SEARS HOMETOWN & OUTLET STR SHOS
October 26, 2012 - 1:10am EST by
85bears
2012 2013
Price: 33.50 EPS $3.20 $0.00
Shares Out. (in M): 21 P/E 10.5x 0.0x
Market Cap (in $M): 770 P/FCF 10.0x 0.0x
Net Debt (in $M): 100 EBIT 126 0
TEV (in $M): 870 TEV/EBIT 6.9x 0.0x

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  • Spin-Off
  • Analyst Coverage
  • Retail
  • Brand

Description

SHOS is a mispriced spinoff that has compelling risk/reward.  The stock has 15%-50% upside to trade to reasonable multiples once the true pro forma financials become more clear.
 
There are a several reasons that Sears Hometown is mis-priced:
- it is a spinoff
- it comes from Sears, a company that few investors follow anymore, and most that do follow SHLD, hate it (probably justifiably)
- it has no research coverage
- the financial disclosure is limited
- the company has changed its business model to a franchise model
- the overall Sears franchise has continued to produce horrible operating results for most of the last decade
- the company provided unrealistically low financial projections
 
And, there are good reasons to think the situation is compelling:
- it is cheap
- the financial model is being de-risked with the conversion of Hometown to a franchise model
- the main brands - Craftsman, Kenmore, Diehard - are still well known and respected
- the business has leverage to the housing cycle
- ESL appears to be using this entity to salvage part of its investment in Sears/Kmart
- ESL invested $215m of new equity to capitalize this entity
- the company is already far in excess of its plan
- SHOS is conservatively capitalized
 
Background:
Sears spun off Sears Hometown and Outlets in a rights offering in September to holders of Sears stock.  Each holder of Sears was given a right to purchase SHOS at $15/share.
 
The company operates in 2 segments:  Sears Hometown and Hardware and Sears Outlet.
 
Sears Hometown and Hardware sells national brand appliances, tools, lawn and garden equipment, sporting goods, consumer electronics, and household goods.  It operates over 1,100 stores consisting of 944 Sears Hometown stores which are smaller versions of Sears stores located mostly in metropolitan areas with <50,000 people, 96 Sears Hardware stores that are basically like Ace Hardware stores, and 76 Sears Appliance Showroom stores located mostly in larger metropolitan areas.  SHOS has transitioned this segment from primarily company owned stores to franchise stores that are independently run.  Approximately 55% of sales are appliances, another 20% is lawn and garden product, and another 15% is tools.
 
Sears Outlet sells new and out-of-box, dented, obsolete, reconditioned products at a discount to standard retail price in 122 stores.  Over 80% of sales are appliances.
 
Capitalization:
After the rights offering and a $100m draw on an ABL facility, the capital structure is:  23.1m shares outstanding and $100m of gross and net debt.  At the recent price of $33.50, this gives $770m of market cap and $870m of enterprise value.
 
Historical financials:
The business has demonstrated remarkable consistency in revenue - basically flat at $2.3b since 2007, but has had somewhat mixed performance in EBITDA.  The revenue through 2011 had 2 offsetting trends, weakness in Sears Hometown, which declined low single digits, offset by strength in Sears Outlet which has been growing at 10%+.  Outlet revenue grew from $395m in 2009 to $505m in 2011.  EBITDA grew from $39m to $46m over that period.  LTM revenue and EBITDA at Outlet as of July was $537m and $49m.  Hometown revenue shrank from $1.94b to $1.84b from 2009-2011 and EBITDA fell from $70m to $35m over that same period.  Part of the decline in revenue and EBITDA was from store closures in 2011.  The Hometown model has recently changed from company owned and operated stores to franchise operations where independent local management runs store operations and pays for rent but Hometown provides inventory management on a consignment basis.  This has increased reported EBITDA and capex as rent has been effectively transferred.  LTM revenue and EBITDA were $1.86b and $64m.
On a comparable store basis, outlet has been generating positive comps since 2008.  Howetown however, has produced negative MSD comps consistently since 2008.  However, that ended in Q1 2012 and comps have been flat for the first 2 quarters this year.
 
Projected financials vs PF financials:
As part of the rights offering, SHOS got a fairness opinion from Duff and Phelps to evaluate a fair price for the rights and valuation for the company.  SHOS provided projections to Duff through 2014.
SHOS projected 2012 revenue and EBITDA of $2.48b and $85m increasing to $2.7b and $100m by 2014.  However, on an LTM basis, the company is already running at $2.4b of revenue and $113m of EBITDA.
The improvement in EBITDA has come mostly from Hometown.  On a PF basis, giving a full year benefit to the change in operating model, Hometown is now running between $85-90m of EBITDA on its own (vs the projections given for $85m for all of SHOS) and the full SHOS is running at $130-140m of EBITDA which is 30-40% ahead of their 2014 projections from just a few months back.
One potential reason for such a big disparity between PF financials and the projections given to Duff was that the lower projections lowered the overall valuation for the spinco, and thus lowered the price of the rights.  This value benefited holders of SHLD at the time of the rights offering.
 
Valuation:
Given the PF financials, SHOS now trades at very compelling multiples of EBITDA, earnings and free cash flow.
Assuming $135m of PF EBITDA, $9m of D&A, $3m of interest on the $100m of borrowing (L+200-250), and 40% tax rate, produces $3.20 of EPS and $3.30 of FCF/share.  So at the current price, you can buy SHOS at 10% FCF yield, 6.5x EBITDA, 6.8x EBITDA-capex, and 10.5x eps.
 
Comparables:
The company lists appliance and hardware comparables as HD, LOW, and CONN.  Comps to discounters are DLTR, DG, FDO, FRED, ROST, TJX.  The appliance comps trade at ~9-11x EBITDA and 17-20x eps.  The dollar stores trade at 8-9x EBITDA and 15-16x eps.  The discounters trade at 8-9x ebitda and 17x eps.
 
Price Target for SHOS:
Applying a discount of 7x EBITDA and 12x eps gets a price target of $37-38/share or 10-15% upside.  These are very large discounts to the group.  This would be ~8.5% FCF yield.
At the low end of the group trading range of 8x EBITDA and 15x eps, SHOS would trade at $42-48/share or 25-40% upside.  This would be about a 7% FCF yield.
At the middle of the group range of 9x EBITDA and 16x eps, SHOS would trade at $48-51/share or 45-55% upside.  This would also be ~6.5% FCF yield.
 
Given the transition in the model on Hometown to more of a franchise model, the business should ultimately command a better multiple.
Also, given the exposure to appliance, lawn and garden, and tools, the business should benefit to the extent that housing recovery continues as there is clear leverage to the housing cycle.  It is reasonable to argue that the business should not be given trough multiples on trough earnings power.  It is hard to figure out what mid-cycle earnings power is though.
 
Risks:
The biggest risk in the business is the uncertainty around the relationships with Sears and the Sears brands.  However, given that ESL has invested new capital into SHOS and this appears to be a mechanism to extract value from SHLD, those risks appear to be limited in the near- to mid-term.
 
There is operational risk around the transition in model in Hometown, and stabilization or growth in that segment may not continue.  Again, "new" management, renewed focus on the business, and a housing tailwind may argue for strong growth.
 
Limited financial history and disclosure. 
 
SHLD bankruptcy.  That is a risk, but SHLD is in the process of monetizing assets to provide itself liquidity.
I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

Financial results clarify PF financial position
 
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