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Sears, Roebuck & Co G5 Investment Group Matt Nutsch Renis Kacani Melody Seely Ashley Green Wiley Eagle .

Sears, Roebuck, & Co - Mark E. Moore

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Page 1: Sears, Roebuck, & Co - Mark E. Moore

Sears, Roebuck & Co

G5 Investment Group

Matt Nutsch Renis Kacani Melody Seely Ashley Green Wiley Eagle

.

Page 2: Sears, Roebuck, & Co - Mark E. Moore

G5 Investment Group December 4, 2004 Retail – Broadline

Buy

Stock Data Valuation (per share) Summary Financials (in millions) for 2004

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

Current Price Comparables DCF Analysis Residual Income DD Analysis Abnormal Earnings

$34.78 $36.60 $36.94 $38.38 $27.97 $46.49

Revenue Earnings

$36.6 billion $550 million

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Page 3: Sears, Roebuck, & Co - Mark E. Moore

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 company’s large cash. Also, the company’s 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.

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Page 4: Sears, Roebuck, & Co - Mark E. Moore

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

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the retail market, behind: Wal-mart Stores Inc., Target Corp., Kohl’s 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

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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 aren’t 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.

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Page 7: Sears, Roebuck, & Co - Mark E. Moore

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.

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Page 8: Sears, Roebuck, & Co - Mark E. Moore

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 company’s

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 customer-

oriented 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 Land’s 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

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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

company’s 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).

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Page 10: Sears, Roebuck, & Co - Mark E. Moore

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 company’s 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.

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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 company’s

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 company’s

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 can’t 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 Roebuck’s critical estimates of the company’s 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 company’s 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 management’s

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

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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 write-

down 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 company’s 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 management’s 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

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via store credit cards, they do provide financing from external companies.

Sears Roebuck’s management’s 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 company’s 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

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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 company’s 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 company’s

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 long-

term debt.

Another key disclosure seen in the notes section on the 10-K is earning per share

ratio:

(Millions, except per share data) 2003 2002 2001

Net Income (1) $3,397 $1,376 $735

Average Common Shares Outstanding 284.3 317.4 326.4

Dilutive Effect of Stock Options 2 3.3 2.1

Total Average Common Shares

Outstanding 286.3 320.7 328.5

Earnings per Share:

Basic $11.95 $4.34 $2.25

Diluted $11.86 $4.29 $2.24

17

Page 19: Sears, Roebuck, & Co - Mark E. Moore

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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Page 20: Sears, Roebuck, & Co - Mark E. Moore

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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Page 21: Sears, Roebuck, & Co - Mark E. Moore

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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Page 22: Sears, Roebuck, & Co - Mark E. Moore

Preliminary Ratio Analysis (Screening Ratios)

2003

Sales Manipulation Diagnostics

Net Sales/Cash from sales 12.11

Net Sales/Net Accounts Receivable 3.22

Net Sales/Unearned Revenues 33.06

Net Sales/Inventory 7.71

Core Expense Manipulation

Diagnostics

Declining Asset Turnover (sales/assets) 1.48

Changes in CFFO/OI 2.53

Changes in CFFO/NOA 2.53

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Page 23: Sears, Roebuck, & Co - Mark E. Moore

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

Balance Sheet

Original Adjusted

2003/01/03 2003/01/03

ASSETS

Current assets

Cash and cash equivalents $9,057,000,000 $9,057,000,000

Credit card receivables $1,998,000,000 $1,998,000,000

Less allowance for uncollectible accounts $31,000,000 $992,000,000

Net credit card receivables $1,956,000,000 $1,956,000,000

Other receivables $733,000,000 $733,000,000

Merchandise inventories, net $5,335,000,000 $5,335,000,000

Prepaid expenses and deferred charges $407,000,000 $407,000,000

Deferred income taxes $708,000,000 $708,000,000

Total current assets $18,196,000,000 $17,235,000,000

Property and equipment

Land $392,000,000 $392,000,000

Buildings and improvements $7,151,000,000 $7,151,000,000

Furniture, fixtures and equipment $4,972,000,000 $4,972,000,000

Capitalized leases $609,000,000 $609,000,000

Gross property and equipment $13,124,000,000 $13,124,000,000

Less accumulated depreciation $6,336,000,000 $6,336,000,000

Total property and equipment, net $6,788,000,000 $6,788,000,000

Deferred income taxes $378,000,000 $378,000,000

Goodwill $943,000,000 $943,000,000

Tradenames and other intangible assets $710,000,000 $710,000,000

Other assets $708,000,000 $708,000,000

TOTAL ASSETS $27,723,000,000 $26,762,000,000

LIABILITIES

Current liabilities

Short-term borrowings $1,033,000,000 $1,033,000,000

Current portion of long-term debt and $2,950,000,000 $2,950,000,000

capitalized lease obligations

Merchandise payables $3,106,000,000 $3,106,000,000

Income taxes payable $1,867,000,000 $1,867,000,000

Other liabilities $2,950,000,000 $2,950,000,000

Unearned revenues $1,244,000,000 $1,244,000,000

Other taxes $609,000,000 $609,000,000

Total current liabilities $13,759,000,000 $13,759,000,000

Long-term debt and capitalized lease $4,218,000,000 $4,218,000,000

obligations

Pension and postretirement benefits $1,956,000,000 $1,956,000,000

Minority interest and other liabilities $1,389,000,000 $1,389,000,000

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Page 24: Sears, Roebuck, & Co - Mark E. Moore

Total Liabilities $21,322,000,000 $21,322,000,000

COMMITMENTS AND CONTINGENT LIABILITIES

SHAREHOLDERS EQUITY

Common shares issued ($.75 par value per share, $323,000,000 $323,000,000

1,000 shares authorized, 230.4 and 316.7 shares

outstanding, respectively)

Capital in excess of par value $3,519,000,000 $3,519,000,000

Retained earnings $11,636,000,000 $10,675,000,000

Treasury stock - at cost ($7,945,000,000) ($7,945,000,000)

Deferred ESOP expense ($26,000,000) ($26,000,000)

Accumulated other comprehensive loss ($1,106,000,000) ($1,106,000,000)

Total Shareholders Equity $6,401,000,000 $5,440,000,000

TOTAL LIABILITIES AND SHAREHOLDERS

EQUITY

$27,723,000,000 $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 company’s

competitors, and also we will compare Sears’ ratios with retail industry’s ratios.

These comparisons will help us see where Sears stands in the retail industry as

far as profitability and liquidity. In most people’s 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 & Roebuck’s 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) 1.32 2.15 2.32 1.95 2.09

Quick Asset Ratio (T) 0.85 1.81 1.92 1.48 1.63

Receivables Turnover (T) 2.43 1.39 1.67 1.95 1.88

Inventory Turnover (T) 5.01 5.12 5.06 5.1 5.58

Working Capital T/O (T) 9.88 5 4.8 4.97 5.14

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

Gross Profit Margin (%) 34.07 35.89 33.82 32.31 31.68

Operating Expense

Ratio(%)

26.9 27 24.9 23.27 22.6

Net Profit Margin (%) 8.26 3.33 1.79 3.28 3.54

Asset Turnover (T) 1.5 0.83 0.94 1.11 1.12

Return on Assets (%) 8.2 4.85 4.54 5.92 6.17

Return on Equity (%) 57.36 21.36 11.49 19.74 22.61

Capital Structure Ratios 12/31/03 12/31/02 12/31/01 12/31/00 12/31/99

Debt to Equity Ratio (T) 3.33 6.46 6.24 4.45 4.4

Times Interest Earned(T) 5.32 2.15 0.86 1.78 1.9

Debt Service Margin (T) 0.52 N/A 1.34 N/A 2.38

Level II Ratios

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

Dividend Payout Ratio

(%)

9.63 21.29 41.09 23.98 24.43

SGR (%) 51.83 16.81 6.77 15 17

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Page 26: Sears, Roebuck, & Co - Mark E. Moore

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

company’s 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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Page 27: Sears, Roebuck, & Co - Mark E. Moore

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 owner’s 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 high-

return investment projects are less likely to pay out a high proportion of earnings

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Page 28: Sears, Roebuck, & Co - Mark E. Moore

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 2002 2001 2000 1999

51.83% 16.81% 6.77% 15% 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 Sears Wal-Mart JC-Penney Target

5-Year Averages

Current Ratio (T) 1.97 0.83 2.31 1.64

Quick Asset Ratio (T) 1.54 0.14 1.58 0.77

Receivables Turnover (T) 1.86 229.44 65.43 28.4

Inventory Turnover (T) 5.17 7.5 3.23 4.2

Working Capital T/O (T) 5.96 6.2 5.2 4.3

Profitability Ratios

5-Year Averages

Gross Profit Margin (%) 33.55 21.94 33.03 31.25

Operating Expense Ratio

(%)

24.93 15.6 27.23 22.15

Net Profit Margin (%) 4.04 3.39 0.69 3.59

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Asset Turnover (T) 1.1 2.6 1.02 0.98

Return on Assets (%) 5.94 8.89 0.51 6.56

Return on Equity (%) 26.51 21.5 1.13 19.58

Capital Structure Ratios

5-Year Averages

Debt to Equity Ratio (T) 4.98 1.36 2.02 1.98

Times Interest Earned (T) 2.4 15.85 4.51 3.2

Debt Service Margin (T) 1.41 2.09 3.34 2.64

Comparison between Sears and Competitors: We are comparing Sears’ ratios with Wal-Mart’s, JC-Penney’s, and Target’s. 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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Page 30: Sears, Roebuck, & Co - Mark E. Moore

and 77% of the current liabilities for Target. Sears’ days to receivables ratio is

196 days, which compares unfavorably with Wal-Mart’s 1.6 days, JC-Penney’s 5.6

days, and Target’s 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-Penney’s

1.02 and Target’s 0.98 but is lower than Wal-Mart’s 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 Wal-

Mart 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.

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• Gross Profit Margin

Year Wal-Mart Target JC-Penney Sears

12/31/2003 20.14 28.87 30.02 34.07

12/31/2002 19.72 28.99 28.42 35.89

12/31/2001 20.68 28.91 27.3 33.82

12/31/2000 21.42 29.13 25.08 32.31

12/31/1999 21.94 31.02 32.06 31.68

05

10152025303540

1999 2000 2001 2002 2003

Wal-MartTargetJC-PennySears

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• Net Profit Margin

Year Wal-Mart Target JC-Penney Sears

12/31/2003 3.29 3.77 1.25 8.26

12/31/2002 3.06 3.43 .31 3.33

12/31/2001 3.29 3.43 -2.21 1.79

12/31/2000 3.26 3.39 1.03 3.28

12/31/1999 3.21 3.41 1.11 3.54

-4

-2

0

2

4

6

8

10

1999 2000 2001 2002 2003

Wal-MartTargetJC-PennySears

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• Return on Assets (ROA)

Year Wal-Mart Target JC-Penney Sears

12/31/2003 10.47 8.45 3.81 8.2

12/31/2002 9.66 8.59 1.95 4.85

12/31/2001 10.24 9.01 -1.87 4.54

12/31/2000 12.10 8.96 3.3 5.92

12/31/1999 11.19 8.88 2.12 6.17

-2

0

2

4

6

8

10

12

14

1999 2000 2001 2002 2003

Wal-MartTargetJC-PennySears

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• Return on Equity (ROE)

Year Wal-Mart Target JC-Penney Sears

12/31/2003 15.02 12.12 5.62 57.36

12/31/2002 13.77 12.87 3.23 21.36

12/31/2001 14.64 14.19 -2.78 11.49

12/31/2000 18.05 13.97 4.66 19.74

12/31/1999 17.65 13.12 4.02 22.61

-10

0

10

20

30

40

50

60

1999 2000 2001 2002 2003

Wal-MartTargetJC-PennySears

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• Inventory Turnover

Year Wal-Mart Target JC-Penney Sears

12/31/2003 8.08 6.52 4.45 5.01

12/31/2002 7.79 6.27 4.35 5.12

12/31/2001 7.29 6.29 4.00 5.06

12/31/2000 6.90 6.33 3.95 5.1

12/31/1999 7.15 6.31 4.15 5.58

0

1234

56789

1999 2000 2001 2002 2003

Wal-MartTargetJC-PennySears

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• Quick Ratio

Year Wal-Mart Target JC-Penney Sears

12/31/2003 .15 .84 .76 .85

12/31/2002 .15 .61 .79 1.81

12/31/2001 .13 .36 .43 1.92

12/31/2000 .12 .35 .53 1.48

12/31/1999 .13 .42 .62 1.63

00.20.40.60.8

11.21.41.61.8

2

1999 2000 2001 2002 2003

Wal-MartTargetJC-PennySears

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• Current Ratio

Year Wal-Mart Target JC-Penney Sears

12/31/2003 .93 1.59 2.01 1.32

12/31/2002 1.04 1.37 1.93 2.15

12/31/2001 .92 1.16 1.71 2.32

12/31/2000 .94 1.11 1.90 1.95

12/31/1999 .96 1.24 1.97 2.09

0

0.5

1

1.5

2

2.5

1999 2000 2001 2002 2003

Wal-MartTargetJC-PennySears

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Sears & Roebuck vs. Industry

Liquidity Ratios Company Industry

5-Year Averages

Current Ratio (T) 1.97 1.22

Quick Asset Ratio (T) 1.54 0.4

Receivables Turnover (T) 1.86 10.87

Inventory Turnover (T) 5.17 5.72

Working Capital T/O (T) 5.96 8.9

Profitability Ratios

5-Year Averages

Gross Profit Margin (%) 33.55 25.4

Operating Expense

Ratio(%) 24.93

21.66

Net Profit Margin (%) 4.04 3.39

Asset Turnover (T) 1.1 2.06

Return on Assets (%) 5.94 7.68

Return on Equity (%) 26.51 18.96

Capital Structure Ratios

5-Year Averages

Debt to Equity Ratio (T) 4.98 1.79

Times Interest Earned (T) 2.4 7.85

Debt Service Margin (T) 1.41 2.69

Comparison between Sears and Retail Industry:

Sears’ current ratio is 1.97 and this means that to satisfy the claims of short-

term creditors exclusively from existing current assets, Sears must be able to

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Page 39: Sears, Roebuck, & Co - Mark E. Moore

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 industry’s 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 industry’s 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 company’s 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 industry’s 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 industry’s 18.96%. The company’s higher profit margins have

resulted in profitability ratios superior to the industry’s norms, even after the

effects of debt financing are considered.

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Financial Statements Forecasting – EXHIBIT AA

Sears & Roebuck’s 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 didn’t 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 company’s domestic credit sector. We didn’t

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 year’s 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 K-

Mart 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

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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) EPS BPS DPS PPS P/E P/B D/P P/S

Sears & Roebuck 36,600 2.75 28.3 0.92 34.8

Wal - Mart 287,100 2.4 10.75 0.48 53.8 22.44 5 0.0089 0.00019

Target 46,550 2.15 14.35 0.3 50.39 23.44 3.51 0.006 0.001

J.C - Penney 18,600 2.15 18.75 0.5 34.78 16.18 1.86 0.0143 0.0019Industry Average: 20.69 3.46 0.0097 0.001W/O Trimming Sears P from P/E: 56.9 industry P/E * Sears EPS Sears P from P/B: 97.92 industry P/B * Sears BPS Sears P from DPS/PPS: 94.84 Sears DPS/ industry DPS/PPS Sears P from P/S: 36.6 industry P/S * Sears Sales Industry Average: 22.94 2.94 0.0075 0.0015 With Trimming Sears P from P/E: 63.08 industry P/E * Sears EPS Sears P from P/B: 83.2 industry P/B * Sears BPS Sears P from DPS/PPS: 122.66 Sears DPS/ industry DPS/PPS Sears P from P/S: 54.9 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

company’s 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 company’s

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 Average (i) MV (mil.) Percent Wtd Average

1-3 years 6.25% 236 10.00% 0.63%

4-9 years 9.38% 251 10.00% 0.94%

10+ years 7.50% 1838 80.00% 6.00%

Sum of MV 2325

Long term debt rate 7.57%

Short term debt

rate 3.76%

Weight of ST Debt = ((ST debt + LT debt)/Tot. Liabilities) 19.8%

Weight of LT Debt 80.2%

Cost of Debt (Kd) = (Avg. ST Debt * Weight ST Debt) + (Avg. LT Debt * Weight LT Debt) 6.80%

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%,

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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 0.0732 0.0850 0.0950 WACC

0.0250 38.5584 28.2920 18.4327 12.6719

0.0350 52.7774 36.9408 23.2434 15.8358

0.0450 81.2152 51.7236 30.4594 20.2652

0.0550 166.5288 82.7512 42.4861 26.9093

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.

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Sensitivity Analysis

0.0849 0.0949 0.1049 0.1149 Ke

0.015 44.748 37.3288 31.6835 27.27

0.025 46.1116 37.7786 31.6472 26.974

0.035 48.0217 38.3786 31.6006 26.604

0.045 50.8893 39.219 31.5383 26.1281

Growth

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 0.0949 0.1049 0.1149 Ke

0.015 54.7923 44.5106 37.264 31.9465

0.025 56.5927 45.3606 37.6453 32.0891

0.035 59.1147 46.4944 38.1358 32.2673

0.045 62.9009 48.0827 38.7899 32.4966

Growth

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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 doesn’t represent the fundamental value of

Sears’ stock price in 2004.

Sensitivity Analysis

0.0667 0.0767 0.0867 0.0967 Ke

0.015 25.496 21.096 17.9363 15.56004

0.025 29.919 23.87 19.7937 16.8635

0.035 37.133 27.975 22.3697 18.58946

0.045 50.996 34.669 26.1812 20.98311

Growth

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.

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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 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Total Sales 36,600 37,332 38,078 38,840 39,617 40,409 41,218 42,041 42,882 43,740

Cost of Goods Sold 23,954 23,714 23,477 23243 23,010 22,789 22,552 22,327 22,103 21,882

Gross Profit 12,646 13,618 14,601 15,597 16,607 17,620 18,666 19,714 20,779 21,858

Operating Expense 7,956 8,275 8,605 8,949 9,307 9,680 10,067 10,470 10,889 11,324

NIBIT 4,690 5,343 5,996 6,648 7,300 7,940 8,599 9,244 9,890 10,534

Interest Expense 1,225 1,167 1,111 1,059 1,008 961 915 871 830 790

Pretax Income 3,465 4,176 4,885 5,589 6,292 6,979 7,684 8,373 9,060 9,744

Income Taxes (37%) 1,282 1,545 1,807 2,068 2,328 2,582 2,843 3,098 3,352 3,605

NET INCOME 2,183 2,631 3,078 3,521 3,964 4,397 4,841 5,275 5,708 6,139

BALANCE SHEET

Year 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Cash & Equivalents 3,509 4,210 5,053 6,063 7,276 8,731 10,488 12,573 15,088 18,105

Accounts Receivables 9,205 8,100 7,128 6,272 5,520 4,858 4,275 3,762 3,310 2,913

Inventory 5,850 5,932 6,015 6,099 6,185 6,271 6,359 6,448 6,538 6,630

Total Current Assets 18,564 18,242 18,196 18,434 18,981 19,860 21,122 22,783 24,936 27,648

Accounts Payable 4,019 3,506 3,059 2,669 2,329 2,031 1,772 1,546 1,349 1,177

Total Current Liabilities 9,612 9,107 8,629 8,176 7,747 7,340 6,955 6,590 6,244 5,916

Working Capital 8,952 9,135 9,567 10,258 11,234 12,520 14,167 16,193 18,692 21,732

Total Assets 22,432 21,748 21,084 20,441 19,818 19,213 18,628 18,059 17,509 16,975

Total Liabilities 16,834 16,329 15,839 15,364 14,903 14,456 14,022 13,601 13,193 12,798

Total Shareholder's Equity 5,598 5,419 5,245 5,077 4,915 4,757 4,606 4,458 4,316 4,177

Statement of Cash Flows

Year 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

CFFO 2,612.33 2,703.77 2,798.40 2,896.35 2,997.72 3,102.64 3,211.23 3,323.63 3,439.95 3,560.05

CFFI 1,989 2,074.44 2,164.55 2,257.81 2,354.33 2,454.23 2,557.63 2,664.65 2,775.41 2,890.05

Free Cash Flows 623.33 629.330 633.850 638.540 643.390 648.410 653.600 658.980 664.540 670.300

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EXHIBIT A (amounts in millions) 5 YR ANNUAL BALANCE SHEET 12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999Assets

Cash & Equivalents 9,057.00 1,962.00 1,064.00 842 729 Receivables Net 2,689.00 31,622.00 28,813.00 20,928.00 21,581.00 Inventories 5,335.00 5,115.00 4,912.00 5,618.00 5,069.00 Prepaid Expenses n/a n/a n/a n/a n/a Other Current Assets 1,115.00 1,284.00 1,316.00 1,406.00 1,288.00 Total Current Assets 18,196.00 39,983.00 36,105.00 28,794.00 28,667.00 Long Term Receivables 0 0 0 0 0 Investments in Unconsol Subsidiaries 0 0 0 0 0 Other Investments 0 0 0 0 0 Property, Plant & Equip - Gross 13,124.00 12,979.00 13,137.00 12,585.00 11,912.00 Accumulated Depreciation 6,336.00 6,069.00 6,313.00 5,932.00 5,462.00 Property, Plant & Equipment - Net 6,788.00 6,910.00 6,824.00 6,653.00 6,450.00 Other Assets 2,361.00 2,782.00 973 1,278.00 1,470.00 Total Assets 27,345.00 49,675.00 43,902.00 36,725.00 36,587.00 Liabilities Accounts Payable 3,106.00 2,945.00 7,176.00 7,336.00 6,992.00 ST Debt & Current Portion Due LT Debt 3,983.00 9,333.00 6,714.00 6,840.00 5,154.00 Accrued Payroll n/a n/a n/a n/a n/a Income Taxes Payable 1,867.00 787 n/a 562 n/a Dividends Payable n/a n/a n/a n/a n/a Other Current Liabilities 4,803.00 5,532.00 1,694.00 0 1,555.00 Total Current Liabilities 13,759.00 18,597.00 15,584.00 14,738.00 13,701.00 Long Term Debt 4,218.00 21,304.00 18,921.00 11,020.00 12,884.00 Provision For Risks And Charges 1,956.00 2,491.00 1,732.00 1,951.00 2,180.00 Deferred Income n/a n/a n/a 1,058.00 0 Deferred Taxes -378 -734 -415 -174 -367 Deferred Tax Liability In Untaxed Reserves n/a n/a n/a n/a n/a Other Liabilities 0 0 0 0 0 Total Liabilities 19,555.00 41,658.00 35,822.00 28,593.00 28,398.00 Shareholders' Equity Non-Equity Reserves 0 0 0 0 0 Minority Interest 1,389.00 1,264.00 1,961.00 1,363.00 1,350.00 Preferred Stock n/a n/a n/a 0 0 Common Equity 6,401.00 6,753.00 6,119.00 6,769.00 6,839.00 Total Liabilities & Shareholders' Equity 27,345.00 49,675.00 43,902.00 36,725.00 36,587.00 * Balance Sheet comes from Thomson One Business website

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

NET INCOME 8.35% 3.81% 1.81% 3.40% 3.69%

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EXHIBIT B (amounts in millions) 5 YR ANNUAL INCOME STATEMENT 12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999 Sales 41,124.00 41,366.00 41,078.00 40,937.00 41,071.00 Cost of Goods Sold 26,202.00 25,646.00 26,322.00 26,885.00 27,212.00 Depreciation, Depletion & Amortization 909 875 863 826 848 Gross Income 14,013.00 14,845.00 13,893.00 13,226.00 13,011.00

Selling, General & Admin Expenses 10,951.00 11,210.00 10,236.00 9,526.00 9,289.00

Other Operating Expenses 0 0 0 0 0

Total Operating Expenses 38,062.00 37,731.00 37,421.00 37,237.00 37,349.00

Operating Income 3,062.00 3,635.00 3,657.00 3,700.00 3,722.00 Extraordinary Credit - Pretax 93 0 0 0 0

Extraordinary Charge - Pretax 932 411 1,064.00 265 41

Non-Operating Interest Income 0 0 0 0 0 Reserves - Inc(Dec) 0 0 0 0 0 Pretax Equity Interest Earnings 0 0 0 0 n/a Other Income/Expense - Net 4,243.00 352 33 36 6 Earnings Bef Interest & Taxes 6,466.00 3,576.00 2,626.00 3,471.00 3,687.00 Interest Expense on Debt 1,027.00 1,147.00 1,426.00 1,252.00 1,273.00 Interest Capitalized 2 4 11 4 5 Pretax Income 5,441.00 2,433.00 1,211.00 2,223.00 2,419.00 Income Taxes 2,007.00 858 467 831 904 Minority Interest 45 11 21 49 62 Equity Interest Earnings 8 20 12 0 0 After Tax Other Income/Expense 0 0 0 0 0 Discontinued Operations 0 0 0 0 0 Net Income Bef Extraordinary Items & Disc Ops 3,397.00 1,584.00 735 1,343.00 1,453.00 Preferred Dividends 0 0 0 0 0 Extraordinary Items & Gain(Loss) Sale of Assets 0 -208 0 0 0 Net Income Bef Preferred Dividends 3,397.00 1,376.00 735 1,343.00 1,453.00

Preferred Dividend Requirements 0 0 0 0 0 Net Income Available To Common 3,397.00 1,376.00 735 1,343.00 1,453 * Balance Sheet comes from Thomson One Business website

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EXHIBIT C (amounts in millions) 5 YEAR ANNUAL CASH FLOW STATEMENT 12/31/2003 12/31/2002 12/31/2001 12/31/2000 12/31/1999Operating Activities Income Bef Extraordinary Items 3,397.00 1,584.00 735 1,343.00 1,453.00 Depreciation, Depletion & Amortization 909 875 751 826 848

Deferred Inc Taxes & Inv Tax Credit 648 -203 146 26 356 Other Cash Flow -1,561.00 2,049.00 2,401.00 1,208.00 967 Funds From Operations 3,393.00 4,305.00 4,033.00 3,403.00 3,624.00 Extraordinary Items 0 0 0 0 n/a

Funds From/For Other Operating Acts -869 -4,810.00 -1,771.00 -701 73 Net Cash Flow From Operating Activities 2,524.00 -505 2,262.00 2,702.00 3,697.00 Investing Activities Capital Expenditures 925 1,035.00 1,126.00 1,084.00 1,033.00 Additions To Other Assets 0 0 0 0 0 Net Assets From Acquisitions 0 1,840.00 0 1 68

Increase In Investments 21 15 21 40 0 Decrease In Investments 0 0 0 75 0 Disposal of Fixed Assets 21,704.00 568 0 0 118 Other Use/(Source) - Investing 0 0 59 0 0 Net Cash Flow From Investing Activities -20,758.00 2,322.00 1,088.00 1,050.00 983 Financing Activities Net From Sales/Issue of Com/Prf Stock 0 0 0 0 0

Com/Prf Purchased,Retired,Converted 3,673.00 427 625 1,233.00 570

Long Term Borrowings 3,757.00 6,565.00 4,124.00 824 1,491.00

Inc(Dec) In ST Borrowings -3,519.00 964 -708 1,295.00 -1,653.00

Reduction In Long Term Debt 12,643.00 3,256.00 3,552.00 2,277.00 1,516.00

Cash Dividends Paid - Total 327 293 302 322 355

Other Source/(Use) - Financing 2 11 33 118 57 Net Cash Flow From Financing Activities -16,212.00 3,721.00 -955 -1,537.00 -2,485.00 * Balance Sheet comes from Thomson One Business website

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EXHIBIT 2

DATE S&P 500 Return

T-Bills Returns

Excess Return (Rm-Rf)

Adjusted Price Return

19991030 8.03% 0.35% 7.68% 38.83

19991130 5.91% 0.38% 5.53% 41.18 5.71%

19991231 5.64% 0.37% 5.27% 36.89 -11.63%

20000129 4.10% 0.38% 3.72% 34.84 -5.88%

20000226 -3.23% 0.41% -3.64% 35.47 1.78%

20000331 3.88% 0.43% 3.45% 39.45 10.09%

20000430 3.79% 0.42% 3.37% 40.15 1.74%

20000528 -2.50% 0.45% -2.95% 41.93 4.25%

20000630 5.44% 0.48% 4.96% 39.08 -7.29%

20000730 -3.21% 0.47% -3.68% 35.52 -10.02%

20000831 -0.63% 0.49% -1.11% 33.08 -7.38%

20000930 -2.86% 0.48% -3.34% 27.67 -19.55%

20001029 6.25% 0.50% 5.75% 24.86 -11.30%

20001130 1.91% 0.50% 1.41% 30.38 18.17%

20001231 5.78% 0.52% 5.27% 26.99 -12.56%

20010131 -5.09% 0.55% -5.64% 27.49 1.82%

20010229 -2.01% 0.56% -2.57% 24.71 -11.25%

20010331 9.67% 0.54% 9.13% 27.45 9.98%

20010428 -3.08% 0.52% -3.60% 32.94 16.67%

20010531 -2.19% 0.56% -2.75% 33.32 1.14%

20010630 2.39% 0.53% 1.87% 29.43 -13.22%

20010731 -1.63% 0.52% -2.15% 26.95 -9.20%

20010831 6.07% 0.51% 5.57% 28.34 4.90%

20010929 -5.35% 0.49% -5.84% 29.46 3.80%

20011031 -0.50% 0.48% -0.98% 27.02 -9.03%

20011130 -8.01% 0.48% -8.48% 29.69 8.99%

20011229 0.41% 0.43% -0.03% 31.81 6.66%

20020131 3.46% 0.41% 3.06% 35.47 10.32%

20020228 -9.23% 0.41% -9.64% 37.79 6.14%

20020330 -6.42% 0.39% -6.81% 32.47 -16.38%

20020430 7.68% 0.40% 7.28% 33.92 4.27%

20020531 0.51% 0.41% 0.10% 36.92 8.13%

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20020629 -2.50% 0.40% -2.90% 39.17 5.74%

20020731 -1.08% 0.40% -1.47% 43.49 9.93%

20020831 -6.41% 0.38% -6.79% 39.78 -9.33%

20020928 -8.17% 0.34% -8.52% 32.24 -23.39%

20021031 1.81% 0.33% 1.48% 36.08 10.64%

20021130 7.52% 0.33% 7.19% 42.57 15.25%

20021231 0.76% 0.37% 0.39% 44.56 4.47%

20030131 -1.56% 0.36% -1.92% 49.43 9.85%

20030228 -2.08% 0.36% -2.44% 49.39 -0.08%

20030328 3.67% 0.40% 3.28% 48.16 -2.55%

20030430 -6.14% 0.39% -6.53% 49.55 2.81%

20030531 -0.91% 0.37% -1.28% 55.7 11.04%

20030628 -7.25% 0.35% -7.60% 51.22 -8.75%

20030731 -7.90% 0.32% -8.22% 44.49 -15.13%

20030830 0.49% 0.27% 0.21% 43.14 -3.13%

20030930 -11.00% 0.25% -11.25% 36.97 -16.69%

20031031 8.64% 0.25% 8.40% 24.9 -48.47%

20031129 5.71% 0.25% 5.45% 26.49 6.00%

20031231 -6.03% 0.25% -6.29% 22.9 -15.68%

20040131 -2.74% 0.25% -3.00% 25.29 9.45%

20040228 -1.70% 0.24% -1.94% 21.05 -20.14%

20040331 0.84% 0.23% 0.60% 23.34 9.81%

20040430 8.10% 0.24% 7.86% 27.39 14.79%

20040530 5.09% 0.21% 4.88% 29.2 6.20%

20040630 1.13% 0.19% 0.94% 32.77 10.89%

20040731 1.62% 0.24% 1.38% 39.64 17.33%

20040829 1.79% 0.28% 1.51% 43.11 8.05%

20040930 -1.19% 0.27% -1.46% 42.83 -0.65%

20041031 5.50% 0.27% 5.23% 51.54 16.90%

Average 0.18% 0.39% -0.21%

Beta Intercept R^2 T-Test

0.48991 -0.0008446 0.038576 0.489913 Cost of Equity (estimated B) 3.82%

55

Page 57: Sears, Roebuck, & Co - Mark E. Moore

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

Commercial Paper (Financial)

Date % Paid

Oct-99 5.09%

Nov-99 5.15%

Dec-99 5.04%

Jan-00 4.81%

Feb-00 4.82%

Mar-00 4.84%

Apr-00 4.80%

May-00 4.83%

Jun-00 5.04%

Jul-00 5.14%

Aug-00 5.28%

Sep-00 5.32%

Oct-00 5.93%

Nov-00 5.85%

Dec-00 5.93%

Jan-01 5.81%

Feb-01 5.90%

Mar-01 6.03%

Apr-01 6.15%

May-01 6.57%

Jun-01 6.59%

Jul-01 6.54%

Aug-01 6.49%

Sep-01 6.47%

Oct-01 6.52%

Nov-01 6.52%

Dec-01 6.33%

Jan-02 5.51%

Feb-02 5.19%

Mar-02 4.81%

Apr-02 4.47%

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Page 58: Sears, Roebuck, & Co - Mark E. Moore

May-02 3.96%

Jun-02 3.69%

Jul-02 3.62%

Aug-02 3.44%

Sep-02 2.84%

Oct-02 2.29%

Nov-02 2.00%

Dec-02 1.81%

Jan-03 1.72%

Feb-03 1.80%

Mar-03 1.87%

Apr-03 1.83%

May-03 1.80%

Jun-03 1.78%

Jul-03 1.76%

Aug-03 1.71%

Sep-03 1.74%

Oct-03 1.71%

Nov-03 1.37%

Dec-03 1.32%

Jan-04 1.27%

Feb-04 1.25%

Mar-04 1.21%

Apr-04 1.23%

May-04 1.20%

Jun-04 1.02%

Jul-04 1.03%

Aug-04 1.06%

Sep-04 1.06% Oct-04 1.06% Sh-T Debt 3.76%

TTM Average MV (mill.) Percent Wtd Avg 1-3 years 6.25% 236 10.00% 0.63% 4-9 years 9.38% 251 10.00% 0.94% 10+ years 7.50% 1838 80.00% 6.00% Sum of MV 2325

L-T Debt 7.57%

57

Page 59: Sears, Roebuck, & Co - Mark E. Moore

58

Cost of Debt = 6.8% Cost of Debt = 0.0376 * 0.198 + 0.0757 * 0.802

Z - Score

WC/Total Assets 0.1622 1.2 1.946

Ret Earnings/TA 0.426 1.4 0.6

EBIT/Total Assets 0.236 3.3 0.78

MV Equity/BV Liab 2.44 0.6 1.14

Sales/Total Assets 1.5 1 1.5

Z -

Score 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%

Page 60: Sears, Roebuck, & Co - Mark E. Moore

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= 0.0949

230.38 million shares outstanding Free Cash Flow (2014 and on) = 170.3 mill $693.7 mill

0 1 2 3 4 5 6 7 8 9 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Cash Flow from Operations $2,703.77 $2,798.40 $2,896.35 $2,997.72 $3,102.64 $3,211.23 $3,323.63 $3,439.95 $3,560.35

Cash Provided by Inv Activities ($2,074.44) ($2,164.55) ($2,257.81) ($2,354.33) ($2,454.23) ($2,557.63) ($2,664.65) ($2,775.41) ($2,890.05) Free Cash Flow (to firm) 629.330 633.850 638.540 643.390 648.410 653.600 658.980 664.540 670.300 693.761 Discount Rate (WACC) 0.0732 Present Value Factors 0.932 0.868 0.809 0.754 0.702 0.655 0.610 0.568 0.530 PV of Free Cash Flows 586.405 550.333 516.590 485.011 455.456 427.787 401.890 377.638 354.930 Total PV Annual Cash Flows 4156.04 PV of Terminal Value 9616.57

(693.76/(.0732-.035))*.529 Sensitivity Analysis Value of the Firm 13772.61 Value of Debt 5251.00 0.0650 0.0732 0.0850 0.0950 WACC

Value of Equity 8521.61 0.0250 38.5584 28.2920 18.4327 12.6719

VE = VF - VD 0.0350 52.7774 36.9408 23.2434 15.8358

Estimated per Value Share 12/31/2004 36.989 0.0450 81.2152 51.7236 30.4594 20.2652

PPS= VE / #shares outstanding 0.0550 166.5288 82.7512 42.4861 26.9093

Estimated Value per Share 11/01/2004 36.941 Growth 36.989/(1+Ke/12^(2/12)) Actual Price per Share ($) 34.78

59

Page 61: Sears, Roebuck, & Co - Mark E. Moore

EXHIBIT 4

Residual Income Method All data is stated in Per Share amounts Ke = 0.0949 Growth 3.50% 0 1 2 3 4 5 6 7 8 9 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Beginning BE (per share) 30.36 33.22 36.26 39.57 43.05 46.65 50.25 53.95 57.75 EPS 3.8 4 4.3 4.5 4.8 5 5.2 5.4 6 DPS 0.94 0.96 0.99 1.02 1.2 1.4 1.5 1.6 1.6 Ending BE (per share) 30.36 33.22 36.26 39.57 43.05 46.65 50.25 53.95 57.75 62.15 Ke 0.0949 Normal Income 2.881164 3.152578 3.441074 3.755193 4.085445 4.427085 4.768725 5.119855 5.480475 (BE * Ke) Residual Income (RI) 0.918836 0.847422 0.858926 0.744807 0.714555 0.572915 0.431275 0.280145 0.519525 0.5377084 (EPS - NI) Present Value Factors 0.913325 0.834163 0.76186256 0.695828 0.635518 0.580435 0.530126 0.484177 0.442211 Present value of RI 0.839196 0.706888 0.65438356 0.518258 0.454112 0.33254 0.22863 0.13564 0.22974 BV Equity (per share) 2003 30.36 Total PV of RI (end 2003) 4.09939 PV of Terminal Value (end 2003) 3.969629 Sensitivity Analysis 0.538/(.0949-0.035) * 0.442 0.0849 0.0949 0.1049 0.1149 Ke Estimated Value per Share 12-31-04 38.43 0.015 44.748 37.3288 31.6835 27.27 Estimated Value per Share 11-01-04 38.38 0.025 46.1116 37.7786 31.6472 26.974

Actual Price per Share ($) 34.78 0.035 48.0217 38.3786 31.6006 26.604 0.045 50.8893 39.219 31.5383 26.1281

Growth

60

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EXHIBIT 5

Abnormal Earnings Growth All data is stated in Per Share amounts Ke = 0.0949 Growth 3.50% 1 2 3 4 5 6 7 8 9 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 EPS 3.5 3.8 4 4.3 4.5 4.8 5 5.2 5.4 6 DPS 0.92 0.94 0.96 0.99 1.02 1.2 1.4 1.5 1.6 1.6 DPS invested at 9.49% 0.087308 0.089206 0.091104 0.093951 0.096798 0.11388 0.13286 0.14235 0.15184 Cum-Dividend Earnings 3.887308 4.089206 4.391104 4.593951 4.896798 5.11388 5.33286 5.54235 6.15184 (EPS + DRIP) Normal Earnings 3.83215 4.16062 4.3796 4.70807 4.92705 5.25552 5.4745 5.69348 5.91246 [EPS * (1+ Ke)] Abnormal Earning Growth (AEG) 0.055158 -0.07141 0.011504 -0.11412 -0.03025 -0.14164 -0.14164 -

0.15113 0.23938 0.102014

(Cum Div - Normal EPS) PV of AEG 0.050377 0.008764 0.10585656 EPS 2004 3.5 Total PV of AEG 0.164998 ( We excluded the negative AEGs) PV of Terminal Value 0.753 Sensitivity Analysis Total PV of AEG + EPS 2004 4.418 0.0849 0.0949 0.1049 0.1149 Ke

Capitalization Rate (perpetuity) 0.0949 0.015 54.7923 44.5106 37.264 31.9465

0.025 56.5927 45.3606 37.6453 32.0891 Estimated Value per Share 12-31-04 46.56 0.035 59.1147 46.4944 38.1358 32.2673

(4.418 / 0.0949) 0.045 62.9009 48.0827 38.7899 32.4966 Estimated Value per Share 11-01-04 46.49 Growth

61

46.56/(1+Ke/12^(2/12)) Actual Price per Share ($) 34.78

Page 63: Sears, Roebuck, & Co - Mark E. Moore

62

EXHIBIT 6

Discounted Dividends Method All data is stated in Per Share amounts WACC= 0.0732 Kd = 0.068 Growth= 0.035 Ke(new) = 0.0767 0 1 2 3 4 5 6 7 8 9 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 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 0.94 0.96 0.99 1.02 1.2 1.4 1.5 1.6 1.6 1.656 PV Factors 0.928764 0.862602 0.801154 0.744083 0.691077 0.641847 0.59612455 0.553659 0.51422 PV of Forecasted Dividends 0.873038 0.828098 0.793142 0.758964 0.829292 0.898586 0.89418683 0.885854 0.82275 Total PV of Forecasted Dividends 7.583912 PV of terminal value 20.42076 (1.656/(.0767-.035))*.514 Estimated Value Per Share 12-31-04 28 Estimated Value Per Share 11-01-04 27.97 Sensity Analysis 28.0/(1+(Ke/12))^(2/12) Actual Price Per Share (2003) ($) 34.78 0.0667 0.0767 0.0867 0.0967 Ke 0.015 25.496 21.096 17.9363 15.56004 0.025 29.919 23.87 19.7937 16.8635 0.035 37.133 27.975 22.3697 18.58946 0.045 50.996 34.669 26.1812 20.98311

Growth

Page 64: Sears, Roebuck, & Co - Mark E. Moore

Bibliography Sources

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63