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Long Sears Hometown and Outlet Stores (SHOS)

March 30th 2014

Tianyou Gu

Sagehen Capital Management

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Sears Hometown & Outlet Stores Overview

SHOS, traded at Nasdaq, $23.6, Market Cap $537 Million

Spinoff from Sears Holdings Corporation in late 2012

Sells hardware, home appliances, lawn and garden equipment

– 4th largest retailer of home appliances, 1,200 stores across 50 US states

– 2013 Revenue of $2.45 Billion

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Why Buy SHOS?

Cheap and Undercovered Spinoff

– No analyst coverage

– Valuation in the Range of $32 - $48

– Has declined 60% from its high

– Insiders purchased at much higher prices

Core Strengths and Superior Business Model

– Keeps the core strength of hardware and appliance brands from Sears

– Expands in a “capital-light” franchise operating model

Favorable Tailwinds

– Benefactor of Sears Holdings store closings

– US housing recovery, online platform expansion

Shareholder Friendly

– Created specifically to unlock value from Sears Holdings by hedge fund manager Eddie Lampert, who’s currently the chairman

– Share buybacks

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Superior Operating Model

Dealer/Franchise Model

– SHOS collects a royalty for the use of the Sears trademarks meanwhile offloading the capital-intensive parts of managing a retail operation to its dealers/ franchisees

– The inventory is provided by Sears Holdings and SHOS receives a percentage of profit from sold goods

Benefits from Franchise Model

– Capital light; high margin royalty income

– Effective than centralized model

– Asymmetric risk/reward

Profitable and growing online business platforms

Favorable Alliance with Sears Holdings

– Rapidly expanding membership rewards program operated by Sears Holdings Corporation – SHOP YOUR WAY™

– Delivery, installation and product service capabilities through alliance with Sears Holdings

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Competition

Competitors: Home Depot, Lowe’s, BestBuy, Kohl’s, Walmart, Amazon

Safe from competitive threats due to different product and geographic focus

– Locate stores in more rural settings and smaller markets, generally in areas that are too small to attract the Home Depot and Lowe’s

– SHOS is isolated from competition from Amazon and Wal-Mart given the types of items it sells: consumer durables, tools and lawn & garden equipment

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Valuation $23 is at bottom of 52-Week Range (between $20.5 and $57.5)

Comparable Implies $32 – $42

– Using Implied EV/EBITDA of 7.5x – 8.5x and P/E of 15x – 18x

DCF Implies $36 - $48, under Conservative Assumptions

– 25% - 28% gross margins (LTM 24.5%) and 4 - 5% net profit margins (LTM 3.2%)

– These net profit margins are less than the 4 and 6% generated by Lowe's and Home Depot, respectively

– Growth rate 2.5% (historically 1.5%) in next 5 years, then 1.5% terminal growth rate

– Stable capital structure

Insider’s Buying at $30 – 40 in Past Twelve Months

EV/Revenues EV/EBITDA EV/EBIT Forward P/E Growth Gross

Margin

EBITDA

Margin

Net Income

Margin

SHOS 0.2x 7.0x 7.9x 13.0x 3.20% 25.35% 2.82% 1.47%

BestBuy 0.2x 4.0x 6.5x 16.8x 1.20% 22.90% 3.25% 1.30%

Lowe's 1.1x 10.6x 10.2x 15.40x 2.50% 32.44% 10.69% 4.28%

Home Depot 1.6x 11.4x 13.6x 21.20x 5.40% 32.70% 13.90% 6.80%

Valuation Multiples Operating Ratios

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Tailwinds/Catalysts

Benefactor of Sears Holdings store closings

– As Sears executes its transition plan (closing department stores and switching channels to online and SHOS), more retail flow will be directed to SHOS

– This creates significant, long-term revenue growth opportunity

Improving 2014 financials

– Fiscal 2013 results were significantly below expectation, caused by unusually severe winter weather in many of trade areas and disappointing holiday sales of important Kenmore appliances and Craftsman tools

– Positions favorably for 2014 as SHOS opened 30 stores last year, with half of those openings occurring in January

– Double-digit year-on-year growth in both online and multichannel sales

– Product mix shifts towards high-margin tools from home electronics

Real estate market recovery

Rural market expansion, Online platform growth

Share buyback plans

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Risks

The U.S. real estate market reverses its upward trend

– Clean balance sheet protects the company from severe hits

Continued lack of coverage from the investment industry; stays undervalued in the near term

– Tailwinds

– Already at bottom of trading range, very little downside risk

New franchises may expand at a slower speed

Bottom line: majority shareholder is a hedge fund manager (Eddie Lambert), who will maximize shareholder value

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Recommendation

Buy 1000 Shares of SHOS worth $2,3600

Adjust position based on earnings calls (Q1, 2014 comes out in three months)