Sears Hometown Will Rejoin the Shrinking Sears Empire

In late 2012, Sears Holdings spun off its small-format store operations as Sears Hometown and Outlet Stores (NASDAQ: SHOS). The move was mainly a ploy to raise cash to fund turnaround efforts at Sears and Kmart. Sears received a $100 million dividend from Sears Hometown, as well as proceeds of $346.5 million from a rights offering whereby Sears Holdings shareholders acquired shares of the new spinoff.

Chairman Eddie Lampert may have expected the profitable Sears Hometown and Outlet Stores business to thrive as an independent entity. However, it has struggled nearly as much as its former parent, which filed for bankruptcy last October and barely survived.

As a result, Lampert -- who acquired the remnants of Sears and Kmart out of bankruptcy through his hedge fund -- is now set to buy Sears Hometown, reuniting it with Sears' full-line operations. Unfortunately, bulking up in this way isn't likely to help Sears survive in the face of withering competition from the likes of Best Buy (NYSE: BBY).

Another Sears disappointment

When Sears Hometown and Outlet Stores became independent, investors were initially bullish about its prospects. After all, Sears Hometown primarily operates in small markets where there is limited competition, while the outlet segment dominates the domestic market for refurbished and as-is appliances.

Sears Hometown stock quickly doubled from the $15 price at which Sears Holdings sold shares in the late-2012 rights offering. The stock briefly surpassed $50 in 2013. But it's been all downhill since then. Sears Hometown shares have traded for less than $5 since 2017 and have changed hands for less than $2 at times during the past two years.

The problems were much the same as at Sears Holdings. Sears Hometown and Outlet Stores suffered a series of sales declines and severe margin erosion over its first several years as an independent company. Adjusted earnings before interest, taxes, depreciation, and amortization plummeted from nearly $100 million in 2012 to less than $10 million in 2014 and 2015 before falling into negative territory by 2016.

Management did a decent job of getting the outlet business back on track last year. However, the larger Sears Hometown segment continues to bleed cash, having been hit hard by the growth of e-commerce and reputational damage caused by Sears Holdings' slow slide into bankruptcy.

Lampert gets what he wants -- again

The Sears Hometown segment has lost an average of about $50 million in each of the past two fiscal years. Management has warned investors that there's no clear path back to profitability for that segment. As a result, the company's board was on the verge of voting to liquidate the Hometown part of the business in April.

Lampert blocked that move through a boardroom coup -- made possible by his majority stake in Sears Hometown and Outlet Stores. He replaced two board members and instituted new rules to make it harder to approve a liquidation.

That cleared the way for Lampert to achieve his ultimate aim: buying Sears Hometown and combining it with the rest of his Sears empire again. Last Monday, Lampert's holding company announced a deal to acquire Sears Hometown and Outlet Stores for $2.25 per share.

As part of the sale agreement, Sears Hometown has a few months to try to sell its outlet segment -- which produced a $19 million operating profit last year -- to a third party. If another buyer is willing to pay more than $97.5 million for that segment, the deal price will be adjusted upward. Thus, Lampert is only guaranteed to receive the core Hometown segment, while the outlet business ultimately may be sold to another party.

Another marriage of two dying retailers

Lampert's move to buy Sears Hometown is part of a broader effort to double down on appliance sales, particularly in small-format stores. The two companies said that on a combined basis, they would be the third-largest appliance retailer in the U.S., surpassing Best Buy.

That might have been true a year ago, but it's not the case today. Sears (including its Kmart and Monark Premium Appliances chains) and Sears Hometown (including the outlet stores) had combined appliance sales of $4.5 billion in 2017. However, Sears has closed more than half of its stores since then, while Sears Hometown's appliance revenue fell by about $200 million last year and will likely keep falling due to additional store closures. Meanwhile, Best Buy -- which already did $3.4 billion of appliance sales in 2017, including its Pacific Sales subsidiary -- has been averaging roughly 10% comp sales growth for appliances recently.

Together, Sears and Sears Hometown will have less scale than Sears did by itself just two years ago. As a result, they will continue to lose top-of-mind status and purchasing power relative to the three appliance retail giants: Lowe's, The Home Depot, and Best Buy. Making matters worse, Sears' weak financial position means it can't make the big marketing investments that would be necessary to rebuild the Sears brand.

Thus, the Sears-Sears Hometown deal looks like a miniature version of the Sears-Kmart merger. We all know how that played out. Combining two weak, declining companies might unlock some savings on overhead, but it won't stop them from sliding into oblivion. While they may stumble on for a few more years, neither Sears nor Sears Hometown has a long-term future.

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Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool recommends Home Depot and Lowe's. The Motley Fool has a disclosure policy.