The initial taste in people’s mouths when they hear of a Sears’s spinoff is what initially drew us to the situation. Over the last seven years, many value investors have fallen into the “SHLD” trap hoping that the market will value the assets on a “sum of the parts” / liquidation value higher than where they bought it for. This has been a fool’s errand because Eddie Lampert – the chairman of Sears Holdings Corp. (SHLD) and CEO of ESL Investments, Inc. has an “infinite” time horizon and is eager to own 100 percent of the business himself.
While Sears has been slowly shedding assets (primarily real estate), most of the cash flows have gone to reduce debt and shore up the firm’s short term liquidity. With little in the way of operating earnings, limited recent share buybacks and/or dividends, SHLD has left many a value investor fatigued. The reality is that Sears as an operating business is in a state of transformation.
While many of its stores (largely K-Mart’s) are unprofitable, a core group of Sears’ are hugely profitable especially in hardline goods – appliances, hardware, etc. This is not only driven by the exclusive brands that they own/carry – Kenmore, Craftsman, and Diehard but also the service quality and the Company’s warranty policy. Many people forget that Sears is still the largest appliance seller in the world – that means something. But how does this relate to us?
The reality is that a number of Sears’ stores have been, and will be, closed because the hardline sales have not been able to compensate for the size of the box and weakness in soft goods. But by simply closing the “box”, Eddie is effectively “throwing away” good, loyal, and repeat hardline sales. What if he didn’t have to throw away the sales and he could just “divert” them? Enter Sears Hometown.
The Sears Hometown concept has been around for almost 15 years but has really grown to prominence over the last four or five. Many of you may remember a similar format years ago called the Sears catalog store.
Sears would open small format stores in rural markets with a few items, but mostly the stores had knowledgeable sales staff who would guide individuals on big ticket purchases from their catalog (pre-internet). When the Company discontinued these catalog stores they enlisted small business owners / entrepreneurs to take over these units as “franchisees” and begin selling mostly hardline goods. This evolved into a profitable endeavor for Sears and its franchisees / “dealers” because many of these rural markets were too small for direct competition from Home Depot and Lowes.
The concept continued to grow its unit base within SHLD until the housing crisis, when limited credit for the dealers coupled with waning demand in its end-markets constrained the concept’s growth. It took a few years, but credit began to ease and demand began to pick up off a low base sparking unit growth in the concept once again. The Company began to take the concept one step further. In addition to creating new dealer incentives to ramp store growth in rural markets, the Company invented / created two new franchise concepts. The first concept was the Sears Hardware and Appliance store, a larger format hometown with a full service hardware department. These stores were positioned for suburban markets where people like the convenience of a smaller format store with hands-on customer service. The Company also began to market a Sears Appliance Showroom concept.
This concept was intended for urban markets, specifically “NFL” cities – cities with over a million people who are from an income strata that could support big ticket higher end appliance sales. The stores are beautiful and carry a full-line of Dacor, Electrolux, Bosch, Kenmore, and even Viking / SubZero at request.
This concept is meant to compete directly with Home Depot and Lowes in urban markets where the consumer is educated, wants a great price, and also wants to be “sold” on a product by someone knowledgeable and not a teenager at the competition.
What is most interesting about this investment is that there are a number of cost and revenue synergies that exist between SHOS and SHLD. For example, a salesman in a Hometown can sell you a product that he may not carry. All the dealer needs to do is send the consumer an e-mail with a link to the product on Sears.com and SHLD can credit the dealer with the sale.
Because SHLD drives the supply chain/manages distribution, SHOS dealers have the benefit of almost every SKU in the appliance domain and also the purchasing power (availability to price profitably against competitors) of the largest appliance seller in the world. There is also a moat for each of the concepts; the quality of the product the stores carry (Kenmore, Craftsman, DieHard), the geographical competitive advantage of being in rural markets, or simply the quality of the Sears service and being run by an entrepreneur.
It sounds like a great business but what makes the investment interesting?
*Valuation – the stock trades at roughly 6.5x our conservative 2012 EBITDA estimates which is on a cyclically low base of earnings – appliances is the lone sector that has yet to come back in housing. Last quarter, industry wide appliance sales were basically flat. Yet SHOS grew double digits implying they are taking share. Large manufacturers, such as Whirlpool, believe that we are on the verge of an appliance replacement super-cycle. The Company also has a sizable owned real estate portfolio, carried at historical cost, which may provide an additional path to value creation. In addition, we believe improved working capital management will free up excess cash to deploy in additional unit growth or buybacks.
*Unit Growth- Today the business is at roughly 1,200 units. After doing additional scuttlebutt, we came across information online that implies SHOS is trying to get the concept to over 3,000 locations. Because the individual dealer is responsible for the lease and tenant improvements, SHOS can grow substantially without significant capital investment.
*Management / Capital Allocation / Return on Invested Capital Opportunity – One could not ask for a better capital allocator than Eddie Lampert. He has not only created a tremendous amount of wealth for the limited partners in his fund but has also successfully optimized and grown prolific retailers such as AutoZone and AutoNation. It is also worth noting that Eddie (ESL Investments) has made a number of “in kind” distributions to his partners in stock to satisfy certain redemptions over the last couple years. He has distributed significant stakes in many of his holdings with the exception of SHOS – we think this is meaningful.
But most importantly, Eddie is one of the most disciplined capital allocators in corporate America. After losing his father early in life, Eddie became consumed with making money and earning financial independence. Even today as he sits atop a multibillion dollar personal fortune and a $15 billion dollar hedge fund, he still “counts the pennies” and personally signs off on every employee expense report.
This is the kind of man we want as our steward – he truly is fanatical about the return on every incremental capital dollar. As unit growth matures (which is yielding in excess of 35 percent ROIC), we expect Eddie to start bringing down the share count the only way he knows how.
**Full Write-Up Available with Attachment Including Formatted Tables, Charts and Valuation Analysis on SumZero Elite).**