Avoid Sears Spinoff

Sears Holdings Corporation (SHLD), a HypeZero recommendation, in order to raise capital and focus on its main business is spinning of yet an another business, Sears Hometown and Outlet (SHOS). (Read our article on its last spinoff, Orchard Supply Hardware (OSH)).

Business

Sears Hometown and Outlet operates two segments: Sears Hometown and Hardware and Sears Outlet. Sears Hometown and Hardware, the larger of the two with 1,105 stores, sells “national brands of home appliances, tools, lawn and garden equipment, sporting goods, consumer electronics and household goods, depending on the particular store.” The Outlet segment with 123 stores sells “new, one-of-a-kind, out-of-carton, discontinued, obsolete, used, reconditioned, overstocked and scratched and dented products, including home appliances, lawn and garden equipment, apparel, mattresses, televisions, sporting goods and tools at prices that are significantly lower than manufacturers’ suggested retail prices.”

Spinoff

For each Sears share held, investors received a subscription right (SHOSR) that would allow them to purchase 0.218091 of a share of SHOS common stock at $15/share. So you would need ~4.59 (1/.218091) subscription rights and $15 to purchase 1 share of SHOS. Currently, SHOSR is trading at $2.33. So, you would expect SHOS to start trading at 4.59*$2.33 + $15 = $25.7/share.

Holders of SHOSR have until October 8 to exercise the subscription right. If the offering is fully subscribed, Sears expects to raise $446.5 million (23.1 million shares*$15/share + $100 million SHOS will pay to Sears).

Valuation

Sears provided the latest quarterly report for SHOS. A cursory read of the report point to a great deal for investors:

  • For the 26 weeks ended July 28, 2012, revenues are up over 4% and net income is up over 100% to $41.66 million or $1.80/share. If SHOS earns $3.60 for this fiscal year, it would trade a P/E of a little over 7 at the current subscription rights price.
  • Other valuations measures such as sales per share ($100+/share) seems to indicate that SHOS is cheap compared to its peers. 
  • ESL Investments (Eddie Lampert), Sears biggest shareholder, has said that it fully intends to exercise its subscription rights. “In addition, ESL has indicated to Sears Holdings that it intends to exercise its over-subscription privilege in full, such that it will purchase the maximum number of shares allocated to it under the oversubscription privilege.”
Lipstick On A Pig
 
However, a closer look reveals that:
 
  • From 2007 to 2011, comparable store sales have been down every year.
  • From 2007 to 2011, total store sales have been flat to slightly up due to an increasing store count.
  • From 2009 to 2011, the gross profit margin rate and net income have been down every year.   

So, what happened in the first 2 quarters of 2012? Why the triple digit increase in net income?  The simple answer is that the increase in net income came from substantial improvements in the gross profit margin rate. The margin rate increased in 2012 to 25.2% from 21.6%. 

Sears explains the dramatic margin improvements: “The 360 basis point increase in gross margin rate was primarily driven by lower occupancy expenses from the conversion of company-operated stores to franchisee-operated stores, initial franchise fees, lower free-delivery promotional expense, better inventory management, and a higher balance of sales in higher margin categories”. 

It is interesting that the first few reasons for the significant margin improvements are from converting company-operated stores to franchisee-operated stores. It is not a coincidence that they waited until they were spinning off the company to do this conversion and thus, improve profitability. 

Another reason that profitability improved is the $15 million charge it took in 2011 to close 84 under performing stores. This has two effects:

  • The net income in 2011 is lower. Thus, the 2012 net income will look better.
  • As it closed underperforming stores, the profit margin rates, and comparable store sales improved in 2012.  

It seems Sears is trying to fool investors into thinking the underlying fundamentals of the company are improving when they clearly are not. In addition, the following costs have not been taken into account in the income statement:

  • There will be an “additional annual operating charges are estimated to be approximately $8.0 million to $9.0 million” from being a public company.
  • “One-time information technology costs related to the separation to be approximately $6.0 million to $7.0 million.”
  • Interest expense from the $100 million borrowed from the Senior ABL Facility in order to pay Sears.
If you add to the fact that $167 million of SHOS’s equity is not tangible, it operates in one of most competitive industries, and it is heavily dependant on Sears, you have a multitude of reasons to avoid the spinoff of Sears Hometown and Outlet.

Disclosure: I do not own shares of SHLD or SHOSR and I do not plan to initiate a position within the next week. 

4 thoughts on “Avoid Sears Spinoff

  1. What are your thoughts about them converting more of their stores to the franchise model, thus effectively changing their business model from that of a low return, highly cyclical retailing operation to a much more stable, recurring and predictable revenue stream common with franchise operations?

    • It will work for a little while, but not for long run. Also, most of their stores are already run as franchise model. So, they don’t have much to convert. Fundamentally, they are in a super competitive marketplace and as comps continue to go down there will be margin pressure. So, I would not be surprised if stock goes up initially, but then slows goes down as profit continues to decrease.

      • At first glance that is what I thought. However, when looking at their most recent prospectus, about 85 of 150 hardware stores are run as a franchise model, while the remaining 900+ hometown stores are all dealer based models. Whats weird is that I cannot find any difference between the dealer and franchise based model, in terms of how they would affect sears at the operating level. Another weird thing is that the company has only committed to transferring the remaining stores in their hardware segment to that of the franchise model, which would only amount to about 75 remaining stores, and none of the 900+ hometown stores, which would provide tremendous potential..

        • Where do you see that the company has committed to transferring the remaining stores in the hardware segment to the franchise model?

          Also, when they take about gross margin improvement they always talk about converting company owned stores to franchise stores. I have
          not see where they talk about converting dealer to franchise stores.

          I also looked to see if I could find a difference between dealer and franchise and I could not. Interesting. Let me know
          if you find anything else.