Sears Holdings Corporation (SHLD), a HypeZero recommendation, is spinning off yet another business, Sears Hometown and Outlet (SHOS), in order to raise capital and focus on its main business . (Read our article on its last spinoff, Orchard Supply Hardware (OSH)).
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."
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).
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 Sears waited until it was 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 dependent on Sears, you have a multitude of reasons to avoid the spinoff of Sears Hometown and Outlet.