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SEARS HOMETOWN AND OUTLET STORES, INC. REPORTS 2Q 2017 RESULTS
Source: Sears Hometown And Outlet Stores, Inc. news release

Hoffman Estates, Illinois OFFMAN -- Sears Hometown and Outlet Stores, Inc. ("SHO," "our," "we," or the "Company") has reported results for the quarter ended July 29, 2017. 

Overview of Unaudited Results

Results for the second fiscal quarter of 2017 compared to the second fiscal quarter of 2016 included:

Comparable store sales decreased 2.1% ;
Net loss increased $40.0 million to $29.4 million from net income of $10.6 million;

Loss per share increased $1.77 to $(1.30) loss per share from $0.47 earnings per share;

Adjusted EBITDA increased $3.7 million to $2.8 million income from a $0.9 million loss.

In the second quarter of 2017 the Company incurred charges of $12.6 million (of which $2.4 million were non-cash) for the previously announced accelerated store-closing initiative and non-cash charges of $5.6 million related to the write-off of, and additional reserves taken on, franchisee notes receivable.  In addition, IT infrastructure investments increased $5.2 million to $8.5 million in the second quarter of 2017 compared to $3.3 million in the second quarter of 2016. In the second quarter of 2016, the Company recognized a $25.3 million gain related to the sale of an owned property located in San Leandro, California. 

Will Powell, Chief Executive Officer and President, said, "Our reported results for net loss and loss per share were unfavorable to the prior year primarily due to the charges and IT infrastructure investments incurred this year and the recognition in the prior year of a $25.3 million gain on sale of assets. However, our continuing progress to transform our business is evidenced by our year-over-year adjusted EBITDA improvement in the second quarter. We still have much work ahead to complete our transformation efforts, but it is apparent that many of the initiatives that we are pursuing are positively impacting our business including attracting new customer segments, transitioning to a fully-integrated omni-channel customer experience, optimizing our store portfolio, and improving our merchandise assortments."

"We converted 74 stores to our America's Appliance Experts (AAE) format in the second quarter, and these stores consistently outperform our other stores. We are growing our lease-to-own program at a rapid pace, exceeding our full-year 2016 leasing sales in the first half of 2017. We continue to make progress on the optimization of our store portfolio through carefully timed and targeted store closures, which we believe will give us a base of stores that will provide a long-term platform for success. Our commercial sales business is in its third year and and continues its rapid growth, up 25.2% in the first half of 2017."

"Although our new Hometown segment websites are starting from a low revenue base, they continue to grow quickly relative to their share of our total sales volume, nearly doubling this share in the second quarter compared to first quarter. Our merchandising initiatives have made significant progress in 2017, first with our previously announced strategic relationship with KENMORE, and in July our completion of a direct-purchase supply agreement with a leading appliance manufacturer, which we believe will ensure a significant source of supply, ongoing support, and competitive pricing."

"Finally, we continue to work towards completion of our IT infrastructure project, which we believe will provide greater strategic and operational flexibility, provide better control of our systems and processes, and reduce our total costs of information-system ownership. We are already achieving many benefits from the portions of this project that have been completed, including the ability to directly purchase from manufacturers and other vendors."

Segment Performance Highlights

Consolidated comparable store sales were down 2.1% in the second quarter of 2017:

Hometown comparable store sales declined 0.9% in the second quarter of 2017. Home Appliances comparable store sales performed slightly better than the first quarter of this year. The Lawn & Garden and tools businesses realized a material improvement over its first quarter performance.

Outlet comparable store sales declined 5.0% in the second quarter of 2017. Home appliances had negative comparable store sales comparisons but improved its performance against the first quarter of this year. Furniture achieved strong, double-digit comparable store sales increases, the result of our transition to the new furniture program through our relationship with Ashley Furniture. We believe this will be a strong growth category that should provide positive sales and margin growth for the balance of 2017. Mattresses also posted positive comparable store sales for the quarter, due to improved inventory availability and a favorable promotional pricing structure.

Progress on Initiatives

Lease-to-Own: Our lease-to-own program (made available through Sears Holdings Corporation by a non-affiliated leasing-program provider) continues to represent one of our biggest opportunities to attract new customers to our business and provide meaningful long-term sales growth at better margins. We grew year-over-year leasing sales by 110% in the second quarter, more than doubling the leasing share of our total business to 5.7%. In the first half of 2017 we exceeded our total leasing sales for the full-year 2016 and we expect that this business will generate more than $100 million in sales during our 2017 fiscal year. The third-party commissions we receive on leasing sales are also becoming a noteworthy contributor to our margin.

Hometown Transactional Websites:  Sales through our new Hometown segment websites are below our expectations, but we are experiencing consistent sales growth that demonstrates the long-term potential of this channel for our business.  Sales through the Hometown segment websites sales nearly doubled in the second quarter compared to the first quarter, driven by our expansion of the online free-delivery program, free shipping for qualifying items, and the rapid growth of customers applying for and completing lease-to-own transactions online.  We expect the Hometown segment websites to continue to grow rapidly and become a more meaningful contributor to our business over the balance of 2017 and beyond.

America's Appliance Experts:  Our program to refresh our store base and offer appliance customers a unique, high-quality shopping experience through the AAE program continues to expand.  We converted 74 stores to the AAE format in the second quarter, ending the quarter with 616 total AAE stores, representing 77% of the Hometown segment stores. The  dealer-format AAE stores continue to outperform non-AAE locations year-to-date, with better comparable store sales performance (+442 basis points) in appliances and total comparable store sales (+224 basis points).  These stores also continue to achieve measurably higher adjusted margin in appliances than non-AAE locations.  In the third quarter we plan to complete an additional 50 AAE remodels.

Commercial Sales:  Our commercial sales business highlights our capability to build new customer segments. This relatively new business for SHO continues to grow rapidly, with year-to-date sales up 25.2% to last year and a higher percentage of stores participating in the program.  Our ability to provide customized solutions for commercial customers in rural markets, featuring convenient store locations, large assortments, competitive pricing and local delivery/installation services is a key competitive advantage that is allowing us the opportunity to grow this business quickly.

Merchandise Sourcing Strategic Relationships:  The strategic relationship we forged with Sears Holdings's Kenmore business at the end of the first quarter has proved to be beneficial for the Kenmore brand and SHO, as we increased our Kenmore comparable store sales and margin rate year-over-year in the second quarter. Separately, starting later in the third quarter we will begin purchasing appliances directly from a leading appliance manufacturer. This is an important milestone for SHO, as this is our first direct-purchase relationship with an appliance vendor since our 2012 separation (the "Separation") from Sears Holdings. Our direct-purchase ability is enabled by our new IT infrastructure investments, as previously we did not have the capabilities necessary to manage direct purchases. We expect to enter into direct-purchase supply agreements with additional manufacturers in the third quarter of this year.

Store Portfolio:  We continue to make significant progress on the optimization of our store portfolio, ensuring capital will be allocated to those stores that can be productive for the Company over the long-term. We closed 81 stores in the second quarter, 70 in the Hometown segment and 11 in the Outlet segment. This resulted in store-closing related charges of $12.6 million including $1.0 million of fixed asset impairment charges. These stores had significant negative EBITDA and required over $26 million in inventory working capital. Improving the overall health of our store portfolio is an important part of our transformation strategy. While we have completed many of the difficult store-closing actions we have planned, there are still opportunities remaining to close stores that are weighing on our performance as we near lease-end dates or identify other financially prudent opportunities to more quickly close these stores.

We also completed the reacquisition of 14 Outlet store locations from a franchisee in the second quarter.  As a result of this action, we took a charge of $5.5 million to write-off a portion of the note receivable balance from the franchisee.  These stores were poor performers, and we believe that we have the opportunity to run them more effectively and profitably as Company-operated stores.  In addition, if we cannot improve the performance of these stores, we can close them at our discretion. We are pleased with our progress since the reacquisition as the sales and margin trends for these stores in aggregate has improved.

IT Infrastructure and Operational Separation: We continued to make progress on our IT infrastructure initiative in the second quarter of 2017. Through this initiative, we will enable greater strategic and operational flexibility within our business as we finalize a broad-scale implementation of customized information technology and business operating systems. This action will further reduce our reliance on Sears Holdings for IT services and support, which have been provided since the Separation. In the second quarter our efforts were largely focused on finalizing systems development, progressing through various forms of systems integration and cut-over testing, and preparing for user-acceptance testing and full-scale deployment. To date, we have completed partial migration, and have been utilizing several components of the new systems architecture including; but not limited to, Hometown transactional websites, human resources management, payroll and owner commissions management, merchandise sourcing, procurement, accounts payable and accounts receivable. In the third quarter, we expect to increase our direct merchandise sourcing and procurement capabilities via the expansion of our NetSuite ERP functionality using SPS Commerce. In the upcoming quarter, we will roll out the necessary training so that the new systems can be fully implemented later this year.  Selling and administrative expenses included $8.5 million of IT infrastructure investments in the second quarter of 2017 compared to $3.3 million in the second quarter of 2016. We expect store deployment of point-of-sale systems and other major components of our IT infrastructure initiative to be to be substantially completed by the end of our 2017 fiscal year.

Second Quarter Results

Net sales in the second quarter of 2017 decreased $66.4 million to $490.0 million, or 11.9%, from the second quarter of 2016.  This decrease was driven primarily by the impact of closed stores (net of new store openings) and a 2.1% decrease in comparable store sales. Comparable store sales were down 0.9% and 5.0% in Hometown and Outlet, respectively.

Gross margin was $92.3 million, or 18.8% of net sales, in the second quarter of 2017 compared to $114.9 million, or 20.6% of net sales, in the second quarter of 2016. The decrease in gross margin rate was primarily driven by $11.2 million of store closing costs, partially offset by a $1.7 million physical inventory gain in Outlet.  The combined impact of store closing costs and shrink on the gross margin rate was a reduction of 233 basis points in the second quarter of 2017 and a reduction of 32 basis points in the second quarter of 2016.

Selling and administrative expenses decreased to $115.2 million, or 23.5% of net sales, in the second quarter of 2017 from $118.8 million, or 21.4% of net sales, in the prior-year comparable quarter.  The decrease was primarily due to lower expenses from stores closed (net of new store openings) since the third quarter of 2016 and lower commissions paid to dealers and franchisees on lower sales volume. The reductions were partially offset by higher IT transformation investments and charges of $5.6 million related to the write-off of, and additional reserves taken on, franchisee notes receivable in the second quarter of 2017.  IT transformation investments were $8.5 million, or 1.7% of sales, in the second quarter of 2017 compared to $3.3 million, or 0.6% of sales, in the second quarter of 2016.  Excluding the impact of the higher IT transformation investments and the charge related to franchisee notes receivable, selling and administrative expenses as a percent of sales were unchanged.

During the second quarter of 2016, we completed the sale of an owned property located in San Leandro, California. Net proceeds from the sale were $26.1 million, and we recorded a gain on the sale of $25.3 million.  In the second quarter of 2017, we took a $1.0 million charge related to the write-off of closed-store fixed assets.

We recorded an operating loss of $27.6 million during the second quarter of 2017 compared to operating income of $18.0 million during the second quarter of 2016, which period included the $25.3 million gain on sale of assets.  The decrease in operating income was also due to lower volume and a lower gross margin rate partially offset by a decrease in selling and administrative expenses.

Second Quarter Net Loss

We recorded a net loss of $29.4 million for the second quarter of 2017 compared to net income of $10.6 million for the prior-year comparable quarter. The increase in our net loss was primarily attributable to the factors discussed above.  Income tax expense of $0.2 million and $6.9 million were recorded in the second quarters of 2017 and 2016, respectively. The effective tax expense rate was (0.8)% in the second quarter of 2017 and 39.3% in the second quarter of 2016.

Financial Position

We had cash and cash equivalents of $18.3 million as of July 29, 2017 and $18.7 million as of July 30, 2016.  Unused borrowing capacity as of July 29, 2017 under our Amended and Restated Credit Agreement dated as of November 1, 2016 (the "Senior ABL Facility") was $86.8 million with $112.4 million drawn and $6.1 million of letters of credit outstanding. For the first two quarters of 2017, we funded ongoing operations with cash provided by financing activities. Our primary needs for liquidity are to fund inventory purchases, IT transformation investments, and capital expenditures and for general corporate purposes.
In the first quarter of 2017, we resumed our agreement with Sears Holdings whereby we paid Sears Holdings's invoices for merchandise and services on accelerated terms in exchange for a 37 to 43-basis point cash discount. The discounts we received for the accelerated payments, less incremental interest expense, resulted in a net financial benefit to the Company. Our Senior ABL Facility borrowings increased as of July 29, 2017 by approximately $23 million as a result of the agreement.  We can, in our sole discretion, revert to ten-day, no-discount payment terms at any time.

Total merchandise inventories were $356.9 million at July 29, 2017, $427.2 million at July 30, 2016 and $373.8 million at January 28, 2017.  Merchandise inventories declined $53.5 and $16.8 million in Hometown and Outlet, respectively, from July 30, 2016. The decrease in Hometown was primarily due to store closures. Outlet's decrease was primarily driven by store closures, lower home appliances receipts, and a furniture assortment transition partially offset by higher lawn and garden inventory resulting from opportunistic buys.

Comparable Store Sales

Comparable store sales include merchandise sales for all stores operating for a period of at least 12 full months, including remodeled and expanded stores but excluding store relocations and stores that have undergone format changes.  Comparable store sales include online transactions fulfilled and recorded by SHO and give effect to the change in the unshipped sales reserves recorded at the end of each reporting period.

Adjusted EBITDA

In addition to our net loss determined in accordance with generally accepted accounting principles ("GAAP"), for purposes of evaluating operating performance we also use adjusted earnings before interest, taxes, depreciation and amortization, or "adjusted EBITDA," which excludes certain significant items as set forth and discussed below.  Our management uses adjusted EBITDA, among other factors, for evaluating the operating performance of our business for comparable periods. Adjusted EBITDA should not be used by investors or other third parties as the sole basis for formulating investment decisions as it excludes a number of important cash and non-cash recurring items.  Adjusted EBITDA should not be considered as a substitute for GAAP measurements.

While adjusted EBITDA is a non-GAAP measurement, we believe it is an important indicator of operating performance for investors because:

EBITDA excludes the effects of financing and investing activities by eliminating the effects of interest and depreciation costs; and

Other significant items, while periodically affecting our results, may vary significantly from period to period and may have a disproportionate effect in a given period, which affects comparability of results. These items may also include cash charges such as severance and executive transition costs and IT transformation investments that make it difficult for investors to assess the Company's core operating performance.

Since the second quarter of  2015 the Company has excluded initial franchise revenues from adjusted EBITDA.  This change is based on (1) the Company's decision to indefinitely suspend its franchising of additional stores except to existing Company franchisees and (2) to better align adjusted EBITDA for purposes of incentive compensation.

The Company has undertaken an initiative on a limited number of occasions to accelerate the closing of under-performing locations in an effort to improve profitability and make the most productive use of capital.  Under-performing locations are typically closed during the normal course of business at the termination of a lease or expiration of a franchise or dealer agreement and, as a result, do not have significant future lease, severance, or other non-recurring store-closing costs. When we conduct a significant number of store closings or we close stores on an accelerated basis (closing prior to termination or expiration), the Company excludes the associated costs of the closings from adjusted EBITDA. In the second quarter of 2017, we excluded $11.6 million of costs associated with the accelerated closure of 81 stores. An additional $1.0 million of costs related to the accelerated closings is included in depreciation and amortization expense.