Sears, Roebuck & Co
G5 Investment Group
Matt Nutsch
Renis Kacani
Melody Seely
Ashley Green
Wiley Eagle
.
G5 Investment Group
December 4, 2004
Retail – Broadline
Buy
Stock Data
Price (52 weeks)
Symbol/Exchange
Beta
Fully Diluted Shrs
Average Daily Vol
Current market
cap
Book Value / Share
Current ratio
$31.21 - $55.90
S / NYSE
1.3
230.4 million
5,028,000 shrs
10.82B
$28.3
1.32
Valuation (per share)
Current Price
Comparables
DCF Analysis
Residual Income
DD Analysis
Abnormal Earnings
$34.78
$36.60
$36.94
$38.38
$27.97
$46.49
Summary Financials (in millions) for 2004
Revenue
Earnings
$36.6 billion
$550 million
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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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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
4
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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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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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 customeroriented practices. Such practices range from designing its stores around
merchandise placement to staffing the most experienced associates during the
peak hours of evenings and weekends, thereby allowing it to turn superior
customer service into a competitive advantage (http://www.searsarchives.com,
2004).
• Superior
Product Quality. Sears has expanded and integrated vertically by
establishing its own suppliers. In doing so it has afforded itself not only the
opportunity to provide a higher quality of products, but also greater control over
the merchandise that it sells. Brands owned by Sears include Diehard,
Craftsman, Kenmore, and 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
7
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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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.
9
Some possibilities are the Lands' End Custom™ and Lands’ End Swim Finder.
They should also capitalize in Lands' End Guaranteed Period service (Halligan,
2002). The reputation of the Lands’ End brand contributes to Sears’ brand
name, thus bolstering its key success factor: investment in brand image.
External Threats:
• The retail industry is highly competitive with both old names, like Wal-Mart and
K-Mart taking the lead above Sears and with new companies opening both on
the Internet and in physical buildings (Prentice-Hall, 2003).
• Departments, like women's apparel are constantly under siege from other
stores who capitalize on the notion of quality clothing and sales, such as Liz
Claiborne (Prentice-Hall, 2003).
• More and more discount stores are opening, further driving sales in certain
departments at Sears lower, such as all apparel departments (Prentice-Hall,
2003).
There are two levels in the external environment: the macro-environment,
which incorporates all of the major sectors, such as political aspects,
sociopolitical aspects, technological aspects, socio-cultural aspects and
economical aspects, and the micro-environment, which includes all the
stakeholders relative to a specific organization to include shareholders,
partners, financial institutions, regulators, customers and competitors.
The major issue at this writing is the economic condition of the country. We are
in an economic downturn, still. This means the company must take steps to
reduce costs but increase revenue. There are no political issues that would
have a dramatic impact at this time. Social values, however, have changed.
Consumers are looking for convenience and value-added products and services.
Lands' End Guarantee Period is a value-added service and should be
emphasized. In fact, Sears could initiate the very same guarantee; it offers this
on Craftsman tools but not for any other product. Technology continues to
change and Sears has made good use of it, often spending more on technology
10
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
12
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
13
considers the current condition of the portfolio and factors such as bankruptcy
filings, historical charge off patterns and other portfolio data (Sears 10K Filing,
2003). The management reviews these calculation to decide if additional analysis
are required, based on economic events. In 2003 Sears earmarked
$1,747,000,000 for uncollectible accounts (Sears 10K Filing, 2003).
Valuation of long-lived assets
Sears Roebuck evaluates the carrying value of long-lived assets whenever events
or changes in circumstances indicate that a potential has occurred (Sears 10K
Filing, 2003). When a potential impairment has occurred, an impairment writedown is recorded if the carrying value of the long lived asset exceeds its fair
value. Fair value is measured based on a projected discounted cash flow model
using a discount rate the company feels is commensurate with the risk inherent
in the 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
14
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
15
effect of the change in accounting principle reduced other comprehensive income
by 262 million dollars. This included the reclassification of other comprehensive
income of a 228 million dollars deferred loss on an interest rate swap that was
terminated in 1997 and the recognition in other comprehensive income of 34
million dollars related to a cash flow hedge (Sears 10K Filing, 2003).
Also, sears plans to change its method of accounting for its domestic defined
benefit (explained above) plans to immediately recognize any experience gains
or loss in excess of the 10% corridor and to value plan assets at fair value. This
method of accounting in contrast with the above accounting methods is not
required to be changed by any new accounting standard. The reason for change
is because the company believes that the new method is preferable in regard to
changes made to its domestic benefit plans to discontinue providing pension and
retiree medical benefits to associates under the age of 40 as the new policy
accelerates recognition of events which have already occurred. (Sears 10K Filing,
2003). But under this new accounting method, Sears’ pension expense in future
periods may be more volatile as this method accelerates recognition of actual
experience.
IV. Evaluation of the Quality of Disclosure
Sears Roebuck & Co. discloses sufficient information for the public through their
10-K and 10-Q reports. These disclosures are present in the footnotes of the
financial statements, and they give light on certain policies that might have been
misunderstood.
In their most recent 10-K filing on January 3, 2004, they disclose a special
category of information in the body of their financial statements concerning
market risk affecting their company. They show that their primary market risk is
interest rate risk that mainly stems from their amount of variable rate debt.
They went from variable rate funding of $24.2 billion in 2002 to $4.3 billion in
2003. This dramatic decrease in variable rate debt is explained through the sale
of the 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 longterm 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
2
3.3
2.1
286.3
320.7
328.5
Basic
$11.95
$4.34
$2.25
Diluted
$11.86
$4.29
$2.24
Dilutive Effect of Stock Options
Total Average Common Shares
Outstanding
Earnings per Share:
17
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.
18
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
19
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)
20
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
21
Exhibit 1
SEARS ROEBUCK & CO 10-K 2004-01-03:
Original
Adjusted
2003/01/03
2003/01/03
Balance Sheet
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
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
Property and equipment
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
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
Merchandise payables
$3,106,000,000
$3,106,000,000
Income taxes payable
$1,867,000,000
$1,867,000,000
LIABILITIES
Current liabilities
capitalized lease obligations
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
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
obligations
22
Total Liabilities
$21,322,000,000
$21,322,000,000
$323,000,000
$323,000,000
$3,519,000,000
$3,519,000,000
COMMITMENTS AND CONTINGENT LIABILITIES
SHAREHOLDERS EQUITY
Common shares issued ($.75 par value per share,
1,000 shares authorized, 230.4 and 316.7 shares
outstanding, respectively)
Capital in excess of par value
Retained earnings
$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
$27,723,000,000
$26,762,000,000
EQUITY
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.
23
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
Gross Profit Margin (%)
12/31/03 12/31/02 12/31/01 12/31/00 12/31/99
34.07
35.89
33.82
32.31
31.68
26.9
27
24.9
23.27
22.6
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
Operating Expense
Ratio(%)
Net Profit Margin (%)
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
51.83
16.81
6.77
15
17
(%)
SGR (%)
24
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
25
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 highreturn investment projects are less likely to pay out a high proportion of earnings
26
as dividends because of their need for the capital to finance these projects. As a
matter of fact, Sears has expanded its stores in Canada and Puerto Rico the last
2 years, and just recently Sears bought a few discount stores from K-Mart. These
expanding projects that Sears has undertaken the last years might have forced
the company to cut its dividends.
Sears’ sustainable growth rate (ROE * [1 – Dividend payout ratio]) for
the years 1999 – 2003 is as follows:
2003
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
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
Gross Profit Margin (%)
33.55
21.94
33.03
31.25
Operating Expense Ratio
24.93
15.6
27.23
22.15
4.04
3.39
0.69
3.59
5-Year Averages
Profitability Ratios
5-Year Averages
(%)
Net Profit Margin (%)
27
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
4.98
1.36
2.02
1.98
2.4
15.85
4.51
3.2
1.41
2.09
3.34
2.64
Capital Structure Ratios
5-Year Averages
Debt to Equity Ratio (T)
Times Interest Earned (T)
Debt Service Margin (T)
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,
28
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 WalMart and Target. Sears has a higher return on equity ratio (26.51) compared
to its competitors (Wal-Mart: 21.50, JC-Penney: 1.13, Target: 19.58). This is due
to Sears’ higher profit margins, which have resulted in profitability ratios higher
than its competitors. Sears’ debt to equity (4.98) is higher than its competitors’
debt to equity ratios. This indicates that Sears uses more than the usual amount
of borrowed funds to finance its activities compared to its competitors. Sears’
times interest earned ratio (2.4 times) is less than its competitors’ ratio (Wal –
Mart: 15.85, JC – Penney: 4.51; Target: 3.2). This shows that Sears’ competitors’
income from operations is more adequate to cover required interest charges than
Sears.
29
•
Gross Profit Margin
Year
Wal-Mart
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
40
35
30
25
Wal-Mart
Target
JC-Penny
Sears
20
15
10
5
0
1999
2000
2001
2002
2003
30
•
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
10
8
6
Wal-Mart
Target
JC-Penny
Sears
4
2
0
-2
-4
1999 2000 2001 2002 2003
31
•
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
14
12
10
8
Wal-Mart
Target
JC-Penny
Sears
6
4
2
0
-2
1999
2000 2001 2002
2003
32
•
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
60
50
40
Wal-Mart
Target
JC-Penny
Sears
30
20
10
0
-10
1999 2000 2001 2002 2003
33
•
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
9
8
7
6
Wal-Mart
Target
JC-Penny
Sears
5
4
3
2
1
0
1999 2000 2001 2002 2003
34
•
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
2
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
Wal-Mart
Target
JC-Penny
Sears
1999 2000 2001 2002 2003
35
•
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
2.5
2
Wal-Mart
Target
JC-Penny
Sears
1.5
1
0.5
0
1999 2000 2001 2002 2003
36
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
33.55
25.4
24.93
21.66
4.04
3.39
1.1
2.06
Return on Assets (%)
5.94
7.68
Return on Equity (%)
26.51
18.96
4.98
1.79
2.4
7.85
1.41
2.69
Profitability Ratios
5-Year Averages
Gross Profit Margin (%)
Operating Expense
Ratio(%)
Net Profit Margin (%)
Asset Turnover (T)
Capital Structure Ratios
5-Year Averages
Debt to Equity Ratio (T)
Times Interest Earned (T)
Debt Service Margin (T)
Comparison between Sears and Retail Industry:
Sears’ current ratio is 1.97 and this means that to satisfy the claims of shortterm creditors exclusively from existing current assets, Sears must be able to
37
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.
38
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.
39
Overall based on our ten-year forecast we found that Sears will perform at a
steady growth rate. For example, we forecasted that sales would increase each
year by 1.02%. We support this forecast not only because Sears’ sales have
increased by 1.02% in average for the past 5 years but also due to the fact that
Sears has started to expand its stores by acquiring 61 off-mall stores from KMart and Wall-Mart. And this has been due to the high demand of the services
and brand name products that Sears offers. Sales increased by 1.29% during Q3
of 2003 and the first 2 quarters of 2004, which shows that consumers have
responded favorably to the expanded product lineup of this one-stop shopping
destination. We believe that this off-mall concept will progress well, and will be a
major factor in Sears’ growth for the next 10 years.
However, for two reasons we do not assume that our financial statements’
forecasts are free of errors and that our forecasts will be accurate for each year
in the next decade. The first reason is that as past economic practices have
dictated, the longer the time horizon the less accurate the forecasts will be.
Second, future economic conditions might cause Sears not to perform as
forecasted. For instance, an economic downturn might turn sears’ forecasted
growth in sales the other way around, as people would want to save more
money instead of to spend in buying Sears’ products and services.
Valuations Section
Introduction
This section shows the value of Sears Roebuck & Co. by taking risk into
consideration, and calculating how much of the firm is financed by debt and
equity. Discounted free cash flows, discounted dividends, discounted residual
income, and abnormal growth earnings models are used in the following section
to provide an intrinsic valuation of Sears Roebuck & Co. This section also values
the company by using the retail industry averages and comparing the ratios of
the company. The ratios used are price to earnings, price to book, dividend to
40
price, and price to sales. These valuation methods will show the true value of
Sears Roebuck & Co., and will also assess the risk involved with this company.
Method of Comparables Valuation
EXHIBIT 1
2004 (11/01/2004)
Sears & Roebuck
Wal - Mart
Target
J.C - Penney
Industry Average:
Sales
(mill)
EPS
BPS
DPS
PPS
36,600
2.75
28.3
0.92
34.8
287,100
2.4
10.75
0.48
46,550
2.15
14.35
18,600
2.15
18.75
P/E
P/B
D/P
P/S
53.8
22.44
5
0.0089
0.00019
0.3
50.39
23.44
3.51
0.006
0.001
0.5
34.78
16.18
20.69
1.86
3.46
0.0143
0.0097
0.0019
0.001
22.94
2.94
0.0075
0.0015
W/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:
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
41
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)
42
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.
Average (i)
MV (mil.)
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%
TTM
Sum of MV
Percent Wtd Average
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:
43
Vd = $1033 (million) + $4218 (million) = $5251 (million)
The value of equity (Ve) was calculated by multiplying price per share (PPS) by
shares outstanding: Ve = $27.78 * 230.4 (million) = $6401 (million)
The value of the firm (Vf) is simply the sum of the value of debt (Vd) and the
value of equity (Ve): Vf = $5251 (million) + $6401 (million) = $11,652 (million)
Now with all of the components to WACC, we are able to calculate this model.
The corporate tax rate for the firm was given at 31%. (See Exhibit 2) The
following is the calculation:
WACC = ($5251/$11,652) * (1-.31) * (.068) + ($6401/$11,652) * (.0949) =
.0732
Discounted Free Cash Flows – Exhibits 3
The discounted free cash flows model was performed by using a WACC = 7.32%
and an implied growth rate = 3.5% after 2013. Our analysis found an estimated
price of $36.94 compared to the actual price of $34.78. Based on this valuation
method, we conclude that the firm is slightly undervalued. This is evident
because our estimated price exceeds the actual price. During our sensitivity
analysis we found that there was a high amount of sensitivity in this valuation
model. This is evident because a slight change in WACC or growth will result in a
large change of price. These analyses also show that our estimated WACC and
growth rate were not too far off from the actual rates found by using sensitivity
analyses. They also show that a change in WACC without a corresponding
change in growth will cause the estimated price to deviate greatly from the
actual price (and vice versa). For example, an increase to 8.5% WACC causes a
decrease in estimated price to $23.24 per share, while an increase in the growth
rate to 4.5% causes the estimated price to increase to $51.7236. This valuation
method has the highest sensitivity to changes of all of the valuation methods
used. For example if WACC decreases by .82% and growth increases by 2%,
44
estimated price per share deviates to $166.53 per share. This is in sharp contrast
to the scenario in which WACC is increased by 2.23% and growth is decreased
by 1%, which results in a price per share of $12.67.
Sensitivity Analysis
0.0650
0.0732
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.
45
Sensitivity Analysis
0.0849
0.015
0.0949
0.1049
0.1149 Ke
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
0.025 56.5927
45.3606 37.6453 32.0891
37.264 31.9465
0.035 59.1147 46.4944 38.1358 32.2673
0.045 62.9009
48.0827 38.7899 32.4966
Growth
46
Discounted Dividends – Exhibits 6
The discounted dividends model was performed by using a Ke = 7.67%. We
found the Ke = 7.67% by using the WACC formula with the numbers taken from
discounted free cash flows model. The discounted dividend model gave us the
lowest price per share ($27.98). The discounted dividends model has a moderate
sensitivity to changes in cost of equity and growth. For example a 1% increase in
Ke changes the estimated price per share by a negative $5.61, while a 1% in
growth rate increases price per share by $6.69. This model is the only one that
shows the company to be overvalued. As a result, we think that the estimated
price of $27.98 that we obtained doesn’t represent the fundamental value of
Sears’ stock price in 2004.
Sensitivity Analysis
0.0667
0.015 25.496
0.025 29.919
0.0767
0.0867
0.0967 Ke
21.096 17.9363 15.56004
23.87 19.7937
16.8635
0.035 37.133 27.975 22.3697 18.58946
0.045 50.996
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.
47
In the abnormal growth earnings model our Ke proved to be a weakness because
of the significant increase from 9.49% to 11.49%.
We believe that our WACC valuation proved to be strong in comparison to our
estimated growth rate and our Ke. The forecasted cash flows for Sears Roebuck
& Co. are important in the estimation of the stock price using the discounted free
cash flows valuation.
We feel that the Discounted Dividends Model may be the least accurate of the
three because it showed Sears to be overvalued, while all three of the other
models showed Sears to be undervalued. If the Discounted Dividends Model is
ignored, the price of Sears’ stock is undervalued by $5.82 per share.
48
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
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
BALANCE SHEET
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
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
Statement of Cash Flows
49
EXHIBIT A
5 YR ANNUAL BALANCE SHEET
Assets
Cash & Equivalents
Receivables Net
Inventories
Prepaid Expenses
Other Current Assets
Total Current Assets
Long Term Receivables
Investments in Unconsol Subsidiaries
Other Investments
Property, Plant & Equip - Gross
Accumulated Depreciation
Property, Plant & Equipment - Net
Other Assets
Total Assets
(amounts in millions)
12/31/2003 12/31/2002
12/31/2001
12/31/2000
12/31/1999
9,057.00
2,689.00
5,335.00
n/a
1,115.00
18,196.00
0
0
0
13,124.00
6,336.00
6,788.00
2,361.00
27,345.00
1,064.00
28,813.00
4,912.00
n/a
1,316.00
36,105.00
0
0
0
13,137.00
6,313.00
6,824.00
973
43,902.00
842
20,928.00
5,618.00
n/a
1,406.00
28,794.00
0
0
0
12,585.00
5,932.00
6,653.00
1,278.00
36,725.00
729
21,581.00
5,069.00
n/a
1,288.00
28,667.00
0
0
0
11,912.00
5,462.00
6,450.00
1,470.00
36,587.00
7,176.00
6,714.00
n/a
n/a
n/a
1,694.00
15,584.00
18,921.00
1,732.00
n/a
-415
7,336.00
6,840.00
n/a
562
n/a
0
14,738.00
11,020.00
1,951.00
1,058.00
-174
6,992.00
5,154.00
n/a
n/a
n/a
1,555.00
13,701.00
12,884.00
2,180.00
0
-367
n/a
0
35,822.00
n/a
0
28,593.00
n/a
0
28,398.00
0
1,961.00
n/a
6,119.00
0
1,363.00
0
6,769.00
0
1,350.00
0
6,839.00
43,902.00
36,725.00
36,587.00
1,962.00
31,622.00
5,115.00
n/a
1,284.00
39,983.00
0
0
0
12,979.00
6,069.00
6,910.00
2,782.00
49,675.00
Liabilities
Accounts Payable
3,106.00
2,945.00
ST Debt & Current Portion Due LT Debt
3,983.00
9,333.00
Accrued Payroll
n/a
n/a
Income Taxes Payable
1,867.00
787
Dividends Payable
n/a
n/a
Other Current Liabilities
4,803.00
5,532.00
Total Current Liabilities
13,759.00
18,597.00
Long Term Debt
4,218.00
21,304.00
Provision For Risks And Charges
1,956.00
2,491.00
Deferred Income
n/a
n/a
Deferred Taxes
-378
-734
Deferred Tax Liability In Untaxed
n/a
n/a
Reserves
Other Liabilities
0
0
Total Liabilities
19,555.00
41,658.00
Shareholders' Equity
Non-Equity Reserves
0
0
Minority Interest
1,389.00
1,264.00
Preferred Stock
n/a
n/a
Common Equity
6,401.00
6,753.00
Total Liabilities & Shareholders'
Equity
27,345.00
49,675.00
* Balance Sheet comes from Thomson One Business website
50
INCOME STATEMENT
(Common Size)
YEAR
Total Sales
Cost of Goods Sold
Gross Profit
Operating Expense
NIBIT
Interest Expense
Pretax Income
Income Taxes
NET INCOME
12/31/2003
100%
63.71%
36.2900%
26.63%
15.72%
2.50%
13.23%
4.88%
12/31/2002
100%
62%
38.0000%
27.10%
8.64%
2.77%
5.88%
2.07%
12/31/2001
100%
64.08%
35.9200%
24.92%
6.39%
3.47%
2.95%
1.14%
12/31/2000
100%
65.67%
34.3300%
23.27%
8.48%
3.06%
5.43%
2.03%
12/31/1999
100%
66.26%
33.7400%
22.62%
8.98%
3.10%
5.89%
2.20%
8.35%
3.81%
1.81%
3.40%
3.69%
51
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
Depreciation, Depletion &
Amortization
26,202.00
25,646.00
26,322.00
26,885.00
27,212.00
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
Pretax Income
2
5,441.00
4
2,433.00
11
1,211.00
4
2,223.00
5
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
Discontinued Operations
Net Income Bef Extraordinary Items
& Disc Ops
0
0
0
0
0
0
0
0
0
0
3,397.00
1,584.00
735
1,343.00
1,453.00
0
0
0
0
0
0
-208
0
0
0
3,397.00
1,376.00
735
1,343.00
1,453.00
0
0
0
735
1,343.00
1,453
Preferred Dividends
Extraordinary Items & Gain(Loss)
Sale of Assets
Net Income Bef Preferred
Dividends
Preferred Dividend Requirements
0
0
Net Income Available To
3,397.00
1,376.00
Common
* Balance Sheet comes from Thomson One Business website
52
EXHIBIT C
(amounts in millions)
5 YEAR ANNUAL CASH FLOW
STATEMENT
12/31/2003
12/31/2002
12/31/2001
12/31/2000
12/31/1999
3,397.00
1,584.00
735
1,343.00
1,453.00
909
875
751
826
848
Deferred Inc Taxes & Inv Tax Credit
Other Cash Flow
648
-1,561.00
-203
2,049.00
146
2,401.00
26
1,208.00
356
967
Funds From Operations
Extraordinary Items
3,393.00
0
4,305.00
0
4,033.00
0
3,403.00
0
3,624.00
n/a
-869
-4,810.00
-1,771.00
-701
73
2,524.00
-505
2,262.00
2,702.00
3,697.00
925
0
1,035.00
0
1,126.00
0
1,084.00
0
1,033.00
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
0
0
59
0
0
-20,758.00
2,322.00
1,088.00
1,050.00
983
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
327
293
302
322
355
33
118
57
-955
-1,537.00
-2,485.00
Operating Activities
Income Bef Extraordinary Items
Depreciation, Depletion & Amortization
Funds From/For Other Operating Acts
Net Cash Flow From Operating
Activities
Investing Activities
Capital Expenditures
Additions To Other Assets
Other Use/(Source) - Investing
Net Cash Flow From Investing
Activities
Financing Activities
Net From Sales/Issue of Com/Prf Stock
Cash Dividends Paid - Total
Other Source/(Use) - Financing
2
11
Net Cash Flow From Financing
Activities
-16,212.00
3,721.00
* Balance Sheet comes from Thomson One Business website
53
EXHIBIT 2
Excess
Return Adjusted
T-Bills
Returns (Rm-Rf)
Price
DATE
S&P 500
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%
Return
54
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
0.48991
Intercept
R^2
T-Test
-0.0008446
0.038576
0.489913
Cost of Equity (estimated B)
3.82%
55
Cost of Equity (published B)
Ke = Rf + B(Rm-Rf)
Ke = 0.39% + 1.3(7%) = 9.49%
Commercial Paper
(Financial)
Date
9.49%
% 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%
56
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
Oct-04
1.06%
1.06%
Sh-T Debt
TTM
1-3 years
4-9 years
10+ years
Sum of MV
L-T Debt
3.76%
Average
6.25%
9.38%
7.50%
MV (mill.)
236
251
1838
2325
Percent
10.00%
10.00%
80.00%
Wtd Avg
0.63%
0.94%
6.00%
7.57%
57
Cost of Debt = 6.8%
Cost of Debt = 0.0376 * 0.198 + 0.0757 * 0.802
ZScore
WC/Total Assets
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
1.5
1
1.5
Sales/Total Assets
ZScore
5.97
VE = PPS * # shares outstanding
VE = 34.8 * 230.4 mill.
VE (mill) = $6,401
VD = Book value of liabilities
VD = 1,033 + 4,218
VD (mill) = $5,251
VF = VE + VD
VF (mill) = $11,652
WACC=7.32%
WACC = (Vd/Vf)*(1-T)*Kd + (Ve/Vf)*Ke
T = 31%
58
EXHIBIT 3
Discounted Free Cash Flows Method
Amounts in millions of dollars except per share data
WACC=
0.0732
Kd=
0.068 Growth =
0.035
Ke=
Free Cash Flow (2014 and on) = 170.3
230.38 million shares outstanding
mill
0
2004
Cash Flow from Operations
Cash Provided by Inv Activities
Free Cash Flow (to firm)
Discount Rate (WACC)
Present Value Factors
PV of Free Cash Flows
Total PV Annual Cash Flows
PV of Terminal Value
4
2008
5
2009
6
2010
7
2011
8
2012
9
2013
$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
($2,074.44)
($2,164.55)
($2,257.81)
($2,354.33)
($2,454.23)
($2,557.63)
($2,664.65)
($2,775.41)
($2,890.05)
629.330
633.850
638.540
643.390
648.410
658.980
664.540
670.300
653.600
0.932
0.868
0.809
0.754
0.702
0.655
0.610
0.568
0.530
586.405
550.333
516.590
485.011
455.456
427.787
401.890
377.638
354.930
9616.57
Sensitivity Analysis
Value of Debt
5251.00
Value of Equity
8521.61
VE = VF - VD
36.989
PPS= VE / #shares outstanding
Actual Price per Share ($)
3
2007
4156.04
13772.61
Estimated Value per Share 11/01/2004
36.989/(1+Ke/12^(2/12))
2
2006
$693.7 mill
0.0732
(693.76/(.0732-.035))*.529
Value of the Firm
Estimated per Value Share 12/31/2004
1
2005
0.0949
36.941
0.0650
0.0732
0.0850
0.0950
0.0250
38.5584
28.2920
18.4327
12.6719
0.0350
52.7774
36.9408
23.2434
15.8358
0.0450
81.2152
51.7236
30.4594
20.2652
0.0550
166.5288
82.7512
42.4861
26.9093
WACC
Growth
34.78
59
693.761
EXHIBIT 4
Residual Income Method
All data is stated in Per Share amounts
Ke =
0.0949 Growth
3.50%
0
2004
Beginning BE (per share)
EPS
DPS
Ending BE (per share)
Ke
Normal Income
(BE * Ke)
Residual Income (RI)
(EPS - NI)
Present Value Factors
Present value of RI
BV Equity (per share) 2003
30.36
3
2007
4
2008
5
2009
6
2010
7
2011
8
2012
9
2013
30.36
33.22
36.26
39.57
43.05
46.65
50.25
53.95
57.75
3.8
4
4.3
4.5
4.8
5
5.2
5.4
6
0.94
0.96
0.99
1.02
1.2
1.4
1.5
1.6
1.6
33.22
36.26
39.57
43.05
46.65
50.25
53.95
57.75
62.15
2.881164
3.152578
3.441074
3.755193
4.085445
4.427085
4.768725
5.119855
5.480475
0.918836
0.847422
0.858926
0.744807
0.714555
0.572915
0.431275
0.280145
0.519525
0.913325
0.834163
0.76186256
0.695828
0.635518
0.580435
0.530126
0.484177
0.442211
0.839196
0.706888
0.65438356
0.518258
0.454112
0.33254
0.22863
0.13564
0.22974
Ke
0.5377084
30.36
4.09939
PV of Terminal Value (end 2003)
3.969629
Actual Price per Share ($)
2
2006
0.0949
Total PV of RI (end 2003)
0.538/(.0949-0.035) * 0.442
Estimated Value per Share 12-3104
Estimated Value per Share 11-0104
1
2005
Sensitivity Analysis
0.0849
0.0949
0.1049
0.1149
38.43
0.015
44.748
37.3288
31.6835
27.27
38.38
34.78
0.025
46.1116
37.7786
31.6472
26.974
0.035
0.045
48.0217
50.8893
38.3786
39.219
31.6006
31.5383
26.604
26.1281
Growth
60
EXHIBIT 5
Abnormal Earnings Growth
All data is stated in Per Share amounts
Ke =
0.0949 Growth
3.50%
2004
EPS
DPS
DPS invested at 9.49%
Cum-Dividend Earnings
(EPS + DRIP)
Normal Earnings
[EPS * (1+ Ke)]
1
2005
2
2006
3
2007
4
2008
5
2009
6
2010
7
2011
8
2012
9
2013
3.5
3.8
4
4.3
4.5
4.8
5
5.2
5.4
6
0.92
0.94
0.96
0.99
1.02
1.2
1.4
1.5
1.6
1.6
0.087308
0.089206
0.091104
0.093951
0.096798
0.11388
0.13286
0.14235
0.15184
3.887308
4.089206
4.391104
4.593951
4.896798
5.11388
5.33286
5.54235
6.15184
3.83215
4.16062
4.3796
4.70807
4.92705
5.25552
5.4745
5.69348
5.91246
Abnormal Earning Growth (AEG)
0.055158
-0.07141
0.011504
-0.11412
-0.03025
-0.14164
-0.14164
0.15113
0.23938
(Cum Div - Normal EPS)
PV of AEG
0.050377
EPS 2004
Total PV of AEG
PV of Terminal Value
0.008764
0.102014
0.10585656
3.5
0.164998
( We excluded the negative AEGs)
0.753
Sensitivity Analysis
Total PV of AEG + EPS 2004
4.418
Capitalization Rate (perpetuity)
0.0949
Estimated Value per Share 12-3104
(4.418 / 0.0949)
46.56
Estimated Value per Share 11-0104
46.56/(1+Ke/12^(2/12))
Actual Price per Share ($)
46.49
0.0849
0.0949
0.1049
0.1149
0.015
54.7923
44.5106
37.264
31.9465
0.025
56.5927
45.3606
37.6453
32.0891
0.035
59.1147
46.4944
38.1358
32.2673
0.045
62.9009
48.0827
38.7899
32.4966
Ke
Growth
61
34.78
EXHIBIT 6
Discounted Dividends Method
All data is stated in Per Share amounts
WACC= 0.0732 Kd =
0.068 Growth=
0
2004
0.035
Ke(new) =
0.0767
1
2005
2
2006
3
2007
4
2008
5
2009
6
2010
7
2011
8
2012
9
2013
0.94
0.96
0.99
1.02
1.2
1.4
1.5
1.6
1.6
0.928764
0.862602
0.801154
0.744083
0.691077
0.641847
0.59612455
0.553659
0.51422
0.873038
0.828098
0.793142
0.758964
0.829292
0.898586
0.89418683
0.885854
0.82275
Cost of Equity:
0.0767
WACC = (VD / VF)Kd + (VE / VF)Ke
0.0732=(5251/13053)0.068+(7802/13053)Ke
Ke = 7.67%
DPS
PV Factors
PV of Forecasted Dividends
Total PV of Forecasted Dividends
PV of terminal value
(1.656/(.0767-.035))*.514
7.583912
Estimated Value Per Share 12-31-04
28
27.97
Estimated Value Per Share 11-01-04
28.0/(1+(Ke/12))^(2/12)
Actual Price Per Share (2003) ($)
1.656
20.42076
Sensity Analysis
34.78
0.015
0.025
0.035
0.045
0.0667
25.496
29.919
37.133
50.996
0.0767
21.096
23.87
27.975
34.669
0.0867
17.9363
19.7937
22.3697
26.1812
0.0967
15.56004
16.8635
18.58946
20.98311
Ke
Growth
62
Bibliography Sources
o Halligan, Cathy. (2002, July 9). Will Sears Be More Like Target Than Kmart?
http://www.marketingprofs.com/2/prophet3.asp
o Hoover's. (2002). Lands' End. Austin, TX: Hoover's Inc.
o Multex Investor. (2003). Sears, Roebuck & Co. Profile. from Reuters Research Inc
http://businessmajors.about.com/gi/dynamic/offsite.htm?site=http://biz.yahoo.
com/p/s/s.html
o Prentice-Hall. (2003). Can Sears Reinvent Itself?
http://wps.prenhall.com/bp_laudon_essmis_5/0,,155336-,00.html
o Scheraga, Dan. (2002, July). Lands' End lends a hand: Sears' direct marketing will get a boost
from newly acquired know-how. Chain Store Age Executive with Shopping Center Age 78(7),
58(1).
o
http://finance.yahoo.com/q/pr?s=s
o
http://www.searsarchives.com/
o
http://www.marketresearch.com/researchindex/764369.html
o Sears Roebuck & Co. 2003 10K Filing
o Sears Roebuck & Co. 2003-09 10Q Filing
o Sears Roebuck & Co. 2004-07 10Q Filing
o http://biz.yahoo.com/e/031105/s10q.html
o https://us.etrade.com/e/t/invest/performance?sym=S&pr
od=S:NYSE:EQ
o Thomson One Analytical Business
o Morningstar.com
o Sears Roebuck & CO 10K 2000-12-30 Income Statement
o Sears Roebuck & CO 10-K 2004-01-03 Income Statement
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