the economist case competition – submission sprott school of
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The Economist Case Competition – Submission
Sprott School of Business
Members:
Asmerom (Peter) Tewolde
Geng Pei
Kyle Stolys
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Table of Contents 1.00 Introduction: .................................................................................................................................... 3
1.10 Objective ..................................................................................................................................... 3
1.20 Background ................................................................................................................................. 3
1.21 Kmart ...................................................................................................................................... 4
1.22 Sears Domestic ........................................................................................................................ 4
1.23 Sears Canada............................................................................................................................ 4
1.30 Industry ....................................................................................................................................... 5
1.40 Why Sears is a “Zero” by 2020? ................................................................................................... 5
1.41 Shop Your Way ....................................................................................................................... 6
2.00 Financial Analysis ........................................................................................................................... 7
2.10 Income Statement ........................................................................................................................ 9
2.20 Balance Sheet ............................................................................................................................ 11
2.30 Cash from Operations ................................................................................................................ 12
3.00 Valuations under distress: .............................................................................................................. 12
3.10 Modified Discounted Cash Flow Valuation: ............................................................................... 13
3.20 Monte Carlo Simulation of DCF Valuation ................................................................................ 14
4.00 Quantitative Bankruptcy Model ..................................................................................................... 15
4.10 Retail Bankruptcy Model ........................................................................................................... 15
4.20 Methodology: ............................................................................................................................ 15
4.30 Results and Comparison: ............................................................................................................ 16
4.40 Application to Sears Holdings: ................................................................................................... 16
Works Cited .......................................................................................................................................... 17
Appendix A: “Shop Your Way” Screenshots ......................................................................................... 19
Appendix B: Historical Income Statement ............................................................................................. 20
Appendix C: Historical Income Statement – Common Size .................................................................... 21
Appendix D: Historical Balance Sheet ................................................................................................... 22
Appendix E: Historical Balance Sheet – Common Size .......................................................................... 23
Appendix F: Historical Cash flow Statement – Common Size ................................................................ 24
Appendix G: Historical Financial Ratios ................................................................................................ 25
Appendix H: Monte Carlo Simulation .................................................................................................... 26
Appendix I: Modified Discounted Cash Flow Valuation – Revenue Forecast ......................................... 28
Appendix J: Modified Discounted Cash Flow Valuation – CapEx and Working Capital Assumptions .... 29
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Appendix: Modified Discounted Cash Flow Valuation – WACC Calculation ......................................... 29
Appendix K: Modified Discounted Cash Flow Valuation – Probability of Distress Calculation .............. 30
Appendix L: Modified Discounted Cash Flow Valuation – Calculation for Market Value of Debt .......... 31
Appendix M: Modified Discounted Cash Flow Valuation – Forecast Assumptions ................................ 32
Appendix N: Modified Discounted Cash Flow Valuation – Forecast Assumptions ................................. 33
Appendix O: Quantitative Bankruptcy Model ........................................................................................ 34
1.00 Introduction:
1.10 Objective
The objective of this report is to show why Sears Holdings Corporation will be bankrupt
by 2020. We will cover the history of Sears, its current operations and business model, current
industry trends, the company‟s financial situation, and various models that sum up our argument
for Sears‟ inevitable bankruptcy.
1.20 Background
Sears Holding Corporation (Sears) is the parent company of Kmart Holding Corporation
and Sears, Roebuck and Co. which together create an integrated retailer offering an assortment of
apparel, appliances, electronics, and automotive parts, among several other categories. The
history of the two company‟s begins in 1893 when Sears, Roebuck and Co. was founded. The
company began as a mail order business with their famous catalog, and later began operating
retail stores that were largely successful and led to a rapid expansion of the business. Kmart
began in 1899 with 1 store, selling all products for 5 and 10 cents built on the business
philosophy of “offer customer‟s products they need at prices they can afford”. In 2002 Kmart
filed for Chapter 11 and while in bankruptcy ESL Investments, managed by Edward S. Lampert
purchased the majority of the company‟s debt and later listed it on the NASDAQ, retaining an
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ownership of over 50%. In 2004 Kmart announced that it would be purchasing Sears, Roebuck
and Co. The newly formed company became Sears Holding Corporation and Edward S. Lampert
remains a 50% shareholder today.
The business can be split into three segments, Kmart, Sears Domestic, and Sears Canada..
1.21 Kmart
Kmart operates 1050 stores as of November 1, 2014 throughout the U.S. Most Kmart
stores are one-floor, free-standing units that offer a wide array of products including consumer
electronics, outdoor living, toys, lawn and garden equipment, appliances, food and consumables,
and apparel. In 2013, the Kmart segment had $13.2B in revenues, and -$351M in operating
income. Comparable store sales also declined 3.6%.
1.22 Sears Domestic
Sears Domestic operates 781 stores as of November 1, 2014 across the U.S. These stores are
primarily mall based and offer a wide array of products including appliances, consumer
electronics, tools, sporting goods, outdoor living, lawn and garden equipment, automotive
services and products, apparel, and home fashion. Sears also operates approximately 690 Auto
Centers in Sears‟ stores and 34 free standing stores. In 2013, the Sears Domestic segment had
$19.2B in revenues, and -$940M operating income. Comparable store sales also declined 4.1%.
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1.23 Sears Canada
Sears Canada operates 418 stores as of November 1, 2014 and conducts retail operations
similar to Sears Domestic, with greater emphasis on apparel, footwear, and accessories. In 2013,
the Sears Canada segment had $3.8B in revenues, and $538M in operating income. Comparable
sales declined 2.7%. As of November 1, 2014 this segment was de-consolidated from Sears as
the company completed a rights offering of 40 million Sears Canada shares, bringing their stake
in the company down to approximately 10% from 51%.
1.30 Industry
The retail industry has undergone drastic change since the turn of the century. The rise of the
internet has resulted in greater competition in an already cut-throat retail market. Consumers can now
purchase products on any device from almost any retailer around the globe calling into question the
traditional retail model and particularly department stores. U.S. Department stores have performed poorly
in recent years growing revenues at rates below the pace of the overall retail channel (Bloomberg). PwC
expects this trend to continue projecting department stores to be the second worst performing channel in
retail growing at a CAGR of 1.6% from 2015-2020. By 2020 PwC expects non-store retail to play an
increasingly larger role in the retail channel accounting for 12% of the retail marketplace by 2020.
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Sears fits into this picture as one of the worst performing department stores over the past
10 years. Since 2001 U.S. retail sales (ex. Auto) has grown at an average rate of 4%. Over this
same period comparable store sales at Sears have fallen every single year at an average rate of -
5.4%. Department stores have been slow to react to changing consumers who today are more
informed and have greater empowerment due to the ease of access to price comparisons, detailed
product information, and user reviews. Sears has been far worse than most, with customers
clearly displeased with the retailer moving their shopping elsewhere. The days of flipping
through the Sears catalogue creating a Christmas wishlist are over, and Sears has completely
failed to adapt to today‟s environment. Since 2009 Sears has reduced its store count from over
4000 to 1831. During that time Sears has spun off their Hometown and Outlet business, Sears
Canada, Orchard Supply Hardware, and have sold many of their owned stores, all in an effort to
raise liquidity and simplify their business.
1.40 Why Sears is a “Zero” by 2020?
The company was founded in the 1890‟s during the era of the rural general store. Farmers
struggled, unable to sell enough crops to live, and the inefficient distribution network of the
general store resulted in large mark ups in rural retail prices of up to 100% greater than
wholesale prices. Farmers protested, and Sears was born. Due to volume buying, and later free
rural delivery Sears was a happy alternative to the high priced rural stores. Sears developed their
catalogue and by 1895 was 532 pages full of „fanciful writing‟ that enticed farmers to make
orders. As time went on, and customers changed, Sears adapted. Buyers began to look beyond
price tags towards quality and around the turn of the 20th century the catalog shifted from the
“flamboyant to the factual”. Sears understood their value proposition, their customers and
prospered because of it. Today Sears is big, slow and is attempting to react in an industry that as
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written in their annual report is “...rapidly changing. The progression of the internet, mobile
technology, social networking and social media is fundamentally reshaping the way we interact
with our core customers and members.” In response Sears is realigning their business to a
member-centric, and integrated retail model. They are focusing on core customers (members)
and striving to bring them value and convenience.
1.41 Shop Your Way
Tying together the goals for a member centric and integrated business, Sears created Shop Your
Way, a program that rewards members and enhances interaction between them, creating an e-
commerce platform and a social network. Shop Your Way is the company‟s answer to declining
sales and negative profitability. With this program they believe they can compete with Walmart,
Target, Macy‟s, and Amazon, and begin to regain market share. Shop Your Way was launched in
2009 as a rewards program and Sears invested heavily building it to the program it is today.
Initially Shop Your Way sounds like an excellent idea. It brings social media into the shopping
experience enabling customers to interact, creates loyalty through their membership program that
Costco has been famous for, and develops a Sears presence on all platforms. However, Shop
Your Way has been met with mixed reviews. By searching through customer reviews and
judging our own experiences as new members we have found major flaws in Shop Your Way.
First, Shop Your Way is a completely free membership service. We initially imagined the
membership program as a paid service similar to that of Costco‟s that drives brand loyalty and
allows the company to sell its products at razor thin margins while remaining profitable through
membership fees.
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Second, our experience using the company‟s app has been disappointing. Having signed
up as free members, we began using the app and found it very frustrating. Upon installation we
searched through different promotions Sears was offering and repeatedly found examples where
the app would list an item as in stock but upon purchase the item would actually be out of stock
and a purchase could not be made. In addition we received emails to redeem various coupons
that would not load properly and offered no solution for the problem.
Third, the website at first appears impressive and robust, however it is lacking content. A
large selling point of Shop Your Way is its social media presence and the ability to engage
customers. Clicking the „explore‟ tab we are taken to a page of What‟s Trending. This appears to
be a great idea except the top trends haven‟t changed in over 1 week and only has 15 likes, a
meagre amount considering its been at the top of the trending page for an entire week. This leads
us to conclude that very few members are engaged in the social media aspect of Shop Your Way.
Fourth, consumers are clearly unhappy about their experiences with Shop Your Way. We have
read numerous articles about Sears‟ poor customer service and unorganized supply chain that
have resulted in cancelled orders, misinformation and poor communication. Even if some of
these claims are blown out of proportion a simple google search of „Shop Your Way reviews‟
reveals an assortment of negative articles that hurt the brand strength of Sears. Sears has a
broken business model. They have lost touch with their customers‟ needs and the perception of
the Sears and Kmart brands has degraded significantly as evidenced by the consecutive 13 year
comparable store sales decline. Competitors such as Amazon, Walmart, Target and Macy‟s have
stolen market share (Bloomberg) and Sears is stuck in vicious cycle of declining revenues and
negative profitability. Sears‟ value proposition lies in providing value and convenience for
customers. Because of this, the degraded perception of the brand has forced Sears to compete
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solely on price to attempt to win back customers causing negative profitability and still failing to
turn around comparable store sales. Sears‟ answer to this issue has been Shop Your Way. The
problem with this solution, other than the issues we have already outlined is that this is not a
differentiation strategy. Sears claims to be focused on becoming a member-centric business
however, memberships are free and it is unclear how Sears‟ free membership is different from
the emailing lists anyone can sign up for retailers websites that send out emails with deals,
promotions and reward points. Sears is merely trying to catch up to their competitors with Shop
Your Way instead of trying to differentiate themselves. Sears‟ failure to fix their business model
and consistent erosion of shareholder value leads us to believe the company should be pursuing
other alternatives.
2.00 Financial Analysis
2.10 Income Statement
Sears Domestic, Kmart, and Sears Canada revenue segments declined in 2013
(sequentially) by 8.5%, 9.4%, 12%, respectively. This has been a consistent trend in all of Sears
Holdings business segments and highlights the firm‟s inability to stimulate consumer demand.
This primarily is driven by the firm‟s inability to improve its branding strength relative to its
competitors. The firm has been experiencing declining revenues and same store sales (averaging
-5.4%) for the past 10 years. Most notably management has highlighted that the electronics
business of Sears has underperformed relative to management‟s expectations. To help address
this lack of performance, management has expressed a desire to provide more consumer-focused
solutions as complementary products in an effort to help stimulate demand.
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Margins have compressed materially over the past 10 years, and in 2013 it had negative
earnings before interest and taxes (EBIT), of $1.36 billion. This material loss was mainly driven
by the firm‟s inability to control its costs given current waning consumer demand. While total
revenue declined 9.2% sequentially from 2012 to 2013, cost of sales only declined 6.5%. These
compressed margins have had pervasive impacts on the firm‟s operating cash flows and
profitability. Additionally management has highlighted that the “Shop Your Way” program, and
store closures have been a factor impacting margins through lower realized revenue on products
sold during the period, and lower sales due to less locations. It is expected that the success of
“Shop Your Way” program will continue to hinder margin expansion in the future, given it
become a large contributor to revenue growth. EBITDA, operating income, and profit margins
have been negative since 2010 and have also led to material declines in the firms retained
earnings. It is expected that these declines will continue as the firm has done little to effectively
improve operating efficiency and margins. Mirroring these declines in margins and returns are
Sears‟ profitability ratios, particularly their return on assets, return on equity, and return on
invested capital. These relatively recent results have resulted in the firm closing stores that have
been underperforming in an effort to focus resources in regions where customer demand is the
strongest.
Income Statement Margins Profitability Ratios
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2.20 Balance Sheet
As of fiscal year 2013, Sears‟ liquidity and solvency ratios have declined materially since
2009. Firstly, there is a stark difference between the firm‟s current and quick ratios. High levels
of inventory have skewed the current ratio above one making it seem the firm has ample liquidity
to meet its current liabilities. The firm‟s quick ratio as of 2013 current stands at .19, showing
liquidity risks and a likely chance the firm can have difficulty meeting its current liabilities in the
short term. Insolvency risks are also high as the firm‟s debt and interest coverage ratio are 88%
and -5.36, respectively in 2013. This has also been reflected in the firms credit default spreads as
they climbed 1,434 basis points as off February 18, 20141. In their most recent conference call,
the firm has expressed they have sufficient financial resources and liquid assets to help meet
their financial needs. This is likely unsustainable given that 60% of all their store locations are
currently under lease contracts. The ability for them to continue selling locations or entering into
leaseback transactions to raise capital are limited and do not resolve current fundamental risk
pertaining to their management of capital and operations.
1 http://www.bloomberg.com/news/articles/2015-02-19/sears-turnaround-seen-failing-by-traders-in-credit-swaps-market
-10%
-5%
0%
5%
20
09
20
10
201
1
20
12
20
13
EBITDA Margin Operating Margin
Profit Margin
-100%
-50%
0%
50%
2009
2010
2011
2012
2013
ROA ROE ROIC
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Liquidity Ratios
Solvency Ratios
2.30 Cash from Operations
As of 2013, Sears had negative cash from operations totalling $1.1 billion. This was
primarily a result of negative earnings for the year and increases in working capital and pension
contributions. With respect to their pension obligations, it is currently underfunded by
approximately 74% indicating the firm will likely have continued contributions in the short term.
Management has highlighted in their third quarter 2014 conference call that they will use their
credit facilities to help fund any short comings in contributions due to constraints in cash from
operations.
3.00 Valuations under distress:
To determine the value of the firm under distress we have applied both a Monte Carlo
simulation and a Modified Discounted Cash Flow valuation. The methodology and steps taken to
arrive at our conclusions are expressed in detail in the appendix.
0.0
0.5
1.0
1.5
20
09
20
10
20
11
201
2
20
13
Current Ratio Quick Ratio
Cash Ratio
0%
20%
40%
60%
80%
100%
-6
-4
-2
0
2
4
200
9
201
0
201
1
201
2
20
13
Interest Coverage Debt Ratio (%)
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3.10 Modified Discounted Cash Flow Valuation:
The modified discounted cash flow analysis incorporates the probability of distress by
adjusting the expected cash flows of the firm. Probabilities and details with respect to the
liquidation value of Sears Holdings are provided in detail in the appendix (I to N). As per the
analysis conducted it is clear that the firm has no equity value given its financial obligations,
underfunded pension, and estimated future cash flows from the firm. This supports our thesis that
there is zero equity value in Sears Holdings given their historical financial performance and
ineffective corporate strategy to help increase returns to shareholders.
Component Breakdown of FCFF Forecasts by Year (under the going concern assumption)
Summary of Modified Discounted Cash flow Valuation
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3.20 Monte Carlo Simulation of DCF Valuation
In order to provide a more fluid and robust Cash Flow valuation, we assume two normal
probability distributions for two important variables: EBITAR Margin and WACC fitted using
historical and forecasted parameters. See appendix H for technical details. Running 500,000
simulated samples, we find the mean equity value of Sears Holdings to be -$10.07 per share.
Since prices cannot be negative, we instead find the mean equity value of samples with positive
equity price to be $17.54 per share. Positive equity value only happens 29.89% of the time
within the simulated sample. See appendix figure M for the histogram of equity value. What the
simulation implies is, given current forecasts, Sears will need to have extremely favourable
surprises within the next four years to stay alive as a public company.
Total PV of Free Cash Flows 5,615.27$ Probability of Default:
Add: Cash and Cash Equivalents 1,261.24$ Probability of distress (Annual) = 9.79%
Less: Market Value of Short-term Debt 1,323.00$ Probability of distress over 5 years = 40.27%
Less: Market Value of Long-term Debt 1,148.29$ Probability of distress over 10 years = 64.32%
Less: Capitalized Lease Obligations 346.00$
Less: Capitalized Operating Leases 3,007.91$
Equity Value*(1-Probability of Distress) 627.94$
1,954.16-$
Modified Value of Equity under distress 1,326.21-$
Number of Shares Outstanding 106.5
Equity Value per Share -$
Current Stock price 36.24$
Overvalued by : -100%
WACC for Sears Holding Corporation 11.19%
Add: Liquidation Value*(Probability of Distress)
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4.00 Quantitative Bankruptcy Model
4.10 Retail Bankruptcy Model
Following the seminal work by Altman (1968), we introduce a similar bankruptcy model to
complement our valuation of Sears Holdings. We shall refer to this new model as the Retail
Bankruptcy Model (RBM). The need for a new retail bankruptcy model is primarily motivated
through four main reasons:
1. Obtaining more accurate predictions through the use of new computation methods that
can classify non-linear hypothesis.
2. Altman‟s original model is built through a mixed-industry sample. McGurr and
DeVaney (1998) show that when applying mixed-industry samples onto one specific
industry, existing models tend to underperform in predictability. Likewise, Platt and Platt
(1990) argue that the difference in industry dynamics such as reported financial ratios
drive the disparity in out-of-sample testing.
3. Additional variables more pertinent to the retail industry, ex: Interest coverage ratios.
4. More recent and available datasets to improve current forecasts.
4.20 Methodology:
RBM is constructed through a probit artificial neural network. This methodology
improves upon the original Multiple Discriminant Analysis through the ability to fit non-linear
classifiers. To prevent the possibility of over fitting, training (70%), validation (15%) and test
(15%) sets are sectioned to ensure best possible generalization. Sample of 108 (54 bankrupt and
54 non-bankrupt) General Retailer firms were collected from the Bloomberg database under the
Industrial Classification Benchmark (ICB). The filing dates for the 54 delisted firms are from
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2001 to 2015. Bankrupt variables were collected one fiscal year prior to the firm filing a Chapter
11, thus the RBM predicts bankruptcy one year ahead.
4.30 Results and Comparison:
The neural network classifier was shown to be superior in forecast accuracy when
compared with traditional Altman Z score methodology on original samples. Using a cut-off of
60% for the neural network and 2.675 for the Altman Z Score, the RBM outperforms the Z score
model by accurately predicting bankruptcy 92.6% of the time and non-bankruptcy 88.9% of the
time versus 79.63% and 85.19% respectively. See appendix O for a detailed table of results.
4.40 Application to Sears Holdings:
In summary to this section, we apply the Retail Bankruptcy Model to Sears Holdings.
Using most recent quarterly data from Bloomberg, we find that the model predicts a near-definite
bankruptcy in one fiscal year with an assigned probability of 98.67%. Since this is a one-year
forecast, it is difficult to confidently assume that the probability increases with a five year time
period since financial conditions can change. However, we are confident that if current valuation
and metrics hold in the future, the cumulative likelihood of Sears Holdings to become financially
insolvent increases.
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Works Cited
Altman Edward I, Financial ratios, discriminant analysis and the prediction of corporate
bankruptcy, The Journal of Finance, Volume 23, Issue 4, 1968, Pages 589-609.
James Gentry, Paul Newbold and David Whitford, Classifying Bankrupt Firms with Funds Flow
Components, Journal of Accounting Research, Volume 23, Issue 1, Spring 1985, Pages 146-160.
Paul McGurr, Sharon DeVaney, Predicting Business Failure of Retail Firms: An Analysis Using
Mixed Industry Models, Journal of Business Research, Volume 43, Issue 3, November 1998,
Pages 169-176, ISSN 0148-2963.
Platt, H. P. and M. B. Platt. (1990): Development of a class of stable predictive variables: the
case of bankruptcy prediction. Journal of Business Finance and Accounting, Volume 17, Issue 1,
Pages 31-51.
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Appendix A: “Shop Your Way” Screenshots
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Appendix B: Historical Income Statement
2009 2010 2011 2012 2013
Revenues 44,043 42,664 41,567 39,854 36,188
Expenses:
Cost of Sales, Buying and Occupancy 31,824 31,000 30,966 29,340 27,433
Selling and Administrative 10,654 10,425 10,664 10,660 9,384
EBITDA 1,565 1,239 -63 -146 -629
Depreciation Expense 926 869 853 830 732
EBIT 639 370 -916 -976 -1,361
Interest Expense (Income) -265 -293 -289 -267 -254
EBT (Before Other Items) 374 77 -1,205 -1,243 -1,615
Non-Operating Items
Write-down/Impairment of Assets 0 0 649 330 233
Interest and Investment Income 33 36 41 94 207
Other Income (Loss) -61 -14 -2 -1 -2
Gain on Sales of Assets -74 -67 -64 -468 -667
Income (Loss) from Discontinued Operations, Net of Tax 0 11 -27 0 0
EBT (After Other Items) 420 177 -1,778 -1,010 -972
Income Tax Expense -123 -27 -1,369 -44 -144
Non-Controlling Interest 0(Income) Loss Attributable to Noncontrolling Interests -62 -17 7
Net Income 235 133 -3,140 -930 -1,365
Common Shares Outstanding 118 112 107 106 106
Exercisable/Convertible Shares 0 0 0 0 0
Basic Earnings Per Share $1.99 $1.19 -$29.40 -$8.78 -$12.86
Diluted Earnings Per Share $1.99 $1.19 -$29.40 -$8.78 -$12.86
Sears HoldingsIncome Statement - USD Millions
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Appendix C: Historical Income Statement – Common Size
2009 2010 2011 2012 2013
Revenues -100% 0% 100% 100% 100%
Expenses:
Cost of Sales, Buying and Occupancy 72% 73% 74% 74% 76%
Selling and Administrative 26% 25% 26% 27% 26%
EBITDA 4% 3% 0% 0% -2%
Depreciation Expense 2% 2% 2% 2% 2%
EBIT 2% 1% -2% -2% -4%
Interest Expense (Income) -1% -1% -1% -1% -1%
EBT (Before Other Items) 1% 0% -3% -3% -4%
Non-Operating Items
Write-down/Impairment of Assets 0% 0% 2% 1% 1%
Interest and Investment Income 0% 0% 0% 0% 1%
Other Income (Loss) 0% 0% 0% 0% 0%
Gain on Sales of Assets 0% 0% 0% -1% -2%
Income (Loss) from Discontinued Operations, Net of Tax0% 0% 0% 0% 0%
EBT (After Other Items) 1% 0% -4% -3% -3%
Income Tax Expense 0% 0% -3% 0% 0%
Non-Controlling Interest 0% #VALUE! 0% 0% 0%
Net Income 1% 0% -8% -2% -4%
Sears HoldingsCommon Size Income Statement
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Appendix D: Historical Balance Sheet
2009 2010 2011 2012 2013
Assets:
Cash and Equivalents 1,680 1,359 747 609 1,028
Accounts Receivable 652 689 695 635 553
Merchandise Inventories 8,705 8,951 8,407 7,558 7,034
Restricted Cash 11 15 7 9 10
Prepaid Expenses and Other Current Assets 351 334 388 454 334
Current Assets 11,399 11,348 10,244 9,265 8,959
Total Property and Equipment, Net 7,709 7,102 6,577 6,053 5,394
Goodwill 1,392 1,392 841 379 379
Other Assets 1,061 899 782 762 679
Trade Names and Other Intangible Assets 3,208 2,993 2,937 2,881 2,850
Total Assets 24,769 23,734 21,381 19,340 18,261
Liabilities:
Merchandise Payables 3,335 3,046 2,912 2,761 2,496
Other Current liabilities 3,098 2,937 2,892 2,683 2,527
Current Portion of Long-Term Debt and Capitalized Lease Obligations482 489 230 83 83
Other Taxes 534 546 523 480 460
Liabilities from Discontinued Operations (Short-Term) 0 124 0 0 0
Current Liabilities 8,786 8,643 9,212 8,414 8,185
Long-Term Debt and Capitalized Lease Obligations 1,698 2,344 2,088 1,943 2,834
Pension and Postretirement Benefits 2,271 2,151 2,738 2,730 1,942
Other Long-term Liabilities 2,618 2,207 2,186 2,126 2,008
Long-Term Deferred Tax Liabilities 0 0 816 955 1,109
Total Liabilities 15,373 15,345 17,040 16,168 16,078
Equity:
Common Stock 1 1 1 1 1
Retained Earnings 4,797 4,930 1,865 885 -480
Treasury Stock – At Cost -5,446 -5,826 -5,981 -5,970 -5,963
Capital in Excess of Par Value 10,465 10,185 10,005 9,298 9,298
Total Equity 9,096 8,286 4,281 2,755 1,739
Noncontrolling Interest 302 103 60 417 444
Total Liabilities and Equity 24,771 23,734 21,381 19,340 18,261
Sears HoldingsBalance Sheet - USD Millions
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Appendix E: Historical Balance Sheet – Common Size
2009 2010 2011 2012 2013
Assets:
Cash and Equivalents 7% 6% 3% 3% 6%
Accounts Receivable 3% 3% 3% 3% 3%
Merchandise Inventories 35% 38% 39% 39% 39%
Restricted Cash 0% 0% 0% 0% 0%
Prepaid Expenses and Other Current Assets 1% 1% 2% 2% 2%
Current Assets 46% 48% 48% 48% 49%
Total Property and Equipment, Net 31% 30% 31% 31% 30%
Goodwill 6% 6% 4% 2% 2%
Other Assets 4% 4% 4% 4% 4%
Trade Names and Other Intangible Assets 13% 13% 14% 15% 16%
Total Assets 100% 100% 100% 100% 100%
Liabilities:
Merchandise Payables 13% 13% 14% 14% 14%
Other Current liabilities 13% 12% 14% 14% 14%
Current Portion of Long-Term Debt and Capitalized Lease Obligations2% 2% 1% 0% 0%
Other Taxes 2% 2% 2% 2% 3%
Liabilities from Discontinued Operations (Short-Term)0% 1% 0% 0% 0%
Current Liabilities 35% 36% 43% 44% 45%
Long-Term Debt and Capitalized Lease Obligations7% 10% 10% 10% 16%
Pension and Postretirement Benefits 9% 9% 13% 14% 11%
Other Long-term Liabilities 11% 9% 10% 11% 11%
Long-Term Deferred Tax Liabilities 0% 0% 4% 5% 6%
Total Liabilities 62% 65% 80% 84% 88%
Equity:
Common Stock 0% 0% 0% 0% 0%
Retained Earnings 19% 21% 9% 5% -3%
Treasury Stock – At Cost -22% -25% -28% -31% -33%
Capital in Excess of Par Value 42% 43% 47% 48% 51%
Total Equity 37% 35% 20% 14% 10%
Noncontrolling Interest 1% 0% 0% 2% 2%
Total Liabilities and Equity 100% 100% 100% 100% 100%
Sears HoldingsCommon Size Balance Sheet
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Appendix F: Historical Cash flow Statement – Common Size
2011 2011 2011 2012 2013
Cash From Operating ActivitiesNet Income 297 150 -3,147 -1,054 -1,116
Add (Deduct) Non-Cash Items:
Add: Depreciation Expense 926 869 853 830 732
Change in Non Cash Working Capital 412 -537 498 187 -328
Gain on Sales of Assets - CF -74 -67 -64 -468 -667
Deferred Income Taxes 90 -15 -533 -206 720
Bankruptcy-Related Recoveries -CF 0 0 0 0 -97
Settlement of Canadian Dollar Hedges 0 -3 0 6 9
Cash From Operations 1,507 123 -275 -303 -1,109
Cash From Investing ActivitiesCapital Expenditures / Acquisitions -361 -426 -432 -378 -329
Proceeds from Sales of Property and Investments 23 35 72 532 995
Net Decrease (Increase) in Investments and Restricted Cash 166 0 8 37 -2
Net Cash Provided by (Used in) Investing Activities—Discontinued O0 -15 43 0 0
Disposition of Sears Canada Equity Stake 0 0 0 0 0
Cash From Investing -172 -406 -309 191 664
Cash From Financing ActivitiesAdditions of Long-Term Debt 0 1,353 104 5 994
Reductions of Long-Term Debt -335 -358 -611 -335 -83
Additions of Short-Term Debt -117 35 815 -81 238
Reductions of Short-Term Debt 0 0 0 0 0
Net Debt Additions (Reductions) -452 1,030 308 -411 1,149
Issuance of Common Shares 0 0 0 0 0
Redemption of Common Shares -424 -997 -226 -10 0
Cash Dividends Paid 0 -69 0 -50 -233
Net Cash Used in Financing Activities—Discontinued Operations 0 -31 -75 0 0
Cash From Financing -951 -95 -28 -27 902
Foreign Exchange Rate Gain (Loss) 132 57 0 1 -38
Net Change in Cash 516 -321 -612 -138 419
Cash Balance, Beginning 1,164 1,680 1,359 747 609
Cash Balance, Ending 1,680 1,359 747 609 1,028
Sears HoldingsCash Flow Statement - USD Millions
25
Appendix G: Historical Financial Ratios
Activity Ratios 2009 2010 2011 2012 2013
Days Inventory on Hand 100 105 99 99 97(365/(COGS/Avg. Inventory))
Average Collection Period 5.40 5.89 6.10 5.82 5.58(Avg. Receivables/(Net Sales/365))
Asset Turnover 1.78 1.80 1.94 1.96 1.92(Net Sales/Avg. Total Assets)
Liquidity Ratios 2009 2010 2011 2012 2013
Current Ratio 1.30 1.31 1.11 1.10 1.09(Current Assets/Current Liabilities)
Quick Ratio 0.27 0.24 0.16 0.15 0.19(Cash+AR+ST Invest/Current Liabilities)
Cash Ratio 0.19 0.16 0.08 0.07 0.13(Cash/Current Liabilities)
Solvency Ratios 2009 2010 2011 2012 2013
Debt Ratio 0.62 0.65 0.80 0.84 0.88(Total Liabilities/Total Assets)
Cash Flow to Debt 0.69 0.04 -0.12 -0.15 -0.38(Ops Cash Flow/Total Debt)
Interest Coverage 2.41 1.26 -3.17 -3.66 -5.36(EBIT/Interest Expense)
Profitability Ratios 2009 2010 2011 2012 2013
EBITDA Margin 3.6% 2.9% -0.2% -0.4% -1.7%(EBITDA/Total Revenue)
Operating Margin 1.5% 0.9% -2.2% -2.4% -3.8%(EBIT/Total Revenue)
Profit Margin 0.5% 0.3% -7.6% -2.3% -3.8%(Net Income/Total Revenue)
ROA 0.9% 0.6% -14.7% -4.8% -7.5%(Net Income/Total Assets)
ROE 2.6% 1.6% -73.3% -26.4% -60.7%(Net Income/Avg. BV of Equity)
ROIC 4.8% 2.6% 3.7% -8.5% -12.1%(EBIT(1-T)/(Total Assets-Current Liab)
Historical
26
Appendix H: Monte Carlo Simulation
Section - Monte Carlo Technical
EBITAR Margin
Quarterly EBITAR Margin forecasts were fitted with a rational function of the form
where a,b,c,d are constants. A rational function is most appropriate since both linear and
quadratic forms produce unrealistic forecast assumptions. See below figure. To simulate noise,
we assume a normal distribution with parameters sampled from residuals of the fitted function.
The final equation becomes:
WACC
27
Sampling Bloomberg historical WACC, we forecast current WACC to be 11.91% through the
DCF Valuation and changes stochastically at each time-step. The change can be modelled by a
normal distribution with mean 0 and variance of 0.1072. An important assumption being made
is that the parameters of the distribution do not change over each period.
Figure M - Simulated Histogram of Equity Value with Fitted Curve
28
Appendix I: Modified Discounted Cash Flow Valuation – Revenue Forecast
FY2014 FY2015 FY2016 FY2017 FY2018 Steady State
Beginning Number of
locations 2,429 1,831 1,732 1,732 1,732 1,732
Closure of Lands End
Locations 13
Closure of Sears Canada
Stores (2014) 449
Closure of Sears Holdings
Locations (actual) 136
Annouced Store Closures 99
Expected Closure of Sears
Auto Centers 34
Forecast stores for new year 1,831 1,732 1,732 1,732 1,732 1,732
Percent growth in store
locations -24.6% -28.7%
Historical Revenue
Revenue for the first 9
months of 2014 23,099.00$
Forecast Revenue for Q4
2014 7,903.33$
Forecast Yearly Revenue 31,002.33$ 21,720.55$ 21,720.55$ 21,720.55$ 21,720.55$ 21,720.55$
Same Store Sales Growth
Adjustment (estimate) -2.0% -2.0% -2.0% -2.0% -2.0%
Adjusted Forecast Total
Revenue 31,002.33$ 21,720.55$ 21,286.14$ 20,860.41$ 20,443.20$ 20,034.34$
Total Revenue Growth -14.33% -29.94% -2.00% -2.00% -2.00% -2.00%
Revenue per store
Forecast
12.5415 year average revenue per store
29
Appendix J: Modified Discounted Cash Flow Valuation – CapEx and Working Capital
Assumptions
FY2009 FY2010 FY2011 FY2012 FY2013 5 year
Average
Revenue $
44,043.00
$
42,664.00
$
41,567.00
$
39,854.00
$
36,188.00
40863.2
Capital
expenditures
-$
361.00
-$
426.00
-$
432.00
-$
378.00
-$
329.00
-385.2
CAPEX as % of
Revenues
0.82% 1.00% 1.04% 0.95% 0.91% 0.94%
Working Capital 2272 2803 2087 1732 1624 2103.6
Working Capital
as % of Revenue
5.16% 6.57% 5.02% 4.35% 4.49% 5.12%
Appendix: Modified Discounted Cash Flow Valuation – WACC Calculation
Risk Free Rate 2.14% (Use 10 Year T-bond)
Debt Rating CCC (S&P Rating)
Implied Yield Spread 7.00%
Cost of Debt Before Tax 9.14%
Effective Tax Rate 25.00%
After-Tax Cost of Debt 6.86%
Cost of Debt Calculation
Risk Free Rate 2.14%
Adj Raw Beta 2.27
Market Risk Premium 6.50%
Cost of Equity 16.87%
Cost of Equity Calculation
30
--- The Adjusted Raw Beta was computed following a top down approach using the S&P 500 monthly
returns.
Appendix K: Modified Discounted Cash Flow Valuation – Probability of Distress
Calculation
Source: Damadoran, Sears Holdings Annual Report, Student Estimates
Market Capitaliztion $3,845
Debt Outstanding $5,043
Market Cap of Pref Shares $0
Value of Firm $8,888
Weighted Average Cost of Capital 11.19%
Cost of Capital Calculation
Risk Free Rate 2.14% (Use 10 Year T-bond)
Debt Rating CCC (S&P Rating)
Implied Yield Spread 7.00%
Cost of Debt Before Tax 9.14%
Effective Tax Rate 25.00%
After-Tax Cost of Debt 6.86%
Cost of Debt Calculation
Risk Free Rate 2.14%
Adj Raw Beta 2.27
Market Risk Premium 6.50%
Cost of Equity 16.87%
Cost of Equity Calculation
Probability of Distress InputsCoupon Rate = 14.14%
Maturity of bond= 8.73
Riskfree rate = 2.15%
Market price of bond= $673.22
Year Cash Flow CF (1-p) Present Value
1 $141.45 $127.59 $124.91
2 $141.45 $115.10 $110.30
3 $141.45 $103.83 $97.41
4 $141.45 $93.66 $86.02
5 $141.45 $84.48 $75.96
6 $141.45 $76.21 $67.08
7 $141.45 $68.75 $59.24
8 $141.45 $62.01 $52.31
$0.00
Value of bond = $673.22
Probability of distress (Annual) = 9.79%
Probability of distress over 5 years = 40.27%
Probability of distress over 10 years = 64.32%
31
Appendix L: Modified Discounted Cash Flow Valuation – Calculation for Market Value of
Debt
To determine the market value of debt for Sears Holdings, all their outstanding long term bonds
were treated as one bond. Thus the weighted average maturity and coupon were used in the
calculation.
Issuer Cpn Year to
Maturity
Amt
Out(M)
Mty Type Cpn Freq Principal
Due(M)
Interest
Due(M)
Weighted
Maturity
Weighted
Coupon
Weighted
Face Value
Sears Roebuck
Acceptance
Corp
6.875 2 43,454 BULLET SEMI
ANNUAL
43,454 1,494 0.0413401 0.142 898.197
Sears Holdings
Corp
6.625 3 2,510 BULLET SEMI
ANNUAL
2,510 83 0.0035818 0.008 2.997
Sears Holdings
Corp
6.625 3 1,234,490 BULLET SEMI
ANNUAL
1,234,490 40,892 1.7616546 3.890 724914.978
Sears Holdings
Corp
8 4 625,000 BULLET SEMI
ANNUAL
625,000 25,000 1.1891919 2.378 185811.229
Sears Roebuck
Acceptance
Corp
7.5 12 43,179 CALLABLE SEMI
ANNUAL
43,179 1,619 0.246471 0.154 886.864
Sears Roebuck
Acceptance
Corp
6.75 13 23,943 BULLET SEMI
ANNUAL
23,943 808 0.1480587 0.077 272.690
Sears Roebuck
Acceptance
Corp
6.5 13 38,640 BULLET SEMI
ANNUAL
38,640 1,256 0.2389419 0.119 710.209
Sears Roebuck
Acceptance
Corp
7 17 91,052 BULLET SEMI
ANNUAL
91,052 3,187 0.7362924 0.303 3943.582
$74,339.00 4.366 7.072 $
2,102,268.00
32
Appendix M: Modified Discounted Cash Flow Valuation – Forecast Assumptions
Risk free rate 2.12
Default spread 8
Current cost of debt 10.12
Adjustment for Semi-annual Coupon
Interest expense 74,339.00$ 37,169.50$
Weighted Maturity 4.365532368 8.73106474
Weighted Coupon 7.072291925 14.1445838
Weighted Face Value 917,440.74$
Market value of
Bonds 1,148,286.70$
FCFF Model Forecast Assumptions
Sears Holdings Corporation
5 year average Capex as percentage of revenue0.94%
Common size assumptions % of Revenues Assumptions:
Cost of Goods Sold 74.00%
General and Administrative expenses 25.00% CV Growth rate 3.50%
Depreciation 2.00% Tax rate 25.00%
Non Cash Working Capital as a % of Revenue 5.12%
33
Appendix N: Modified Discounted Cash Flow Valuation – Forecast Assumptions
FY20
10FY
2011
FY20
13FY
2014
FY20
15FY
2016
FY20
17FY
2018
Stea
dy
Sta
te
Re
ven
ue
s41
,187
.1$
39
,762
.4$
37
,606
.6$
31
,002
.3$
21
,720
.5$
21
,286
.1$
20
,860
.4$
20
,443
.2$
20
,034
.3$
YoY
% G
row
th-6
%-3
%-5
%-1
8%
-30
%-2
%-2
%-2
%-2
%
Co
st o
f G
oo
ds
Sold
30,6
83.0
$
29,2
72.6
$
28,5
08.4
$
22,9
41.7
$
16,0
73.2
$
15,7
51.7
$
15,4
36.7
$
15,1
28.0
$
14,8
25.4
$
% o
f Rev
enu
es7
4%
74
%7
6%
74
%7
4%
74
%7
4%
74
%7
4%
Ge
ne
ral a
nd
Ad
min
istr
ativ
e e
xpe
nse
s10
,664
.0$
10
,660
.0$
9,
384.
0$
7,
750.
6$
5,
430.
1$
5,
321.
5$
5,
215.
1$
5,
110.
8$
5,
008.
6$
%
of R
even
ues
26
%2
7%
25
%2
5%
25
%2
5%
25
%2
5%
25
%
De
pre
ciat
ion
853.
0$
83
0.0
$
732.
0$
62
0.0
$
434.
4$
42
5.72
$
41
7.21
$
40
8.86
$
40
0.69
$
%
of R
even
ues
2%
2%
2%
2%
2%
2%
2%
2%
2%
Cu
rre
nt
ren
t e
xpe
nse
827.
5$
79
2.8
$
801.
0$
68
4.0
$
605.
0$
49
9.0
$
383.
0$
28
9.0
$
400.
69$
% o
f Rev
enu
es2
%2
%2
%2
%3
%2
%2
%1
%2
%
EBIT
AR
(185
.4)
$
(2
07.3
)$
(216
.8)
$
37
4.0
$
387.
8$
28
6.1
$
174.
4$
84
.6$
20
0.3
$
% o
f Rev
enu
es0
%-1
%-1
%1
%2
%1
%1
%0
%1
%
Taxe
s1,
356.
5$
43
.9$
14
9.6
$
93.5
$
96.9
$
71.5
$
43.6
$
21.1
$
50.1
$
% o
f Rev
enu
es3
%0
%0
%0
%0
%0
%0
%0
%0
%
NO
PA
T e
xclu
din
g re
nt
exp
en
se(1
,541
.9)
$
(251
.2)
$
(3
66.4
)$
280.
5$
29
0.8
$
214.
6$
13
0.8
$
63.4
$
150.
3$
%
of R
even
ues
-4%
-1%
-1%
1%
1%
1%
1%
0%
1%
620.
05$
434.
41$
425.
72$
417.
21$
408.
86$
400.
69$
337.
91$
474.
91$
22.2
3$
21
.78
$
21.3
5$
20
.92
$
(292
.35)
$
(204
.83)
$
(200
.73)
$
(196
.72)
$
(192
.78)
$
(188
.93)
$
946.
09$
995.
34$
461.
82$
373.
07$
300.
86$
4,98
2.32
$
946.
09$
895.
20$
373.
57$
271.
42$
196.
86$
2,93
2.12
$
1,92
4.17
$
1,58
6.26
$
1,11
1.35
$
1,08
9.12
$
1,06
7.34
$
1,04
5.99
$
1,02
5.07
$
Tota
l PV
of
Fre
e C
ash
Flo
ws
5,61
5.27
$
Pro
bab
ilit
y o
f D
efa
ult
:
Ad
d: C
ash
an
d C
ash
Eq
uiv
ale
nts
1,26
1.24
$
Pro
bab
ilit
y o
f d
istr
ess
(A
nn
ual
) =
9.79
%
Less
: Mar
ket
Val
ue
of
Sho
rt-t
erm
De
bt
1,32
3.00
$
Pro
bab
ilit
y o
f d
istr
ess
ove
r 5
year
s =
40.2
7%
Less
: Mar
ket
Val
ue
of
Lon
g-te
rm D
eb
t1,
148.
29$
P
rob
abil
ity
of
dis
tre
ss o
ver
10 y
ear
s =
64.3
2%
Less
: Cap
ital
ize
d L
eas
e O
bli
gati
on
s34
6.00
$
Less
: Cap
ital
ize
d O
pe
rati
ng
Leas
es
3,00
7.91
$
Equ
ity
Val
ue
*(1-
Pro
bab
ilit
y o
f D
istr
ess
)62
7.94
$
1,95
4.16
-$
Mo
dif
ied
Val
ue
of
Equ
ity
un
de
r d
istr
ess
1,32
6.21
-$
Nu
mb
er
of
Shar
es
Ou
tsta
nd
ing
106.
5
Equ
ity
Val
ue
pe
r Sh
are
-$
Cu
rre
nt
Sto
ck p
rice
36.2
4$
Ove
rval
ue
d b
y :
-100
%
WA
CC
fo
r Se
ars
Ho
ldin
g C
orp
ora
tio
n11
.19%
Ad
d: L
iqu
idat
ion
Val
ue
*(P
rob
abil
ity
of
Dis
tre
ss)
Fore
cast
Ad
d:
De
pre
ciat
ion
Less
:
Incr
eas
e in
No
n C
ash
Wo
rkin
g ca
pit
al
Cap
ital
exp
en
dit
ure
s
Fre
e C
ash
Flo
w
His
tori
c
Dis
cou
nte
d F
ree
Cas
flo
w
Tota
l No
n-C
ash
Wo
rkin
g C
apti
al
34
Appendix O: Quantitative Bankruptcy Model
Table A - Factors selected in the Bankruptcy Model
Ratios Group Mean
(Bankrupt)
Group Mean (Non-bankrupt) t-statistic
(NB-B)
Working Capital/Total Asset 0.053 0.279 4.04
EBIT/Total Asset 0.0257 -0.061 4.09
Retained Earnings/Total Asset 0.082 -0.82 3.66
MV of Equity/Total Liabilities 4.04 0.86 5.07
Sales/Total Asset 1.81 1.91 -0.32
Interest Coverage Ratio 321 -24.5 3.06
CFFO/Total Asset 0.029 -0.023 4.28
Current Ratio 2.43 1.45 4.18
Return on Asset 5.21 -22.3 6.49
List A - Factor Summary
Working Capital/Total Asset: Liquidity measure that proxies a firm‟s ability to convert to
cash.
EBIT/Total Asset: Profitability measure that tracks a firm‟s earning power with its assets.
Retained Earnings/Total Asset: Earning surplus of a firm, proxies relative leverage and
overall age of the firm as explained by Altman (1968).
MV of Equity/Total Liabilities: Measure of safety margins that shows how many times
asset values can fall before the firm becomes insolvent.
Sales/Total Asset: Profitability measure from assets that proxies competitiveness and
especially useful in the retail landscape despite weak t-statistic.
35
Interest Coverage Ratio: The ability for a firm to cover its leverage. It is common for
soon-to-be insolvent firms to take on an unprecedented amount of leverage.
CFFO/Total Asset: Measures cash flow from operations generated from total assets. Later
development of Altman‟s model advocates the use of cash flow models such as Gentry,
Newbold and Whitford (1985).
Current Ratio: Liquidity measure that proxies a firms ability to pay back its short-term
obligations with short-term assets.
Return on Asset: Similar profitability proxy of how well a firm can generate net income
from its invested capital.
Table B - Full Sample Performance Test
RBM
Predicted
Actual Bankrupt Non-Bankrupt
Bankrupt 43 11
Non-Bankrupt 8 46
Altman Z Score
Predicted
Actual Bankrupt Non-Bankrupt
Bankrupt 50 4
Non-Bankrupt 6 48
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