Sears Hometown and Outlet Stores (NASDAQ:SHOS) didn't fit into former parent company Sears Holdings' (NASDAQ:SHLD) grand plans, which led to its eventual spinoff to Sears' shareholders in October 2012. The move rid the company of its former parent's legacy baggage and freed it to pursue growth initiatives independently, included an expansion of its Outlet brand. 

Sears Hometown and Outlet Stores hasn't exactly received a welcoming reception from Wall Street, though, due to a generally poor sales and profitability trajectory since going public as well as stiff competition from the likes of Home Depot (NYSE:HD). However, with the company's stock price down sharply over the past year, is it a good bet?

What's the value?
Sears Hometown and Outlet has a solid store footprint around the country, with roughly 1,260 locations that mostly operate under the Hometown banner, basically a larger version of a neighborhood hardware store. The two sides of Sears Hometown and Outlet's business have slightly different product assortments and target customer profiles; both, however, were designed to extend Sears' brand into smaller communities in the hope of helping it boost sales of excess hardlines merchandise, especially appliances.

Unfortunately, business hasn't been too noteworthy lately; this was highlighted by a 1.3% top-line decline in FY 2013 that was hurt by negative comparable-store sales at Sears Hometown and Outlet's Hometown unit, the source of three-quarters of its total sales. In addition, the company was negatively affected by a highly promotional selling environment, which led to a sharp reduction in its operating profitability. The net result for Sears Hometown and Outlet was a decline in operating cash flow, reducing its ability to invest in growth initiatives, like its recent move into the furniture category.

On the upside, though, the company's Outlet unit reported positive comparable- store sales in FY 2013, thanks to a more well-balanced product mix and lower average price points compared to that of the Hometown unit. The trouble is that those incremental sales were money-losers for the company, evidenced by a slight decline in segment operating income for the Outlet unit during the period.

Looking into the crystal ball
Of course, with a majority of its inventory coming from Sears itself, Sears Hometown and Outlet is highly dependent on its former parent company's ability to continue to draw customers with its portfolio of popular brands, including Craftsman, Kenmore, and Diehard. 

However, a quick glance at Sears' recent results would indicate that the Sears' brand name might be losing the customer mind-share battle, evidenced by continued declines in customer volumes at both Sears and K-Mart stores in FY 2013. More ominously, the declines show no signs of letting up, a trend that certainly doesn't bode well for the company's partners, like Sears Hometown and Outlet.

Go with the best of breed
Sears Hometown and Outlet's management seems to have its work cut out for itself in order to find a path to higher profitability and sustainable top-line growth. Therefore investors should probably avoid the company's shares in favor of the best of breed in the appliance-retailer category, Home Depot(NYSE:HD).  While Home Depot is undoubtedly about more than just appliances, with a store base that averages more than 100,000 square feet, the company has been focusing on the appliance category lately with an improved product mix, hoping to capitalize on rising demand from a rebounding domestic housing market.

More importantly, Home Depot uses its massive overall buying power to maintain a merchandise margin of more than 30% versus a mid-20s percentage for Sears Hometown and Outlet, a competitive advantage that ensures consistent profitability over the long run. The net result for Home Depot is incredibly powerful cash flow generation, which is funding its growth initiatives, including a larger presence in cyberspace as well an aggressive drive for greater market share in the professional-customer segment.

The bottom line
Sears Hometown and Outlet is certainly an intriguing investment story, given its position as the fourth-largest domestic retailer of appliances and its national base of stores. However, the company must find a way to close the large gap between its merchandise margin and that of the top retailers, like Home Depot, probably by improving its merchandise selection beyond its core stable of Sears' brands. Until then, investors need to keep this potential gem on the shelf.

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Robert Hanley owns shares of Sears Hometown and Outlet Stores and Sears Holdings. The Motley Fool recommends Home Depot. The Motley Fool owns shares of Sears Hometown and Outlet Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.