SHOS - Sears Hometown and Outlet Store

[rukawa]

Now its 30$ of NCAV.

[samwise]

Rarely do net-nets liquidate. In this case seems like the directors wanted to liquidate the unprofitable segment. ESL stopped them. The buyout offer was for 2.25. The ask was for $9.50.

 

https://www.sec.gov/Archives/edgar/data/923727/000119312519106129/d730562dex9910.htm

 

 

I've had a small 1.5% position for a couple of years, which has halved in this time period. Now the possibilities have opened up.

 

1. ESL could bid up a bit. Anywhere between 2.25 to 9 sounds good to me.

2. ESL could do a take under for cash. At 2.25 or even lower because they can cause operational losses, can pressure the board, can change bylaws on a whim, and the dollar amounts are too small for any litigious party to get involved. But perhaps there is some check under law?

3. Reverse merger to take the old sears stores public.

4. ESL or transformco buy the assets which SHOS wants to liquidate, at a reasonable price. Shos ends up with a debt free profitable segment.

 

Not sure what rights minority holders have here. ESL has a lot of leverage. But surely the board had some support for the price they asked for? Is there a valuation opinion from an investment bank? Good questions for which I have no answers.

 

SHOS seems to have something ESL wants: an updated ERP system, as they keep mentioning sharing technology in their proposals. (Anecdotally SHLD had terrible technology from the 90s where it was mind numbing to implement simple stuff like buy one- get one at 50% off.)

 

I was considering selling the small position I have, but the $9 ask price seems very tempting. It's become clear that there will be no liquidation. If ESL stays in control they will either make this a successful retailer or die trying. But if they buy it off our hands at a premium first, that might be good for us.

 

All comes down to what leverage the minority holders have here versus ESL. Any opinions?

[BTShine]

Great questions and good insight.

 

I'm surprised they easily terminated the Chairman of the Board.  And, I'd also think it would be fairly easy to get a 3rd party valuation of the company that shows a share price of $5 to $10.  If I had to guess I'd think a deal gets done around $4 or higher. 

 

ESL/SHLD buying the inventory of Hometown, or the entire Hometown Segment, would be an ideal outcome.  Not likely, but I'd rather just own Outlet and make $1.00 EPS, which might give us an $8.00+ stock.

[Guest roark33]

I am still so confused why people bother with stuff like this.  They love the idea of winning at game theory or some other notion here.  Just seems like a quick glance at the financials shows how clearly this business has been and is struggling over the years.  Sure, maybe ESL takes them out and you make a quick buck if you bought recently, but spend your time else where a company doesn't lose 90% of its value over the past 5 years. 

[BTShine]

I am still so confused why people bother with stuff like this.  They love the idea of winning at game theory or some other notion here.  Just seems like a quick glance at the financials shows how clearly this business has been and is struggling over the years.  Sure, maybe ESL takes them out and you make a quick buck if you bought recently, but spend your time else where a company doesn't lose 90% of its value over the past 5 years.

 

On the surface I completely agree with your thoughts.  I think one reason people spend time on this name is because there's an underlying Outlet business that is very profitable ($35m in EBITDA).  That's likely one reason some people on here are interested.  And, the Hometown business, while money losing, is a net-net and therefore some may believe the company would be liquidated and therefore realize much of that inherent value.  That said, this has been a terrible investment for anyone that held over the last 5 years.     

[Picasso]

What does a company losing 90% of its value over the past five years have to do with someone looking to invest in it now.

[Guest roark33]

Oh, picasso, good to have you back.  Obviously, it's not a compounder, Bro, haven't you learned anything from being on twitter? 

 

I know you disagree with me, but unless you get the game theory right, you are going to be stuck expecting a return from the operating business, which is what I focus on, then the performance of the business over the past 5 years should matter to the investor looking to invest today. 

 

 

[samwise]

unless you get the game theory right, you are going to be stuck expecting a return from the operating business

 

Surely you meant valuation. In this case liquidation value seems higher than what operating results will tell you. You are right that holding this for a very long term will give you just the operating results. But buying cheap gives you an option that things get better, there is a liquidation, or the market just gets silly. No game theory required.  Yes game theory is fun in this case, but it's not the main point. The main point is always valuation.

And starting valuation matters even with wonderful businesses. Just look at msft operating and stock performance from 2000 to 2006.

 

BTShine,

 

Roark is right. The predictions about the future are just too hard to make. Good enough to know that there is $9.5 in value according to the fired directors. And some good possibilities exist along with the possibility that we get to watch a rerun of shldq.

 

What worries me though is not a prediction about the future. It's about the motivation of the main shareholder, who doesn't seem to have purely financial motivations.

[Saluki]

Sears has been sliding since the late 70s.  There's a book I'm reading called The Big Store (they should've called it the Big Book About the Big Store b/c it's 600+ pages) about the history of Sears and although they've made mistakes at least it wasn't because of inaction.  They've been trying lots of things for decades to turn that ship around and nothing seems to work.

 

When SHLD started spinning off assets I looked at SHOS and IIRC they had some real estate that looked okay, but I couldn't get comfortable with it as operating business (I hate retail in general).  The only SHLD spinoff I pulled the trigger on was SRG which is doing okay, but will take time to realize its potential. 

 

I'm surprised that other bidders haven't turned up.  If Lampert got sued for giving himself a sweetheart deal on SRG wouldn't other private buyers be interested since insiders are saying his offer is way too low?

[Guest roark33]

https://www.sec.gov/Archives/edgar/data/1548309/000119312519163460/d754469d8k.htm

 

I am not sure if I would really call this a take-under because I think it is a donut eventually, but just FYI. 

[motown]

Just so I've got this right,  unless the purchase price for Outlets goes over $97,500,000, $2.25 per share is the buyout price.  (Transform would have first refusal.)

 

If an Outlet Sale is consummated and the net proceeds of the Outlet Sale exceed the Minimum Sales Proceeds, then the base merger consideration of $2.25 per Company Common Share will be increased by an amount equal to (i) such excess amount divided by (ii) the aggregate number of Company Common Shares and unvested Company restricted stock units issued and outstanding as of the closing of the Merger.

 

If I'm reading this right, going over $2.25 looks to be a low probability event, right?  [2018 segment OI for outlets was $19M, so 5x multiple on minimum purchase price.]

[Foreign Tuffett]

Just so I've got this right,  unless the purchase price for Outlets goes over $97,500,000, $2.25 per share is the buyout price.  (Transform would have first refusal.)

 

If an Outlet Sale is consummated and the net proceeds of the Outlet Sale exceed the Minimum Sales Proceeds, then the base merger consideration of $2.25 per Company Common Share will be increased by an amount equal to (i) such excess amount divided by (ii) the aggregate number of Company Common Shares and unvested Company restricted stock units issued and outstanding as of the closing of the Merger.

 

If I'm reading this right, going over $2.25 looks to be a low probability event, right?  [2018 segment OI for outlets was $19M, so 5x multiple on minimum purchase price.]

 

What makes you assume it's a low probability event? The current market price?

[samwise]

https://www.sec.gov/Archives/edgar/data/1548309/000119312519163460/d754469d8k.htm

 

I am not sure if I would really call this a take-under because I think it is a donut eventually, but just FYI.

 

This provides ESL plausible deniability. They can say that the original ask from previous BoD $9 was tested in the market and found ridiculously optimistic. So the $2.25 offer that ESL had proposed is the best.

 

Based on ESL's actions during the sears banckruptcy, where they seem to have screwed everyone (including lawyers, employees, longstanding "partners" and shareholders) I will not bet on a good faith auction of outlets. I would expect it to be just enough to provide cover for what ESL wanted to do anyway.

 

On ongoing business basis this could very well be a donut, a rerun of sears at smaller scale. As a net net, the value was in the liquidation or possibility (however small) of a turnaround, or liquidation of just the bad business. Liquidation was ruled out by the controlling shareholder 1.5 months ago, and the only possibility left was that he would have to up his bid to provide some cover to the new "independent" directors. This device of a short dated auction provides the cover without spending a penny more. Ingenious.

 

I sold out today at 2.35. If the auction goes well and outlets gets sold for a good price, ongoing shareholders will do well. But ESL's record in negotiations and financial transactions is that they will find a way to win and I don't feel like betting against them.

[Foreign Tuffett]

https://www.sec.gov/Archives/edgar/data/1548309/000119312519163460/d754469d8k.htm

 

I am not sure if I would really call this a take-under because I think it is a donut eventually, but just FYI.

 

This provides ESL plausible deniability. They can say that the original ask from previous BoD $9 was tested in the market and found ridiculously optimistic. So the $2.25 offer that ESL had proposed is the best.

 

Based on ESL's actions during the sears banckruptcy, where they seem to have screwed everyone (including lawyers, employees, longstanding "partners" and shareholders) I will not bet on a good faith auction of outlets. I would expect it to be just enough to provide cover for what ESL wanted to do anyway.

 

On ongoing business basis this could very well be a donut, a rerun of sears at smaller scale. As a net net, the value was in the liquidation or possibility (however small) of a turnaround, or liquidation of just the bad business. Liquidation was ruled out by the controlling shareholder 1.5 months ago, and the only possibility left was that he would have to up his bid to provide some cover to the new "independent" directors. This device of a short dated auction provides the cover without spending a penny more. Ingenious.

 

I sold out today at 2.35. If the auction goes well and outlets gets sold for a good price, ongoing shareholders will do well. But ESL's record in negotiations and financial transactions is that they will find a way to win and I don't feel like betting against them.

 

All good points. Putting aside all concerns about Lampert, how much do you think the Outlet segment is worth?

[BTShine]

I think a fair assessment is that it cash flows about $25 million a year on an unlevered basis.  At a FCF yield of 15%, which would be a good buy price and a fine sale price, that makes the Outlet Stores worth about $167 million.  I would think anyone that buys the unit for $100 million is getting a steal.  Anyone that buys it for over $250 million is paying more than it’s conservatively worth. 

 

Therefore, my valuation range is $100 to $250 million.  FCF multiple between 4x and 10x.

[Foreign Tuffett]

I think a fair assessment is that it cash flows about $25 million a year on an unlevered basis.  At a FCF yield of 15%, which would be a good buy price and a fine sale price, that makes the Outlet Stores worth about $167 million.  I would think anyone that buys the unit for $100 million is getting a steal.  Anyone that buys it for over $250 million is paying more than it’s conservatively worth. 

 

Therefore, my valuation range is $100 to $250 million.  FCF multiple between 4x and 10x.

 

Yeah, I think those are reasonable estimates. The outlet segment is the only nationwide player in the small "scratch-and-dent" appliance market. I think it's a valuable, defensible niche. The segment's historical earnings power reappeared last year after it struggled to diversify its appliance supply away from Sears post-spinoff.

[Foreign Tuffett]

Link below to an early 2018 presentation from Crossroads Capital (no affiliation) that covers the Outlet segment's strengths in some detail:

 

http://www.crossroadscap.io/research-1 

 

Scroll down to the bottom of the page

[BTShine]

Link below to an early 2018 presentation from Crossroads Capital (no affiliation) that covers the Outlet segment's strengths in some detail:

 

http://www.crossroadscap.io/research-1 

 

Scroll down to the bottom of the page

 

Thanks for posting this link. 

 

One could make an argument that it deserves a higher range of multiples than I mentioned.  But, those seem to be conservative estimates.  Seems fairly safe to assume the stock will be bought out at $2.25 or more.  I’d like to know how the board gets to the $9.50 valuation they asked for during negotiations.  I’m not yet an expert in analyzing these situations, but seems like there’s a decent chance the payout to SHOS holders is well above $2.25.

[samwise]

 

All good points. Putting aside all concerns about Lampert, how much do you think the Outlet segment is worth?

 

Sorry, I never tried to value it as a going concern. My earlier position was based on the net net value, with management trying to fix things, and possibly a good business segment. I have no problem with any of the valuations above. They seem reasonable enough if one has any view on normalizing earnings.

 

This may have made me pass on what seems to be a very good asymmetric situation: 2.25 downside + outlet price above 97M. Investing on that basis would involve valuing outlets. But I think it would also involve understanding the current merger agreement.

 

I did read the news in detail with an assumption that ESL would have a bunch of conditions. I found what I was looking for (confirmation bias? Possibly). I've listed a few below (from memory, so please verify).

 

1. SHOS should receive 97M *net* after a bunch of deductions, including tax. Is this structured as an asset sale? At a 20% tax rate with very low basis, the required price might be ~125. What are the other deductions roughly in dollars?

 

2. Maximum inventory is 75m. Is that reasonable? No idea. Perhaps one should compare to outlets yearly sales and asset base to see if that seems reasonable. If inventory is $100. Then required price jumps to over 150M.

 

3. What exactly is being sold? The business has just been through a lot of pain in updating IT systems and trying to split from Sears support. Does the buyer receive a free cash flow of 20 or 25 or whatever normalized number one wants? Or do they also get one-time or ongoing costs to fix/support infrastructure, IT systems etc. The buyer will deduct the extra costs from their offer price.

 

4. It wasn't in the release, but anyone serious about this should check the merger agreement for working capital adjustments. Is the 2.25 really the minimum, or can they adjust it down later? Didn't they back out from a number of commitments when they bought assets from Sears?

 

In other words, it looks like you are buying a cheap call option with a strike at 97, and the question of valuation determines possible upside and hence attractiveness of the option. But based on who is selling you the option, I would really check for conditions and possible traps. Their incentive isn't aligned with yours. No one is on your side. The ones who tried to be on your side got fired. So do read the fine print, besides valuing outlets.

[Foreign Tuffett]

 

All good points. Putting aside all concerns about Lampert, how much do you think the Outlet segment is worth?

 

Sorry, I never tried to value it as a going concern. My earlier position was based on the net net value, with management trying to fix things, and possibly a good business segment. I have no problem with any of the valuations above. They seem reasonable enough if one has any view on normalizing earnings.

 

This may have made me pass on what seems to be a very good asymmetric situation: 2.25 downside + outlet price above 97M. Investing on that basis would involve valuing outlets. But I think it would also involve understanding the current merger agreement.

 

I did read the news in detail with an assumption that ESL would have a bunch of conditions. I found what I was looking for (confirmation bias? Possibly). I've listed a few below (from memory, so please verify).

 

1. SHOS should receive 97M *net* after a bunch of deductions, including tax. Is this structured as an asset sale? At a 20% tax rate with very low basis, the required price might be ~125. What are the other deductions roughly in dollars?

 

2. Maximum inventory is 75m. Is that reasonable? No idea. Perhaps one should compare to outlets yearly sales and asset base to see if that seems reasonable. If inventory is $100. Then required price jumps to over 150M.

 

3. What exactly is being sold? The business has just been through a lot of pain in updating IT systems and trying to split from Sears support. Does the buyer receive a free cash flow of 20 or 25 or whatever normalized number one wants? Or do they also get one-time or ongoing costs to fix/support infrastructure, IT systems etc. The buyer will deduct the extra costs from their offer price.

 

4. It wasn't in the release, but anyone serious about this should check the merger agreement for working capital adjustments. Is the 2.25 really the minimum, or can they adjust it down later? Didn't they back out from a number of commitments when they bought assets from Sears?

 

In other words, it looks like you are buying a cheap call option with a strike at 97, and the question of valuation determines possible upside and hence attractiveness of the option. But based on who is selling you the option, I would really check for conditions and possible traps. Their incentive isn't aligned with yours. No one is on your side. The ones who tried to be on your side got fired. So do read the fine print, besides valuing outlets.

 

Thanks for your thoughtful post. I agree with being skeptical about anything involving Lampert, but I would quibble with some of your points:

 

* Outlet segment earned $19.3M in operating profit last year. While it likely is counter cyclical, I don't think you need to count on earnings "normalizing" here

 

* SHOS has over $280M in NOLs and the merger plan hints at their use ("it being understood, for the avoidance of doubt, that any net operating losses, tax credits, tax basis or any other tax attributes that would reduce such Taxes payable by the Company shall be taken into account in calculating such amount").

 

* Re the IT issue...This is from SHOS's Q4 earnings release: "We do not expect significant IT build fees or systems development costs after the second quarter of our 2019 fiscal year."

[samwise]

 

Thanks for your thoughtful post. I agree with being skeptical about anything involving Lampert, but I would quibble with some of your points:

 

* Outlet segment earned $19.3M in operating profit last year. While it likely is counter cyclical, I don't think you need to count on earnings "normalizing" here

 

* SHOS has over $280M in NOLs and the merger plan hints at their use ("it being understood, for the avoidance of doubt, that any net operating losses, tax credits, tax basis or any other tax attributes that would reduce such Taxes payable by the Company shall be taken into account in calculating such amount").

 

* Re the IT issue...This is from SHOS's Q4 earnings release: "We do not expect significant IT build fees or systems development costs after the second quarter of our 2019 fiscal year."

 

To be clear, I have no points besides pointing out that you need to

1. Value outlets

2. Understand the merger agreement

 

If you are comfortable with both (and it does seem so because you quoted the merger agreement on tax and NOLs) then maybe this is truly a very asymmetric bet which could work out very well.

 

Everything else I mentioned above are things I noticed and would have looked at if I wanted to do the work. The conditions for the merger may check out and appear reasonable, in which case this could be a good investment with limited downside and a short timeline. That's actually a perfect investment.

 

Normalization of earnings: the last few years have been variable. Maybe last years value is the true earnings power, or an average, or something else. You just need to judge that. No other implication of the word normalization here.

 

Good point about the NOL.

 

IT: splitting IT systems is painful. Look at what SHOS went through splitting from Sears. How easy will outlets be extracted from SHOS? What about warehouses and distribution? If the two segments run very independently with little shared infrastructure, then that's the easiest sale. Again, I have no point, except it's something to consider in the value of outlets to another buyer, whether it's a PE shop or Home Depot.

[BTShine]

This story should be getting an update considering the Outlet Stores sale process is supposed to end by Aug 24th, or proceed with an extension of 10 days. 

[writser]

Liberty Tax, Inc. To Acquire Outlet Business From Sears Hometown And Outlet Stores, Inc.