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The Economist Case Competition – Submission

Sprott School of Business

Members:

Asmerom (Peter) Tewolde

Geng Pei

Kyle Stolys

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Table of Contents 1.00 Introduction: .................................................................................................................................... 3

1.10 Objective ..................................................................................................................................... 3

1.20 Background ................................................................................................................................. 3

1.21 Kmart ...................................................................................................................................... 4

1.22 Sears Domestic ........................................................................................................................ 4

1.23 Sears Canada............................................................................................................................ 4

1.30 Industry ....................................................................................................................................... 5

1.40 Why Sears is a “Zero” by 2020? ................................................................................................... 5

1.41 Shop Your Way ....................................................................................................................... 6

2.00 Financial Analysis ........................................................................................................................... 7

2.10 Income Statement ........................................................................................................................ 9

2.20 Balance Sheet ............................................................................................................................ 11

2.30 Cash from Operations ................................................................................................................ 12

3.00 Valuations under distress: .............................................................................................................. 12

3.10 Modified Discounted Cash Flow Valuation: ............................................................................... 13

3.20 Monte Carlo Simulation of DCF Valuation ................................................................................ 14

4.00 Quantitative Bankruptcy Model ..................................................................................................... 15

4.10 Retail Bankruptcy Model ........................................................................................................... 15

4.20 Methodology: ............................................................................................................................ 15

4.30 Results and Comparison: ............................................................................................................ 16

4.40 Application to Sears Holdings: ................................................................................................... 16

Works Cited .......................................................................................................................................... 17

Appendix A: “Shop Your Way” Screenshots ......................................................................................... 19

Appendix B: Historical Income Statement ............................................................................................. 20

Appendix C: Historical Income Statement – Common Size .................................................................... 21

Appendix D: Historical Balance Sheet ................................................................................................... 22

Appendix E: Historical Balance Sheet – Common Size .......................................................................... 23

Appendix F: Historical Cash flow Statement – Common Size ................................................................ 24

Appendix G: Historical Financial Ratios ................................................................................................ 25

Appendix H: Monte Carlo Simulation .................................................................................................... 26

Appendix I: Modified Discounted Cash Flow Valuation – Revenue Forecast ......................................... 28

Appendix J: Modified Discounted Cash Flow Valuation – CapEx and Working Capital Assumptions .... 29

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Appendix: Modified Discounted Cash Flow Valuation – WACC Calculation ......................................... 29

Appendix K: Modified Discounted Cash Flow Valuation – Probability of Distress Calculation .............. 30

Appendix L: Modified Discounted Cash Flow Valuation – Calculation for Market Value of Debt .......... 31

Appendix M: Modified Discounted Cash Flow Valuation – Forecast Assumptions ................................ 32

Appendix N: Modified Discounted Cash Flow Valuation – Forecast Assumptions ................................. 33

Appendix O: Quantitative Bankruptcy Model ........................................................................................ 34

1.00 Introduction:

1.10 Objective

The objective of this report is to show why Sears Holdings Corporation will be bankrupt

by 2020. We will cover the history of Sears, its current operations and business model, current

industry trends, the company‟s financial situation, and various models that sum up our argument

for Sears‟ inevitable bankruptcy.

1.20 Background

Sears Holding Corporation (Sears) is the parent company of Kmart Holding Corporation

and Sears, Roebuck and Co. which together create an integrated retailer offering an assortment of

apparel, appliances, electronics, and automotive parts, among several other categories. The

history of the two company‟s begins in 1893 when Sears, Roebuck and Co. was founded. The

company began as a mail order business with their famous catalog, and later began operating

retail stores that were largely successful and led to a rapid expansion of the business. Kmart

began in 1899 with 1 store, selling all products for 5 and 10 cents built on the business

philosophy of “offer customer‟s products they need at prices they can afford”. In 2002 Kmart

filed for Chapter 11 and while in bankruptcy ESL Investments, managed by Edward S. Lampert

purchased the majority of the company‟s debt and later listed it on the NASDAQ, retaining an

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ownership of over 50%. In 2004 Kmart announced that it would be purchasing Sears, Roebuck

and Co. The newly formed company became Sears Holding Corporation and Edward S. Lampert

remains a 50% shareholder today.

The business can be split into three segments, Kmart, Sears Domestic, and Sears Canada..

1.21 Kmart

Kmart operates 1050 stores as of November 1, 2014 throughout the U.S. Most Kmart

stores are one-floor, free-standing units that offer a wide array of products including consumer

electronics, outdoor living, toys, lawn and garden equipment, appliances, food and consumables,

and apparel. In 2013, the Kmart segment had $13.2B in revenues, and -$351M in operating

income. Comparable store sales also declined 3.6%.

1.22 Sears Domestic

Sears Domestic operates 781 stores as of November 1, 2014 across the U.S. These stores are

primarily mall based and offer a wide array of products including appliances, consumer

electronics, tools, sporting goods, outdoor living, lawn and garden equipment, automotive

services and products, apparel, and home fashion. Sears also operates approximately 690 Auto

Centers in Sears‟ stores and 34 free standing stores. In 2013, the Sears Domestic segment had

$19.2B in revenues, and -$940M operating income. Comparable store sales also declined 4.1%.

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1.23 Sears Canada

Sears Canada operates 418 stores as of November 1, 2014 and conducts retail operations

similar to Sears Domestic, with greater emphasis on apparel, footwear, and accessories. In 2013,

the Sears Canada segment had $3.8B in revenues, and $538M in operating income. Comparable

sales declined 2.7%. As of November 1, 2014 this segment was de-consolidated from Sears as

the company completed a rights offering of 40 million Sears Canada shares, bringing their stake

in the company down to approximately 10% from 51%.

1.30 Industry

The retail industry has undergone drastic change since the turn of the century. The rise of the

internet has resulted in greater competition in an already cut-throat retail market. Consumers can now

purchase products on any device from almost any retailer around the globe calling into question the

traditional retail model and particularly department stores. U.S. Department stores have performed poorly

in recent years growing revenues at rates below the pace of the overall retail channel (Bloomberg). PwC

expects this trend to continue projecting department stores to be the second worst performing channel in

retail growing at a CAGR of 1.6% from 2015-2020. By 2020 PwC expects non-store retail to play an

increasingly larger role in the retail channel accounting for 12% of the retail marketplace by 2020.

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Sears fits into this picture as one of the worst performing department stores over the past

10 years. Since 2001 U.S. retail sales (ex. Auto) has grown at an average rate of 4%. Over this

same period comparable store sales at Sears have fallen every single year at an average rate of -

5.4%. Department stores have been slow to react to changing consumers who today are more

informed and have greater empowerment due to the ease of access to price comparisons, detailed

product information, and user reviews. Sears has been far worse than most, with customers

clearly displeased with the retailer moving their shopping elsewhere. The days of flipping

through the Sears catalogue creating a Christmas wishlist are over, and Sears has completely

failed to adapt to today‟s environment. Since 2009 Sears has reduced its store count from over

4000 to 1831. During that time Sears has spun off their Hometown and Outlet business, Sears

Canada, Orchard Supply Hardware, and have sold many of their owned stores, all in an effort to

raise liquidity and simplify their business.

1.40 Why Sears is a “Zero” by 2020?

The company was founded in the 1890‟s during the era of the rural general store. Farmers

struggled, unable to sell enough crops to live, and the inefficient distribution network of the

general store resulted in large mark ups in rural retail prices of up to 100% greater than

wholesale prices. Farmers protested, and Sears was born. Due to volume buying, and later free

rural delivery Sears was a happy alternative to the high priced rural stores. Sears developed their

catalogue and by 1895 was 532 pages full of „fanciful writing‟ that enticed farmers to make

orders. As time went on, and customers changed, Sears adapted. Buyers began to look beyond

price tags towards quality and around the turn of the 20th century the catalog shifted from the

“flamboyant to the factual”. Sears understood their value proposition, their customers and

prospered because of it. Today Sears is big, slow and is attempting to react in an industry that as

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written in their annual report is “...rapidly changing. The progression of the internet, mobile

technology, social networking and social media is fundamentally reshaping the way we interact

with our core customers and members.” In response Sears is realigning their business to a

member-centric, and integrated retail model. They are focusing on core customers (members)

and striving to bring them value and convenience.

1.41 Shop Your Way

Tying together the goals for a member centric and integrated business, Sears created Shop Your

Way, a program that rewards members and enhances interaction between them, creating an e-

commerce platform and a social network. Shop Your Way is the company‟s answer to declining

sales and negative profitability. With this program they believe they can compete with Walmart,

Target, Macy‟s, and Amazon, and begin to regain market share. Shop Your Way was launched in

2009 as a rewards program and Sears invested heavily building it to the program it is today.

Initially Shop Your Way sounds like an excellent idea. It brings social media into the shopping

experience enabling customers to interact, creates loyalty through their membership program that

Costco has been famous for, and develops a Sears presence on all platforms. However, Shop

Your Way has been met with mixed reviews. By searching through customer reviews and

judging our own experiences as new members we have found major flaws in Shop Your Way.

First, Shop Your Way is a completely free membership service. We initially imagined the

membership program as a paid service similar to that of Costco‟s that drives brand loyalty and

allows the company to sell its products at razor thin margins while remaining profitable through

membership fees.

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Second, our experience using the company‟s app has been disappointing. Having signed

up as free members, we began using the app and found it very frustrating. Upon installation we

searched through different promotions Sears was offering and repeatedly found examples where

the app would list an item as in stock but upon purchase the item would actually be out of stock

and a purchase could not be made. In addition we received emails to redeem various coupons

that would not load properly and offered no solution for the problem.

Third, the website at first appears impressive and robust, however it is lacking content. A

large selling point of Shop Your Way is its social media presence and the ability to engage

customers. Clicking the „explore‟ tab we are taken to a page of What‟s Trending. This appears to

be a great idea except the top trends haven‟t changed in over 1 week and only has 15 likes, a

meagre amount considering its been at the top of the trending page for an entire week. This leads

us to conclude that very few members are engaged in the social media aspect of Shop Your Way.

Fourth, consumers are clearly unhappy about their experiences with Shop Your Way. We have

read numerous articles about Sears‟ poor customer service and unorganized supply chain that

have resulted in cancelled orders, misinformation and poor communication. Even if some of

these claims are blown out of proportion a simple google search of „Shop Your Way reviews‟

reveals an assortment of negative articles that hurt the brand strength of Sears. Sears has a

broken business model. They have lost touch with their customers‟ needs and the perception of

the Sears and Kmart brands has degraded significantly as evidenced by the consecutive 13 year

comparable store sales decline. Competitors such as Amazon, Walmart, Target and Macy‟s have

stolen market share (Bloomberg) and Sears is stuck in vicious cycle of declining revenues and

negative profitability. Sears‟ value proposition lies in providing value and convenience for

customers. Because of this, the degraded perception of the brand has forced Sears to compete

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solely on price to attempt to win back customers causing negative profitability and still failing to

turn around comparable store sales. Sears‟ answer to this issue has been Shop Your Way. The

problem with this solution, other than the issues we have already outlined is that this is not a

differentiation strategy. Sears claims to be focused on becoming a member-centric business

however, memberships are free and it is unclear how Sears‟ free membership is different from

the emailing lists anyone can sign up for retailers websites that send out emails with deals,

promotions and reward points. Sears is merely trying to catch up to their competitors with Shop

Your Way instead of trying to differentiate themselves. Sears‟ failure to fix their business model

and consistent erosion of shareholder value leads us to believe the company should be pursuing

other alternatives.

2.00 Financial Analysis

2.10 Income Statement

Sears Domestic, Kmart, and Sears Canada revenue segments declined in 2013

(sequentially) by 8.5%, 9.4%, 12%, respectively. This has been a consistent trend in all of Sears

Holdings business segments and highlights the firm‟s inability to stimulate consumer demand.

This primarily is driven by the firm‟s inability to improve its branding strength relative to its

competitors. The firm has been experiencing declining revenues and same store sales (averaging

-5.4%) for the past 10 years. Most notably management has highlighted that the electronics

business of Sears has underperformed relative to management‟s expectations. To help address

this lack of performance, management has expressed a desire to provide more consumer-focused

solutions as complementary products in an effort to help stimulate demand.

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Margins have compressed materially over the past 10 years, and in 2013 it had negative

earnings before interest and taxes (EBIT), of $1.36 billion. This material loss was mainly driven

by the firm‟s inability to control its costs given current waning consumer demand. While total

revenue declined 9.2% sequentially from 2012 to 2013, cost of sales only declined 6.5%. These

compressed margins have had pervasive impacts on the firm‟s operating cash flows and

profitability. Additionally management has highlighted that the “Shop Your Way” program, and

store closures have been a factor impacting margins through lower realized revenue on products

sold during the period, and lower sales due to less locations. It is expected that the success of

“Shop Your Way” program will continue to hinder margin expansion in the future, given it

become a large contributor to revenue growth. EBITDA, operating income, and profit margins

have been negative since 2010 and have also led to material declines in the firms retained

earnings. It is expected that these declines will continue as the firm has done little to effectively

improve operating efficiency and margins. Mirroring these declines in margins and returns are

Sears‟ profitability ratios, particularly their return on assets, return on equity, and return on

invested capital. These relatively recent results have resulted in the firm closing stores that have

been underperforming in an effort to focus resources in regions where customer demand is the

strongest.

Income Statement Margins Profitability Ratios

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2.20 Balance Sheet

As of fiscal year 2013, Sears‟ liquidity and solvency ratios have declined materially since

2009. Firstly, there is a stark difference between the firm‟s current and quick ratios. High levels

of inventory have skewed the current ratio above one making it seem the firm has ample liquidity

to meet its current liabilities. The firm‟s quick ratio as of 2013 current stands at .19, showing

liquidity risks and a likely chance the firm can have difficulty meeting its current liabilities in the

short term. Insolvency risks are also high as the firm‟s debt and interest coverage ratio are 88%

and -5.36, respectively in 2013. This has also been reflected in the firms credit default spreads as

they climbed 1,434 basis points as off February 18, 20141. In their most recent conference call,

the firm has expressed they have sufficient financial resources and liquid assets to help meet

their financial needs. This is likely unsustainable given that 60% of all their store locations are

currently under lease contracts. The ability for them to continue selling locations or entering into

leaseback transactions to raise capital are limited and do not resolve current fundamental risk

pertaining to their management of capital and operations.

1 http://www.bloomberg.com/news/articles/2015-02-19/sears-turnaround-seen-failing-by-traders-in-credit-swaps-market

-10%

-5%

0%

5%

20

09

20

10

201

1

20

12

20

13

EBITDA Margin Operating Margin

Profit Margin

-100%

-50%

0%

50%

2009

2010

2011

2012

2013

ROA ROE ROIC

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Liquidity Ratios

Solvency Ratios

2.30 Cash from Operations

As of 2013, Sears had negative cash from operations totalling $1.1 billion. This was

primarily a result of negative earnings for the year and increases in working capital and pension

contributions. With respect to their pension obligations, it is currently underfunded by

approximately 74% indicating the firm will likely have continued contributions in the short term.

Management has highlighted in their third quarter 2014 conference call that they will use their

credit facilities to help fund any short comings in contributions due to constraints in cash from

operations.

3.00 Valuations under distress:

To determine the value of the firm under distress we have applied both a Monte Carlo

simulation and a Modified Discounted Cash Flow valuation. The methodology and steps taken to

arrive at our conclusions are expressed in detail in the appendix.

0.0

0.5

1.0

1.5

20

09

20

10

20

11

201

2

20

13

Current Ratio Quick Ratio

Cash Ratio

0%

20%

40%

60%

80%

100%

-6

-4

-2

0

2

4

200

9

201

0

201

1

201

2

20

13

Interest Coverage Debt Ratio (%)

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3.10 Modified Discounted Cash Flow Valuation:

The modified discounted cash flow analysis incorporates the probability of distress by

adjusting the expected cash flows of the firm. Probabilities and details with respect to the

liquidation value of Sears Holdings are provided in detail in the appendix (I to N). As per the

analysis conducted it is clear that the firm has no equity value given its financial obligations,

underfunded pension, and estimated future cash flows from the firm. This supports our thesis that

there is zero equity value in Sears Holdings given their historical financial performance and

ineffective corporate strategy to help increase returns to shareholders.

Component Breakdown of FCFF Forecasts by Year (under the going concern assumption)

Summary of Modified Discounted Cash flow Valuation

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3.20 Monte Carlo Simulation of DCF Valuation

In order to provide a more fluid and robust Cash Flow valuation, we assume two normal

probability distributions for two important variables: EBITAR Margin and WACC fitted using

historical and forecasted parameters. See appendix H for technical details. Running 500,000

simulated samples, we find the mean equity value of Sears Holdings to be -$10.07 per share.

Since prices cannot be negative, we instead find the mean equity value of samples with positive

equity price to be $17.54 per share. Positive equity value only happens 29.89% of the time

within the simulated sample. See appendix figure M for the histogram of equity value. What the

simulation implies is, given current forecasts, Sears will need to have extremely favourable

surprises within the next four years to stay alive as a public company.

Total PV of Free Cash Flows 5,615.27$ Probability of Default:

Add: Cash and Cash Equivalents 1,261.24$ Probability of distress (Annual) = 9.79%

Less: Market Value of Short-term Debt 1,323.00$ Probability of distress over 5 years = 40.27%

Less: Market Value of Long-term Debt 1,148.29$ Probability of distress over 10 years = 64.32%

Less: Capitalized Lease Obligations 346.00$

Less: Capitalized Operating Leases 3,007.91$

Equity Value*(1-Probability of Distress) 627.94$

1,954.16-$

Modified Value of Equity under distress 1,326.21-$

Number of Shares Outstanding 106.5

Equity Value per Share -$

Current Stock price 36.24$

Overvalued by : -100%

WACC for Sears Holding Corporation 11.19%

Add: Liquidation Value*(Probability of Distress)

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4.00 Quantitative Bankruptcy Model

4.10 Retail Bankruptcy Model

Following the seminal work by Altman (1968), we introduce a similar bankruptcy model to

complement our valuation of Sears Holdings. We shall refer to this new model as the Retail

Bankruptcy Model (RBM). The need for a new retail bankruptcy model is primarily motivated

through four main reasons:

1. Obtaining more accurate predictions through the use of new computation methods that

can classify non-linear hypothesis.

2. Altman‟s original model is built through a mixed-industry sample. McGurr and

DeVaney (1998) show that when applying mixed-industry samples onto one specific

industry, existing models tend to underperform in predictability. Likewise, Platt and Platt

(1990) argue that the difference in industry dynamics such as reported financial ratios

drive the disparity in out-of-sample testing.

3. Additional variables more pertinent to the retail industry, ex: Interest coverage ratios.

4. More recent and available datasets to improve current forecasts.

4.20 Methodology:

RBM is constructed through a probit artificial neural network. This methodology

improves upon the original Multiple Discriminant Analysis through the ability to fit non-linear

classifiers. To prevent the possibility of over fitting, training (70%), validation (15%) and test

(15%) sets are sectioned to ensure best possible generalization. Sample of 108 (54 bankrupt and

54 non-bankrupt) General Retailer firms were collected from the Bloomberg database under the

Industrial Classification Benchmark (ICB). The filing dates for the 54 delisted firms are from

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2001 to 2015. Bankrupt variables were collected one fiscal year prior to the firm filing a Chapter

11, thus the RBM predicts bankruptcy one year ahead.

4.30 Results and Comparison:

The neural network classifier was shown to be superior in forecast accuracy when

compared with traditional Altman Z score methodology on original samples. Using a cut-off of

60% for the neural network and 2.675 for the Altman Z Score, the RBM outperforms the Z score

model by accurately predicting bankruptcy 92.6% of the time and non-bankruptcy 88.9% of the

time versus 79.63% and 85.19% respectively. See appendix O for a detailed table of results.

4.40 Application to Sears Holdings:

In summary to this section, we apply the Retail Bankruptcy Model to Sears Holdings.

Using most recent quarterly data from Bloomberg, we find that the model predicts a near-definite

bankruptcy in one fiscal year with an assigned probability of 98.67%. Since this is a one-year

forecast, it is difficult to confidently assume that the probability increases with a five year time

period since financial conditions can change. However, we are confident that if current valuation

and metrics hold in the future, the cumulative likelihood of Sears Holdings to become financially

insolvent increases.

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Works Cited

Altman Edward I, Financial ratios, discriminant analysis and the prediction of corporate

bankruptcy, The Journal of Finance, Volume 23, Issue 4, 1968, Pages 589-609.

James Gentry, Paul Newbold and David Whitford, Classifying Bankrupt Firms with Funds Flow

Components, Journal of Accounting Research, Volume 23, Issue 1, Spring 1985, Pages 146-160.

Paul McGurr, Sharon DeVaney, Predicting Business Failure of Retail Firms: An Analysis Using

Mixed Industry Models, Journal of Business Research, Volume 43, Issue 3, November 1998,

Pages 169-176, ISSN 0148-2963.

Platt, H. P. and M. B. Platt. (1990): Development of a class of stable predictive variables: the

case of bankruptcy prediction. Journal of Business Finance and Accounting, Volume 17, Issue 1,

Pages 31-51.

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Appendix A: “Shop Your Way” Screenshots

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Appendix B: Historical Income Statement

2009 2010 2011 2012 2013

Revenues 44,043 42,664 41,567 39,854 36,188

Expenses:

Cost of Sales, Buying and Occupancy 31,824 31,000 30,966 29,340 27,433

Selling and Administrative 10,654 10,425 10,664 10,660 9,384

EBITDA 1,565 1,239 -63 -146 -629

Depreciation Expense 926 869 853 830 732

EBIT 639 370 -916 -976 -1,361

Interest Expense (Income) -265 -293 -289 -267 -254

EBT (Before Other Items) 374 77 -1,205 -1,243 -1,615

Non-Operating Items

Write-down/Impairment of Assets 0 0 649 330 233

Interest and Investment Income 33 36 41 94 207

Other Income (Loss) -61 -14 -2 -1 -2

Gain on Sales of Assets -74 -67 -64 -468 -667

Income (Loss) from Discontinued Operations, Net of Tax 0 11 -27 0 0

EBT (After Other Items) 420 177 -1,778 -1,010 -972

Income Tax Expense -123 -27 -1,369 -44 -144

Non-Controlling Interest 0(Income) Loss Attributable to Noncontrolling Interests -62 -17 7

Net Income 235 133 -3,140 -930 -1,365

Common Shares Outstanding 118 112 107 106 106

Exercisable/Convertible Shares 0 0 0 0 0

Basic Earnings Per Share $1.99 $1.19 -$29.40 -$8.78 -$12.86

Diluted Earnings Per Share $1.99 $1.19 -$29.40 -$8.78 -$12.86

Sears HoldingsIncome Statement - USD Millions

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Appendix C: Historical Income Statement – Common Size

2009 2010 2011 2012 2013

Revenues -100% 0% 100% 100% 100%

Expenses:

Cost of Sales, Buying and Occupancy 72% 73% 74% 74% 76%

Selling and Administrative 26% 25% 26% 27% 26%

EBITDA 4% 3% 0% 0% -2%

Depreciation Expense 2% 2% 2% 2% 2%

EBIT 2% 1% -2% -2% -4%

Interest Expense (Income) -1% -1% -1% -1% -1%

EBT (Before Other Items) 1% 0% -3% -3% -4%

Non-Operating Items

Write-down/Impairment of Assets 0% 0% 2% 1% 1%

Interest and Investment Income 0% 0% 0% 0% 1%

Other Income (Loss) 0% 0% 0% 0% 0%

Gain on Sales of Assets 0% 0% 0% -1% -2%

Income (Loss) from Discontinued Operations, Net of Tax0% 0% 0% 0% 0%

EBT (After Other Items) 1% 0% -4% -3% -3%

Income Tax Expense 0% 0% -3% 0% 0%

Non-Controlling Interest 0% #VALUE! 0% 0% 0%

Net Income 1% 0% -8% -2% -4%

Sears HoldingsCommon Size Income Statement

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Appendix D: Historical Balance Sheet

2009 2010 2011 2012 2013

Assets:

Cash and Equivalents 1,680 1,359 747 609 1,028

Accounts Receivable 652 689 695 635 553

Merchandise Inventories 8,705 8,951 8,407 7,558 7,034

Restricted Cash 11 15 7 9 10

Prepaid Expenses and Other Current Assets 351 334 388 454 334

Current Assets 11,399 11,348 10,244 9,265 8,959

Total Property and Equipment, Net 7,709 7,102 6,577 6,053 5,394

Goodwill 1,392 1,392 841 379 379

Other Assets 1,061 899 782 762 679

Trade Names and Other Intangible Assets 3,208 2,993 2,937 2,881 2,850

Total Assets 24,769 23,734 21,381 19,340 18,261

Liabilities:

Merchandise Payables 3,335 3,046 2,912 2,761 2,496

Other Current liabilities 3,098 2,937 2,892 2,683 2,527

Current Portion of Long-Term Debt and Capitalized Lease Obligations482 489 230 83 83

Other Taxes 534 546 523 480 460

Liabilities from Discontinued Operations (Short-Term) 0 124 0 0 0

Current Liabilities 8,786 8,643 9,212 8,414 8,185

Long-Term Debt and Capitalized Lease Obligations 1,698 2,344 2,088 1,943 2,834

Pension and Postretirement Benefits 2,271 2,151 2,738 2,730 1,942

Other Long-term Liabilities 2,618 2,207 2,186 2,126 2,008

Long-Term Deferred Tax Liabilities 0 0 816 955 1,109

Total Liabilities 15,373 15,345 17,040 16,168 16,078

Equity:

Common Stock 1 1 1 1 1

Retained Earnings 4,797 4,930 1,865 885 -480

Treasury Stock – At Cost -5,446 -5,826 -5,981 -5,970 -5,963

Capital in Excess of Par Value 10,465 10,185 10,005 9,298 9,298

Total Equity 9,096 8,286 4,281 2,755 1,739

Noncontrolling Interest 302 103 60 417 444

Total Liabilities and Equity 24,771 23,734 21,381 19,340 18,261

Sears HoldingsBalance Sheet - USD Millions

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Appendix E: Historical Balance Sheet – Common Size

2009 2010 2011 2012 2013

Assets:

Cash and Equivalents 7% 6% 3% 3% 6%

Accounts Receivable 3% 3% 3% 3% 3%

Merchandise Inventories 35% 38% 39% 39% 39%

Restricted Cash 0% 0% 0% 0% 0%

Prepaid Expenses and Other Current Assets 1% 1% 2% 2% 2%

Current Assets 46% 48% 48% 48% 49%

Total Property and Equipment, Net 31% 30% 31% 31% 30%

Goodwill 6% 6% 4% 2% 2%

Other Assets 4% 4% 4% 4% 4%

Trade Names and Other Intangible Assets 13% 13% 14% 15% 16%

Total Assets 100% 100% 100% 100% 100%

Liabilities:

Merchandise Payables 13% 13% 14% 14% 14%

Other Current liabilities 13% 12% 14% 14% 14%

Current Portion of Long-Term Debt and Capitalized Lease Obligations2% 2% 1% 0% 0%

Other Taxes 2% 2% 2% 2% 3%

Liabilities from Discontinued Operations (Short-Term)0% 1% 0% 0% 0%

Current Liabilities 35% 36% 43% 44% 45%

Long-Term Debt and Capitalized Lease Obligations7% 10% 10% 10% 16%

Pension and Postretirement Benefits 9% 9% 13% 14% 11%

Other Long-term Liabilities 11% 9% 10% 11% 11%

Long-Term Deferred Tax Liabilities 0% 0% 4% 5% 6%

Total Liabilities 62% 65% 80% 84% 88%

Equity:

Common Stock 0% 0% 0% 0% 0%

Retained Earnings 19% 21% 9% 5% -3%

Treasury Stock – At Cost -22% -25% -28% -31% -33%

Capital in Excess of Par Value 42% 43% 47% 48% 51%

Total Equity 37% 35% 20% 14% 10%

Noncontrolling Interest 1% 0% 0% 2% 2%

Total Liabilities and Equity 100% 100% 100% 100% 100%

Sears HoldingsCommon Size Balance Sheet

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Appendix F: Historical Cash flow Statement – Common Size

2011 2011 2011 2012 2013

Cash From Operating ActivitiesNet Income 297 150 -3,147 -1,054 -1,116

Add (Deduct) Non-Cash Items:

Add: Depreciation Expense 926 869 853 830 732

Change in Non Cash Working Capital 412 -537 498 187 -328

Gain on Sales of Assets - CF -74 -67 -64 -468 -667

Deferred Income Taxes 90 -15 -533 -206 720

Bankruptcy-Related Recoveries -CF 0 0 0 0 -97

Settlement of Canadian Dollar Hedges 0 -3 0 6 9

Cash From Operations 1,507 123 -275 -303 -1,109

Cash From Investing ActivitiesCapital Expenditures / Acquisitions -361 -426 -432 -378 -329

Proceeds from Sales of Property and Investments 23 35 72 532 995

Net Decrease (Increase) in Investments and Restricted Cash 166 0 8 37 -2

Net Cash Provided by (Used in) Investing Activities—Discontinued O0 -15 43 0 0

Disposition of Sears Canada Equity Stake 0 0 0 0 0

Cash From Investing -172 -406 -309 191 664

Cash From Financing ActivitiesAdditions of Long-Term Debt 0 1,353 104 5 994

Reductions of Long-Term Debt -335 -358 -611 -335 -83

Additions of Short-Term Debt -117 35 815 -81 238

Reductions of Short-Term Debt 0 0 0 0 0

Net Debt Additions (Reductions) -452 1,030 308 -411 1,149

Issuance of Common Shares 0 0 0 0 0

Redemption of Common Shares -424 -997 -226 -10 0

Cash Dividends Paid 0 -69 0 -50 -233

Net Cash Used in Financing Activities—Discontinued Operations 0 -31 -75 0 0

Cash From Financing -951 -95 -28 -27 902

Foreign Exchange Rate Gain (Loss) 132 57 0 1 -38

Net Change in Cash 516 -321 -612 -138 419

Cash Balance, Beginning 1,164 1,680 1,359 747 609

Cash Balance, Ending 1,680 1,359 747 609 1,028

Sears HoldingsCash Flow Statement - USD Millions

25

Appendix G: Historical Financial Ratios

Activity Ratios 2009 2010 2011 2012 2013

Days Inventory on Hand 100 105 99 99 97(365/(COGS/Avg. Inventory))

Average Collection Period 5.40 5.89 6.10 5.82 5.58(Avg. Receivables/(Net Sales/365))

Asset Turnover 1.78 1.80 1.94 1.96 1.92(Net Sales/Avg. Total Assets)

Liquidity Ratios 2009 2010 2011 2012 2013

Current Ratio 1.30 1.31 1.11 1.10 1.09(Current Assets/Current Liabilities)

Quick Ratio 0.27 0.24 0.16 0.15 0.19(Cash+AR+ST Invest/Current Liabilities)

Cash Ratio 0.19 0.16 0.08 0.07 0.13(Cash/Current Liabilities)

Solvency Ratios 2009 2010 2011 2012 2013

Debt Ratio 0.62 0.65 0.80 0.84 0.88(Total Liabilities/Total Assets)

Cash Flow to Debt 0.69 0.04 -0.12 -0.15 -0.38(Ops Cash Flow/Total Debt)

Interest Coverage 2.41 1.26 -3.17 -3.66 -5.36(EBIT/Interest Expense)

Profitability Ratios 2009 2010 2011 2012 2013

EBITDA Margin 3.6% 2.9% -0.2% -0.4% -1.7%(EBITDA/Total Revenue)

Operating Margin 1.5% 0.9% -2.2% -2.4% -3.8%(EBIT/Total Revenue)

Profit Margin 0.5% 0.3% -7.6% -2.3% -3.8%(Net Income/Total Revenue)

ROA 0.9% 0.6% -14.7% -4.8% -7.5%(Net Income/Total Assets)

ROE 2.6% 1.6% -73.3% -26.4% -60.7%(Net Income/Avg. BV of Equity)

ROIC 4.8% 2.6% 3.7% -8.5% -12.1%(EBIT(1-T)/(Total Assets-Current Liab)

Historical

26

Appendix H: Monte Carlo Simulation

Section - Monte Carlo Technical

EBITAR Margin

Quarterly EBITAR Margin forecasts were fitted with a rational function of the form

where a,b,c,d are constants. A rational function is most appropriate since both linear and

quadratic forms produce unrealistic forecast assumptions. See below figure. To simulate noise,

we assume a normal distribution with parameters sampled from residuals of the fitted function.

The final equation becomes:

WACC

27

Sampling Bloomberg historical WACC, we forecast current WACC to be 11.91% through the

DCF Valuation and changes stochastically at each time-step. The change can be modelled by a

normal distribution with mean 0 and variance of 0.1072. An important assumption being made

is that the parameters of the distribution do not change over each period.

Figure M - Simulated Histogram of Equity Value with Fitted Curve

28

Appendix I: Modified Discounted Cash Flow Valuation – Revenue Forecast

FY2014 FY2015 FY2016 FY2017 FY2018 Steady State

Beginning Number of

locations 2,429 1,831 1,732 1,732 1,732 1,732

Closure of Lands End

Locations 13

Closure of Sears Canada

Stores (2014) 449

Closure of Sears Holdings

Locations (actual) 136

Annouced Store Closures 99

Expected Closure of Sears

Auto Centers 34

Forecast stores for new year 1,831 1,732 1,732 1,732 1,732 1,732

Percent growth in store

locations -24.6% -28.7%

Historical Revenue

Revenue for the first 9

months of 2014 23,099.00$

Forecast Revenue for Q4

2014 7,903.33$

Forecast Yearly Revenue 31,002.33$ 21,720.55$ 21,720.55$ 21,720.55$ 21,720.55$ 21,720.55$

Same Store Sales Growth

Adjustment (estimate) -2.0% -2.0% -2.0% -2.0% -2.0%

Adjusted Forecast Total

Revenue 31,002.33$ 21,720.55$ 21,286.14$ 20,860.41$ 20,443.20$ 20,034.34$

Total Revenue Growth -14.33% -29.94% -2.00% -2.00% -2.00% -2.00%

Revenue per store

Forecast

12.5415 year average revenue per store

29

Appendix J: Modified Discounted Cash Flow Valuation – CapEx and Working Capital

Assumptions

FY2009 FY2010 FY2011 FY2012 FY2013 5 year

Average

Revenue $

44,043.00

$

42,664.00

$

41,567.00

$

39,854.00

$

36,188.00

40863.2

Capital

expenditures

-$

361.00

-$

426.00

-$

432.00

-$

378.00

-$

329.00

-385.2

CAPEX as % of

Revenues

0.82% 1.00% 1.04% 0.95% 0.91% 0.94%

Working Capital 2272 2803 2087 1732 1624 2103.6

Working Capital

as % of Revenue

5.16% 6.57% 5.02% 4.35% 4.49% 5.12%

Appendix: Modified Discounted Cash Flow Valuation – WACC Calculation

Risk Free Rate 2.14% (Use 10 Year T-bond)

Debt Rating CCC (S&P Rating)

Implied Yield Spread 7.00%

Cost of Debt Before Tax 9.14%

Effective Tax Rate 25.00%

After-Tax Cost of Debt 6.86%

Cost of Debt Calculation

Risk Free Rate 2.14%

Adj Raw Beta 2.27

Market Risk Premium 6.50%

Cost of Equity 16.87%

Cost of Equity Calculation

30

--- The Adjusted Raw Beta was computed following a top down approach using the S&P 500 monthly

returns.

Appendix K: Modified Discounted Cash Flow Valuation – Probability of Distress

Calculation

Source: Damadoran, Sears Holdings Annual Report, Student Estimates

Market Capitaliztion $3,845

Debt Outstanding $5,043

Market Cap of Pref Shares $0

Value of Firm $8,888

Weighted Average Cost of Capital 11.19%

Cost of Capital Calculation

Risk Free Rate 2.14% (Use 10 Year T-bond)

Debt Rating CCC (S&P Rating)

Implied Yield Spread 7.00%

Cost of Debt Before Tax 9.14%

Effective Tax Rate 25.00%

After-Tax Cost of Debt 6.86%

Cost of Debt Calculation

Risk Free Rate 2.14%

Adj Raw Beta 2.27

Market Risk Premium 6.50%

Cost of Equity 16.87%

Cost of Equity Calculation

Probability of Distress InputsCoupon Rate = 14.14%

Maturity of bond= 8.73

Riskfree rate = 2.15%

Market price of bond= $673.22

Year Cash Flow CF (1-p) Present Value

1 $141.45 $127.59 $124.91

2 $141.45 $115.10 $110.30

3 $141.45 $103.83 $97.41

4 $141.45 $93.66 $86.02

5 $141.45 $84.48 $75.96

6 $141.45 $76.21 $67.08

7 $141.45 $68.75 $59.24

8 $141.45 $62.01 $52.31

$0.00

Value of bond = $673.22

Probability of distress (Annual) = 9.79%

Probability of distress over 5 years = 40.27%

Probability of distress over 10 years = 64.32%

31

Appendix L: Modified Discounted Cash Flow Valuation – Calculation for Market Value of

Debt

To determine the market value of debt for Sears Holdings, all their outstanding long term bonds

were treated as one bond. Thus the weighted average maturity and coupon were used in the

calculation.

Issuer Cpn Year to

Maturity

Amt

Out(M)

Mty Type Cpn Freq Principal

Due(M)

Interest

Due(M)

Weighted

Maturity

Weighted

Coupon

Weighted

Face Value

Sears Roebuck

Acceptance

Corp

6.875 2 43,454 BULLET SEMI

ANNUAL

43,454 1,494 0.0413401 0.142 898.197

Sears Holdings

Corp

6.625 3 2,510 BULLET SEMI

ANNUAL

2,510 83 0.0035818 0.008 2.997

Sears Holdings

Corp

6.625 3 1,234,490 BULLET SEMI

ANNUAL

1,234,490 40,892 1.7616546 3.890 724914.978

Sears Holdings

Corp

8 4 625,000 BULLET SEMI

ANNUAL

625,000 25,000 1.1891919 2.378 185811.229

Sears Roebuck

Acceptance

Corp

7.5 12 43,179 CALLABLE SEMI

ANNUAL

43,179 1,619 0.246471 0.154 886.864

Sears Roebuck

Acceptance

Corp

6.75 13 23,943 BULLET SEMI

ANNUAL

23,943 808 0.1480587 0.077 272.690

Sears Roebuck

Acceptance

Corp

6.5 13 38,640 BULLET SEMI

ANNUAL

38,640 1,256 0.2389419 0.119 710.209

Sears Roebuck

Acceptance

Corp

7 17 91,052 BULLET SEMI

ANNUAL

91,052 3,187 0.7362924 0.303 3943.582

$74,339.00 4.366 7.072 $

2,102,268.00

32

Appendix M: Modified Discounted Cash Flow Valuation – Forecast Assumptions

Risk free rate 2.12

Default spread 8

Current cost of debt 10.12

Adjustment for Semi-annual Coupon

Interest expense 74,339.00$ 37,169.50$

Weighted Maturity 4.365532368 8.73106474

Weighted Coupon 7.072291925 14.1445838

Weighted Face Value 917,440.74$

Market value of

Bonds 1,148,286.70$

FCFF Model Forecast Assumptions

Sears Holdings Corporation

5 year average Capex as percentage of revenue0.94%

Common size assumptions % of Revenues Assumptions:

Cost of Goods Sold 74.00%

General and Administrative expenses 25.00% CV Growth rate 3.50%

Depreciation 2.00% Tax rate 25.00%

Non Cash Working Capital as a % of Revenue 5.12%

33

Appendix N: Modified Discounted Cash Flow Valuation – Forecast Assumptions

FY20

10FY

2011

FY20

13FY

2014

FY20

15FY

2016

FY20

17FY

2018

Stea

dy

Sta

te

Re

ven

ue

s41

,187

.1$

39

,762

.4$

37

,606

.6$

31

,002

.3$

21

,720

.5$

21

,286

.1$

20

,860

.4$

20

,443

.2$

20

,034

.3$

YoY

% G

row

th-6

%-3

%-5

%-1

8%

-30

%-2

%-2

%-2

%-2

%

Co

st o

f G

oo

ds

Sold

30,6

83.0

$

29,2

72.6

$

28,5

08.4

$

22,9

41.7

$

16,0

73.2

$

15,7

51.7

$

15,4

36.7

$

15,1

28.0

$

14,8

25.4

$

% o

f Rev

enu

es7

4%

74

%7

6%

74

%7

4%

74

%7

4%

74

%7

4%

Ge

ne

ral a

nd

Ad

min

istr

ativ

e e

xpe

nse

s10

,664

.0$

10

,660

.0$

9,

384.

0$

7,

750.

6$

5,

430.

1$

5,

321.

5$

5,

215.

1$

5,

110.

8$

5,

008.

6$

%

of R

even

ues

26

%2

7%

25

%2

5%

25

%2

5%

25

%2

5%

25

%

De

pre

ciat

ion

853.

0$

83

0.0

$

732.

0$

62

0.0

$

434.

4$

42

5.72

$

41

7.21

$

40

8.86

$

40

0.69

$

%

of R

even

ues

2%

2%

2%

2%

2%

2%

2%

2%

2%

Cu

rre

nt

ren

t e

xpe

nse

827.

5$

79

2.8

$

801.

0$

68

4.0

$

605.

0$

49

9.0

$

383.

0$

28

9.0

$

400.

69$

% o

f Rev

enu

es2

%2

%2

%2

%3

%2

%2

%1

%2

%

EBIT

AR

(185

.4)

$

(2

07.3

)$

(216

.8)

$

37

4.0

$

387.

8$

28

6.1

$

174.

4$

84

.6$

20

0.3

$

% o

f Rev

enu

es0

%-1

%-1

%1

%2

%1

%1

%0

%1

%

Taxe

s1,

356.

5$

43

.9$

14

9.6

$

93.5

$

96.9

$

71.5

$

43.6

$

21.1

$

50.1

$

% o

f Rev

enu

es3

%0

%0

%0

%0

%0

%0

%0

%0

%

NO

PA

T e

xclu

din

g re

nt

exp

en

se(1

,541

.9)

$

(251

.2)

$

(3

66.4

)$

280.

5$

29

0.8

$

214.

6$

13

0.8

$

63.4

$

150.

3$

%

of R

even

ues

-4%

-1%

-1%

1%

1%

1%

1%

0%

1%

620.

05$

434.

41$

425.

72$

417.

21$

408.

86$

400.

69$

337.

91$

474.

91$

22.2

3$

21

.78

$

21.3

5$

20

.92

$

(292

.35)

$

(204

.83)

$

(200

.73)

$

(196

.72)

$

(192

.78)

$

(188

.93)

$

946.

09$

995.

34$

461.

82$

373.

07$

300.

86$

4,98

2.32

$

946.

09$

895.

20$

373.

57$

271.

42$

196.

86$

2,93

2.12

$

1,92

4.17

$

1,58

6.26

$

1,11

1.35

$

1,08

9.12

$

1,06

7.34

$

1,04

5.99

$

1,02

5.07

$

Tota

l PV

of

Fre

e C

ash

Flo

ws

5,61

5.27

$

Pro

bab

ilit

y o

f D

efa

ult

:

Ad

d: C

ash

an

d C

ash

Eq

uiv

ale

nts

1,26

1.24

$

Pro

bab

ilit

y o

f d

istr

ess

(A

nn

ual

) =

9.79

%

Less

: Mar

ket

Val

ue

of

Sho

rt-t

erm

De

bt

1,32

3.00

$

Pro

bab

ilit

y o

f d

istr

ess

ove

r 5

year

s =

40.2

7%

Less

: Mar

ket

Val

ue

of

Lon

g-te

rm D

eb

t1,

148.

29$

P

rob

abil

ity

of

dis

tre

ss o

ver

10 y

ear

s =

64.3

2%

Less

: Cap

ital

ize

d L

eas

e O

bli

gati

on

s34

6.00

$

Less

: Cap

ital

ize

d O

pe

rati

ng

Leas

es

3,00

7.91

$

Equ

ity

Val

ue

*(1-

Pro

bab

ilit

y o

f D

istr

ess

)62

7.94

$

1,95

4.16

-$

Mo

dif

ied

Val

ue

of

Equ

ity

un

de

r d

istr

ess

1,32

6.21

-$

Nu

mb

er

of

Shar

es

Ou

tsta

nd

ing

106.

5

Equ

ity

Val

ue

pe

r Sh

are

-$

Cu

rre

nt

Sto

ck p

rice

36.2

4$

Ove

rval

ue

d b

y :

-100

%

WA

CC

fo

r Se

ars

Ho

ldin

g C

orp

ora

tio

n11

.19%

Ad

d: L

iqu

idat

ion

Val

ue

*(P

rob

abil

ity

of

Dis

tre

ss)

Fore

cast

Ad

d:

De

pre

ciat

ion

Less

:

Incr

eas

e in

No

n C

ash

Wo

rkin

g ca

pit

al

Cap

ital

exp

en

dit

ure

s

Fre

e C

ash

Flo

w

His

tori

c

Dis

cou

nte

d F

ree

Cas

flo

w

Tota

l No

n-C

ash

Wo

rkin

g C

apti

al

34

Appendix O: Quantitative Bankruptcy Model

Table A - Factors selected in the Bankruptcy Model

Ratios Group Mean

(Bankrupt)

Group Mean (Non-bankrupt) t-statistic

(NB-B)

Working Capital/Total Asset 0.053 0.279 4.04

EBIT/Total Asset 0.0257 -0.061 4.09

Retained Earnings/Total Asset 0.082 -0.82 3.66

MV of Equity/Total Liabilities 4.04 0.86 5.07

Sales/Total Asset 1.81 1.91 -0.32

Interest Coverage Ratio 321 -24.5 3.06

CFFO/Total Asset 0.029 -0.023 4.28

Current Ratio 2.43 1.45 4.18

Return on Asset 5.21 -22.3 6.49

List A - Factor Summary

Working Capital/Total Asset: Liquidity measure that proxies a firm‟s ability to convert to

cash.

EBIT/Total Asset: Profitability measure that tracks a firm‟s earning power with its assets.

Retained Earnings/Total Asset: Earning surplus of a firm, proxies relative leverage and

overall age of the firm as explained by Altman (1968).

MV of Equity/Total Liabilities: Measure of safety margins that shows how many times

asset values can fall before the firm becomes insolvent.

Sales/Total Asset: Profitability measure from assets that proxies competitiveness and

especially useful in the retail landscape despite weak t-statistic.

35

Interest Coverage Ratio: The ability for a firm to cover its leverage. It is common for

soon-to-be insolvent firms to take on an unprecedented amount of leverage.

CFFO/Total Asset: Measures cash flow from operations generated from total assets. Later

development of Altman‟s model advocates the use of cash flow models such as Gentry,

Newbold and Whitford (1985).

Current Ratio: Liquidity measure that proxies a firms ability to pay back its short-term

obligations with short-term assets.

Return on Asset: Similar profitability proxy of how well a firm can generate net income

from its invested capital.

Table B - Full Sample Performance Test

RBM

Predicted

Actual Bankrupt Non-Bankrupt

Bankrupt 43 11

Non-Bankrupt 8 46

Altman Z Score

Predicted

Actual Bankrupt Non-Bankrupt

Bankrupt 50 4

Non-Bankrupt 6 48