We have divided our "Management's Discussion and Analysis of Financial Condition and Results of Operations" ("MD&A") into the following six sections:

• Overview of Holdings

• Results of Operations:

Fiscal Year

Holdings' Consolidated Results

Business Segment Results

• Analysis of Consolidated Financial Condition

• Contractual Obligations and Off-Balance Sheet Arrangements

• Application of Critical Accounting Policies and Estimates

• Cautionary Statement Regarding Forward-Looking Information

The discussion that follows should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8.

OVERVIEW OF HOLDINGS

Holdings is the parent company of Kmart and Sears. We are a broadline retailer and, at the end of fiscal 2008, had 2,297 Kmart and domestic full-line stores and 1,233 specialty retail stores in the United States operating through Kmart and Sears and 388 full-line and specialty retail stores in Canada operating through Sears Canada, a 73%-owned subsidiary.

We currently conduct our operations in three business segments: Kmart, Sears Domestic and Sears Canada. The nature of operations conducted within each of these segments is discussed within the "Business Segments" section of Item 1 in this report on Form 10-K. Our business segments have been determined in accordance with SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information."

The retail industry is highly competitive and as such, Holdings faces significant challenges including the current macroeconomic environment, as many of our product categories are impacted by the housing market and availability of credit to our customers. However, we believe that we possess unique resources that differentiate us from our competitors. These resources include:

• The brands we own (Kenmore, Craftsman, DieHard, and Lands' End) are one of our most important resources. We believe that each of these four brands has significant recognition and value with customers.

• Home services, including installation, delivery, and repair, represent another important resource of our Company. Our extensive network of in-home and in-store service businesses supports our broad-line stores and gives us the opportunity to retain long-term relationships with our customers-a chance to deliver value not only at the point of sale but also on an ongoing basis, and a chance to learn continuously about our customers and what they like and do not like about our products.

• Our existing store base is another resource, as our more than 3,500 domestic stores provide us with a physical presence in all major communities in the United States.

• We also have viable online businesses, which enhance our multi-channel customer experience. Sears.com, Landsend.com and PartsDirect.com are examples of online channels where we engage and transact with our customers. We continue to invest in these online capabilities, as we believe that a compelling multi-channel experience will be an important factor for success in the years and decades to come.

In addition to these resources, we believe that we have a solid balance sheet, as we own substantial inventory and real estate assets and have only $2.3 billion of debt ($2.9 billion with capital leases).

RESULTS OF OPERATIONS

Fiscal Year

Our fiscal year end is the Saturday closest to January 31st. In fiscal 2006, the Saturday closest to January 31st was February 3, 2007 and, as a result, fiscal 2006 consisted of 53 weeks. Both fiscal 2008 and fiscal 2007 consisted of 52 weeks. Unless otherwise stated, references to years in this report relate to fiscal years rather than to calendar years. The following fiscal periods are presented in this report.

                       Fiscal year        Ended         Weeks
                       2008          January 31, 2009    52
                       2007          February 2, 2008    52
                       2006          February 3, 2007    53

Prior to fiscal 2007, Sears Canada's fiscal year end was the Saturday closest to December 31st and therefore we consolidated Sears Canada's results on a one-month lag. During the fourth quarter of 2007, Sears Canada changed its fiscal year end from the Saturday nearest December 31st to the Saturday nearest January 31st. The change in Sears Canada's year end was considered a preferable change in accounting principle as it allows a full seasonal cycle, including the liquidation of holiday merchandise, for Sears Canada to be included in the results of Holdings. Furthermore, Sears Canada's fiscal year end is now aligned with the fiscal year end of Holdings and its results are no longer accounted for on a one-month lag. As required by SFAS No. 154, "Accounting Changes and Error Corrections-A Replacement of APB Opinion No. 20 and SFAS No. 3," this change has been retrospectively applied to all prior year amounts included in the financial statements of Sears Canada for fiscal 2006. See Note 2 of Notes to Consolidated Financial Statements for further explanation of this change.

Holdings' Consolidated Results

Holdings' consolidated results of operations for fiscal 2008, 2007, and 2006 are
summarized as follows:



millions, except per share data                            2008         2007(1)        2006(1)
REVENUES

Merchandise sales and services                           $ 46,770       $ 50,703       $ 53,016

COSTS AND EXPENSES
Cost of sales, buying and occupancy                        34,118         36,638         37,824
Gross margin dollars                                       12,652         14,065         15,192
Gross margin rate                                            27.1 %         27.7 %         28.7 %
Selling and administrative                                 11,060         11,468         11,574
Selling and administrative expense as a percentage
of total revenues                                            23.6 %         22.6 %         21.8 %
Depreciation and amortization                                 981          1,049          1,143
Impairment charges                                            360             -              -
Gain on sales of assets                                       (51 )          (38 )          (82 )
Restructuring charges                                          -              -              28

Total costs and expenses                                   46,468         49,117         50,487

Operating income                                              302          1,586          2,529

Interest and investment income                                (46 )         (135 )         (253 )
Interest expense                                              272            286            335
Other income                                                 (108 )          (17 )          (24 )

Income before income taxes and minority interest              184          1,452          2,471

Income taxes                                                   85            550            933
Minority interest                                              46             76             46


NET INCOME                                               $     53       $    826       $  1,492

EARNINGS PER COMMON SHARE
Diluted earnings per share $ 0.42 $ 5.70 $ 9.58 Diluted weighted average common shares outstanding 127.0 144.8 155.7

(1) During the fourth quarter of 2007, Sears Canada changed its fiscal year end from the Saturday nearest December 31 st to the Saturday nearest January 31st. This change has been retrospectively applied to prior year amounts reported in the fiscal 2006 column as required by SFAS No. 154. See Note 2 of Notes to Consolidated Financial Statements.

References to comparable store sales amounts within the following discussion include sales for all stores operating for a period of at least 12 full months, including remodeled and expanded stores, but excluding store relocations and stores that have undergone format changes. Comparable store sales results for fiscal 2008 were calculated based on the 52-week period ended January 31, 2009 as compared to the comparable 52-week period in the prior year.

Fiscal 2008 Compared to Fiscal 2007

Net Income

For the fiscal year ended January 31, 2009, net income was $53 million, or $0.42 per diluted share compared with net income of $826 million, or $5.70 per diluted share, for the fiscal year ended February 2, 2008. Fiscal 2008 results include charges of $437 million ($248 million after tax and minority interest or $1.94 per

diluted share) related to goodwill and asset impairments, store closings and severance, of which $360 million ($201 million after tax or $1.57 per diluted share) relates to non-cash items. These charges were partially offset by mark-to-market gains on Sears Canada hedge transactions of $81 million ($33 million after tax and minority interest or $0.26 per diluted share), the positive impact of the reversal of a $62 million ($37 million after tax or $0.29 per diluted share) reserve because of the overturning of an adverse jury verdict relating to the redemption of certain Sears, Roebuck and Co. bonds in 2004, a tax benefit of $8 million ($0.06 per diluted share) related to the resolution of certain income tax matters, and gains on negotiated repurchases of debt securities prior to maturity of $13 million ($8 million after tax or $0.06 per diluted share). Excluding the significant items above, net income was $215 million, or $1.69 per diluted share, for the full year in fiscal 2008.

Net income for fiscal 2007 was $826 million, or $5.70 per diluted share. Fiscal 2007 results include the impact of a gain of $19 million ($12 million after tax or $0.08 per diluted share) for insurance recoveries received on hurricane claims filed for certain of our property damaged by hurricanes during fiscal 2005 and a curtailment gain of $27 million ($17 million after tax or $0.12 per diluted share) related to certain amendments made to Sears Canada's post-retirement benefit plans. These gains were partially offset by losses of $14 million ($9 million after tax or $0.06 per diluted share) on our total return swap investments. Excluding the significant items above, net income was $806 million, or $5.56 per diluted share, in fiscal 2007.

Excluding the items noted above, net income decreased $591 million during fiscal 2008. The decrease in net income for the year reflects a decrease in operating income of $1.3 billion (or $863 million excluding the impact of certain items noted above), primarily due to lower operating income at Kmart and Sears Domestic, as well as slightly lower operating income at Sears Canada. The decrease in net income was also due to lower interest and investment income, partially offset by lower income tax expense.

Declines in the operating results of Sears Domestic and Kmart are primarily the result of a decline in gross margin across most major merchandise categories, reflecting both sales declines as well as an overall decline in our gross margin rate for the year due to increased markdowns taken across most merchandise categories and reduced leverage of buying and occupancy costs. During 2008, we made a concerted effort to reduce our inventory levels due to the deterioration of the economic climate in the latter half of 2007 and what we anticipated to be a higher risk environment in 2008.

Total Revenues and Comparable Store Sales

Total revenues for fiscal 2008 were $46.8 billion, as compared to revenues of $50.7 billion for fiscal 2007. The decline in revenues of $3.9 billion is primarily due to a $2.5 billion decline at Sears Domestic, a $1.0 billion decline at Kmart, and a $366 million decline at Sears Canada, which includes a decrease of $96 million related to the impact of exchange rates during fiscal 2008. Exchange rates did not have as significant an impact on the results of Sears Canada in 2008 as compared to 2007, as rates were less volatile during the current year. The decrease in fiscal 2008 revenues as compared to fiscal 2007 was primarily due to the impact of lower comparable store sales at Kmart and Sears Domestic.

Fiscal 2008 domestic comparable store sales were down 8.0% in the aggregate, with Sears Domestic declining 9.5% and Kmart declining 6.1%. In fiscal 2008, declines were experienced across most major merchandise categories. Domestic comparable store sales declines continue to be driven by categories most directly impacted by housing market conditions (including a high single digit percentage decline in home appliances at Sears Domestic) and a slowdown in consumers' discretionary spending (including a high single digit percentage decline in home goods, a mid single digit percentage decline in apparel at Kmart, high single digit percentage declines in home and household goods at Sears Domestic, and a low double digit percentage decline in apparel, tools, and lawn and garden at Sears Domestic). If the overall retail environment continues to be impacted by unfavorable economic factors, our sales will likely continue to be pressured in fiscal 2009.

Gross Margin

Gross margin declined from $14.1 billion in fiscal 2007 to $12.7 billion in fiscal 2008. The decline of $1.4 billion was mainly attributable to lower gross margin dollars generated at both Kmart and Sears Domestic as a result of the above-noted sales declines, as well as a decline in the gross margin rate. Gross margin also includes a charge of $36 million for markdowns recorded in connection with store closings announced during the third and fourth quarters of fiscal 2008.

Gross margin as a percentage of merchandise sales and services revenue ("gross margin rate") was 27.1% in fiscal 2008, as compared to 27.7% in fiscal 2007. The 60 basis point decline consisted of a 100 basis point decline at Sears Domestic and a 20 basis point decline at Kmart, partially offset by an increase of 10 basis points at Sears Canada. Our buying and occupancy costs are relatively fixed in nature, and therefore did not decrease as much as sales decreased during 2008. Reduced leverage of buying and occupancy costs, given lower overall sales levels in fiscal 2008, accounted for approximately 20 basis points of the total decline in our gross margin rate in fiscal 2008.

The remaining 40 basis point decline was primarily the result of a decline in gross margin rate at Sears Domestic, which declined mainly due to increased markdown activity across most merchandise categories. The impact of increased markdowns on Sears Domestic throughout the year was somewhat mitigated by fewer markdowns taken in the seasonal and winter apparel category during the fourth quarter of fiscal 2008 as our purchases of merchandise were more consistent with the sales trends.

Selling and Administrative Expenses

Selling and administrative expenses decreased $408 million during fiscal 2008 as compared to fiscal 2007. Fiscal 2008 selling and administrative expenses include a $41 million charge related to store closing and severance reserves and the positive impact of the reversal of a $62 million reserve because of the overturning of an adverse jury verdict relating to the redemption of certain Sears, Roebuck and Co. bonds in 2004. Fiscal 2007 selling and administrative expenses include a $27 million curtailment gain recorded in connection with changes made to Sears Canada's benefit plans and a $19 million gain related to insurance recoveries for certain Sears Domestic properties damaged by hurricanes during fiscal 2005. Excluding the impact of these items, selling and administrative expenses decreased $433 million during fiscal 2008 mainly due to a $259 million reduction in payroll and benefits expense, as well as a $94 million reduction in advertising expense.

Selling and administrative expenses as a percentage of total revenues ("selling and administrative expense rate") were 23.6% in fiscal 2008, as compared to 22.6% for fiscal 2007. While total selling and administrative expenses were reduced in fiscal 2008, the current year selling and administrative expense rate increased, primarily reflecting lower expense leverage resulting from lower overall sales levels.

Throughout 2008 we took a number of actions to decrease our expenses and in the fourth quarter of 2008 we announced that we were suspending the Company contribution to the 401(k) plan in fiscal year 2009. We plan to pursue additional expense reductions in fiscal 2009.

Depreciation and Amortization

Depreciation and amortization expense decreased by $68 million during fiscal 2008 as compared to fiscal 2007. The decrease is primarily attributable to additional property and equipment becoming fully depreciated during the year, thereby decreasing our depreciable asset base.

Impairment Charges

In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," we performed an impairment test of certain of our long-lived assets (principally the value of buildings and other

fixed assets associated with our stores) due to events and changes in circumstances during the third quarter of 2008 that indicated an impairment might have occurred. The impairment review was triggered by the increased severity of the economic turmoil and weakening in the U.S. economy during the third quarter, which had a negative impact on the performance of our stores. As a result of this review, we recorded an impairment charge of $76 million during the third quarter of fiscal 2008. This impairment charge includes a charge for the 22 stores that we decided to close in the third quarter and early fourth quarter of fiscal 2008. We also recorded a $22 million impairment charge related to the property and equipment at 24 stores we decided to close in January 2009.

During the fourth quarter of 2008, we performed our annual impairment test of goodwill and intangible assets pursuant to SFAS No. 142 "Goodwill and Other Intangible Assets." As a result of our tests, we recorded an impairment charge of $262 million related to the fair value of goodwill associated with our Orchard Supply Hardware ("OSH") subsidiary. SFAS No. 142 requires interim tests for impairment of goodwill and intangible assets be performed should indicators of such an impairment arise as a result of changes in existing business conditions. We did not perform an interim test of goodwill during fiscal 2008 as we did not have any indicators of potential impairment prior to the fourth quarter.

See Notes 1 and 14 in Notes to Consolidated Financial Statements, as well as the discussion of our critical accounting policies and estimates below, for further information on the $360 million of impairment charges we recorded during fiscal 2008.

Operating Income

We reported operating income of $302 million in fiscal 2008, as compared to operating income of $1.6 billion for fiscal 2007. Excluding the effects of one-time charges discussed above, operating income declined $863 million in fiscal 2008 as compared to fiscal 2007, mainly due to lower gross margin dollars, partially offset by a decrease in selling and administrative expense, as well as lower depreciation and amortization expense.

Interest and Investment Income

We earned $46 million in interest and investment income in fiscal 2008, as compared to $135 million in fiscal 2007. Interest and investment income for fiscal 2008 is mainly comprised of a dividend of $10 million from our investment in Sears Mexico and interest income of $25 million. Interest and investment income for fiscal 2007 was mainly comprised of a dividend of $20 million from Sears Mexico and interest income of $107 million, partially offset by investment losses of $14 million on total return swaps outstanding during the fiscal year ended February 2, 2008. There were no total return swaps outstanding during the 2008 fiscal year. The decrease in interest income in fiscal 2008 is primarily due to lower overall cash and cash equivalent balances maintained during the first three quarters of fiscal 2008 as compared to the same period in fiscal 2007.

Interest Expense

We incurred $272 million in interest expense during fiscal 2007, as compared to $286 million last year. The reduction in interest expense is mainly the result of a reduction in long-term borrowings and lower short-term interest rates, partially offset by an increase in the amount of short-term borrowings under our revolving credit facility.

Other Income

Other income in fiscal 2008 is primarily comprised of mark-to-market gains on Sears Canada hedge transactions. Total net gains of $81 million were recorded on these transactions in fiscal 2008. Other income also includes gains on negotiated repurchases of debt securities prior to their maturity and bankruptcy-related recoveries. We recorded $13 million in gains related to the repurchases of debt securities in fiscal 2008. We had

no comparable gains in fiscal 2007. We recorded $5 million of bankruptcy-related recoveries during fiscal 2008 as compared to $18 million of such recoveries in fiscal 2007. Bankruptcy-related recoveries represent amounts collected from vendors who had received cash payment for pre-petition obligations. See Note 10 of Notes to Consolidated Financial Statements for further information on bankruptcy claims resolution and settlements.

Income Taxes

Our effective tax rate in fiscal 2008 was 46.2% as compared to 37.9% in fiscal 2007. The increase in our tax rate is primarily due to the fact that a portion of our impairment charge for goodwill is not deductible for tax purposes. Income tax expense in 2008 also includes a benefit of $8 million related to the resolution of certain tax matters.

Fiscal 2007 Compared to Fiscal 2006

Net Income

Net income for fiscal 2007 was $826 million, or $5.70 per diluted share. Fiscal 2007 results include the impact of a gain of $19 million ($12 million after tax or $0.08 per diluted share) for insurance recoveries received on hurricane claims filed for certain of our property damaged by hurricanes during fiscal 2005 and a curtailment gain of $27 million ($17 million after tax or $0.12 per diluted share) related to certain amendments made to Sears Canada's post-retirement benefit plans. These gains were partially offset by losses of $14 million ($9 million after tax or $0.06 per diluted share) on our total return swap investments. Excluding significant items, net income was $806 million, or $5.56 per diluted share, in fiscal 2007.

Net income for fiscal 2006 was $1.5 billion, or $9.58 per diluted share. Fiscal 2006 results include the impact of a $74 million ($45 million after tax or $0.29 per diluted share) gain derived from our investments in total return swaps, $36 million ($22 million after tax or $0.14 per diluted share) related to the June 2006 settlement of Visa/MasterCard antitrust litigation, a tax benefit of $31 million ($0.20 per diluted share) related to the resolution of certain income tax matters, restructuring charges of $28 million ($17 million after tax or $.09 per diluted share), a $41 million gain ($26 million after tax or $0.17 per diluted share) on the sale of Kmart's former headquarters building, and a charge of $74 million ($45 million after tax or $0.29 per diluted share) related to an unfavorable verdict in connection with a pre-Merger legal matter concerning Sears Roebuck's redemption of certain bonds in 2004. Excluding significant items, net income was $1.4 billion, or $9.16 per diluted share, in fiscal 2006.

The decrease in net income in fiscal 2007 reflects lower operating results at both Sears Domestic and Kmart, partially offset by improved operating results at Sears Canada. Declines in the operating results of Sears Domestic and Kmart are primarily the result of a decline in gross margin across most major merchandise categories, reflecting both sales declines, as well as an overall decline in our gross margin rate for the year.

We made a strategic decision in 2006 to begin fiscal 2007 with more inventory than we held in the past in order to meet higher anticipated customer demand, based on the projected performance of several of our businesses. The higher inventory investment coupled with the difficult economic environment led to a significant increase in markdowns to clear product, especially seasonal product that has a shorter life than basic items. This affected gross margin in two ways; both lower volume due to declining sales (a $2.3 billion sales decline over the prior year) and a lower gross margin rate due to the increased markdowns (27.7% in fiscal 2007 compared to 28.7% in fiscal 2006).

Interest and investment income also declined during the year as we settled our investments in total return swaps during the third quarter. The negative impact of these declines on our fiscal 2007 results was only partially offset by declines in selling, general and administrative expenses, depreciation and amortization, income tax expense (given lower levels of pre-tax income in fiscal 2007), and reduced interest expense (given lower average outstanding borrowings).

Total Revenues and Comparable Store Sales

Fiscal 2007 revenues were $50.7 billion as compared to $53.0 billion in fiscal 2006. The decrease in fiscal 2007 revenues, as compared to reported revenues for fiscal 2006, was primarily due to the impact of lower domestic comparable store sales, and to a lesser degree, the inclusion of an additional week of sales in fiscal 2006 (comprised of 53 weeks) as compared to fiscal 2007 (comprised of 52 weeks). We recorded a total of $711 million in revenues during the 53rd week of fiscal 2006. These declines were partially offset by sales increases at Sears Canada of $412 million, including an increase of $382 million related to the impact of favorable exchange rates, as the Canadian dollar strengthened in fiscal 2007.

Fiscal 2007 domestic comparable store sales were down 4.3% in the aggregate, with Sears Domestic declining 4.0% and Kmart declining 4.7%. Declines were experienced across most major merchandise categories in fiscal 2007 reflecting increased competition, the impact of a deteriorating housing market, the increased costs of consumer staples and a decrease in consumers' disposable income. In fiscal 2007, notably larger declines within the home appliance and apparel categories were partially offset by increased sales of consumer electronics. The increase in sales of consumer electronics reflected increased consumer demand and our ability to improve market share in this category in which the prices of products increasingly became more commodity based during 2007.

Gross Margin

The gross margin rate was 27.7% in fiscal 2007, as compared to 28.7% in fiscal 2006. Gross margin rate declines at Kmart and Sears Domestic were partially . . .