Don’t Short Sears Hometown… Yet!

Eddie Lampert of ESL Investments the major holder of SearsSears Holding’s (SHLD) latest spin-off, Sears Hometown and Outlet (SHOS), starts to trade tomorrow. Based on the subscription rights price, it is expected to trade in the high 20s. I originally wrote an article back in September advising investors to stay away from SHOS.

 

However, avoiding does not necessarily mean shorting it. In the short term, SHOS could go higher because:

  • It is profitable.
  • It is cheap by a lot of valuation measures. 
  • It earned $1.80 in the first half of this year. It will trade at less than 10 times this years earnings. A lot of value investors will be fooled by these numbers.
  • There are still 60 company owned stores. Let me explain.
As I mentioned in my original article, SHOS profitability rose due to huge margin improvements. Part of that margin improvement was due to the conversion of company owned stores to franchisee operated stores. The franchisee operated stores have to pay an initial franchisee fee of $25,000 and also have lower occupancy costs.
 
Here is the numbers breakdown for Hometown and Hardware Stores and Home Appliance Showrooms for last 2 quarters:
 
Hometown and Hardware stores and Home Appliance Showrooms
 Figure 1: Number of Hometown and Hardware Stores and Home Appliance Showrooms
 
 The company owned stores went down from 85 to 60 in the last quarter, while the franchisee operated stores went up from 86 to 104. The 941 independently owned and operated stores are all Sears Hometown stores and are not available to be converted to franchisee stores. However, the good news for SHOS is that there are still 60 company owned Hardware Stores and Home Appliance Showrooms which are available to be converted. This will at least keep margins flat in the near term.
 
However, what happens when there are no more stores left to convert? Margins will slide as the negative business fundamentals catch up with the company!
 
My advice is to avoid SHOS in the near term because there are catalysts that will drive the share price higher. However, with every quarterly report watch the number of company owned stores. When it reaches close to 0, think about shorting this stock!
 
Disclosure: I do now own SHLD or SHOS. I am short OSH.