Description

Executive Summary

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

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

More specifically, the market does not appreciate the growth potential of the company’s Home Appliance Showroom format.  Although the company only has 95 Home Appliance Showrooms currently, the format can grow to at least 500 locations, potentially many more.  The Home Appliance Showroom format is successful, has some distinct 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 areas 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 Appliance Showrooms under a franchised model, so the format generates phenomenal ROIC.  Growth anywhere near the level I expect should create a lot of value.

Background

SHO 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-branded specialty retail formats, Sears Hometown Stores, Sears Hardware Stores, Sears Home Appliance Showrooms and Sears Outlet Stores, under three ownership models, dealership, franchised and company-operated.

Appliances are SHO’s biggest business, accounting for about 2/3 of sales.  Appliances are one of the few merchandise categories in which the Sears brand remains relevant.  Sears is the leading appliance retailer in the U.S. with about 29% share of the market.  Lowe’s is second with about 19%, Home Depot is third with 12% and Best Buy is fourth with 8%.

Sears/SHO have a number of advantages in appliance retailing.  The Kenmore-brand is the most important advantage.  Kenmore is manufactured for Sears by Whirlpool, Electrolux, Samsung and LG.  Those companies incorporate additional features in Kenmore products and offer Kenmore products at a lower cost than they do their own brand products.  This enables Sears to offer better value for the money with its Kenmore brand relative to national brands.  Around 75% of Sears’s appliance sales are under the 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 commission-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.  The 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 confer some benefit.

Hometown Stores

The Hometown Store format was born out of the decision to shutter Sears’s main catalog, the “Big Book”, in 1993.  At the time, there were around 2,200 independently owned and operated Sears Authorized Catalog Sales Merchants, small locations in rural markets where people could go to browse the Sears catalog, get assistance placing orders, 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 merchants 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 retail presence in many of these smaller markets.  Sears converted less than 200 of the independent catalog merchants into what are now called Hometown Stores.

Hometown Stores are small format stores averaging 8,500 sq. ft. located outside of major urban areas.  They primarily offer hardline merchandise, including major appliances, tools, hardware and lawn & garden equipment, under both Sears brands and national brands.  In many cases, Hometown Stores are intentionally located near a Wal-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 support big box category killers, such as Home Depot, Lowe’s and Best Buy, but over the years these competitors have encroached to the point where about 2/3 of the Hometown Stores now face direct competition.

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

Sears opened Hometown Stores aggressively during the 90’s as part of its strategy to grow its off-mall, specialty formats.  The format grew from 192 locations at the end of 1993 to 790 locations at the end of 2000, a 22% CAGR.  While Sears’s strategic plan had been to reach 3,000 Hometown Stores, challenges finding capable owner-operators, difficulties finding appropriate real estate, and increasing big box competition have conspired to keep the total number of Hometown Stores below 1,000.  Since 2000, the number of Hometown Stores has grown in a “two-steps forward, one-step back” pattern to 925 as of November 2, 2013.

Hardware Stores

Sears has made several attempts over the years to build a national chain of free-standing hardware stores.  Its first push was in the 1980’s with a small, 5,000 sq. ft. format that 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 competitors or neighborhood hardware stores.  Sears continued to operate the stores it had opened, but killed plans for further expansion.

Arthur Martinez, Sears’s first outsider CEO, reinvigorated the idea in the mid-90’s.  Learning from its mistakes, Sears expanded the format to 20,000 sq. ft. and aimed to offer 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 more productive and profitable than Sears’s own hardware stores.  At the time, Sears thought it could ultimately have as many as 500 hardware stores across the nation.

But 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 productivity.  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 hardware 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 poor locations.

Over the course of the mid-2000’s, Sears implemented a variety of initiatives to improve the performance of the Hardware Stores.  It detached the hardware store chain’s pricing 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 the assortment of hardware and brought in appliances to improve productivity.  It also closed many poorly-performing locations as leases expired, bringing the number of Sears 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 profitability.

The 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 model for the Hometown Stores.

In 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 better financial results and reinvigorate the chain’s growth potential.  The first prototypes were opened in Dallas, TX, Big Rapids, MI and Cedar City, UT.  The new format ranges 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 similar to that of an Ace Hardware or True Value.

Home Appliance Showrooms

Sears launched the Home Appliance Showroom format in the Houston metropolitan area in 2007.  The strategy is to leverage Sears’s greatest strength, major home appliances, 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-Line Store.  The format aims to compete with Home Depot, Lowe’s and Best Buy by offering a broader and higher-end assortment of appliances, including Kenmore-branded appliances; better service, a more convenient location and shopping experience; and more aspirational merchandise presentation.

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

Outlet Stores

Sears has operated outlet stores in one form or another since at least the 1970s.  Outlet stores complemented Sears’s catalog operation well, because liquidating discontinued, overstocked, returned and damaged merchandise through a catalog presents many challenges, such as inflexible prices, long catalog production lead times, non-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-back guarantee only compounded those challenges and heightened the need for a company-operated liquidation channel.  By the early 90’s, Sears was operating around 90 outlet stores.

Needless to say, when Sears shut down its catalog operation in 1993, the company’s need for outlet stores diminished considerably.  Sears originally planned to close all of its 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 focus of the outlet stores shifted away from a balanced mix of Sears merchandise toward an emphasis on major appliances.

By the mid-2000’s, Sears came to realize that its outlet channel had actually shrunk too small for its new purpose, liquidating distressed major appliance inventory.  At one point, Sears had a backup of over 200 trailers of damaged appliance inventory.  Sears was also incurring substantial transportation costs to move heavy, bulky appliances from 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 channel for the distressed inventory of appliance manufacturers as well as its own.  Sears changed course and began to open new Outlet Stores, improving the chain’s profitability in the process.  The format has now grown to 131 stores, representing a 14% CAGR since the end of 2007. 

Inventory availability is a key constraint on the format’s ultimate growth potential, and the company is facing some issues on that front.  New store openings have slowed, and profitability has deteriorated over the past few quarters due to lower availability of high-margin scratch and dent merchandise.  On one hand, the availability of scratch-and-dent appliances should benefit from a recovery in appliance industry unit volumes to more normalized levels.  More appliances being moved around means more appliances getting damaged.  On the other hand, the Outlet Stores are particularly reliant on sourcing scratch and dent merchandise from Sears, and Sears's appliance business – presumably including the scratch and dent merchandise it generates – has been declining despite recovering appliance industry unit volumes overall.

Key Points

The Home Appliance Showroom format has a huge runway for growth.

SHO plans to use the Home Appliance Showroom format for two purposes: i) to in-fill markets in areas that are not well served by an existing Sears full-line store, and ii) to recapture the appliance business from Sears full-lines stores that close.  Between these two sources of growth, the Home Appliance Showroom format should be able to grow to at least 500 locations.

The Houston metropolitan area, the most developed market for the Home Appliance Showroom format, provides a window into the potential to in-fill existing markets.  Sears opened its first Home Appliance Showroom prototypes in the Houston market.  SHO now has 12 showrooms in the market that complement 12 full-line stores.

Houston is a microcosm of Sears’s challenges in markets across the nation.  Over the years, Sears has lost share of outlet as Home Depot, Lowe’s and Best Buy have expanded aggressively in off-mall locations close to suburban population centers.  Lowe’s and Best Buy each have more than twice as many locations in the Houston market as Sears has full-line stores.  Home Depot has four times as many.  Despite Sears’s real advantages in appliance retailing, there is only so far a customer will drive and only so many competitors a customer will pass to shop for appliances at Sears.  Prior to opening showrooms in the market, many Home Depot/Lowe’s/Best Buy locations would be 10-15 miles or more away from the nearest Sears location.  Sears was at a distinct disadvantage being so far away.

In the Houston market, SHO basically identified the appliance retailing centers of gravity created by Home Depot/Lowe’s/Best Buy locations where Sears didn’t have an effective presence, and opened a Home Appliance Showroom right in the mix.  The Home Appliance Showrooms can compete effectively with Home Depot/Lowe’s/Best Buy by offering a broader selection, better service, a more convenient shopping experience, and superior merchandise presentation.

The opportunity to use the Home Appliance Showroom format to in-fill existing markets as SHO has done in Houston implies a large growth opportunity nationwide.  Home Depot and Lowe’s each operate almost 2,000 locations in the U.S. compared to less than 800 Sears full-line stores.  If we more specifically look at the ratio showrooms to relevant appliance retailing outlets in the Houston market, we get to an implied potential of 500-700 Home Appliance Showrooms nationwide from in-filling existing markets.

And in-filling existing markets is only one part of the strategy for the format.  The other part of the strategy is to use the format to recapture appliance sales from Sears full-line stores that close.  When a full-line store closes, SHO can typically recapture 40-60% of the appliance business of the closed store by opening a new Home Appliance Showroom in a nearby location.  A typical full-line store will do around $7 million in appliance business, so a Home Appliance Showroom that replaces an average full-line store will do $3 million to $4 million in volume, well above the average for the format of around $2 million.  In some cases, more than one Home Appliance Showroom may be opened to replace a full-line store. 

There are currently 785 full-line stores nationwide, down from over 900 a few years ago.  These stores are losing money as a whole.  Many believe the Sears full-line store format is fundamentally broken and unfixable.  Sears recently announced along with disappointing results for the fourth quarter that it would “continue to reduce unprofitable stores as leases expire and in some cases accelerate closings when circumstances dictate.”  It is a safe bet that many more, if not all, full-line stores will close over the coming years.  The opportunity for showrooms to replace full-line stores that close should add a few hundred locations to the 500-700 locations that can be opened as in-fill complements to existing full-line stores.

We have confirmed the magnitude of the growth opportunity for the Home Appliance Showroom format with a number of sources.

SHO is already accelerating the growth of the format.  SHO disclosed in the most recent Franchise Disclosure Document for the Home Appliance Showroom format that it planned to open 42 new franchised showrooms and 4 new company-operated showrooms in 2013.  That would represent over 50% growth in the store count for the year.  While the total number of showrooms in operation has increased by only 10 through the first nine months of 2013, that is net of 21 locations that were closed as a result of Orchard Supply’s bankruptcy proceeding.  On a gross basis, SHO has opened 31 showrooms through the first nine months of fiscal 2013, and appears to be roughly on track with the expansion plan laid out in the FDD.

Franchised Home Appliance Showrooms generate phenomenal returns for SHO.  Growth of the format should create a lot of value.

Each 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 about $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)

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

The appliance industry is poised for growth.

According to a recent investor presentation by Whirlpool, appliance industry unit volumes are currently 15% below normalized levels and 25% below the 2005 peak.  Major appliance 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 these 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 level of 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 SHO’s 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-2000’s 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.

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

Sears Outlet Stores are a unique liquidation channel for distressed major appliance inventory.  Although Outlet’s performance over the past several quarters has been soft due 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 digit 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 extent 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 Outlet format.  If successful, franchising the Outlet stores would enable SHO to unlock additional value by recapturing invested capital while retaining a disproportionate share of the economics of the business.

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

Since 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 $49 per share.

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

Sears/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 format that the company is testing has not gotten off to a great start.  Consumers just don’t understand the concept yet.  What products does a Sears hardware store carry and 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.

Growing tangible book value should provide solid downside protection.

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

Tangible book value should provide solid downside support for the stock.  Most of SHO’s book value is tied up in readily saleable inventory, and SHO has substantially less exposure than a typical retailer to real estate and personnel-related liabilities due to its primarily dealership and franchise-based business model.

Valuation

1)      Valued at estimated tangible invested capital.  See Appendix A.

2)      DCF value of incremental showrooms.  See Appendix B.

3)      Low: 7.0% yield on LTM Pro Forma NOPAT / High: 6.0% yield on 3-year average Pro Forma NOPAT.  See Appendix D.

Key Risks

• SHO is still heavily reliant on Sears in a number of ways and will be for the foreseeable future.  While SHO benefits from Sears gradually closing stores, SHO would be hurt if Sears’s decline became more disorderly.  Additionally, Eddie Lampert has implemented a Lord of the Flies management structure at Sears (http://www.businessweek.com/articles/2013-07-11/at-sears-eddie-lamperts-warring-divisions-model-adds-to-the-troubles).  This has created friction between even internal parts of Sears.  Similarly, there has been some documented friction between SHO and Sears since the separation (See Appendix #1 & #2 - http://www.sec.gov/Archives/edgar/data/1548309/000154830913000077/ex104-supplementalagreement.htm)
• The success of the Home Appliance Showroom is intricately tied to the Kenmore brand.  If the Kenmore brand and Kenmore products were to diminish in competitiveness, the Home Appliance Showroom business would be negatively impacted. 
• High-margin, scratch and dent merchandise drives the profitability of the Outlet segment.  Most of that merchandise comes from Sears.  If Sears’s appliance business continues to shrink, it will generate less and less scratch and dent merchandise.
• SHO needs to attract a sufficient number of capable franchisees in order to grow the Home Appliance Showroom format.

Catalyst