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SEARS HOMETOWN & OUTLET STORES, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the Consolidated Financial Statements and notes contained in our Annual Report on Form 10-K for the fiscal year ended February 2, 2013. For pre-Separation periods these financial statements and notes reflect the combined Sears Hometown and Hardware and Sears Outlet businesses of Sears Holdings, which, together with our operation of these businesses following the Separation, are referred to herein as "our" financial condition and results of operations. This discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. Executive Overview We are a national retailer primarily focused on selling home appliances, hardware, tools, and lawn and garden equipment. As of November 2, 2013, we and our dealers and franchisees operated 1,239 stores across all 50 states, Puerto Rico, and Bermuda. In the third quarter of 2013, the Company opened 16 new stores and closed 27 stores. Fourteen of the closures in the third quarter, and 21 year-to-date, resulted from the termination by Orchard Supply Hardware LLC ("OSH") during its bankruptcy proceeding of its Consignment Agreement with us pursuant to which OSH had sold our home-appliance inventory at appliance showrooms that OSH operated in its stores (the "OSH Termination"). In addition to merchandise, we provide our customers with access to a full suite of services, including home delivery, installation, and extended service contracts. Our Hometown and Hardware stores are designed to provide our customers with in-store and online access to a wide selection of national brands of home appliances, tools, lawn and garden equipment, sporting goods, and household goods, depending on the particular format. Our Outlet stores are designed to provide our customers with in-store and online access to purchase, at prices that are significantly lower than manufacturers' list prices, new, one-of-a-kind, out-of-carton, discontinued, obsolete, used, reconditioned, overstocked and scratched and dented products across a broad assortment of merchandise categories, including home appliances, lawn and garden equipment, apparel, mattresses, sporting goods, and tools. As of November 2, 2013, Hometown consisted of 1,108 stores as follows: • 925 Sears Hometown Stores-Primarily independently owned stores, predominantly located in smaller communities and offering appliances, lawn and garden equipment, and hardware. Most of our Sears Hometown Stores carry proprietary Sears brand products, such as Kenmore, Craftsman, and DieHard, as well as a wide assortment of other national brands. • 88 Sears Hardware Stores-Hardware stores that carry Craftsman brand tools and lawn and garden equipment, DieHard brand batteries and a wide assortment of other national brands and other home improvement products along with a selection of Kenmore and other national brands of home appliances. • 95 Sears Home Appliance Showrooms-Stores that have a simple, primarily appliance showroom design that are positioned in metropolitan areas. As of November 2, 2013, Hometown operated through 926 dealer-operated stores, 154 franchisee-operated stores, and 28 Company-operated stores. The business model and economic structure of the dealer-operated and franchisee-operated stores, which are independently owned, are substantially similar to Company-operated stores. The Company requires all of the dealers and franchisees to operate according to the Company's standards. Dealers and franchisees must display the required merchandise, offer all required products and services, and use the Company's point of sale system. Also, the Company has the right to approve advertising and promotional and marketing materials and imposes certain advertising requirements on the dealers and franchisees. The Company establishes selling prices of merchandise inventories (which are owned by the Company) and establishes a common commission structure for the dealers and for the franchisees, who are paid commissions on the merchandise they sell. Because the merchandise is owned by the Company and delivered to dealers and franchisees on consignment, we maintain general inventory risk (with specific exceptions) before the completion of the customer purchase and upon merchandise return by the customer, if any. In addition, because each transaction is recorded in the Company's point-of-sale system (maintained by Sears Holdings), we bear the collection risk. Dealers and franchisees exercise predominant control over the day-to-day operations of their stores, and are solely responsible for supervising their employees and making capital decisions. The primary difference between independently operated stores and Company-operated stores is that the Company is responsible for occupancy and payroll costs associated with Company-operated stores. Independent store operators are responsible for the occupancy costs in their stores and the payroll of their employees. 18-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 In the normal course of business stores can transition from Company-operated to franchisee or dealer-operated, and vice-versa. Potential new store locations may be identified by the Company, an existing dealer or franchisee, or a potential dealer or franchisee. If the Company identifies and develops a location, it will generally seek to transfer that store to a dealer or franchisee. When a dealer or franchisee ceases to operate a store, the Company may take over the operation of the store, generally on an interim basis until the store can be transferred to a new dealer or franchisee. At any given time, the Company is generally operating a number of stores that are in transition from one dealer or franchisee to another dealer or franchisee. Transition stores are included in our count of Dealer or franchisee-operated stores and are not included in our count of Company-operated stores due to the expected short-term nature of transition operation. Due to new stores developed and transferred to franchisees, as well as existing Company-operated stores transferred to franchisees, the Company has recorded initial franchise revenue in ten of the last eleven quarters. Both the number of store locations transferred in a period, and the revenue recorded on those transfers, is highly variable. The variation is driven by a number of factors, including (1) general economic conditions (which influence both the level of new store development and the level of interest of existing or potential dealers and franchisees in acquiring store locations), and (2) economic factors specific to our major product categories, such as appliances, which impact the expected returns on new store development and the number of Company-operated locations available for transfer. Historically, all of the Company's Outlet stores have been owned by the Company. The Company began a trial program for franchising Outlet stores in late 2012. The initial franchise transfers under this program were completed in the first quarter of 2013. As of November 2, 2013, Outlet consisted of 131 Sears Outlet stores including fourteen franchisee-operated stores. Impacts from Our Separation from Sears Holdings Following the Separation, we have operated as a publicly traded company independent from Sears Holdings, which has, and will have, a range of impacts on our operations: General Administrative and Separation Costs. SHO consists of what were formerly the Sears Hometown and Hardware and Sears Outlet businesses owned by Sears Holdings. Prior to the Separation we used the corporate functions of Sears Holdings for a variety of services including treasury, accounting, tax, legal, and other shared services, which included the costs of payroll, employee benefits and other payroll-related costs. Also prior to the Separation Sears Holdings contributed other corporate functions, such as senior management and centrally managed employee benefit arrangements. We were allocated $6.7 million and $14.6 million of shared services costs incurred by Sears Holdings in the third quarter and first three quarters of 2012, respectively. Such expenses may not be indicative of the actual level of expense that would have been incurred by us if we had operated as a publicly traded company independent from Sears Holdings. For the third quarter of 2013 and the first nine months of 2013, we were charged $5.6 million and $16.0 million, respectively, by Sears Holdings for shared services costs. We will incur increased costs as a result of having become, and maintaining our status as, a publicly traded company independent from Sears Holdings. As an independent public company, we have incurred, and will continue to incur, incremental costs to support our businesses, including management personnel, legal, finance, and human resources costs. Prior to the Separation, we entered into various agreements with Sears Holdings that, among other things, (1) govern the principal transactions relating to the Separation and aspects of our relationship with Sears Holdings following the Separation, (2) establish terms under which subsidiaries of Sears Holdings are providing services to us, and (3) establish terms pursuant to which subsidiaries of Sears Holdings obtain merchandise for us (collectively, the "Separation Transactions"). See Note 4 to our Condensed Consolidated Financial Statements included herein. For the third quarter of 2013 the Company estimates that it incurred $5.0 million in costs above the level incurred in the third quarter of 2012 in categories impacted by the Separation. These higher costs included $1.0 million in commissions paid to Sears Holdings' online business, where such a commission arrangement was not in place pre-Separation. $1.1 million of the higher cost resulted from additional staffing, home office rent, D&O insurance, and other costs related to being independent. Another $2.9 million of the higher costs was associated with staffing, marketing, and other corporate services that had been provided by Sears Holdings but only some of which had been allocated to the combined Hometown and Hardware and Outlet business units prior to the Separation. Part II, Item 5 includes a discussion of the December 9 Agreements between the Company and Sears Holdings regarding the resolution of disputes between them. While it is not practicable for the Company to calculate precise amounts, it estimates that, but for the uncertainties arising from these disputes, the Company might have been in a position to record in prior quarters 19-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 of 2013 between $4.0 million and $4.5 million of the operating income recorded in the third quarter of 2013. The Company estimates that of this amount an approximately even split would have been allocated to the Hometown segment and the Outlet segment. 20-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012Seasonality Our business is not concentrated in the holiday season, as the majority of the products we sell are not typically thought of as holiday gifts. Lawn and Garden sales generally peak in our second quarter as customers prepare for and execute outdoor projects during the spring and early summer. Additional data on the revenue, cost, and net income seasonality of the business is available in the Quarterly Financial Data in Note 9 to our Annual Report on Form 10-K for the fiscal year ended February 2, 2013. Results of Operations The following table sets forth items derived from our consolidated results of operations for the 13 and 39 weeks ended November 2, 2013 and October 27, 2012. 13 Weeks Ended 39 Weeks Ended Thousands November 2, 2013 October 27, 2012 November 2, 2013 October 27, 2012 NET SALES $ 561,068 $ 556,903 $ 1,819,084 $ 1,822,445 COSTS AND EXPENSES Cost of sales and occupancy 425,596 418,490 1,380,966 1,365,347 Gross margin dollars 135,472 138,413 438,118 457,098 Margin rate 24.1 % 24.9 % 24.1 % 25.1 % Selling and administrative 121,698 122,054 379,815 368,031 Selling and administrative expense as a percentage of net sales 21.7 % 21.9 % 20.9 % 20.2 % Depreciation 2,177 2,282 6,569 6,815 Gain on the sale of assets (1,567 ) - (1,567 ) - Total costs and expenses 547,904 542,826 1,765,783 1,740,193 Operating income 13,164 14,077 53,301 82,252 Interest income (expense) (738 ) (70 ) (1,969 ) (111 ) Other income 460 382 1,306 968 Income before income taxes 12,886 14,389 52,638 83,109 Income tax expense (5,191 ) (5,629 ) (20,812 ) (32,689 ) NET INCOME $ 7,695 $ 8,760 $ 31,826 $ 50,420 References to comparable store sales amounts within the following discussion include 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 amounts have also been adjusted for the change in the unshipped sales reserves recorded at the end of each reporting period. In addition to our net income determined in accordance with GAAP, for purposes of evaluating operating performance we generally use Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization, or "Adjusted EBITDA." Following the Separation our management has used Adjusted EBITDA to evaluate the operating performance of our business for comparable periods. While Adjusted EBITDA is a non-GAAP measurement, management believes that it can be an important indicator of operating performance because it excludes (1) the effects of financing and investing activities by eliminating interest and depreciation costs and (2) store closing charges and severance costs that may vary significantly from period to period and have a disproportionate effect in a given period, which affects comparability of results. During the 13 and 39 weeks ended November 2, 2013 and the 13 weeks ended October 27, 2012 we incurred zero store closing and severance charges. During the 39 weeks ended October 27, 2012 we incurred $0.8 million of store closing charges and severance costs. Adjusted EBITDA should not be used by investors or other third parties as the sole basis for formulating investment decisions as Adjusted EBITDA excludes a number of important cash and non-cash recurring items. Adjusted EBITDA should not be considered as a substitute for GAAP measurements. The following table presents a reconciliation of Adjusted EBITDA to Net income, the most comparable GAAP measure, for each of the periods indicated: 21-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 13 Weeks Ended 39 Weeks Ended Thousands November 2, 2013 October 27, 2012 November 2, 2013 October 27, 2012 Net income $ 7,695 $ 8,760 $ 31,826 $ 50,420 Income tax expense 5,191 5,629 20,812 32,689 Other income (460 ) (382 ) (1,306 ) (968 ) Interest expense 738 70 1,969 111 Operating income 13,164 14,077 53,301 82,252 Depreciation 2,177 2,282 6,569 6,815 Store closing charges and severance costs (1) - - - 797 Gain on the sale of assets (1,567 ) - (1,567 ) - Adjusted EBITDA $ 13,774 $ 16,359 $ 58,303 $ 89,864 (1) See Note 5 to our Condensed Consolidated Financial Statements included herein. 22-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 201213-Week Period Ended November 2, 2013 Compared to the 13-Week Period Ended October 27, 2012 Net Sales Net sales in the third quarter of 2013 increased $4.2 million, or 0.7%, to $561.1 million from the third quarter of 2012. This increase was driven primarily by higher initial franchise revenues (which were $7.8 million in the third quarter of 2013 compared to $1.5 million in the third quarter of 2012) and new store sales (net of closures). Partially offsetting these increases were a 2.0% decrease in comparable store sales and an unfavorable impact of $3.6 million due to the the 53rd week calendar shift in 2012. The comparable store sales decrease of 2.0% was comprised of a 1.5% decrease in Hometown and a 3.4% decrease in Outlet. The 2.0% decrease was primarily driven by lower major appliances and apparel sales in Outlet; lower Hometown lawn and garden sales; lower tools category sales in both segments; and lower consumer electronics sales following a planned exit of the business in the majority of Hometown stores. These decreases were partially offset by higher major appliances sales in Hometown. Gross Margin Gross margin was $135.5 million, or 24.1% of net sales, in the third quarter of 2013 compared to $138.4 million, or 24.9% of net sales, in the third quarter of 2012. The decrease in gross margin rate was primarily driven by (1) lower margins on merchandise sales, (2) $3.7 million of Outlet distribution center costs that were separated from selling store costs and were reflected in selling and administrative expense in 2012, (3) a $2.3 million warranty expense timing benefit in 2012, (4) $0.9 million primarily consisting of additional occupancy costs incurred as a result of operating as an independent company since the Separation, and (5) lower Outlet merchandise-liquidation income. These decreases were partially offset by an increase in initial franchise revenues, $3.3 million to $3.8 million from the impact of items ultimately reflected in the December 9 Agreements, a $2.1 million increase in warranty reserves in 2012, and lower occupancy costs resulting from the conversion of Company-operated stores to franchisee-operated stores. Selling and Administrative Expenses Selling and administrative expenses decreased to $121.7 million, or 21.7% of net sales, in the third quarter of 2013 from $122.1 million, or 21.9% of net sales, in the prior year quarter. The decrease was primarily due to a reduction in payroll and benefits related to the franchise conversions and $3.7 million in Outlet distribution-center costs (which were separated from selling store costs and reflected in selling and administrative expense in the third quarter of 2012 and reflected in gross margin in the third quarter of 2013), and also included a reduction in expense of $0.7 million from the impact of items ultimately reflected in the December 9 Agreements. These decreases were partially offset by an estimated $4.1 million in higher costs resulting from operating as an independent company, higher owner commissions in both Hometown and Outlet (primarily related to the conversion of Company-operated stores to franchisee-operated stores) and higher marketing costs in Hometown. Operating Income We recorded operating income of $13.2 million and $14.1 million in the third quarters of 2013 and 2012, respectively. The $0.9 million decrease in operating income was driven by the above mentioned lower gross profit rate partially offset by higher net sales, lower selling and administrative expenses, and a $1.6 million gain on the sale of an Outlet store location. Income Taxes Income tax expense of $5.2 million and $5.6 million was recorded in the third quarters of 2013 and 2012, respectively. The effective tax rate was 40.3% and 39.1% in the third quarter of 2013 and 2012, respectively. Net Income We recorded net income of $7.7 million for the third quarter of 2013 compared to $8.8 million for the prior year quarter. The decrease in net income was primarily attributable to the factors discussed above. 23-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 201239-Week Period Ended November 2, 2013 Compared to the 39-Week Period Ended October 27, 2012 Net Sales Net sales in the first three quarters of 2013 decreased $3.4 million, or 0.2%, to $1,819.1 million from the first three quarters of 2012. This decrease was driven primarily by a 1.8% reduction in comparable store sales and lower Outlet merchandise liquidation revenues. These decreases were partially offset by an increase in initial franchise revenues and new store sales (net of closures). Initial franchise revenues were $14.8 million in the first three quarters of 2013 compared to $11.2 million in the first three quarters of 2012. The comparable store sales decrease of 1.8% was comprised of a 2.9% decrease in Hometown and a 1.9% increase in Outlet. The 1.8% comparable store sales decrease was primarily driven by lower sales of lawn and garden in Hometown due to weather-related late starts to the spring/summer and fall seasons and higher sales in 2012 related to Super Storm Sandy, lower consumer electronics sales due to the completed exit of the business in the majority of Hometown stores, and lower Outlet apparel sales due to a narrower assortment. These decreases were partially offset by increases in mattress sales following category expansion in fiscal 2012 and higher home appliances sales. Gross Margin Gross margin was $438.1 million, or 24.1% of net sales, in the first three quarters of 2013 compared to $457.1 million, or 25.1% of net sales, in the first three quarters of 2012. The decrease in gross margin rate was primarily driven by (1) lower margins on merchandise sales, (2) $10.0 million of distribution center costs that were separated from selling store costs and were reflected in selling and administrative expense in 2012 and are now reflected in gross margin, (3) a $3.7 million benefit in the first three quarters of 2012 from the impact of store closing reserves established in 2011 (which benefit did not recur in the first three quarters of 2013), (4) a $2.3 million warranty expense timing benefit in the third quarter of 2012, (5) $2.2 million primarily due to additional occupancy costs as a result of operating as an independent company, and (6) lower Outlet liquidation income. These decreases were partially offset by lower occupancy costs, excluding incremental standalone costs, resulting from the conversion of Company-operated stores to franchisee-operated stores, higher initial franchise revenues, a $2.1 million increase in warranty reserves in the third quarter of 2012, and the pass-through by Sears Holdings of higher cash discounts on Sears Holdings' purchases of merchandise sold to us. Selling and Administrative Expenses Selling and administrative expenses increased to $379.8 million, or 20.9% of net sales in the first three quarters of 2013 from $368.0 million, or 20.2% of net sales, in the prior year quarters. The increase was primarily due to higher owner commissions in both Hometown and Outlet (primarily related to the conversions of Company-operated stores to franchisee-operated stores) and an estimated $14.9 million of higher operating costs incurred as a result of operating as an independent company. These increases were partially offset by $10.0 million in Outlet distribution-center costs that were separated from selling store costs and were reflected in selling and administrative expense in the first three quarters of 2012 and a reduction in payroll and benefits related to the Company-operated stores conversions. Operating Income We recorded operating income of $53.3 million and $82.3 million in the first three quarters of 2013 and 2012, respectively. The $29.0 million decrease in operating income was driven by the decrease in sales, a lower gross margin rate, and an increase in selling and administrative expenses. Income Taxes Income tax expense of $20.8 million and $32.7 million was recorded in the first three quarters of 2013 and 2012, respectively. The effective tax rate was 39.5% and 39.3% in the first half of 2013 and 2012, respectively. Net Income We recorded net income of $31.8 million for the first three quarters of 2013 compared to $50.4 million for the first three quarters of the prior year. The decrease in net income was primarily attributable to the factors discussed above. 24-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 Business Segment Results Hometown Hometown results and key statistics were as follows: 13 Weeks Ended 39 Weeks Ended Thousands, except for number of stores November 2, 2013 October 27, 2012 November 2, 2013 October 27, 2012 Net sales $ 413,171 $ 414,985 $ 1,361,908 $ 1,403,218 Comparable store sales % (1.5 )% 4.4 % (2.9 )% 1.0 % Cost of sales and occupancy 318,362 316,820 1,040,750 1,066,728 Gross margin dollars 94,809 98,165 321,158 336,490 Margin rate 22.9 % 23.7 % 23.6 % 24.0 % Selling and administrative 94,818 94,149 299,175 287,400 Selling and administrative expense as a percentage of net sales 22.9 % 22.7 % 22.0 % 20.5 % Depreciation 760 797 2,372 2,423 Total costs and expenses 413,940 411,766 1,342,297 1,356,551 Operating income $ (769 ) $ 3,219 $ 19,611 $ 46,667 Total Hometown stores 1,108 1,111 13-Week Period ended November 2, 2013 Compared to the 13-Week Period Ended October 27, 2012 Net Sales Hometown net sales decreased $1.8 million, or 0.4%, to $413.2 million in the third quarter of 2013 from $415.0 million in the third quarter of 2012. The decrease was primarily due to a 1.5% decrease in comparable store sales, an unfavorable impact of $4.0 million due to the the 53rd week calendar shift and a $1.2 million reduction related to the OSH Termination. These declines were partially offset by new store sales (net of closures). The comparable store sales decline in the third quarter of 2013 was primarily driven by (1) lower consumer electronics sales after completing the exit of the category in most stores, (2) lower lawn and garden sales due to the impact of higher sales in 2012 related to Super Storm Sandy and declines in fall cleanup sales in 2013 resulting from a late fall, and (3) lower sales in tools and paint as a result of 2012 sales related to Super Storm Sandy that were not repeated in 2013 and a tool storage transition that shifted sales to clearance products as new product arrived. These decreases were partially offset by higher major appliance sales driven by the strong performance during the Labor Day and Columbus Day events of bottom freezers, side-by-side refrigeration, free-standing ranges and dishwashers. Gross Margin Gross margin was $94.8 million, or 22.9% of net sales, in the third quarter of 2013 compared to $98.2 million, or 23.7% of net sales, in the prior year quarter. The reduction in gross margin rate over the prior year quarter was driven primarily by lower margins on merchandise sales due to increased promotional activity, a $2.1 million warranty expense timing benefit in 2012, and lower commissions on online sales. These decreases were partially offset by an increase in warranty reserves in 2012, lower occupancy expenses in 2013 from the conversions of Company-operated stores to franchisee-operated stores, and the impact of items ultimately reflected in the December 9 Agreements. Selling and Administrative Expenses Selling and administrative expenses increased to $94.8 million, or 22.9% of net sales, in the third quarter of 2013 from $94.1 million, or 22.7% of net sales, in the prior year quarter. The increase was primarily due to an estimated $2.6 million in higher costs from operating as an independent company, higher owner commissions mainly related to the conversions of Company-operated stores to franchisee-operated stores, and higher marketing costs. These increases were partially offset by a reduction in payroll and benefits related to the Company-operated store conversions, $0.9 million in lower costs related to the OSH Termination and lower costs due to the impact of items ultimately reflected in the December 9 Agreements. 25-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 Operating Income We recorded an operating loss of $0.8 million in the third quarter of 2013 and operating income of $3.2 million in the third quarter of 2012. The overall decrease in operating income of $4.0 million was driven by the decrease in sales, lower gross margin rate, the increase in selling and administrative expense as noted above, and $0.3 million related to the OSH Termination. 26-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 Business Segment Results Hometown 39-Week Period Ended November 2, 2013 Compared to the 39-Week Period Ended October 27, 2012 Net Sales Hometown net sales decreased $41.3 million, or 2.9%, to $1.36 billion in the first three quarters of 2013 from $1.40 billion in the first three quarters of 2012. The decrease was primarily due to a 2.9% decrease in comparable store sales and lower initial franchise revenues partially offset by new store sales (net of closures). The comparable store sales decrease was driven primarily by declines in lawn and garden resulting from weather-related late starts to the spring/summer and fall seasons, and in consumer electronics after completing the exit of the category in the majority of stores. These decreases were partially offset by increases in home appliances. Gross Margin Gross margin was $321.2 million, or 23.6% of net sales, in the first three quarters of 2013 compared to $336.5 million, or 24.0% of net sales, in the prior year quarters. The decrease in gross margin rate over the prior year was driven primarily by lower initial franchise revenues, lower margins on merchandise sales, a $3.7 million benefit in the first half of 2012 from the impact of store closing reserves established in 2011 (which benefit did not recur in the first half of 2013) and a $2.1 million warranty expense timing benefit in the third quarter of 2012. Partially offsetting these items were lower occupancy expenses from the conversion of Company-operated stores to franchisee-operated stores and a $1.7 million increase in warranty reserves in the third quarter of 2012. Selling and Administrative Expenses Selling and administrative expenses increased to $299.2 million, or 22.0% of net sales in the first three quarters of 2013 from $287.4 million, or 20.5% of net sales, in the first three quarters of 2012. The increase was primarily due to higher owner commissions mainly related to the conversion of Company-operated stores to franchisee-operated stores and an estimated $10.0 million in higher costs from operating as an independent company. These increases were partially offset by a reduction in payroll and benefits related to the Company-operated stores conversions. Operating Income We recorded operating income of $19.6 million and $46.7 million in the first three quarters of 2013 and 2012, respectively. The overall decrease in operating income of $27.1 million was driven by the decrease in sales, an increase in selling and administrative expense and the decrease in gross margin rate as noted above. 27-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012Outlet Outlet results and key statistics were as follows: 13 Weeks Ended 39 Weeks Ended Thousands, except for number of stores November 2, 2013 October 27, 2012 November 2, 2013 October 27, 2012 Net sales $ 147,897 $ 141,918 $ 457,176 $ 419,227 Comparable store sales % (3.4 )% (0.8 )% 1.9 % 0.6 % Cost of sales and occupancy 107,234 101,670 340,216 298,619 Gross margin dollars 40,663 40,248 116,960 120,608 Margin rate 27.5 % 28.4 % 25.6 % 28.8 % Selling and administrative 26,880 27,905 80,640 80,631 Selling and administrative expense as a percentage of net sales 18.2 % 19.7 % 17.6 % 19.2 % Depreciation 1,417 1,485 4,197 4,392 Gain on the sale of assets (1,567 ) - (1,567 ) - Total costs and expenses 133,964 131,060 423,486 383,642 Operating income $ 13,933 $ 10,858 $ 33,690 $ 35,585 Total Outlet stores 131 126 13-Week Period ended November 2, 2013 Compared to the 13-Week Period Ended October 27, 2012 Net Sales Outlet net sales increased $6.0 million, or 4.2%, to $147.9 million in the third quarter of 2013 from $141.9 million in the third quarter of 2012. The increase was primarily due to $6.2 million of initial franchise revenues and sales from new stores (net of closures). These increases were partially offset by a 3.4% decrease in comparable store sales and lower apparel liquidation revenues compared to the third quarter of 2012. The decrease in comparable store sales for the third quarter of 2013 was primarily driven by lower sales in apparel due to a narrower assortment, lower home appliances sales, lower tools sales resulting from a special purchase and promotion of industrial tools in the third quarter of 2012, and lower availability of tools storage in the third quarter of 2013. These decreases were partially offset by sales in the furniture category, which was introduced in the second quarter of 2013 and was expanded into the majority of Outlet stores in the third quarter of 2013. Gross Margin Gross margin was $40.7 million, or 27.5% of net sales, in the third quarter of 2013 compared to $40.2 million, or 28.4% of net sales, in the prior year quarter. The gross margin rate decreased in the third quarter of 2013 compared to the prior year quarter primarily due to (1) lower margins on merchandise sales due to a higher balance-of-sales in lower-margin, in-box goods partially offset by improvements in apparel margins, (2) $3.7 million of distribution center costs that were separated from selling store costs and were reflected in selling and administrative expense in 2012 and are now reflected in gross margin, (3) $0.8 million primarily due to additional occupancy costs as a result of operating as an independent company, and (4) lower apparel liquidation margins. These decreases were partially offset by $6.2 million in initial franchise revenues (which had not been recorded prior to the first quarter of 2013), lower occupancy costs (excluding incremental standalone costs as a result of Company-operated store conversions), the impact of items ultimately reflected in the December 9 Agreements, and a net benefit of $0.2 million related to an increase in warranty reserves and a warranty timing benefit in 2012. Excluding the impact of the reclassification of distribution center expenses, gross margin was $44.4 million, or 30.0% of net sales, in the third quarter of 2013. Selling and Administrative Expenses Selling and administrative expenses decreased to $26.9 million, or 18.2%, in the third quarter of 2013 from $27.9 million, or 19.7%, in the prior year quarter. The decrease in selling and administrative expenses is primarily due to $3.7 million in distribution center costs that were separated from selling store costs and were reflected in selling and administrative expense in 28-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 2012 and are now reflected in gross margin, partially offset by an estimated $1.5 million in higher costs from operating as an independent company and higher franchisee commissions for stores that we converted from Company-operated to franchisee-operated. Excluding the impact of the reclassification of distribution center expenses, selling and administrative expenses were $30.6 million, or 20.7% of net sales, in the third quarter of 2013. Operating Income We recorded operating income of $13.9 million and $10.9 million in the third quarter of 2013 and 2012, respectively. The increase in operating income of $3.0 million was driven by higher net sales, a $1.6 million gain on the sale of the outlet store in Woodstock, Illinois in the third quarter of 2013, and lower selling and administrative expenses partially offset by a lower gross profit rate. 29-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012Outlet 39-Week Period Ended November 2, 2013 Compared to the 39-Week Period Ended October 27, 2012 Net Sales Outlet net sales increased $38.0 million, or 9.1%, to $457.2 million in the first three quarters of 2013 from $419.2 million in the first three quarters of 2012. The increase was primarily due to new store openings (net of closures), $10.1 million of initial franchise revenues, and a 1.9% increase in comparable store sales, partially offset by lower apparel liquidation revenues. The increase in comparable store sales for 2013 was primarily driven by higher home appliances sales, increases in lawn and garden driven by grills, patio furniture and mowers, and in mattresses following category expansion in fiscal 2012, partially offset by a decrease in apparel due to a narrower assortment. Gross Margin Gross margin was $117.0 million, or 25.6% of net sales in the first three quarters of 2013 compared to $120.6 million, or 28.8% of net sales in the prior year. The gross margin rate decreased 320 basis points in the first three quarters of 2013 compared to the prior year primarily due to lower margins on merchandise sales due to lower availability of higher-margin scratch-and-dent items, $10.0 million of distribution center costs that were separated from selling store costs and were reflected in selling and administrative expense in 2012 and are now reflected in gross margin, lower liquidation income and an additional $2.1 million in occupancy costs as a result of operating as an independent company since the Separation. These decreases were partially offset by $10.1 million in initial franchise revenues, lower occupancy costs (excluding incremental standalone costs) as a result of Company-operated store conversions, and the pass-through by Sears Holdings of higher cash discounts on Sears Holdings' purchases of merchandise sold to us. No initial franchise revenues were recorded in Outlet prior to fiscal 2013. Excluding the impact of the reclassification of distribution center expenses, gross margin was $127.0 million, or 27.8% of net sales, for the first three quarters of 2013. Selling and Administrative Expenses Selling and administrative expenses were $80.6 million, or 17.6% of net sales, in the first three quarters of 2013 compared to $80.6 million, or 19.2% of net sales, in the prior year first three quarters. Selling and administrative expenses included an estimated $4.9 million in higher costs from operating as an independent company, higher franchise commissions for the Company-operated stores that we converted to franchisee-operated stores in the first three quarters of 2013, and increased marketing investments. These increases were offset by $10.0 million in distribution center costs that were separated from selling store costs and were reflected in selling and administrative expense in 2012 and are now reflected in gross margin. Excluding the impact of the reclassification of distribution center expenses, selling and administrative expenses were $90.6 million, or 19.8% of net sales, for the first three quarters of 2013. Operating Income We recorded operating income of $33.7 million and $35.6 million in the first three quarters of 2013 and 2012, respectively. The decrease in operating income of $1.9 million was driven by a lower gross profit rate partially offset by higher net sales and a $1.6 million gain in the third quarter of 2013 on the sale of the outlet store in Woodstock, Illinois. 30-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 Analysis of Financial Condition Cash and Cash Equivalents We had cash and cash equivalents of $21.5 million as of November 2, 2013, $21.8 million as of October 27, 2012, and $20.1 million as of February 2, 2013. For the first, second, and third quarters of 2013 we financed our operations and investments primarily with short-term borrowings under the Senior ABL Facility. Our primary need for liquidity is to fund inventory purchases and capital expenditures and for general corporate purposes. Cash Flows from Operating Activities For the three quarters ended November 2, 2013 cash used in operating activities was $54.2 million compared to $93.3 million generated in the three quarters ended October 27, 2012. The decrease in operating cash flows compared to 2012 was due predominately to a decrease in the payable to Sears Holdings compared to an increase in the first nine months of 2012, increased investments in inventory, and lower net income. Total merchandise inventories were $488.6 million at November 2, 2013 and $429.4 million at October 27, 2012. Merchandise inventories for Hometown increased from $336.9 million at October 27, 2012 to $352.0 million at November 2, 2013 primarily due to (1) home appliances resets, (2) completion of the tools expansion initiative, (3) inventory associated with new stores (net of closures), (4) higher air conditioner inventory due to a cooler summer, (5) expansion of vacuum cleaner inventory, and (6) an increase in the cost of Kenmore and Craftsman merchandise resulting from a post-Separation change in the treatment of warranty costs. Post-Separation SHO purchases Kenmore and Craftsman products with warranty included, which results in a higher product cost but eliminates any later warranty costs to SHO. The Company expects that generally the higher product costs and the resulting warranty savings will typically offset each other. These inventory increases were partially offset by a reduction in consumer electronics due to the exit of this category in the majority of Hometown stores. Merchandise inventories for Outlet increased from $92.5 million at October 27, 2012 to $136.6 million at November 2, 2013, primarily driven by (1) home appliances due to additional flow of scratch-and-dent units and large buys of discontinued and obsolete product, (2) an increase in the number of stores, (3) higher receipts in mattresses, and (4) seasonal-purchases of grills and late-season receipts of lawn tractors in lawn and garden. These increases were partially offset by lower receipts of apparel. We obtain our merchandise through agreements with Sears Holdings and from other vendors. In the first three quarters of 2013 merchandise acquired from subsidiaries of Sears Holdings, including Kenmore, Craftsman, DieHard, and other products, accounted for approximately 84% of total purchases of all inventory from all vendors. The loss of, or a material reduction in, the amount of merchandise made available to us by Sears Holdings could have a material adverse effect on our business and results of operations. Cash Flows from Investing Activities Cash used in investing activities was $3.3 million for the first three quarters of 2013 compared to $5.5 million for the first three quarters of 2012. Cash used in investing activities in both periods was for purchases of property and equipment partially offset by $2.6 million in proceeds from sales of property and investments in 2013. Cash Flows from Financing Activities Cash generated by financing activities was $58.9 million for the 39 weeks ended November 2, 2013 compared to $66.6 million used for the 39 weeks ended October 27, 2012. The increase of $125.5 million in cash generated by financing activities in 2013 from 2012 was primarily due to the cash dividend paid to Sears Holdings of $100.0 million at the time of Separation, an increase of $20.8 million in short-term borrowing in the first three quarters of 2013 and a $12.3 million reduction in transfers to Sears Holdings at the time of Separation partially offset by the repurchase of 0.3 million shares of stock for $8.4 million as part of the $25 million share repurchase program authorized by the Company's Board of Directors on August 28, 2013. Financing Arrangements 31-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 Under the Senior ABL Facility the Company initially borrowed $100 million which was used to pay a cash dividend to Sears Holdings prior to the Separation. As of November 2, 2013, we had $87.9 million outstanding under the Senior ABL Facility, which approximated the fair value of these borrowings. The Senior ABL Facility provides (subject to availability under a borrowing base) for maximum borrowings up to the aggregate commitments of all of the lenders, which as of November 2, 2013 totaled $250 million. Up to $75 million of the Senior ABL Facility is available for the issuance of letters of credit and up to $25 million is available for swingline loans. The Senior ABL Facility permits us to request commitment increases in an aggregate principal amount of up to $100 million. Availability under the Senior ABL Facility as of November 2, 2013 was $158.7 million with $3.4 million of letters of credit outstanding under the facility. 32-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 The principal terms of the Senior ABL Facility are summarized below. Senior ABL Facility Maturity; Amortization and Prepayments The Senior ABL Facility will mature on the earlier of (i) October 11, 2017 or (ii) six months prior to the expiration of the Merchandising Agreement and the other agreements with Sears Holdings or its subsidiaries in connection with the Separation that are specified in the Senior ABL Facility, unless such agreements have been extended to a date later than October 11, 2017 or terminated on a basis reasonably satisfactory to the administrative agent under the Senior ABL Facility. The Senior ABL Facility is subject to mandatory prepayment in amounts equal to the amount by which the outstanding extensions of credit exceed the lesser of the borrowing base and the commitments then in effect. Guarantees; Security The obligations under the Senior ABL Facility are guaranteed by us and each of our existing and future direct and indirect wholly owned domestic subsidiaries (subject to certain exceptions). The Senior ABL Facility and the guarantees thereunder are secured by a first priority security interest in certain assets of the borrowers and guarantors consisting primarily of accounts receivable, inventory, cash, cash equivalents, deposit accounts and securities accounts, as well as certain other assets (other than intellectual property) ancillary to the foregoing and all proceeds of all of the foregoing, including cash proceeds and the proceeds of applicable insurance. Interest; Fees The interest rates per annum applicable to the loans under the Senior ABL Facility are based on a fluctuating rate of interest measured by reference to, at our election, either (1) adjusted LIBOR plus a borrowing margin or (2) an alternate base rate plus a borrowing margin, with the borrowing margin subject to adjustment based on the average excess availability under the facility for the preceding fiscal quarter. The interest rate was 4.25% at November 2, 2013. Customary fees are payable in respect of the Senior ABL Facility, including letter of credit fees and commitment fees. Covenants The Senior ABL Facility includes a number of covenants that, among other things, limit or restrict our ability to, subject to specified exceptions, incur additional indebtedness (including guarantees), grant liens, make investments, make prepayments on other indebtedness, engage in mergers, or change the nature of our business. The Senior ABL Facility limits SHO's ability to declare and pay cash dividends and repurchase its common stock. SHO may declare and pay cash dividends to its stockholders and may repurchase stock if the following conditions are satisfied: either (a) (i) no specified default then exists or would arise as a result of the declaration or payment of the cash dividend or as a result of the stock repurchase, (ii) SHO and its subsidiaries that are also borrowers have demonstrated to the reasonable satisfaction of the agent for the lenders that monthly availability (as determined in accordance with the Senior ABL Facility), immediately following the declaration and payment of the cash dividend or the stock repurchase and as projected on a pro forma basis for the twelve months following and after giving effect to the declaration and payment of the cash dividend or the stock repurchase, would be at least equal to the greater of (x) 25% of the Loan Cap (which is the lesser of (A) the aggregate commitments of the lenders and (B) the borrowing base) and (y) $50,000,000, and (iii) after giving pro forma effect to the declaration and payment of the cash dividend or the stock repurchase as if it constituted a specified debt service charge, the specified consolidated fixed charge coverage ratio, as calculated on a trailing twelve months basis, would be equal to or greater than 1.1:1.0, or (b) (i) no specified default then exists or would arise as a result of the declaration or payment of the cash dividend or the stock repurchase, (ii) payment of the cash dividend or the stock repurchase is not made with the proceeds of any credit extension under the Senior ABL Facility, (iii) during the 120-day period prior to declaration and payment of the cash dividend or the stock repurchase, no credit extension was outstanding under the Senior ABL Facility, and (iv) SHO demonstrates to the reasonable satisfaction of the agent for the lenders that, on a 33-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 pro forma and projected basis, no credit extensions would be outstanding under the Senior ABL Facility for the 120-day period following the declaration and payment of the cash dividend or the stock repurchase. The Senior ABL Facility also contains certain affirmative covenants, including financial and other reporting requirements. Events of Default The Senior ABL Facility includes customary events of default including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties, cross default to certain other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of guarantees or security interests, material judgments, and change of control. Uses and Sources of Liquidity We believe that our existing cash and cash equivalents, cash flows from our operating activities and, to the extent necessary, availability under the Senior ABL Facility will be sufficient to meet our anticipated liquidity needs for at least the next 12 months. As of November 2, 2013, we had cash and cash equivalents of $21.5 million. Over the next twelve months, we expect to fund our ongoing operations and any stock repurchases with cash on-hand, cash generated by operating activities, and borrowings under the Senior ABL Facility. The adequacy of our available funds will depend on many factors, including the macroeconomic environment and the operating performance of our stores. Capital lease obligations as of November 2, 2013 and October 27, 2012 were $1.2 million and $2.4 million, respectively. Off-Balance Sheet Arrangements As of November 2, 2013, we had no off-balance sheet arrangements as defined in Item 303(a)(4) of the Securities and Exchange Commission's Regulation S-K. 34-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 Recent Accounting Pronouncements See Part I, Item 1, "Financial Statements-Notes to Condensed Consolidated Financial Statements- Note 9 - Recent Accounting Pronouncements," for information regarding new accounting pronouncements. CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION Certain statements made in this Quarterly Report on Form 10-Q contain forward-looking statements. Forward-looking statements are subject to risks and uncertainties that may cause our actual results, performance, or achievements to be materially different from any future results, performance, or achievements expressed or implied by these forward-looking statements. Forward-looking statements include without limitation information concerning our future financial performance, business strategy, plans, goals, and objectives. Statements preceded or followed by, or that otherwise include, the words "believes," "expects," "anticipates," "intends," "project," "estimates," "plans," "forecast," "is likely to," "continue," and similar expressions or future or conditional verbs such as "will," "may," "would," "should" and "could" are generally forward-looking in nature and not historical facts. Such statements are based upon the current beliefs and expectations of our management and are subject to significant risks and uncertainties. Actual results may differ materially from those set forth in the forward-looking statements. The following factors, among others, could cause our actual results, performance or achievements to differ from those set forth in the forward-looking statements: • our continued reliance on Sears Holdings for most products and services that are important to the successful operation of our business; • our continuing dependence on Sears Holdings subsequent to the Separation, and our potential need to depend on Sears Holdings beyond the expiration of certain of our agreements with Sears Holdings; • our ability to offer merchandise and services that our customers want, including those under the Kenmore, Craftsman, and DieHard brands. • the sale by Sears Holdings and its subsidiaries to other retailers that compete with us of major home appliances and other products branded with the Kenmore, Craftsman and DieHard brands; • our ability to successfully manage our inventory levels and implement initiatives to improve inventory management and other capabilities; • competitive conditions in the retail industry; • worldwide economic conditions and business uncertainty, the availability of consumer and commercial credit, changes in consumer confidence, tastes, preferences and spending, and changes in vendor relationships; • the fact that our past performance generally, as reflected in on our historical financial statements, may not be indicative of our future performance as a result of, among other things, the consolidation of Hometown and Outlet into a single business entity, the Separation, and operating as a standalone business entity; • the impact of increased costs due to a decrease in our purchasing power following the Separation and other losses of benefits that were associated with having been wholly owned by Sears Holdings and its subsidiaries; • our agreements related to the rights offering and Separation Transactions and our continuing relationship with Sears Holdings were negotiated while we were a subsidiary of Sears Holdings and we may have received different terms from unaffiliated third parties; • the ability and willingness of Sears Holdings to perform its contractual obligations to us; • our ability to successfully resolve existing and, if any arise, future contractual disputes with Sears Holdings; • limitations and restrictions in the Senior ABL Facility and our ability to service our indebtedness; • our ability to obtain additional financing on acceptable terms; • our dependence on independent dealers and franchisees to operate our stores profitably and in a manner consistent with our concepts and standards; • our dependence on sources outside the U.S. for significant amounts of our merchandise; • impairment charges for goodwill or fixed-asset impairment for long-lived assets; • our ability to attract, motivate, and retain key executives and other employees; • the impact of increased costs associated with being an independent company; 35 -------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012• our ability to maintain effective internal controls as a public company; • our ability to realize the benefits that we expect to achieve from the Separation; • low trading volume of our common stock due to limited liquidity or a lack of analyst coverage; and • the impact on our common stock and our overall performance as a result of our principal stockholders' ability to exert control over us. These factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements, including our "Risk Factors," that are included in our other filings with the Securities and Exchange Commission and our other public announcements. While we believe that our forecasts and assumptions are reasonable, we caution that actual results may differ materially. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we projected. Consequently, actual events and results may vary significantly from those included in or contemplated or implied by our forward-looking statements. The forward-looking statements included in this Quarterly Report on Form 10-Q are made only as of the date of this Quarterly Report on Form 10-Q, and we undertake no obligation to publicly update or review any forward-looking statement made by us or on our behalf, whether as a result of new information, future developments, subsequent events or circumstances, or otherwise. 36-------------------------------------------------------------------------------- Table of Contents SEARS HOMETOWN AND OUTLET STORES, INC. 13 and 39 Weeks Ended November 2, 2013 and October 27, 2012 |