2014 01 28-Sears Hometown SHOS

8/12/2019 2014 01 28-Sears Hometown SHOS

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EARS HOMETOWN & OUTLET STR ( SHOS ) - $20.70sted on 01/28/14 01:18 PM by mjw248

Description

xecutive Summary

ecommend a long position in Sears Hometown & Outlet Stores, Inc. common stock (NASDAQ: SHOS). Sitting at its 52 week low, below where insiders have purchased

ares, below book value and near tangible book value, SHOS represents a compelling investment. The stock is worth at least $40 per share, almost double its current

ce.

nly a limited amount of information about Sears Hometown & Outlet Stores, Inc. (SHO) has come to light since its separation from Sears Holdings Corporation (Sears).

HO management has been tight-lipped. There are no earnings calls and management does not attend investor conferences. The company has no sell-side coverage. As a

sult of the dearth of information about and understanding of the company, SHOS has had some big moves since it started trading. It started trading around $30,

most hit $60, and now sits near $20, all in a little over a year. Simply put, the company is poorly understood by the market. That is why the stock is mispriced.

ore specifically, the market does not appreciate the growth potential of the companys Home Appliance Showroom format. Although the company only has 95 Home

ppliance Showrooms currently, the format can grow to at least 500 locations, potentially many more. The Home Appliance Showroom format is successful, has some

stinct competitive advantages, and there is strong interest among franchisees to open additional locations. SHO can grow the format both by in-filling existing markets in

eas not well served by Sears full-line stores and using the format to recapture appliance sales from Sears full-line stores that close. SHO primarily operates the Home

ppliance Showrooms under a franchised model, so the format generates phenomenal ROIC. Growth anywhere near the level I expect should create a lot of value.

ackground

HO was a subsidiary of Sears until October 2012, when it became an independent, publicly-traded company through a rights offering. The company operates four Sears-

anded specialty retail formats, Sears Hometown Stores, Sears Hardware Stores, Sears Home Appliance Showrooms and Sears Outlet Stores, under three ownership

odels, dealership, franchised and company-operated.

ppliances are SHOs biggest business, accounting for about 2/3 of sales. Appliances are one of the few merchandise categories in which the Sears brand remains relevant.

ars is the leading appliance retailer in the U.S. with about 29% share of the market. Lowes is second with about 19%, Home Depot is third with 12% and Best Buy is

urth with 8%.

ars/SHO have a number of advantages in appliance retailing. The Kenmore-brand is the most important advantage. Kenmore is manufactured for Sears by Whirlpool,

ectrolux, Samsung and LG. Those companies incorporate additional features in Kenmore products and offer Kenmore products at a lower cost than they do their own

and products. This enables Sears to offer better value for the money with its Kenmore brand relative to national brands. Around 75% of Searss appliance sales are under

e Kenmore brand. Sears/SHO also derive an advantage in appliance retailing from their sales associates. Sears/SHO are the only national retailers that still have

mmission-based appliance sales associates, and as a result, Sears/SHO have the most knowledgeable sales associates by a distinct margin when it comes to appliances.

e Sears brand is also an advantage in appliance retailing. Sears has been the dominant retailer of appliances for generations, and that heritage and awareness clearly

nfer some benefit.

ometown Stores

2010 2011 2012 11/02/13

ompany-Operated - - 1 -

ealer - - 942 -

tal Stores 938 986 943 925

erage Store Size 8,500 8,500 8,500

erage Merchandise Sales per Store $1,600,000 $1,450,000 $1,480,000

erage Merchandise Sales per Sq. Ft. $188 $171 $174

tal Net Sales (000's) $1,472,000 $1,392,000 $1,428,000

e Hometown Store format was born out of the decision to shutter Searss main catalog, the Big Book, in 1993. At the time, there were around 2,200 independently

wned and operated Sears Authorized Catalog Sales Merchants, small locations in rural markets where people could go to browse the Sears catalog, get assistance placing

ders, pick-up merchandise free of delivery charges, and in some cases examine a limited selection of merchandise on display. Without the Big Book, these catalog

erchants no longer had a reason to exist. Sears initially planned to simply close all of them, but eventually determined that it would make sense to maintain some form of

tail presence in many of these smaller markets. Sears converted less than 200 of the independent catalog merchants into what are now called Hometown Stores.

ometown Stores are small format stores averaging 8,500 sq. ft. located outside of major urban areas. They primarily offer hardline merchandise, including major

pliances, tools, hardware and lawn & garden equipment, under both Sears brands and national brands. In many cases, Hometown Stores are intentionally located near a

al-Mart store, because Wal-Mart tends to be the hub of commercial activity in smaller communities. The concept was originally designed to operate in markets too small to

pport big box category killers, such as Home Depot, Lowes and Best Buy, but over the years these competitors have encroached to the point where about 2/3 of the

ometown Stores now face direct competition.

sentially all of the Hometown Stores are independently owned and operated under a dealership model. Sears provides the inventory, manages pricing and promotion, and

velops a local marketing program. The dealer is responsible for everything else, most notably real estate and personnel. Sears pays the dealer a commission based on

les.

ars opened Hometown Stores aggressively during the 90s as part of its strategy to grow its off-mall, specialty formats. The format grew from 192 locations at the end of

93 to 790 locations at the end of 2000, a 22% CAGR. While Searss strategic plan had been to reach 3,000 Hometown Stores, challenges finding capable owner-

erators, difficulties finding appropriate real estate, and increasing big box competition have conspired to keep the total number of Hometown Stores below 1,000. Since00, the number of Hometown Stores has grown in a two-steps forward, one-step back pattern to 925 as of November 2, 2013.

ardware Stores

2010 2011 2012 11/02/13

ompany-Operated 105 72 33 -

anchised 1 24 57 -
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tal Stores 106 96 90 88

erage Store Size 28,000 28,000 28,000



tal Merchandise Sales (000's) $340,000 $315,000 $289,000

ars has made several attempts over the years to build a national chain of free-standing hardware stores. Its first push was in the 1980s with a small, 5,000 sq. ft. format

at replicated the hardware department of a Sears full-line store. Those stores proved too small with too narrow of an assortment to compete against either big box

mpetitors or neighborhood hardware stores. Sears continued to operate the stores it had opened, but killed plans for further expansion.

thur Martinez, Searss first outsider CEO, reinvigorated the idea in the mid-90s. Learning from its mistakes, Sears expanded the format to 20,000 sq. ft. and aimed to

fer a full assortment of hardware. Sears also acquired Orchard Supply Hardware Stores, a California-based chain of 61 hardware stores, whose 40,000 sq. ft. stores were

ore productive and profitable than Searss own hardware stores. At the time, Sears thought it could ultimately have as many as 500 hardware stores across the nation.

t the second attempt to build a chain of hardware stores sputtered much like the first. The key challenge of carrying a broad and deep assortment of hardware was low

oductivity. That challenge was exacerbated by the fact that pricing and promotion at the hardware stores was aligned with that of the full-line stores. In essence, the

rdware stores had a specialist, high-service, convenience offering, but were priced and promoted like a mass-market discounter. Many of the hardware stores were also in

or locations.

ver the course of the mid-2000s, Sears implemented a variety of initiatives to improve the performance of the Hardware Stores. It detached the hardware store chains

cing and promotion from that of the full-line stores, positioning the hardware stores as more of a convenience offering and improving profitability considerably. It edited

e assortment of hardware and brought in appliances to improve productivity. It also closed many poorly-performing locations as leases expired, bringing the number of

ars Hardware Stores to 88 as of November 2013, down from 147 at the end of 2005. The Hardware Stores went from losing about $20 million per year to modest

ofitability.

e company began franchising the stores in 2009, and now about 2/3 of the stores are franchised. The franchise model for the Hardware Stores is similar to the dealer

odel for the Hometown Stores.

what could be considered a third attempt at cracking the hardware store nut, SHO recently began testing a new, smaller format hardware store that it hopes will deliver

tter financial results and reinvigorate the chains growth potential. The first prototypes were opened in Dallas, TX, Big Rapids, MI and Cedar City, UT. The new format

nges in size from 16,000 sq. ft. to 18,000 sq. ft. It offers a full complement of appliances and lawn & garden merchandise with an edited assortment of hardware that is

milar to that of an Ace Hardware or True Value.

ome Appliance Showrooms

2010 2011 2012 11/02/13

ompany-Operated 40 33 27 -

anchised 16 39 56 -

tal Stores 56 72 83 95

erage Store Size 5,000 5,000 5,000



tal Merchandise Sales (000's) $102,000 $120,000 $161,000

ars launched the Home Appliance Showroom format in the Houston metropolitan area in 2007. The strategy is to leverage Searss greatest strength, major home

pliances, in a small, specialty format that can be used to in-fill areas not well served by an existing Sears Full-Line Store or recapture business from a closing Sears Full-

ne Store. The format aims to compete with Home Depot, Lowes and Best Buy by offering a broader and higher-end assortment of appliances, including Kenmore-branded

pliances; better service, a more convenient location and shopping experience; and more aspirational merchandise presentation.

e Home Appliance Showroom format has been a success. SHO has grown the format to around 100 locations. The stores have achieved solid sales productivity,

eraging nearly $2.0 million in annual sales or about $400 per sq. ft. About 2/3 of the Home Appliance Showrooms are franchised. Franchisees have been pleased with

e financial performance and are eager to open up additional locations. In some locations, SHO has added mattresses to the assortment, and that has further boosted

les productivity and profitability.

utlet Stores

2010 2011 2012 11/02/13

ompany-Operated 100 117 125 117

anchised 0 0 2 14

tal Stores 100 117 127 131

erage Store Size 26,000 26,000 26,000



tal Net Sales (000's) $432,000 $505,000 $564,000

ars has operated outlet stores in one form or another since at least the 1970s. Outlet stores complemented Searss catalog operation well, because liquidating

scontinued, overstocked, returned and damaged merchandise through a catalog presents many challenges, such as inflexible prices, long catalog production lead times,

n-standard merchandise, and limited quantities, among others. The fact that much of Sears merchandise was sold under its own brands and backed by a money-backarantee only compounded those challenges and heightened the need for a company-operated liquidation channel. By the early 90s, Sears was operating around 90 outlet

ores.

eedless to say, when Sears shut down its catalog operation in 1993, the companys need for outlet stores diminished considerably. Sears originally planned to close all of

outlet stores, but ended up keeping about 60 of them open. That number continued to shrink over the years, reaching 34 by the end of 2000. Over the same period, the

cus of the outlet stores shifted away from a balanced mix of Sears merchandise toward an emphasis on major appliances.

the mid-2000s, Sears came to realize that its outlet channel had actually shrunk too small for its new purpose, liquidating distressed major appliance inventory. At one

int, Sears had a backup of over 200 trailers of damaged appliance inventory. Sears was also incurring substantial transportation costs to move heavy, bulky appliances

om all over the country to the limited number of remaining outlet stores. Additionally, the company saw the opportunity for its outlet stores to serve as a liquidation

annel for the distressed inventory of appliance manufacturers as well as its own. Sears changed course and began to open new Outlet Stores, improving the chains


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ch showroom requires a net investment from SHO of about $100k ($125k for display inventory net of a $25k initial franchise fee). That modest investment yields SHO

out $240k of incremental annual operating income assuming the following:

$2.0 million average unit volume (2012 average)

25% gross margin (based on Hometown segment actual and appliance retailer average)

11.0% commission paid to franchisees (2012 average)

2.0% for marketing (per FDD)

other words, the after-tax return from a franchised Home Appliance Showroom is well over 100%. Reaching 500 locations would require around $50 million in capital and

ould generate more than $100 million in incremental annual operating income.

he appliance industry is poised for growth.

cording to a recent investor presentation by Whirlpool, appliance industry unit volumes are currently 15% below normalized levels and 25% below the 2005 peak. Major

pliance sales are driven by four primary factors: i) new home construction, ii) existing home sales, iii) remodeling activity, and iv) replacement of obsolete units. All of

ese factors are likely to lead to more normal levels of demand for appliances over the next several years.

Housing Starts Housing starts reached an estimated 923k units in 2013, up 18% from 2012. The SAAR reached 999k units in December 2013. A normalized levelof housing starts would be around 1.5 million units, 63% higher than the level achieved in 2013. Housing starts should continue to move towards a more normal

level over the next few years, driving demand for major appliances. That said, housing starts are likely a less significant driver of demand for major appliances

sold through the retail channel, so the implications of a recovery in housing starts for SHOs appliance sales are unclear.

Existing Home Sales Existing home sales were at a 4.87 million SAAR in December 2013 and came in at 5.09 million for all of 2013. Annual existing home sales

have averaged 4.4% of U.S. total households since 1989. That implies a normalized rate for existing home sales of about 5.3 million units, moderately above the

current rate.

Remodeling Market Index The RMI is prepared by the National Association of Home Builders. An RMI above 50 indicates more remodelers report activity is higher

compared to the prior quarter than report it is lower. In other words, it is a measure of the sequential change in remodeling activity, not the absolute level. The RMI

for the third quarter of 2013 came in at 57, the highest level since the first quarter of 2004 and only the fourth reading above 50 since 2005.

Leading Indicator of Remodeling Activity The LIRA is prepared by the Joint Center for Housing Studies of Harvard University. The most recently released LIRA

projects double-digit gains in annual home improvement spending for the first half of 2014, moderating to just under 10% by the third quarter.

Replacement The housing market boom of the mid-2000s drove appliance industry unit volumes to a peak level around 25% higher than the current level.

Appliances last around 10 years on average, so we are now entering the sweet spot of the replacement cycle for all of those units sold during the boom.

ears Outlet Stores are a good business that may have additional upside from unit growth and franchising.

ars Outlet Stores are a unique liquidation channel for distressed major appliance inventory. Although Outlets performance over the past several quarters has been soft

e tight supply of high-margin scratch and dent merchandise, its performance over the past three years has been relatively strong and consistent, generating high single

git operating margins and attractive returns on capital. Outlet has grown its store count by about 30% since 2010, though unit growth has slowed more recently. To the

tent SHO can rectify its recent sourcing challenges in the Outlet business, it may be able to expand the format further. SHO is also testing a franchise model for the

utlet format. If successful, franchising the Outlet stores would enable SHO to unlock additional value by recapturing invested capital while retaining a disproportionate

are of the economics of the business.

siders have bought stock at prices well above the current price.

nce SHO became a publicly-traded company, insiders have bought almost $500k worth of stock at an average price of about $40 per share. The highest price paid was

9 per share.

ate Name Position Shares Price Cost

/04/13 Jeffery Flug Director 2,000 $31.39 $62,780

/13/13 James Gooch Director 2,000 43.00 86,000

/10/13 Bruce Johnson CEO 3,000 49.02 147,060

/31/13 Bruce Johnson CEO 4,672 36.42 170,154

tal 11,672 $39.92 $465,994

he new, smaller format Sears Appliance & Hardware Store could become another growth platform if successful.

ars/SHO has failed on several different attempts over the past few decades to develop a successful hardware store format. From what we understand, the new hardware

rmat that the company is testing has not gotten off to a great start. Consumers just dont understand the concept yet. What products does a Sears hardware store carry

d why should I go there? While the odds of the hardware format turning into a growth vehicle are long, it could add a noticeable amount of value if successful.

rowing tangible book value should provide solid downside protection.

ngible book value was $18.41 per share as of November 2013. The company generated about $1.40 in pro-forma earnings per share for the last twelve months, so that

ure is growing at a decent clip. Tangible book value should exceed the current stock price at some point over the next few years.

ngible book value should provide solid downside support for the stock. Most of SHOs book value is tied up in readily saleable inventory, and SHO has substantially less

posure than a typical retailer to real estate and personnel-related liabilities due to its primarily dealership and franchise-based business model.

aluationgures in thousands, except per share

ures)

Low High

Hometown1 $300,000- $300,000

Home Appliance Showroom NPV2 500,000- 750,000

Outlet3 250,000- 350,000

Total Enterprise Value 1,050,000- 1,400,000

Add: Cash & Equivalents 21,487- 21,487

Add: Other Non-Operating Assets 0- 0


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Outlet Net Sales $432,171 $505,402 $564,343 $592,092

Outlet Operating Income, GAAP $39,093 $40,547 $42,135 $38,675

Less: Initial Franchise Revenues 0 0 0 (10,200)

Less: Stand-Alone Costs Adjustment (7,000) (7,000) (7,000) 0

Outlet Operating Income, Pro Forma 32,093 33,547 35,135 28,475

Less: Taxes 38.5% (12,356) (12,916) (13,527) (10,963)

Outlet NOPAT, Pro Forma $19,737 $20,631 $21,608 $17,512

do not hold a position of employment, directorship, or consultancy with the issuer.and/or others I advise hold a material investment in the issuer's securities.

atalyst

Value creation from showroom growth

mproved communication from the company

Sell-side analyst coverage

Market appreciation of showroom growth as it becomes more apparent (i.e. no longer offset by OSH-related closings)

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2014 01 28-Sears Hometown SHOS