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Wednesday, November 01, 2006

Comprehensive Sears Holdings (SHLD) Analysis

By Yaser Anwar, CSC of Equity Investment Ideas

Sears has successfully managed through its turnaround phase of extensive cost cutting and inventory rationalization to yield impressive margin expansion and cash build up.
Due to the high turnover at the senior management level and Eddie Lampert’s limited history of driving long-term sales improvement, investors should expect growth through
acquisitions to be the likely strategy (that's where the massive cash flow comes handy).

SHLD has projected $500 million in annualized merger-related cost and revenue synergies by the end of 07, consisting of- $200 million in increased revenue through Kmart-to-Sears store conversions and cross-selling opportunities between Kmart and Sears proprietary brands; $200 million in purchasing cost reductions as a result of increased purchasing scale in both merchandise and non-merchandise procurement; and $100 million from other cost reductions, particularly with respect to the consolidation of shared headquarter functions and corporate services.

Projected cost reductions seem attainable, as SG&A expenses decreased by $399 million in FY 06 on a pro forma basis, which assumes the merger had occurred at the beginning of FY 05.

According to a Goldman Sachs research report

Valuation: somewhat appealing, but outlook still unclear

"We are initiating with a $188, one-year price target based on four separate analyses—sum
of the parts, best-/worst-case scenarios, CROCI, and DCF. Our price target is equavalent to
16.2X our fiscal 2008E EPS, slightly below two-year averages of 16.8X.

• Sum-of-the-parts analysis leads to a $185, one-year valuation: Our analysis breaks out the three operating segments of Sears Holdings and uses comparable EV/EBITDA multiples from representative mass retailers, department stores, and hardline competitors;

• Best- and worst-case scenarios point to a $182, one-year valuation: Our analysis “shock tests” various EPS and multiple scenarios and probability weights the outcomes.

• Our CROCI analysis points to a $195, one-year valuation: Sears Holdings trades at a discount to other retail names when plotted on our retail regression line.

• Our detailed DCF model points to a $192, one-year valuation: Our model contains explicit forecasts through fiscal 2014.

Given its somewhat appealing valuation, we see greater risks to the upside based on continued margin expansion, a successful sales recovery, and continued acquisitions."

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