We were born retail developers, but early on we learned about mining. Some of you may remember an oilman named T. Boone Pickens, who in the 1970s discovered that one could mine for oil cheaper on the New York Stock Exchange than in the oil fields. We learned that lesson too, with respect to mining for retail square footage in the stock market, where irreplaceable retail real estate can be obscured by a failing retailer. Extracting these values is indeed a core competency of ours, and one that has created vast wealth for our shareholders. Our 1980 takeover of Vornado, whose sole asset at the time was the failing Two Guys discount store chain, and our investment in Alexander's are both examples of this, as are our recent investments in Sears and Toys "R" Us.(11)

Toys "R" Us was started by the brilliant Charles Lazarus in 1978. It was the first category killer in America and started a retailing revolution. Fast forward to today. The modern Toys "R" Us is comprised of three segments: Domestic Toys, International Toys (together Global Toys) and Babies "R" Us. Toys' Board initially offered for sale only Global Toys, but after a process decided to sell the entire company. We were the winning bidder with partners Bain Capital and Kohlberg Kravis Roberts, with each of us owning an equal one-third. Toys "R" Us has $11 billion in sales and 1,500 stores.(12) We will pay $6.6 billion for the equity, with a total price of $7.2 billion taking into account net debt and expenses. Our plan for this business is simple. International Toys and Babies "R" Us are growth businesses that we intend to continue to grow aggressively. Domestic Toys is a turn around, underpinned


by real estate asset values. While each equal partner will participate in the entire enterprise in full measure, as you would expect, we will be the leader on the real estate side.

In between Mervyn's and Toys "R" Us came Sears. Sears was generally perceived as a slowly but surely declining retailer à la Two Guys and Alexander's, but we saw a collection of truly great (many irreplaceable) assets: 128 million square feet in 873 stores, of which over two-thirds are owned or ground leased in (I'm guessing) 70% of the best malls in America; the Kenmore appliance brand; the Craftsmen tool brand; 54% ownership of separately traded Sears Canada; the Orchard supply chain; a highly profitable in-home service business and more.

We acquired 1,176,600 shares directly and 7,916,900 shares derivatively for a 4.3% position. ESL Investments, headed by the investor Ed Lampert, already had a 14.6% position pre-dating our position by years.

One of the outcomes we anticipated (although not our preferred outcome) was the Kmart-Sears merger proposed by Ed Lampert, the majority owner of Kmart, as well as the largest holder of Sears. We investigated numerous alternatives while avoiding saber rattling and in the end elected to support the merger and receive all stock.(13)

Here's the math: Marked-to-market as of today, we have a recognized $20 million short-term capital gain and an unrecognized $161 million capital gain that we intend to defer until it becomes long-term in September 2005. Our total economic gain as of today is $181 million.(14)

(11) We missed Mervyn's, however. We were the underbidders. The fact of life is that Mike and I lose or turn down many more deals than we make. Remember, even a 300 batting average is pretty good and financial discipline is everything.
(12) Includes 300 franchised stores.
(13) This was a no-brainer. The cash election yielded $50 per share while the Kmart stock alternative was worth $59 per share. This was as much an economic imperative as it was a show of support for the future prospects of the company. The actual pro ration formula was 37% cash, 63% stock.
(14) Over the last weeks, our economic gain had been as high as $215 million. This young stock is moving around a bit, but we believe it has an upward bias.