| BACKGROUND AND BASIS OF PRESENTATION | BACKGROUND AND BASIS OF PRESENTATION Background Sears Hometown and Outlet Stores, Inc. is a national retailer primarily focused on selling home appliances, lawn and garden equipment, and tools. As of November 3, 2018 the Company or its dealers and franchisees operated a total of 761 stores across 49 states, Puerto Rico, and Bermuda. In these notes and elsewhere in this Quarterly Report on Form 10-Q the terms “we,” “us,” “our,” “SHO,” and the “Company” refer to Sears Hometown and Outlet Stores, Inc. and its subsidiaries. Our common stock trades on the NASDAQ Stock Market under the trading symbol “SHOS.” The Separation The Company separated from Sears Holdings Corporation (“Sears Holdings”) in October 2012 (the “Separation”). To our knowledge Sears Holdings does not own any shares of our common stock. The Company has specified rights to use the "Sears" name under a license agreement from Sears Holdings. Basis of Presentation These unaudited Condensed Consolidated Financial Statements include the accounts of Sears Hometown and Outlet Stores, Inc. and its subsidiaries, all of which are wholly owned. These unaudited Condensed Consolidated Financial Statements do not include all of the information and footnotes required in annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). In the opinion of management, all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the 13 and 39 weeks ended November 3, 2018 are not necessarily indicative of the results that may be expected for the full fiscal year. These financial statements and related notes should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended February 3, 2018 (the "2017 10-K"). We operate through two segments--our Sears Hometown segment ("Hometown") and our Sears Outlet segment ("Outlet"). Our third fiscal-quarter end is the Saturday closest to October 31. For 2018 and 2017, our third fiscal quarters ended as follows: Fiscal Year Third Quarter Ended Weeks 2018 November 3, 2018 13 2017 October 28, 2017 13 Our fiscal year end is the Saturday closest to January 31. Our 2018 fiscal year will end February 2, 2019. Unless otherwise stated, references to specific years and quarters in these notes are to fiscal years and fiscal quarters, respectively. On October 15, 2018 and thereafter Sears Holdings and many of its subsidiaries filed voluntary petitions in the United States Bankruptcy Court for the Southern District of New York seeking relief under Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code"). The Company, which is not a subsidiary of Sears Holdings, is not included in the bankruptcy petitions filed by Sears Holdings and its subsidiaries, and neither the Company nor its subsidiaries have filed a bankruptcy petition. The Company has significant business relationships with Sears Holdings and its affiliates that are Chapter 11 debtors (together, the "Sears Holdings Debtors") through various agreements among the Company, Sears Holdings and, in some circumstances, subsidiaries of Sears Holdings (as amended, the “SHO-Sears Holdings Agreements”). Generally, debtors in Chapter 11 cases, like the Sears Holdings Debtors, have the right, subject to bankruptcy court approval, to reject contracts that are deemed to be "executory contracts" within the meaning of the Bankruptcy Code. Generally, the effect of rejection of an executory contract is that the debtor is relieved of its future performance obligations and any damages resulting from the rejection would be treated as prepetition unsecured claims. Some or all of the SHO-Sears Holdings Agreements may constitute executory contracts that could be subject to rejection in the Chapter 11 cases of the Sears Holdings Debtors (the "Sears Holdings Bankruptcy Proceedings"). None of the Sears Holdings Debtors has disclosed whether it will seek to reject the SHO-Sears Holdings Agreements. Sears Holdings has announced that it is seeking in the Sears Holdings Bankruptcy Proceedings to liquidate its assets through the sale of several hundred stores, together with other assets, on a going concern basis, and that it is seeking bids with the goal of completing a going concern sale in January 2019. The Official Committee of Unsecured Creditors appointed in the Sears Holdings Bankruptcy Proceedings (the "Sears Holdings UCC") objected to the entry of an order to approve bidding procedures for a going concern sale on the basis that the Sears Holdings UCC believes that the sale as a going concern, in contrast to a complete asset liquidation, might not maximize creditor recoveries. Sears Holdings has obtained Bankruptcy Court approval for the bid procedures, which contemplate going-concern and liquidation-basis bids. The Company believes that if the Sears Holdings Debtors were to liquidate on a basis other than as a going concern, there is an increased likelihood that the Sears Holdings Debtors would seek to reject some or all of the SHO-Sears Holdings Agreements. If Sears Holdings were to cease performing under any of the SHO-Sears Holdings Agreements, as a result of the rejection in the Sears Holdings Bankruptcy Proceedings or otherwise, the Company could lose access to services performed by Sears Holdings (including merchandise supply services) and rights granted to the Company under the SHO-Sears Holdings Agreements that are critical to the operation of the Company’s businesses. In such a situation, there could be a significant risk (1) to the Company's ability to conduct its businesses in the ordinary course (especially the Hometown businesses, given their dependence on purchasing KENMORE ® and CRAFTSMAN ® branded merchandise and other merchandise from Sears Holdings under the SHO-Sears Holdings Agreements), and (2) that the Company's results of operations, financial condition, liquidity, and cash flows could be materially and adversely affected. A termination of the SHO-Sears Holdings Agreements could require the Company to, among other things, find different service and product providers. Even if the Company were able to find replacement products and services, these products and services might not be of the same type or quality as those which are currently provided by Sears Holdings, and the Company's access to Kenmore and Craftsman branded merchandise could become significantly more expensive or cease altogether. If the Company were forced to enter into new agreements for replacement products and services, the new agreements could include terms and conditions that were less favorable to the Company than the terms and conditions of the SHO-Sears Holdings Agreements, including products and services that are lower in quality and value and more expensive. The Company has developed plans and alternatives that are intended to mitigate many of the adverse consequences to the Company if Sears Holdings were to cease performing critical services (including merchandise supply services) for the Company. These plans and alternatives include but are not limited to (1) taking actions to reduce or eliminate dependence on Sears Holdings’s IT systems by completing the Company’s IT transformation project, (2) contracting with third-party logistics providers to replace services currently provided by Sears Holdings, and (3) using direct purchasing agreements that are in place with a significant portion of the Company’s merchandise vendors to provide to the Company critical categories of merchandise currently supplied by Sears Holdings. The Company is party to an Amended and Restated Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent and collateral agent, which provides (subject to availability under a borrowing base) for aggregate maximum borrowings of $170 million (the “Senior ABL Facility”). The Company is also a party to a Term Loan Agreement with Gordon Brothers Finance Company, as agent, lead arranger, and sole bookrunner, and Gordon Brothers Finance Company, LLC, as lender (the “Term Loan”). See Note 8 - Financing Arrangements. The Senior ABL Facility will mature on the earliest of the following dates: (1) February 29, 2020; (2) six months prior to the expiration of specified "Separation Agreements" (which term is defined in the Senior ABL Facility to include specified SHO-Sears Holdings Agreements) unless the Separation Agreements are extended to a date later than February 29, 2020 or are terminated on a basis reasonably satisfactory to the Senior ABL lenders; and (3) acceleration of the maturity date following an event of default in accordance with the Senior ABL Facility. The Term Loan will mature on the earliest of (1) the maturity date specified in the Senior ABL Facility, (2) February 16, 2023, and (3) acceleration of the maturity date following an event of default in accordance with the Term Loan Agreement. The Senior ABL Facility and the Term Loan Agreement each provides that the rejection by Sears Holdings of "the Separation Agreements" is an event of default thereunder, which could result in all amounts outstanding to become immediately due and payable. The Company has proposed to Sears Holdings that the duration of the Separation Agreements that expire on February 1, 2020 be extended, which proposal Sears Holdings has not yet accepted. The Company believes that the Senior ABL Facility lenders, with respect to the Senior ABL Facility, and the Term Loan lenders, with respect to the Term Loan, could assert that the Senior ABL Facility and the Term Loan would mature on August 1, 2019. The Company will seek to refinance the Senior ABL Facility and Term Loan prior to August 1, 2019, which efforts the Company believes will be augmented by the Company’s improved adjusted EBITDA performance over the last 18 months as well as the value of the Company’s inventory and other assets that would be available as collateral to lenders. The Company has had initial discussions with the administrative agent for the Senior ABL Facility about its extension or refinancing, and the Company expects to continue such discussions and to engage in discussions with the Term Loan lender, with a goal of completing a replacement credit facility or facilities for the Senior ABL Facility and the Term Loan during the first quarter of fiscal 2019. The Company is subject to Accounting Standards Update 2014-15, Presentation of Financial Statements - Going Concern, codified as Accounting Standards Codification (ASC) 205-40 (the "Accounting Evaluation Requirements"), which requires management to evaluate an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or, in certain cases, available to be issued). ASC 205-40 states that conditions or events that raise "substantial doubt" about an entity’s ability to continue as a going concern typically relate to the entity’s ability to meet its obligations as they become due, generally within one year after the date that the financial statements are issued. The evaluation of whether substantial doubt is raised does not take into account the potential mitigating effect of management’s plans that have not been fully implemented. If conditions or events indicate that substantial doubt is raised, management is required to evaluate whether its plans that are intended to mitigate those conditions and events will alleviate substantial doubt. ASC 205-40 specifies that management may consider its plans only when it is "probable" that those plans will be effectively implemented and that the plans will mitigate the relevant conditions and events within one year after the financial statements are issued. This probability determination is based on the specific facts and circumstances of the entity and involves significant judgment. While we believe that we will be able to refinance the Senior ABL Facility and the Term Loan, and that the refinancing would satisfy our liquidity needs through the end of our 2019 fiscal year, such refinancing has not occurred and cannot be considered "probable" (as defined by the Accounting Evaluation Requirements) as of the date of inclusion of these financial statements in the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended November 3, 2018. The Company will continue to seek to refinance the Senior ABL Facility and the Term Loan. Because we cannot at this time conclude that any proposed refinancing is "probable" of occurring under the Accounting Evaluation Requirements, and due to the uncertainty of the effect on our businesses (especially with respect to our Hometown businesses) and financial performance that could occur if Sears Holdings were to cease performing critical services for the Company, "substantial doubt" (as defined by the Accounting Evaluation Requirements) is deemed to exist about our ability to continue as a going concern. Reclassifications Certain amounts have been reclassified in order to conform to the current-period presentation. Revenue Recognition Revenues from contracts with customers include sales of merchandise, commissions on merchandise sales made through www.sears.com, Company websites, services and extended-service plans, financing programs, and delivery and handling revenues related to merchandise sold. Revenue is measured based on the amount of fixed consideration that we expect to receive, reduced by estimates for variable consideration such as returns. Revenue also excludes any amounts collected from customers and remitted or payable to governmental authorities. In arrangements where we have multiple performance obligations, the transaction price is allocated to each performance obligation using the relative stand-alone selling price. We recognize revenues from retail operations upon the transfer of control of goods to the customer. We satisfy our performance obligations at the point of sale for retail store transactions and upon delivery for online transactions. We defer revenue for retail store and online transactions including commissions on extended-service plans, where we have received consideration but have not transferred control of the goods to the customer at the end of the period. The performance obligation is generally satisfied in the following reporting period. The balance of deferred revenue was $16.6 million and $16.4 million at November 3, 2018 and February 3, 2018 , respectively. The change in deferred revenue represents additional revenue deferred during the first three quarters of 2018 . We recognize revenues from commissions on services, and delivery and handling revenues related to merchandise sold, at the point of sale as we are not the primary obligor with respect to such services and have no future obligations for future performance. The Company accepts Sears Holdings gift cards as tender for purchases and is reimbursed weekly by Sears Holdings for gift cards tendered. Cost of Sales and Occupancy Cost of sales and occupancy is comprised principally of merchandise costs, warehousing and distribution (including receiving and store delivery) costs, retail store occupancy costs, home services and installation costs, warranty cost, royalties payable to Sears Holdings related to our sale of products branded with one of the KENMORE ® , CRAFTSMAN ® , and DIEHARD ® marks (the "KCD Marks"), customer shipping and handling costs, vendor allowances, markdowns, and physical inventory losses. The KCD Marks are owned by, or licensed to, subsidiaries of Sears Holdings. Reserve for Sales Returns and Allowances Revenues from merchandise sales and services are reported net of estimated returns and allowances and exclude sales taxes. The typical return period is 30 days. The refund liability for returns is calculated as a percentage of sales based on historical return percentages. Estimated returns are recorded as a reduction of revenues. The reserve for returns and allowances was $3.9 million and $1.1 million at November 3, 2018 and February 3, 2018 , respectively. Refer to the Recently Adopted Accounting Pronouncements discussion below. Variable Interest Entities and Consolidation The Financial Accounting Standards Board ("FASB") has issued guidance on variable interest entities and consolidation for determining whether an entity is a variable interest entity ("VIE") as well as the methods permitted for determining the primary beneficiary of a VIE. In addition, this guidance requires ongoing reassessments as to whether a reporting company is the primary beneficiary of a VIE and disclosures regarding the reporting company’s involvement with a VIE. On an ongoing basis the Company evaluates its business relationships, such as those with its independent dealers, independent franchisees, and suppliers, to identify potential VIE's. Generally, these businesses either qualify for a scope exception under the consolidation guidance or, where a variable interest exists, the Company does not possess the power to direct the activities that most significantly impact the economic performance of these businesses. The Company has not consolidated any of such entities in the periods presented. Fair Value of Financial Instruments We determine the fair value of financial instruments in accordance with standards pertaining to fair value measurements. Such standards define fair value and establish a framework for measuring fair value under GAAP. Under fair value measurement accounting standards, fair value is considered to be the exchange price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. We report the fair value of financial assets and liabilities based on the fair value hierarchy prescribed by accounting standards for fair value measurements, which prioritizes the inputs to valuation techniques used to measure fair value into three levels, as follows: Level 1 inputs —unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. An active market for the asset or liability is one in which transactions for the asset or liability occurs with sufficient frequency and volume to provide ongoing pricing information. Level 2 inputs —inputs other than quoted market prices included in Level 1 that are observable, either directly or indirectly, for the asset or liability. Level 2 inputs include, but are not limited to, quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs other than quoted market prices that are observable for the asset or liability, such as interest-rate curves and yield curves observable at commonly quoted intervals, volatilities, credit risks, and default rates. Level 3 inputs —unobservable inputs for the asset or liability. Cash and cash equivalents, merchandise payables, accrued expenses (Level 1), accounts and franchisee notes receivable, and short-term debt (Level 2) are reflected in the Condensed Consolidated Balance Sheets at cost, which approximates fair value due to the short-term nature of these instruments. For short-term borrowings and our Term Loan, the variable interest rates are a significant input in our fair value assessments and are consistent with the interest rates in the market. The carrying value of long-term notes receivable approximates fair value. We may be required, on a nonrecurring basis, to adjust the carrying value of the Company's long-lived assets. When necessary, these valuations are determined by the Company using Level 3 inputs. These assets are subject to fair value adjustments in certain circumstances as when there is evidence that impairment may exist. The Company was not required to measure any other significant non-financial asset or liability at fair value as of November 3, 2018 . Recently Issued Accounting Pronouncements Recently issued accounting pronouncements that are not yet effective and that we have not discussed in the 2017 10-K or below are either inapplicable to us or, if applicable, we do not expect that they will have a material impact on our consolidated results of operations, consolidated financial condition, or consolidated cash flows. ASU 2016-02 "Leases (Topic 842)" In February 2016, the FASB issued Accounting Standards Update ("ASU") 2016-02, "Leases (Topic 842)". This ASU is a comprehensive new accounting standard with respect to leases that amends various aspects of existing guidance for leases and requires additional disclosures about leasing arrangements. It requires companies to record assets and liabilities on the balance sheet for leases that were formerly designated as operating leases as well as leases designated as financing leases. The provisions of the ASU predominately change the recognition of leases for lessees, but the provisions do not substantially change the accounting for lessors. This ASU will supersede the provisions of Topic 840 Leases. In July 2018, the FASB issued ASU 2018-11, "Leases (Topic 842): Targeted Improvements", which provides an optional transition method to apply ASU 2016-02 in the period of adoption and recognize a cumulative-effect opening transition adjustment to retained earnings, without applying the standard to comparative periods. This ASU also provides lessors with a practical expedient to account for lease and associated non-lease components as a single component when certain criteria are met. The provisions of this ASU are effective for fiscal years beginning after December 15, 2018, and interim periods within those periods. Early adoption is allowed; however, we will adopt the standard in the first quarter of fiscal 2019. We have upgraded our existing third-party leasing software and identified business processes, systems and controls to support adoption of the new standard. We are in the process of evaluating the impact that the new standard will have on the condensed consolidated financial statements. While we are unable to quantify the impact at this time, we expect the adoption of the new standard to result in a material increase in the assets and liabilities in the condensed consolidated balance sheets. At this time, we do not expect the adoption of ASU 2016-02 to have a material impact on our condensed consolidated statements of operations as the majority of our leases will remain operating in nature. As such, expense recognition will be similar to previously required straight-line expense treatment. Recently Adopted Accounting Pronouncements ASU 2014-09 , "Revenue from Contracts with Customers (Topic 606)" In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)", which supersedes the revenue recognition requirements in Accounting Standards Codification (ASC) 605, Revenue Recognition . Several additional ASUs have subsequently been issued amending and clarifying the standard. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance provides a five-step process to achieve that core principle and to determine when and how revenue is recognized. The updates may be applied retrospectively for each period presented or as a cumulative-effect adjustment at the date of adoption. We adopted this standard on February 4, 2018, using the modified retrospective approach. The impact of the adoption of ASU 2014-09 on our condensed consolidated financial statements is as follows: • Our revenue is primarily generated from the sales of merchandise to customers through the retail, e-commerce or wholesale channels. Our performance obligations underlying such sales, and the timing of revenue recognition related thereto, remain substantially unchanged following the adoption of this ASU. • The adoption of ASU No. 2014-09 requires that we recognize our sales return allowance on a gross basis rather than as a net liability. As such, we now recognize (i) a return asset for the right to recover the goods returned by the customer, measured at the former carrying amount of the goods, less any expected recovery costs (recorded as an increase to prepaid expenses and other current assets), (ii) a return liability for the amount of expected returns (recorded as an increase to other current liabilities) and (iii) deferred revenue for commissions earned on extended protection agreements (recorded as an increase to other current liabilities). We have made accounting policy elections to (1) exclude from the measurement of transaction price all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by us from a customer (sales tax, value added tax, etc.) and (2) account for shipping and handling activities performed after a customer obtains control of the good as activities to fulfill the promise to transfer the good. We applied ASU No. 2014-09 only to contracts that were not completed prior to fiscal 2018. The cumulative effect of initially applying ASU No. 2014-09 was a $2.1 million increase to the opening balance of accumulated deficit as of February 4, 2018. The comparative prior period information continues to be reported under the accounting standards in effect during those periods. The effect of the adoption of ASU No. 2014-09 on our consolidated balance sheet as of November 3, 2018 was as follows: Thousands As Reported ASU 2014-09 Effect Excluding ASU 2014-09 Effect Prepaid expenses and other current assets $ 7,749 $ 1,226 $ 6,523 Other current liabilities 57,076 3,345 53,731 Accumulated deficit (405,380 ) (2,119 ) (403,261 ) |
