Near the end of 2012, former department store legend turned mall wasteland Sears (NASDAQ: SHLD ) segregated its high-value segments into one quickly growing, typically undervalued spinoff opportunity. And, in classic spinoff style, the stock was largely ignored upon its debut. Since its market entrance, Sears Hometown and Outlet Stores (NASDAQ: SHOS ) has made a nearly flawless run up roughly 24%, posting a stellar earnings report along the way. Though the stock has appreciated substantially and made today's entry point much less appealing, there is still room to get in before the company releases what I expect to be another great report.
A quick review
Sears Hometown and Outlet Stores consists of the parts of Sears you may not automatically think of upon hearing the name. It includes the Craftsman brand, Kenmore appliances, DieHard batteries, and the warehouses and outlets in which these still valuable brands are sold.
Sears Hometown and Outlet Stores owns 126 outlet stores that can take possession of "as-is" and dated model-year appliances from its parent, Sears Holdings, and then sell them with a high margin in its stores. If the items don't sell, it has the option of selling them back to Sears Holdings at cost. This is the definition of zero downside risk for a retail company. That aforementioned 126 outlet stores is a tiny number, leaving plenty of room for more stores further down the line. These stores can offer fantastic prices to customers with a wide array of brands and, in a worst-case scenario, a money-back guarantee for anything they don't sell to shoppers.
Sears Hometown and Outlet Stores also operates smaller hardware stores that are faring much better in today's retail environment than the traditional big-box store. They sell Craftsman products, appliances, and other high-value brands. Most important, these stores are increasingly franchise-owned -- making their profitability to Sears Hometown and Outlet Stores (and its investors) less dependent on the low-margin hardware business.
It's a simple, easy-to-understand business model with strong growth prospects. The company's November earnings release confirmed it, too.
A quarter for your thoughts
Now old news, but important in looking forward, the company had a stellar third quarter of 2012, with operating income rising 27% to $14.1 million and net income attributable to shareholders boosting up 29% to $8.8 million, or $0.38 per share. Adjusted EBITDA was up 19%, and same-store sales were up 3%. The company witnessed double-digit increases in appliance sales, as well as sales of mattresses and, surprisingly, apparel. Hometown and Hardware drove the same-store sales, and ultimately net income, with more than 4% year-over-year growth.
While many big-box stores are clawing to stay profitable, Sears Hometown and Outlet Stores seems to be sailing smoothly in calm water.
Of course, we must look forward and not back to determine if Sears Hometown and Outlet Stores still looks like a buy. Spoiler alert: It does.
I am expecting more strong news coming from the company in the upcoming earnings release. While the stock is trading at its high since its market debut, I find there to be more room to run given the original thesis.
In that third quarter mentioned above, the company opened nine new stores. While nine is plenty for a 13-week period, there is much, much more room for growth. At the end of the third quarter, there were 126 outlets, up from 123. The other six are presumably Hometown and Hardware stores that will be or have already been transferred to franchise-owned.
On the valuation front, the stock isn't as cheap, but is still nonetheless trading at a discount to its peers. At an enterprise value of $906 million, today's stock price implies a slight discount -- valuing the company at $897 million. The company's EV/EBITDA remains below comps at roughly 7.8. For comparison, look at Costco's 10.83, Wal-Mart's 7.87, and, though not a direct comparison, Amazon.com's 53.94. For a warehouse retailer with a very, very small number of stores comparatively, Sears Hometown and Outlet Stores looks to be still undervalued.
Foolish bottom line
So what should potential investors do if they have yet to get in on the stock? As mentioned earlier, there is still some upside potential here, but it may not be for long if the upcoming earnings release is as positive as I am expecting. The company remains an attractive investment for its growth, its value, its insider ownership (Eddie Lampert owns a substantial amount of shares), and in true value investor form, its simple, cash-generating business model.
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