Sears Hometown and Outlet Stores (NASDAQ:SHOS)

Sears and Growth? —Not As Surprising As You Might Think
Newly spun off division of Sears, Sears Hometown and Outlet (SHOS), promises to be a high-growth value stock.
Business Overview
SHOS operates through two segments: Sears Hometown and Hardware, and Sears Outlet. Sears Hometown engages in the retail sale of home appliances, hardware, tools, and lawn and garden equipment. Sears Outlet provides in-store and online access to purchase outlet-value products across an assortment of merchandise categories: home appliances, consumer electronics, apparel, etc. Given the single-page constraint of the report, I will neglect to discuss the vanilla Outlet stores and will solely focus on the Hometown stores, where there is a chockfull of growth potential.
Major Weakness and Risk
The competition from online sources like Amazon is definitely a concern, however, appliances are one of the few things that consumers are still more likely to buy offline. Aside from that, the Hometown stores are franchised stores that sell appliances and hardware, which puts ownership in the hands of individuals who will be incentivized to do the best they can to ensure that their stores are run well and that profits are maximized. On the other hand, it is certainly worrisome that SHOS is reliant upon franchise owners for the majority of its stores, which the future growth and well-being of the company depends heavily upon. However, the franchising model is attractive to potential franchisees, and is therefore, conducive to the growth of the company.
Attractive Franchising Model—Continued Growth of Hometown Stores
The franchisee will be responsible for paying rent and labor. They will profit through earning commissions through the sales made. The remaining profit will make its way back to SHOS. There are currently 941 Hometown stores, 90 Sears Hardware Stores, and 80 Sears Home Appliance Showrooms, across the country. But more growth is expected given the franchisee-friendly model of the hometown stores that includes ownership perks such as no franchising fees, corporate market support, training, and importantly, inventory on consignment. In this way, owners won’t have to worry about not ordering enough, or conversely, ordering too much. They will be able to return unsold products to Sears without losing a penny. If one wishes to own an appliances franchise, there are not many companies besides Sears to obtain a license from. Its biggest competitors, Home Depot and Lowe’s, are all corporate-owned and operated. The SHOS franchise model provides franchisees with a low risk of owning, as well as the promise of growth (as shown by the growth in comparable sales), making Sears Hometown an attractive franchise to own and operate. All of this contribute to an attractive franchising model that allows the company to expand with speed and efficiency that is unparalleled by other models of expansion while mitigating risks that the company has to shoulder.
Third quarter results have already reported a net increase of 3.1% in comparable sales overall for SHOS, with 4.4% increase in Hometown and a 0.8% decrease in Outlet. The decrease can be attributed to declines in lawn and garden due to drought conditions experienced in large portions of the U.S. and in consumer electronics resulting from management’s strategy to de-emphasize the category. The increase is incredible considering that the third quarter has historically been their seasonally weakest sales quarter. In short, decreases in sales are weather-related and caused by the enactment of new strategy, and that we can expect future growth.
Healthy Financials and a Discount
A simple mark of a good business is healthy financials, and SHOS has healthy financials to show. From the most recent 10-Q, we can see that the operating income has increased by 27% and adjusted EBITDA increased by 19%, since last year. It also has a healthy cash flow of 118 million, approximately twice of its net income of 58 million, and enough to pay off its total debt of 48 million, making SHOS extremely financially sound.
Aside from healthy financials, SHOS is also offered at a discount to its biggest competitors in the U.S. SHOS is trading at 6.23x EBITDA while Home Depot is trading at 9.03x EBITDA, and Lowe’s at 8x.
Hidden Value
The average days payable outstanding within the retail industry is around 20 days or more, which raises an eyebrow when you see that SHOS is paying off its accounts payable a lot faster—averaging 5.7 days. Essentially it is paying its accounts at 4 times the rate of the industry average, concealing value by reducing the net income that appears on its quarterly income statements.
Watching the Insiders—Edward Lampert
Edward Lampert, the chairman of Sears Holdings as well as ESL Investments (a major holder of SHOS), acquired as much as he could get of SHOS through the rights offerings back in October—Mr. Lampert personally owns 10% of the SHOS stock. The rights offering gave Sears Holdings stockholders preferential access to the new spinoff stock at a huge discount and barred others from buying in until the spinoff date. Lampert and ESL Investments, which he chairs alongside Sears, bought in the stock at $15, and have made a tidy profit. Since then the stock had more than doubled at its peak of $37 (now it has fallen to around $30, still double the initial price). Insider activity is a good sign for the value of a stock. The rights offering, instead of allowing just anyone to purchase the stock, allows the insiders to gain exclusive rights to purchase the stock in greater quantities. And as we can see, Mr. Lampert did just that: bought in as much as he could. So, the next question is: is there any more value left?
Conclusion
Although we would have been able to earn even bigger had we gotten the stock through the rights offering or on its climb right after the spinoff. The answer is still a resounding “YES.” SHOS is a good business that is undervalued. According to DCF analysis (assuming 10% discount rate, 20% to 5% growth over the next 5 years, which is relatively conservative given this quarter’s 76% increase in net income since last quarter, and up 17% this quarter from last January; with 2% terminal growth) SHOS would be worth around $37. Given that the stock has been fluctuating around $30, right now is the time to buy in and earn big.