When resurgent discount retailer Kmart (NASDAQ:KMRT) branded a new CEO, it was rumored that chairman Edward Lampert might have designs on merging the company with Sears (NYSE:S), another retailer in which he has a majority stake. ESL Investments owns more than 52% of Kmart and is Sears' largest shareholder at 15%. Both retailers have faced the twin dilemma of declining shopping malls and increased competition from the likes of discounters Target (NYSE:TGT) and Wal-Mart (NYSE:WMT).

Now, in an $11 billion cash and stock deal, the two will merge to become the third-largest retailer, with combined sales of $55 billion and more than 3,400 stores. Sears Holding Corp. will become the holding company for both enterprises, but they will continue to operate their brands separately. It is expected the merger will save some $550 million through procurement, marketing information technology, and supply chain management.

Kmart shareholders will receive one new share in the new holding company for each share they own, while Sears shareholders have the option of receiving $50 per share in cash or getting a half share in the holding company for each share of Sears stock they own. The board of directors of both companies unanimously approved the merger, which still needs shareholder and regulatory approval.

Kmart has been selling off its stores, which tend to be in prime locations. It sold 50 to Sears for $575 million earlier this year and 18 to Home Depot (NYSE:HD) for $271 million. Sears stores are also in demographically prime areas and in shopping malls, even if the malls are no longer a growing segment. Together they have some of the best real estate in the industry. New Jersey-based Vornado Realty (NYSE:VNO) took a 4% stake in Sears just this month, with hopes of cashing in on the retailer's land holdings. Sears shares have gone up 22% since the purchase was announced.

While one analyst has likened the merger to tying two drunks together in hopes they'll be able to walk a straight line, the general view is that the new company will be a stronger competitor to take on the likes of Target and Wal-Mart.

Still Kmart continues to have falling sales. It also reported today that while it has achieved a third-quarter profit of $553 million, it was realized solely through cost-cutting measures. Revenues fell another 14% and same-store sales declined more than 12%. The company expects to end the year with more than $3 billion in cash.

Kmart filed for bankruptcy in early 2002, closed nearly 600 stores and fired 57,000 employees. When it reemerged last year, it surprised analysts with its quick return to profitability, though as noted above, it was built less on the back of sales than on other maneuvers. Sears, too, has long been mired in a morass of sluggish sales. It is trying to reinvent itself through the introduction of the Sears Grand concept, a traditional retail store of clothing, appliances, and tools, which also offers grocery and convenience items.

How long now before Sears starts running "blue light specials?"

Motley Fool contributor Rich Duprey has often resembled two drunks tied together. He does not own any of the stocks mentioned in this article.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.