears
57.36 21.36 11.49 19.74 22.61

60 50 40 30 20 10 0 -10 1999 2000 2001 2002 2003 Wal-Mart Target JC-Penny Sears

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Inventory Turnover Year

Wal-Mart
8.08 7.79 7.29 6.90 7.15

Target
6.52 6.27 6.29 6.33 6.31

JC-Penney
4.45 4.35 4.00 3.95 4.15

Sears
5.01 5.12 5.06 5.1 5.58

12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999

9 8 7 6 5 4 3 2 1 0 1999 2000 2001 2002 2003 Wal-Mart Target JC-Penny Sears

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Quick Ratio

Year 12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999

Wal-Mart
.15 .15 .13 .12 .13

Target
.84 .61 .36 .35 .42

JC-Penney
.76 .79 .43 .53 .62

Sears
.85 1.81 1.92 1.48 1.63

2 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 1999 2000 2001 2002 2003

Wal-Mart Target JC-Penny Sears

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Current Ratio

Year 12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999

Wal-Mart
.93 1.04 .92 .94 .96

Target
1.59 1.37 1.16 1.11 1.24

JC-Penney
2.01 1.93 1.71 1.90 1.97

Sears
1.32 2.15 2.32 1.95 2.09

2.5 2 1.5 1 0.5 0 1999 2000 2001 2002 2003 Wal-Mart Target JC-Penny Sears

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Sears & Roebuck vs. Industry

Liquidity Ratios
Company Industry

5-Year Averages
Current Ratio (T) Quick Asset Ratio (T) Receivables Turnover (T) Inventory Turnover (T) Working Capital T/O (T)

1.97 1.54 1.86 5.17 5.96

1.22 0.4 10.87 5.72 8.9

Profitability Ratios
5-Year Averages Gross Profit Margin (%) Operating Expense Ratio(%) Net Profit Margin (%) Asset Turnover (T) Return on Assets (%) Return on Equity (%)

33.55

25.4

24.93 4.04 1.1 5.94 26.51

21.66 3.39 2.06 7.68 18.96

Capital Structure Ratios

5-Year Averages Debt to Equity Ratio (T) Times Interest Earned (T) Debt Service Margin (T)

4.98 2.4 1.41

1.79 7.85 2.69

Comparison between Sears and Retail Industry: Sears current ratio is 1.97 and this means that to satisfy the claims of shortterm creditors exclusively from existing current assets, Sears must be able to

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convert each dollar of current assets into at least 0.5 dollars of cash (1/1.97 = 0.50). The industry average for the current ratio is 1.22 times, meaning that the average firm in the retail industry must convert only 0.82 dollars (1/1.22 = 0.82) of each dollar of current assets in to cash to meet short-term obligations. Sears quick ratio is 1.54 times, which compares unfavorably to the industrys 0.4 times. This ratio shows that Sears current assets are equal to 154% of the current liabilities compared to 40% of the retail industry. Sears inventory turnover of 5.17 is unsatisfactory compared to the industrys 5.72. It takes Sears 70.6 days (365/5.17) to sell its entire inventory, whereas the retail industry only 63.81 days. Sears days to receivable ratio is 196 days (365/1.86). Because the industry average for this ratio is 63.8 days, Sears ratio is substantially above the average. Sears debt-to-equity is 4.98 times. Because the retail industry average is 1.79 times, Sears ratio indicates that the company uses more than the usual amount of borrowed funds to finance its activities. Specifically, it raises 4.98 dollars from creditors for each dollar invested by stockholders, which means that the companys debt suppliers have a lower margin of safety than is common in retail industry. Sears gross profit margin ratio is 33.55%, and is above the industrys 25.4%. This higher percentage indicates that Sears pricing policies and/or its production methods are more effective than the average company in retail industry. Sears net profit margin is 4.04%, which is higher than the industry average of 3.39% and is interpreted to mean that the company is earning 0.65% more on each dollar of sales than the average firm in retail industry. Sears return on equity is 26.51%, which is higher than the industrys 18.96%. The companys higher profit margins have resulted in profitability ratios superior to the industrys norms, even after the effects of debt financing are considered.

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Financial Statements Forecasting EXHIBIT AA Sears & Roebucks fiscal year ends on Dec 31st. We started our forecasting of financial statements (Income Statement, Balance Sheet and Statement of Cash Flows) by forecasting first the last quarter of 2004. Since Sears is not affected much by seasonality and since we didnt find any big financial fluctuations from normal operations in the first 3 quarters, to forecast Q4 we took the average of the first 3 quarters. To forecast Sears financial information, we computed the percentage change for each line in the financial statements by using Sears past financial statements information starting with fiscal year 1999 and ending with 2004 (See Exhibit A, B, C for past financial statements). We averaged the four values obtained in order to get an expected future percentage change. Then we multiplied this future percentage change by the forecasted 2004 financial statements information to obtain forecasted financial information for fiscal year 2005. The same approach was followed for most of the lines in financial statements to arrive at forecasted values for each fiscal year until 2013. The only lines we did not follow this straight-line percentage change method were the cash and equivalents line in the Balance Sheet and the income taxes line in the Income Statement. In 2003 Sears cash increased from 1,962 mill in 2002 to 9,057 mill, and this was due to the sale of the companys domestic credit sector. We didnt use the straight-line method because Sears balance of cash in 2003 deviates a lot from its balances in the previous years. And this high percentage increase from 2002 to 2003 would have caused our future cash and equivalents predictions not to grow by a smooth and normal growth. Also, we did not use the straight-line method to obtain Sears tax rate to compute its income taxes. Sears income tax rate ranged from 35.6% to 38.5% for the past 5 years. In fact, we took the average of the five income tax rates, which we found to be 37%, and then we multiplied that by each years forecasted pretax income in order to obtain net income for each year.

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Overall based on our ten-year forecast we found that Sears will perform at a steady growth rate. For example, we forecasted that sales would increase each year by 1.02%. We support this forecast not only because Sears sales have increased by 1.02% in average for the past 5 years but also due to the fact that Sears has started to expand its stores by acquiring 61 off-mall stores from KMart and Wall-Mart. And this has been due to the high demand of the services and brand name products that Sears offers. Sales increased by 1.29% during Q3 of 2003 and the first 2 quarters of 2004, which shows that consumers have responded favorably to the expanded product lineup of this one-stop shopping destination. We believe that this off-mall concept will progress well, and will be a major factor in Sears growth for the next 10 years. However, for two reasons we do not assume that our financial statements forecasts are free of errors and that our forecasts will be accurate for each year in the next decade. The first reason is that as past economic practices have dictated, the longer the time horizon the less accurate the forecasts will be. Second, future economic conditions might cause Sears not to perform as forecasted. For instance, an economic downturn might turn sears forecasted growth in sales the other way around, as people would want to save more money instead of to spend in buying Sears products and services.

Valuations Section
Introduction
This section shows the value of Sears Roebuck & Co. by taking risk into consideration, and calculating how much of the firm is financed by debt and equity. Discounted free cash flows, discounted dividends, discounted residual income, and abnormal growth earnings models are used in the following section to provide an intrinsic valuation of Sears Roebuck & Co. This section also values the company by using the retail industry averages and comparing the ratios of the company. The ratios used are price to earnings, price to book, dividend to

40

price, and price to sales. These valuation methods will show the true value of Sears Roebuck & Co., and will also assess the risk involved with this company.

Method of Comparables Valuation

EXHIBIT 1

2004 (11/01/2004)
Sales (mill) Sears & Roebuck Wal - Mart Target J.C - Penney Industry Average:
W/O Trimming

EPS
2.75 2.4 2.15 2.15

BPS
28.3 10.75 14.35 18.75

DPS
0.92 0.48 0.3 0.5

PPS
34.8 53.8 50.39 34.78

P/E
22.44 23.44 16.18 20.69

P/B
5 3.51 1.86 3.46

D/P
0.0089 0.006 0.0143 0.0097

P/S
0.00019 0.001 0.0019 0.001

36,600 287,100 46,550 18,600

Sears P from P/E:

industry P/E * Sears EPS

56.9 97.92

Sears P from P/B:

industry P/B * Sears BPS

Sears P from DPS/PPS:

Sears DPS/ industry DPS/PPS

94.84 36.6
22.94 2.94 0.0075 0.0015

Sears P from P/S:

industry P/S * Sears Sales

Industry Average:
With Trimming

Sears P from P/E:

industry P/E * Sears EPS

63.08 83.2

Sears P from P/B:

industry P/B * Sears BPS

Sears P from DPS/PPS:

Sears DPS/ industry DPS/PPS

122.66 54.9

Sears P from P/S:

industry P/S * Sears Sales

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In the multiple valuation model we found that the method that came closest to the current market price ($34.8 as of 11/01/2004) of Sears Roebuck & Co. was the price-to-sales ratio. (See Exhibit 1) We believe this is the case because the value of the company is closely related to the amount of revenues in the retail industry. Sears Roebuck & Co. is priced at the level of performance they are currently operating at. The retail industry as a whole is priced according to their revenues, or sales. Even when the outlier was excluded price-to-sales ratio provided a price closer to the companys current price, even though the current price valued changed from $36.6 (w/o trimming) to $54.9 (with trimming). The sales used in our analysis were found using Edgarscan, and finding historical data from each companys income statement.

Intrinsic Valuation Methods

In order to continue with performing the valuation models mentioned above, we must first calculate WACC in which our cost of capital (Ke) and cost of debt (Kd) will be found. The cost of capital (Ke) was found by using historical data over the past 60 months of the return on market (Rm), S&P 500, and the risk-free rate (Rf), nominal Treasury Bill (5 year). We then did a regression analysis using the percentage return of the firm (Y-variable) and the market spread (X-variable) data from the past 60 months (October 1999 October 2004). With this analysis we found that our estimated beta equals .4899. We believe that this beta is extremely low given that the published beta is 1.3 (Value Line). The CAPM was figured using both the estimated beta and the published beta, which equaled 3.82% and 9.49% respectively. We believe that the Ke found using the published beta of 9.49% best represents Sear Roebuck & Co. because the actual Ve is greater than the Vd, which leads to believe that the Ke will be greater than the Kd (See Exhibit 2)

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The next valuation that must be done is WACC. Now that the Ke has been calculated we must solve for the other variables. The cost of debt (Kd) is calculated by using the balance sheet notes for 2003 to figure the weighted average of interest for Sears Roebuck & Co.s long-term debt. The average rate for short-term debt was also computed by taking the average of the commercial paper rates (6 month financial) for the past 60 months (October 1999 October 2004), which equals 3.76%. (See Exhibit 2) This is shown in the table below.

TTM 1-3 years 4-9 years 10+ years Sum of MV Long term debt rate Short term debt rate

Average (i) 6.25% 9.38% 7.50%

MV (mil.) 236 251 1838 2325

Percent Wtd Average 10.00% 10.00% 80.00% 0.63% 0.94% 6.00%

7.57%

3.76% 19.8% 80.2% 6.80%

Weight of ST Debt = ((ST debt + LT debt)/Tot. Liabilities)

Weight of LT Debt
Cost of Debt (Kd) = (Avg. ST Debt * Weight ST Debt) + (Avg. LT Debt * Weight LT Debt)

Sears & Roebuck has a Z-Score of 5.97 (See Exhibit 2). This shows that Sears has a very good credit rating, which will allow Sears to obtain credit funds if needed. Also, this high Z-Score indicates that Sears will not face any state of distress for at least within the next year. This prime rating of Sears has been due to its strong financial performance. The value of debt (Vd) was computed by using the book value of liabilities from the balance sheet for 2004. This is found by adding short-term borrowings and long-term borrowings to find total liabilities:

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Vd = $1033 (million) + $4218 (million) = $5251 (million) The value of equity (Ve) was calculated by multiplying price per share (PPS) by shares outstanding: Ve = $27.78 * 230.4 (million) = $6401 (million) The value of the firm (Vf) is simply the sum of the value of debt (Vd) and the value of equity (Ve): Vf = $5251 (million) + $6401 (million) = $11,652 (million) Now with all of the components to WACC, we are able to calculate this model. The corporate tax rate for the firm was given at 31%. (See Exhibit 2) The following is the calculation: WACC = ($5251/$11,652) * (1-.31) * (.068) + ($6401/$11,652) * (.0949) = .0732

Discounted Free Cash Flows Exhibits 3

The discounted free cash flows model was performed by using a WACC = 7.32% and an implied growth rate = 3.5% after 2013. Our analysis found an estimated price of $36.94 compared to the actual price of $34.78. Based on this valuation method, we conclude that the firm is slightly undervalued. This is evident because our estimated price exceeds the actual price. During our sensitivity analysis we found that there was a high amount of sensitivity in this valuation model. This is evident because a slight change in WACC or growth will result in a large change of price. These analyses also show that our estimated WACC and growth rate were not too far off from the actual rates found by using sensitivity analyses. They also show that a change in WACC without a corresponding change in growth will cause the estimated price to deviate greatly from the actual price (and vice versa). For example, an increase to 8.5% WACC causes a decrease in estimated price to $23.24 per share, while an increase in the growth rate to 4.5% causes the estimated price to increase to $51.7236. This valuation method has the highest sensitivity to changes of all of the valuation methods used. For example if WACC decreases by .82% and growth increases by 2%,

44

estimated price per share deviates to $166.53 per share. This is in sharp contrast to the scenario in which WACC is increased by 2.23% and growth is decreased by 1%, which results in a price per share of $12.67. Sensitivity Analysis 0.0650 0.0250 0.0350 0.0450 38.5584 0.0732 0.0850 0.0950 WACC

28.2920 18.4327 12.6719

52.7774 36.9408 23.2434 15.8358 81.2152 51.7236 30.4594 20.2652 82.7512 42.4861 26.9093

0.0550 166.5288 Growth

Discounted Residual Income Exhibits 4

The discounted residual income model was performed by using a Ke = 9.49% and an implied growth rate = 3.5% after 2013. Our analysis found an estimated price of $38.38 per share compared to the actual price of $34.78 per share. From this valuation method we conclude that the firm is undervalued, because the actual price is less than our estimated price by $3.6 per share. From our sensitivity analysis we learned that the estimated price per share is much more susceptible to changes in the cost of equity than to changes in the growth rate. This is apparent because a 1% increase in cost of equity results in a $6.78 decrease in the price per share, while a 1% increase in the growth rate causes only a $0.84 increase in the price per share.

45

Sensitivity Analysis 0.0849 0.015 44.748 0.0949 0.1049 0.1149 Ke 27.27 26.974 26.604 37.3288 31.6835 37.7786 31.6472

0.025 46.1116

0.035 48.0217 38.3786 31.6006 0.045 50.8893 Growth

39.219 31.5383 26.1281

Abnormal Earnings Growth Exhibits 5

The abnormal growth earnings model was performed by using a Ke = 9.49% and an implied growth rate = 3.5% after 2013. Our analysis found an estimated share price of $46.49 compared to the actual price of $34.78. This valuation method shows the firm is highly undervalued by $11.71 per share. During the sensitivity analysis we discovered that the estimated price is much more sensitive to changes in cost of equity than to changes in growth. For example a 1% increase Ke results in an estimated price decrease of $8.36 per share, while a 1% increase in growth rate results in a decrease of $1.59 per share.

Sensitivity Analysis 0.0849 0.015 54.7923 0.025 56.5927 0.0949 44.5106 0.1049 0.1149 Ke 37.264 31.9465

45.3606 37.6453 32.0891

0.035 59.1147 46.4944 38.1358 32.2673 0.045 62.9009 Growth 48.0827 38.7899 32.4966

46

Discounted Dividends Exhibits 6

The discounted dividends model was performed by using a Ke = 7.67%. We found the Ke = 7.67% by using the WACC formula with the numbers taken from discounted free cash flows model. The discounted dividend model gave us the lowest price per share ($27.98). The discounted dividends model has a moderate sensitivity to changes in cost of equity and growth. For example a 1% increase in Ke changes the estimated price per share by a negative $5.61, while a 1% in growth rate increases price per share by $6.69. This model is the only one that shows the company to be overvalued. As a result, we think that the estimated price of $27.98 that we obtained doesnt represent the fundamental value of Sears stock price in 2004.

Sensitivity Analysis 0.0667 0.015 25.496 0.025 29.919 0.0767 0.0867 0.0967 Ke 21.096 17.9363 15.56004 23.87 19.7937 16.8635

0.035 37.133 27.975 22.3697 18.58946 0.045 50.996 Growth 34.669 26.1812 20.98311

Discussion and Summary of Overall Results

In all of the valuation models, except discounted dividends, our estimated price exceeded the actual price. With these results we determine that the stock price of Sears Roebuck & Co. is undervalued by an average of $2.67 per share. This was computed using a average of the difference between estimated price and actual price from all four valuation models. The discounted free cash flows model was found to be most representative of the actual stock price in 2004. In all of these models, growth rate was the most sensitive factor to change.

47

In the abnormal growth earnings model our Ke proved to be a weakness because of the significant increase from 9.49% to 11.49%. We believe that our WACC valuation proved to be strong in comparison to our estimated growth rate and our Ke. The forecasted cash flows for Sears Roebuck & Co. are important in the estimation of the stock price using the discounted free cash flows valuation. We feel that the Discounted Dividends Model may be the least accurate of the three because it showed Sears to be overvalued, while all three of the other models showed Sears to be undervalued. If the Discounted Dividends Model is ignored, the price of Sears stock is undervalued by $5.82 per share.

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EXHIBIT AA Sears & Roebuck Forecasted Financial Values Income Statement; Balance Sheet; Statement of Cash Flows (Amounts in millions) INCOME STATEMENT YEAR Total Sales Cost of Goods Sold Gross Profit Operating Expense NIBIT Interest Expense Pretax Income Income Taxes (37%) NET INCOME 2004 36,600 23,954 12,646 7,956 4,690 1,225 3,465 1,282 2,183 2005 37,332 23,714 13,618 8,275 5,343 1,167 4,176 1,545 2,631 2006 38,078 23,477 14,601 8,605 5,996 1,111 4,885 1,807 3,078 2007 38,840 23243 15,597 8,949 6,648 1,059 5,589 2,068 3,521 2008 39,617 23,010 16,607 9,307 7,300 1,008 6,292 2,328 3,964 2009 40,409 22,789 17,620 9,680 7,940 961 6,979 2,582 4,397 2010 41,218 22,552 18,666 10,067 8,599 915 7,684 2,843 4,841 2011 42,041 22,327 19,714 10,470 9,244 871 8,373 3,098 5,275 2012 42,882 22,103 20,779 10,889 9,890 830 9,060 3,352 5,708 2013 43,740 21,882 21,858 11,324 10,534 790 9,744 3,605 6,139

BALANCE SHEET Year Cash & Equivalents Accounts Receivables Inventory Total Current Assets Accounts Payable Total Current Liabilities Working Capital Total Assets Total Liabilities Total Shareholder's Equity 2004 3,509 9,205 5,850 18,564 4,019 9,612 8,952 22,432 16,834 5,598 2005 4,210 8,100 5,932 18,242 3,506 9,107 9,135 21,748 16,329 5,419 2006 5,053 7,128 6,015 18,196 3,059 8,629 9,567 21,084 15,839 5,245 2007 6,063 6,272 6,099 18,434 2,669 8,176 10,258 20,441 15,364 5,077 2008 7,276 5,520 6,185 18,981 2,329 7,747 11,234 19,818 14,903 4,915 2009 8,731 4,858 6,271 19,860 2,031 7,340 12,520 19,213 14,456 4,757 2010 10,488 4,275 6,359 21,122 1,772 6,955 14,167 18,628 14,022 4,606 2011 12,573 3,762 6,448 22,783 1,546 6,590 16,193 18,059 13,601 4,458 2012 15,088 3,310 6,538 24,936 1,349 6,244 18,692 17,509 13,193 4,316 2013 18,105 2,913 6,630 27,648 1,177 5,916 21,732 16,975 12,798 4,177

Statement of Cash Flows Year CFFO CFFI Free Cash Flows 2004 2,612.33 1,989 623.33 2005 2,703.77 2,074.44 629.330 2006 2,798.40 2,164.55 633.850 2007 2,896.35 2,257.81 638.540 2008 2,997.72 2,354.33 643.390 2009 3,102.64 2,454.23 648.410 2010 3,211.23 2,557.63 653.600 2011 3,323.63 2,664.65 658.980 2012 3,439.95 2,775.41 664.540 2013 3,560.05 2,890.05 670.300

49

EXHIBIT A
5 YR ANNUAL BALANCE SHEET Assets Cash & Equivalents Receivables Net Inventories Prepaid Expenses Other Current Assets Total Current Assets Long Term Receivables Investments in Unconsol Subsidiaries Other Investments Property, Plant & Equip - Gross Accumulated Depreciation Property, Plant & Equipment - Net Other Assets Total Assets (amounts in millions) 12/31/2003 12/31/2002 9,057.00 2,689.00 5,335.00 n/a 1,115.00 18,196.00 0 0 0 13,124.00 6,336.00 6,788.00 2,361.00 27,345.00 1,962.00 31,622.00 5,115.00 n/a 1,284.00 39,983.00 0 0 0 12,979.00 6,069.00 6,910.00 2,782.00 49,675.00 12/31/2001 1,064.00 28,813.00 4,912.00 n/a 1,316.00 36,105.00 0 0 0 13,137.00 6,313.00 6,824.00 973 43,902.00 7,176.00 6,714.00 n/a n/a n/a 1,694.00 15,584.00 18,921.00 1,732.00 n/a -415 n/a 0 35,822.00 0 1,961.00 n/a 6,119.00 43,902.00 12/31/2000 842 20,928.00 5,618.00 n/a 1,406.00 28,794.00 0 0 0 12,585.00 5,932.00 6,653.00 1,278.00 36,725.00 7,336.00 6,840.00 n/a 562 n/a 0 14,738.00 11,020.00 1,951.00 1,058.00 -174 n/a 0 28,593.00 0 1,363.00 0 6,769.00 36,725.00 12/31/1999 729 21,581.00 5,069.00 n/a 1,288.00 28,667.00 0 0 0 11,912.00 5,462.00 6,450.00 1,470.00 36,587.00 6,992.00 5,154.00 n/a n/a n/a 1,555.00 13,701.00 12,884.00 2,180.00 0 -367 n/a 0 28,398.00 0 1,350.00 0 6,839.00 36,587.00

Liabilities Accounts Payable 3,106.00 2,945.00 ST Debt & Current Portion Due LT Debt 3,983.00 9,333.00 Accrued Payroll n/a n/a Income Taxes Payable 1,867.00 787 Dividends Payable n/a n/a Other Current Liabilities 4,803.00 5,532.00 Total Current Liabilities 13,759.00 18,597.00 Long Term Debt 4,218.00 21,304.00 Provision For Risks And Charges 1,956.00 2,491.00 Deferred Income n/a n/a Deferred Taxes -378 -734 Deferred Tax Liability In Untaxed n/a n/a Reserves Other Liabilities 0 0 Total Liabilities 19,555.00 41,658.00 Shareholders' Equity Non-Equity Reserves 0 0 Minority Interest 1,389.00 1,264.00 Preferred Stock n/a n/a Common Equity 6,401.00 6,753.00 Total Liabilities & Shareholders' Equity 27,345.00 49,675.00 * Balance Sheet comes from Thomson One Business website

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INCOME STATEMENT
(Common Size)
YEAR Total Sales Cost of Goods Sold Gross Profit Operating Expense NIBIT Interest Expense Pretax Income Income Taxes 12/31/2003 100% 63.71% 36.2900% 26.63% 15.72% 2.50% 13.23% 4.88% 8.35% 12/31/2002 100% 62% 38.0000% 27.10% 8.64% 2.77% 5.88% 2.07% 3.81% 12/31/2001 100% 64.08% 35.9200% 24.92% 6.39% 3.47% 2.95% 1.14% 1.81% 12/31/2000 100% 65.67% 34.3300% 23.27% 8.48% 3.06% 5.43% 2.03% 3.40% 12/31/1999 100% 66.26% 33.7400% 22.62% 8.98% 3.10% 5.89% 2.20% 3.69%

NET INCOME

51

EXHIBIT B
(amounts in millions) 5 YR ANNUAL INCOME STATEMENT Sales Cost of Goods Sold Depreciation, Depletion & Amortization Gross Income Selling, General & Admin Expenses Other Operating Expenses Total Operating Expenses Operating Income Extraordinary Credit - Pretax Extraordinary Charge - Pretax Non-Operating Interest Income Reserves - Inc(Dec) Pretax Equity Interest Earnings Other Income/Expense - Net Earnings Bef Interest & Taxes Interest Expense on Debt Interest Capitalized Pretax Income Income Taxes Minority Interest Equity Interest Earnings After Tax Other Income/Expense Discontinued Operations Net Income Bef Extraordinary Items & Disc Ops Preferred Dividends Extraordinary Items & Gain(Loss) Sale of Assets Net Income Bef Preferred Dividends 12/31/2003 41,124.00 26,202.00 909 14,013.00 10,951.00 0 38,062.00 3,062.00 93 932 0 0 0 4,243.00 6,466.00 1,027.00 2 5,441.00 2,007.00 45 8 0 0 3,397.00 0 0 3,397.00 12/31/2002 41,366.00 25,646.00 875 14,845.00 11,210.00 0 37,731.00 3,635.00 0 411 0 0 0 352 3,576.00 1,147.00 4 2,433.00 858 11 20 0 0 1,584.00 0 -208 1,376.00 12/31/2001 41,078.00 26,322.00 863 13,893.00 10,236.00 0 37,421.00 3,657.00 0 1,064.00 0 0 0 33 2,626.00 1,426.00 11 1,211.00 467 21 12 0 0 735 0 0 735 0 735 12/31/2000 40,937.00 26,885.00 826 13,226.00 9,526.00 0 37,237.00 3,700.00 0 265 0 0 0 36 3,471.00 1,252.00 4 2,223.00 831 49 0 0 0 1,343.00 0 0 1,343.00 0 1,343.00 12/31/1999 41,071.00 27,212.00 848 13,011.00 9,289.00 0 37,349.00 3,722.00 0 41 0 0 n/a 6 3,687.00 1,273.00 5 2,419.00 904 62 0 0 0 1,453.00 0 0 1,453.00 0 1,453

Preferred Dividend Requirements 0 0 Net Income Available To 3,397.00 1,376.00 Common * Balance Sheet comes from Thomson One Business website

52

EXHIBIT C
(amounts in millions) 5 YEAR ANNUAL CASH FLOW STATEMENT Operating Activities Income Bef Extraordinary Items Depreciation, Depletion & Amortization Deferred Inc Taxes & Inv Tax Credit Other Cash Flow Funds From Operations Extraordinary Items Funds From/For Other Operating Acts Net Cash Flow From Operating Activities Investing Activities Capital Expenditures Additions To Other Assets Net Assets From Acquisitions Increase In Investments Decrease In Investments Disposal of Fixed Assets Other Use/(Source) - Investing Net Cash Flow From Investing Activities Financing Activities Net From Sales/Issue of Com/Prf Stock Com/Prf Purchased,Retired,Converted Long Term Borrowings Inc(Dec) In ST Borrowings Reduction In Long Term Debt Cash Dividends Paid - Total 3,397.00 909 648 -1,561.00 3,393.00 0 -869 2,524.00 1,584.00 875 -203 2,049.00 4,305.00 0 -4,810.00 -505 735 751 146 2,401.00 4,033.00 0 -1,771.00 2,262.00 1,343.00 826 26 1,208.00 3,403.00 0 -701 2,702.00 1,453.00 848 356 967 3,624.00 n/a 73 3,697.00 12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999

925 0 0 21 0 21,704.00 0 -20,758.00 0 3,673.00 3,757.00 -3,519.00 12,643.00 327

1,035.00 0 1,840.00 15 0 568 0 2,322.00 0 427 6,565.00 964 3,256.00 293

1,126.00 0 0 21 0 0 59 1,088.00 0 625 4,124.00 -708 3,552.00 302 33 -955

1,084.00 0 1 40 75 0 0 1,050.00 0 1,233.00 824 1,295.00 2,277.00 322 118 -1,537.00

1,033.00 0 68 0 0 118 0 983 0 570 1,491.00 -1,653.00 1,516.00 355 57 -2,485.00

Other Source/(Use) - Financing 2 11 Net Cash Flow From Financing Activities -16,212.00 3,721.00 * Balance Sheet comes from Thomson One Business website

53

EXHIBIT 2
Excess Return Adjusted T-Bills Returns (Rm-Rf) Price
0.35% 0.38% 0.37% 0.38% 0.41% 0.43% 0.42% 0.45% 0.48% 0.47% 0.49% 0.48% 0.50% 0.50% 0.52% 0.55% 0.56% 0.54% 0.52% 0.56% 0.53% 0.52% 0.51% 0.49% 0.48% 0.48% 0.43% 0.41% 0.41% 0.39% 0.40% 0.41% 7.68% 5.53% 5.27% 3.72% -3.64% 3.45% 3.37% -2.95% 4.96% -3.68% -1.11% -3.34% 5.75% 1.41% 5.27% -5.64% -2.57% 9.13% -3.60% -2.75% 1.87% -2.15% 5.57% -5.84% -0.98% -8.48% -0.03% 3.06% -9.64% -6.81% 7.28% 0.10% 38.83 41.18 36.89 34.84 35.47 39.45 40.15 41.93 39.08 35.52 33.08 27.67 24.86 30.38 26.99 27.49 24.71 27.45 32.94 33.32 29.43 26.95 28.34 29.46 27.02 29.69 31.81 35.47 37.79 32.47 33.92 36.92 5.71% -11.63% -5.88% 1.78% 10.09% 1.74% 4.25% -7.29% -10.02% -7.38% -19.55% -11.30% 18.17% -12.56% 1.82% -11.25% 9.98% 16.67% 1.14% -13.22% -9.20% 4.90% 3.80% -9.03% 8.99% 6.66% 10.32% 6.14% -16.38% 4.27% 8.13%

DATE 19991030 19991130 19991231 20000129 20000226 20000331 20000430 20000528 20000630 20000730 20000831 20000930 20001029 20001130 20001231 20010131 20010229 20010331 20010428 20010531 20010630 20010731 20010831 20010929 20011031 20011130 20011229 20020131 20020228 20020330 20020430 20020531

S&P 500 Return

8.03% 5.91% 5.64% 4.10% -3.23% 3.88% 3.79% -2.50% 5.44% -3.21% -0.63% -2.86% 6.25% 1.91% 5.78% -5.09% -2.01% 9.67% -3.08% -2.19% 2.39% -1.63% 6.07% -5.35% -0.50% -8.01% 0.41% 3.46% -9.23% -6.42% 7.68% 0.51%

Return

54

20020629 20020731 20020831 20020928 20021031 20021130 20021231 20030131 20030228 20030328 20030430 20030531 20030628 20030731 20030830 20030930 20031031 20031129 20031231 20040131 20040228 20040331 20040430 20040530 20040630 20040731 20040829 20040930 20041031

-2.50% -1.08% -6.41% -8.17% 1.81% 7.52% 0.76% -1.56% -2.08% 3.67% -6.14% -0.91% -7.25% -7.90% 0.49% -11.00% 8.64% 5.71% -6.03% -2.74% -1.70% 0.84% 8.10% 5.09% 1.13% 1.62% 1.79% -1.19% 5.50%

0.40% 0.40% 0.38% 0.34% 0.33% 0.33% 0.37% 0.36% 0.36% 0.40% 0.39% 0.37% 0.35% 0.32% 0.27% 0.25% 0.25% 0.25% 0.25% 0.25% 0.24% 0.23% 0.24% 0.21% 0.19% 0.24% 0.28% 0.27% 0.27%

-2.90% -1.47% -6.79% -8.52% 1.48% 7.19% 0.39% -1.92% -2.44% 3.28% -6.53% -1.28% -7.60% -8.22% 0.21% -11.25% 8.40% 5.45% -6.29% -3.00% -1.94% 0.60% 7.86% 4.88% 0.94% 1.38% 1.51% -1.46% 5.23%

39.17 43.49 39.78 32.24 36.08 42.57 44.56 49.43 49.39 48.16 49.55 55.7 51.22 44.49 43.14 36.97 24.9 26.49 22.9 25.29 21.05 23.34 27.39 29.2 32.77 39.64 43.11 42.83 51.54

5.74% 9.93% -9.33% -23.39% 10.64% 15.25% 4.47% 9.85% -0.08% -2.55% 2.81% 11.04% -8.75% -15.13% -3.13% -16.69% -48.47% 6.00% -15.68% 9.45% -20.14% 9.81% 14.79% 6.20% 10.89% 17.33% 8.05% -0.65% 16.90%

Average Beta 0.48991

0.18% Intercept
-0.0008446

0.39% R^2
0.038576

-0.21% T-Test
0.489913

Cost of Equity (estimated B)

3.82%

55

Cost of Equity (published B) Ke = Rf + B(Rm-Rf) Ke = 0.39% + 1.3(7%) = 9.49%

9.49%

Commercial Paper (Financial) Date Oct-99 Nov-99 Dec-99 Jan-00 Feb-00 Mar-00 Apr-00 May-00 Jun-00 Jul-00 Aug-00 Sep-00 Oct-00 Nov-00 Dec-00 Jan-01 Feb-01 Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02

% Paid 5.09% 5.15% 5.04% 4.81% 4.82% 4.84% 4.80% 4.83% 5.04% 5.14% 5.28% 5.32% 5.93% 5.85% 5.93% 5.81% 5.90% 6.03% 6.15% 6.57% 6.59% 6.54% 6.49% 6.47% 6.52% 6.52% 6.33% 5.51% 5.19% 4.81% 4.47%

56

May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Feb-03 Mar-03 Apr-03 May-03 Jun-03 Jul-03 Aug-03 Sep-03 Oct-03 Nov-03 Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04

3.96% 3.69% 3.62% 3.44% 2.84% 2.29% 2.00% 1.81% 1.72% 1.80% 1.87% 1.83% 1.80% 1.78% 1.76% 1.71% 1.74% 1.71% 1.37% 1.32% 1.27% 1.25% 1.21% 1.23% 1.20% 1.02% 1.03% 1.06% 1.06% 1.06%

Sh-T Debt
TTM 1-3 years 4-9 years 10+ years Sum of MV L-T Debt Average 6.25% 9.38% 7.50%

3.76%
MV (mill.) 236 251 1838 2325 Percent 10.00% 10.00% 80.00% Wtd Avg 0.63% 0.94% 6.00%

7.57%

57

Cost of Debt = 6.8% Cost of Debt = 0.0376 * 0.198 + 0.0757 * 0.802 ZScore
WC/Total Assets Ret Earnings/TA EBIT/Total Assets MV Equity/BV Liab Sales/Total Assets 0.1622 0.426 0.236 2.44 1.5 1.2 1.4 3.3 0.6 1 1.946 0.6 0.78 1.14 1.5

ZScore

5.97

VE = PPS * # shares outstanding VE = 34.8 * 230.4 mill. VE (mill) = $6,401 VD = Book value of liabilities VD = 1,033 + 4,218 VD (mill) = $5,251 VF = VE + VD VF (mill) = $11,652 WACC=7.32% WACC = (Vd/Vf)*(1-T)*Kd + (Ve/Vf)*Ke T = 31%

58

EXHIBIT 3 Discounted Free Cash Flows Method

Amounts in millions of dollars except per share data WACC= 0.0732 Kd= 0.068 Growth = 0.035 Ke= Free Cash Flow (2014 and on) = 170.3 230.38 million shares outstanding mill 0 2004 Cash Flow from Operations Cash Provided by Inv Activities Free Cash Flow (to firm) Discount Rate (WACC) Present Value Factors PV of Free Cash Flows Total PV Annual Cash Flows PV of Terminal Value (693.76/(.0732-.035))*.529 Value of the Firm Value of Debt Value of Equity VE = VF - VD Estimated per Value Share 12/31/2004 PPS= VE / #shares outstanding Estimated Value per Share 11/01/2004 36.989/(1+Ke/12^(2/12)) Actual Price per Share ($) 1 2005
$2,703.77 ($2,074.44) 629.330 0.0732 0.932 586.405 4156.04 9616.57 0.868 550.333 0.809 516.590 0.754 485.011 0.702 455.456 0.655 427.787 0.610 401.890 0.568 377.638 0.530 354.930

0.0949 $693.7 mill 7 2011

$3,323.63 ($2,664.65) 658.980

2 2006
$2,798.40 ($2,164.55) 633.850

3 2007
$2,896.35 ($2,257.81) 638.540

4 2008
$2,997.72 ($2,354.33) 643.390

5 2009
$3,102.64 ($2,454.23) 648.410

6 2010
$3,211.23 ($2,557.63) 653.600

8 2012
$3,439.95 ($2,775.41) 664.540

9 2013
$3,560.35 ($2,890.05) 670.300 693.761

Sensitivity Analysis
13772.61 5251.00 8521.61

0.0650 0.0250 0.0350 38.5584 52.7774 81.2152 166.5288

0.0732 28.2920 36.9408 51.7236 82.7512

0.0850 18.4327 23.2434 30.4594 42.4861

0.0950 12.6719 15.8358 20.2652 26.9093

WACC

36.989 36.941 34.78

0.0450 0.0550

Growth

59

EXHIBIT 4 Residual Income Method

All data is stated in Per Share amounts Ke = 0.0949 Growth 3.50% 0 2004 Beginning BE (per share) EPS DPS Ending BE (per share) Ke Normal Income (BE * Ke) Residual Income (RI) (EPS - NI) Present Value Factors Present value of RI 1 2005
30.36 3.8 0.94 30.36 0.0949 2.881164 0.918836 0.913325 0.839196 3.152578 0.847422 0.834163 0.706888 3.441074 0.858926 0.76186256 0.65438356 3.755193 0.744807 0.695828 0.518258 4.085445 0.714555 0.635518 0.454112 4.427085 0.572915 0.580435 0.33254 4.768725 0.431275 0.530126 0.22863 5.119855 0.280145 0.484177 0.13564 5.480475 0.519525 0.442211 0.22974 0.5377084 33.22

2 2006
33.22 4 0.96 36.26

3 2007
36.26 4.3 0.99 39.57

4 2008
39.57 4.5 1.02 43.05

5 2009
43.05 4.8 1.2 46.65

6 2010
46.65 5 1.4 50.25

7 2011
50.25 5.2 1.5 53.95

8 2012
53.95 5.4 1.6 57.75

9 2013
57.75 6 1.6 62.15

BV Equity (per share) 2003 Total PV of RI (end 2003) PV of Terminal Value (end 2003) 0.538/(.0949-0.035) * 0.442 Estimated Value per Share 12-3104 Estimated Value per Share 11-0104 Actual Price per Share ($)

30.36 4.09939
3.969629

Sensitivity Analysis
0.0849 0.0949 37.3288 37.7786 38.3786 39.219 0.1049 31.6835 31.6472 31.6006 31.5383 0.1149 27.27 26.974 26.604 26.1281

Ke

38.43 38.38 34.78

0.015 0.025 0.035 0.045

44.748 46.1116 48.0217 50.8893

Growth

60

EXHIBIT 5 Abnormal Earnings Growth

All data is stated in Per Share amounts Ke = 0.0949 Growth 3.50% 1 2005
3.8 0.94 0.087308 3.887308 3.83215

2004 EPS DPS DPS invested at 9.49% Cum-Dividend Earnings (EPS + DRIP) Normal Earnings [EPS * (1+ Ke)] Abnormal Earning Growth (AEG) (Cum Div - Normal EPS) PV of AEG EPS 2004 Total PV of AEG PV of Terminal Value Total PV of AEG + EPS 2004 Capitalization Rate (perpetuity) Estimated Value per Share 12-3104 (4.418 / 0.0949) Estimated Value per Share 11-0104 46.56/(1+Ke/12^(2/12)) Actual Price per Share ($)
3.5 0.164998 0.753 3.5 0.92

2 2006
4 0.96 0.089206 4.089206 4.16062

3 2007
4.3 0.99 0.091104 4.391104 4.3796

4 2008
4.5 1.02 0.093951 4.593951 4.70807

5 2009
4.8 1.2 0.096798 4.896798 4.92705

6 2010
5 1.4 0.11388 5.11388 5.25552

7 2011
5.2 1.5 0.13286 5.33286 5.4745

8 2012
5.4 1.6 0.14235 5.54235 5.69348 0.15113

9 2013
6 1.6 0.15184 6.15184 5.91246

0.055158

-0.07141

0.011504

-0.11412

-0.03025

-0.14164

-0.14164

0.23938

0.102014

0.050377

0.008764

0.10585656

( We excluded the negative AEGs)

Sensitivity Analysis
4.418
0.0949

0.0849 0.015 0.025 54.7923 56.5927 59.1147 62.9009

0.0949 44.5106 45.3606 46.4944 48.0827

0.1049 37.264 37.6453 38.1358 38.7899

0.1149 31.9465 32.0891 32.2673 32.4966

Ke

46.56

0.035 0.045

46.49 34.78

Growth 61

EXHIBIT 6 Discounted Dividends Method

All data is stated in Per Share amounts WACC= 0.0732 Kd = 0.068 Growth= 0 2004 Cost of Equity: 0.0767 WACC = (VD / VF)Kd + (VE / VF)Ke 0.0732=(5251/13053)0.068+(7802/13053)Ke Ke = 7.67% DPS PV Factors PV of Forecasted Dividends Total PV of Forecasted Dividends PV of terminal value (1.656/(.0767-.035))*.514 Estimated Value Per Share 12-31-04 Estimated Value Per Share 11-01-04 28.0/(1+(Ke/12))^(2/12) Actual Price Per Share (2003) ($)
7.583912 20.42076 0.94 0.928764 0.873038 0.96 0.862602 0.828098 0.99 0.801154 0.793142 1.02 0.744083 0.758964 1.2 0.691077 0.829292 1.4 0.641847 0.898586 1.5 0.59612455 0.89418683 1.6 0.553659 0.885854 1.6 0.51422 0.82275 1.656

0.035 6 2010

Ke(new) = 7 2011

0.0767 8 2012 9 2013

1 2005

2 2006

3 2007

4 2008

5 2009

28 27.97 34.78
0.015 0.025 0.035 0.045

Sensity Analysis
0.0667 25.496 29.919 37.133 50.996 0.0767 21.096 23.87 27.975 34.669 0.0867 17.9363 19.7937 22.3697 26.1812 0.0967 15.56004 16.8635 18.58946 20.98311

Ke

Growth

62

Bibliography Sources
o Halligan, Cathy. (2002, July 9). Will Sears Be More Like Target Than Kmart? http://www.marketingprofs.com/2/prophet3.asp o Hoover's. (2002). Lands' End. Austin, TX: Hoover's Inc. o Multex Investor. (2003). Sears, Roebuck & Co. Profile. from Reuters Research Inc http://businessmajors.about.com/gi/dynamic/offsite.htm?site=http://biz.yahoo. com/p/s/s.html o Prentice-Hall. (2003). Can Sears Reinvent Itself? http://wps.prenhall.com/bp_laudon_essmis_5/0,,155336-,00.html o Scheraga, Dan. (2002, July). Lands' End lends a hand: Sears' direct marketing will get a boost
from newly acquired know-how. Chain Store Age Executive with Shopping Center Age 78(7), 58(1).

o o o

http://finance.yahoo.com/q/pr?s=s http://www.searsarchives.com/ http://www.marketresearch.com/researchindex/764369.html

o Sears Roebuck & Co. 2003 10K Filing o Sears Roebuck & Co. 2003-09 10Q Filing o Sears Roebuck & Co. 2004-07 10Q Filing o http://biz.yahoo.com/e/031105/s10q.html

o https://us.etrade.com/e/t/invest/performance?sym=S&pr od=S:NYSE:EQ o Thomson One Analytical Business o Morningstar.com o Sears Roebuck & CO 10K 2000-12-30 Income Statement o Sears Roebuck & CO 10-K 2004-01-03 Income Statement

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