The discount retailer Kmart Holding Corp. (KMRT) is combining with one of the most venerable names in U.S. retailing, Sears, Roebuck & Co. (S), in an $11 billion deal that will create the nation's third largest retailer.

The company being created by the surprise combination announced Wednesday would be known as Sears Holdings Corp., but will continue to operate the Kmart and Sears stores under their current brand names.

Shares of both companies surged on news of the deal. Kmart shares climbed $17.38, or 17 percent, to $118.60 on the Nasdaq Stock Market (search), while Sears shares soared $9.69, or 21 percent, to $54.89 on the New York Stock Exchange (search).

The combined company is expected to have $55 billion in annual revenues, 2,350 full-line and off-mall stores, and 1,100 specialty retail stores. That will mean it will trail only Wal-Mart Stores Inc. (WMT) and Target Corp. (TGT) among the biggest U.S. retailers.

The deal marks a remarkable comeback for Kmart, a company once known for its "Blue Light Specials," that scaled back its operations after seeking bankruptcy protection in 2002. Sears' roots date to the late 1800s when it offered merchandise by mail order to farmers, opened its first retail store in 1925 and eventually became the nation's biggest department store operator.

It will be headquartered in the northwestern Chicago suburb of Hoffman Estates, where Sears has its headquarters, but will maintain a "significant presence" in Troy, Mich., where Kmart is based.

Under the agreement, which was unanimously approved by both companies' boards of directors, Kmart shareholders will receive one share of new Sears Holdings stock for each Kmart share. Sears, Roebuck shareholders can choose $50 in cash or half a share of Sears Holdings stock. That portion of the deal values Sears shares at $11 billion, a 10.6 percent premium over its value at Tuesday's close.

Kmart chairman Edward Lampert (search) will be the chairman of Sears Holdings, while Sears CEO Alan Lacy (search) will be vice chairman and CEO of the new company. The new 10-member Sears Holdings board will have seven members from Kmart and three from Sears.

"The merger will enable us to manage the businesses of Sears and Kmart to produce a higher return than either company could achieve on its own," Lampert said in a press release.

The merger, expected to close by the end of March 2005, is subject to approval by Kmart and Sears shareholders, regulatory approvals and customary closing conditions.

Kmart filed for Chapter 11 bankruptcy protection in early 2002, leading to the closing of about 600 stores, termination of 57,000 Kmart employees and cancellation of company stock. The retailer emerged from bankruptcy in May 2003 and in March posted its first profitable quarter in three years.

Mired in a retail slump, Sears had long fallen out of favor on Wall Street after losing ground to competitors and enduring sluggish sales for years.

The company last fall introduced its Sears Grand (search) stores, which offer grocery and convenience items besides traditional Sears fare such as clothing, home appliances and tools. The concept had delivered promising results for the struggling retailer at its first three stores in metropolitan Salt Lake City, Las Vegas and Chicago, in the suburb of Gurnee.

Kmart, in recent years, has been shedding many of its underperforming stores, a strategy that has helped the once-struggling discount retailer bounce back after it emerged from bankruptcy. In fact, Kmart has sold 50 stores to Sears for $575 million as part of that strategy.

Earlier this month, it appeared that Sears could be shifting toward a similar direction after the disclosure that Vornado Realty Trust (VNO), a real estate investment trust, had purchased a 4.3 percent interest in the department-store chain.

That move left the impression that the value of Sears' real estate holdings may be not be fully reflected in its stock price. Since that Nov. 5 announcement, Sears' stock has jumped 25 percent.

Company officials said the merger would help make their properties more profitable through a broader retail presence and improved operational efficiency in areas such as procurement, marketing, information technology and supply chain management.

"The combination will greatly strengthen both the Sears and Kmart franchises by accelerating the Sears off-mall growth strategy and enhancing the brand portfolio of both companies," Lacy said. "This will clearly be a win for both companies' customers while significantly enhancing value for all shareholders."

The merger will not affect agreements to carry home and fashion lines including Martha Stewart Everyday (search), Lands' End and Sesame Street, the companies said.