Retailers Join Forces for a "Make or Break" Attempt in Their Competitive Landscape

Event Summary

Amid the ongoing spate of mergers in the business software market, our attention was drawn to the recent mega-merger of two of the oldest retailers in the US. In late in 2004, just before the holiday rush, Kmart Holding Corporation (NASDAQ:KMRT), and Sears, Roebuck and Co. (NYSE:S), announced a definitive merger agreement to form the Sears Holdings Corporation. What is interesting, is not that Sears Holdings will become the US' third largest retailer, with approximately $55 billion in annual revenues, 2,350 full-line and off-mall stores, and 1,100 specialty retail stores. It is how they will merge two disparate information technology departments and supply chains.

Part One of the Retailers Join Forces for a "Make or Break" Attempt Their Competitive Landscapeseries.

The issue isn't that they offer diametrically opposed products and services. Kmart is a mass merchandising company that offers customers products through a portfolio of exclusive brands that include Thalia Sodi, Jaclyn Smith, Joe Boxer, Martha Stewart Everyday, Route 66 and Sesame Street. Similarly, Sears is a broad-line retailer providing merchandise and services including home merchandise, apparel, and automotive products and services through more than 2,300 Sears-branded and affiliated stores in the US and Canada. While the combined business will supposedly create a broader retail presence and improved scale through a national footprint of nearly 3,500 retail stores, it also will create significant issues for their supply chain systems. Alone, the sheer size of these enterprises can make internal coordination difficult with their odd conglomerations of business practices and enterprise application packages from a variety of vendors. The problem is further exasperated by how these systems will be amalgamated. Recognizing this issue, both Sears and Kmart have lately made significant strides in transforming their organizations. The merger is hoped to further accelerate this process. It hopes to also benefit from improved operational efficiency in areas such as procurement, marketing, IT and supply chain management (SCM).

Terms of the Agreement

The fruits of this merger were borne when Sears purchased around fifty Kmart store locations for approximately $575 million (USD) earlier in 2004. Edward S. Lampert, a savvy financier who acquired the $23 billion Kmart for less than $1 billion of Kmart bonds and other debt in bankruptcy court and became its largest shareholder and chairman of the board, has since orchestrated the merger.

Under the terms of the agreement, which was unanimously approved by both companies' boards of directors, Sears Holdings will be headquartered in Hoffman Estates, Illinois (US), and Kmart will continue to have a significant presence in Troy, Michigan (US). Kmart shareholders will receive one share of new Sears Holdings common stock for each Kmart share. Sears shareholders, in turn, can elect to receive $50.00 (USD) in cash or 0.5 shares of Sears Holdings (valued at $50.61 based on the closing price of Kmart shares at the time of the announcement) for each Sears share. Shareholder elections will be prorated to ensure that in the aggregate 55 percent of Sears shares will be converted into Sears Holdings shares and 45 percent of Sears shares will be converted into cash. The value of the transaction to Sears shareholders was, at the time, valued at approximately $11 billion (USD). Additionally, ESL Investments Inc., a Greenwich, Connecticut-based hedge fund, and its affiliates, which were founded and controlled by Kmart's chairman Lampert, agreed to vote all their Kmart and Sears shares in favor of the merger. They also elected the stock option with respect to their shares of Sears. Lampert will become the chairman of Sears Holdings.

Lampert will be joined in the office of the chairman by Alan J. Lacy, current chair and chief executive officer (CEO) of Sears, and Aylwin B. Lewis, current president and CEO of Kmart. Lacy will be vice chairman and CEO of Sears Holdings, and Lewis will be president of Sears Holdings and CEO of Kmart and Sears Retail. Glenn R. Richter, currently executive vice president (EVP) and chief financial officer (CFO) of Sears, will be EVP and CFO of Sears Holdings. William C. Crowley, currently senior vice president (SVP) of finance of Kmart and a Kmart Board member will be EVP of finance and integration of Sears Holdings. Lampert, Lacy, and Lewis will join the ten-member Sears Holdings board of directors, which will include seven members of the current Kmart board and three members of the current Sears board. Sears Holdings will act as the holding company for the Sears and Kmart businesses, which will continue to operate separately under their respective brand names.

Kmart has made great progress over the past eighteen months to strengthen the organization in terms of profitability and product offerings. The merger marks a remarkable comeback for Kmart, which filled for Chapter 11 bankruptcy protection in early 2002 (see Wet Quarter Postpones Amazon's Desiccation While Kmart Drowns), which lead to about 600 stores (one third of stores at the time) to close; the termination of 57,000 former Kmart employees; and cancellation of company stock.

In March 2004, Kmart posted its first profitable quarter in three years, and the new management believes the merger will create a true leader in the retail industry—both as a key part of local communities and as a national presence. Together, Sears and Kmart hope to further enhance their capabilities to better serve customers by improving in-store execution and ultimately transform the customer's in-store experience.

Sears Holdings will strive to feature a renowned home appliance franchise as well as strong positions in the tools, lawn and garden, home electronics, and automotive repair and maintenance categories. Key proprietary brands coming from Sears include Kenmore, Craftsman, and DieHard. The combined company will naturally have a broader apparel offering, including well-known labels such as Lands' End, Jaclyn Smith, and Joe Boxer as well as the Apostrophe and Covington brands. It will also have Martha Stewart Everyday products, which are now offered exclusively in the US by Kmart and in Canada by Sears Canada.

With revenues in 2003 of $41.1 billion (USD), the independent Sears has been offering its wide range of merchandise through its stores and through sears.com, landsend.com, and specialty catalogs. It is also possibly the largest provider of product repair services with more than 14 million (USD) service calls made annually. Kmart specialty retail stores will, for some time, continue to carry their current lineup in proprietary home and fashion lines

K-Mart/Sears Merger Process Details

The combined companies is conservatively estimated to generate $500 million (USD) of annualized cost and revenue synergies to be fully realized by the end of the third year after closing. The transaction is reportedly expected to be significantly accretive to earnings per share in the first year before one-time restructuring costs. For one, the companies expect approximately $200 million (USD) in incremental gross margin by capitalizing on cross-selling opportunities between Kmart and Sears' proprietary brands and by converting a substantial number of off-mall Kmart stores to the Sears nameplate in addition to the fifty Kmart stores Sears acquired earlier in year.

Namely, in mid 2004, Kmart announced that it has signed a definitive agreement with Sears to sell up to 54 of its stores for a maximum purchase price of $621 million (USD) in cash. Kmart will continue to operate them until March or April 2005. Sears initially agreed to consider offering employment to any Kmart employee at the converted stores. Earlier in June, Kmart announced that it has also signed similar definitive agreements with The Home Depot, Inc., to sell up to twenty-four stores for a maximum purchase price of $365 million (USD) in cash. The exact number of stores, locations, and total purchase amount were based upon the satisfaction of certain conditions to occur within the next sixty days.

Eventually, the transactions with Sears and Home Depot represented a total purchase price of almost $1 billion (USD) for less than eighty of Kmart stores, or approximately 5 percent of its erstwhile store base. Thus, for each of the past several quarters, Kmart has consistently delivered improved year-over-year profitability and cash flow by focusing on the fundamental aspects of its business. Operationally, it touts improved several areas including product design, buying, inventory management, distribution and the in-store environment. By the same token, the retailer pledges to take advantage of opportunities to create value that include the sale of existing stores, or the acquisition of new stores and businesses. Some who follow Kmart have speculated solely on the real estate value of the company; however, the company counters that it has been taking action on many different fronts simultaneously, all with the goal of making Kmart a great retail company once again.

Additionally, Sears Holdings expects to achieve annual cost savings of over $300 million (USD) through improved merchandising and non-merchandising purchasing scale and improved supply chain, administrative, and other operational efficiencies. Further, the combined company will complete a full store asset review as part of a plan to monetize non-strategic real estate assets as appropriate. Crowley and Richter will jointly lead an integration team of key operating executives from both companies to drive planning and execution of the integration of the companies' operations. The merger, which is expected to close by the end of March 2005, is subject to approval by Kmart and Sears shareholders, regulatory approvals, and customary closing conditions. Lehman Brothers served as financial advisor to Kmart, and Simpson Thacher & Bartlett LLP provided legal counsel to Kmart, whereas Morgan Stanley served as financial advisor to Sears, and Wachtell, Lipton, Rosen & Katz provided legal counsel to Sears.

Early in 2005 Kmart Holding Corporation announced strong profitability and cash generation for November and December of 2004 (period ending December 29, 2004). At that time, Kmart's same store sales has a significantly moderate rate of decline. Kmart expected to generate a net income (excluding any asset sales and bankruptcy-related expenses) of approximately $250 million (USD) for November and December of 2004 with income before interest and income taxes (excluding any asset sales and bankruptcy-related expenses) of approximately $400 million (USD). This will represented an increase income of approximately $23 million (USD), or 10 percent over the same period in 2003. Same store sales for November and December declined by 4.6 percent—in December alone, same store sales declined approximately 2.6 percent. This, however, represented a significant improvement compared to trends from earlier in 2004. Gross margin improved by over 100 basis points over the prior year period. The goal for the combined company is to achieve a 10 percent operating margin like those of Gap and Target.

At the end of December, Kmart's inventory levels were approximately $3.1 billion (USD), while its cash balance grew from $2.1 billion (USD) at the end of its 2003 fiscal year on January 28, 2004 to approximately $3.9 billion (USD) at the end of December. Kmart is expected to be approximately $3.2 billion (USD) at the end of its 2004 fiscal year on January 26, 2005. The $3.2 billion (USD) does not include the roughly $400 million (USD) receivable from Sears, expected in March and April of 2005.

As a result of its cash balances and cash generation, Kmart has terminated the balance of an existing credit agreement which it has never drawn from, with the exception of letters of credit. Kmart also has stated that several banks have committed $3.5 billion of a $4 billion (USD) loan for capital to be used once during its $11 billion (USD) deal to buy Sears. The loan will be effective when Kmart buys retailer Sears, and the money will be available for five years to pay for working capital needs, capital expenditures, acquisitions, and other general corporate purposes. Banks providing money for the loan include JPMorgan Chase, Citigroup, and Bank of America.

Federated/May Merger Details

Beside Kmart and Sears, it appears that many other retailers, especially department stores, have gone shopping for one another in their quest to increase revenues; fend off the scissor-like competition from both leading mass discounters and specialists; and lure to customers that are growing tired and bored with shopping malls. Recently, on February 28, Federated Department Stores, Inc. (NYSE:FD) and The May Department Stores Company (NYSE:MAY) announced a merger agreement. Pursuant to the transaction, each share of May will be converted into the right to receive $17.75 (USD) per share of cash and 0.3115 shares of Federated stock. Based on the 10-day trading average of Federated stock as of Friday, February 25, 2005, this equates to a value per share of $35.50, or $11 billion (USD) in total equity value. In addition, Federated will assume May's debt that was approximately $6 billion (USD) at year-end, for a total consideration of approximately $17 billion (USD). As part of this transaction, Federated has committed to increase its annual dividend to $1 (USD) per share.

The deal, reportedly approved by both companies' respective boards of directors a day before the announcement, will establish Federated as a $30 billion (USD) national retailer whose economies of scale and scope of operations—with stores in forty-nine states, Guam, Puerto Rico, and the District of Columbia—should enable it to compete more effectively in the highly competitive retail sector. Currently, Federated has annual sales of $15.6 billion (USD) and has about 111,000 employees in 34 states. Founded 1929, headquartered in Cincinnati, Ohio, with corporate offices in Cincinnati and New York, Federated currently operates more than 450 stores in 34 states, Guam, and Puerto Rico under the names of Macy's, Bloomingdale's, Bon-Macy's, Burdines-Macy's, Goldsmith's-Macy's, Lazarus-Macy's, and Rich's-Macy's. The company also operates macys.com and Bloomingdale's By Mail, and is converting all regional department stores to Macy's brand effective March 6, 2005.

In the case of May, it has annual sales of $14.4 billion (USD) and about 132,000 employees in 46 states. Founded 1910, headquartered in St. Louis, Missouri (US), at the end of the fiscal 2004, May operated 491 department stores under the names of Famous-Barr, Filene's, Foley's, Hecht's, Kaufmann's, Lord & Taylor, L.S. Ayres, Marshall Field's, Meier & Frank, Robinsons-May, Strawbridge's, and The Jones Store. It also operated 239 David's Bridal stores, 449 After Hours Formalwear stores, and 11 Priscilla of Boston stores. May currently operates in forty-six states, the District of Columbia, and Puerto Rico.

Along a similar rationale to the earlier Kmart/Sears merger, this merger also touts the potential synergies from an expanded geographic reach, gathering more market power with suppliers, and slashing overlapping expenses. Once consummated, Federated will operate more than 950 department stores, along with approximately 700 bridal and formalwear stores. In addition, fifteen new states, mostly in the US heartland, will be layered onto Federated's existing thirty-four state operating base, with relatively little overlap between the companies' locations. As a result, Federated for the first time will supposedly have a truly national retail footprint, with stores in sixty-four of the nation's top sixty-five markets.

This transaction is expected to be accretive to Federated's earnings per share in 2007, whereby Federated expects to realize approximately $450 million (USD) in cost synergies by 2007. This will result from the consolidation of central functions, division integrations, and the adoption of best practices across the combined company. In addition, the company anticipates approximately $1 billion (USD) in one-time costs related to the acquisition and integration, spread out over a three-year period beginning in 2005. Federated said that while it intends to merge May's St. Louis corporate headquarters functions into its own Cincinnati and New York corporate offices, beginning this year, it intends to make St. Louis the headquarters of one of the major operating divisions to take advantage of St. Louis' considerable talent pool. Federated also said it will continue to honor and practice May's extensive philanthropic commitments to its communities.

While no division consolidations or store name changes are planned before 2006, Federated also said that it is likely that most of May's regional department stores will ultimately be converted to Macy's. The company touts considerable success in re-branding its own regional stores as Macy's, and obviously it anticipates continuing this strategy to some extent with its new stores. Operating regional stores primarily under one brand means the combined company can advertise nationally, unlike regional retailers, and this will be more cost-effective.

Among the benefits to customers arising from the acquisition, Federated cites lower costs; national marketing initiatives; expanded private brand merchandise lines; roll-outs of Federated's successful reinvented initiatives to May's department stores; expanded customer loyalty programs; and bridal and gift registries to a national customer base. The company admits it will take until mid-2007 to implement all of the anticipated changes from the acquisition, and it intends to take time to do it right. Its first priority is to continue to execute in all of its stores this year, while focusing behind the scenes on consolidating corporate and support operations.

This deal is contingent on a regulatory review and approval by shareholders from both companies, a process that is expected to take several months. It is expected to close in the third quarter of 2005. Federated was advised by and received a fairness opinion from Goldman, Sachs & Co. Federated received financial advice on certain matters pertaining to the merger from Credit Suisse First Boston LLC., while Jones, Day provided legal advice. May was advised by Morgan Stanley Dean Witter, Inc. and received a fairness opinion from Peter J. Solomon Company, Limited, while Skadden Arps provided legal advice to May.

This is Part One of a three-part note.

Part Two will discuss the market impact and will compare the result to Wal-Mart.

Part Three will cover technology and make user recommendations.