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Next, Sears reports its total domestic (U.S.) credit card receivables, showing the
amounts securitized and the retained interest in those securitized receivables separately. It
also reports the charge-off rate for the year (note the decline in 2000) and the year-end delin-
quency rate. These data can be compared with those of similar companies.
Finally, Sears reports the cash ¬‚ows associated with its securitization activities. These
amounts are not reported in the company™s statement of cash ¬‚ows. Sears received more than
$2.6 billion from securitizations in 2000 and reinvested more than $3.5 billion of collections
in previous securitizations. The company received $200 million of servicing fees, consistent
with the 2% fee reported earlier in Note 3. Sears spent $522 million to repurchase charged-
off balances, net of recovery of earlier repurchased receivables.
These disclosures provide the analyst with a reasonable understanding of the importance
of securitization as a source of ¬nancing for Sears. Comparisons can be made with other
¬rms, especially once more years of data are accumulated.


Part C: Disclosures”Sears 2001 Annual Report
Note 3”Credit Card Receivables
The addition of previously uncommitted assets to the securitization trust in April 2001 re-
quired the Company to consolidate the securitization structure for ¬nancial reporting pur-
poses on a prospective basis. Accordingly, the company recognized approximately $8.1
billion of previously unconsolidated securitized credit card receivables and related securiti-
zation borrowings in the second quarter of 2001. In addition, approximately $3.9 billion of
assets were reclassi¬ed to credit card receivables from retained interests in transferred credit
card receivables. The Company now accounts for securitizations as secured borrowings.
In connection with the consolidation of the securitization structure, the Company recog-
nized a non-cash, pretax charge of $522 million to establish an allowance for uncollectible
accounts related to the receivables, which were previously considered sold or accounted for
as retained interests in transferred credit card receivables.
W53
ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION


Accounting for Securitizations”SFAS 125
Prior to April 2001, the issuance of certi¬cates to outside investors was considered a sale of
receivables for which the Company recognized a gain on the sale. The Company recognized
incremental operating income of $40, $128, and $86 million in 2001, 2000, and 1999, re-
spectively, from net securitization activity.
The Company™s retained interests were recorded by the Company at the date of the sale
to the trusts by allocating the original carrying amounts of the credit card receivables held by
the Company between the sold interests and the retained interests based on their relative fair
values. Management used certain assumptions in determining the fair value of its retained in-
terests. Key assumptions used in the ¬rst quarter of 2001 and in ¬scal 2000 were a yield of
19.85%, a monthly principal payment rate of 5.26%, a discount rate of 12.0%, and an annual
charge-off rate of 7.40%.

Securitization Cash Flow Data
The table below summarizes certain cash ¬‚ows that the Company received from and paid to
the securitization trust in 2000. Cash ¬‚ow data has not been provided for 2001 as the securi-
tization trust was consolidated beginning in the second quarter.

Millions 2000
Proceeds from new securitizations $2,620
Proceeds from collections reinvested in previous securitizations 3,547
Servicing fee received 200
Purchase of charged-off balances, net of recoveries (522)


ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION

The Company has signi¬cant ¬nancial capacity and ¬‚exibility due to the quality and liquidity
of its assets, principally its credit card receivables. As such, the Company has the ability to
access multiple sources of capital.
A summary of the Company™s credit card receivables at year-end is as follows:

Millions 2001 2000 1999

Domestic:
Managed credit card receivables $27,599 $27,001 $26,785
Securitized balances sold ” (7,834) (6,579)
Retained interest in transferred credit card ” (3,051) (3,175)
receivables(1)
Other customer receivables $27,640 $16,159 $17,037
Domestic owned credit card receivables $27,639 $16,175 $17,068
Sears Canada credit card receivables $21,682 $11,828 $11,725
Consolidated owned credit card receivables $29,321 $18,003 $18,793
(1)
The 2000 and 1999 retained interest amounts exclude reserves of $82 and $31 million, respectively, and interest-
only strip balances of $136 and $67 million, respectively, related to the transfer of credit card receivables into the
Trust.


As of year-end 2000 and 1999, the credit card receivables balance of $18.0 billion and
$18.8 billion, respectively, excluded credit card receivables transferred to a securitization
Master Trust (“Trust”). Through its subsidiary, SRFG, Inc., the Company obtains funding
by selling securities backed by a portion of the receivables in the Trust. In addition to the re-
ceivables in the Trust, which support securities sold to third parties, the Company transfers
W54 APPENDIX 11-A SECURITIZATION: SFAS 140 REPORTING AND DISCLOSURE REQUIREMENTS” SEARS


additional receivables to the Trust to have receivables readily available for future securitiza-
tions. As discussed in Note 3 of the Company™s Consolidated Financial Statements, the
Company consolidated its Master Trust beginning in the second quarter of 2001, subsequent
to the adoption of SFAS No. 140. The Company continues to utilize securitizations as a key
funding source.

CAPITAL RESOURCES

Total borrowings outstanding at the end of 2001 and 2000 were $25.6 billion and $25.7 bil-
lion, respectively. Total borrowings, including debt re¬‚ected on the balance sheet and in-
vestor certi¬cates related to credit card receivables issued through securitizations, were as
follows:

% of % of % of
Millions 2001 Total 2000 Total 1999 Total
Short-term borrowings $ 3,557 13.9% $ 4,280 16.7% $ 2,989 12.2%
Long-term debt(1) $22,078 186.1% $13,580 152.8% $15,049 161.1%
Securitized balances sold(2) $22,0” ” 7,834 30.5% 6,579 26.7%
Total borrowings $25,635 100.0% $25,694 100.0% $24,617 100.0%
(1)
Includes capitalized lease obligations.
(2)
Included in long-term debt in 2001 due to the change in securitization accounting; the securitization trust was not
consolidated in 2000 and 1999 (see Note 3 of the Notes to the Consolidated Financial Statements).
Source: Sears 2001 Annual Report


Part D: Discussion
Adoption of SFAS 140 requires consolidation of receivables previously considered sold.
Sears notes (1) the impact of non-recognition of any gain on sale on operating income and
(2) the impact on reported leverage. Although the change in operating income is not signi¬-
cant, reported income better re¬‚ects the earnings process and the impact of charge-offs. Re-
ported leverage shows a signi¬cant increase. Exhibit 11A-1 shows an increase in reported
leverage to approximately 419% from 286% that would have been reported had Sears contin-
ued to report the securitizations as sales. The inclusion of receivables and related borrowings
also better re¬‚ects the liquidity and the interest coverage.


EXHIBIT 11A-1
Sears: Impact of SFAS 140

Capitalization at 12/31/01
Amounts in $millions Pro Forma* As Reported

Short-term debt $ 6,714 $ 6,714
Long-term debt 10,778 18,921
Total debt 17,492 25,635
Stockholders™ equity 6,119 6,119
Debt-equity ratio 286% 419%

*Pro Forma assumes that SFAS 140 was not adopted on April 1
Appendix 18-A
RATIOS USED IN CREDIT AND EQUITY RISK
PREDICTION MODELS


Chapter 18 discusses research that examined the utility of accounting (and other ¬nancial)
measures in risk evaluation and prediction. The exhibits provided in this appendix list the ex-
planatory independent variables (¬nancial risk measures) used in the key research studies in
this area. The topics covered by the exhibits are:

Exhibits 18A-1(a) and (b) Bankruptcy Prediction Models
Exhibit 18A-2 Bond Ratings Prediction Models
Exhibit 18A-3 Beta Prediction Models

The exhibits, except for Exhibit 18A-1(b), are all similar in layout detailing the speci¬c vari-
ables used in each of the studies. Exhibit 18A-1(b) [adapted from Reilly (1991) and work by
Gentry, Newbold, and Whitford (1994)], on the other hand, summarizes the ¬ndings of four-
teen studies that focused on bankruptcy prediction.
As noted in the chapter, for the most part, the ratios found to be useful in the research
correspond to the categories (activity, liquidity, solvency, and pro¬tability) that we have
used throughout the book. Additional new indicators are primarily measures of earnings vari-
ability and size.




W55
W56 APPENDIX 18-A RATIOS USED IN CREDIT AND EQUITY RISK PREDICTION MODELS

EXHIBIT 18A-1(a)
Independent Variables Used in Bankruptcy Prediction Models

Ohlson (1980) Altman et al. (1977) Deakin (1972) Altman (1968)

Activity Four asset categories Sales to total assets
divided by sales:
(1) Current assets
(2) Quick assets
(3) Working capital
(4) Cash

Liquidity Current ratio Current ratio Current ratio
Quick ratio
Cash ratio
Four asset categories
divided by total assets:
(1) Current assets
(2) Quick assets
(3) Working capital
Working capital to (4) Cash Working capital to
total assets total assets

Leverage and Solvency Liabilities to assets Equity (market) to Capital Debt to assets Equity (market) to
Times Interest earned debt (book)
Funds from operations Funds from operations
to total liabilities to debt
Dummy variable
indicating if net
worth is negative

Pro¬tability Return on assets Return on assets Return on assets Return on assets
Dummy variable indicating Retained earnings to Retained earnings
if net income was total assets to total assets
negative in last two years

Earnings variability Percentage change in net Standard error of
income return on assets

Size Total Assets Total Assets
W57
RATIOS USED IN CREDIT AND EQUITY RISK PREDICTION MODELS

EXHIBIT 18A-1(b)
Summary of Most Useful Ratios for Predicting Failure

Category/Ratios Number of Studies in Which the Ratio Was Signi¬cant

Financial Leverage
Cash Flow/Total Debt 7
Total Debt/Total Assets 6
Retained Earnings/Total Assets 5

Short-term Liquidity
Net Working Capital/Total Assets 6
Current Assets/Current Liabilities 6
Cash/Sales 2
Cash/Current Liabilities 4

Pro¬tability
Net Income/Total Assets 5
EBIT/Total Assets 4

Activity
Quick Assets/Sales 2

Adapted from Frank K. Reilly, “Using Cash Flows and Financial Ratios to Predict Bankruptcies,” Analyzing Invest-
ment Opportunities in Distressed and Bankrupt Companies, Charlottesville, VA: The Institute of Chartered Finan-
cial Analysts, 1991, Table 1, P.25
W58 APPENDIX 18-A RATIOS USED IN CREDIT AND EQUITY RISK PREDICTION MODELS

EXHIBIT 18A-2
Independent Variables Used in Bond Ratings Prediction Models

Kaplan and Pinches and Pogue and
Belkaoui Belkaoui Urwitz Mingo Soldovsky Horrigan West
(1983) (1980) (1979) (1973) (1969) (1966) (1966)

Activity and Current ratio Current ratio Working capital
liquidity to sales
Sales to equity

Leverage and Long-term debt Long-term debt Long-term debt Total debt to Debt to capital Equity to debt Debt to equity
solvency to capital to capital to assets assets (market
values)
Short-term debt Short-term Long-term debt
to capital debt to to equity
capital
Fixed charge Fixed charge Times interest Times interest Times interest
coverage coverage earned earned earned
Cash ¬‚ow to Cash ¬‚ow to debt
investment in
¬xed assets and
inventory plus
dividends

Pro¬tability Return on assets Return on Return on Operating pro¬t
assets assets

Earnings Accounting beta Years of Coef¬cient of
variability consecutive variation”
dividends ROA
Coef¬cient of Coef¬cient of
variation”net variation”net
income income

Size Total assets Total assets Total assets Issue size Total assets Total assets Bonds
outstanding

Subordination 0-1 dummy 0-1 dummy 0-1 dummy 0-1 dummy 0-1 dummy

Market-based Price to net Price to net Market beta
book value book value

Other Coef¬cient of Industry Period of
variation”total dummy solvency
assets variable
W59
RATIOS USED IN CREDIT AND EQUITY RISK PREDICTION MODELS

EXHIBIT 18A-3
Independent Variables Used in Beta Prediction Models

Predictive and Explanatory Explanatory

Rosenberg Mandelker Ball
and and and
Hochman McKibben Beaver et al. Rhee Bildersee Lev Brown
(1983) (1973) (1970) (1984) (1975) (1974) (1968)

Earnings Operating Accounting beta * OLE Variable Accounting
Variability Risk (operating cost % beta
income) (v)

Financial Debt to capital FLE Debt to equity
Risk Preferred equity
to common
equity
Total Standard Standard
Risk† deviation deviation
earnings/ earnings/price
price

Growth Dividend yield Asset growth

Dividends Dividend
payout

Liquidity Current ratio

*See Exhibit 18-8 in text.

Earnings variability can be measured as the sum of operating risk and ¬nancial risk.
Appendix 19-A
MULTISTAGE GROWTH MODELS


The original formulation of the discounted models discussed in the chapter is presented below:
kEi
P0
r)i
(1
i1

Theoretically, by predicting each year individually, any assumed growth rate of dividends or
earnings payout (even zero dividends) can be accommodated. From a practical point of view,
of course, one would not attempt to forecast individual periods over a very long horizon.
One palatable approach is to forecast the near future individually and then impose an as-
sumption as to the appropriate valuation after that period. Recall that the preceding expres-
sion is equivalent to
kEn Pn
kE1 kE2
P0
(1 r)n r)n
(1 r) 2 (1
(1 r)
This is the present value of the dividends over the ¬rst n years plus the discounted value at
the end of year n.
For example, assume that you forecast a ¬rm™s net income over the next three years as
year 1 100, year 2 120, and year 3 150. The ¬rm™s k 20% and its r 10%. To use
the preceding equation, one must derive a terminal value for the ¬rm at the end of year 3.
You may at this point decide to make some general assumptions. One assumption might be
that from the third year on the ¬rm will experience growth of 8%. The implicit forecast for
year 4™s earnings is (1.08 $150) $162, and the terminal value at the end of year 3 (if we
use the constant growth model presented earlier) is equal to
0.2 $162
P3 $1,620
0.10 0.08
The value now will be equal to
$1,620
$100 $120 $150
P0
(1.1) 2 3
(1.1)3
(1.1) (1.1)
$91 $99 $133 $1,217 $1,520


VALUING A NONDIVIDEND-PAYING FIRM

A ¬rm paying zero dividends can also be modeled along these lines. A ¬rm that pays zero
dividends reinvests everything in the ¬rm. Its growth rate is equal to [1 k]r* r* since
k 0. Assume that a ¬rm having an r* of 25% for the next ¬ve years does not plan to pay
dividends for those ¬ve years. If its present earning level is $10, its earnings in year 5 will
equal $10(1.25)5 $30.5. From year 6 and on, assume that its r* will be 20% and the ¬rm will
pay dividends at a rate k 60%. Its growth rate will therefore equal (1 60%) 20% 8%.
Earnings in year 6 will equal $30.5(1.08) $32.9. The ¬rm™s value at the beginning of year
6 will be equal to
0.6 $32.9
$987
0.1 0.08


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W61
SHIFTING GROWTH RATE PATTERNS


The value today will be equal to the $987 discounted (back ¬ve years) to the beginning
of year 1 or $987/(1.10)5 $613.

SHIFTING GROWTH RATE PATTERNS

Variations of this approach assume a certain level of growth over some initial phase and dif-
ferent growth rates after the initial phase (Figure 19A-1).
The ¬nite growth model (Figure 19A-1a) assumes that the ¬rm will experience growth
of g (1 k)r* for n years. After that point, the abnormal investment opportunities of r*
r will not exist. The value of equity for such a ¬rm will equal
n
E1 g r (1 k) 1 g
E1
P0 1
r r rg 1 r

Other models commonly referred to as three-phase models assume (Figure 19A-1b) an
initial (phase 1) high abnormal growth rate ga for a number of years that tapers off (in phase
2) to a long-term (phase 3) normal growth pattern of gn. The calculations for these models




FIGURE 19A-1a“c. Simpli¬ed three-phase model
(Fuller and Hsia, 1984). Source: Russel J. Fuller
and Chi-Cheng Hsia, “A Simpli¬ed Common
Stock Valuation Model,” Financial Analysts Jour-
nal, September“October 1984, pp. 49“56 (Figure
B, p. 50, and Figure E, p. 53).
W62 APPENDIX 19-A MULTISTAGE GROWTH MODELS


are somewhat complex. Fuller and Hsia (1984) simpli¬ed these models by assuming a
growth pattern as depicted in Figure 19A-1c. They start with initial above-normal growth,
but assume that it converges gradually to a stable long-term growth pattern. If we stay with
the de¬nitions of ga as the initial growth pattern and gn as the long-term growth pattern to be
reached within n years, the value of the equity is equal to
kE0 n
P0 r gn (1 gn) (g gn)
2a
Appendix 19-B
THE EBO AND TERMINAL VALUE
ASSUMPTIONS


The terminal value calculations in the chapter assume that ROE remains constant after pe-
riod T, at r or some other level. Figure 4-3, however, indicates that it is more likely for ROE
to converge asymptotically to a steady-state level. This appendix presents valuation formulae
that can be used when the rate of convergence can be modeled as an autoregressive process,
that is,
(ROEt ROE) c(ROEt ROE)
1

or
ROEt ROE c(ROEt ROE) where 0 c 1
1

where ROEt converges to the steady-state level ROE. The equation indicates that, in each pe-
riod, the gap between the actual ROE and the steady-state level narrows as a function of the
autoregressive parameter c.
Under these assumptions, the valuation formula becomes
(ROEj r)Bj
T (ROET ROE)c (ROE r)
BT
1 1
P0 B0 rg
T 1 r c(1 g)
j
(1 r)
(1 r)
j1


where g represents the assumed growth rate in book value. Explicit forecasts of earnings
(ROE and book value) are made for T periods, followed by the terminal value calculation in
the braces.
In the chapter, we note that, even if abnormal earnings were to continue inde¬nitely
(ROE r) because of a special situation such as patent protection, it is unlikely that similar
higher returns could be earned on new projects. Thus, the abnormal earnings would not grow
as book value increases. Setting g 0 yields
(ROEj r)Bj
T (ROET ROE)c (ROE r)
BT 1
P0 B0 r
r)T 1rc
r) j (1
(1
j1


If competitive pressures force abnormal pro¬ts to zero, then at steady state, ROE r and the
valuation formula becomes
(ROEj r)Bj
T (ROET r)c
BT 1
P0 B0 T 1r c
j
(1 r)
(1 r)
j1




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