SHOS - Sears Hometown and Outlet Store

[ZenaidaMacroura]

I have a small position in SHOS today. Eric Khrom of Khrom capital liked this stock. I am sure we cannot put lot of weight on this, but he has a impressive track record despite holding lot of cash. See his thesis in the attached file

I wonder why Fairholme is so hesitant to own SHOS

[Spekulatius]

It was a bad quarter. I'm confident the future is a bit brighter, skate to where the puck is going and so on.. Sears full line store closings provide a runway for SHOS. I see more stores in 3 years, similar same store sales and less shares. 2013 was a bad year, the shares fell, you get a good year the shares will rise.

 

Two articles provide some colour on the future, I think; check out the most recent VIC write up(should be free to access for non members now) and the SA article that came out today.

 

What makes you think that the puck is going in the right direction for SHOS? HD had double digit growth in appliances in the last reported quarter, SHOS is down 4.5%. The environment is great for appliance sales right now, so if they cannot make a decent profit right now, what makes you think that they can in the longer run?

 

I think the competitors are eating SHLD and SHOS breakfast, lunch and dinner.

[Spekulatius]

Can you explain to me why any of the 3 variables I listed might not work out over time? I would appreciate the feedback.

 

1. Why is it likely that SSS will fall over a longer period?. You'd think the franchisees/dealers would be working their butts off to maintain them.

 

That is why:

http://www.forbes.com/sites/prospernow/2014/01/09/sears-slumps-in-appliances-as-kenmore-fails-to-attract-millennial-shoppers/

 

Sears an Kenmore are not relevant brands any more for younger folks. Samsung and LG have agressively cornered the high end of the appliance market and Kenmore does not have the necessary resources to compete with them. Even GE is under pressure. Likewise, the Sears brand is damaged as well and the bad Sears brand image radiates out to SHOS as well.

 

My concern is that SHOS is quickly becoming a melting icecube. Franchises working their but of won't suffice, since they neither have the product, nor a good brand themselves to compete.

[DTEJD1997]

I have a small position in SHOS today. Eric Khrom of Khrom capital liked this stock. I am sure we cannot put lot of weight on this, but he has a impressive track record despite holding lot of cash. See his thesis in the attached file

 

HMMM

 

Color me skeptical of at least Mr. Khrom's poker playing skills.  When you are dealt POCKET ACES, you play them very aggressively.  You want to drive everybody out of the pot.  The last thing you want is 8 limpers and somebody connecting on the flop.  That is a GREAT way to get your aces cracked.

 

Also color me skeptical of SHOS great brand positioning.  They might be able to hold out in some pockets here & there...but they are fighting a rear guard action. 

 

I just don't see SHOS being an attractive investment.

[TheEnterprisingInvestor]

So I agree with the concern about the melting ice cube.  The quarter looked quite bad, and muddy, due to the lack of a 14th week and the tough weather for most of the country, usually I think weather mentions are red herrings but it was quite extreme. 

 

I see the case about the closing of SHLD stores and low capital intensity.  Clearly they're signing up franchisees, 30 in the quarter and 10 (that they announced) in February, so there must be some value prop that franchisees are seeing.  I guess what I'm trying to figure out here is whether or not the quarter was just optically bad (with really no management commentary), or if something more significant is going on.  In the past year, they had headwinds of the OSH liquidation, exiting electronics, some refranchising going on, and the tough weather in Q4.  I guess my question is, are the problems(to the extent there are true problems) fixable or not?  There's just no commentary or guidance from management on that.  That said the business model itself seems sound, costs should be, for the most part, variable. 

 

At this point, if I look out 2 years I see:

- fewer SHLD stores and more SHO franchisees

- decent (probably increasing) cash flows

- fewer shares outstanding

 

I would be more concerned if they were having a hard time signing up franchisees, but that doesn't seem to be the problem. 

[Luke 532]

Lampert adds 173,000+ shares of Sears Hometown & Outlet Stores from 4/15-4/17

http://www.sec.gov/Archives/edgar/data/860585/000118143114016477/xslF345X03/rrd407580.xml

[yzstevie]

Anyone knows how to or has contacted SHOS management in the past?  I sent them an email with a few questions to their general IR email but haven't gotten a reply yet.  The Lampert insider buy is intriguing even though the amount is fairly small. 

[Kash50]

Keep trying. They don't actually have IR. The IR email just forwards to the CFO's assistant. Eventually, after several emails and phone calls, i did hear back from IR and got a call scheduled with the CFO.

 

Is anyone planning on attending the SHOS annual meeting next week?

[PatientCheetah]

That's how you play with Eddie no pain no gain. Imagine if it would all be easy instead we get just pure pain up or down hell of a lot of fun :D

 

Playing with John Malone is much more rewarding

[Kash50]

Did anyone attend the SHOS annual meeting?

[Evolveus]

I did not but the CEO presentation slides are on the website. Nothing to get too excited about other than now the bar is set pretty low. Seems the senior ABL has a lot of restrictions and stipulations in regards to SHOS being able to repurchase significant amounts of stock.

 

From 10k:

 

Operating Income

Full year operating income decreased to $61.1 million in 2013 compared to $99.5 million in 2012. The $38.4 million decrease was primarily due to the lower sales, lower gross margin rate, and higher selling and administrative expenses noted above, and includes the impact of an estimated $3.1 million earned during the 53rd week of 2012.

 

Again - a pretty low bar. I'll go on record and say that for a store selling these types of goods, this protracted winter likely had some sort of negative affect. Not saying just blame it on the weather but this winter (at least in the southern us) was long and dismal. I'll be watching to see if margins stabilize and look for an uptick in sales into the spring/summer. Also I'll watch to see the impact of additional franchisee fees and see how that falls to the bottom line. Seems like they've been opening/franchising a good many new stores.

 

[TeddyLampert]

I've followed Sears for a little bit now, and in doing so, I've looked at SHOS as well.

 

Some of the messages I've seen posted about SHOS (here and elsewhere) have been about how SHOS is great because it's a franchise model. Here's an example from a value investing site: "Sears Hometown and Outlets has been built as a capital-light, fast-growth business"

 

So, on that basis, I looked at SHOS as a possibly interesting investment opportunity. 

 

What I discovered: NOT capital light

 

After looking at the financials, what bothered me about the SHOS model is how it's actually pretty capital intensive because it  has to buy all the inventory from Sears. The basic dealer and franchise model for SHOS involves providing inventory to the dealers/franchisee on consignment. This does not seem like a capital-light franchise model to me. Before digging into the 10-K, I assumed SHOS would be like any other generic franchise: franchise pays upfront fees and ongoing royalty fees and is responsible for all COGS and SG&A. Wrong.

 

From the 10-K:

The primary difference between Company-operated stores and dealer/franchisee-operated stores is that the Company is

responsible for occupancy and payroll costs associated with Company-owned stores. Dealers and franchisees are responsible for the occupancy costs in their stores and the payrolls of their employees, and we pay commissions to the dealers and franchisees.

 

We depend on existing agreements with Sears Holdings and manufacturers to provide our inventory.

 

Our Hometown and Outlet businesses rely on Sears Holdings (or its subsidiaries) for a significant portion of their inventory,

including KCD Products. For the year ended February 1, 2014, products which we acquired through Sears Holdings accounted

for approximately 84% of our merchandise purchases. Hometown merchandise purchases are sourced predominantly through

Sears Holdings.

 

In order for our business to be successful, we must identify, obtain supplies of, and offer to our customers, attractive,

innovative and high-quality merchandise on a continuous basis. Our products and services must satisfy the desires of our customers, whose preferences in appliances, hardware and lawn and garden products may change in the future. If we misjudge either the demand for the products we sell or our customers' purchasing habits and tastes, we may be faced with excess inventories of some products and missed opportunities for products we chose not to offer. In addition, our sales may decline or we may be required to sell the merchandise we have obtained at lower prices, increasing our inventory markdowns and promotional expenses. This would have a negative effect on our business and results of operations.

 

As of February 1, 2014 the significant majority of stores in our Hometown business were operated by independent dealers and franchisees that sell our inventory on a consignment basis.

 

The Company owns the merchandise, establishes all selling prices for the merchandise, and bears general inventory risk (with specific exceptions) until sale of the merchandise and if the customer returns the merchandise.

 

Under both our dealer model and our franchise model, SHO provides inventory (on a consignment basis), branding and marketing to the stores and the dealer or franchisee is responsible for start-up costs, lease payments and other operating costs including payroll

 

You get the idea.

 

Eh Returns on Invested Capital

 

Corroborating my view of the capital intensive nature of the business is the low returns SHOS generates on tangible invested capital. I calculated that in FY14, its after-tax (35%) ROIC was a ho hum 13%. Eh.

 

 

Why are people so excited?

 

I guess bulls might argue that SHOS is actually a growth story, in which case why care about the low-ish/average returns. This might be a simplistic view, but I think if you grow the number of franchisees, SHOS's inventory levels will have to grow commensurately. Earnings will grow with revenues since there wont be a lot of EVA created by the average-ROIC growth. This means SHOS wont be deserving of a high multiple since its growth doesn't generate a lot of excess shareholder returns (thus it should trade in line with the overall market on a multiples basis, and maybe average 15x in the LT).

 

If someone disagrees with me and has some variant view of the business model or thinks incremental returns is a lot higher going forward for whatever reason (e.g. operating leverage??), it'd be great to hear from you. With the share price taking a big hit from disappointing earnings, it's worth revisiting SHOS to see if there's a compelling reason to own it. From what I have observed thus far by reading the 10-K, I fail to see how SHOS is the wonderful franchise model that many have claimed it to be.

 

Thanks.

[Carvel46]

TeddyLampert,

 

The bull case (in my mind) is that earnings are cyclically depressed. I don't think it makes sense to base ROIC off of depressed earnings.

 

I have concerns about what a "normal" housing market looks like, although this seems priced into the stock. At this price, the inventory provides some downside protection.

 

At some point, appliances need replacing. Right? Unlike my car, my friends don't comment on my old "s***box" washing machine...so maybe it's easier for consumers to delay purchasing a new appliance.

 

Chou owns it:

http://www.chouamerica.com/Opportunity.html

 

 

[krazeenyc]

Well... the other theory is that as Sears closes stores SHOS will be able to open new ones in SOME of the locations Sears vacates.

[cubsfan]

Looks like Eddie is buying:

 

http://www.dataroma.com/m/stock.php?sym=SHOS

 

[TeddyLampert]

Well... the other theory is that as Sears closes stores SHOS will be able to open new ones in SOME of the locations Sears vacates.

 

Ok, I want to explore this comment a little bit. So based on what you are saying, as SHLD closes stores, it shifts its appliance sales to SHOS. So SHOS will open up new locations under its dealer/franchise model. SHOS will still need to purchase inventory from Sears (due to a supply agreement that goes out to 2018, plus extensions). The fact that SHOS purchases inventory is another way of saying that it has to tie up a lot of cash flow in order to grow its store count.

 

TeddyLampert,

 

The bull case (in my mind) is that earnings are cyclically depressed. I don't think it makes sense to base ROIC off of depressed earnings.

 

 

 

I have a quibble about the above comment as well. Sure, it's never a good idea to calculate ROIC off cyclically depressed earnings. But first of all, are we even in a depressed housing cycle? I'm not trying to create a debate on this, but I thought ever since 2009, the US has been experiencing a gradually recovering housing market.  That point aside, let's assume the housing market hypothetically rebounds from here. Won't SHOS's ROIC still be kind of average simply because the business model is really not as asset-lite as people think it is? Let's also imagine that the housing market goes gangbusters and store productivity (sales per SF) in a SHOS store doubles or triples. That's great for the franchisee. But what about for SHOS? Won't SHOS have had to use capital to fund all that inventory to start with?

 

The point I raised has nothing to do with whether there are factors that will lead to growth in SHOS stores or whether appliances and other goods will experience a cyclical rebound. My point is that even with revenue growth, so what? Will it improve the core profitability of the company (as measured by ROIC)? Or will the nature of the business model keep returns average, leading therefore to average stock performance?

 

Anyone with a different view of the business model and changes to incremental ROIC, it would be great to hear from you.

 

And sure, Eddie has been buying, but what is $600K as a % of his net worth? 3-6 bps?

 

 

 

[jeffmori7]

@Teddy Lampert Ok, I don't understand something in your comment about SHOS. SHOS is supposed to be an asset-light retailer because they don't have to spend capex on stores, as this is relegated to the franchisees, who pay fees to SHOS. But no one never say that they won't have to buy inventory...which retailer don't buy inventory? They surely have to purchase goods to sell them, like very retailer since the first retailer?!

[merkhet]

What he's saying is that it's not like McDonald's. McD doesn't take inventory risk in hamburger buns, etc...

[jeffmori7]

What he's saying is that it's not like McDonald's. McD doesn't take inventory risk in hamburger buns, etc...

 

Ok thanks, got it!

[Carvel46]

TeddyLampert,

 

If there is some cyclical recovery, inventory turns will improve. A better housing market/appliance demand will benefit ROIC (numerator and denominator). I think that incremental ROIC will also benefit from Outlet is being franchised more.

 

I agree that SHOS is not like McDonalds. But why not compare it to something like Ross Stores?

Ross has better industry dynamics, better margins, better inventory turns...

From a Porter 5 Forces perspective, Ross has more fragmented suppliers (smaller size and irrational), less rivalry/price competition (more loyalty and better customer experience) and less buyer power (smaller order size and less price sensitive customer).

SHOS is not ROST. I'm guessing Eddie Lampert understands SHOS' weaknesses and strengths and is trying to improve its competitive position, where possible.

 

 

[TeddyLampert]

I don't have a position in SHOS. The decline in the share price has caught my attention. I'm not trying to poo-poo SHOS for the sake of being snide or cynical. I'm genuinely interested in what the long thesis is, and I'd really love to hear from someone who's done their homework. Feel free to PM if you don't want to post your thoughts for all the world to see. In exchange, I can promise I'll dig deep and be value adding. If you are long because it's a bet-on-the-jockey-not-the-horse Eddie fan club situation, I think it's still work pondering the following questions:

 

1) why have operating margins consistently fallen in the last several years and quarters?

2) what are the company's normalized operating margins? And why do you believe that?

3) what is your simplified model of the unit-economics, and what incremental ROIC does it imply?

4) where are we in the appliance/hard goods cycle?

5) what are casual observers/the street/consensus missing in their understanding about the business model?

6) what is SHOS's competitive advantage?

[Kash50]

Teddy, you ask some good questions that i have been thinking about myself. SHOS has not been spared in the recent sell-off across retailers. With SHOS now trading close to 1x TBV, i thought it was worth spending a bit of time digging into SHOS.

 

RE the single-unit economics and incremental ROIC for SHOS as a franchise operator: i think this is the key question. The rough math for the Hometown segment works out as follows. Hometown stores have averaged ~$1.6-$1.7mm in sales for the past 4 years. Gross margins past 2-years have been ~23-24%. So that comes out to ~400k in gross profits per store. If you dig around the Ks, you can figure out that commissions paid out as a % of franchise fees have averaged 13-15%, so that is another $220k-$250k of commissions paid out to the franchisee. Therefore SHOS is left with $150k-180k of incremental contribution before overheads. In return for that, SHOS has to put up ~$300-340k of inventory per store. So the rough math here is that for each hometown franchise store, SHOS is able to generate an incremental return on invested capital of 40-60%. If this is correct, then the incremental return to SHOS from opening an additional store is actually very high and certainly an attractive use of capital.

 

Of course this is before overheads. But i guess the argument is that overheads should be relatively fixed for SHOS. Advertising costs have been flat last 4-years. And given the franchise model, for each additional store opening, there shouldn't be a large incremental overhead cost borne by SHOS. Therefore, you would expect to see incremental operating leverage as SHOS opens new stores.

 

The other important point is that the commission structure paid to the franchisee is based on how much they sell. There is a hometown franchisee powerpoint deck on slideshare floating around. Basically, what the ppt indicates is a poor franchisee will only get paid a 3-5% commission, while the best franchisee could earn 18-20%. What that means is the net contribution to SHOS is actually pretty fixed as most of the upside (and downside) is borne by the franchisee.

 

So hope that adds a bit to the discussion on the incremental ROIC for hometown. I am unclear of the economics of a sears outlet in the franchise model.

 

To your other questions: i think operating margins have consistently fallen over the last few quarters because of sears outlet. If you look at the historical numbers, outlet had generated $45mm in EBITDA pretty consistently for the last 3 years. And then it fell off the cliff - falling to $25mm in 2013 and $10mm LTM EBITDA (excluding initial franchise fees). This under performance looks to be almost entirely attributed to the lack of available scratch-and-dent inventory. COGS (ex-franchise fees) have increased from 70-72% to 77-78%. It is unclear to me whether the availability scratch-and-dent inventory is cyclical or structural or temporary. Management seemed to indicate in the last earnings release that is is temporary.

 

On SHOS's competitive advantage - this is one area i worry about. In an attempt to survive in a post-amazon world, it seems that every retailer is pivoting to/doubling down on appliances/large-ticket items. I think HHGregg paints a good picture. They have gone from 60% consumer electronics in 2010 to 60% appliances and that trend is only going to increase as electronics comps are down and appliance comps are up. HD/LOW/BB - everyone is pushing into appliances as the last zone of safety from amazon.

 

So what is SHOS's competitive advantage with every other retailer trying to push the same products? I think it comes down to a) geography (hometown focused on small rural areas where other stores don't exist) and b) the outlet channel, which is the only liquidation channel for appliances).

 

I know that the home appliance showroom concept is growing and people are very bullish on it, especially given its success in houston. But beyond the elbow grease that a franchisee brings to the format and the "showrooming" sales concept, i dont see a ton of competitive advantage vs. other urban-metro retailers. But if SHOS can find some good multi-unit franchise operators, I am still optimistic on the home appliance showroom concept. I just don't think it will be a straight up/to the right trajectory that the bulls are calling for. The closing of SHLD full-line retail stores is not a slam dunk opportunity. The most recent home appliance showroom store opening announcement was at 3838 William Penn Highway in Monroeville, Pa. If you look up that area on google maps, you will see there was a SHLD down the road that closed in 2012, with a whole bunch of negative press. Soon after SHLD closed, a HHGregg opened a brand new store in its place. Now , over a year later , sears home appliance retail is opening - in a 2nd tier location way down on the strip. It is not obvious to me while customers will suddenly rush back to sears over hhgregg and other existing options.

 

Anyway. those are some thoughts. apologies they weren't better organized. stream of consciousness. Would be interested to hear your views

 

[Fat Pitch]

Retail is a tough business, especially with Amazon around. I think there are niches some retailers can occupy and do well. Take Nebraska Furniture Mart as a prime example. Small gross margins, but high turnover translate to great ROIC and at the same time superb value to the customer.

 

The question to ask here is what value is SHOS offering to the customer? If they are some commodity retailer looking to make a large profit per item sold then the business will die over the long term.

 

SHOS gross margin appears to be 23%

HomeDeport GM 34%

HHGreg GM 28%

 

SHOS appears to be offering customers a compelling value based on GM alone. I haven't dug in deeper so I might be missing something here.

[Luke 532]

An excerpt from something I recently read.  Any thoughts on this?

While this thought experiment is not an exercise in precision, one would assume that this tripling in franchise units should result in at least a commensurate move in total revenues (in truth we think odds are much likelier to be higher given better efficiency/throughput of new units vs. the older Hometown units but we digress). In that case, a tripling of last year’s revenues of $2.5B over the next 10 years would leave us with ~$7.5B come 2023. If we assume modest additional gross margin expansion of another ~3% between now and then, SHOS would generate approximately $2.25B in total gross profit. With SGA likely to remain flattish around ~$504m, then 2023 operating income would be a whopping ~$1.75B.

 

At 12x ~$1.75B op income, SHOS’ equity value would be ~$21b. Assuming the same 23m shares outstanding, that is over $900 per share for a 20x return. Better yet, if Lampert manages to retire half the float along the way, then you can double that number.  One could do worse than make almost 40x their money over the next decade, no?

 

What’s crazy about the above is that none of the inputs feel unreasonable assuming they can deliver in terms of unit growth. Indeed, the above assumptions seem down right conservative. Revenues could just as well be higher, as could gross margins. SG&A could conceivably be half the present run rate or less. Either way, looking out over the long run, an exponential compounding of per share value seems almost assured.

[merkhet]

I believe that management came out and said that 3,000 stores was an aggressive goal and not likely or something along those lines.