Home Improvement Company Finding Gains Among the Volatility

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Since its October 12 spin-off from parent company Sears Holdings (NASDAQ: SHLD), shares of Sears Hometown and Outlet Stores (NASDAQ: SHOS) have performed roughly 7% better than the S&P 500 and NASDAQ stock indexes, but with a lot more volatility. In absolute terms, the company's shares have increased by about 12 percent from a first-day closing price of $30.68 to a January 18 closing price of $34.50. The spun-off company is known interchangeably as "Sears Outlet" and "Sears Hometown."

Sears Outlet shareholders who cashed out their holdings during late October or early November may have profited considerably from the deal. Shares of Sears Outlet rose rapidly after the spin-off to reach an all-time closing high of $37.14 on November 5. Initial investors who sold their holdings at this high point earned a 21-day return north of 21 percent. This translates to an annualized return of nearly 300 percent.

The Spin-off Deal
The terms of the deal involved a one-month rights offering to all Sears Holdings shareholders of record as of September 7, 2012. The rights offering expired as indicated on October 8, 2012. Each rights-holder was entitled to purchase 2.18091 shares of Sears Outlet stock for every 10 shares of Sears Holdings stock that he or she owned. No fractional shares were issued in the deal. According to Sears Holdings, more than 95 percent of the company's shareholders had exercised their purchase rights by the October 8, 2012 expiration date.

The deal has proven to be lucrative for Chicago-based Sears Holdings. The company estimates that it has earned $446.5 million from the spin-off. The balance of these proceeds came from the initial shareholder-rights offering. The company also received $100 million in funding for a special cash dividend from a new secured line of credit. This dividend was paid out to Sears Holdings shareholders before the spin-off was completed.

The spin-off's performance has special implications for the current chairman of Sears Holdings. As part of the deal, Edward Lampert's investment firm ESL investments received a majority stake in the new company.

Sears Holdings is one of the largest North American retailers. It employs nearly 300,000 people in several thousand retail stores in the United States and Canada. The company also operates an e-store and runs a growing appliance-repair service known as the "Blue Team." Specialty businesses under the ownership of Sears Holdings include a 108-branch travel agency, a mail-order catalog and e-store that collectively utilize over 1,700 pick-up locations in the United States, and a standalone flooring division.

Sears Holdings continues to struggle to turn around a sprawling and uncompetitive retail business. During the past several years, it has posted quarterly losses on a consistent basis and continues to shed stores and employees. Worse, it typically experiences weak sales figures during the all-important holiday shopping season. In addition to the Sears Hometown and Outlet spin-off, it recently spun off its struggling Sears Canada business.

Sears Hometown is significantly more profitable than its struggling parent company. In 2011, the division took in over $2.3 billion in revenues and realized about $33 million in net profits. At its current float levels, the company produces over $100 in sales per outstanding share. Unlike its former parent, Sears Hometown continues to open new retail locations. It operates about 1,300 stores between its Sears Outlet and Sears Hometown and Hardware Divisions. Both store types cater to tradesmen, building contractors and "do-it-yourself" home improvement enthusiasts.

Sears Hometown and Outlet has not been not immune to the problems that have weakened Sears Holdings. The company has seen comparable-store sales and net profits decrease during the past three fiscal years. The deep slump in construction spending hit its core customer base of home-improvement contractors and home-builders. What's more, it has been forced to slash its prices in order to remain competitive with larger home-improvement warehouse stores like Home Depot (NYSE: HD) and Lowe's (NYSE: LOW).  Both Home Depot and Lowes do over $50 billion in sales annually (compared to Sears Hometown’s $2.4 billion) and can use these sales figures to get inventory for lower prices than Sears Hometown.  Plus, Home Depot and Lowes can afford the ups and downs of the construction industry even with tight margins due to their cash reserves.

Ongoing economic trends could prove favorable for both businesses. As North American residential construction ramps up, Sears Outlet may see an uptick in demand from builders and contractors for its raw materials, tools and landscaping equipment. Likewise, Sears Holdings's flagship retail outlets may see increased demand from retrofitting homeowners for its Kenmore-branded line of energy-efficient appliances. However, it is likely that Sears Holdings will continue to consolidate its core operations in the face of price pressure from discounters like Wal-Mart and Target.

By traditional metrics, both companies are significantly undervalued. If Sears Holdings and its new spin-off can produce several consecutive quarters of meaningful sales growth, the companies' stock prices may rise sharply. Given the secular trends working in its favor, this would make the decision to spin off Sears Outlet look prescient.

mthiessen has no position in any stocks mentioned. The Motley Fool recommends Home Depot and Lowe's Companies. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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