One of the opportunities of creating value for the Sears shareholders is to unload some of the assets buried on the balance sheet. How many investors that owned the stock last year even knew about the Orchard Supply Hardware Stores (OSH) stores or these spin-off properties? All of these assets have been buried and under appreciated for a long time.
As mentioned, this is the third part of a series. Previously, the first part focused on the highlights of Q2 earnings while the second part focused on the case study prepared by Bruce Berkowitz and Fairholme Funds.
Sears Hometown and Outlet Stores
Sears originally announced (see all spin-off documents here) in late February the intention to spin-off the Hometown and Outlet stores with the plan of selling subscription rights in order to raise around $450M for the company.
This division is a national retailer primarily focused on selling home appliances, hardware, tools and lawn and garden equipment. The Hometown segment consists of 944 Hometown stores, 96 Hardware Stores, and 76 Home Appliance Stores. The Outlet segment consists of 122 Outlet Stores.
Just last week, Sears announced that shareholders of record as of the close of business on September 7, 2012 would be distributed the subscription rights. The actual distribution date has yet to be set.
Details of this spin-off:
- One transferable subscription right for each share of Sears Holdings common stock held.
- The exercise price of the subscription rights will be $15 per whole share of Sears Hometown.
- Subscription rights are transferable and expected to be listed on the NASDAQ under the symbol "SHOSR".
- Sears Hometown expects to list its stock under the symbol "SHOS".
- Sears Hometown currently expects to draw $100M under the new credit facility to pay a cash dividend to Sears Holdings.
- In total, Sears Holdings will receive $446.5M in gross proceeds from the transaction.
Confused yet? The company has created this transaction in order to obtain cash from the spin-off. Not a bad idea considering the feared cash issues at the parent company as 2012 started. What it also does is provide for a confusing transaction that the average investor doesn't have the time to understand.
One interesting part is that Eddie Lampert's investment partnership, ESL Investments, expects to fully participate in the transaction. The ability to fully participate and purchase additional shares also sounds like a move to allow his partnership to benefit from any shareholders not exercising rights. Maybe that is just my skeptical nature.
The deal comes down to whether investors view the Sears Hometown stock as worth $15 or more. Shareholders might be able to sell the rights for a fair value prior to the exercise date, but otherwise to obtain full value the rights will need to be exercised. Ultimately, ESL wouldn't agree to exercise the rights if the price wasn't favorable.
Sears Hometown And Outlet Stores Q2 2012 Highlights
The most surprising part about the deal is that this new company has consistently been profitable. At the listed 23.1M shares outstanding, Sears Hometown had profits of $0.89 on $621M in sales during Q1. The earnings were nearly triple that of Q1 2011 when the company only earned $1.43 for the full year.
Highlights for Q2 earnings per page 60 of the prospectus:
- Net sales of approximately $645 million for the second quarter of fiscal 2012 as compared to approximately $630 million for the second quarter of fiscal 2011.
- Comparable store sales decrease of 1.2%, decrease of 0.7% at Sears Hometown and Hardware stores and 3.3% at Sears Outlet, in the second quarter of fiscal 2012 driven primarily by declines in lawn and garden due to drought conditions experienced throughout the country partially offset by an increase in appliances due to increased inventory in large capacity refrigeration.
- Gross margin rate of approximately 25% for the second quarter of fiscal 2012 as compared to approximately 22% for the second quarter of fiscal 2011.
- Net income of between $16 million and $21 million for the second quarter of fiscal 2012 as compared to $10 million to $12 million for the second quarter of fiscal 2011.
At the upper range, the income would be comparable to Q1 or around the $0.89. At the low end, the company will have made at least $1.50 for the 1H of 2012.
The company was also profitable back in 2009 suggesting this slimmed down concept focused on appliances and tools works better than the full-line Sears stores with an expanded apparel offering.
What appliance customer wants to go to the local mall? That just isn't the Sears customer base, nor is it convenient to make a major purchase at the most crowded place in a city.
The annual revenue base now exceeds $2.35B with positive comps for the Outlet stores while the Hometown stores have mostly been negative.
The store base has grown to 1,238 stores in Q1 2012 from 1,166 in 2009.
Based on the revenue base and the 1H 2012 profits, the valuation the subscription price places on the stock of $346.5M appears low.
While the Hometown spin-off transaction is complex, the Sears Canada is more straight forward to understand. Sears owns approximately 95% of the company and plans to reduce ownership to 51%.
What makes this transaction easier to follow is that the spin-off company already trades on the Toronto Stock Exchange and has independent financials already reported.
At a valuation of $1B, the spin-off of this company is worth paying attention.
With similar shares outstanding, investors should assume an approximate 2-for-1 deal considering only 44% of the Sears Canada shares are being distributed to shareholders.
While the deal will help the liquidity of the existing shares, it remains unclear how any real value will be created from this deal. Sears will not obtain cash from the transaction and it remains a question whether this will help push both shares higher.
Sears Canada Q2 2012 Highlights
The company reported the following highlights for Q2:
- Total revenues for the 13-week period ended July 28, 2012 were $1.050 billion compared to $1.148 billion for the 13 weeks ended July 30, 2011, a decrease of 8.5%.
- Same store sales decreased 7.1% over the same periods.
- The net loss for the second quarter was $9.8 million or 10 cents per share compared to a net loss of $0.2 million or nil earnings per share for the 13-week period ended July 30, 2011.
- Adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization and Non-Operating Activities) for the quarter this year was $17.8 million versus $30.0 million in the same 13-week period last year.
Clearly one benefit to the spin-off will be greater focus on the Canadian stores that are starting to suffer larger losses than the domestic ones. With comp sales down 7.1%, Sears Canada has quickly dropped from a top performer just a few years back.
With over $2B in sales for the first half of the year, this operation clearly has scale worth turning around.
These spin-offs provide ways to get more value from Sears Holdings. Questions will remain on whether a true separation of these businesses will be effective while growing pains will persist.
Both Sears Canada and Sears Hometown will be reliant on Sears for the major brands for sales. In fact, Hometown gets 90% of revenue from the Kenmore, Craftsman, and DieHard brands suggesting that future sales for them could be reduced if the company eventually expands by selling other brands. Conversely, the Hometown stores are restricted from growth where full-line stores exists suggesting future growth could be constrained.
All of these issues highlight the inherent problems with supporting major brands limited to company stores. These spin-offs will move Sears closer to the separation of the brands from the stores. In fact, the earnings results of the Hometown and Outlet stores further highlight how the full-line store concept might be better focused on leasing or selling the valuable real estate rather than hawking the Kardashian Kollection.
Ultimately these spin-offs should unlock value of under appreciated assets.