United States
Securities And Exchange Commission

FORM 10-Q

Commission file number 000-51217

SEARS HOLDINGS CORPORATION

Registrant’s Telephone Number, Including Area Code: (847) 286-2500

Indicate by check mark whether the Registrant [1] has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and [2] has been subject to such filing requirements for the past 90 days.

Yes      x                No      o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

Yes      x                No      o

As of May 28, 2005, the Registrant had 164,909,735 common shares, $0.01 par value, outstanding.

SEARS HOLDINGS COPORATION
INDEX TO QUARTERLY REPORT ON FORM 10-Q
13 Weeks Ended April 30, 2005

SEARS HOLDINGS CORPORATION
Condensed Consolidated Statements of Operations
(Unaudited)

See accompanying notes.

2

See accompanying notes.

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SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

Sears Holdings Corporation (“Holdings” or the “Company”) is a Delaware corporation formed for the purpose of consummating the business combination of Kmart Holding Corporation (“Kmart”) and Sears, Roebuck and Co., (“Sears”) which was completed on March 24, 2005. Holdings is the nation’s third largest broadline retailer with approximately 2,300 full-line and 1,200 specialty retail stores in the United States operating through Kmart and Sears and 340 full-line and specialty retail stores in Canada operating through Sears Canada Inc. (“Sears Canada”), a 54%-owned subsidiary. Holdings common stock is traded on The NASDAQ Stock Market under the symbol “SHLD”.

The merger of Kmart and Sears has been treated as a purchase business combination for accounting purposes, with Kmart designated as the acquirer. As such, the historical financial statements for Kmart become the historical financial statements of Holdings, the registrant. The accompanying condensed consolidated statements of operations and cash flows for the 13-week period ended April 30, 2005 include the results of operations of Sears since March 24, 2005, the date of acquisition. Therefore, the results for the first quarter of 2005 include approximately five weeks of Sears results and 13 weeks of Kmart’s results. Note 2 provides summary unaudited pro forma information and details on the purchase accounting.

These interim unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation have been included. All significant intercompany accounts and transactions have been eliminated. Operating results for the interim period are not necessarily indicative of the results that may be expected for the full year. The Company typically earns a disproportionate share of its operating income in the fourth quarter due to seasonal customer buying patterns.

Effective March 23, 2005, the Company changed its fiscal year end from the last Wednesday in January to the Saturday closest to January 31st. The change in fiscal year end reflects a change of only three days; as such, the historical financial statements have not been recast to reflect this change. Sears Canada is a publicly traded company whose shares are traded on the Toronto Stock Exchange. Its fiscal year end is the Saturday closest to December 31st. The results of operations for Sears Canada are reported to Holdings on a one-month lag. As such, the statements of operations and cash flows for the 13-week period ended April 30, 2005 include nine days of operating results for Sears Canada, for the period from March 25, 2005 through April 2, 2005.

Readers of these interim period statements should refer to the audited consolidated financial statements and notes thereto which are included in Kmart’s Annual Report on Form 10-K for its fiscal year ended January 26, 2005. For information relating to Sears prior to the merger, readers should refer to the audited consolidated financial statements and notes thereto which are included in Sears’ Annual Report on Form 10-K for its fiscal year ended January 1, 2005.

Certain prior period amounts have been reclassified to conform to the current interim period presentation.

NOTE 2 – MERGER OF KMART AND SEARS

On March 24, 2005, Kmart and Sears completed their previously announced merger pursuant to the Agreement and Plan of Merger, dated as of November 16, 2004 (the “Merger Agreement”). Upon the consummation of the merger, Kmart and Sears became wholly-owned subsidiaries of Holdings.

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SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Under the terms of the Merger Agreement, Kmart shareholders received one share of Holdings common stock for each Kmart share owned. Approximately 94.9 million shares of Holdings common stock were issued in exchange for all outstanding common stock of Kmart based on the one-for-one ratio. Sears shareholders had the right to elect to receive $50 in cash or 0.5 of a share of Holdings common stock for each Sears share owned. Sears shareholder elections were prorated to ensure that, in the aggregate, 55 percent of Sears shares were converted into Holdings shares and 45 percent of Sears shares were converted to cash. Restricted shares of Sears common stock at the effective date were converted into Holdings common stock on a 0.5 for 1 basis. In aggregate, approximately 62.2 million shares of Holdings common stock were issued to Sears shareholders at a value of approximately $6.5 billion (based on the average closing price of $104.33 of Kmart’s common stock during the period from November 15, 2004 through November 19, 2004, two business days before and after the date the merger was announced). In addition, approximately $5.4 billion in cash was paid in consideration for (i) all outstanding common stock of Sears, based upon the proration provisions of the Merger Agreement and (ii) all outstanding stock options of Sears. Including transaction costs of $18 million, the total consideration paid was approximately $11.9 billion.

The merger has been treated as a purchase business combination for accounting purposes, and as such, Sears’ assets acquired and liabilities assumed have been recorded at their fair value. Kmart and Sears determined that the merger would be accounted for as an acquisition by Kmart of Sears. In identifying Kmart as the acquiring entity, the companies took into account the relative share ownership, the composition of the governing body of the combined entity and the designation of certain senior management positions. As a result, the historical financial statements of Kmart become the historical financial statements of Holdings. The purchase price for the acquisition, including transaction costs, has been allocated to the assets acquired and liabilities assumed based on estimated fair values at the date of acquisition, March 24, 2005. The purchase price allocation is preliminary and further refinements may be necessary.

The preliminary purchase price allocation, is as follows:

The Company has allocated approximately $3.9 billion to identifiable intangible assets, of which approximately $2.8 billion relates to the indefinite lived tradenames of Sears, Kenmore, Craftsman, Lands’ End and Diehard. The remaining intangible assets include finite lived tradenames, favorable leases, contractual arrangements and customer lists, which will be amortized over their estimated useful lives.

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SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

The Company has established reserves relating to employee separation costs related to the integration of certain Sears functions into Holdings. Costs associated with these integration actions do not impact current earnings and are recognized as a component of purchase accounting, resulting in an adjustment to goodwill. During the first quarter of 2005, Holdings notified approximately 780 former Sears employees of the decision to eliminate their positions in connection with these integration efforts. A $53 million reserve was recorded in the first quarter of 2005 for costs associated with severance, benefits and outplacement services for the impacted individuals. Payments to these individuals will be made throughout the remainder of 2005 in accordance with the Company’s severance plan.

Holdings Selected Unaudited Pro Forma Combined Financial Information

The unaudited pro forma financial information in the table below summarizes the combined results of operations of Kmart and Sears for the thirteen-week periods ended April 30, 2005 and April 28, 2004 as though the companies had been combined as of the beginning of 2004. The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the merger had taken place at the beginning of each period, or that may result in the future. In addition, the following pro forma information has not been adjusted to reflect any operating efficiencies that may be realized as a result of the merger.

NOTE 3 – RESTRUCTURING

During the first quarter of 2005, Holdings recorded a $3 million pretax charge related to employee termination costs associated with former Kmart employees impacted by Holdings’ home office integration efforts. This charge is recorded within selling and administrative expense in the condensed consolidated statement of operations. The charge recorded in the first quarter includes costs associated with severance, benefits and outplacement services provided to approximately 70 individuals. These individuals had been notified prior to April 30, 2005 that their positions would be eliminated by June 2005.

Subsequent to the end of the first quarter, Holdings notified approximately 1,400 additional Kmart employees that either their positions would be eliminated or their positions would be relocated to the Hoffman Estates, Illinois Holdings headquarters or the Dallas, Texas Holdings transaction processing center. Of the associates notified, approximately 300 have accepted the relocation offer. The total cost related to the relocation or

6

SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

severance, benefits and outplacement services associated with these 1,400 individuals is currently estimated to be $57 million. The actual costs are dependent on the number of associates who ultimately accept the relocation offers and the number of associates who remain with Holdings through a transition period. Holdings will record charges for these costs over the next several months in accordance with Statement of Financial Accounting Standards, (“SFAS”) No. 146, “Accounting for Costs Associated with Disposal and Exit Activities”. As this action impacts the acquiring company’s associates, these costs will be charged to the condensed consolidated statement of operations.

NOTE 4 – CHANGE IN ACCOUNTING PRINCIPLE

Effective January 27, 2005, the Company changed its method of accounting for certain indirect buying, warehousing and distribution costs. Prior to this change, the Company had included indirect buying, warehousing and distribution costs as inventoriable costs. Beginning in the fiscal year ending January 28, 2006, such costs are expensed as incurred, which is the method of accounting followed by Sears. The Company believes that this change provides a better measurement of operating results in light of the anticipated changes to the Company’s supply chain to realize cost savings from the business combination, the anticipated closure of certain facilities and the combined capacity of the existing distribution and headquarters facilities. In accordance with Accounting Principles Board Opinion No. 20, “Accounting Changes”, changes in accounting policy to conform the acquirer’s policy to that of the acquired entity is treated as a change in accounting principle. The indirect buying, warehousing and distribution costs that were capitalized to inventory as of January 26, 2005 are reflected in the first quarter 2005 condensed consolidated statement of operations as a cumulative effect of change in accounting principle in the amount of $90 million ($0.72 per share), net of income taxes of $58 million. The impact of this change on income before the cumulative effect of accounting change for the quarter ended April 30, 2005 was not significant. The pro forma effect of application of the change to prior years’ quarterly net income and net income per share is not significant.

NOTE 5 – SECURITIZED ASSETS

The Company securitizes certain of its Canadian credit card receivables through trusts. Under the Sears Canada securitization program, trusts purchased undivided interests in the receivable balances totaling $977 million for the first quarter of 2005, funded by issuing short-term and long-term debt, primarily commercial paper and senior and subordinated receivables-backed notes. These certificates entitle the holder to a series of scheduled cash flows under preset terms and conditions, the receipt of which is dependent upon cash flows generated by the related trusts’ assets. The trusts meet the definition of a qualified special purpose entity. In accordance with Financial Accounting Standards Board Interpretation (“FIN”) No. 46(R), “Consolidation of Variable Interest Entities”, qualifying special purpose entities are not consolidated. As a result, the Sears Canada securitized receivables and related borrowings are not presented in the condensed consolidated balance sheets.

The undivided co-ownership interest in the receivable balances is sold on a fully serviced basis and the Company receives no fee for ongoing servicing responsibilities. The Company receives proceeds equal to fair value for the assets sold and retains rights to future cash flows arising after the investors in the securitization trusts have received the contracted return. The co-owners have no recourse to the Company’s retained interest in the receivables sold other than in respect of amounts in the cash reserve account and the interest-only strip receivable.

7

Under the securitization program, there is a daily distribution of collections from credit card receivables and a reinvestment of those amounts by the trusts to purchase additional credit card receivables in order to maintain existing outstanding debt levels.

In addition to Canadian credit card securitizations, certain domestic real estate assets were transferred to a wholly-owned consolidated subsidiary of Sears and segregated into a trust owned by the consolidated subsidiary. As of April 30, 2005, the net book value of the securitized real estate was $466 million. These assets are related to an inter-company loan agreement.

NOTE 6 — BORROWINGS

Total borrowings outstanding as of April 30, 2005, April 28, 2004 and January 26, 2005 were $4.4 billion, $0.5 billion and $0.4 billion, respectively.

Total borrowings are presented on the condensed consolidated balance sheets as follows:

Credit Agreement

On March 24, 2005, the Company’s five-year $4.0 billion credit agreement (the “Credit Agreement”) became effective. The Credit Agreement is available for general corporate purposes and includes a $1.5 billion letter of credit sublimit. The Credit Agreement is a revolving credit facility under which Sears Roebuck Acceptance Corp. (“SRAC”) and Kmart Corporation are the borrowers. The Credit Agreement is guaranteed by Holdings

8

SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

and certain of its direct and indirect subsidiaries and secured by a first lien on domestic inventory, credit card accounts receivable and the proceeds thereof. Availability under the Credit Agreement is determined pursuant to a borrowing base formula, based on domestic inventory and credit card accounts receivable, subject to certain limitations. As of April 30, 2005, the Company had $156 million of letters of credit outstanding under the Credit Agreement with $3.8 billion of availability remaining under the Credit Agreement. The Credit Agreement does not contain provisions that would restrict borrowings or letter of credit issuances based on material adverse changes or credit ratings. The Company capitalized $19 million of debt issuance costs in connection with entering into the Credit Agreement. These costs are being amortized over the life of the Credit Agreement.

Letter of Credit Agreement

The Company has a letter of credit agreement (the “LC Agreement”) with a commitment amount of up to $600 million. As of April 30, 2005, there were $393 million in letters of credit outstanding under the LC Agreement.

Under the terms of the LC Agreement, the Company has the ability to post either cash or inventory as collateral. However, the Credit Agreement prohibits the Company from using inventory as collateral under the LC Agreement. The cash collateral account is subject to a pledge and security agreement pursuant to which if the Company elects to post cash collateral, it must maintain cash in an amount equal to 100.5% of the face value of letters of credit outstanding. The Company had $395 million of cash posted as collateral as of April 30, 2005. The Company continues to classify the cash collateral as cash and cash equivalents due to its ability to substitute these letters of credit with letters of credit under the Credit Agreement, which would not require cash collateral. There are no provisions in the LC Agreement that would restrict issuances based on credit ratings, but issuances could be restricted under certain circumstances based on a material adverse change.

Cash Collateral

The Company posts cash collateral for certain self-insurance programs. The Company continues to classify the cash collateral as cash and cash equivalents in the accompanying condensed consolidated balance sheets due to the Company’s ability to convert the cash to letters of credit at any time at its discretion. As of April 30, 2005, $138 million of cash was posted as collateral for self-insurance programs.

Convertible Notes

On January 31, 2005, ESL Investments, Inc. (“ESL”) and its affiliates converted, in accordance with the terms of the convertible notes, all of the outstanding 9% convertible subordinated notes of Kmart and six months of accrued interest into an aggregate of 6.3 million shares of Kmart common stock. In consideration of ESL’s conversion of the notes prior to maturity, ESL received a $3 million payment from Kmart. The cash payment was equivalent to the approximate discounted after-tax cost of the future interest payments that would have otherwise been paid by Kmart to ESL and its affiliates in the absence of the early conversion. In conjunction with the conversion, the Company recognized the unamortized debt discount of $17 million as interest expense in the first quarter of 2005.

9

Sears’ Benefit Plans

Expense associated with the Sears benefit plans is included in the condensed consolidated financial statements subsequent to the effective date of the merger. Certain domestic full-time and part-time employees of Sears are eligible to participate in noncontributory defined benefit plans after meeting age and service requirements. Substantially all full-time Canadian employees as well as some part-time employees are eligible to participate in contributory defined benefit plans. Pension benefits are based on length of service, compensation and, in certain plans, social security or other benefits. Funding for the various plans is determined using various actuarial cost methods.

During the first quarter of 2005, Holdings announced that the Sears domestic pension plan would be frozen effective January 1, 2006. Domestic associates will earn no additional benefits after December 31, 2005. Benefits earned through December 31, 2005 will be paid out to eligible participants following retirement. The effect of this plan change, which is to reduce the projected benefit obligation of the Sears domestic pension plan by approximately $80 million, is recorded as a component of purchase accounting.

Subsequent to the end of the first quarter and in connection with the decision to freeze the Sears domestic pension plan, Holdings revised the target allocation of the Sears domestic pension plan assets to approximately 42.5% fixed income, 42.5% equity, and 15% alternative investments that incorporate absolute return investment strategies. Previously, the plan asset allocation was approximately 70% equity and 30% fixed income. The Company will review its long-term return rate assumption in light of the change in asset allocation and may reduce it from its current level of 8% in the future.

In addition to providing pension benefits, Sears provides domestic and Canadian employees and retirees certain medical benefits. Certain domestic Sears retirees are also provided life insurance benefits. Certain Sears employees may become eligible for medical benefits if they retire in accordance with Sears’ established retirement policy and are continuously insured under the Sears group medical plans or other approved plans for 10 or more years immediately prior to retirement. The Company shares the cost of the retiree medical benefits with retirees based on years of service. Generally the Company’s share of these benefit costs will be capped at Sears’ contribution calculated during the year of retirement. Sears’ postretirement benefit plans are not funded. The Company has the right to modify or terminate these plans.

Contributions

Contributions were made to the Kmart and Sears domestic pension plans in the amount of $1 million and $33 million, respectively, for the 13-weeks ended April 30, 2005. There is a $3 million required pension contribution for the remainder of fiscal 2005 to the Kmart pension plan and no minimum required pension contribution for the remainder of fiscal 2005 to the Sears domestic pension plan. However, Holdings expects to

10

SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

make a $240 million voluntary contribution to the Kmart pension plan during the third quarter of 2005. Sears made a $634 million voluntary contribution to its domestic pension plan in the fourth quarter of 2003.

NOTE 8 – (LOSS) EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted (loss) earnings per share.

A reconciliation of net income available to common shareholders to net income available to common shareholders with assumed conversions is as follows:

The 9% convertible notes and accrued interest were converted into 6.3 million shares of Kmart common stock on January 31, 2005.

Kmart’s existing treasury shares were retired and cancelled in connection with the merger and, accordingly, did not participate in the merger exchange.

NOTE 9 – STOCK-BASED COMPENSATION

The Company accounts for stock-based compensation using the fair value method. Total stock-based compensation expense of approximately $11 million is expected to be recognized in 2005.

Upon consummation of the merger, 8,011 shares of restricted stock were granted to Aylwin B. Lewis, President of Holdings, at a grant price of $124.83 per share. The grant vests in installments over 3 years from the grant date subject to satisfaction of certain performance criteria. The Company will recognize compensation expense of $1 million over the vesting period.

In addition, on March 28, 2005, Alan J. Lacy, Vice Chairman and Chief Executive Officer of Holdings, was granted 75,000 shares of restricted stock at a grant price of $131.11 per share. The grant vests in full on June 30, 2006. The Company will recognize compensation expense of $10 million over the vesting period. Mr.

11

SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Lacy was also granted a stock option to purchase 200,000 shares of common stock with an exercise price of $131.11 per share. The options vest in equal installments over 4 years. The Company will recognize compensation expense of $11 million over the vesting period.

Upon the completion of the merger, each option held by directors or executives of Kmart to purchase shares of Kmart common stock (whether vested or unvested) was converted into the right to purchase an equivalent number of shares of Holdings common stock at an exercise price per share equal to the exercise price per share of the Kmart common stock subject to the option before the conversion. In addition, each restricted share of Kmart common stock was converted into a restricted share of Holdings’ common stock.

Upon adoption of the Merger Agreement by Sears stockholders, a pro rata portion of shares of Sears common stock owned by Sears employees that were subject to restrictions and that were granted at least six months prior to the adoption of the Merger Agreement became free of restrictions. As a result, the holder was able to make an election to receive shares of Holdings or cash with respect to such shares. The restricted shares of Sears stock that did not vest were each converted into 0.5 of a share of Holdings common stock and will continue to vest over their original vesting period. Approximately 250,000 shares of Holdings common stock resulted from this conversion. The Company remeasured these shares to fair value at $124.83 per share (as of the acquisition date) and will recognize compensation expense of $31 million over the remaining vesting period.

NOTE 10 – CLAIMS RESOLUTION AND BANKRUPTCY-RELATED SETTLEMENTS

Claims Resolution

On May 6, 2003, Kmart Corporation (the “Predecessor Company”) emerged from reorganization proceedings under Chapter 11 of the federal bankruptcy laws pursuant to the terms of a plan of reorganization. Kmart Corporation is presently an indirect wholly-owned subsidiary of the Company.

The Company continues to make progress in the reconciliation and settlement of various classes of claims associated with the discharge of the Predecessor Company’s liabilities subject to compromise pursuant to the plan of reorganization. Since June 30, 2003, the first distribution date established in the plan of reorganization, approximately 24.4 million shares of the 31.9 million shares, which had been set aside for distribution, have been distributed to holders of Class 5 claims and approximately $4 million in cash has been distributed to holders of Class 7 claims. Due to the significant volume of claims filed to-date, it is premature to estimate with any degree of accuracy the ultimate allowed amount of such claims for each class of claims under the plan of reorganization. Accordingly, the Company’s current distribution reserve for Class 5 claim settlements is 15 percent of the total shares expected to be distributed. Differences between amounts filed and the Company’s estimates are being investigated and will be resolved in connection with its claims resolution process. In this regard, it should be noted that the claims reconciliation process may result in material adjustments to current estimates of allowable claims.

During the first quarter of 2005, the Company reduced the distribution reserve from 20 percent to 15 percent, resulting in the distribution of approximately 1.5 million additional shares to claimants who had previously received shares for allowed claims. In connection with this action, Kmart received an additional 66,889 shares in the first quarter as a result of bankruptcy-related settlements entered into prior to the April 1, 2005 distribution date in which the Company was assigned Class 5 claims.

The remaining shares in the distribution reserve will be issued to claimants on a pro-rata basis if, upon settlement of all claims, the ultimate amount allowed for Class 5 claims is consistent with the plan of reorganization. The next scheduled distribution under the plan of reorganization is expected to commence on or about July 1, 2005.

12

SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Bankruptcy-Related Settlements

The Company recognized recoveries of $17 million for the 13 weeks ended April 30, 2005 related to vendors who had received cash payments for pre-petition obligations (critical vendor claims) or preference payments. In conjunction with these recoveries, the Company was assigned 127,046 shares of common stock (weighted average price of $99.33 per share) with an approximate value of $13 million for the 13 weeks ended April 30, 2005. Of the 127,046 shares, 50,748 were cancelled on the effective date of the merger.

NOTE 11 – SHAREHOLDERS’ EQUITY

Following is a summary of the activity impacting shareholders’ equity during for the 13-week period ended April 30, 2005:

On March 25, 2005, ESL and its affiliates exercised an option to purchase approximately 6.5 million shares of Holdings common stock granted pursuant to an investment agreement dated January 24, 2003 between Kmart Corporation, ESL and Third Avenue Trust, on behalf of certain of its investment series (“Third Avenue”). In accordance with the investment agreement, Holdings issued shares of its common stock upon the receipt of $84 million. As a result of these transactions, ESL and its affiliates do not own any more options to purchase shares of Holdings pursuant to the investment agreement.

On April 26, 2005, Third Avenue Trust exercised options to purchase 140,000 shares of Holdings common stock for a purchase price of $2 million. Third Avenue acquired these options pursuant to an assignment and assumption agreement, dated May 5, 2003, by and between ESL and Third Avenue. All of the options assigned to Third Avenue under the assignment and assumption agreement were exercised as a result of this transaction.

Comprehensive (Loss) Income and Accumulated Other Comprehensive Loss

The following table shows the computation of comprehensive (loss) income:

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NOTE 12 – INCOME TAXES

The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the financial reporting and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion of or all of the deferred tax asset will not be realized.

During the first quarter of fiscal 2005, the Company recorded a reversal of approximately $1.1 billion of its pre-merger deferred income tax valuation allowance as a result of the business combination and the combined tax attributes resulting from this combination. In accordance with SFAS No. 109, the recognition of this reversal is included in the Company’s purchase accounting adjustments as a reduction to goodwill attributable to the acquisition. Given the Company’s current and forecasted levels of profitability, as well as its ability to realize the deferred tax assets through tax strategies if necessary, management believes that the federal deferred tax assets will more likely than not be realized.

Deferred tax assets of $284 million, with a corresponding valuation allowance, were recorded related to state tax benefits of Sears which are not expected to be realized. As a result, the consolidated valuation allowance as of April 30, 2005 is $460 million and relates to the uncertainty around the realization of certain state deferred tax assets. The Company will continue to assess the likelihood of realization of these state deferred tax assets and will reduce the valuation allowance on such assets in the future if it becomes more likely than not that the net deferred tax assets will be utilized.

The Company recorded tax provisions of $52 million and $56 million during the 13-weeks ended April 30, 2005 and April 28, 2004, respectively. The tax provisions were based on estimated effective tax rates of 38.5% and 38.1% for fiscal 2005 and 2004, respectively.

NOTE 13 – INVESTMENTS IN AFFILIATED COMPANIES

On March 2, 2004, Footstar, Inc. (“FTS”) and its direct and indirect subsidiaries, including the Meldisco subsidiaries of FTS, filed for Chapter 11 protection in the United States Bankruptcy Court for the Southern District of New York. FTS continues to operate its businesses and manage its properties as debtors-in-possession. Kmart is a party to a master agreement with FTS that provides FTS with a non-transferable, exclusive right and license to operate the footwear departments in Kmart stores. Subsidiaries of Meldisco, substantially all of which are 49% owned by Kmart and 51% owned by FTS, operate the footwear departments pursuant to license agreements between those subsidiaries and Kmart.

On August 12, 2004, FTS filed a motion with the bankruptcy court to assume the master agreement and the license agreements. On September 30, 2004, the Company objected to that motion, and also filed a separate motion to terminate the master agreement and the license agreements because of various defaults by FTS under the master agreement. On February 16, 2005, the bankruptcy court overruled one of the Company’s objections

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SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

to assumption of the master agreement. On May 10, 2005, the bankruptcy court denied the Company’s motion to terminate the master agreement based on one of FTS’s defaults. The bankruptcy court has yet to rule on the Company’s several other grounds for objecting to assumption and moving to terminate the master agreement. Should the bankruptcy court overrule the Company’s objection in its entirety and permit FTS to assume the master agreement and the license agreements, FTS must cure all past defaults under those agreements. On July 26, 2004, the Company filed a proof of claim in the FTS bankruptcy case for an amount in excess of Kmart’s recorded receivable of $24 million. The Company believes the cure amount may be substantially in excess of $24 million. FTS asserts that the amount required to cure past defaults is not more than $19 million, and that such amount should be reduced by overpayments FTS alleges it made to the Company for certain fees. If no resolution is achieved consensually with FTS with respect to the assumption of the master agreement, the license agreements and the cure amount, and the bankruptcy court permits FTS to assume the master agreement and the license agreements, the cure amount will be determined by the bankruptcy court.

On March 4, 2005, the Company filed a motion with the bankruptcy court for relief from the automatic stay to cause FTS to vacate stores that would be converted to the Sears Essentials format. On May 10, 2005, the bankruptcy court granted the Company’s motion. On May 16, 2005, the bankruptcy court ordered FTS to vacate 38 future Sears Essentials stores. FTS has moved for reconsideration of the May 16, 2005 orders.

FTS filed a proposed plan of reorganization with the bankruptcy court on November 12, 2004. Kmart’s results, with respect to the footwear master agreement, may be affected by whether (i) FTS is authorized by the bankruptcy court to assume the master agreement and the license agreements, obtains bankruptcy court approval of its plan of reorganization and successfully emerges from bankruptcy; (ii) FTS is able to successfully manage its business in the future and achieve the results projected in its plan of reorganization; or (iii) Kmart’s motion to terminate the master and license agreements is granted or FTS fails to obtain bankruptcy court approval of its plan of reorganization, which would cause Kmart to pursue alternative arrangements, including potentially sourcing footwear merchandise directly.

In September 2004, FTS restated six years of its consolidated financial statements for fiscal years 1997 through 2002. These restatements have not had a significant effect on Kmart’s previously reported equity income derived from its investment in the Meldisco subsidiaries. FTS filed its Form 10-K for fiscal year 2003 on March 18, 2005. FTS has yet to file audited financial statements and periodic reports for fiscal year 2004.

The Company has received preliminary financial results from FTS for fiscal year 2004 and has reviewed Monthly Operating Reports filed with the bankruptcy court for the first quarter of 2005. These statements provide the basis of the Company’s estimate of equity income as presented in its condensed consolidated statements of operations for the Meldisco subsidiaries with which Kmart does business. FTS has allocated certain of its reorganization and other costs to the Meldisco entities. These charges have adversely affected the financial performance of these businesses. Kmart disagrees with FTS’ approach and has notified FTS of its position. The Company’s equity earnings for fiscal 2004 and 2005 do not reflect its 49% share of the net losses generated by the Meldisco subsidiaries in these fiscal years, as the Company believes it has no obligation to provide future capital contributions.

For the 13-weeks ended April 30, 2005 and April 28, 2004, Meldisco had net sales of $157 million and $186 million, respectively.

The table below lists the fees, rental and equity income earned from Meldisco, dividend payments received from Meldisco, and unremitted equity earnings from the Company’s minority ownership in Meldisco for the 13-weeks ended April 30, 2005 and April 28, 2004, respectively.

15

As of April 30, 2005, ESL had a 9.9% ownership in the common stock of FTS.

NOTE 14 – RELATED PARTY DISCLOSURE

The Company’s Board of Directors has delegated authority to direct investment of the Company’s surplus cash to Edward S. Lampert, subject to various limitations that have been or may be from time to time adopted by the Board of Directors and/or the Finance Committee of the Board of Directors. Mr. Lampert is Chairman of the Company’s Board of Directors and is the Chairman and Chief Executive Officer of ESL. Neither Mr. Lampert nor ESL will receive compensation for any such investment activities undertaken on behalf of the Company. ESL owned approximately 39% of the Company’s common stock as of April 30, 2005.

Further, to clarify the expectations that the Board of Directors has with respect to the investment of the Company’s surplus cash, the Board has renounced, in accordance with Delaware law, any interest or expectancy of the Company associated with any investment opportunities in securities that may come to the attention of Mr. Lampert or any employee, officer, director or advisor to ESL and its affiliated investment entities who also serves as an officer or director of the Company (each, a “Covered Party”) other than (a) investment opportunities that come to such Covered Party’s attention directly and exclusively in such Covered Party’s capacity as a director, officer or employee of the Company, (b) control investments in companies in the mass merchandising, retailing, commercial appliance distribution, product protection agreements, residential and commercial product installation and repair services and automotive repair and maintenance industries and (c) investment opportunities in companies or assets with a significant role in the Company’s retailing business, including investment in real estate currently leased by the Company or in suppliers for which the Company is a substantial customer representing over 10% of such companies’ revenues, but excluding pre-existing investments of ESL.

Holdings employs certain employees of ESL. William C. Crowley is a director and the Executive Vice President and Chief Financial Officer of the Company while continuing his role as President and Chief Operating Officer of ESL. The Vice President, Business Development and the Senior Vice President of Real Estate for the Company are also employed by ESL.

NOTE 15 – FINANCIAL GUARANTEES

The Company issues various types of guarantees in the normal course of business. The Company had the following guarantees outstanding as of April 30, 2005:

millions

16

SEARS HOLDING CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

The secondary lease obligations relate to certain store leases of previously divested Sears businesses. The Company remains secondarily liable if the primary obligor defaults. As of April 30, 2005, the Company had a $20 million liability recorded in other liabilities which represents the Company’s current estimate of potential obligations related to these leases.

The performance guarantee relates to certain municipal bonds issued in connection with the Company’s headquarters building. This guarantee expires in 2007.

NOTE 16 – SUMMARY OF SEGMENT DATA

The Company currently has three reportable segments: Kmart, Sears Domestic and Sears Canada, compared to one segment in the prior year. The accompanying summary of segment data for the 13-week period ended April 30, 2005 includes the results of operations of Sears since March 24, 2005, the date of acquisition. Sears Canada’s results are reported to Holdings on a one-month lag. As a result, the results of operations for the first quarter of 2005 include approximately five weeks of Sears’ Domestic results, nine days of Sears Canada results and 13 weeks of Kmart’s results.

NOTE 17 – LEGAL PROCEEDINGS

Pending against Sears and certain of its officers and directors are a number of lawsuits, described below, that relate to Sears’ credit card business and public statements about it. The Company believes that all of these claims lack merit and is defending against them vigorously.

•

On and after October 18, 2002, several actions were filed in the United States District Court for the Northern District of Illinois against Sears and certain current and former officers alleging that certain public announcements by Sears concerning its credit card business violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The Court has consolidated the actions and certified the consolidated action as a class action. Discovery is underway. The trial is scheduled to begin in April 2006.

•	On and after November 15, 2002, several actions were filed in the United States District Court for the Northern District of Illinois against Sears, certain officers and directors, and alleged fiduciaries of Sears’

17

SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

401(k) Savings Plan (the “Plan”), seeking damages and equitable relief under the Employee Retirement Income Security Act of 1974 (“ERISA”). The plaintiffs purport to represent participants in the Plan, and allege breaches of fiduciary duties under ERISA in connection with the Plan’s investment in Sears’ common shares and alleged communications made to Plan participants regarding Sears’ financial condition. The Court has consolidated these actions and certified the consolidated action as a class action. Discovery is underway. No trial date has been set.

•

On October 23, 2002, a purported derivative suit was filed in the Supreme Court of the State of New York (the “New York Court”) against Sears (as a nominal defendant) and certain current and former directors seeking damages on behalf of Sears. The complaint purports to allege a breach of fiduciary duty by the directors with respect to Sears’ management of its credit business. Two similar suits were subsequently filed in the Circuit Court of Cook County, Illinois (the “Illinois State Court”), and a third was filed in the United States District Court for the Northern District of Illinois. The New York Court derivative suit was dismissed on June 21, 2004 and the plaintiff has filed a notice of appeal. The two Illinois State Court derivative suits were dismissed on September 30, 2004. The order of dismissal became final on December 1, 2004, and the time to appeal has expired. The Illinois federal court suit has been stayed pending resolution of the New York Court derivative action.

•

On June 17, 2003, an action was filed in the Northern District of Illinois against Sears and certain officers, purportedly on behalf of a class of all persons who, between June 21, 2002 and October 17, 2002, purchased the 7% notes that Sears’s domestic wholly-owned financing subsidiary, Sears Roebuck Acceptance Corp. (“SRAC”), issued on June 21, 2002. An amended complaint has been filed, naming as additional defendants certain former officers, SRAC and several investment banking firms who acted as underwriters for SRAC’s March 18, May 21 and June 21, 2002 notes offerings. The amended complaint alleges that the defendants made misrepresentations or omissions concerning its credit business during the class period and in the registration statements and prospectuses relating to the offerings. The amended complaint alleges that these misrepresentations and omissions violated Sections 10(b) and 20(a) of the Securities Exchange Act and Rule 10b-5 promulgated thereunder, and Sections 11, 12 and 15 of the Securities Act of 1933 and purports to be brought on behalf of a class of all persons who purchased any security of SRAC between October 24, 2001 and October 17, 2002, inclusive. The defendants filed motions to dismiss the action. On September 24, 2004, the court granted these motions in part, and denied them in part. The court dismissed the claims related to the March 18 and May 21, 2002 note offerings because the plaintiff did not purchase notes in those offerings. The court dismissed the Section 10(b) and Rule 10b-5 claims against several of the individual defendants because the plaintiff failed to adequately plead such claims. The court sustained the remaining claims. By leave of court, the plaintiffs filed a second amended complaint on November 15, 2004. Defendants (other than one of the underwriter defendants) filed motions to partially dismiss the second amended complaint on January 10, 2005. The defendant that did not move to partially dismiss filed an answer to the second amended complaint on January 28, 2005, denying all liability.

Following the announcement on November 17, 2004 of the business combination transaction between Sears and Kmart, several actions have been filed relating to the transaction. These lawsuits are in their preliminary stages, and defendants have not yet been required to respond to certain of the complaints. The Company believes that all of these claims lack merit and intends to defend against them vigorously.

•

Three actions have been filed in the Circuit Court of Cook County, Illinois. These actions assert claims on behalf of a purported class of Sears’ stockholders against Sears and certain of its officers and directors, together with Kmart, Edward S. Lampert and other affiliated entities, alleging breach of fiduciary duty in connection with the merger. The plaintiffs allege that the merger favors interested defendants by awarding them disproportionate benefits, and that the defendants failed to take appropriate steps to maximize the value of a merger transaction for Sears’ stockholders. The actions have been consolidated, and an amended complaint was filed in early January 2005. The amended complaint asserts similar breach-of-fiduciary duty

18

SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

claims, as well as alleging that defendants have made insufficient and misleading disclosures in connection with the mergers, and seeks injunctive relief. The plaintiffs have moved for expedited discovery. On February 1, 2005, the court granted the defendants’ motion to stay or dismiss these actions in favor of the pending New York actions discussed below. Accordingly, these actions are stayed pending resolution of the New York actions. Plaintiffs have appealed the stay order to the Appellate Court of Illinois-First District, and briefing on that appeal is complete.

•

Two actions have been filed in the Supreme Court of the State of New York, New York County, asserting substantially similar claims against Sears and certain of its officers and directors. The parties have agreed to consolidate these two actions. Pending consolidation, the defendants moved to dismiss the complaint in both actions for lack of standing and failure to state a cause of action. On February 15, 2005, the Court ordered that the two cases be consolidated as a single action. On February 16, 2005, the plaintiffs filed a superceding consolidated amended class action complaint. The amended complaint asserts claims on behalf of a purported class of Sears’ stockholders against Sears and certain of its officers and directors for breach of fiduciary duty in connection with the mergers on the grounds that defendants allegedly failed to take proper steps to maximize the value of a merger transaction for Sears’ stockholders. Additionally, the plaintiffs claim that the defendants made insufficient and misleading disclosures in connection with the mergers. The amended complaint also names Kmart, Edward S. Lampert, and ESL, Inc. as defendants on the grounds that they aided and abetted the alleged breaches of fiduciary duty. The amended complaint seeks provisional and permanent injunctive relief, as well as damages. On March 24, 2005, the Court denied plaintiffs’ motions for expedited discovery and a preliminary injunction against the closing of the mergers. All defendants have moved to dismiss the amended complaint, and briefing on the motions was completed in early March 2005.

•

One action has been filed in the United States District Court for the Northern District of Illinois. This action asserts claims under the federal securities laws on behalf of a purported class of Sears’ stockholders against Sears and Alan J. Lacy, for allegedly failing to make timely disclosure of merger discussions with Kmart during the period November 8 through 16, 2004, and seeks damages. The court appointed a lead plaintiff and lead counsel, and an amended complaint was filed on March 11, 2005. The amended complaint, names Edward S. Lampert and ESL Partners, L.P., as additional defendants, and purports to assert claims on behalf of sellers of Sears stock during the period September 9 through November 16, 2004. All defendants have moved to dismiss, and briefing on the motions is still in progress.

The Company is subject to various other legal and governmental proceedings, many involving litigation incidental to the businesses. Some matters contain class action allegations, environmental and asbestos exposure allegations and other consumer-based claims that involve compensatory, punitive or treble damage claims in very large amounts as well as other types of relief. The consequences of these matters are not presently determinable but, in the opinion of management of the Company after consulting with legal counsel, and taking into account insurance and reserves, the ultimate liability is not expected to have a material adverse effect on annual results of operations, financial position, liquidity or capital resources of the Company. Additional information regarding legal proceedings may be found in Kmart’s Annual Report on Form 10-K for its fiscal year ended January 26, 2005.

NOTE 18 – EFFECT OF NEWLY RELEASED ACCOUNTING STANDARDS

In March 2005, the FASB issued Staff Position (“FSP”) No. FIN 46®-5, “Implicit Variable Interests under FASB Interpretation No. 46 (revised December 2003).” The statement addresses whether a reporting enterprise should consider whether it holds an implicit variable interest in a variable interest entity (“VIE”) or potential VIE when specific conditions exist. The guidance should be applied in the first reporting period beginning after March 3, 2005. The adoption of FSP No. FIN 46®-5 does not have an impact on Holdings’ condensed consolidated financial statements.

19

SEARS HOLDINGS CORPORATION
Notes to Condensed Consolidated Financial Statements
(Unaudited)

In March 2005, the FASB issued FIN No. 47, “Accounting for Conditional Asset Retirement Obligations.” This interpretation clarifies that the term conditional asset retirement obligation as used in FASB No. 143, “Accounting for Assets Retirement Obligation,” refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. This interpretation is effective no later than the end of fiscal years ending after December 15, 2005. The adoption of FIN No. 47 is not expected to have a material impact on Holdings’ financial position or results of operation.

NOTE 19 – SUBSEQUENT EVENTS

On May 9, 2005, the Company announced its intention to pursue alternatives for the separation of the Company’s Orchard Supply Hardware (“OSH”) business, which could include a sale of the business or an initial public offering.

Effective May 11, 2005, Sears terminated for cause its Master Services Agreement (the “Agreement”) with Computer Sciences Corporation (“CSC”). CSC has been providing information technology infrastructure support services, including desktops, servers, and systems to support Sears-related websites, voice and data networks and decision support technology to Sears and its subsidiaries under the 10-year Agreement entered into in June 2004. CSC is obligated to continue providing these services for an extended period following termination of the Agreement. CSC disputes Sears’ assertion that grounds for termination for cause existed and claims that, as a result of terminating the Agreement, Sears is liable to CSC for damages of an unspecified amount.

On May 13, 2005, the Company announced that its indirect wholly-owned subsidiary, SRAC, commenced tender offers to purchase for cash any and all of its outstanding 7% Notes due 2042 at a fixed price of $25.65 per $25 principal amount and for any and all of its outstanding 7.40% Notes due 2043 at a fixed price of $25.75 per $25 principal amount (the “Offers”). Each Offer will expire on Monday, June 13, 2005, unless earlier extended or terminated.

20

SEARS HOLDINGS CORPORATION
13 Weeks Ended April 30, 2005 and April 28, 2004

SEARS HOLDINGS CORPORATION
13 Weeks Ended April 30, 2005 and April 28, 2004

with Kmart’s real estate adding important urban and high–density suburban locations, resulting in more rapid and lower-cost store base growth than Sears would have been able to accomplish on its own.

Holdings expects to realize significant synergies as a result of the merger between Kmart and Sears. The synergies include increased revenue through cross-selling proprietary brands and converting off-mall Kmart locations to the Sears nameplate and cost savings through improved merchandising and non-merchandising procurement, improved logistics and supply chain management and the consolidation of shared headquarters functions and corporate services. All such synergies, should positively impact the Company’s earnings and create value for shareholders.

During the first quarter of 2005, Holdings initiated actions to begin achieving the objectives discussed above, including:

•

launching its newest off-mall format, Sears Essentials. This new mid-size store format will offer customers the “best of both,” meeting the everyday needs of customers as well as offering more-destination-focused purchase categories. As of May 31, 2005, Holdings had opened 10 Sears Essentials stores and expects to have at least 50 Sears Essentials stores operating by the end of 2005. The Company expects to convert approximately 400 Kmart stores into the Sears Essential store format by the end of 2007.

•

integrating the home office functions of Kmart and Sears to reduce the overall cost structure of Holdings. During the first quarter of 2005, Holdings notified approximately 780 former Sears and 70 former Kmart employees of the decision to eliminate their position in connection with the integration efforts. Costs associated with the decision include severance, benefits and outplacement services provided to the impacted individuals. Costs associated with the integration actions impacting Sears employees or facilities are recognized as a component of purchase accounting, resulting in an adjustment to goodwill. Accordingly, these costs do not impact current earnings. Costs associated with integration actions impacting Kmart employees and facilities are recorded as expense in the statement of operations. As of April 30, 2005, Holdings had recorded a $56 million reserve related to employee termination costs for Kmart and Sears personnel. A $3 million pretax charge was recorded within selling and administrative expense and $53 million was recorded as an adjustment to goodwill.

Subsequent to the end of the first quarter, Holdings notified approximately 1,400 additional Kmart employees that either their positions would be eliminated or their positions would be relocated to the Hoffman Estates, Illinois, Holdings headquarters or the Dallas, Texas Holdings transaction processing center. The total costs related to relocation and severance associated with these 1,400 individuals are currently estimated to be $57 million. The actual costs are dependent on the number of associates who ultimately accept the relocation offers and the number of associates who remain with Holdings through a transition period.

•

introducing the Sears private label brands into eight Kmart stores, thus enabling the Company to better differentiate itself from other mass market retailers. The Company expects to continue expansion of the Craftsman and Kenmore brands of Sears into Kmart locations and will continue to evaluate putting brands exclusive to Kmart into the Sears locations.

The condensed consolidated statement of operations for the 13-weeks ended April 30, 2005 is not representative of the on-going results for Holdings as it only includes the Sears results from March 25, 2005 forward. Therefore, the Company believes that an understanding of its reported results, trends and on-going performance is not complete without presenting results on a pro forma basis.

22

SEARS HOLDINGS CORPORATION
13 Weeks Ended April 30, 2005 and April 28, 2004

The Holdings consolidated results of operations on both a reported and pro forma basis are summarized below. The pro forma adjustments are described on page 29.

The unaudited pro forma financial information in the table below summarizes the combined results of operations of Kmart and Sears for the thirteen-week periods ended April 30, 2005 and April 28, 2004 as though the companies had been combined as of the beginning of 2004. The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the merger had taken place at the beginning of each period, or that may result in the future. In addition, the following pro forma information has not been adjusted to reflect any operating efficiencies that may be realized as a result of the merger.

Holdings Reported Results

As stated above, the merger of Kmart and Sears was completed during the first quarter of 2005. As a result of the merger, total revenues and expenses for the 13-week period ended April 30, 2005, which includes five weeks of Sears’ results and 13 weeks of Kmart’s results, increased significantly compared to the prior year period as the prior period includes the results of Kmart only.

23

SEARS HOLDINGS CORPORATION
13 Weeks Ended April 30, 2005 and April 28, 2004

Total revenues increased 65% for the quarter as a result of the addition of the Sears revenues of $3.1 billion. On a comparable store basis, Kmart sales declined 3.7% for the 13-week period ended April 30, 2005.

Gross margin as a percentage of merchandise sales and services revenue improved 240 basis points as a result of the inclusion of Sears, which has a higher overall gross margin rate. The Sears Domestic margin rate for the period presented is 29.2% as opposed to 23.4% for Kmart. Kmart’s comparable gross margin rate for the 2005 period was consistent with 2004.

Selling and administrative expenses as a percentage of total revenues increased 210 basis points to 22.5% for the 13-week period ended April 30, 2005 reflecting the inclusion of Sears, which has a higher cost structure. In addition, the 2005 expense includes a $3 million pretax charge related to severance and other employee termination costs associated with Kmart employees impacted by Holdings’ home office integration activities.

Depreciation and amortization increased to $107 million for the first quarter of 2005 as compared to $4 million in the prior year quarter due to the addition of Sears for the last five weeks of the quarter, which accounts for $97 million of the combined expense. Included within the $97 million is $18 million of expense resulting from the increase in tangible and intangible asset values, resulting from the preliminary allocation of purchase price to the acquired tangible and intangible assets of Sears.

Bankruptcy-related recoveries of $17 million were received during the first quarter of 2005 related to recoveries from vendors who had received cash payment for pre-petition obligations.

Interest expense increased $14 million primarily due to the additional interest expense incurred upon the conversion of Kmart’s 9% subordinated convertible notes.

Income tax expense of $52 million and $56 million was recorded for the 13-week periods ended April 30, 2005 and April 28, 2004, respectively. The tax expense was based on estimated effective tax rates of 38.5% and 38.1%, respectively.

Effective January 30, 2005, the Company determined that it would be preferable to conform one of the accounting practices utilized by Kmart to that of Sears. The Company changed its method of accounting for certain indirect overhead costs from inventoriable costs to period expenses. In accordance with Accounting Principles Board Opinion No. 20, “Accounting Changes" , changes in accounting policy to conform the acquirer’s policy to that of the acquired entity are treated as a change in accounting principle. As a result of the accounting change, the Company recorded a charge of $90 million, or $0.72 per share, in the first quarter of 2005 for the cumulative effect of change in accounting principle. The charge represents the amount of indirect costs reflected within inventory at the beginning of 2005.

Holdings Pro Forma Results

The following discussion of Holdings pro forma results is provided to facilitate an understanding of Holdings trends and on-going performance.

Total revenues for the quarter were flat with the prior year at $12.8 billion as revenue increases at Sears Domestic and Sears Canada offset a reduction at Kmart.

Gross margin rate increased 70 basis points to 26.4% due to improved margin at Sears Domestic as a result of higher markon, lower inventory shortage and a reduction in promotional markdowns. The decrease in promotional activity occurred as promotional events have been scaled back in an effort to improve gross margin rates.

24

SEARS HOLDINGS CORPORATION
13 Weeks Ended April 30, 2005 and April 28, 2004

Selling and administrative expenses as a percent of revenues increased from 23.2% last year to 24.0% in the current year. The increase in rate is attributable to $34 million of merger-related transaction expenses and a $10 million charge for restructuring activities at Lands’ End incurred by Sears Domestic in the pre-merger period. Furthermore, Kmart recorded a $3 million charge related to severance and other employee termination costs associated with Holdings integration efforts.

The decrease in interest expense, net is due to a lower average debt balance within Sears Domestic and lower interest expense within Sears Canada as a result of the Canadian credit card securitizations now qualifying for sale treatment. As a result, the securitized credit card receivables and related borrowings are no longer recorded within the financial statements of Holdings. In the prior year period, Sears Canada receivables and related borrowings recorded within securitization trusts were consolidated.

SEGMENT OPERATIONS

Holdings is in the process of integrating Kmart and Sears. A new senior management team was announced for Holdings during April 2005. For purposes of reviewing the results of operations and making asset-allocation decisions during the first quarter of 2005, senior management continued to utilize the reporting structures which existed independently for Sears and Kmart prior to the merger. As a result, the following discussion of segment operations is organized into three principal business segments – Kmart, Sears Domestic and Sears Canada.

Kmart

Kmart results and key statistics were as follows:

Comparable store sales and total sales decreased 3.7% and 2.3%, respectively, for the 13-weeks ended April 30, 2005 as compared to the 13-weeks ended April 28, 2004. The decline in same-store and total sales is due to lower transaction volumes, the impact of poor weather conditions on the Company’s seasonal product lines, and the unfavorable impact of ongoing construction activity in stores which are converting to the Sears Essentials format. Total sales benefited from an additional $153 million of sales as a result of three additional days in the current quarter due to the Company’s change from a Wednesday to Saturday month end. However, total sales were negatively impacted by a reduction in the total number of operating Kmart stores, which more than offset the additional three days of revenue.

Gross margin as a percent of merchandise sales and services of 23.4% was consistent with the prior year period. Improvements reflecting greater use of import goods, favorable vendor negotiations and a reduction in

25

SEARS HOLDINGS CORPORATION
13 Weeks Ended April 30, 2005 and April 28, 2004

clearance markdowns due to improved inventory management were offset by higher promotional markdowns and the impact of fixed store occupancy expenses.

Selling and administrative expenses increased slightly as decreases in payroll and related expenditures resulting from cost saving initiatives were more than offset by an increase in advertising expenses for local advertising programs. The current year selling and administrative expenses also include a $3 million charge related to employee termination costs associated with Holdings’ home office integration efforts. The charge recorded in the first quarter includes the costs associated with severance, benefits and outplacement services offered to approximately 70 individuals. These individuals had been notified prior to April 30, 2005 that their positions would be eliminated by June 2005.

Operating income for the 13-weeks ended April 30, 2005 decreased as compared to the prior year primarily due to the 2.3% decline in merchandise sales and services revenues and the additional $26 million of gains on the sale of assets recognized during the same period in the prior year.

Sears Domestic

Sears Domestic operations consist of the following:

•	Full-line Stores: includes merchandise sales as well as the operations of Sears Auto Centers, Sears Essentials and Sears Grand stores, and online revenues of sears.com

•	Specialty Stores: includes the operations of Dealer Stores, Hardware Stores, The Great Indoors, Commercial Sales and Outlet stores

•	Direct to Customer: includes Lands’ End online, catalog and retail store operations as well as direct marketing of goods and services through specialty catalogs and other direct channels

•

Home Services: includes product repair services, product protection agreements and installation services for all major brands of home products; also includes home improvement services, primarily siding, windows and cabinet refacing, carpet cleaning and the installation and servicing of residential heating and cooling systems

The condensed consolidated statement of operations for Holdings for the 13 weeks ended April 30, 2005 only includes Sears results from March 25, 2005 forward. It does not reflect a full 13-week period for Sears or any prior year operating results for comparison. The Company believes that an understanding of its reported results and its ongoing financial performance is not complete without presenting the Sears results of operations on a pro forma basis. The presentation below provides the results of operations on a reported and pro forma basis:

26

Sears Domestic Pro Forma Results

The discussion below pertains to pro forma information in the table above which compares Sears results for the 13-week period ended April 30, 2005 with Sears results for the comparable 13-week period ended May 1, 2004. These pro forma results have been prepared assuming the business combination between Kmart and Sears occurred at the beginning of 2004.

Merchandise sales and services revenues increased 0.5% for the 13-week period ended April 30, 2005 versus the 13-week period ended May 1, 2004. The slight increase was due to strong home services sales partially offset by a 3.1% decrease in domestic comparable store sales. Within domestic sales, cooler than anticipated weather conditions caused declines in certain seasonal businesses, including lawn and garden and seasonal apparel categories. These declines were partially offset by modest gains within the footwear and automotive categories. Lower sales have also resulted from efforts initiated in 2005 to reduce reliance on certain promotional events and strategies historically executed to drive transactional volumes at the expense of lower margin rates.

The 130 basis point improvement in gross margin rate is primarily due to higher markons, lower inventory shortages and a reduction in promotional markdowns. The decrease in promotional activity occurred as certain promotional events have been scaled back in an effort to improve gross margin and focused on more profitable sales.

Selling and administrative expenses as a percentage of revenues increased 90 basis points primarily due to the current year’s expense including $34 million of merger-related transaction expenses and a $10 million charge recorded for employee termination costs related to restructuring activities at Lands’ End. The $44 million of expense was recorded during the premerger period.

Operating loss declined $34 million as a result of the increased gross margin more than offsetting the higher selling and administrative expenses.

27

SEARS HOLDINGS CORPORATION
13 Weeks Ended April 30, 2005 and April 28, 2004

Sears Canada

Sears Canada, a consolidated, 54%-owned subsidiary of Sears, conducts retail, credit and corporate operations.

The results of operations for Sears Canada are reported to Holdings on a one-month lag. As such, the statements of operations and cash flows for the 13-week period ended April 30, 2005 include nine days of operating results for Sears Canada, from March 25, 2005 through April 2, 2005. It does not reflect a full 13-week period for Sears Canada or any prior year operating results for comparison. The Company believes that an understanding of its reported results and its ongoing financial performance is not complete without presenting the Sears Canada results of operations on a pro forma basis. The presentation below provides the results of operations on a reported and pro forma basis:

The discussion below pertains to pro forma information in the table above which compares Sears Canada’s results for the 13-week period ended April 30, 2005 with Sears Canada’s results for the comparable 13-week period ended May 1, 2004. These pro forma results have been prepared assuming the business combination between Kmart and Sears occurred at the beginning of 2004.

Total revenues increased 6.2% for the 13-week period ended April 30, 2005 versus the 13-week period ended May 1, 2004. The increase was primarily due to favorable foreign currency.

The 120 basis point decline in gross margin rate was primarily due to the higher balance of sales in out-of-season clearance merchandise.

The 30 basis point decline in selling and administrative expense as a percentage of total revenue was primarily due to the prior year including a $12 million charge related to Sears Canada’s decision to license Sears Canada Auto Centers to three auto service providers and other restructuring activities more than offsetting an increase in advertising expense and the reduction in expense leverage resulting from weaker than expected revenues on a Canadian dollar basis.

Operating income declined $10 million primarily due to the decline in gross margin.

28

SEARS HOLDINGS CORPORATION
13 Weeks Ended April 30, 2005 and April 28, 2004

PRO FORMA RECONCILIATION

The following tables provide a reconciliation from the as reported results to the pro forma results presented above for Sears Holdings, Sears Domestic and Sears Canada for the 13-week periods ended April 30, 2005 and May 1, 2004, respectively.

Sears Holdings

29