Sears Spinning Off Sears

| About: Sears Holdings (SHLD)
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Sears Holding Corporation (NASDAQ:SHLD) has been through a tumultuous year. In the past 52 weeks, the stock has traded below $30/share to above $85. Whether you believe in Eddie Lamperts and Bruce Berkowitz's asset valuations or not, Sears has been in the process of raising cash and cleaning up its business. This has included spinning off Orchard Supply Hardware (OSH) stores, planning to reduce their stake in Sears Canada (NYSEARCA:SCC), and now spinning off Sears Hometown and Outlet (NASDAQ:SHOS) stores.

I believe, due to the structuring of the spinoff and the fundamentals of the underlying business, Sears Hometown and Outlet should be considered as an investment.

Sears Hometown and Outlet operates in two segments: Sears Hometown and Hardware segment and Sears Outlet segment.

From the prospectus:

Our Sears Hometown and Hardware segment's stores are designed to provide our customers with instore and online access to a wide selection of national brands of home appliances, tools, lawn and garden equipment, sporting goods, consumer electronics and household goods, depending on the particular store. Our Sears Outlet stores are designed to provide our customers with in-store and online access to purchase new, one-of-a-kind, out-of-carton, discontinued, obsolete, used, reconditioned, overstocked and scratched and dented products, collectively, 'outlet-value products,' across a broad assortment of merchandise categories, including home appliances, lawn and garden equipment, apparel, mattresses, televisions, sporting goods and tools, and at prices that are significantly lower than manufacturers' suggested retail prices.

The main reason for the spinoff? Additional capital for Sears Holdings and a more focused business for each company. The use of a rights offering also allows full subscribers to avoid dilution by retaining the same percentage ownership in the two companies. If the rights offering is fully subscribed, $446.5 million will be raised for Sears Holdings ($346.5M will be raised in subscriptions, along with $100M from Sears Hometown and Outlet funded by new debt). If the rights do not end up being fully subscribed, Sears Holdings will hold the remaining shares.

Some reasons while certain investors will not be interested in exercising their rights (and thus either selling their rights or letting them expire):

  • Sears Holding has an Enterprise value around $8B. Sears Hometown and Outlet's EV will be around $400M. Certainly some investors will have no interest in buying a smaller market capitalization stock.
  • Sears Holdings has 106.5M shares outstanding, but since Eddie Lampert holds 62% of it, the actual float is much smaller. With only 23.1M shares of Sears Hometown and Outlet available and ESL holding at least 60% of it, the float will be significantly too small for certain investors to create a sizeable position.
  • The transaction complexity along with the lack of coverage could automatically disinterest investors.

Eddie Lampert's investment vehicle, ESL, currently owns 62% of Sears Holdings. ESL has given notice that it will exercise the option to fully oversubscribe to the rights offering if possible. ESL will own at a minimum 60% of SHO, and potentially much more.

From yesterday's press release, each Sears Holding share will receive one right, with one right being entitled to purchase 0.218091 of a share of Sears Hometown and Outlet. The subscription price is $15. Therefore with approximately 4.5 rights + $15 cash, you purchase one Sears Hometown and Outlet share. The rights (SHOSR) currently trade on the NASDAQ.

How was the $15 subscriptions price decided upon?

From the prospectus,

In determining the subscription price, the board of directors of Sears Holdings considered, among other things, (1) the opinion of Duff & Phelps, (2) the desirability of broad participation in the rights offering by Sears Holdings' stockholders and of the development of a trading market for both the subscription rights and the SHO common stock and (3) Sears Holdings' liquidity needs and the aggregate amount of proceeds to be paid to Sears Holdings pursuant to the dividend and the rights offering if the rights offering were fully subscribed.

To me, "the desirability of broad participation in the rights offering by Sears Holdings' stockholders" is the key. To raise the much needed capital for Sears Holdings, by definition of a rights offering, people must be willing to exercise their rights and invest in Sears Hometown and Outlet at $15/share (Note, must add rights price to the $15 cash to get the true cost per share).

How does the $15/share price stack up?

The first noticeable difference between the two businesses is that Sears Hometown and Outlet actually makes a profit. In fact, it has been profitable in each of the last 3 years, with gross and net margins holding around 23% and 3% respectively. In the first 2 quarters of this year alone, Sears Hometown and Outlet has produced $1.80 a share in Net Income. Based on Sears Hometown and Outlet pro forma statements in the prospectus, it has a book value of $19 a share and a net tangible value of $12 share. While sales have remained flat over the three years, I expect that could change as management comes in focused solely on this business (Sears Hometown and Outlet represented only 6% of Sears Holdings total 2011 sales).

Over the last three years, Sears Hometown and Outlet have averaged $101 in sales per share. If we were to assume a Price/Sales similar to the specialty retail industry (P/S 0.5), the share price could be valued much higher. There are many different criteria to consider when valuing a company (dividend yield, revenue growth, EBIT/EV, etc.), and Sears Hometown and Outlet is considerably smaller than most of the competition (Home Depot [HD], Lowes [LOW], etc.). That being said, l still think Sears Hometown and Outlet is attractively priced.

Management is staying familiar. Bruce Johnson, the former interim CEO of Sears will be the chief executive and president of Sears Hometown and Outlet Stores once the business is spun off. Considering his intimate knowledge and relationship with Sears in the past, I see it as a positive sign that he has chosen to lead the business. With 4M shares (according to prospectus) reserved for issuance under the employee stock plan, it is possible he will well motivated to improve Sears Hometown and Outlet's share price.

With Sears Holdings desperate for cash, ESL communicating its decision to fully oversubscribe, and Sears Hometown and Outlet being profitable, I believe this is an opportunity worth investigating.

Disclosure: I currently have no positions in any stocks mentioned, but I may go long Sears Hometown and Outlet rights (SHOSR), trading on the Nasdaq. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.