Description

Sears Hometown and Outlet is an attractive investment because it offers downside protection based on its balance sheet and status as a franchisor, and offers dramatic upside as the promotional cadence slows in home appliances.  Sears Holdings, who has been leading the charge on aggressive appliance pricing, has raised prices for the last two quarters so we expect that will begin to flow through SHOS's results over the course of the year.  We believe that the company is worth $12.60 in a downside scenario where the Hometown side slowly liquidates and  $26.50 if the margins on the Outlet side revert back to their historical levels.

Company description

Sears Hometown has four divisions – Hometown stores, Hardware stores, Home Appliance showrooms and Outlets.  The first three are grouped together for segment reporting purposes under the banner of Hometown and Outlet is reported as its own segment.

Hometown

The Hometown stores offer products and services across a wide selection of merchandise categories, including home appliances, lawn and garden equipment, tools, sporting goods, and household goods, with the majority of business driven by big-ticket home appliance and lawn and garden sales. Most of the stores carry Sears-branded products, including products branded with the Kenmore, Craftsman, and Diehard marks (KCD), and an assortment of other national brands. Primarily independently operated, predominantly located in smaller communities and averaging approximately 8,500 square feet, Hometown Stores are designed to serve trade areas that may not support a full-service big-box retailer. As of May 2, 2015, there were 926 hometown stores in all 50 states, Puerto Rico and Bermuda.

Hardware

The Hardware stores offer products and services across a wide selection of merchandise categories with sales primarily driven by home appliances, lawn and garden equipment, tools, and other home improvement products.  The hardware stores are primarily located in suburban trade areas and are positioned as local stores designed to appeal to convenience-oriented customers. These stores carry Craftsman brand tools and lawn and garden equipment, DieHard brand batteries, and a wide assortment of other national brands and other home improvement products. As of May 2, 2015, there were 67 hardware stores in 15 states.   

Home Appliance Showrooms

The Home Appliance Showrooms offer home appliances and related services in stores primarily located in strip malls and lifestyle centers of metropolitan areas. They average 5,000 square feet and sales are primarily driven by big-ticket cooking, laundry, and refrigeration home appliances as well as, in certain stores, mattresses. The stores carry Kenmore and other national brands of home appliances. As of May 2, 2015, there were 98 showrooms in 28 states.

Thoughts

The Hardware stores are caught between not being as convenient as a local hardware store and not having the selection nor pricing of a Home Depot / Lowes.  After speaking with some franchisees, it seems very likely that they will slowly fade away.  Fortunately, the company has had some success converting them into Outlet stores.

The Home appliance showrooms have performed poorly so far, but the jury is still out on what their ultimate potential will be.  They offer appliance dedicated, convenient locations with knowledgeable employees and decent pricing.  Originally the idea was to open them as Sears closed their mainline department stores and try to capture a portion of the appliance sales.   They have started to close some of the poorer performing showrooms in the latest quarter.

The Hometown stores profitability has declined, but is still positive. 

The most important fact is that of the 1,091 total Hometown segment stores, only 58 or 5% are company owned.  In the rest of the stores, SHOS consigns the inventory to the dealer / franchisee.  The franchisee is responsible for labor, rent, utilities, etc.  SHOS has no fixed costs in the four walls with the exception of the cost of carry on its inventory.  It also has corporate spending on advertising in each of the local markets.  As any individual site becomes unprofitable and chooses to shut down, SHOS has 3 options:

1)    Find a new franchisee/dealer if they believe that the market should still statistically be profitable.

2)     Run a liquidation sale on premises.

3)    Ship the inventory to the closest outlet store and liquidate the inventory there.

The CFO has said multiple times that both option 2 and option 3 produce positive gross margins for the company.  The CFO’s statements are supported by the fact that most of the inventory consists of 3-4 month old appliances.  It is difficult for an end consumer to differentiate between a 2014 and 2015 washer/dryer/dishwasher/refrigerator/etc.  The inventory is listed at cost on SHOS’s balance sheet so it’s not a huge surprise that with an additional 20% off retail, the vast majority of the inventory can quickly be liquidated for prices above wholesale.

There is still the possibility that the business turns around.  Last year SHLD began to cut prices on appliances in an effort to gain market share.  Lowes, Home Depot and Best Buy all followed suit and matched SHLD's prices.  The result wasn’t the share shift SHLD hoped for, but instead was a large decline in industry margins.   SHLD began to raise prices over the last 2 quarters once they realized that they were forgoing gross profits for no good reason.  If SHLD reverts back to normal pricing on a more permanent basis, then the Hometown segment should be a huge beneficiary.  Every 1% increase in EBIT margins leads to almost $17 million of EBIT.  

Hometown Operating Results

Outlet Business

Sears Outlet stores are designed to provide in-store and online access to purchase outlet-value products across a broad assortment of merchandise categories, including home appliances, mattresses, apparel, sporting goods, lawn and garden equipment, tools, and other household goods, including furniture, at prices that are significantly lower than list prices. Outlet Stores serve as a liquidation channel for outlet-value home appliances from major appliance vendors. In 2014 Outlet’s most significant merchandise category was home appliances, which made up 79% of Outlet sales revenue. Outlet-value products are generally covered by a warranty. Outlet Stores also offer a full suite of extended-service plans and services. As of May 2, 2015, Outlet operated 157 locations in 34 states and one in Puerto Rico, of which 149 offer a wide range of outlet-value products, and two were retail apparel, mattresses, and furniture only stores. As of May 2, 2015, there were 93 company owned outlet stores and 64 franchisee operated stores.

Thoughts

The Outlet business has not been run particularly well, but has a strong reason to exist.  It is the only appliance liquidation channel with a national footprint and has a compelling consumer value proposition in that it offers dinged up appliances at 20-40% off retail.  When a manufacturer sells appliances to a retailer, the retailer gets the right to return a very small fraction of them to the manufacturer due to damage.  If more become damaged or are returned than the small fraction allowed, then the retailer is responsible for liquidating the overage.  If fewer are damaged or returned then the retailer doesn’t have to worry about liquidating the damaged inventory but, in either case, the manufacturer still has to do so. 

SHOS was originally 100% dependent on getting as-is inventory from SHLD.  In the last few years SHOS signed deals with LG, Samsung and a few other manufacturers to pick up as-is inventory from their customers (Best Buy, Home Depot and Lowes).  More recently, SHOS has begun to try to convince the large retailers to sell them their as-is inventory since they are already sending a truck to the store to pick up the manufactuer’s as-is inventory.  They’ve been reasonably successful in both growing the amount of as-is inventory they are receiving and in diversifying away from SHLD.

Headwinds at Outlet

Outlet’s value proposition has been seriously harmed in the last year by SHLD’s aggressive discounting.   Instead of offering 20-40% off retail, their offers have been closer to 10-20% off retail, which makes their value proposition much less attractive.   In addition their contracts with franchisees are structured such that commission rates are negatively correlated to store revenues.  Several of the franchisees decided to lower the hourly pay at their Outlets shortly after they closed on them which caused a large amount of employee turnover.  That increased employee turnover decreased sales and therefore increased the commission rate that SHOS paid (frequently to its maximum potential level).  That’s the bad news and largely explains why operating income margins declined so much over the last year.  The good news is that both of the headwinds are starting to clear.  SHLD is lessening its discounting and as outlet revenues increase, commission rates will decline which will increase Outlet’s operating income margins.  

Outlet Operating Results

IT Systems & Name Change

The company announced that they are hiring Cap Gemini to migrate from SHLD’s 1980s era IT system to a modern Netsuite SAAS system.  This will give them significantly more flexibility than is currently available to do many things, including source inventory separately from SHLD.  SHLD offers SHOS 15 days terms on payables while the industry standard is 30-45 days.  Moving off SHLD's systems should free up more than $40 million even after allowing for the increase in backstock inventory.  The migration should be fully implemented by early 2017.  They are considering removing Sears from their name and 2017 seems to be the likely timeframe for them to do so.

Valuation

In the most likely liquidation scenario, the Hometown stores are shut down between 2016 and 2018 as leases expire and the stores become unprofitable for a larger portion of the dealers / franchisees.  The losses along the way are borne by those dealers / franchisees.  When they actually close, SHOS has the option of shipping the inventory to a repair site and then on to their Outlet stores.  The Outlet stores simply order less inventory directly from manfacturers than they otherwise would.  Owning the outlet stores allows SHOS to efficiently transform their inventory back into cash.

Balance Sheet

The losses on hometown operating lease calculation is 

130 (SHOS total net minimum lease payments) * 3/4 (conservatively assumed hometown portion of the company's total) * 30% (losses on being unable to sublet, note they've been able to sublet at lower loss ratios so far).

If the outlet side only is able to get its EBIT margins back to 3.5%, then it would produce $30 million in EBITDA.  At a 6x multiple the Outlet side would be worth $180 million.

Therefore the company would be worth $315 million and with $30 million of debt, the shares would be worth $12.60.

In a good scenario, outlet EBIT margins revert back to 7% with sales around $800 million as they continue to open new locations.  That would produce $62 million in EBITDA, which at an 8x multiple would imply that Outlet is worth $496 million.  Total value with Hometown liquidating would be ~$600 million, which would imply the shares are worth $26.50.

In a very good scenario, Hometown is worth considerably more than liquidation value.

ABL Line

There have been concerns regarding the ability of SHOS to renew its ABL line that matures in October 2017.  SHLD just announced that it was able to renew its line with the same exact lenders that SHOS will negotiate with despite a very high level of cash burn.  SHOS is currently drawn on $30 million of a line that has a $250 million maximum borrowing base.  The CFO of SHOS has expressed a great deal of confidence that based on his discussions, the lenders will not only roll the maturity date but will allow for a restricted payments basket.

Catalyst

Outlet's margins increase as SHLD's discounting stops and industry pricing reverts back to normal.