It's no secret that spinoffs often spell big opportunities for the diligent investor. While often too complicated for the average retail investor to glance at, those who spend the time can find hidden value. When ailing retailer Sears announced it was spinning off the most important parts of the company in a special rights offering, the spinoff artists went to work. It was a complicated procedure, and perhaps too daunting for many amateur investors. However, once you scratch beneath the surface, you will find a company with high growth prospects, extremely favorable relationships with its supplier (you can easily guess who that is), and, most importantly, a stock that trades at sharp discount to its potential value.
Here are three great reasons to buy Sears Hometown and Outlet Stores.
It may surprise readers to hear the words "Sears" and "growth" in the same sentence. Sears Holdings (Nasdaq: SHLD) hasn't been a growth story for quite some time. Sears stores are often known to be deserted lands used as oversized mall entrances. Since fund manager Eddie Lampert took control of the company, he has consolidated operations, including merging another ailing retailer, Kmart, with Sears to form Sears Holdings. While there have been many critics of Lampert's actions with Sears, his move to wind down the big-box stores and spin off the high-value concepts cannot be praised enough. This is truly the best news to befall the company in a long time.
The new company, Sears Hometown and Outlets (Nasdaq: SHOS), is, simply put, a high-growth engine of profit. There are three businesses operating under the parent company, and each offers investors a compelling story.
Let's look at Sears Outlets first. It owns and operates 123 warehouse-style stores that sell appliances and other items at steep discounts to average retail pricing, in an approach similar to Costco (Nasdaq: COST). Before we get too far into the details, it's worthwhile to note that Sears, despite its seemingly empty stores, is the largest appliance retailer in the nation. Within Sears is the brand Kenmore, which happens to be the country's biggest-selling brand of appliances, and is available only through Sears.
Sears Outlets finds the vast majority of its sales from its appliance department. In the first six months of this year compared with the prior year, Sears Outlets net sales rose 9.45 %. Since the second quarter of 2011, the company opened 15 new outlet stores. Yet with only 123 stores currently, there remains a wide path for growth of these stores around the nation. By being the child of Sears Holdings, Sears Outlets has a fantastic supplier relationship. Sears Outlets can take "as is" products and old models off Sears Holdings' hands and still sell them at a high margin in its stores. If the company is unable to sell the appliances, it has the ability to then sell back the goods at cost. This is a tremendous advantage for the company over its peers. In addition to its relationship with Sears Holdings, Sears Outlets can buy from other manufacturers as well, thus offering a wide variety of products to consumers at deep discounts.
As the segment grows -- and it will, via new stores and further marketing initiatives -- Sears Outlets will be a revenue powerhouse for the company.
The second element is Sears Hometown stores, which sell appliances and hardware. These stores are great for the company as a whole in that they are:
1. Franchised -- putting ownership in the hands of individuals who will have a lot of incentive to run their own stores well. The franchisee will pay rent and labor costs and earn sales commissions, while the rest flows up to the parent company.
2. Small, neighborhood-friendly stores. The parent company offers corporate support while the store retains the advantage of looking like a family-owned business that puts the customer first.
The era of big-box stores is coming to a close, as the economics simply don't make sense with increasing competition from Internet retailers and a re-emphasis on neighborhood-style businesses. People are more willing to pay full retail price at a small, independently owned business than at a big-box corporate store. All in all, Sears Hometown stores can command higher prices while shifting the risk of selling costs and other fixed costs to the individual storeowner. The result is higher margins on both the top and bottom lines.
The final segment is Sears Appliances and Hardware stores. The appliance stores follow a similar argument to the aforementioned Hometown stores -- franchised out to individuals, which provides better economics to the parent company from a growth and margin point of view. These stores are available in metropolitan areas and will largely replace the closing Sears stores.
The hardware stores are, admittedly, my least favorite part of the business. They tend to be low-margin businesses. Tools represent the least amount of revenue for the stores, even though Sears is the exclusive carrier of the highly respected Craftsman and DieHard brands. According to the company, there is an effort to shift all of these stores to franchise-owned. This will, again, improve the economics and enable to company to realize some additional revenue growth.
All in all
Right now, SearsHometown and Outlets trades at around $37.10 per share. If we annualize the first six months of adjusted EBITDA, as given in the company's 10-Q, we see that the company is trading at roughly 6.8 times its EDITDA with respect to its enterprise value. For some comparison, you can look again at Costco (I realize this is not the ideal competitor), which trades at 10.86 times its EBITDA with respect to its enterprise value and, in my opinion, doesn't offer as attractive growth prospects compared with Sears Hometown and Outlets and its highly segmented industry dynamics. This gives you an idea of how relatively cheap the company is.
These reasons are obviously just the different parts of the business. I could list the external reasons the business will succeed, such as a rebound in housing. Or I could point to the success of Fortune Brands Home and Security (NYSE:FBHS), which did extremely well based on both new housing starts and, for those who could not afford new homes, increased renovations. Sears Holdings is winding down its mall-based empty stores and allowing the new spinoff to take those consumers into a new, more profitable and enjoyable environment.
Fool contributor Michael B. Lewis has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.