Hedge fund manager and longtime Sears Holdings chairman Eddie Lampert spent more than a decade trying to merge and then turn around the storied Sears and Kmart brands. Along the way, he raised billions of dollars of capital through asset sales and spinoffs -- most notably, the creation of retail REIT Seritage Growth Properties (SRG 1.37%). However, those efforts ended in failure, as Sears Holdings filed for bankruptcy protection a little over a year ago.
Despite this poor track record, Lampert's ESL Investments fund bought Sears and Kmart out of bankruptcy earlier this year, with plans to keep both chains alive in a slimmed-down format. Yet once again, Lampert overestimated the prospects of these dying retail brands. As a result, Sears and Kmart are poised to close the majority of their remaining stores between the last few months of 2019 and the first few months of 2020.
As part of the latest round of store closures, Sears and Kmart will close more than half of their Seritage-owned stores in February. However, Seritage has done so much work to redevelop its properties already that the pending store closures will have a negligible impact on the REIT.
Another massive round of store closures
At the time it bought Sears and Kmart out of bankruptcy, ESL expected to continue operating about 425 stores combined between the two chains. For comparison, Sears Holdings had about 1,000 stores at the beginning of 2018, many of which were closed before the bankruptcy filing.
It didn't take long for Sears and Kmart to start missing ESL's projections. As a result, the company closed a handful of stores during the spring and summer. In August, it announced that it would close another 26 stores between late October and mid-November. Soon thereafter, the company quietly made plans to close about 100 stores -- mainly Kmarts -- near the end of the year.
Last Thursday, the ESL affiliate that controls Sears and Kmart announced plans to shutter 96 additional stores next February, split roughly evenly between the two banners. Liquidation sales will begin on Dec. 2. This will leave a grand total of just 182 Sears and Kmart stores, less than half the number Lampert and his team thought could be salvaged.
Seritage gets hit hard -- but not that hard
At the time it became independent in mid-2015, Seritage Growth Properties held interests in 266 properties, with all but a dozen occupied primarily by either Sears or Kmart. Over time, it has trimmed its holdings to 217 properties. Furthermore, before its bankruptcy filing, Sears Holdings had exercised termination rights for 87 properties, and Seritage fully recaptured dozens of others. Additional Sears and Kmart stores in Seritage's portfolio closed during the bankruptcy process.
By the end of last quarter, Seritage had just 52 Sears and Kmart stores left at its properties, including joint venture properties. The most recent round of cutbacks by Sears and Kmart involves closing 29 of those locations, primarily in California and Florida.
Under its current agreement with Seritage, ESL has the right to terminate leases for up to 16 properties in March 2020. It plans to do just that. For the other 13 stores being closed, ESL must pay a termination fee equal to one year of rent and estimated expense reimbursements.
The good news is that the annual base rent for these 29 stores combined is just $8.3 million. For comparison, Sears and Kmart accounted for more than $150 million of rent on an annualized basis back in 2015. That figure has since fallen to less than $20 million. The Sears and Kmart stores that will remain following these closures and a handful of pending asset sales and store recaptures will generate $9.6 million of rent annually for Seritage.
An insignificant headwind
Sears and Kmart will continue to pay full rent for the space they are vacating until March 1. Seritage will also receive a termination fee of several million dollars. Meanwhile, in recent quarters, Seritage has averaged new lease signings worth about $12 million in annual rent. By the end of last quarter, its backlog of signed leases for tenants that had yet to open, and thus aren't paying rent, totaled $89.4 million of annual base rent. The majority of this revenue stream will come on line by the end of next year.
Thus, Seritage is poised to start reporting rapid growth in revenue, net operating income, and other key financial metrics next year. The closure of more than half of its remaining Sears and Kmart stores will be a small blip in that growth story, but nothing more.