UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_______________________________________________
FORM 10-K
_______________________________________________
| ý | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
| FOR THE FISCAL YEAR ENDED FEBRUARY 2, 2019 | |
OR
| ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
Commission file number 001-35641
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SEARS HOMETOWN AND OUTLET STORES, INC.
(Exact Name of Registrant as Specified in its Charter)
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DELAWARE | 80-0808358 | |
| (State or Other Jurisdiction of Incorporation or Organization) | (I.R.S. Employer Identification No.) | |
| 5500 TRILLIUM BOULEVARD, SUITE 501 HOFFMAN ESTATES, ILLINOIS | 60192 | |
| (Address of Principal Executive Offices) | (Zip Code) | |
Registrant’s telephone number, including area code: (847) 286-7000
Securities registered pursuant to Section 12(b) of the Act:
| Title of Each Class | Name of Exchange on Which Registered | |
| Common Stock, par value $0.01 per share | The NASDAQ Stock Market | |
Securities registered pursuant to Section 12(g) of the Act:
None
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Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes ¨ No ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes ¨ No ý
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405) is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer | ¨ | Accelerated filer | ¨ | |||
Non-accelerated filer (Do not check if a smaller reporting company) | ¨ | Smaller reporting company | ý | |||
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No ý
As of May 3, 2019 Sears Hometown and Outlet Stores, Inc. had 22,702,132 shares of common stock, $0.01 par value, outstanding. The aggregate market value (based on the closing price of Sears Hometown and Outlet Stores, Inc.'s common stock quoted on the NASDAQ Stock Market) of Sears Hometown and Outlet Stores, Inc.'s common stock owned by non-affiliates, as of the last business day of Sears Hometown and Outlet Stores, Inc.'s most recently completed second fiscal quarter, was approximately $32,136,000.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of this Annual Report on Form 10-K incorporates by reference certain information from our definitive 2019 Proxy Statement relating to our Annual Meeting of Stockholders to be held on May 29, 2019, which will be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which this Annual Report on Form 10-K relates.
SEARS HOMETOWN AND OUTLET STORES, INC.
TABLE OF CONTENTS TO ANNUAL REPORT ON FORM 10-K
| Page | ||
| PART I | ||
| Item 1. | ||
| Item 1A. | ||
| Item 1B. | ||
| Item 2. | ||
| Item 3. | ||
| Item 4. | ||
| PART II | ||
| Item 5. | ||
| Item 6. | ||
| Item 7. | ||
| Item 7A. | ||
| Item 8. | ||
| Item 9. | ||
| Item 9A. | ||
| PART III | ||
| Item 10. | ||
| Item 11. | ||
| Item 12. | ||
| Item 13. | ||
| Item 14. | ||
| PART IV | ||
| Item 15. | ||
| Item 16. | ||
Part I
Item 1. Business
We are a national retailer primarily focused on selling home appliances, lawn and garden equipment, tools, and hardware at our stores and on our websites. We also offer our customers the opportunity to acquire home appliance, lawn and garden, fitness, bedding, and other categories of merchandise and product protection agreements through our lease-to-own program that we operate by agreement with a third party. As of February 2, 2019, the Company or its independent dealers and franchisees ("our dealers and franchisees") operated a total of 677 stores across 49 states, Puerto Rico, and Bermuda. In addition to merchandise, we provide our customers with access to a full suite of related services, including home delivery, installation, and extended-service plans. In this Annual Report on Form 10-K we refer to ourselves as "SHO," "our company," the "Company," "we," "our," or "us."
We became a publicly held company immediately following our October 11, 2012 separation (the "2012 Separation") from Sears Holdings Corporation ("Sears Holdings").
We operate through two segments—the Sears Hometown segment ("Hometown") and the Sears Outlet segment ("Outlet"). Our Hometown stores are designed to provide our customers with in-store and online access to a wide selection of national brands of home appliances, lawn and garden equipment, tools, sporting goods, and household goods, depending on the particular store. Our Outlet stores are designed to provide in-store and online access to purchase new, one-of-a-kind, out-of-carton, discontinued, obsolete, used, reconditioned, overstocked, and scratched and dented products, collectively "outlet-value products" across a broad assortment of merchandise categories, including home appliances, mattresses, furniture, and lawn and garden equipment at value-oriented prices. See Note 9 to our Consolidated Financial Statements in this Annual Report on Form 10-K for further information about our segments.
The majority of our Hometown stores are operated by our dealers and franchisees. SHO provides brand and marketing support and inventory on consignment. We initiated efforts to franchise Outlet stores in 2012, with the first stores transferred to franchisees during the 2013 fiscal year. Since the second quarter of 2015, franchising of additional Hometown and Outlet stores except to existing Company franchisees has been suspended by the Company. We pay our dealers and franchisees commissions based on their net sales of our inventory that we consign to them. We also authorize our dealers and franchisees to sell post-sale services, such as extended-service plans, for which we also pay commissions.
Hometown
In fiscal 2018 revenue from our Hometown segment was $958.5 million. As of February 2, 2019, the Company or our dealers and franchisees operated a total of 549 Sears Hometown and Hardware stores located across 49 states, Puerto Rico, and Bermuda.
Our Hometown segment operates through four distinct formats: Sears Hometown Stores ("Hometown Stores"), Sears Hardware Stores ("Hardware Stores"), Sears Home Appliance Showrooms ("Home Appliance Showrooms") and Buddy's Home Furnishing Stores ("Buddy's Stores").
| • | Hometown Stores. Our Hometown Stores and website offer products and services across a wide selection of merchandise categories, including home appliances, lawn and garden equipment, tools, sporting goods, and household goods, with the majority of business driven by big-ticket home appliance and lawn and garden sales. Most of our Hometown Stores carry Sears-branded products, including products branded with the KENMORE®, CRAFTSMAN®, and DIEHARD® marks (the "KCD Marks"), and an assortment of other national brands. Primarily independently operated, predominantly located in smaller communities and averaging approximately 8,500 square feet, Hometown Stores are designed to serve trade areas that may not support a full-service big-box retailer. As of February 2, 2019, there were 499 Hometown Stores in 49 states, Puerto Rico and Bermuda. Hometown Stores also sell products and services through our website www.SearsHometownStores.com. When a dealer exits a location, the Company may take over the operation of a store, generally on an interim basis, until the location can be transferred to another dealer. At any given time the Company is generally operating a number of stores that are in transition from one dealer to another dealer. Transition stores are not included in our count of Company-operated locations due to the expected short-term nature of transition operation. Dealers operated 497, and we operated two, Hometown stores. |
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| • | Hardware Stores. Our Hardware Stores and website offer products and services across a wide selection of merchandise categories with sales primarily driven by home appliances, lawn and garden equipment, tools, and other home improvement products including products typically found in local hardware stores, such as fasteners, electrical supplies, and plumbing supplies. Our Hardware stores average approximately 23,000 square feet in size, are primarily located in suburban trade areas and are positioned as local stores designed to appeal to convenience-oriented customers These stores carry Craftsman brand tools and lawn and garden equipment, and a wide assortment of other national brands and other home improvement products. As of February 2, 2019, there were 15 Hardware Stores in ten states, all of which carry a selection of Kenmore and other national brands of home appliances. Hardware Stores also sell products and services through our website www.SearsHardwareStores.com. Franchisees operated seven, and we operated eight, of these stores. |
| • | Home Appliance Showrooms. Our Home Appliance Showrooms and website offer home appliances and related services in stores primarily located in strip malls and lifestyle centers in metropolitan areas. Averaging 5,000 square feet with a simple, primarily appliance-showroom design, our Home Appliance Showrooms offer quality-focused customers a unique store shopping experience. Home Appliance Showroom sales are primarily driven by home appliances as well as, in certain stores, mattresses. These stores carry Kenmore and other national brands of home appliances. As of February 2, 2019, there were 27 Home Appliance Showrooms in eight states. Home Appliance Showrooms also sell products and services through our website www.SearsHomeApplianceShowroom.com. Franchisees operated 11 of these stores, and we operated 16 stores. |
| • | Buddy's Home Furnishings Stores. Our Buddy's Home Furnishings Stores, where we are a franchisee, enable us to benefit from Buddy's expertise and systems infrastructure in the rent-to-own business in which we own the inventory that we rent to our customers. As of February 2, 2019, there were eight Buddy's Home Furnishings Stores in two states, all of which were operated by the Company. |
Outlet
Our Sears Outlet stores (the "Outlet Stores") are designed to provide in-store and online access to purchase outlet-value products across a broad assortment of merchandise categories, including home appliances, mattresses, apparel, sporting goods, lawn and garden equipment, tools, and other household goods, including furniture, at prices that are significantly lower than list prices. Outlet Stores serve as a liquidation channel for outlet-value home appliances from major appliance vendors. In 2018 Outlet’s most significant merchandise category was home appliances, which made up 82.7% of our Outlet sales revenue. Outlet-value products are generally covered by a warranty. Outlet Stores also offer a full suite of extended-service plans and services. As of February 2, 2019, Outlet operated 128 locations in 33 states and Puerto Rico, all of which offer a wide range of outlet-value products. Outlet also sells products and services through our website www.SearsOutlet.com. As of February 2, 2019, we operated 123 Outlet Stores and franchisees operated five Outlet Stores. In fiscal 2018 revenue from our Outlet segment was $491.4 million.
Merchandise and Services from Transform Holdco LLC
Following the 2012 Separation and until mid-February 2019 we had significant business relationships with Sears Holdings and its subsidiaries, and we relied heavily on them for merchandise and services through various agreements among the Company, Sears Holdings and, in some circumstances, subsidiaries of Sears Holdings (as amended, the “Operative Agreements”). Edward S. Lampert (who with investment affiliates (together "ESL") owns 58.8% of our outstanding shares of common stock), was Chief Executive Officer of Sears Holdings, and he served until February 12, 2019 as a member of Sears Holdings’s Board of Directors and as its Chairman of the Board of Directors.
During October 2018, Sears Holdings and many of its subsidiaries (together the “Sears Holdings Companies”) 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 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. As part of the Sears Holdings Companies bankruptcy proceedings, Transform Holdco LLC ("Transform Holdco") acquired most of the operating assets (including Sears stores) and related assets of the Sears Holdings Companies, and the Operative Agreements were assigned by the Sears Holdings Companies to, and the obligations thereunder were assumed by, Transform Holdco on or about February 11, 2019. See "Risk Factors " in this Item 1A. According to publicly available information, ESL controls Transform Holdco.
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Competition
Hometown
Our Hometown business is subject to highly competitive conditions, with varying levels of competition in each store’s trade area. Hometown Stores and Hardware Stores compete with a wide variety of retailers handling similar lines of merchandise, including department stores, discounters, mass merchandisers, specialty retailers, wholesale clubs, and many other competitors operating on a national, regional, or local level. Hometown Stores and Hardware Stores also compete with online and catalog businesses that have similar merchandise offerings. Home Appliance Showrooms compete with all of the previously listed competitors to the extent that they sell home appliances.
The key national competitors of the Hometown Stores, the Hardware Stores, and the Home Appliance Showrooms are The Home Depot, Lowe’s and Best Buy, as well as Ace Hardware and True Value for the Hardware Stores, and Tractor Supply for the Hometown Stores and the Hardware Stores, all of which offer consumers lines of merchandise that are the same as or similar to lines of merchandise offered by the Hometown Stores, the Hardware Stores, and the Home Appliance Showrooms. Transform Holdco's Sears stores offer consumers lines of merchandise that are similar to the lines of merchandise offered by the Hometown Stores, the Hardware Stores, and the Home Appliance Showrooms. As our stores have expanded their merchandise offerings, the level of competition between the Hometown Stores, the Hardware Stores, and the Home Appliance Showrooms and Transform Holdco's Sears stores has increased. In addition to being the principal merchandise vendor for the Hometown business, Transform Holdco also continues to provide some e-commerce services and support to SHO, and Transform Holdco's online sales compete with our business.
We believe that the key differentiating factors among competitors operating in this industry include price, product assortment and quality, service and convenience, brand recognition, existence of loyalty programs, online and multichannel capabilities and availability of retail-related services such as access to lease-to-own and credit-card programs and product delivery, installation, assembly and repair.
Outlet
The Outlet Stores and SearsOutlet.com operate in the outlet-value retail industry. In our primary product category, appliances, our Outlet Stores and SearsOutlet.com compete at one end of the spectrum with big-box retailers that sell primarily new in-box product, as new in-box product competes both with new in-box product and out-of-box product sold in the Outlet Stores. To the extent these big-box competitors choose to liquidate their own out-of-box product on their sales floors, this product would compete directly with out-of-box product sold in the Outlet Stores. At the other end of the spectrum are the locally owned appliance retailers that have historically comprised the bulk of the Outlet Stores' direct competition for sales of out-of-box product. These locally owned appliance retailers generally sell both out-of-box and new in-box appliances. Online retailers that sell new or out-of-box appliances are also competitors.
The Outlet Stores' key national competitors with respect to new, in-box appliances are The Home Depot, Lowe’s and Best Buy. With respect to as-is appliances, which represent 63% of the Outlet segment's 2018 sales, there are no national competitors. In addition, as we have expanded our product lines into categories such as mattresses and furniture, we face additional competition from other discount retailers that focus on those product categories. While Transform Holdco's stores provide similar lines of merchandise as the Outlet Stores, the Outlet Stores are primarily value-price sellers of distressed, refurbished, and marked-out-of-stock merchandise, which merchandise Transform Holdco's stores generally do not sell in what we believe are significant volumes to consumers. As our Outlet business expands its merchandise offerings (for example, our recent increased emphasis on mattresses and furniture) and the level of online price transparency for major appliances, the level of competition between the Outlet Stores and Transform Holdco's stores is increasing.
We believe that the key differentiating factor between competitors operating in the outlet-value retail industry is price. Other factors include product assortment and quality, service and convenience, brand recognition, existence of loyalty programs, online and multichannel capabilities, and availability of retail-related services such as access to credit and product delivery.
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Our Strengths
We believe that our competitive strengths are the following:
Our stores carry a wide variety of well-known, brand-name merchandise. We offer our customers a broad selection of products, including well-known consumer brand names such as Kenmore, Whirlpool®, Samsung, and Craftsman, and we strive to offer high in-stock levels. Our Hometown stores are the only national retail chain that carries the top appliance brands. This ability to offer a wide variety of well-known, consumer brand-name merchandise enables us to remain competitive in our trade areas and to continue to attract customers.
We operate across the nation through distinctly tailored store formats. Our different store formats are targeted to the trade areas in which they compete. Our Hometown Stores offer customers in more rural communities a wide variety of merchandise. In those trade areas, we compete against larger national or regional big-box stores on the basis of the convenient shopping experience we provide, and we compete against local independent stores based on our product offerings and competitive pricing.
Our Hardware Stores are located in neighborhood centers in suburban areas where customers can fulfill their hardware, lawn and garden and home appliance needs. These stores compete against larger warehouse home centers and smaller local hardware stores by offering a broad assortment of products, convenient outlets, and personalized customer assistance.
Our Home Appliance Showrooms include appealing display floors in metropolitan trade areas where we compete with big-box retailers by offering a compelling service model, a wide assortment of brand-name home appliances, significant online and multi-channel capabilities, and convenient locations. We differentiate ourselves from our competitors by providing our customers with a consultative and educational purchase experience.
Our Outlet Stores offer customers a wide range of outlet-value products at locations across the United States and Puerto Rico. Our Outlet Stores differentiate themselves from their competitors by providing a wide range of outlet-value brand-name products, including Kenmore, Whirlpool, GE, LG, Maytag, and Samsung products, at prices that are significantly lower than list prices.
In addition, SHO has stores located in 49 states as well as Puerto Rico and Bermuda, with over 98% of sales in the United States. The ability to generate revenues with a wide variety of products across a diversified mix of regions and trade areas positions us to be able to take advantage of opportunities as they arise.
Our Outlet Stores are the leading liquidation channel of value-priced home appliances. As the nation’s largest chain retailer of outlet-value home appliances, our Outlet business has become increasingly relevant to major appliance vendors as a liquidation channel for outlet-value appliances. We do not believe that we have any national competitors for outlet-value appliances.
Our Strategy
We plan to continue to enhance our competitive position, grow our business, and increase our net sales and profitability by implementing the following strategies:
Expand Product Assortment and Optimize Service Offerings. We strive to provide our customers with complete solutions for their home appliance, lawn and garden, hardware, and other related home needs. We regularly evaluate other merchandise categories and types of services to enhance our product and service offerings and to create cross-selling opportunities for adjacent products and services.
Promote Customer Growth through Enhanced Marketing, Improved Customer Experience, and Integrated Multi-Channel Capabilities. We seek to serve our customers’ needs and drive revenue growth through our integrated multi-channel sale capabilities. We continue to seek to enhance our e-commerce operations and our online product selection to improve our customers’ online shopping experiences. We seek to integrate our online business and our brick-and-mortar stores to provide our customers with a seamless shopping experience across channels. On Company-operated websites we offer our customers the option to purchase items online and pick them up in our local stores as well as order out-of-stock and other items from our in-store kiosks. In addition, Sears.com offers customers the option to purchase items online and pick them up in our local stores. These capabilities allow us to better serve customers across various channels and improve sales. See, however, "We rely on Transform Holdco for services related to our online business and the processing of online orders" in Item 1A. Risk Factors of this Annual Report on Form 10-K.
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We also plan to drive customer growth by refining our marketing initiatives. We believe that we can grow our customer base through advertising in a number of different media, particularly through various forms of digital marketing, including search, social media ads and email marketing. We launched a fully integrated print, digital and television marketing campaign in March 2018 to highlight the unique market position of the Hometown Stores and our strengths in the home appliances category. This included the Company’s first ever national television commercials.
We believe that quality customer service contributes to increased store visits and purchases by our customers. We are focused on building long-term relationships with customers and members by improving their in-store and post-sale experiences. We conduct quality control checks of our store managers and sales associates and our dealers and franchisees to improve the quality of customer interaction and product knowledge in the stores we operate and the stores operated by our dealers and franchisees. We continue to improve and augment our post-sale engagement with customers through access to delivery, assembly, and installation services as well as extended-service plans.
Diversify Our Supply Chain. We intend to continue our efforts to diversify our network of merchandise suppliers and service providers. Such diversification, particularly with respect to merchandise suppliers, is intended to reduce our reliance on Transform Holdco for our inventory. In 2017, we leveraged new systems functionality, enabled by our investments in the IT systems transformation initiative, to enhance our merchandise sourcing and inventory management capabilities. We have established direct purchasing relationships with several of our key strategic product manufacturers which hold significant market share in the product categories we compete in across the industry. SHO's purchases of inventory from Sears Holdings declined to 60% of total purchases in 2018 compared to 78% in 2017. We expect the percentage of total purchases of inventory acquired from Transform Holdco to decrease in the future as we increase our direct purchases from other merchandise vendors, particularly as the proportion of SHO's total inventory purchases in the Outlet business continues to increase as expected.
Provide Industry-Leading Financing Options. We intend to continue to provide our customers many convenient methods of financing their purchases including extended credit-card offers and lease-to-own alternatives. We believe that our store operating practices and our relationships with the issuer of the Sears credit card and our lease-to-own provider allow us to offer attractive financing choices for our customers that will lead to higher customer loyalty and profitability for the Company. Year-over-year leasing comparable store sales increased 39% in fiscal 2018. Our leasing share of the total business grew 27% versus the prior year, growing to 9% share in 2018. Additionally, third-party commissions received on leasing sales became a more meaningful contributor to our margin improvement.
Grow Commercial Sales. We are seeking to continue to grow our revenue with business customers who can benefit from our extensive merchandise offerings, broad store network, and delivery and service capabilities. Businesses such as builders, landlords, and apartment operators represent an attractive incremental customer base in the communities where we operate. In 2018, commercial sales grew 13%. Gross margin rate, net of commissions paid, improved as a result of a more disciplined commercial pricing process. Dealer and franchisee adoption of the program also continued to grow, with 70% of stores participating in 2018 versus 52% in 2017.
Transform our IT Infrastructure. We are replacing the large majority of our information technology infrastructure, which has been provided since the 2012 Separation by Sears Holdings (prior to mid-February 2019 and thereafter by Transform Holdco), with new systems and processes. We expect this change will provide improved operational flexibility, allow better control of our systems and processes, and reduce some of the risks relating to our relationship with, and dependence on, Transform Holdco. See also "We rely on Transform Holdco and other third parties to provide us with key products and services in connection with the administration of many critical aspects of our business, and we may be required to develop our own systems quickly in order to reduce such dependence" in Part 1A. Risk Factors of this Annual Report on Form 10-K for additional information regarding the conversion and migration of our information technology infrastructure.
Improve Operating Performance. We plan to focus on various initiatives intended to improve our gross margins and our inventory management. Our inventory-procurement operations are focused on developing customized merchandise assortments based on store demographics, sales history, customer preferences and margin by product division. Our inventory management focuses on keeping products with higher customer demand in stock. In addition, we intend to focus on controlling costs across our business lines, particularly selling and administrative expenses.
Store Activity. We will continue to take proactive steps to make the best use of capital and reduce costs by closing stores that we determine are not sufficiently profitable. We will also continue to selectively identify trade-area opportunities for new stores over the long term based on market potential, including trade areas where Sears Holdings (prior to mid-February 2019 and thereafter by Transform Holdco) has closed a full-line department store.
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Our Products and Suppliers
Our focus on the preferences of our customers drives our merchandise selection. Our goal is to offer our customers a selection of brands and products within each of our product categories. Our largest revenue-generating category in 2018 was home appliances, representing approximately 73% of net sales.
We are party to an Amended and Restated Merchandising Agreement that was assigned by the Sears Holdings Companies to Transform Holdco (as amended and assigned, the "Merchandising Agreement") pursuant to which subsidiaries of Transform Holdco (1) sell to us, with respect to certain specified product categories, Transform Holdco-branded products (including products branded with the KCD Marks ("KCD Products")) and vendor-branded products obtained from other vendors and suppliers and (2) grant us licenses to use the trademarks owned by Transform Holdco, including the KCD Marks, in connection with the marketing and sale of products sold under the Transform Holdco marks. The initial term of the Merchandising Agreement will expire February 1, 2023 with our right to exercise one three-year extension with respect to KCD Products subject to specified Transform Holdco termination rights and other conditions in the Merchandising Agreement. We expect that our Hometown business will continue to rely on Transform Holdco for a significant majority of its inventory in 2019.
For the year ended February 2, 2019, products that we acquired through Sears Holdings accounted for approximately 60% of SHO's merchandise purchases. Although most merchandise purchases are now sourced through Transform Holdco, this percentage decreased from 78% in 2017. We expect this percentage to continue to decline as we increase our direct purchases from other merchandise vendors, particularly as the proportion of SHO's total inventory purchases in the Outlet business continues to increase as expected.
For example, fourth quarter 2018 purchases from Sears Holdings accounted for 52% of total purchases compared to 74% in the fourth quarter of 2017 and 58% in the third quarter of 2018. During the second half of 2017 and in early 2018, we entered into direct purchasing agreements with Whirlpool Corp., Husqvarna, LG Electronics USA Inc., GE Appliances, Samsung Electronics America Inc., and Stanley, Black and Decker. Our Outlet business primarily relies on suppliers other than Transform Holdco for the vast majority of its inventory. For the quarter and year ended February 2, 2019, products that we acquired through Sears Holdings accounted for approximately 10% and 19% of total Outlet purchases, respectively.
As described in greater detail in Item 1A. Risk Factors of this Annual Report 1A, we have agreements with Transform Holdco as well as with third-party service providers, to provide processing and administrative functions over a broad range of areas.
Our Dealer and Franchise Models
Dealer Model
As of February 2, 2019, 497 of our Hometown Stores were operated by independent authorized dealers who own and operate their stores. The dealer bears responsibility for store operating costs, including all payroll and occupancy costs. SHO provides the inventory to the dealer on a consignment basis, and the dealer earns a variable commission on sales of merchandise, extended-service plans, and other services. SHO also provides support to dealers for recruiting and training dealer staff, marketing, and other support services.
The dealer relationship is governed by a dealer agreement, which generally has either a three or five-year term (depending on its terms and conditions). If a dealer defaults or fails to renew its dealer agreement, SHO may assume responsibility for the operation of the store until a new dealer is recruited to operate the store.
Franchise Model
As of February 2, 2019, 11 of our Home Appliance Showrooms, seven of our Hardware Stores, and five of our Outlet Stores were operated by independent franchisees. Under our primary franchise model, the franchisee operates the store and is responsible for its operating costs, including payroll and leasing costs. SHO provides inventory to the franchisee on a consignment basis, and the franchisee earns variable commissions on sales of merchandise, extended-service plans, and other services. SHO also provides brand and marketing services to the franchisee. In certain cases, SHO remains responsible for lease costs in the case of a default by the franchisees until the expiration of the leases, at which time our franchisees may be required to negotiate new leases to which SHO will not be a party.
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The franchise relationship is governed by a franchise agreement with each franchisee that generally has a ten-year term and includes the franchisee's right to extend the term for an additional five years subject to the franchisee's satisfaction of renewal conditions that are specified in the franchise agreement. The franchise agreement also currently obligates the franchisee to pay to SHO specified fees, including an initial franchise fee, training fees, transfer fees, and successor franchise fees.
During the second quarter of 2015 we suspended our franchising of additional Hometown and Outlet stores except to existing Company franchisees. We have ceased franchising additional Hometown and Outlet stores.
Distribution and Systems Infrastructure
The majority of our merchandise comes to our stores directly from vendors or distributors (including Transform Holdco). Home delivery is provided by the selling dealers and franchisees, by Transform Holdco, and by other parties.
We rely extensively on computer systems to process transactions, summarize results, and manage our business. Given the number of individual transactions we have each year, it is critical that we maintain uninterrupted operation of our computer and communications hardware and software systems. We currently rely on Transform Holdco to provide us with the computer systems and infrastructure that enable our distribution systems. See "If we do not maintain the security of our customer, associate, and company information, we could damage our reputation, incur substantial additional costs, and become subject to litigation" in Item 1A. Risk Factors of this Annual Report on Form 10-K. For information regarding the migration of the current information technology systems and processes provided to us by Holdings to new, business and technology infrastructure and systems see "We rely on Transform Holdco and other third parties to provide us with key products and services in connection with the administration of many critical aspects of our business, and we may be required to develop our own systems quickly in order to reduce such dependence" in Item 1A. Risk Factors of this Annual Report on Form 10-K.
In addition, we also rely on Transform Holdco for warehousing and other logistics services primarily for our Hometown segment stores.
We are party to a Services Agreement pursuant to which a subsidiary of Transform Holdco (as assignee) provides us with a number of services, including logistics and distribution, information technology (including the point-of-sale system used by the Company and our dealers and franchisees), product repair, ecommerce, and payment clearing and other financial services (as amended, the "Services Agreement"). The term of the Services Agreement will expire on February 1, 2023, subject to specified termination rights. We pay fees and rates for the services received in accordance with the Services Agreement. In addition, we are responsible for the payment of all taxes payable in connection with the Services provided under the Services Agreement, including sales, use, excise, value-added, business, service, goods and service, consumption, withholding and other similar taxes or duties. See "Relationships and Transactions with Related Persons" in the definitive 2019 Proxy Statement relating to our Annual Meeting of Stockholders to be held on May 29, 2019, which is incorporated by reference into Item 13 of this Annual Report on Form 10-K (the "2019 Proxy Statement), for a general description of the Services Agreement.
Geographic Information
The vast majority of our revenues are generated within the United States. During 2018 and 2017, approximately 2.0% of our revenues were generated in Puerto Rico. The vast majority of our long-lived assets are located within the United States.
Employees
As of February 2, 2019, we had 2,992 employees, of which 51% were full-time employees and less than 1% were represented by a union. We believe that we have a good working relationship with our employees and we have never experienced a material interruption of business as a result of labor disputes. We offer a broad range of company-paid benefits to our employees. These company-paid benefits include a 401(k) savings plan, medical and dental plans, disability insurance, paid vacation, various employee assistance programs, life insurance, and merchandise discounts.
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Intellectual Property
We are party to several Store License Agreements with a subsidiary of Transform Holdco, as assignee, pursuant to which we have been granted, on a royalty-free basis, among other things, (1) an exclusive, non-transferable and terminable license to operate, and to authorize our dealers and franchisees to operate, retail stores and stores-within-a-store using the "Sears Outlet Store," "Sears Authorized Hometown Store," "Sears Hometown Store," "Sears Home Appliance Showroom," "Sears Hardware Store," and "Sears Appliance & Hardware," store names (together, the "store names"), (2) an exclusive, non-transferable and terminable license to use the store names to promote our products, and services related to our products, by all current and future electronic means, channels, processes and methods, including via the Internet, (3) a non-exclusive, nontransferable and terminable license to use, and to authorize our dealers and franchisees to use, certain other trademarks to market and sell services related to our products under those trademarks and (4) an exclusive, non-transferable and terminable license to use certain domain names in connection with the promotion of our stores, the marketing, distribution and sale of our products and the marketing and offering of services related to our products (collectively, the "Store License Agreements"). We are also party to a Trademark License Agreement with the Transform Holdco subsidiary pursuant to which we have been granted, on a royalty-free basis, a non-exclusive, non-transferable and terminable right to use the "Sears" name in our corporate name and to promote our business (the "Trademark License Agreement"). The Store License Agreements and the Trademark License Agreement will expire in 2029, subject to specified termination rights. For additional information regarding the Store License Agreements and the Trademark License Agreement see "Relationships and Transactions with Related Persons" in the 2019 Proxy Statement.
The Merchandising Agreement provides that (1) Transform Holdco's subsidiary will sell to us, with respect to certain specified product categories, Sears-branded products (including KCD Products) and vendor-branded products obtained from vendors and suppliers and (2) Transform Holdco's subsidiary grants us licenses to use the trademarks owned or licensed by subsidiaries of Transform Holdco (together, the "Sears marks"), including the KCD Marks, in connection with the marketing and sale of products sold under the Sears marks. We pay, on a weekly basis, a royalty determined by multiplying our net sales of the KCD Products by specified fixed royalties rates for each brand’s licensed products.
Seasonality
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, although this can vary with weather conditions.
Corporate Information; Our Website; Availability of SEC Reports and Other Information
Our principal executive offices are located at 5500 Trillium Boulevard, Suite 501, Hoffman Estates, Illinois 60192 and our telephone number is (847) 286-7000. Our website address is www.shos.com.
This Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, and the amendments, if any, to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 ("Exchange Act") are available, free of charge, through the "Investors-U.S. Securities and Exchange Commission Filings" link at our website as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission ("SEC").
The Corporate Governance Guidelines of our Board of Directors, the charters of the Audit Committee, the Compensation Committee, and the Nominating and Corporate Governance Committee of the Board of Directors, our Code of Conduct, our Board of Directors Code of Conduct, and our Code of Vendor Conduct are available at the "Corporate Governance " and the "Vendors" links at www.shos.com. References to www.shos.com do not constitute incorporation by reference of the information at www.shos.com, and the information at www.shos.com is not part of this Annual Report on Form 10-K.
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Item 1A. Risk Factors
You should carefully consider the risks described below, together with all of the other information included in this Annual Report on Form 10-K (including without limitation "Cautionary Statements Regarding Forward-Looking and Other Information" in this Part I), in evaluating SHO and our common stock. Each of the following risk factors could materially and adversely affect, among other things, our business, results of operations, financial condition, stock price, and prospects.
Risks Relating to Our Relationship with, and Dependence on, Transform Holdco
We depend on Transform Holdco to provide us with most key products and services for our business. Consequently, if Transform Holdco is unwilling, unable, or otherwise fails to provide these key products and services or if Transform Holdco’s brands are impaired, we could be materially and adversely affected.
Following the 2012 Separation and until mid-February 2019 we had significant business relationships with Sears Holdings and its subsidiaries, and we relied heavily on them for merchandise and services through various agreements among the Company, Sears Holdings and, in some circumstances, subsidiaries of Sears Holdings (together the “Operative Agreements”). See "Relationships and Transactions with Related Persons" in the 2019 Proxy Statement. During October 2018 Sears Holdings and many of its subsidiaries (together the “Sears Holdings Companies”) 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 Company, which is not a subsidiary of Sears Holdings, is not included in the bankruptcy petitions filed by the Sears Holdings Companies, and neither the Company nor its subsidiaries have filed a bankruptcy petition. As part of the Sears Holdings Companies' bankruptcy proceedings Transform Holdco acquired most of the operating assets (including Sears stores) and related assets of the Sears Holdings Companies (together the “Sears Assets”), and the Operative Agreements were assigned by the Sears Holdings Companies to, and the obligations thereunder were assumed by, Transform Holdco on or about February 11, 2019. According to publicly available information, ESL controls Transform Holdco and owns approximately 58.8% of the Company’s outstanding shares of common stock.
On April 5, 2019 the Company received a proposal from Transform Holdco to acquire all of the outstanding shares of the Company’s common stock not already owned by ESL for a purchase price of $2.25 per share. Following the review of the proposal by a special committee of the Company's independent directors and the special committee's advisors, the special committee communicated to representatives of Transform Holdco that the special committee had concluded that a transaction on the terms contemplated by the Proposal would not be in the best interests of the Company’s unaffiliated stockholders. For additional information see our Current Report on Form 8-K filed with the SEC on April 8, 2019.
The Company can give no assurance that any definitive agreement concerning a transaction with Transform Holdco will be entered into or, if such a definitive agreement is entered into, will result in the consummation of a transaction provided for in the definitive agreement. Discussions concerning a transaction may be terminated at any time and without prior notice. Entry into a definitive agreement concerning a transaction and the consummation of any such transaction is subject to a number of contingencies that are beyond the Company's control.
As described below under the heading “ESL Investments, Inc. and its investment affiliates, whose interests may be different from the interests of other stockholders, are able to exert substantial control and influence over our Company.”, ESL took action on April 15, 2019 to replace two members of our Board of Directors and to amend our Amended and Restated Bylaws.
We rely heavily on the products and services provided since mid-February 2019 by Transform Holdco or its subsidiaries (the "key products and services") including the following:
| • | Inventory procurement from third-party vendors, including KCD Products and other products which collectively account for a majority of our revenue; |
| • | Logistical, supply chain, and inventory support services; |
| • | Accounting and financial reporting services; |
| • | Risk management, tax, and insurance services; |
| • | Online, computer and information technology infrastructure (including the point-of-sale system used by the Company and our dealers and franchisees) and support; |
| • | Certain of our store leases and the leases for stores that we have subleased, or in the future may sublease, to franchisees or others are leased or subleased to us by subsidiaries of Transform Holdco until their expiration at which time we will be required to renegotiate with the landlords directly; |
| • | Our stores continue to use the Sears brand name, and other intellectual property owned by Transform Holdco through our license agreements with Transform Holdco; |
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| • | Our stores continue to participate in the Transform Holdco's Shop Your Way program and rely on the customer data and other information provided by the Shop Your Way program; and |
| • | Our stores continue to accept Sears-branded credit cards. |
Transform Holdco was formed recently, was not an operating retail business prior to its acquisition of the Sears Assets and the assumption of the Operative Agreements, and will rely, at least initially, on the Sears Holdings Companies and its subsidiaries and other third parties to provide to Transform Holdco the merchandising and other services that Transform Holdco is obligated to provide to the Company in accordance with the Operative Agreements. Transform Holdco is not a public company and is not obligated to disclose publicly any information regarding its results of operations, financial condition, liquidity, cash flows, or overall ability to operate its businesses and provide merchandising and other services to the Company in accordance with the Operative Agreements. Transform Holdco has not given the Company any of such information.
As a result of our dependence on Transform Holdco, we are exposed to the risk that Transform Holdco will become unable or unwilling to fulfill its contractual obligations to us in accordance with their terms. Transform Holdco is subject to various risks and uncertainties, which could adversely and materially affect our business, results of operations, financial condition, liquidity, and cash flows. Such risks include (1) risks related to the retail industry, (2) risks related to worldwide economic conditions, (3) risks associated with Transform Holdco's computer systems and infrastructure, (4) risks related to Transform Holdco's ability to access capital markets and other financing sources, and (5) risks associated with what appears to us to be Transform Holdco's inability, possibly temporary, to obtain merchandise on commercially reasonable terms for its businesses and for resale to us.
SHO receives from Transform Holdco specified portions of merchandise subsidies collected by Transform Holdco from its merchandise vendors and specified portions of cash discounts earned by Transform Holdco as a result of its early payment of merchandise-vendor payables (together "Vendor Funds"). SHO's portion of Vendor Funds has significantly declined, and if that decline were to continue, SHO's results of operations and cash flows could be adversely affected to a material extent.
We had been taking action to reduce our dependence on Sears Holdings, and we are taking action to reduce our dependence on Transform Holdco, to enable us to take advantage of what we believe are lower costs, or better terms and conditions, from alternative merchandise and services vendors and to reduce our Transform Holdco-related risks. We will continue to evaluate actions that will enable us to reduce our costs and risks by reducing our dependence on Transform Holdco.
We believe it is necessary for Transform Holdco to continue to provide products and services to us in accordance with the Operative Agreements to facilitate the continued successful operation of our business. Transform Holdco has no obligation to provide assistance to us other than to provide the products and services required to be provided pursuant to the Operative Agreements. Although Transform Holdco is generally obligated to provide us with these products and services until February 1, 2023, these products and services may not be provided at the same level, at the same prices, and, with respect to products, the same amounts of Vendor Funds during the entire duration of the agreements, and we may not be able to obtain the same benefits from these products and services. Generally, we expect to need to rely on Transform Holdco for some products and services for the entire duration of the Operative Agreements. When Transform Holdco is no longer obligated to provide these products and services to us, we may not be able to replace some of these products and services on terms and conditions, including costs, as favorable as those we have with Transform Holdco. See "Relationships and Transactions with Related Persons" in the 2019 Proxy Statement.
The service fees we are obligated to pay to Transform Holdco are not firm and higher service fees could result.
The Services Agreement provides that it will expire on February 1, 2023 unless terminated earlier in accordance with its terms. The Services Agreement also provides that we will pay the service fees specified in the Services Agreement for its duration, subject to (1) fee increases from Transform Holdco's third-party providers providing services and (2) Transform Holdco's right to increase fees for services if a change in legislation, regulation, business conditions, or Transform Holdco’s operations results in an increase in Transform Holdco’s costs associated with one or more of the services.
We depend on Transform Holdco and other vendors to provide our inventory.
Our Hometown and Outlet businesses rely on Transform Holdco (or its subsidiaries) for a significant portion of their inventory, including KCD Products. For the year ended February 2, 2019, products which we acquired through Sears Holdings accounted for approximately 60% of our merchandise purchases. Hometown merchandise purchases are sourced predominantly through Transform Holdco.
If we are unable to obtain adequate amounts and assortments of merchandise from Transform Holdco, we may be unable on short notice to find alternative sources of supply on terms and conditions that we believe are commercially reasonable, or at all. In addition, the third-party vendors from whom Transform Holdco currently obtains merchandise for us may not be willing to continue
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to sell merchandise to Transform Holdco on terms and conditions that it believes are commercially reasonable. During the fourth quarter of 2018 we experienced (and continue to experience) a growing inability to obtain from Transform Holdco sufficient quantities of Craftsman-branded merchandise in product categories important to us, many of which categories we cannot quickly source from other vendors.
In addition, our Outlet business also relies on merchandise vendors other than Transform Holdco ("Other Vendors") for a significant portion of Outlet inventory. For the year ended February 2, 2019, purchases from Other Vendors accounted for approximately 81% of total Outlet purchases. We intend to increase the portion of our Outlet business's inventory that we purchase from Other Vendors if we believe that action will improve our customer service or profitability. Our agreements with Other Vendors generally do not guarantee the availability of specified amounts of merchandise at any given time, and we have no assurance that any of these agreements will be renewed on commercially reasonable terms, or at all. If the Other Vendors decrease their output of merchandise, raise their prices, or find alternative distribution channels for their products, or all of these, and we are required to find one or more additional Other Vendors, we may not be able to contract with them on a timely basis, on commercially reasonable terms, or at all. This could lead to higher prices, decreased inventory, our inability to maintain an appropriate assortment of merchandise in our stores and could cause us to accelerate store closings, all of which could have a material adverse effect on our business, results of operations, financial condition, and stock price. In addition, if we do not maintain our existing relationships, or build new relationships, with Other Vendors we may not be able to maintain an appropriate assortment of merchandise, and customers may not purchase from our stores.
We rely on Transform Holdco and other third parties to provide us with key products and services in connection with the administration of many critical aspects of our business, and we may be required to develop our own systems quickly in order to reduce such dependence.
We are party to various agreements with Transform Holdco (including without limitation the Services Agreement), as well as with third-party service providers, to provide us with processing and administrative functions over a broad range of areas, and we expect to continue to do so in the future. Key products and services provided by Transform Holdco or other third parties as a part of outsourcing initiatives could be interrupted as a result of many factors, such as acts of God or contract disputes, and any failure by third parties to provide us with these key products and services on a timely basis or within our service level expectations and performance standards could result in a disruption to our business.
We rely heavily on the infrastructure of Transform Holdco for a variety of key products and services. Our various agreements with Transform Holdco (including without limitation the Services Agreement and the Merchandising Agreement), which govern the provision of these key products and services, are not long term, and we may seek to continue to rely on the infrastructure of Transform Holdco after February 1, 2023. Our business plans with respect to approximately the next 18 to 24 months depend to a significant extent on Transform Holdco’ willingness and ability to continue to provide us with these key products (including KCD Products as to which products we do not have the right to buy other than from Transform Holdco) and services. Any failure to maintain Transform Holdco as a service provider, or any actions by Transform Holdco, during that period when permitted under the applicable agreement, to raise the prices it charges us for these key products and services, could have a material adverse impact on our business and our results of operations.
In addition, cyber-attacks, other cybersecurity incidents, and other disruptions in the computer and communications hardware and software systems provided by Transform Holdco could harm our ability to run our business, result in the compromise of confidential customer data and lead to significant remediation costs, increased cybersecurity protections costs, lost revenues, increased litigation and other legal risks, increased insurance premiums, reputational damage that adversely affects customer and investor confidence, and damage to the Company’s competitiveness, stock price, and long-term stockholder value. Any significant interruption in our computer operations may have a material adverse effect on our business and results of operations. As a result of our reliance on the computer and information technology infrastructure of Transform Holdco, we have limited control over the timing and implementation of upgrades to our computer and information technology systems that we may believe are integral to the successful operation of our business.
We have entered into a Master Services Agreement with a vendor (the "systems-migration vendor") in which it agrees to provide business process outsourcing services and services for the migration of the current information technology systems and processes provided by Transform Holdco to new business and technology infrastructure and systems provided by a second vendor (collectively, the “BPO”). We expect the new infrastructure and systems will provide greater operational flexibility, provide better control of our systems and processes, reduce our total cost of information-system operation following implementation of the migration, and reduce some of the risks inherent in our services relationship with, and reduce our dependence on, Transform Holdco. The new infrastructure and systems should enable us, and we currently intend, to replace many of the corporate services provided by Transform Holdco with services that we will provide ourselves using the new system, other third-party providers, and, on a limited-basis, internally by SHO. The replaced services could include tax, accounting, non-merchandise procurement, risk management
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and insurance, advertising and marketing, human resources, loss prevention, environmental, product and human safety, facilities, information technology, online, payment clearing, and other financial, real estate management, merchandising, and other support services. Selling and administrative expenses related to the BPO were $25.9 million and $34.4 million in 2018 and 2017, respectively. We expect a decline in BPO-related corporate expenses in fiscal 2019.
Implementation of the BPO involves significant risks for us. The risks include, among other things, the following: conversion and migration of data; availability and customization of solutions that meet our needs and the needs of our dealers and franchisees (especially with respect to our point-of-sale and financial-reporting systems); availability of Company personnel and other resources to manage and implement the project; expansion of migration, implementation, and conversion scope, cost, and timing; current and future disagreements with the systems-migration vendor regarding its and our contractual rights and obligations (in particular with respect to the growing costs of the migration and increasing implementation delays) and the contractual rights and obligations of the systems-migration vendor's contractors regarding, among other things, the suitability of the migration solutions proposed by the systems-migration vendor and its ability and willingness to complete the BPO in accordance with our plans and expectations and on the timetable and at the cost to the Company that we believe we have negotiated with the systems-migration vendor as reflected in the Master Services Agreement. Key BPO conversion and migration milestones have not been, or will not be, met by the systems-migration vendor in accordance with agreed-upon deadlines. The Company believes that the systems-migration vendor is responsible, in all significant respects, for the delays. Other risks include the amount, quality, and timing of cooperation that we receive from Transform Holdco and other contracted service providers with respect to the BPO and disruption of our day-to-day business activities. The risks described above in this paragraph and other risks with respect to the BPO could have a material adverse effect on our business and results of operations.
If our relationships with our vendors, including Transform Holdco, were to be impaired, it could have a negative impact on our competitive position and our business and financial performance.
We obtain our merchandise from Transform Holdco and Other Vendors. For the year ended February 2, 2019, products which we acquired from Transform Holdco, including KCD Products and other products, accounted for approximately 60% of our total purchases of inventory from all vendors. The loss of or a reduction in the amount of merchandise made available to us by Transform Holdco could have a material adverse effect on our business and results of operations.
Pursuant to the Merchandising Agreement, subsidiaries of Transform Holdco have agreed to sell non-Sears-branded products to us until February 1, 2023. If we want to continue to purchase non-Sears-branded products from Transform Holdco after February 1, 2023 we will need to seek to extend or renegotiate on comparable terms and conditions the duration of the Merchandising Agreement with respect to non-Sears-branded products. If those efforts were unsuccessful we might not be able to replace the inventory provided under the Merchandising Agreement on commercially reasonable terms, or at all and any such inability could have a material adverse effect on our prospects and results of operations and our ability to operate our business could be significantly impaired, as we would have to find new sources for our inventory. We now purchase and, when in the Company's best interest, intend to accelerate our purchases of non-Sears-branded products from Other Vendors.
Our vendor arrangements with Transform Holdco and Other Vendors generally are not long-term agreements and none of them guarantee the availability of merchandise in the future. Our growth strategy depends to a significant extent on the willingness and ability of our vendors to supply us with sufficient inventory. As a result, our success depends on maintaining good relations with our existing vendors and developing relationships with new vendors. If we fail to maintain our relations with our existing vendors (including without limitation maintaining an effective and productive business relationship with Transform Holdco) or the quality and quantity of merchandise they supply us, or if we cannot acquire new vendors of favored brand-name merchandise, our ability to obtain a sufficient amount and variety of merchandise at acceptable prices may be limited, which would have a negative impact on our competitive position. In addition, to the extent we are able to develop relationships with new vendors and obtain merchandise from alternative sources, the merchandise obtained may be of a lesser quality and more expensive than the merchandise we currently purchase.
We license from Transform Holdco the use of our current store names, specified domain names, and specified trademarks used to brand our products.
We license from Transform Holdco the use of the "Sears" trademark, the KCD Marks, and the "Sears Hometown Store," "Sears Authorized Hometown Store," "Sears Hardware Store," "Sears Home Appliance Showroom," "Sears Appliance & Hardware," and "Sears Outlet" store names (collectively, the "store names") and domain names for websites we operate (the "domain names"). Pursuant to the Merchandising Agreement, our licenses to use the KCD Marks will expire February 1, 2023 or, if we renew for the renewal term, February 1, 2026. Pursuant to the Store License Agreements and Trademark License Agreement, our licenses to use the Sears trademark, the store names, and the domain names (except as provided in the next sentence) will expire in 2029, subject to specified termination rights. In accordance with the Services Agreement our license from Transform Holdco to use the
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domain name "SearsOutlet.com" on a web platform not operated by Transform Holdco will expire on February 1, 2023. For additional information regarding our license rights see "Relationships and Transactions with Related Persons" in the 2019 Proxy Statement.
If the value of the Sears trademark, the KCD Marks, the store names, or the domain names diminishes, if we are unable to extend, renew, or renegotiate the Merchandising Agreement, the Store License Agreements, or the Trademark License Agreement on comparable terms, or at all, or if one or more of these agreements (or other then-available rights to use the KCD Marks, the store names, or the domain names) were terminated, our prospects and results of operations could be adversely affected and our ability to operate our business could be impaired, as it would require us to stop using one or more of the aforementioned names in our stores, in our online activities, and in our product advertising.
Several of our agreements with subsidiaries of Transform Holdco contain early termination provisions that are outside of our control and, if triggered, could have a material adverse effect on our ability to operate our business and our financial performance.
Our agreements with subsidiaries of Transform Holdco contain various default and termination provisions, some of which are not within our control. For example, under the Merchandising Agreement, if (i) an unaffiliated third party acquires all rights, title, and interest in and to one or more (but not all) of the KCD Marks, then subsidiaries of Transform Holdco may terminate their obligation to sell to us the products that are branded with the KCD Marks that were subject to such acquisition and (ii) if an unaffiliated third party acquires all rights, title, and interest in and to all of the KCD Marks, then subsidiaries of Transform Holdco may terminate the Merchandising Agreement in its entirety. See "The sale of KCD Products to other retailers, including certain of our competitors, may adversely affect our results of operations" in this Item 1A regarding Transform Holdco's sale on March 9, 2017 of its Craftsman brand to Stanley Black & Decker, Inc. Furthermore, the Merchandising Agreement and our other agreements with subsidiaries of Transform Holdco may also be terminated by either party upon a material breach if breaching party fails to cure such breach within 30 days following written notice of such breach or, if such breach is not curable, immediately upon delivery of notice of the non-breaching party’s intention to terminate. The Merchandising Agreement provides that neither Transform Holdco nor SHO may exercise its express termination rights if it or its affiliates have failed to comply with any of its material obligations in the Merchandising Agreement and the failure is continuing.
In addition, a number of our agreements with subsidiaries of Transform Holdco contain cross-termination provisions such that, if a breach of or default under one of the agreements by one party were to result in the termination of such agreement, the other party may terminate a number of the additional agreements between the parties. If one or more of our agreements with subsidiaries of Transform Holdco were to be terminated earlier than currently anticipated, it could have a material adverse effect on our prospects and results of operations and our ability to operate our business would be significantly impaired. For additional information see "Relationships and Transactions with Related Persons" in the 2019 Proxy Statement. The Company's Amended and Restated Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent and collateral agent (the "Senior ABL Facility"), and the Company's Term Loan Credit Agreement with Gordon Brothers Finance Company, as agent, lead arranger, and sole bookrunner, and Gordon Brothers Finance Company, LLC as lender (the “Term Loan Agreement”) each provides that an "Event of Default" would occur with specified consequences if Transform Holdco or its subsidiaries terminated each of the Merchandising Agreement, the Services Agreement, the Store License Agreements, the Trademark License Agreement, and the Tax Sharing Agreement between the Company and Transform Holdco (the "Tax Sharing Agreement"). See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Senior ABL Facility" and "Term Loan Credit Agreement" in this Annual Report on Form 10-K.
The sale of KCD Products to other retailers, including certain of our competitors, may adversely affect our results of operations.
KCD Products accounted for approximately 51% of our consolidated revenue during fiscal year 2018. Transform Holdco has agreed to supply several other retailers, including several of our competitors, with a number of Craftsman and DieHard-branded products that previously were only sold through affiliates of Transform Holdco. If Transform Holdco continues to supply other retailers, including our competitors, with Craftsman and DieHard-branded products, or begins to supply other retailers with Kenmore-branded products, our revenue may be adversely affected.
During 2016 Sears Holdings announced that it would explore alternatives for its Kenmore, Craftsman, and Diehard businesses and further expand the presence of these brands. During 2017 Sears Holdings announced that it had completed its sale to Stanley Black & Decker, Inc. of Sears Holdings's Craftsman business (the "Stanley Purchase"), including the Craftsman brand name and related intellectual property rights. As part of the agreement, Transform Holdco will continue to offer specified Craftsman-branded products, sourced from existing suppliers, through its current retail channels, including the Company, via a perpetual license from Stanley Black & Decker, Inc. As part of the Stanley Purchase Stanley Black & Decker, Inc. agrees that Transform Holdco's license right to sell specified Craftsman-branded products to the Company is exclusive. The Company believes that the Stanley Purchase
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will enable Stanley Black & Decker, Inc. to significantly increase Craftsman sales through the Company's competitors, such as The Home Depot and Lowe’s. In connection with the Stanley Purchase, Transform Holdco has waived its right in the Merchandising Agreement to terminate, solely as a result of the Stanley Purchase, the Company's rights to buy from Transform Holdco merchandise branded with the Craftsman brand. For additional information see the Company's Current Report on Form 8-K (File No. 001-35641) filed with the Securities and Exchange Commission on March 9, 2017 regarding the Amendment to Amended and Restated Merchandising Agreement dated as of March 8, 2017 among the Company, Transform Holdco (as assignee from Sears Holdings), and Stanley Black & Decker. Inc. On July 20, 2017 Sears Holdings announced the launch of Kenmore products on Amazon.com and that Sears Holdings planned to make the full line of Kenmore home appliances available on Amazon.com.
Our agreements with Transform Holdco restrict our ability to expand into certain geographic areas.
Currently, Sears full-line stores, Kmart stores, and certain specialty retail stores owned by Transform Holdco sell product lines that are similar to ours. The Merchandising Agreement prohibits us, subject to specified conditions, from opening new Hometown Stores and Hardware Stores in specified areas and from selling new home appliance, patio, and Craftsman lawn and garden merchandise in new Outlet Stores that are located within two miles of an operating Transform Holdco store. These non-competition obligations restrict our ability to open new stores and sell certain types of products in the specified areas that we might otherwise consider as possible targets for expansion and may limit our growth potential.
We may have been able to receive better terms from unaffiliated third parties than the terms we received in our agreements with Transform Holdco.
The agreements related to the 2012 Separation, including the Services Agreement, the Store License Agreements, the Trademark License Agreement, the Merchandising Agreement, and the Retail Establishment Agreement (other than the post-2012 Separation amendments to these agreements, which have been approved by the Audit Committee of the Company's Board of Directors), were agreed to in the context of a parent-subsidiary relationship and in the overall context of the 2012 Separation. Accordingly, they may not represent the best terms that could have been available to us from third parties. The terms of the agreements negotiated in the context of the 2012 Separation relate to, among other things, the principal actions needed to be taken in connection with the 2012 Separation, indemnification, and other obligations among Transform Holdco and us, and the nature of the commercial arrangements between us and Transform Holdco following the 2012 Separation. For additional information see "Relationships and Transactions with Related Persons" in the 2019 Proxy Statement.
We may not be able to continue to resolve successfully future contractual disputes and other conflicts with Transform Holdco.
Several of our agreements with Transform Holdco, such as the Services Agreement, the Store License Agreements, the Trademark License Agreement, and the Merchandising Agreement, were agreed to in the context of a parent-subsidiary relationship and in the overall context of the 2012 Separation (other than post-2012 Separation amendments to these agreements, which have been approved by the Audit Committee of the Company's Board of Directors). We may be unable to obtain expeditious and economical resolution of future disputes that could arise with respect to the following matters, among others, which also could materially and adversely affect our ability to conduct our business: business opportunities that may be attractive to both Transform Holdco and us; the nature, quality and pricing of services Transform Holdco has agreed to provide to us; tax, real estate (including sublease obligations) and other matters arising from the 2012 Separation; defense and indemnification arising from losses caused by Transform Holdco; major business combinations involving us; employee retention and recruiting; SHO's intellectual property rights; the extent of SHO's rights to conduct multi-channel retailing; and competition between our stores and websites and Transform Holdco’s stores and websites.
Risks Relating to Our Business
If we fail to offer merchandise and services that our customers want, our sales may be limited, which would reduce our revenues and profits.
In order for our business to be successful, we must identify, obtain supplies of, and offer to our customers, attractive, innovative and high-quality merchandise on a continuous basis. Our products and services must satisfy the desires of our customers, whose preferences in appliances, hardware and lawn and garden products may change in the future. If we misjudge either the demand for the products we sell or our customers' purchasing habits and tastes, we may be faced with excess inventories of some products and missed opportunities for products we chose not to offer. In addition, our sales may decline or we may be required to sell the merchandise we have obtained at lower prices, increasing our inventory markdowns and promotional expenses. This would have a negative effect on our business and results of operations.
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Our business has been and will continue to be affected by worldwide economic conditions; a failure of the economy to sustain its recovery, a renewed decline in consumer-spending levels and other conditions, including inflation, could lead to reduced revenues and gross margins, and negatively impact our results of operations.
Many economic and other factors are outside of our control, including, consumer confidence and spending levels, consumer and commercial credit availability, inflation, employment levels, housing sales and remodels, lower housing turnover, increased mortgage delinquency and foreclosure rates, consumer debt levels, fuel costs and other challenges currently affecting the global economy, the full impact of which on our business, results of operations and financial condition cannot be predicted with certainty. These economic conditions adversely affect the disposable income levels of, and the credit available to, our customers, which could lead to reduced demand for our merchandise. Also affected are our vendors, upon which we depend to provide us with inventory and services. Our vendors could seek to change the terms under which they sell inventory or other services to us which could negatively impact our financial condition. In addition, the inability of vendors to access liquidity, or the insolvency of vendors, could lead to their failure to deliver inventory or other services.
The domestic and international political situation also affects consumer confidence. The threat, outbreak or escalation of terrorism, military conflicts or other hostilities could lead to a decrease in consumer spending. Any of these events and factors could cause us to increase inventory markdowns and promotional expenses, thereby reducing our gross margins and operating results.
If we do not successfully manage our inventory levels, our operating results will be adversely affected.
We must maintain sufficient inventory levels to operate our business successfully. However, we also must avoid accumulating excess inventory as we seek to minimize out-of-stock levels across all product categories and to maintain in-stock levels. We continue to rely on and obtain significant portions of our inventory through Transform Holdco, which obtains a significant portion of inventory from vendors located outside the United States. Some of these vendors often require us to provide, through Transform Holdco, lengthy advance notice of our requirements in order to be able to supply products in the quantities we request. This usually requires us, through Transform Holdco, to order merchandise, and enter into purchase order contracts for the purchase and manufacture of such merchandise, well in advance of the time these products will be offered for sale. As a result, we may experience difficulty in responding to a changing retail environment, which makes us vulnerable to changes in price and consumer preferences. If we do not accurately anticipate the future demand for a particular product or the time it will take to obtain new inventory, our inventory levels will not be appropriate and our results of operations may be negatively impacted.
If we are unable to compete effectively in the highly competitive retail industry, our business and results of operations could be materially adversely affected.
The retail industry is intensely competitive and highly fragmented. In addition, there are few barriers to entry into our current trade areas and new competitors may enter our trade areas at any time. We compete with a wide variety of retailers, including department stores, discounters, mass merchandisers, hardware stores, independent dealers, home improvement stores, home appliance and consumer electronics retailers, auto service providers, specialty retailers, wholesale clubs and many other competitors operating on a national, regional or local level. Some of our competitors are actively engaged in new store expansion. Online and catalog businesses, which handle similar lines of merchandise, also compete with us.
We may not be able to compete successfully against existing and future competitors. Some of our competitors have financial resources that are substantially greater than ours and may be able to purchase inventory at lower costs and better endure future economic downturns. As a result, our sales may decline if we cannot offer competitive prices to our customers or we may be required to accept lower profit margins. Our competitors may respond more quickly to new or emerging technologies and consumer preferences and may have greater resources to devote to promotion and sale of products and services.
Our existing competitors or new entrants into our industry may use a number of different strategies to compete against us, including the following:
| • | Expansion into the suburban and rural trade areas in which many of our stores operate; |
| • | Lower pricing, particularly with respect to new, in-box appliances (which, among other things, makes the pricing of our Outlet merchandise less compelling); |
| • | Expanding the offering of free delivery and installation of merchandise and other consumer benefits; |
| • | Expanding online sales; |
| • | Extension of credit to customers on terms more favorable than we offer; and |
| • | Larger store size, which may result in greater operational efficiencies, or innovative store formats, and use of disruptive technology. |
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Competition from any of these sources could cause us to lose trade area share, sales and customers, increase expenditures or reduce prices, any of which could have a material adverse effect on our business and results of operations.
Our operating results are tied in part to the success of our dealers and franchisees, and the inability of our dealers and franchisees to continue operating their stores profitably could adversely affect our operating results.
As of February 2, 2019, the significant majority of the stores in our Hometown business were operated by our dealers and franchisees that sell our inventory on a consignment basis. Our dealers’ and franchisees’ ability to continue operating their stores profitably (which ability to us appears to be worsening) depends on various factors, including their business abilities, financial capabilities (including their access to credit for operating capital), the negotiation of acceptable leases, and general economic conditions. Many of the foregoing factors are beyond the control of both SHO and our dealers and franchisees. If our dealers and franchisees are unable or unwilling to operate their stores, this could have a material adverse effect on our business and results of operations including the necessity that we record additional accelerated store-closing costs.
In addition, if our dealers are unable or unwilling to operate their stores profitably or in a manner consistent with our concepts and standards, we may be required to take over one or more stores from our dealers from time to time. Generally, at any given time, we operate approximately 3-5% of our Sears Hometown Stores as a result of our taking such stores over from our authorized dealers.
Our dealers and franchisees may damage our business or increase our costs by failing to comply with our agreements and operating standards of our dealer and franchise agreements.
Our dealers and franchisees operate their stores pursuant to dealer agreements and franchise agreements, respectively, with us. If our dealers and franchisees do not comply with our established operating concepts and standards or the terms in the franchise or dealer agreements, our business may be damaged. We may incur significant additional costs, including time-consuming and expensive litigation, to enforce our rights under the dealer agreements and the franchise agreements. Furthermore, as a franchisor we have obligations to our franchisees. Franchisees may challenge the performance of our obligations under the franchise agreements and subject us to costs in defending these claims and, if the claims are successful, costs in connection with their compliance.
In addition, as a franchisor we are subject to regulation by the Federal Trade Commission and are subject to state laws that govern the offer, sale and termination of franchises and the refusal to renew franchises. The failure to comply with these regulations in any jurisdiction or to obtain required approvals could result in a ban or temporary suspension on future franchise sales, fines or require us to make a rescission offer to franchisees, any of which could adversely affect our business and operating results.
Our sales may fluctuate for a variety of reasons, which could adversely affect our results of operations.
Our business is sensitive to customers' spending patterns, which in turn are subject to prevailing and perceived longer-term economic conditions. Our sales and results of operations have fluctuated in the past and we expect them to continue to fluctuate in the future. A variety of other factors affect our sales and financial performance, including the following:
| • | Actions by our competitors, including opening of new stores in our existing trade areas or changes to the way these competitors conduct business online; |
| • | Increases to the level of discount on promotional pricing of new-in-box appliances in the industry, which could continue to adversely impact our sales of out-of-box appliances and associated margin; |
| • | The extent to which we are able to generate profitable sales of merchandise and services on our transactional ecommerce websites in the amounts we have planned to generate; |
| • | The availability on commercially reasonable terms of the various types of inventory that we need to sell for the profitable operation of our stores; |
| • | We rely on Transform Holdco to provide product protection agreements that we sell in our stores and online, and deterioration in Transform Holdco's results of operations, financial condition, and liquidity could affect its ability to offer product protection agreements; |
| • | Changes in our merchandise strategy and mix; |
| • | Real estate and maintenance costs for our existing stores; |
| • | Changes in population and other demographics; |
| • | Timing and effectiveness of our promotional events; |
| • | Weather conditions, including level of rainfall, particularly drought, level of snowfall, average temperature, major storms, and delays in, or advances to, the start of seasonal changes; |
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| • | The availability of locations for new stores that can be operated profitability by the Company and by our dealers and franchisees; and |
| • | The growth of online shopping in which we may not be able to fully participate |
Accordingly, our results for any one quarter or year are not necessarily indicative of the results to be expected for any other quarter or year, and comparable store sales for any particular future period may increase or decrease. For more information on our results of operations, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Annual Report on Form 10-K.
ESL Investments, Inc. and its investment affiliates, whose interests may be different from the interests of other stockholders, are able to exert substantial control and influence over our Company.
According to publicly available information, ESL Investments, Inc. and its investment affiliates including Edward S. Lampert (together, "ESL") owns 58.8% of our outstanding shares of common stock. Accordingly, ESL has a substantial influence over many, if not all, actions to be taken or approved by our stockholders and has a significant voice in, for example, the removal, appointment, and election of directors, the ability of the Company to implement business initiatives and transactions, and the implementation of transactions involving a change of control, among other matters affecting the Company.
On April 15, 2019, ESL acted by written consent pursuant to the Company's Amended and Restated Bylaws and the General Corporation Law of the State of Delaware (the "DGCL") to remove William K. Phelan and David Robbins as directors of the Company and appoint Alberto Franco and John E. Tober to the Company's Board of Directors to fill the vacancies created by the removal of Mr. Phelan and Mr. Robbins. ESL also amended the Company’s Amended and Restated Bylaws pursuant to its written consent (the “ESL Bylaw Amendment”) to, among other things, provide for specified approval and procedural requirements that must be met prior to the Company effecting the closure of 20% or more of the stores operating any line of business of the Company or a liquidation, sale or disposal of (x) Company assets representing 20% or more of the consolidated assets of the Company and its subsidiaries, other than in the ordinary course of business, or (y) a line of business of the Company representing 20% or more of the consolidated net sales or net income of the Company and its subsidiaries (each a “Disposal Action”). Under the Company's Amended and Restated Bylaws, as amended by ESL's written consent, the Board must, prior to commencing a Disposal Action, adopt at a meeting a resolution recommending such Disposal Action with the affirmative vote of at least 90% of directors then in office. Following the adoption of such a resolution, the Company must make a public announcement of such recommendation and the Board must then approve such Disposal Action by an affirmative vote of no less than 90% of directors then in office at a second meeting at least thirty business days following the first meeting. For additional information see our Current Report on Form 8-K filed with the SEC on April 19, 2019.
The approval and procedural requirements added by the ESL Bylaw Amendment add, as described above, constraints to the Company’s ability to make specific business decisions and could therefore have a material adverse effect on our business and results of operations. The ESL Bylaw Amendment's terms in some respects create uncertainty about how to comply with them.
We may be subject to product liability claims if people or properties are harmed by the products we sell or the services we offer.
Some of the products we sell may expose us to product liability claims relating to personal injury, death, or property damage caused by such products, and may require us to take actions such as product recalls. Although we maintain liability insurance, we cannot be certain that our coverage will be adequate for liabilities actually incurred or that insurance will continue to be available to us on commercially reasonable terms, or at all.
We may be subject to periodic litigation and regulatory proceedings. These proceedings may be affected by changes in laws and government regulations or changes in the enforcement thereof.
From time to time, we may be involved in lawsuits and regulatory actions relating to our business, certain of which may be in jurisdictions with reputations for aggressive application of laws and procedures against corporate defendants. We are impacted by trends in litigation, including class-action allegations brought under various consumer protection and employment laws, including wage and hour laws. We conduct business in 49 states. Some jurisdictions in which we operate aggressively apply laws and procedures against corporate defendants. Due to the inherent uncertainties of litigation and regulatory proceedings, we cannot accurately predict the ultimate outcome of any such proceedings. An unfavorable outcome could have a material adverse impact on our business, financial condition and results of operations. In addition, regardless of the outcome of any litigation or regulatory proceedings, these proceedings could result in substantial costs and may require that we devote substantial time and resources to defend our Company. Further, changes in governmental regulations in the United States could have adverse effects on our business and subject us to additional regulatory actions.
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If we do not maintain the security of our customer, associate, and company information, we could damage our reputation, incur substantial additional costs, and become subject to litigation.
In the ordinary course of our business, we collect, process, and store a large amount of customer, associate, and Company information, including financial information and sensitive personal information. Until we complete the implementation of the BPO we will continue to rely heavily on access to Transform Holdco’s computer and communications hardware and software systems (such as the point-of-sale system used by the Company and our dealers and franchisees) and related security systems (collectively the "Transform Holdco Systems") to collect, process, and store this information. Transform Holdco Systems are subject to damage or interruption from power outages, computer and telecommunications failures, computer viruses, security breaches, catastrophic events such as fires, tornadoes and hurricanes, and usage errors by Transform Holdco's associates, our associates, and the associates of our dealers and franchisees. The Transform Holdco Systems may be compromised as a result of criminal activity, negligence, or otherwise. Threats may result from human error, fraud, or malice on the part of Transform Holdco's associates, our associates, and the associates of our dealers, franchisees, and other third parties, or may result from accidental technological failure. Any significant compromise or breach of the Transform Holdco Systems could significantly damage our reputation and result in additional costs, lost sales, fines, government investigations, and lawsuits against, or otherwise adversely affecting, SHO. The regulatory environment related to information security and privacy is increasingly rigorous and complex, with new and constantly changing requirements applicable to our business, and compliance with those requirements could result in additional costs. Additionally, several recent, highly publicized data-security breaches and cyber attacks at other large, nationwide retail companies have heightened consumer awareness of this issue and may embolden individuals or groups to target SHO and the Transform Holdco Systems. There is no guarantee that our reliance on the Transform Holdco Systems and related security measures provided by Transform Holdco will protect information against unauthorized access or that the Transform Holdco Systems and related security measures are adequate to safeguard against data-security breaches.
When we complete the implementation of the BPO our systems will be subject to the same information-system risks that are described in the preceding paragraph. See "We rely on Transform Holdco and other third parties to provide us with key products and services in connection with the administration of many critical aspects of our business, and we may be required to develop our own systems quickly in order to reduce such dependence" in this Item 1A for additional information and risks regarding the implementation of the BPO.
If we are unable to renew or enter into new store leases on competitive terms, our revenues or results of operations could be negatively impacted.
A small number of our stores are in locations where Transform Holdco currently operates one of its stores. In such cases we entered into a lease or sublease with Transform Holdco (or one of its subsidiaries) for the portion of the space in which our store operates and pay rent directly to Transform Holdco (or one of its subsidiaries) on the terms negotiated in connection with the 2012 Separation. If we are unable to negotiate leases or subleases with Transform Holdco (or one of its subsidiaries) on commercially reasonable terms, or at all, we may be forced to close the affected stores, which could negatively impact our results of operations.
As of February 2, 2019, we leased 96 Company-operated Outlet store locations under long-term agreements with landlords that are unaffiliated with Transform Holdco, leased 23 locations with landlords affiliated with Transform Holdco, operated two locations that were co-located with a Sears Appliance and Hardware store which were leased by the Hometown segment, and owned one building. Additionally, we are the obligor on three leases which are sublet to our franchisees that are unaffiliated with Transform Holdco and one lease is sublet to a franchisee with a landlord affiliated with Transform Holdco, and two locations are leased by franchisees. If our cost of leasing existing stores increases, we may be unable to maintain our existing store locations as leases expire. Our profitability may decline if we fail to enter into new leases on competitive terms or at all, or we may not be able to locate suitable alternative stores or additional sites for new-store expansion in a timely manner. Furthermore, 52 of our 128 Sears Outlet leases will expire within the next three years and, with respect to 23 of these locations, we do not have lease-renewal rights. A failure to renew or enter into new leases could reduce our revenues and negatively impact our results of operations.
As of February 2, 2019, our Hometown business leased 12 Company-operated locations under long-term agreements with landlords that are unaffiliated with Transform Holdco. Additionally, we are the obligor on an additional two leases which are sublet to our franchisees. If our franchisees are unable to maintain the payments under either our sublease or assigned lease arrangements, we will be required to make payments under the lease. In addition, upon the expiration of the initial lease term, our franchisees are responsible for entering into new leases with existing landlords. If our franchisees are unable to negotiate new leases with existing landlords on commercially reasonable terms, or at all, our franchisees may be required to move or close certain of our stores. A failure to maintain payments or to enter into new leases by our franchisees could negatively impact our results of operations.
As of February 2, 2019, our Hometown businesses leased 2 locations where we closed retail stores but continued to be obligated on the lease. In addition, we are leasing one location currently under construction to open a new store.
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A number of the leases for both our Outlet and Hometown stores were negotiated by and entered into by a subsidiary of Transform Holdco. Upon the expiration of these leases, we will be required to enter into new leases with the landlords for such properties and we may be unable to enter into new leases as a company independent from Transform Holdco on commercially reasonable terms, or at all. Further, a number of our leases were entered into at a time when the commercial real estate market was depressed. We may be required to enter into negotiations with landlords for new leases in the future at times when the commercial real estate market has rebounded and rental payments are generally higher for commercial real estate. Higher occupancy costs could negatively impact our results of operations.
If we fail to timely and effectively obtain shipments of product from our vendors and deliver merchandise to our customers, our operating results will be adversely affected.
We cannot control all of the various factors that might affect our timely and effective procurement of supplies of product from our vendors, including Transform Holdco, and delivery of merchandise to our customers. Our utilization of foreign imports also makes us vulnerable to risks associated with products manufactured abroad, including, among other things, risks of damage, destruction or confiscation of products while in transit to our stores, work stoppages including as a result of events such as strikes, transportation and other delays in shipments including as a result of heightened security screening and inspection processes or other port-of-entry limitations or restrictions in the United States, lack of freight availability and freight cost increases. In addition, if we experience a shortage of a popular item, we may be required to arrange for additional quantities of the item, if available, to be delivered to us through airfreight, which is significantly more expensive than standard shipping by sea. As a result, we may not be able to obtain sufficient freight capacity on a timely basis or at favorable shipping rates and, therefore, we may not be able to timely receive merchandise from our vendors or deliver our products to our customers.
We rely upon Transform Holdco and other third-party land-based carriers for merchandise shipments to our stores and customers. Accordingly, we are subject to the risks, including labor disputes, union organizing activity, inclement weather and increased transportation costs, associated with such carriers' ability to provide delivery services to meet our inbound and outbound shipping needs. In addition, if there was an increase in the cost of fuel above current levels, the cost to deliver merchandise to our stores may rise which could have an adverse impact on our profitability. Failure to procure and deliver merchandise either to us or to our customers in a timely, effective and economically viable manner could damage our reputation and adversely affect our business. In addition, any increase in distribution costs and expenses could adversely affect our future financial performance.
Failure to achieve and maintain effective internal controls in accordance with Section 404 of Sarbanes-Oxley could have a material adverse effect on our business and the market price of our common stock.
As a public company, we are required to document and test our internal control over financial reporting in order to satisfy the requirements of Section 404 of Sarbanes-Oxley, which requires annual management assessments of the effectiveness of our internal control over financial reporting. Testing and maintaining internal control can divert our management’s attention from other matters that are also important to the operation of our business. The imposition of these regulations has increased, and may continue to increase, our legal and financial compliance costs and make some activities more difficult, time consuming and costly. We may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404. If we are unable to conclude that we have effective internal control over financial reporting, investors could lose confidence in our reported financial information, which would likely have a negative effect on the trading price of our common stock. In addition, if we do not maintain effective internal controls, we may not be able to accurately report our financial information on a timely basis, which could harm the trading price of our common stock, impair our ability to raise additional capital, or jeopardize our continued listing on the NASDAQ Capital Market or any other stock exchange on which our common stock may be listed.
Risks Relating to our Indebtedness
We and our subsidiaries may incur additional debt, which could substantially reduce our profitability, limit our ability to pursue certain business opportunities, and reduce the value of your investment.
At February 2, 2019 we had approximately $133 million of debt outstanding. While the instruments governing our indebtedness include restrictions on our ability to incur additional indebtedness, they do not completely prevent us or our subsidiaries from incurring additional debt in the future and do not prevent us or our subsidiaries from incurring other obligations that do not constitute indebtedness, which could increase the risks described below and lead to other risks. For additional information regarding the Senior ABL Facility and the Term Loan Agreement see, "Management’s Discussion and Analysis of Financial Condition and Results of Operations—Analysis of Financial Condition" in this Annual Report on Form 10-K. The amount of our debt or such
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other obligations, and our ability to meet those obligations (including repayment) could have important consequences for holders of our common stock, including, but not limited to:
| • | our ability to satisfy obligations to lenders may be impaired, resulting in possible defaults on and acceleration of our indebtedness; |
| • | our ability to obtain additional financing for refinancing of existing indebtedness, working capital, capital expenditures, product and service development, acquisitions, general corporate purposes and other purposes may be impaired; |
| • | a substantial portion of our cash flow from operations could be dedicated to the payment of the principal and interest on our debt; |
| • | we may be increasingly vulnerable to economic downturns and increases in interest rates; |
| • | our flexibility in planning for and reacting to changes in our business and the retail industry may be limited; and |
| • | we may be placed at a competitive disadvantage relative to other companies in our industry. |
The Senior ABL Facility and the Term Loan Agreement contain financial and operating covenants and restrictions that limit our operations and could lead to adverse consequences if we fail to comply with them.
The Senior ABL Facility and the Term Loan Agreement each contains financial and operating covenants and other restrictions relating to, among other things, an excess availability requirement and a fixed charge coverage ratio, as well as limitations on indebtedness (including guarantees of additional indebtedness) and liens, mergers, consolidations and dissolutions, sales of assets, investments and acquisitions, dividends and other restricted payments (such as stock repurchases), and transactions with affiliates. See "Management’s Discussion and Analysis of Financial Condition and Results of Operations—Analysis of Financial Condition" in this Annual Report on Form 10-K.
Failure to comply with these financial and operating covenants could result from, among other things, changes in our results of operations, the incurrence of additional indebtedness, or changes in general economic conditions, which may be beyond our control. The breach of any of these covenants or restrictions could result in a default under the Senior ABL Facility and the Term Loan Agreement that would permit the lenders to declare all amounts outstanding thereunder to be due and payable, together with accrued and unpaid interest. If we are unable to repay such amounts, lenders having secured obligations, such as the lenders under the Senior ABL Facility and the lender under the Term Loan Agreement, could proceed against the collateral securing the secured obligations. In any such case, we may be unable to borrow under the Senior ABL Facility and may not be able to repay amounts due under such facility and under the Term Loan Agreement. This could have serious consequences to our financial condition and results of operations and could cause us to become bankrupt or insolvent. In addition, these covenants may restrict our ability to engage in transactions (i) that we believe would otherwise be in the best interests of our stockholders or (ii) without which our business and operations could be harmed.
Increases in interest rates would increase the cost of servicing our debt and could reduce our profitability.
A significant portion of our outstanding debt, including amounts under the Senior ABL Facility and the Term Loan Agreement, bears interest at variable rates. As a result, increases in interest rates would increase the cost of servicing our debt and could materially reduce our profitability and cash flows. Assuming our Senior ABL Facility were fully drawn in a principal amount equal to $170 million, each one percentage point change in interest rates would result in a $1.7 million change in annual cash interest expense on our Senior ABL Facility. Assuming our Term Loan Agreement were fully drawn in a principal amount equal to $40 million, each one percentage point change in interest rates would result in a $0.4 million change in annual cash interest expense on our Term Loan Agreement.
We have capital needs and may not be able to refinance our existing indebtedness and obtain additional financing on acceptable terms.
Any reductions in our available borrowing capacity under the Senior ABL Facility or the Term Loan Agreement, or our inability to renew or replace our Senior ABL Facility, when required or when business conditions warrant, could have a material adverse effect on our business, financial condition and results of operations. The economic conditions, credit market conditions and economic climate affecting the retail industry, as well as other factors, may constrain our financing abilities. Our ability to secure additional financing, if available, and to satisfy our financial obligations under indebtedness outstanding from time to time will depend upon our future operating performance, the availability of credit generally, economic conditions and financial, business and other factors, many of which are beyond our control. The market conditions and the macroeconomic conditions that affect the retail industry could have a material adverse effect on our ability to secure financing on favorable terms, if at all.
All amounts outstanding under the Senior ABL Facility and the Term Loan Agreement will become due and payable on February 29, 2020. While the Company has had discussions with the administrative agent for the Senior ABL Facility about its extension
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or refinancing, those discussions have not yet resulted in an agreement to extend or refinance. While we believe that we should be able to refinance the Senior ABL Facility and the Term Loan (and we will continue our efforts to do so), we can give no assurance that our efforts will be successful. Even if we were able to refinance the Senior ABL Facility and the Term Loan, the terms and conditions of the replacement arrangements could be unfavorable, perhaps significantly unfavorable, compared to the terms and conditions of the Senior ABL Facility and the Term Loan. Moreover, to the extent we need financing in addition to the replacement arrangements for the Senior ABL Facility and the Term Loan, we may be unable to secure that additional financing or our operating cash flow may be insufficient to satisfy our financial obligations under the indebtedness outstanding from time to time. Furthermore, if financing is not available when needed or is available on unfavorable terms, we may be unable to take advantage of business opportunities or respond to competitive pressures, any of which could have a material adverse effect on our business, financial condition and results of operations. If we are unable to secure debt financing and instead raise funds through the issuance of additional equity securities, our stockholders may experience significant dilution.
The May 3, 2019 report of the Company's independent registered public accounting firm that accompanies the Consolidated Financial Statements included in this Annual Report on Form 10-K incorporates the firm's audit opinion, which expresses "Going Concern Uncertainty" (hereinafter the "Going Concern Uncertainty").
The Senior ABL Facility and the Term Loan Agreement provide that the Company's inability to obtain from the Company's independent registered public accounting firm a report and opinion that "shall not be subject to any 'going concern' or like qualification or exception" constitutes an event of default, which would give the Senior ABL Facility and the Term Loan Agreement lenders the right to accelerate the maturity of all outstanding loans, among other actions. The Senior ABL Facility and the Term Loan Agreement lenders have waived through October 31, 2019 any default resulting from the Going Concern Uncertainty.
Risks Relating to Our Common Stock
If our share price fluctuates, you could lose all or a significant part of your investment.
Our common stock trades on the NASDAQ Capital Market under the symbol "SHOS." We neither can provide any assurance that a trading market for our common stock will continue to exist nor can we predict the prices at which our common stock may trade in the future. The market price of our common stock may fluctuate widely, depending on many factors, some of which may be beyond our control, including the following:
| • | Our business profile and market capitalization may not continue to fit the investment objectives of some stockholders and, as a result, these stockholders may sell our shares; |
| • | Actual or anticipated fluctuations in our operating results due to factors related to our business; |
| • | Our ability to decrease our reliance on products and services provided by Transform Holdco and ability to diversify our supply chain; |
| • | Success or failure of our business strategy; |
| • | Transform Holdco's financial performance, condition, and prospects, including the risk of insolvency proceedings; |
| • | Our relationship with Transform Holdco; |
| • | Actual or anticipated changes in the U.S. economy or the retailing environment; |
| • | Our quarterly or annual earnings, or those of other companies in our industry; |
| • | Our ability to obtain third-party financing as needed; |
| • | Announcements by us or our competitors of significant acquisitions or dispositions; |
| • | The failure of securities analysts to cover our common stock; |
| • | Changes in earnings estimates by securities analysts or our ability to meet those estimates; |
| • | The operating and stock price performance of other comparable companies; |
| • | Overall market fluctuations; |
| • | Changes in laws and regulations affecting our business; |
| • | Actual or anticipated sales or distributions of our capital stock by our officers, directors or significant stockholders; |
| • | Terrorist acts or wars; and |
| • | General economic conditions and other external factors. |
In addition, the stock market in general has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of companies like us. These broad market and industry factors may materially reduce the market price of our common stock, regardless of our operating performance.
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Our common stock may have a low trading volume and limited liquidity, resulting from a continued lack of analyst coverage and institutional interest.
Our common stock may continue to receive limited attention from market analysts. Lack of analyst coverage may make it difficult for potential investors to fully understand our operations and business fundamentals, which may limit our trading volume. Low trading volumes and lack of analyst coverage may limit your ability to resell your common stock.
Our common stock price may decline if ESL decides to sell a portion of its holdings of our common stock.
According to publicly available information ESL owns approximately 58.8% of our outstanding common stock. ESL will, in its sole discretion, determine the timing and terms of any transactions with respect to its shares in us, taking into account business and market conditions and other factors that it deems relevant. ESL is not subject to any contractual obligation to maintain its ownership position in us, although it may be subject to certain transfer restrictions imposed by securities laws. Consequently, we cannot assure you that ESL will maintain its ownership interest in us. Any sale by ESL of our common stock or any announcement by ESL that it has decided to sell shares of our common stock, or the perception by the investment community that ESL has sold or decided to sell shares of our common stock, could have an adverse impact on the price of our common stock.
Your percentage ownership in us may be diluted in the future.
Your percentage ownership in SHO may be diluted in the future because of equity awards that may be granted to our directors, officers and employees in the future. We may in the future decide to make equity-based awards, as well as establish equity incentive plans that may provide for the grant of common stock-based equity awards to our directors, officers and other employees. In addition, we may issue equity in order to raise capital or in connection with future acquisitions and strategic investments, which would dilute your percentage ownership.
We do not expect to pay dividends for the foreseeable future.
We do not expect to pay cash dividends on our common stock for the foreseeable future. As a result, you may not receive any return on an investment in our common stock in the form of cash dividends. The Senior ABL Facility and the Term Loan Agreement would not have permitted us to pay cash dividends on our common stock as of February 2, 2019.
Item 1B. Unresolved Staff Comments
None.
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Item 2. Properties
As of February 2, 2019, our Hometown business included 549 stores and our Outlet business included 128 stores.
As of February 2, 2019, 491 of our Hometown Store locations were leased by independent dealers from landlords not affiliated with SHO. Also as of that date (1) franchisees leased a total of 16 Home Appliance Showrooms and Hardware Stores directly from landlords not affiliated with SHO and (2) SHO subleased to franchisees a total of two Home Appliance Showrooms and Hardware stores. As part of our sublease arrangements, the franchisees agree with SHO to pay rent to SHO and perform the other lease obligations. As of February 2, 2019 SHO operated 12 leased Home Appliance Showrooms and Hardware Stores and operated five leased Hometown Stores. Further, SHO Operated 12 Home Appliance Showrooms and Hardware Stores on an occupancy agreement with a former franchisee. We also leased and operated eight Buddy’s Rent to Own Stores under our Hometown Segment.
Also as of that date SHO operated 119 leased Outlet Stores (these include the stores rejected by Sears where we are on a short term agreement with landlords and other month to month agreements), owned and operated one Outlet Stores, subleased three Outlet Stores to franchisees, two locations were leased directly by franchisees, and two locations were in premises leased by Hardware stores. Further, SHO operated one Outlet Store on an occupancy agreement with a former franchisee.
As of February 2, 2019, SHO subleased or leased from Transform Holdco a total of 16 Company-operated locations. In some of these locations Transform Holdco currently operates one of its stores or engages in other or, in some cases, no business activity. In most such circumstances we have entered into a sublease with Transform Holdco (or one of its subsidiaries) for the portion of the space in which our store operates and we pay rent directly to Transform Holdco per negotiated terms. We also lease from Transform Holdco approximately 40,000 square feet of office space for our corporate headquarters in Hoffman Estates, Illinois. We believe that our facilities are adequately maintained and are sufficient to meet our current and projected needs. We review all subleases and leases set to expire in the near-term to determine the appropriate action to take with respect to them, including closing stores and entering into new store subleases or leases.
Generally, the form of sublease from Transform Holdco to us with respect to our subleased premises provides for the following, among other terms and conditions: (1) the duration of the sublease and the rent payable by us to Transform Holdco are the same as the duration and the rent payable by Transform Holdco to its landlord; (2) the premises are subleased to us on an "as is" basis and that Transform Holdco, as sublandlord, makes no representation to us regarding the condition of the subleased premises; (3) we as subtenant (A) are subject to easements, covenants, conditions, and restrictions of Transform Holdco's lease from its landlord and (B) are required to comply with and perform obligations of Transform Holdco as tenant under its lease from its landlord; (4) we are required to indemnify and defend Transform Holdco from and against claims by (A) Transform Holdco's landlord that we have not performed Transform Holdco's obligations as tenant under Transform Holdco's lease from the landlord and (B) any person as a result of our use or occupancy of the subleased premises or our failure to comply with the terms of the sublease or Transform Holdco's lease from its landlord; (5) we may not sublet or assign the sublease without the consent of Transform Holdco; and (6) upon specified defaults by us (including our failure to observe and perform any provision of the sublease to be performed by us) Transform Holdco may, among other remedies, (A) reenter the subleased premises and expel us and (B) recover damages from us.
Logistics
We support the distribution of product sold through our Outlet locations through strategically located distribution locations. As of February 2, 2019, we operated 13 distribution locations in 12 states and one in Puerto Rico, with an aggregate square footage of 1,659,000. On occasion, we may lease additional facilities to support additional distribution needs.
Store Openings and Closures
Store opening and closure data for fiscal years 2018 and 2017 is contained in the following table.
| Fiscal Year | |||||
| 2018 | 2017 | ||||
| Beginning store count | 900 | 1,020 | |||
| Store openings | 8 | 7 | |||
| Store closures | (231 | ) | (127 | ) | |
| Ending store count | 677 | 900 | |||
As of February 2, 2019, we had 677 stores in operation, with stores in 49 states in the U.S., as well as a store in Bermuda and stores in Puerto Rico.
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Store Count by State
| Hometown | Outlet | ||||||||||
| Company Operated | Dealer/Franchise | Company Operated | Franchise | ||||||||
| BR | Bermuda | — | 1 | — | — | ||||||
| AL | Alabama | — | 10 | 1 | — | ||||||
| AR | Arkansas | — | 30 | — | — | ||||||
| AZ | Arizona | — | 14 | — | 4 | ||||||
| CA | California | 1 | 23 | 17 | — | ||||||
| CO | Colorado | — | 13 | 2 | — | ||||||
| CT | Connecticut | — | — | 2 | — | ||||||
| DE | Delaware | — | 3 | 1 | — | ||||||
| FL | Florida | — | 15 | 10 | — | ||||||
| GA | Georgia | — | 22 | 4 | — | ||||||
| HI | Hawaii | — | 1 | 1 | — | ||||||
| IA | Iowa | — | 13 | — | — | ||||||
| ID | Idaho | — | 7 | — | 1 | ||||||
| IL | Illinois | 2 | 13 | 8 | — | ||||||
| IN | Indiana | 1 | 10 | 2 | — | ||||||
| KS | Kansas | — | 13 | 2 | — | ||||||
| KY | Kentucky | — | 7 | 1 | — | ||||||
| LA | Louisiana | — | 10 | 2 | — | ||||||
| MA | Massachusetts | — | 1 | 3 | — | ||||||
| MD | Maryland | — | 4 | 3 | — | ||||||
| ME | Maine | — | 5 | — | — | ||||||
| MI | Michigan | — | 22 | 5 | — | ||||||
| MN | Minnesota | — | 13 | 1 | — | ||||||
| MO | Missouri | — | 19 | 2 | — | ||||||
| MS | Mississippi | — | 14 | — | — | ||||||
| MT | Montana | — | 8 | — | — | ||||||
| NC | North Carolina | — | 18 | 4 | — | ||||||
| ND | North Dakota | — | 3 | — | — | ||||||
| NE | Nebraska | — | 7 | — | — | ||||||
| NH | New Hampshire | 1 | 2 | — | — | ||||||
| NJ | New Jersey | 2 | — | 4 | — | ||||||
| NM | New Mexico | — | 7 | — | — | ||||||
| NV | Nevada | — | 5 | 3 | — | ||||||
| NY | New York | — | 8 | 1 | — | ||||||
| OH | Ohio | 1 | 10 | 7 | — | ||||||
| OK | Oklahoma | 1 | 14 | — | — | ||||||
| OR | Oregon | — | 20 | 2 | — | ||||||
| PA | Pennsylvania | 4 | 10 | 4 | — | ||||||
| PR | Puerto Rico | — | 8 | 1 | — | ||||||
| RI | Rhode Island | — | 1 | — | — | ||||||
| SC | South Carolina | — | 8 | 2 | — | ||||||
| SD | South Dakota | — | 3 | — | — | ||||||
| TN | Tennessee | — | 7 | 3 | — | ||||||
| TX | Texas | 21 | 44 | 16 | — | ||||||
| UT | Utah | — | 2 | — | — | ||||||
| VA | Virginia | — | 1 | 3 | — | ||||||
| VT | Vermont | — | 4 | — | — | ||||||
| WA | Washington | — | 13 | 3 | — | ||||||
| WV | West Virginia | — | 4 | — | — | ||||||
| WI | Wisconsin | — | 21 | 3 | — | ||||||
| WY | Wyoming | — | 4 | — | — | ||||||
| Total | 34 | 515 | 123 | 5 | |||||||
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Store Ownership Type
| Hometown | Outlet | ||||
| Company operated stores: | |||||
| Owned | — | 2 | |||
| Leased | 34 | 121 | |||
| Total company operated | 34 | 123 | |||
| Independently owned and operated | 515 | 5 | |||
| Total store count as of February 2, 2019 | 549 | 128 | |||
Item 3. Legal Proceedings
As of the date hereof, we are not party to any litigation which we consider material to our operations.
Notwithstanding the above, from time to time we are (or in the future could be), and will continue to be, subject to legal claims, including without limitation those alleging wage and hour violations, employment discrimination, unlawful employment practices, Americans with Disabilities Act claims, breach of contract and other claims by our independent dealers and franchisees, product liability claims as a result of the sale of certain products, as well as various legal and governmental proceedings. Litigation is inherently unpredictable and each proceeding, claim, and regulatory action against us, whether meritorious or not, could be time consuming, result in significant legal expenses, require significant amounts of management time, result in the diversion of significant operational resources, require changes in our methods of doing business that could be costly to implement, reduce our net sales, increase our expenses, require us to make substantial payments to settle claims or satisfy judgments, require us to cease conducting certain operations or offering certain products in certain areas or generally, and otherwise harm our business, results of operations, financial condition and cash flows, perhaps materially. See also "Risk Factors-Risks Relating to Our Relationship with, and Dependence on, Transform Holdco" and "Risk Factors-Risks Relating to Our Business" in Item 1A of this Annual Report on Form 10-K.
Item 4. Mine Safety Disclosures
Not Applicable.
Part II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
Our common stock is listed and traded on the NASDAQ Stock Market under the ticker symbol SHOS.
Item 6. Selected Financial Data
Not Applicable.
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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the Consolidated Financial Statements and notes contained elsewhere in this Annual Report on Form 10-K. 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. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this Annual Report on Form 10-K, particularly in "Risk Factors" and "Cautionary Statements Regarding Forward-Looking and Other Information."
Overview
We are a national retailer primarily focused on selling home appliances, lawn and garden equipment, tools, and hardware. In addition to merchandise, we provide our customers with access to a full suite of related services, including home delivery, installation, and extended-service plans. As of February 2, 2019, we and our independent dealers and franchisees operated a total of 677 stores across 49 states, Puerto Rico, and Bermuda. In fiscal year 2018, the Company opened eight stores and closed 231 stores.
Our Hometown stores are designed to provide our customers with in-store and online access to a wide selection of national brands of home appliances, lawn and garden equipment, tools, sporting goods, and household goods, depending on the 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 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, apparel, mattresses, lawn and garden equipment, sporting goods and tools.
As of February 2, 2019, Hometown consisted of 549 stores as follows:
| • | 499 Hometown Stores—Primarily independently operated stores, predominantly located in smaller communities, and offering home appliances, lawn and garden equipment, tools, sporting goods, and household goods. All of our Hometown Stores carry proprietary Sears-branded products, such as Kenmore, Craftsman, and DieHard, as well as a wide assortment of other national brands. |
| • | 15 Hardware Stores—Hardware stores that offer primarily home appliances, lawn and garden equipment, tools, and other home improvement products, and featuring Kenmore, Craftsman, and DieHard, as well as a wide assortment of other national brands. |
| • | 27 Home Appliance Showrooms—Stores that have a simple, primarily appliance showroom design that are located in metropolitan areas. |
| • | 8 Buddy's Home Furnishings Stores - Stores where we are a franchisee, enabling us to benefit from Buddy's expertise and system infrastructure in the rent-to-own business which we own the inventory that we rent to our customers. |
As of February 2, 2019, our Hometown segment included 497 dealer-operated stores, 18 franchisee-operated stores, and 34 Company-operated stores, including all eight Buddy's Home Furnishing 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 in many respects. The Company requires all of the stores to operate under specified circumstances according to the Company’s standards. Stores 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 specified advertising requirements on the owners. The Company owns the merchandise, establishes all selling prices for the merchandise, and bears general inventory risk (with specific exceptions) until sale of the merchandise and if the customer returns the merchandise. In addition, because each transaction is recorded in the Company’s point of sale system, the Company bears customer credit risk. The Company establishes a commission structure for stores operated by our dealers and franchisees and pays commissions when our dealers and franchisees sell the merchandise and services.
As of February 2, 2019, five of the 128 Sears Outlet stores were operated by franchisees.
Dealers and franchisees exercise control over the day-to-day operations of their stores, make capital decisions regarding their stores, and exclusively make all hiring, compensation, benefits, termination, and other decisions regarding the terms and conditions of employment, and exclusively establish all employment policies, procedures, and practices with respect to employees.
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Several of the primary differences between Company-operated stores and dealer or franchisee-operated stores are that (1) the Company is responsible for occupancy and payroll costs associated with Company-operated stores while our dealers and franchisees are responsible for these costs for their stores, (2) the Company is responsible for all terms and conditions of employment for the employees in the Company-operated stores and our dealers and franchisees are responsible for all terms and conditions of employment for the employees in their stores, and (3) we pay commissions to our dealers and franchisees.
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 a franchisee unless the store is an Outlet store, which the Company would currently intend to keep as a Company-operated store. When a dealer or franchisee ceases to operate a store, the Company may take over its operations, generally on an interim basis, until the Company can transfer the store to another 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 not included in our count of Company-operated stores due to the expected short-term nature of transition operation.
The Company's transfer of a Company-operated store to a franchisee historically has (1) in most instances increased the Company's gross margin primarily due to decreased occupancy costs and (2) increased the Company's selling and administrative expense primarily due to increased commission payments, offset partially by lower payroll and benefits expense.
Franchisee Receivables Charges
The Company had provisions for losses related to franchisee receivables of $2.6 million and $7.4 million in 2018 and 2017, respectively. As of February 2, 2019, all franchisee receivables have been fully reserved for losses.
Merchandise Subsidies and Cash Discounts from Sears Holdings
In accordance with our Amended and Restated Merchandising Agreement with Transform Holdco (as assignee from Sears Holdings), SHO receives from Transform Holdco (received from Sears Holdings prior to mid-February 2019) specified portions of merchandise subsidies collected by Transform Holdco from its merchandise vendors and specified portions of cash discounts earned by Transform Holdco as a result of its early payment of merchandise-vendor payables (together "Vendor Funds"). During 2018 Sears Holdings's Vendor Funds were lower compared to 2017 and SHO's portion of the collected Vendor Funds during 2018 were approximately $17.3 million lower than SHO's portion for 2017. We recorded a receivable of $1.2 million during the third quarter related to funds due to us at the time of the Sears Holdings bankruptcy filing that were not subsequently paid to us. The receivable has been fully reserved due to the uncertainty of recovery. While we cannot provide any assurance that SHO's portion of Vendor Funds collected by Transform Holdco will not decline, stay the same, or increase, we expect our portion will continue to decline in 2019 due to an expected increase in our purchases through our direct vendor relationships. If SHO's portion of Vendor Funds collected by Transform Holdco were to decline to a significantly greater extent than SHO's purchases through Transform Holdco, SHO's results of operations could be adversely affected to a material extent.
Hometown Segment Profitability Outlook
More than 62% of total Hometown segment 2018 fiscal year sales consisted of Kenmore-branded home appliances and Craftsman-branded lawn and garden merchandise and tools. Until mid-February 2019 we acquired this merchandise exclusively from Sears Holdings and since that time we have been acquiring this merchandise exclusively from Transform Holdco. We do not have rights to acquire KCD-branded merchandise from other vendors. Availability to the Company of Kenmore and Craftsman-branded merchandise significantly declined during the period leading up to the Sears Holdings bankruptcy filings in October 2018. Availability of Kenmore and Craftsman-branded merchandise was slow to recover following the filings but did recover to some extent. However, since mid-February 2019 availability of Kenmore and Craftsman-branded merchandise has again declined.
The Hometown segment has experienced multiple successive years of operating losses that have continued, and are continuing, to worsen. For SHO's 2014 fiscal year the Hometown segment’s operating loss was $11.9 million, excluding the impact of goodwill impairment. The segment’s operating losses have grown each year since then, and the segment suffered an operating loss for our 2018 fiscal year of $58.3 million. In part this is due to growing supply-chain cost increases and the Craftsman and Kenmore merchandise availability issues. These cost increases and merchandise availability issues have, and will continue to have, a disproportionately adverse impact on the Hometown segment. SHO believes that these cost increases and Kenmore and Craftsman availability issues are unlikely to improve in the near term and perhaps longer. We also believe that we have exhausted all of the means at our disposal to turn the segment’s businesses around. We also believe that, regardless of our commercially reasonable efforts to improve the Hometown segment's operating results (which efforts we intend to continue), the segment likely will continue to experience operating losses.
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Home Office Overhead Allocation
Since the 2012 Separation we have included an allocation of Home Office overhead expenses in selling and administrative expenses from Hometown and Outlet. Home Office overhead expenses are primarily comprised of corporate headquarters payroll, benefits, and other costs and include charges related to our Services Agreement with Transform Holdco.
Fiscal Year
Our fiscal years end on the Saturday closest to January 31. Unless otherwise stated, references to specific years in this Annual Report on Form 10-K are to fiscal years. The following fiscal periods are presented herein:
| Fiscal year | Ended | Weeks | ||
| 2018 | February 2, 2019 | 52 | ||
| 2017 | February 3, 2018 | 53 | ||
Results of Operations
The following table sets forth items derived from our consolidated results of operations for our 2018 and 2017 fiscal years.
| Fiscal | ||||||||
| thousands | 2018 | 2017 | ||||||
| NET SALES | $ | 1,449,948 | $ | 1,719,951 | ||||
| COSTS AND EXPENSES | ||||||||
| Cost of sales and occupancy | 1,126,752 | 1,371,408 | ||||||
| Gross margin | 323,196 | 348,543 | ||||||
| Margin rate | 22.3 | % | 20.3 | % | ||||
| Selling and administrative | 349,082 | 419,567 | ||||||
| Selling and administrative expense as a percentage of net sales | 24.1 | % | 24.4 | % | ||||
| Impairment of property and equipment | 2,089 | 3,357 | ||||||
| Depreciation and amortization | 12,374 | 13,039 | ||||||
| Gain on the sale of assets | (1,358 | ) | — | |||||
| Total costs and expenses | 1,488,939 | 1,807,371 | ||||||
| Operating loss | (38,991 | ) | (87,420 | ) | ||||
| Interest expense | (14,676 | ) | (8,058 | ) | ||||
| Other income | 367 | 925 | ||||||
| Loss before income taxes | (53,300 | ) | (94,553 | ) | ||||
| Income tax expense | (164 | ) | (504 | ) | ||||
| NET LOSS | $ | (53,464 | ) | $ | (95,057 | ) | ||
Comparable Store Sales
Comparable store sales amounts 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. In addition, 2017 included an extra week (the "53rd week") compared to our 2018 fiscal year results. The 53rd week is not included in comparable store sales calculations.
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.
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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. |
The Company has undertaken an initiative on a limited number of occasions to accelerate the closing of under-performing stores in an effort to improve profitability and make the most productive use of capital. Under-performing stores 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 close a significant number of stores or close them on an accelerated basis (closing prior to termination or expiration), the Company excludes the associated costs of the closings from adjusted EBITDA. In 2018 and 2017, we excluded $13.4 million and $14.8 million, respectively, of costs associated with the accelerated closure of under-performing stores.
The following table presents a reconciliation of adjusted EBITDA to net loss, the most comparable GAAP measure, for each of the periods indicated:
| Fiscal | ||||||||
| thousands | 2018 | 2017 | ||||||
| Net loss | $ | (53,464 | ) | $ | (95,057 | ) | ||
| Income tax expense | 164 | 504 | ||||||
| Other income | (367 | ) | (925 | ) | ||||
| Interest expense | 14,676 | 8,058 | ||||||
| Operating loss | (38,991 | ) | (87,420 | ) | ||||
| Depreciation and amortization | 12,374 | 13,039 | ||||||
| Gain on the sale of assets | (1,358 | ) | — | |||||
| Impairment of property and equipment | 2,089 | 3,357 | ||||||
| Provision for loan losses, net of franchise revenues | 2,594 | 7,361 | ||||||
| IT transformation investments | 25,923 | 34,374 | ||||||
| Costs associated with accelerated store closings | 13,392 | 14,764 | ||||||
| Adjusted EBITDA | $ | 16,023 | $ | (14,525 | ) | |||
52 Week Period Ended February 2, 2019 Compared to the 53 Week Period Ended February 3, 2018
Net Sales
Net sales for 2018 decreased $270.0 million, or 15.7%, to $1.4 billion from $1.7 billion in 2017. This decrease was driven primarily by the impact of closed stores (net of new store openings), a 4.6% decrease in comparable store sales and sales of $23.4 million in the 53rd week of 2017. Comparable store sales were down 6.0% and 1.8% in Hometown and Outlet, respectively. Home applicances outperformed the average comparable store sales while tools and lawn and garden underperformed to the average.
Gross Margin
Gross margin was $323.2 million, or 22.3% of net sales, for 2018 compared to $348.5 million, or 20.3% of net sales, for 2017. The increase in gross margin rate was primarily driven by higher margin on merchandise sales partially offset by higher occupancy costs as a percentage of sales resulting from a greater mix of Company-operated stores compared to the prior year. Accelerated store closing costs were $12.0 million for 2018 compared to $14.2 million for 2017. The total impact of occupancy costs and accelerated closing store costs reduced gross margin rate 511 basis points for 2018 compared to a 468 basis-point reduction for 2017.
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Selling and Administrative Expenses
Selling and administrative expenses decreased to $349.1 million, or 24.1% of net sales, for 2018 from $419.6 million, or 24.4% of net sales, for 2017. The decrease was primarily due to: (1) lower commissions paid to dealers and franchisees on lower sales volume and lower store count, (2) lower expenses being recorded for stores closed (net of new store openings), (3) lower IT transformation costs ($25.9 million for 2018 compared to $34.4 million for 2017), (4) $4.8 million lower provision related to franchisee notes receivables, and (5) expenses associated with the 53rd week in 2017. These decreases were partially offset by higher payroll and benefits associated with annual incentive plan payouts. On a rate-to-sales basis, IT transformation costs and provisions for franchisee note receivables increased selling and administrative expenses 197 basis points for 2018 compared to 243 basis points for 2017.
Gain on Sale of Assets
During the third quarter of 2018, we completed the sale of an owned property located in Newington, Connecticut. Net proceeds from the sale were $2.8 million, and we recorded a gain on sale of $1.4 million. We did not sell any owned property in fiscal 2017.
Operating Loss
We recorded operating losses of $39.0 million and $87.4 million for 2018 and 2017, respectively. The decrease in operating loss was primarily due to lower selling and administrative expense, a higher gross margin rate partially offset by lower volume and a $2.3 million favorable impact from the 53rd week in 2017.
Income Taxes
Income tax expense was $0.2 million and $0.5 million in 2018 and 2017, respectively. The effective tax rate was (0.3)% in 2018 and (0.5)% in 2017.
Net loss
We recorded a net loss of $53.5 million for 2018 compared to a net loss of $95.1 million for 2017. The decrease in our net loss was primarily attributable to a lower operating loss partially offset by higher interest expense.
Business Segment Results
Hometown
Hometown results and key statistics were as follows:
| Fiscal | ||||||||
| thousands, except for number of stores | 2018 | 2017 | ||||||
| Net sales | $ | 958,518 | $ | 1,177,222 | ||||
| Comparable store sales % | (6.0 | )% | (8.1 | )% | ||||
| Cost of sales and occupancy | 768,624 | 931,078 | ||||||
| Gross margin | 189,894 | 246,144 | ||||||
| Margin rate | 19.8 | % | 20.9 | % | ||||
| Selling and administrative | 240,955 | 283,294 | ||||||
| Selling and administrative expense as a percentage of net sales | 25.1 | % | 24.1 | % | ||||
| Impairment of property and equipment | 1,007 | 2,581 | ||||||
| Depreciation and amortization | 6,263 | 5,378 | ||||||
| Total costs and expenses | 1,016,849 | 1,222,331 | ||||||
| Operating loss | $ | (58,331 | ) | $ | (45,109 | ) | ||
| Total Hometown stores | 549 | 768 | ||||||
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52 Week Period Ended February 2, 2019 Compared to the 53 Week Period Ended February 3, 2018 -- Hometown
Net Sales
Net sales in 2018 decreased $218.7 million, or 18.6%, to $958.5 million from $1.2 billion in 2017. This decrease was driven primarily by the impact of closed stores (net of new store openings), a 6.0% decrease in comparable store sales and sales of $13.9 million in the 53rd week of 2017. Tools and lawn and garden outperformed the average comparable store sales while home appliances and mattresses underperformed to the average.
Gross Margin
Gross margin was $189.9 million, or 19.8% of net sales, in 2018 compared to $246.1 million, or 20.9% of net sales, in 2017. The decrease in gross margin rate was primarily driven by lower margin on merchandise sales, higher closing store costs, and higher supply chain services provided by Sears Holdings partially offset by lower occupancy and shrink. The total impact of store closing, occupancy costs and shrink decreased gross margin rate 245 basis points for the full year 2018 compared to 203 basis points for the full year 2017.
Selling and Administrative Expenses
Selling and administrative expenses decreased to $241.0 million, or 25.1% of net sales, in 2018 from $283.3 million or 24.1% of net sales, in 2017. The decrease was primarily due to the impact of lower expenses being recorded for stores closed (net of new store openings), lower dealer and franchisee commissions on lower sales volume and lower store counts, lower IT transformation costs and lower marketing expenses. These decreases were partially offset by higher payroll and benefits. IT transformation costs were $18.0 million, or 187 basis points on a rate-to-sales basis, for 2018 compared to $22.8 million, or 194 basis points, for 2017.
Operating Loss
We recorded operating losses of $58.3 million and $45.1 million in 2018 and 2017, respectively. The increase in our operating loss was primarily due to lower volume, a lower gross margin rate, and a $0.8 million favorable impact from the 53rd week of 2017 partially offset by lower selling and administrative expense.
Adjusted EBITDA
The following table presents a reconciliation of our Hometown segment's adjusted EBITDA to operating loss, the most comparable GAAP measure for our Hometown segment, for each of the periods indicated:
| 52 and 53 Weeks Ended | ||||||||
| Thousands | February 2, 2019 | February 3, 2018 | ||||||
| Operating loss | $ | (58,331 | ) | $ | (45,109 | ) | ||
| Depreciation and amortization | 6,263 | 5,378 | ||||||
| Impairment of property and equipment | 1,007 | 2,581 | ||||||
| Provision for franchisee note losses, net of recoveries | (245 | ) | (200 | ) | ||||
| IT transformation investments | 17,950 | 22,847 | ||||||
| Accelerated closure of under-performing stores | 13,651 | 6,952 | ||||||
| Adjusted EBITDA | $ | (19,705 | ) | $ | (7,551 | ) | ||
See "Management’s Discussion and Analysis of Financial Condition and Results of Operations-Adjusted EBITDA" in this Item 2 regarding why we believe that presentation of adjusted EBITDA, a non-GAAP financial measure, provides useful information to investors regarding the Company's financial condition and results of operations and how we use adjusted EBITDA.
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Outlet
Outlet results and key statistics were as follows:
| Fiscal | ||||||||
| thousands, except for number of stores | 2018 | 2017 | ||||||
| Net sales | $ | 491,430 | $ | 542,729 | ||||
| Comparable store sales % | (1.8 | )% | (9.1 | )% | ||||
| Cost of sales and occupancy | 358,128 | 440,330 | ||||||
| Gross margin | 133,302 | 102,399 | ||||||
| Margin rate | 27.1 | % | 18.9 | % | ||||
| Selling and administrative | 108,127 | 136,273 | ||||||
| Selling and administrative expense as a percentage of net sales | 22.0 | % | 25.1 | % | ||||
| Impairment of property and equipment | 1,082 | 776 | ||||||
| Depreciation and amortization | 6,111 | 7,661 | ||||||
| Gain on the sale of assets | (1,358 | ) | — | |||||
| Total costs and expenses | 472,090 | 585,040 | ||||||
| Operating income (loss) | $ | 19,340 | $ | (42,311 | ) | |||
| Total Outlet stores | 128 | 132 | ||||||
52 Week Period Ended February 2, 2019 Compared to the 53 Week Period Ended February 3, 2018 -- Outlet
Net Sales
Net sales in 2018 decreased $51.3 million, or 9.5%, to $491.4 million from 2017. This decrease was driven primarily by closed stores (net of new store openings) and by a 1.8% decrease in comparable store sales. Furniture and mattresses outperformed the average comparable store sales while home appliances, lawn and garden and tools underperformed to the average.
Gross Margin
Gross margin was $133.3 million, or 27.1% of net sales, in 2018 compared to $102.4 million, or 18.9% of net sales, in 2017. The increase in gross margin rate was primarily driven by a higher gross profit rate on merchandise sales and lower store closing costs (a benefit of $0.4 million in 2018 compared to a charge of $7.6 million in 2017) partially offset by higher occupancy costs as a percentage of sales as a result of a higher mix of Company-operated stores. The higher rate on merchandise sales was primarily driven by new pricing strategies and renegotiated merchandise costs. The total impact of occupancy and accelerated closing stores costs on gross margin rate was a reduction of 1,061 basis points for 2018 compared to 1,111 basis points for 2017.
Selling and Administrative Expenses
Selling and administrative expenses decreased to $108.1 million, or 22.0% of net sales, for 2018 compared to $136.3 million, or 25.1% of net sales, for 2017. The decrease was primarily due to the impact of lower franchisee commissions on lower sales volumes and lower store counts, lower expenses being recorded for stores closed (net of new store openings), lower provisions for franchisee receivables ($2.8 million for 2018 compared to $7.6 million for 2017), lower IT transformation costs ($8.0 million for 2018 compared to $11.5 million for 2017), and expenses associated with the 53rd week in 2017. On a rate-to-sales basis, IT transformation costs and provisions for franchisee note receivables improved 131 basis points in 2018 compared to 2017.
Gain on Sale of Asset
During the third quarter of 2018, we completed the sale of an owned property located in Newington, Connecticut. Net proceeds from the sale were $2.8 million, and we recorded a gain on sale of $1.4 million. We did not sell any owned property in fiscal 2017.
Operating Income
We recorded operating income of $19.3 million in 2018 and an operating loss of $42.3 million in 2017. The $61.7 million increase in operating income was primarily driven by higher gross margin rates, lower selling and administrative expenses and the gain on the sale of assets partially offset by lower volume, and a $1.5 million favorable impact from the 53rd week in 2017.
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Adjusted EBITDA
The following table presents a reconciliation of our Outlet segment's adjusted EBITDA to operating loss, the most comparable GAAP measure for our Outlet segment, for each of the periods indicated:
| 52 and 53 Weeks Ended | ||||||||
| Thousands | February 2, 2019 | February 3, 2018 | ||||||
| Operating income (loss) | $ | 19,340 | $ | (42,311 | ) | |||
| Depreciation and amortization | 6,111 | 7,661 | ||||||
| Impairment of property and equipment | 1,082 | 776 | ||||||
| Gain on sale of asset | (1,358 | ) | — | |||||
| Provision for franchisee note losses, net of recoveries | 2,839 | 7,561 | ||||||
| IT transformation investments | 7,973 | 11,527 | ||||||
| Accelerated closure of under-performing stores | (259 | ) | 7,812 | |||||
| Adjusted EBITDA | $ | 35,728 | $ | (6,974 | ) | |||
Analysis of Financial Condition
Cash Balances
We had $15.1 million in cash and cash equivalents as of February 2, 2019 and $10.4 million as of February 3, 2018.
During 2018 we financed our operations and investments with cash generated from operating activities. Our primary liquidity needs are for funding inventory purchases, our IT transformation, capital expenditures and general corporate purposes.
Cash Flows from Operating Activities
Cash provided by operating activities in 2018 was $15.1 million compared to cash used in operating activities of $105.6 million in 2017. The $15.1 million of cash provided by operating activities was primarily due to a $49.1 million reduction in net inventory investment (inventory less payable) partially offset by the net loss. Total merchandise inventories were $277.3 million at February 2, 2019 and $336.3 million at February 3, 2018. Merchandise inventories declined $56.6 million and $2.4 million in Hometown and Outlet, respectively, primarily due to store closures.
We obtain our merchandise through agreements with subsidiaries of Transform Holdco (Sears Holdings prior to mid-February 2019) and with other vendors. Merchandise acquired from subsidiaries of Transform Holdco (including Kenmore, Craftsman, DieHard, and other merchandise) accounted for approximately 60% and 78% of total purchases of all inventory from all vendors for 2018 and 2017, respectively. We expect the percentage of total purchases of inventory acquired from subsidiaries of Transform Holdco to decrease in the future as we increase our direct purchases from other merchandise vendors. Fourth quarter 2018 purchases from Sears Holdings accounted for 52% of total purchases compared to 74% in the fourth quarter of 2017 and 58% in the third quarter of 2018. The loss of, or a material reduction in, the amount of merchandise made available to us by Transform Holdco could have a material adverse effect on our business and results of operations.
In addition, our merchandise-vendor arrangements generally are not long-term agreements and none of them guarantees the availability of merchandise inventory in the future. Our growth strategy depends to a significant extent on the willingness and ability of our vendors to supply us with sufficient merchandise inventory. As a result, our success depends on maintaining good relations with our existing vendors and on developing relationships with new vendors, especially with respect to merchandise inventory to be sold by Outlet. If we fail to maintain our relations with our existing vendors or to maintain the quality of merchandise inventory they supply to us, or if we cannot maintain or acquire new vendors of favored brand-name merchandise inventory, and if we cannot acquire new vendors of merchandise inventory to be sold by Outlet, our ability to obtain a sufficient amount and variety of merchandise at acceptable prices may be limited, which would have a negative impact on our competitive position. In addition, merchandise inventory acquired from alternative sources, if any, may be of a lesser quality and more expensive than the merchandise inventory that we currently purchase. See "Item 1A. Risk Factors" in this Annual Report on Form 10-K.
Cash Flows from Investing Activities
Cash used in investing activities was $3.6 million and $9.2 million in 2018 and 2017, respectively. Capital expenditures were $6.4 million in 2018 compared to $9.2 million in 2017. In the third quarter of 2018 we received proceeds of $2.8 million from the sale of assets.
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Cash Flows from Financing Activities
Cash used in financing activities was $6.8 million for 2018 compared to cash provided by financing activities of $111.2 million for 2017. The decrease of $117.9 million in cash provided by financing activities in 2018 from 2017 was primarily due to a reduction in net borrowings in 2018 compared to an increase in net borrowings in 2017 under our Senior ABL Facility.
Senior ABL Facility
In October 2012 the Company entered into a Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent, which provided (subject to availability under a borrowing base) for aggregate maximum borrowings of $250 million (the "Prior Facility"). Under the Prior Facility the Company initially borrowed $100 million which was used to pay a cash dividend to Sears Holdings prior to the 2012 Separation.
On November 1, 2016, the Company and its primary operating subsidiaries, entered into 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 $250 million (the "Senior ABL Facility"). The Senior ABL Facility, which amended and restated the Prior Facility in its entirety, provides for extended revolving credit commitments of specified lenders in an aggregate amount equal to $170 million (the “Extended Revolving Credit Commitments”) and non-extended revolving credit commitments of specified lenders in an aggregate amount equal to $80 million (the “Non-Extended Revolving Credit Commitments”). The Extended Revolving Credit Commitments will mature on the earlier of (1) February 29, 2020 and (2) six months prior to the expiration of the Operative Agreements entered into with Transform Holdco as assignee and its subsidiaries in connection with the 2012 Separation -(the “Subject Agreements”) unless they are extended to a date later than February 29, 2020 or terminated on a basis reasonably satisfactory to the administrative agent under the Senior ABL Facility (and the Company has obtained an extension of maturity of the Subject Agreements to February 1, 2023). The Non-Extended Revolving Credit Commitments were not extended by the Non-Extending Lenders in accordance with the Senior ABL Facility and matured on October 11, 2017. Unamortized debt costs related to the Senior ABL Facility of $1.3 million and $3.5 million are included in Prepaid and Other current assets on the Consolidated Balance Sheets as of February 2, 2019 and February 3, 2018, respectively, and are being amortized over the remaining term of the Senior ABL Facility.
As of February 2, 2019 we had $93.0 million outstanding under the Senior ABL Facility, which approximated the fair value of these borrowings. 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 February 2, 2019 was $27.7 million, with $7.2 million of letters of credit outstanding under the facility.
The principal terms of the Senior ABL Facility are summarized below.
Prepayments
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.
Security and Guarantees
The Senior ABL Facility is secured by a first lien security interest on substantially all the assets of the Company and its subsidiaries, including, without limitation, accounts receivable, inventory, general intangibles, investment property, equipment, cash, cash equivalents, deposit accounts and securities accounts, as well as certain other assets (other than intellectual property and fee-owned interests in real property) ancillary to any of the foregoing and all proceeds of any of the foregoing, including cash proceeds and the proceeds of applicable insurance. The Senior ABL Facility is guaranteed by the Company and each of its existing and future direct and indirect wholly owned domestic subsidiaries (other than specified immaterial subsidiaries).
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 the Company’s election, either (1) an adjusted London inter-bank offered rate (LIBOR) plus a borrowing margin ranging from 3.50% to 4.50%, (the rate was approximately 6.50% at February 2, 2019), and in each case based on availability under the Senior ABL Facility, or (2) an alternate base rate plus a borrowing margin, ranging from 2.50% to 3.50% (the rate was approximately 8.5% at February 2, 2019), and in each case based on availability under the Senior ABL Facility.
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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 negative covenants that, among other things, limit or restrict the ability of the Company and its subsidiaries (including the guarantors) to, subject to certain exceptions, incur additional indebtedness (including guarantees), grant liens, make investments, make prepayments on other indebtedness, and engage in mergers or change the nature of the business of the Company and its subsidiaries (including the guarantors). The Senior ABL Facility also imposes various other requirements, which take effect if availability falls below designated thresholds, including a cash dominion requirement with additional borrowing base reporting requirements in addition to a requirement that the fixed charge ratio at the last day of any quarter be not less than 1.0 to 1.0. The Senior ABL Facility also limits SHO’s ability to declare and pay cash dividends and to repurchase its common stock. The Senior ABL Facility would not have permitted us to pay cash dividends or to repurchase our common stock as of February 2, 2019. The Senior ABL Facility also contains affirmative covenants, including financial and other reporting requirements.
Events of Default
The Senior ABL Facility includes customary and other events of default including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties, cross default to other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of guarantees or security interests, material judgments, change of control, failure to perform a "Material Contract" (which includes the Merchandising Agreement and other Operative Agreements) to the extent required to maintain it in full force and effect, the failure to enforce a Material Contract in accordance with its terms, or Transform Holdco's termination of the "Separation Agreements" (which include, among other Operative Agreements, the Merchandising Agreement and the Services Agreements).
The Senior ABL Facility provides that the Company's inability to obtain from its independent registered public accounting firm a report and opinion that "shall not be subject to any 'going concern' or like qualification or exception" constitutes an event of default, which would give the Senior ABL Facility lenders the right to accelerate the maturity of all outstanding loans, among other actions. The Senior ABL Facility lenders have waived through October 31, 2019 any default resulting from the Going Concern Uncertainty.
Term Loan Agreement
On February 16, 2018 the Company’s three operating subsidiaries, Sears Authorized Hometown Stores, LLC, Sears Home Appliance Showrooms, LLC, and Sears Outlet Stores, LLC, as borrowers, and the Company, as guarantor, entered into a Term Loan Credit Agreement with Gordon Brothers Finance Company, as agent, lead arranger, and sole bookrunner, and Gordon Brothers Finance Company, LLC, as lender (the “Term Loan Agreement”). The Term Loan Agreement provides for a $40 million term loan (the “Term Loan”), which amount the Company has borrowed, and is outstanding, in accordance with and subject to the terms and conditions of the Term Loan Agreement. The Company used the proceeds of the Term Loan to pay down borrowings under 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.
Unamortized debt costs of $0.9 million related to the Term Loan are netted against the Term Loan on the Consolidated Balance Sheets as of February 2, 2019 and are being amortized over the remaining term of the Term Loan.
The principal terms of the Term Loan Agreement are summarized below.
Security and Guarantees
The Term Loan Agreement is secured by a second lien security interest (subordinate only to the liens securing the Senior ABL Facility) on substantially all the assets of the Company and its subsidiaries (the same assets as the assets securing the Senior ABL Facility), including without limitation accounts receivable, inventory, general intangibles, investment property, equipment, cash, cash equivalents, deposit accounts and securities accounts, as well as other assets (other than intellectual property and fee-owned interests in real property) ancillary to any of the foregoing and all proceeds of any of the foregoing, including cash proceeds and the proceeds of applicable insurance. The Term Loan Agreement is guaranteed by the Company and each of its existing and future direct and indirect wholly owned domestic subsidiaries (other than specified immaterial subsidiaries).
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Prepayments
The Term Loan is subject to mandatory prepayment in amounts equal to the amount by which the outstanding Term Loan exceeds the borrowing base specified in the Term Loan Agreement plus a reserve to be maintained against the borrowing base for the Senior ABL Facility (the “push-down reserve”), which reserve will be equal to total outstandings under the Term Loan Agreement that exceed the Term Loan Agreement’s borrowing base, if such excess were to arise. If any additional reserves are imposed by the Senior ABL Facility agent against the borrowing base under the Senior ABL Facility or if, under certain circumstances, the agent under the Term Loan imposes reserves against the borrowing base under the Term Loan Agreement, the Company may be required to make additional prepayments under the Term Loan. The Company may not reborrow amounts prepaid.
Interest; Fees
The interest rate applicable to the Term Loan under the Term Loan Agreement is a fluctuating rate of interest (payable and adjusted monthly) equal to the greater of (1) three-month LIBOR (the rate was approximately 2.73% at February 2, 2019) plus 8.50% per annum and (2) a minimum interest rate of 9.50% per annum. Customary fees are payable in respect of the Term Loan Agreement, including a commitment fee and an early prepayment fee.
Covenants
The Term Loan Agreement includes a number of negative covenants that, among other things, limit or restrict the ability of the Company, the Borrowers, and the Company’s other subsidiaries to, subject to exceptions, incur additional indebtedness (including guarantees), grant liens, make investments, make dividends or other distributions with respect to, or repurchase, the Company’s capital stock, make prepayments on other indebtedness, engage in mergers, or change the nature of the business. In addition, upon excess availability falling below a specified level or the occurrence of an event of default the Company would be subject to a cash dominion requirement. The Term Loan Agreement also provides that the Borrowers will not permit availability under the Term Loan Agreement and the Senior ABL Facility to be less than 10% of a combined loan cap.
The Term Loan Agreement also contains affirmative covenants including, among others, financial and other reporting and notification requirements, maintenance of properties, inspection rights, and physical inventories. The Company and the Borrowers also agree that the Company and the Borrowers will cause the push-down reserve to be established and maintained when and if required by the Term Loan Agreement. The Term Loan Agreement borrowing base generally means specified amounts of credit card receivables and inventory (net of reserves), minus the loan cap for the Senior ABL Facility and availability reserves. The borrowing base under the Term Loan Agreement may be further reduced if the agent under the Senior ABL Facility or, under certain circumstances, the agent under the Term Loan elects in their respective applicable discretion to impose additional reserves against the borrowing base under the Senior ABL Facility or the Term Loan.
Events of Default
The Term Loan Agreement includes customary events of default including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties in any material respect, cross default to the Senior ABL Facility and other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of the Term Loan Agreement and the other related loan documents (including the guarantees or security interests provided therein and other Term Loan loan documents (including an agreement with the Company, Transform Holdco, and the agents under the Senior ABL Facility and the Term Loan Agreement)), material judgments, change of control, and failure to perform a “Material Contract” (which includes specified Operative Agreements) to the extent required to maintain it in full force and effect, failure to enforce a Material Contract in accordance with its terms, or termination (including as a result of rejection in an insolvency proceeding) by Transform Holdco of "the Separation Agreements” (which include specified Operative Agreements) and cessation of business activities in the ordinary course.
The Term Loan Agreement provides that the Company's inability to obtain from its independent registered public accounting firm a report and opinion that "shall not be subject to any 'going concern' or like qualification or exception" constitutes an event of default, which would give the Term Loan Agreement lenders the right to accelerate the maturity of all outstanding loans, among other actions. The Term Loan Agreement lenders have waived through October 31, 2019 any default resulting from the Going Concern Uncertainty.
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May 2, 2019 Amendments to the Senior ABL Facility and the Term Loan Agreement
On May 2, 2019 the Company entered into (i) a First Amendment to Amended and Restated Credit Agreement (the “ABL Amendment”), among Sears Authorized Hometown Stores, LLC, as the Lead Borrower, Sears Home Appliance Showrooms, LLC and Sears Outlet Stores, L.L.C., as borrowers (collectively, the “Borrowers”), the Company, as parent, Bank of America, N.A., as administrative agent and collateral agent (in such capacities, the “ABL Agent”), and the ABL lenders party thereto, amending the Amended and Restated Credit Agreement dated as of November 1, 2016 among the Borrowers, the Company, the ABL Agent and the ABL lenders party thereto from time to time (the “ABL Credit Agreement”), and (ii) the First Amendment to Term Loan Credit Agreement (the “Term Loan Amendment”), among the Borrowers, the Company, as parent, Gordon Brothers Finance Company, as administrative agent and collateral agent (in such capacities, the “Term Agent”), and the Term lenders party thereto, amending the Term Loan Credit Agreement dated as of February 16, 2018 among the Borrowers, the Company, the Term Agent and the Term Lenders party thereto (the “Term Loan Agreement”).
Copies of the ABL Amendment and the Term Loan Amendment are filed together as Exhibit 10.54 to this Form 10-K and are incorporated herein by reference. The following summary of terms and conditions of the ABL Amendment and the Term Loan Amendment is qualified by, and is subject to, the terms and conditions of the ABL Amendment and the Term Loan Amendment.
The ABL Amendment and the Term Loan Amendment generally provide for the following, among other things: (1) the definition of “Change of Control” is amended to provide that a Change of Control occurs if the Permitted Holders (as defined in the ABL Credit Agreement and the Term Loan Agreement) beneficially own more than 75.0% of the Company’s common stock; (2) under specified conditions cash in excess of $2 million must be applied to pay amounts outstanding under the ABL Credit Agreement and the Term Loan Agreement under specified circumstances; (3) the ABL lenders and the Term lenders waive until October 31, 2019 any default arising as a result of the Going Concern Uncertainty; and (4) the ABL lenders and the Term lenders consent on a limited basis to the Loan Parties (as defined in the ABL Credit Agreement and the Term Loan Agreement) negotiating and entering into specified acquisitions with Permitted Holders upon compliance with specified conditions, including a requirement that the acquisition agreement must contain a condition precedent to the closing of the acquisition requiring payment in full in cash of all outstanding loans under the ABL Credit Agreement and the Term Loan Agreement. The Term Loan Amendment changes the "February 16, 2023" reference in the definition of "Maturity Date" to February 29, 2020.
Uses and Sources of Liquidity
As of February 2, 2019, we had cash and cash equivalents of $15.1 million. The adequacy of our available funds will depend on many factors, including the macroeconomic environment, the operating performance of our stores, the availability under the Senior ABL Facility and the ability to refinance our debt. We believe that we should be able to refinance the Senior ABL Facility and the Term Loan, but the refinancing has not yet occurred and the terms and conditions of the refinancing arrangements, if we obtain them, may be less favorable to the Company than the terms and conditions of the ABL Facility and the Term Loan. See Note 1 in reference to the Senior ABL Facility and Term Loan.
The Senior ABL Facility and the Term Loan Agreement provide that the Company's inability to obtain from its independent registered public accounting firm a report and opinion that "shall not be subject to any 'going concern' or like qualification or exception" constitutes an event of default, which would give the Senior ABL Facility and the Term Loan Agreement lenders the right to accelerate the maturity of all outstanding loans, among other actions. The Senior ABL Facility and the Term Loan Agreement lenders have waived through October 31, 2019 any default resulting from the Going Concern Uncertainty.
Capital lease obligations were $0.7 million and $0.6 million as of February 2, 2019 and February 3, 2018, respectively.
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Contractual Obligations and Off-Balance Sheet Arrangements
Information concerning our obligations and commitments to make future payments under contract such as debt and lease agreements and under contingent commitments as of February 2, 2019 is as aggregated in the following table:
| thousands | Total | Within 1 Year | 1-3 Years | 4-5 Years | After 5 Years | |||||||||||||||
| Short-term borrowings | $ | 93,000 | $ | 93,000 | $ | — | $ | — | $ | — | ||||||||||
| Term loan | 40,000 | 40,000 | — | — | — | |||||||||||||||
| Capital leases | 658 | 259 | 394 | 5 | — | |||||||||||||||
| Operating leases | 132,378 | 39,292 | 60,189 | 28,523 | 4,374 | |||||||||||||||
| Total Contractual Obligations | $ | 266,036 | $ | 172,551 | $ | 60,583 | $ | 28,528 | $ | 4,374 | ||||||||||
IT Transformation and Operational Independence
We continue to make progress toward the implementation of our new information technology and operating systems. At the end of fiscal 2018, system architecture, coding and testing were substantially complete. We are working to finalize the Outlet segment deployment which we anticipate will continue into the second fiscal quarter of 2019. We intend to initiate the IT systems deployment in the Hometown segment after we finalize our conversion in the Outlet business segment. We do not expect significant IT build fees or systems development costs after the second quarter of our 2019 fiscal year.
The migration to the new infrastructure and systems involves significant risks for us, which we have summarized in Item 1A, "Risk Factors," in the 2018 10-K. These risks could have a material adverse effect on our business and results of operations.
Application of Critical Accounting Policies and Estimates
In preparing the financial statements, certain accounting policies require considerable judgment to select the appropriate assumptions to calculate financial estimates. These estimates are complex and subject to an inherent degree of uncertainty. We base our estimates on historical experience, terms of existing contracts, evaluation of trends and other assumptions that we believe to be reasonable under the circumstances. We continually evaluate the information used to make these estimates as our business and the economic environment change. Although the use of estimates is pervasive throughout the financial statements, we consider an accounting estimate to be critical if:
| • | it requires assumptions to be made about matters that were highly uncertain at the time the estimate was made, and |
| • | changes in the estimate that are reasonably likely to occur from period to period or different estimates that could have been selected would have a material effect on our financial condition, cash flows or results of operations. |
We believe that the current assumptions and other considerations used to estimate amounts reflected in the financial statements are appropriate. However, if actual experience differs from the assumptions and the considerations used in estimating amounts, the resulting changes could have a material adverse effect on our results of operations, and in certain situations, could have a material adverse effect on our financial condition.
The following is a summary of our most critical policies and estimates. See Note 1 of the Notes to the Consolidated Financial Statements for a listing of our other significant accounting policies.
Valuation of Inventory
Our inventory is valued at the lower of cost or market determined under the retail inventory method, or "RIM," using primarily a last-in, first-out, or "LIFO," cost-flow assumption. To determine inventory cost under RIM, inventory at its retail selling value is segregated into groupings of merchandise having similar characteristics, which are then converted to a cost basis by applying specific average cost factors for each grouping of merchandise. Cost factors represent the average cost-to-retail ratio for each merchandise group based upon the year’s purchasing activity for each store location. Accordingly, a significant assumption under the retail method is that inventory in each group is similar in terms of its cost-to-retail relationship and has similar turnover rates. We monitor the content of merchandise in these groupings to prevent distortions that would have a material effect on inventory valuation.
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RIM inherently requires management judgment and certain estimates that may significantly affect the ending inventory valuation, as well as gross margin. The methodologies utilized by SHO in its application of RIM are consistent for all periods presented. Such methodologies include the development of the cost-to-retail ratios, the groupings of homogeneous classes of merchandise, the development of shrinkage and obsolescence reserves, and the accounting for retail price changes. We believe that SHO’s RIM provides an inventory valuation that reasonably approximates cost. Among others, two significant estimates used in inventory valuation are the level and timing of permanent markdowns (clearance markdowns used to clear unproductive or slow-moving inventory) and shrinkage. Amounts are charged to cost of sales at the time the retail value of inventory is reduced through the use of permanent markdowns.
Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise, fashion and design trends and weather conditions. In addition, inventory is also evaluated against corporate pre-determined historical markdown cadences. When a decision is made to permanently mark down merchandise, the resulting gross margin reduction is recognized in the period the markdown is recorded. The timing of the decision, particularly surrounding the balance sheet date, can have a significant effect on the results of operations.
Income Taxes
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act made broad and complex changes to the U.S. tax code that affected our fiscal year ending February 3, 2018, including, but not limited to, (1) reducing the U.S. federal corporate tax rate, (2) eliminating the corporate alternative minimum tax (AMT) and changing how existing AMT credits can be realized, and (3) various other miscellaneous changes that are effective in fiscal 2017. The Tax Act reduced the federal corporate tax rate to 21% in the fiscal year ending February 3, 2018. Based on Section 15 of the Internal Revenue Code, our fiscal year ending February 3, 2018 will have a blended corporate tax rate of 33.7%, which is based on the applicable tax rates before and after the Tax Act and the number of days in the year.
The Tax Act also established new tax laws that will affect fiscal 2018, including, but not limited to, (1) reduction of the U.S. federal corporate tax rate; (2) the elimination of corporate AMT; (3) a new limitation on deductible interest expense; (4) limitations on the deductibility of certain executive compensation; (5) limitations on the use of FTCs to reduce the U.S. income tax liability; and (6) limitations on net operating losses (NOLs) generated in tax years beginning after December 31, 2017, to 80% of taxable income. The impact of the new tax law on the Company’s financial statements and the related accounting requirements are discussed in Note 5.
Our deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial reporting and tax bases of recorded assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Management has determined a valuation allowance for the full amount of the net deferred tax assets is still necessary as of February 2, 2019. The valuation allowance increased by $12.6 million for the current year to an ending balance of $105.0 million. The increase in the valuation allowance is mainly attributable to the increase in operating loss carryover but is reduced by a valuation allowance release and corresponding tax benefit of $0.8 million due to the reclassification of the AMT DTA. In the future, we may record additional net deferred tax assets and if future utilization of deferred tax assets is uncertain, we may record additional valuation allowance against such deferred tax assets. In evaluating our ability to recover our deferred tax assets within the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies, and results of recent operations. In projecting future taxable income, we begin with historical results and incorporate assumptions including the amount of future federal, state and foreign pre-tax operating income (loss), the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income.
We account for uncertainties in income taxes according to accounting standards for uncertain tax positions. We are present in a large number of taxable jurisdictions, and at any point in time, can have audits underway at various stages of completion in any of these jurisdictions. We evaluate our tax positions and establish liabilities for uncertain tax positions that may be challenged by local authorities and may not be fully sustained, despite the belief that the underlying tax positions are fully supportable. Unrecognized tax benefits are reviewed on an ongoing basis and are adjusted in light of changing facts and circumstances, including progress of tax audits, developments in case law, and closing of statutes of limitation. Such adjustments are reflected in the tax provision as appropriate. Pursuant to the Tax Sharing Agreement, which governs the rights and obligations of the parties with respect to pre-2012 Separation and post-2012 Separation tax matters, Transform Holdco is responsible for any unrecognized tax benefits through the date of the 2012 Separation.
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Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and the valuation allowance recorded against our net deferred tax assets, if any. As further described above, we consider estimates of the amount and character of future taxable income in assessing the likelihood of realization of deferred tax assets. Our actual effective tax rate and income tax expense could vary from estimated amounts due to the future impacts of various items, including changes in income tax laws, tax planning and our forecasted financial condition and results of operations in future periods. Although we believe current estimates are reasonable, actual results could differ from these estimates.
In accordance with the Tax Sharing Agreement, Sears Holdings is responsible for any federal, state or foreign income tax liability relating to tax periods ending on or before the 2012 Separation.
Reserve for Losses on Franchisee Receivables
The Company recognizes a reserve for losses on franchisee receivables (which consist primarily of franchisee promissory notes) in an amount equal to estimated probable losses net of recoveries. The reserve is based on an analysis of expected future write-offs, existing economic conditions, and an assessment of specific identifiable franchisee promissory notes and other franchisee receivables considered at risk or uncollectible. The expense associated with the reserve for losses on franchisee receivables is recognized as selling and administrative expense. Most of our franchisee promissory notes authorize us to deduct debt service from our commissions otherwise due and payable to the franchisees, and we routinely make those deductions to the extent of available commissions payable. The reserve for losses on franchisee receivables is evaluated based on our receivable-by-receivable assessment during the year that loan balances would be potentially uncollectible in future periods due to declining results of operations of, or other adverse financial events with respect to, franchise stores that indicated that the franchisees might not be able to meet their debt-service and other obligations to us as they became due. During fiscal 2017 and 2018 we forgave balances due on franchisee receivables in accordance with negotiated franchise-termination agreements, and as part of these transactions, the Company purchased store furniture, fixtures, and equipment from franchisees. As of February 2, 2019, all franchisee receivables have been fully reserved.
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CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING AND OTHER INFORMATION
This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “forward looking statements”). Statements preceded or followed by, or that otherwise include, the words “believes,” “expects,” “anticipates,” “intends,” “project,” “estimates,” “plans,” “forecast,” “is likely to,” "on target," 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. The forward-looking statements are subject to significant risks and uncertainties that may cause our actual results, performance, and achievements in the future to be materially different from the future results, future performance, and future achievements expressed or implied by the forward-looking statements. The forward-looking statements include, without limitation, information concerning our future financial performance, business strategies, plans, goals, beliefs, expectations, and objectives. The forward-looking statements are based upon the current beliefs and expectations of our management.
Subsequent to the 2012 Separation and until mid-February 2019 the Company had significant business relationships with the Sears Holdings Companies and we relied heavily on them for merchandise and services through the Operative Agreements. Edward S. Lampert, Chairman, Chief Executive Officer, and Director of ESL Investments, Inc. (which is among the related entities that we refer to as “ESL” in this Annual Report on 10-K), was until October 15, 2018 the Chief Executive Officer of Sears Holdings, and served until February 12, 2019 as a member of Sears Holdings’s Board of Directors and as its Chairman of the Board of Directors.
During October 2018 the Sears Holdings Companies 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 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. As part of the Sears Holdings Companies' bankruptcy proceedings Transform Holdco acquired the Sears Assets, and the Operative Agreements were assigned by the Sears Holdings Companies to, and the obligations thereunder were assumed by, Transform Holdco on or about February 11, 2019. According to publicly available information, ESL controls Transform Holdco and owns approximately 58.8% of the Company’s outstanding shares of common stock.
The following factors, among others, could (A) cause our actual results, performance, and achievements to differ materially from those expressed in the forward-looking statements, and one or more of the differences could have a material adverse effect on our ability to operate our business and (B) have a material adverse effect on our results of operations, financial condition, liquidity, cash flows, and overall ability to operate our businesses (especially the Hometown segment businesses, given their dependence on purchasing merchandise branded with the KCD Marks and obtaining supply-chain services, in accordance with the Operative Agreements):
| • | The willingness and ability of Transform Holdco to perform all of its obligations in accordance with the terms and conditions of the Operative Agreements; |
| • | Transform Holdco was formed recently, was not an operating retail business prior to its acquisition of the Sears Assets and its assumption of the Operative Agreements, and will rely, at least initially, on Sears Holdings and its subsidiaries and other third parties to provide to Transform Holdco the merchandising and other services that Transform Holdco is obligated to provide to the Company in accordance with the Operative Agreements; |
| • | The ability of Transform Holdco to resolve, on operational and financial terms that are satisfactory to Transform Holdco, its reported current disputes and future disputes, if any, with the Sears Holdings Companies regarding Transform Holdco's acquisition of the Sears Assets and the assumption of related obligations; |
| • | Transform Holdco is a private company and is not obligated to disclose publicly any information regarding its results of operations, financial condition, liquidity, cash flows, or overall ability to operate its businesses and provide merchandising and other services to the Company in accordance with the Operative Agreements (and Transform Holdco has not given the Company any of such information); |
| • | With respect to the Sears Holdings Companies' bankruptcy proceedings and Transform Holdco’s assumption of the Operative Agreements, (1) the Senior ABL Facility provides for significant lender discretion, such as the ability to reduce loan advance-rates (through the imposition of reserves against the Company’s borrowing base), which could reduce the amounts that the Company could borrow or require the Company to repay amounts already borrowed and (2) the lenders could assert that they have no obligation to extend to the Company additional loans on the basis that the Company has suffered a “Material Adverse Effect” and (3) the Company’s inability to enforce any of the Separation Agreements could be an “Event of Default” under the Senior ABL Facility that would permit the lenders to accelerate and immediately call due all of the Company's outstanding loans; |
| • | With respect to the Sears Holdings Companies' bankruptcy proceedings and Transform Holdco’s assumption of the Operative Agreements, (1) the Term Loan Agreement provides for significant lender discretion, such as the ability to |
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increase reserves with respect to the Term Loan Agreement's borrowing base, which could require the establishment and maintenance of a reserve under, and thereby reduce the amounts that the Company could borrow under, the Senior ABL Facility, and could also require the Company to make a prepayment under the Term Loan Agreement, and (2) the Company’s inability to enforce any of the Separation Agreements could be an “Event of Default” under the Term Loan Agreement that would permit the lender to accelerate and immediately call due the Company's outstanding loan under the Term Loan Agreement;
| • | The report of the Company’s independent registered public accounting firm, which includes their opinion on the consolidated financial statements included in this Annual Report on Form 10-K and in which the firm expresses “Going Concern Uncertainty,” could result in adverse reactions by the Company’s vendors, customers, and associates that would have a material adverse effect on the Company's business; |
| • | Sears Holdings and several of its subsidiaries, acting at the direction of the Restructuring Sub-Committee of the Restructuring Committee of the Board of Directors of Sears Holdings has commenced an adversary proceeding in the the Sears Holdings Companies' bankruptcy proceedings against ESL and other current and former insiders of Sears Holdings alleging fraudulent transfers and breaches of fiduciary duty and seeking against ESL and several of the other defendants to avoid as actual fraudulent transfers the 2012 Separation-associated distribution by Sears Holdings of subscription rights to purchase the Company's common stock; while the Company is not a defendant in the adversary proceeding, developments in the adversary proceeding could involve the Company, its equity interests, or its assets, and could affect the ability of Transform Holdco to perform the Operative Agreements, which could have a material adverse effect on our business; |
| • | The Sears Holdings Unsecured Creditors Committee is investigating transfers to ESL and other current and former insiders of Sears Holdings in connection with “Insider Transactions,” including the 2012 Separation; |
| • | The possible perceptions of our vendors, suppliers, lenders under the Senior ABL Facility and the Term Loan, and customers that, as a result of the Sears Holdings bankruptcy proceedings and Transform Holdco’s assumption of the Operative Agreements, the Company's ability to operate its businesses (especially the Company's Hometown segment businesses) has been materially and adversely affected; |
| • | Transform Holdco, which has assumed the Operative Agreements, could decline to extend or renew, or upon renewal or extension materially modify to our material disadvantage, our rights under the Amended and Restated Merchandising Agreement, one of the Operative Agreements, pursuant to which we have rights to acquire merchandise branded with the KCD Marks from Transform Holdco (we do not have rights to purchase directly from manufacturers merchandise branded with the KCD Marks and, despite our efforts, we have been unable to obtain those rights); |
| • | The Amended and Restated Merchandising Agreement provides that (1) if a third party that is not an affiliate of Transform Holdco (as assignee) acquires the rights to one or more (but less than all) of the KCD Marks Transform Holdco may terminate our rights to buy merchandise branded with any of the acquired KCD Marks and (2) if a third party that is not an affiliate of Transform Holdco acquires the rights to all of the KCD Marks Transform Holdco may terminate the Amended and Restated Merchandising Agreement in its entirety, over which events we have no control; |
| • | The sale by Transform Holdings and its subsidiaries to other retailers that compete with us on major home appliances and other products branded with one of the KCD Marks; |
| • | Our ability to offer merchandise and services that our customers want, including those branded with the KCD Marks; |
| • | Transform Holdco may explore alternatives for its Kenmore, Craftsman, and Diehard businesses and further expand the presence of these brands including by evaluating potential partnerships or other transactions (for example, Kenmore and Diehard products are being sold on Amazon.com); |
| • | 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 on our historical financial statements, may not be indicative of our future performance as a result of, among other things, our reliance on Transform Holdco for most products and services that are important to the successful operation of our business, and our potential need to rely on Transform Holdco for some products and services beyond the expiration of our agreements with Transform Holdco; |
| • | Transform Holdco is seeking to negotiate supply agreements with its appliance, lawn and garden, tools, and other vendors, which vendors may be willing to supply merchandise to Transform Holdco on terms (including vendor-payment terms for Transform Holdco’s merchandise purchases) that are either unacceptable to Transform Holdco or acceptable to Transform Holdco but would uneconomic for us; |
| • | The willingness of Transform Holdco’s appliance, lawn and garden, tools, and other vendors to continue to pay to Transform Holdco’s merchandise-related subsidies and allowances and cash discounts (Transform Holdco is obligated to pay to a |
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portion of these subsidies and allowances to us, and the amounts required to be paid to us declined significantly during 2018);
| • | Our ability to resolve, on commercially reasonable terms, future disputes with Transform Holdco, if any, regarding the material terms and conditions of our agreements with Transform Holdco; |
| • | Our ability to establish information, merchandising, logistics, and other systems separate from Transform Holdco that would be necessary to ensure continuity of merchandise supplies and services for our businesses if, in connection with Transform Holdco’s acquisition of the Sears Assets, vendors were to reduce, or cease, their merchandise sales to Transform Holdco or provide logistics and other services to Transform Holdco or if Transform Holdco were to reduce, or cease, its merchandise sales to us or reduce providing, or cease to provide, logistics and other services to us; |
| • | If Transform Holdco’s sales of major appliances and lawn and garden merchandise to its retail customers decline Transform Holdco’s sales to us of outlet-value merchandise could decline; |
| • | Our ability to maintain an effective and productive business relationship with Transform Holdco, especially if future disputes were to arise with respect to the terms and conditions of the Operative Agreements; |
| • | Most of our agreements related to the 2012 Separation and our continuing relationship with Sears Holdings (Transform Holdco after mid-February 2019) were negotiated while we were a subsidiary of Sears Holdings (except for amendments agreed to after the 2012 Separation), and we may have received different terms from unaffiliated third parties (including with respect to merchandise-vendor and service-provider indemnification and defense for negligence claims and claims arising out of failure to comply with contractual obligations); |
| • | Our reliance on Transform Holdco to provide access to computer systems acquired as part of the Sears Assets to process transactions with our customers (including the point-of-sale system for the stores we operate and the stores that our independent dealers and independent franchisees operate, which point-of-sale system captures, among other things, credit-card information supplied by our customers) and others, quantify our results of operations, and manage our business (“SHO's TH-Supplied Systems”); |
| • | SHO's TH-Supplied Systems could be subject to disruptions and data/security breaches (Sears Holdings announced during 2017 that its Kmart store payment-data systems had been infected with a malicious code and that the code had been removed and the event contained and during April 2018 Sears Holdings announced that one of its vendors that provides online support services to Sears and Kmart had notified Sears Holdings that the vendor had experienced a security incident during 2017 that involved unauthorized access to credit card information with respect to less than 100,000 Sears Holdings's customers), and Transform Holdco could be unwilling or unable to indemnify and defend us against third-party claims and other losses resulting from such disruptions and data/security breaches, which could have one or more material adverse effects on SHO; |
| • | Our ability to implement our IT transformation by the end of the second quarter of our 2019 fiscal year in accordance with our plans, expectations, current timetable, and anticipated cost; |
| • | Limitations and restrictions in the Senior ABL Facility and the Term Loan Agreement and their related agreements governing our indebtedness and our ability to service our indebtedness; |
| • | Competitors could continue to reduce their promotional pricing on new-in-box appliances, which could continue to adversely impact our sales of out-of-box appliances and associated margin; |
| • | Our ability to generate profitable sales of merchandise and services on our transactional ecommerce websites in the amounts we have planned to generate; |
| • | Our ability to refinance the Senior ABL Facility and the Term Loan and obtain additional financing on acceptable terms; |
| • | Our dependence on the ability and willingness of our independent dealers and independent franchisees to operate their stores profitably and in a manner consistent with our concepts and standards; |
| • | Our ability to (1) significantly reduce or eliminate the Hometown segment's growing operating losses (due in part to increasing supply-chain costs and Craftsman and Kenmore merchandise availability issues that are disproportionately affecting the Hometown segment) and (2) close, or seek the closure of, unproductive Hometown segment stores and to reduce the inventory, marketing, promotion, supply chain, and other expenses associated with these stores; |
| • | Our dependence on sources outside the U.S. for significant amounts of our merchandise inventories; |
| • | Fixed-asset impairment for long-lived assets; |
| • | Our ability to attract, motivate, and retain key executives and other employees; |
| • | Our ability to maintain effective internal controls as a publicly held company; |
| • | 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 stockholder's ability to exert control over us. |
The foregoing factors should not be understood as exhaustive and should be read in conjunction with the other cautionary statements, including the "Risk Factors," that are included in this Annual Report on Form 10-K and 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,
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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 Annual Report on Form 10-K are made only as of the date of this Annual Report on Form 10-K. 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, except as required by law.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Not applicable.
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Item 8. Financial Statements and Supplementary Data
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SEARS HOMETOWN AND OUTLET STORES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
| Fiscal Year Ended | ||||||||
| thousands, except per share amounts | February 2, 2019 | February 3, 2018 | ||||||
| NET SALES | $ | 1,449,948 | $ | 1,719,951 | ||||
| COSTS AND EXPENSES | ||||||||
| Cost of sales and occupancy | 1,126,752 | 1,371,408 | ||||||
| Selling and administrative | 349,082 | 419,567 | ||||||
| Impairment of property and equipment | 2,089 | 3,357 | ||||||
| Depreciation and amortization | 12,374 | 13,039 | ||||||
| Gain on the sale of assets | (1,358 | ) | — | |||||
| Total costs and expenses | 1,488,939 | 1,807,371 | ||||||
| Operating loss | (38,991 | ) | (87,420 | ) | ||||
| Interest expense | (14,676 | ) | (8,058 | ) | ||||
| Other income | 367 | 925 | ||||||
| Loss before income taxes | (53,300 | ) | (94,553 | ) | ||||
| Income tax expense | (164 | ) | (504 | ) | ||||
| NET LOSS | $ | (53,464 | ) | $ | (95,057 | ) | ||
| NET LOSS PER COMMON SHARE ATTRIBUTABLE TO STOCKHOLDERS | ||||||||
| Basic: | $ | (2.36 | ) | $ | (4.19 | ) | ||
| Diluted: | $ | (2.36 | ) | $ | (4.19 | ) | ||
| Basic weighted average common shares outstanding | 22,702 | 22,702 | ||||||
| Diluted weighted average common shares outstanding | 22,702 | 22,702 | ||||||
See Notes to Consolidated Financial Statements.
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SEARS HOMETOWN AND OUTLET STORES, INC.
CONSOLIDATED BALANCE SHEETS
| thousands | February 2, 2019 | February 3, 2018 | ||||||
| ASSETS | ||||||||
| CURRENT ASSETS | ||||||||
| Cash and cash equivalents | $ | 15,110 | $ | 10,402 | ||||
| Accounts and franchisee receivables, net | 11,916 | 14,672 | ||||||
| Merchandise inventories | 277,285 | 336,294 | ||||||
| Prepaid expenses and other current assets | 9,452 | 7,131 | ||||||
| Total current assets | 313,763 | 368,499 | ||||||
| PROPERTY AND EQUIPMENT, net | 27,731 | 36,049 | ||||||
| OTHER ASSETS, net | 2,277 | 8,140 | ||||||
| TOTAL ASSETS | $ | 343,771 | $ | 412,688 | ||||
| LIABILITIES | ||||||||
| CURRENT LIABILITIES | ||||||||
| Short-term borrowings | $ | 93,000 | $ | 137,900 | ||||
| Term Loan, net | 39,057 | — | ||||||
| Payable to Sears Holdings Corporation | 14,080 | 28,082 | ||||||
| Accounts payable | 19,830 | 15,741 | ||||||
| Other current liabilities | 56,009 | 53,142 | ||||||
| Total current liabilities | 221,976 | 234,865 | ||||||
| OTHER LONG-TERM LIABILITIES | 1,839 | 2,284 | ||||||
| TOTAL LIABILITIES | 223,815 | 237,149 | ||||||
| COMMITMENTS AND CONTINGENCIES (Note 10) | ||||||||
| STOCKHOLDERS' EQUITY | ||||||||
| Common stock: $.01 par value; 400,000 shares authorized, 22,702 issued and outstanding in 2018 and 2017, respectively | 227 | 227 | ||||||
| Capital in excess of par value | 555,378 | 555,378 | ||||||
| Accumulated deficit | (435,649 | ) | (380,066 | ) | ||||
| TOTAL STOCKHOLDERS' EQUITY | 119,956 | 175,539 | ||||||
| TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY | $ | 343,771 | $ | 412,688 | ||||
See Notes to Consolidated Financial Statements.
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SEARS HOMETOWN AND OUTLET STORES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
| Fiscal Year Ended | ||||||||
| thousands | February 2, 2019 | February 3, 2018 | ||||||
| CASH FLOWS FROM OPERATING ACTIVITIES | ||||||||
| Net loss | $ | (53,464 | ) | $ | (95,057 | ) | ||
| Adjustments to reconcile net loss to net cash provided by (used in) operating activities | ||||||||
| Depreciation and amortization | 12,374 | 13,039 | ||||||
| Gain on the sale of assets | (1,358 | ) | — | |||||
| Amortization of debt issuance costs | 2,946 | 2,174 | ||||||
| Impairment of property and equipment | 2,089 | 3,357 | ||||||
| Provision for losses on franchisee receivables | 2,594 | 7,361 | ||||||
| Share-based compensation | — | (103 | ) | |||||
| Change in operating assets and liabilities: | ||||||||
| Accounts and franchisee receivables | 162 | (2,508 | ) | |||||
| Merchandise inventories | 59,009 | 37,521 | ||||||
| Payable to Sears Holdings Corporation | (14,002 | ) | (52,642 | ) | ||||
| Accounts payable | 4,089 | (2,112 | ) | |||||
| Store closing accrual | (2,010 | ) | (3,004 | ) | ||||
| Customer deposits | (3,829 | ) | (3,287 | ) | ||||
| Other operating assets and liabilities, net | 6,477 | (10,385 | ) | |||||
| Net cash provided by (used in) operating activities | 15,077 | (105,646 | ) | |||||
| CASH FLOWS FROM INVESTING ACTIVITIES | ||||||||
| Proceeds from sale of property | 2,837 | — | ||||||
| Purchases of property and equipment | (6,438 | ) | (9,228 | ) | ||||
| Net cash used in investing activities | (3,601 | ) | (9,228 | ) | ||||
| CASH FLOWS FROM FINANCING ACTIVITIES | ||||||||
| Net borrowings of capital lease obligations | 45 | 72 | ||||||
| Net (payments) borrowings on short-term borrowings | (44,900 | ) | 111,100 | |||||
| Proceeds from term loan | 40,000 | — | ||||||
| Debt issuance costs | (1,913 | ) | — | |||||
| Net cash (used in) provided by financing activities | (6,768 | ) | 111,172 | |||||
| NET CHANGE IN CASH AND CASH EQUIVALENTS | 4,708 | (3,702 | ) | |||||
| CASH AND CASH EQUIVALENTS—Beginning of period | 10,402 | 14,104 | ||||||
| CASH AND CASH EQUIVALENTS—End of period | $ | 15,110 | $ | 10,402 | ||||
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION | ||||||||
| Cash paid for interest | $ | 11,546 | $ | 7,848 | ||||
| Cash paid for income taxes | $ | 1,148 | $ | 808 | ||||
See Notes to Consolidated Financial Statements.
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SEARS HOMETOWN AND OUTLET STORES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
| thousands | Number of Shares of Common Stock | Common Stock/Par Value | Capital in Excess of Par Value | Retained Earnings (Deficit) | Total Stockholders' Equity | |||||||||||||
| Balance at January 28, 2017 | 22,716 | $ | 227 | 555,481 | (285,009 | ) | 270,699 | |||||||||||
| Net loss | — | — | — | (95,057 | ) | (95,057 | ) | |||||||||||
| Share-based compensation | (14 | ) | — | (103 | ) | — | (103 | ) | ||||||||||
| Balance at February 3, 2018 | 22,702 | $ | 227 | $ | 555,378 | $ | (380,066 | ) | $ | 175,539 | ||||||||
| Net loss | — | — | — | (53,464 | ) | (53,464 | ) | |||||||||||
| Cumulative effect adjustment from adoption of new revenue recognition standard | — | — | — | (2,119 | ) | $ | (2,119 | ) | ||||||||||
| Balance at February 2, 2019 | 22,702 | $ | 227 | $ | 555,378 | $ | (435,649 | ) | $ | 119,956 | ||||||||
See Notes to Consolidated Financial Statements.
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NOTE 1—BACKGROUND, BASIS OF PRESENTATION, AND SIGNIFICANT ACCOUNTING POLICIES
Background
Sears Hometown and Outlet Stores, Inc. is a national retailer primarily focused on selling home appliances, hardware, tools and lawn and garden equipment. As of February 2, 2019, the Company and our independent dealers and franchisees operated a total of 677 stores across 49 states and in Puerto Rico and Bermuda. In these notes the terms "we," "us," "our," "SHO," and the "Company" refer to Sears Hometown and Outlet Stores, Inc. and its subsidiaries.
The Company separated from Sears Holdings Corporation (“Sears Holdings”) in October 2012 (the “2012 Separation”). The Company has specified rights to use the "Sears" name under a license agreement from Sears Holdings.
Basis of Presentation
These consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated.
We operate through two segments--our Sears Hometown segment ("Hometown") and our Sears Outlet segment ("Outlet").
Subsequent to the 2012 Separation and until mid-February 2019 we had significant business relationships with Sears Holdings and its subsidiaries, and we relied heavily on them for merchandise and services through various agreements among the Company, Sears Holdings and, in some circumstances, subsidiaries of Sears Holdings (together the “Operative Agreements”). During October 2018 Sears Holdings and many of its subsidiaries (together the “Sears Holdings Companies”) 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 Company, which is not a subsidiary of Sears Holdings, is not included in the bankruptcy petitions filed by the Sears Holdings Companies, and neither the Company nor its subsidiaries have filed a bankruptcy petition. As part of the Sears Holdings Companies' bankruptcy proceedings Transform Holdco LLC ("Transform Holdco") acquired most of the operating assets (including Sears stores) and related assets of the Sears Holdings Companies (together the “Sears Assets”), and the Operative Agreements were assigned by the Sears Holdings Companies to, and the obligations thereunder were assumed by, Transform Holdco on or about February 11, 2019. According to publicly available information, (1) ESL Investments, Inc. and investment affiliates including Edward S. Lampert (together “ESL”) control Transform Holdco and (2) ESL owns approximately 58.8% of the Company’s outstanding shares of common stock.
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 Operative 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 termination of "the Separation Agreements" is an event of default thereunder, which could result in all amounts outstanding becoming immediately due and payable. The Company and specified subsidiaries have entered into an Amendments Agreement dated March 12, 2019 with Transform Holdco LLC and its subsidiaries party thereto, as assignees. The Amendments Agreement extends until February 1, 2023 the duration of those Separation Agreements that by their express terms would have expired on February 1, 2020 (October 11, 2022 with respect to the Shop Your Way Rewards Retail Establishment Agreement).
Our consolidated operating loss for our fiscal year 2018 was $39 million and included an operating loss of $58.3 million from our Hometown segment and $19.3 million of operating income from our Outlet segment. The Hometown segment has experienced multiple successive years of operating losses that have continued, and are continuing to worsen. For SHO's 2014 fiscal year the Hometown segment’s operating loss was $11.9 million, excluding the impact of goodwill impairment. The segment’s operating
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losses have grown each year since then, and the segment suffered an operating loss for our 2018 fiscal year of $58.3 million. In part this is due to growing supply-chain cost increases and Craftsman and Kenmore merchandise availability issues. These cost increases and merchandise availability issues have, and will continue to have, a disproportionately adverse impact on the Hometown segment. SHO believes that these cost increases and Kenmore and Craftsman availability issues are unlikely to improve in the near term and perhaps longer. We also believe that we have exhausted all of the means at our disposal to turn the segment’s businesses around. We also believe that, regardless of our commercially reasonable efforts to improve the Hometown segment's operating results (which efforts we intend to continue), the segment likely will continue to experience operating losses.
The Company is seeking to refinance the Senior ABL Facility and Term Loan prior to February 29, 2020, which efforts the Company believes will be augmented by the Company’s improved consolidated operating 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. While the Company has had discussions with the administrative agent for the Senior ABL Facility about its extension or refinancing, those discussions have not yet resulted in an agreement to extend or refinance. 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 before the maturity dates of these facilities. We can give no assurance that (1) the discussions will be successful or (2) if the discussions result in an agreement to extend or refinance, that the terms and conditions of the extension or replacement arrangements would not be unfavorable, perhaps significantly unfavorable, compared to the terms and conditions of the Senior ABL Facility and the Term Loan.
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.
The Senior ABL Facility and the Term Loan Agreement provide that the Company's inability to obtain from the Company's independent registered public accounting firm a report and opinion that "shall not be subject to any 'going concern' or like qualification or exception" constitutes an event of default, which would give the Senior ABL Facility and the Term Loan Agreement lenders the right to accelerate the maturity of all outstanding loans, among other actions. The Senior ABL Facility and the Term Loan Agreement lenders have waived through October 31, 2019 any default resulting from the Going Concern Uncertainty.
While we believe that we should be able to refinance the Senior ABL Facility and the Term Loan, and that the refinancing should satisfy our liquidity needs through the next twelve months from date of issuance, such refinancing has not occurred and cannot be considered "probable" (as defined by the Accounting Evaluation Requirements) as of the date these financial statements are issued. 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 uncertain impact on our business and financial performance associated with ongoing operating losses in our Hometown segment, "substantial doubt" (as defined by the Accounting Evaluation Requirements) is deemed to exist about our ability to continue as a going concern.
The May 3, 2019 report of the Company's independent registered public accounting firm that accompanies these Consolidated Financial Statements incorporates the firm's audit opinion, which expresses "Going Concern Uncertainty" (hereinafter the "Going Concern Uncertainty").
The Senior ABL Facility and the Term Loan Agreement provide that the Company's inability to obtain from the Company's independent registered public accounting firm a report and opinion that "shall not be subject to any 'going concern' or like qualification or exception" constitutes an event of default, which would give the Senior ABL Facility and the Term Loan Agreement lenders the right to accelerate the maturity of all outstanding loans, among other actions. The Senior ABL Facility and the Term Loan Agreement lenders have waived through October 31, 2019 any default resulting from the Going Concern Uncertainty.
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Reclassifications - Certain prior period reclassifications were made to conform with the current period presentation. These reclassifications had no effect on reported operations, cash flows, total assets, or stockholders' equity as previously reported.
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 as well as the methods permitted for determining the primary beneficiary of a variable interest entity. In addition, this guidance requires ongoing reassessments of whether a company is the primary beneficiary of a variable interest entity and disclosures related to a company’s involvement with a variable interest entity.
On an ongoing basis the Company evaluates its business relationships, such as those with its dealers, franchisees, and suppliers, to identify potential variable interest entities. Generally, these businesses 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.
SIGNIFICANT ACCOUNTING POLICIES
Fiscal Year
Our fiscal years end on the Saturday closest to January 31. Unless otherwise stated, references to specific years in these notes are to fiscal years. The following fiscal periods are presented herein.
| Fiscal Year | Ended | Weeks |
| 2018 | February 2, 2019 | 52 |
| 2017 | February 3, 2018 | 53 |
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Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions about future events. The estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an ongoing basis using historical experience and other factors that management believes to be reasonable under the circumstances. Adjustments to estimates and assumptions are made when facts and circumstances dictate. As future events and their effects cannot be determined with absolute certainty, actual results may differ from the estimates used in preparing the accompanying consolidated financial statements. Significant estimates and assumptions are required as part of determining inventory and accounts and franchisee receivables valuation, estimating depreciation and recoverability of long-lived assets, establishing insurance, warranty, legal and other reserves, performing long-lived asset impairment analysis, and establishing valuation allowances on deferred income tax assets and reserves for tax examination exposures.
Cash and Cash Equivalents
Cash equivalents include (1) all highly liquid investments with original maturities of three months or less at the date of purchase and (2) deposits in-transit from banks for payments related to third-party credit card and debit card transactions.
Allowance for Doubtful Accounts
We provide an allowance for doubtful accounts based on both historical experience and a specific identification basis. Allowances for doubtful accounts on accounts and franchisee receivable balances were $2.0 million at February 2, 2019 and $5.8 million at February 3, 2018. Our accounts receivable balance is comprised of various vendor-related and customer-related accounts receivable. Our franchisee receivable balance is comprised of promissory notes that relate primarily to the sale of assets for our franchised locations.
The Company provides an allowance for losses on franchisee receivables (which consist primarily of franchisee promissory notes) in an amount equal to estimated probable losses net of recoveries. The allowance is based on an analysis of expected future write-offs, existing economic conditions, and an assessment of specific identifiable franchisee promissory notes and other franchisee receivables considered at risk or uncollectible. The expense associated with the allowance for losses on franchisee receivables is recognized as selling and administrative expense. As of February 2, 2019, all franchisee receivables have been fully reserved.
Merchandise Inventories
Merchandise inventories are valued at the lower of cost or market. Merchandise inventories are valued under the retail inventory method, or "RIM," using primarily a last-in, first-out, or "LIFO," cost-flow assumption.
Inherent in RIM calculations are certain significant management judgments and estimates including, among others, merchandise markons, markups, markdowns, and shrinkage, which significantly impact the ending inventory valuation at cost and resulting gross margins. The methodologies utilized by us in our application of RIM are consistent for all periods presented. Such methodologies include the development of the cost-to-retail ratios, the groupings of homogeneous classes of merchandise, the development of shrinkage and obsolescence reserves, the accounting for price changes, and the computations inherent in the LIFO adjustment (where applicable). Management believes that RIM provides an inventory valuation that reasonably approximates cost and results in carrying inventory at the lower of cost or market.
In connection with our LIFO calculation we estimate the effects of inflation on inventories by utilizing external price indices determined by the U.S. Bureau of Labor Statistics. If we had used the first-in, first-out, or "FIFO" method of inventory valuation instead of the LIFO method, merchandise inventories would have been insignificantly higher at February 2, 2019 and February 3, 2018.
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Vendor Rebates and Allowances
We receive rebates and allowances from vendors through a variety of programs and arrangements intended to offset the costs of promoting and selling the vendors' products. In addition, Transform Holdco (Sears Holdings prior to February 11, 2019) allocates a portion of the rebates and allowances it receives from vendors based on shipments to or sales of the related products to the Company. Vendor payments are recognized and recorded as a reduction to the cost of merchandise inventories when earned and, thereafter, as a reduction of cost of sales and occupancy as the merchandise is sold. Up-front consideration received from vendors linked to purchases or other commitments is initially deferred and amortized ratably to cost of sales and occupancy over the life of the contract or as performance of the activities specified by the vendor to earn the fee is completed.
Property and Equipment
Property and equipment are recorded at cost, less accumulated depreciation. Additions and substantial improvements are capitalized and include expenditures that materially extend the useful lives of existing facilities and equipment. Maintenance and repairs that do not materially improve or extend the lives of the respective assets are expensed as incurred.
Property and equipment consists of the following:
| thousands | February 2, 2019 | February 3, 2018 | ||||||
| Land | $ | 1,638 | $ | 1,741 | ||||
| Buildings and improvements | 29,735 | 35,065 | ||||||
| Furniture, fixtures and equipment | 35,526 | 37,303 | ||||||
| Capitalized leases | 1,648 | 1,276 | ||||||
| Total property and equipment | 68,547 | 75,385 | ||||||
| Less: accumulated depreciation | (40,816 | ) | (39,336 | ) | ||||
| Total property and equipment, net | $ | 27,731 | $ | 36,049 | ||||
Depreciation expense, which includes depreciation on assets under capital leases, is recorded over the estimated useful lives of the respective assets using the straight-line method for financial statement purposes and accelerated methods for tax purposes. The range of lives are generally 15 to 25 years for buildings, 3 to 10 years for furniture, fixtures, and equipment, and 3 to 5 years for computer systems and equipment. Leasehold improvements are depreciated over the shorter of the associated lease term or the estimated useful life of the asset. Total depreciation expense was $12.4 million and $11.8 million, for fiscal years 2018 and 2017, respectively.
As of February 2, 2019, management has identified one property that is deemed held for sale based on criteria in Accounting Standards Codification ("ASC") 360-10-45-9. This property is reflected in each category of Property and Equipment with the exception of capitalized leases in the table above and had a carrying value of $1.0 million as of February 2, 2019. As of February 2, 2019, the expected fair value less the cost of sale exceeded the carrying value of the Property and Equipment resulting in an impairment charge of $0.5 million.
Impairment of Long-Lived Assets and Costs Associated with Exit Activities
In accordance with accounting standards governing the impairment or disposal of long-lived assets, the carrying value of long-lived assets, including property and equipment, is evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred. Factors that could result in an impairment review include, but are not limited to, a current period cash flow loss combined with a history of cash flow losses, current cash flows that may be insufficient to recover the investment in the property over the remaining useful life, or a projection that demonstrates continuing losses associated with the use of a long-lived asset, significant changes in the manner of use of the assets, or significant changes in business strategies. An impairment loss is recognized when the estimated undiscounted cash flows expected to result from the use of the asset plus net proceeds expected from disposition of the asset (if any) are less than the carrying value of the asset. When an impairment loss is recognized, the carrying amount of the asset is reduced to its estimated fair value as determined based on quoted market prices or through the use of other valuation techniques. We recorded impairment charges with respect to long-lived assets of $2.1 million and $3.4 million
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in fiscal years 2018 and 2017, respectively, included in Impairment of property and equipment in the accompanying Consolidated Statements of Operations.
We account for costs associated with location closings in accordance with accounting standards pertaining to accounting for costs associated with exit or disposal activities and compensation. When management makes a decision to close a location we record a reserve as of that date for the expected inventory markdowns associated with the closing. We also record a liability for future lease costs (net of estimated sublease income) when we cease to use the location. As of February 2, 2019 and February 3, 2018, this liability was approximately $2.6 million and $4.7 million, respectively. See Note 15.
Leases
We lease certain stores, office facilities, computers and transportation equipment. The determination of operating and capital lease obligations is based on the expected durations of the leases and contractual minimum lease payments specified in the lease agreements. For certain stores, amounts in excess of these minimum lease payments are payable based upon a specified percentage of sales. Contingent rent is accrued during the period it becomes probable that a particular store will achieve a specified sales level thereby triggering a contingent rental obligation. Certain leases also include an escalation clause or clauses and renewal option clauses calling for increased rents. Where the lease contains an escalation clause or concession such as a rent holiday, rent expense is recognized using the straight-line method over the term of the lease. We have subleases with Transform Holdco (as assignee) for 23 locations. We had rent expense paid to Sears Holdings (Transform Holdco after February 11, 2019) of $7.2 million and $10.8 million in 2018 and 2017, respectively.
We also had rent expense paid to Seritage Growth Properties, a related party, in occupancy charges for of $0.6 million and $1.1 million in 2018 and 2017, respectively, for occupancy charges for properties we lease from Seritage.
Rental expense for operating leases was as follows:
| Fiscal Year | ||||||
| thousands | 2018 | 2017 | ||||
| Minimum rentals | 44,379 | 59,533 | ||||
| Less-Sublease rentals | (2,553 | ) | (7,399 | ) | ||
| Total | 41,826 | 52,134 | ||||
Minimum lease obligations excluding taxes, insurance and other expenses are as follows:
Fiscal Year (thousands) | Capital Leases | Operating Leases | ||||||
| 2019 | $ | 259 | $ | 39,292 | ||||
| 2020 | 359 | 33,666 | ||||||
| 2021 | 21 | 26,523 | ||||||
| 2022 | 14 | 19,037 | ||||||
| 2023 | 5 | 9,486 | ||||||
| Thereafter | — | 4,374 | ||||||
| Total Minimum Lease Payments | 658 | 132,378 | ||||||
| Less - Sublease Income on Leased Properties | — | (3,036 | ) | |||||
| Net Minimum Lease Payments | $ | 658 | $ | 129,342 | ||||
| Capital lease obligations | 658 | |||||||
| Less Current Portion of Capital Lease Obligations | (259 | ) | ||||||
| Long-term Capital Lease Obligations | $ | 399 | ||||||
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Insurance Programs
We maintain our own insurance arrangements with third-party insurance companies for exposures incurred for a number of risks including worker’s compensation and general liability claims. Insurance expense of $4.5 million and $5.3 million was recorded during 2018 and 2017, respectively.
Loss Contingencies
We account for contingent losses in accordance with accounting standards pertaining to loss contingencies. Under accounting standards, loss contingency provisions are recorded for probable losses at management’s best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount is recorded. These estimates are often initially developed substantially earlier than the ultimate loss is known, and the estimates are refined each accounting period, as additional information is known.
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 $11.9 million and $16.4 million at February 2, 2019 and February 3, 2018, respectively. The change in deferred revenue represents revenue recognized during 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. Commissions earned on services, and delivery and handling revenues are presented net of related costs because we are acting as an agent in arranging the services for the customer and do not control the services being rendered.
The Company accepts Transform Holdco (Sears Holdings prior to February 11, 2019) gift cards as tender for purchases and is reimbursed weekly by Transform Holdco for gift cards tendered.
Refund Liability and Right of Return Asset
Fiscal 2018 and Subsequent Periods. 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 and recognized at the transaction price as a reduction of revenues. The refund liability was $2.9 million at February 2, 2019. We also recognize a return asset, and corresponding adjustment to cost of sales, for our right to recover the goods returned by the customer, measured at the former carrying amount of the goods, less any expected recovery cost. The right of return asset was $1.4 million at February 2, 2019.
At each financial reporting date, we assess our estimates of expected returns, refund liabilities, and return assets.
Reserve for Sales Returns and Allowances
Fiscal 2017. Revenues from merchandise sales and services are reported net of estimated returns and allowances and exclude sales taxes. The refund liability for returns and allowances, including the impact to gross profit, is calculated as a percentage of sales based on historical return percentages. Estimated returns are recorded as a reduction of sales and cost of sales. The reserve for returns and allowances was $1.1 million at February 3, 2018.
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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 Transform Holdco 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 Transform Holdco.
Selling and Administrative Expenses
Selling and administrative expenses are comprised principally of dealer and franchisee commissions, payroll and benefits costs for retail and support employees, advertising, pre-opening costs, and other administrative expenses.
Dealer and Franchisee Commissions
In accordance with our agreements with our dealers and franchisees, we pay commissions to our dealers and franchisees on the net sales of merchandise and extended-service plans. In addition, each dealer and franchisee can earn marketing support, home improvement referrals, rent support, and other items. Commission costs are expensed as incurred and reflected within selling and administrative expenses. Commission costs were $126.8 million and $171.7 million in 2018 and 2017, respectively. Commission costs vary based on factors including store count, number of dealer and franchise locations, sales mix, sales volume, and commission rates.
Pre-Opening Costs
Pre-opening and start-up activity costs are expensed in the period in which they occur.
Advertising Costs
Advertising costs are expensed as incurred, generally the first time the advertising occurs, and were $40.0 million and $48.2 million for 2018 and 2017, respectively. These costs are included within selling and administrative expenses in the accompanying Consolidated Statements of Operations.
Income Taxes
We provide deferred income tax assets and liabilities based on the estimated future tax effects of differences between the financial and tax basis of assets and liabilities based on currently enacted tax laws. The tax balances and income tax expense recognized by us are based on management’s interpretation of the tax laws of multiple jurisdictions. Income tax expense also reflects our best estimates and assumptions regarding, among other things, the level of future taxable income, tax planning, and any valuation allowance. For the year-ended February 2, 2019, a valuation allowance of $105.0 million has been recorded for the full amount of the net deferred tax assets. In the future, we may record additional net deferred tax assets and if future utilization of deferred tax assets is uncertain, we may record additional valuation allowance against such deferred tax assets. In evaluating our ability to recover our deferred tax assets within the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies, and results of recent operations. In projecting future taxable income, we begin with historical results and incorporate assumptions including the amount of future federal, state and foreign pre-tax operating income (loss), the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income.
Tax benefits are recognized when they are more likely than not to be sustained upon examination. The amount recognized is measured as the largest amount of benefit that is more likely than not of being recognized upon settlement. We will be subject to periodic audits by the Internal Revenue Service and other state local and foreign taxing authorities. Theses audits may challenge certain of the Company’s tax positions such as the timing and amount of income and deductions and the allocation of taxable income to various tax jurisdictions. We evaluate our tax positions and establish liabilities in accordance with the applicable guidance on uncertainty in income taxes. These tax uncertainties are reviewed as facts and circumstances change and are adjusted accordingly. This requires significant management judgment in estimating final outcomes. Actual results could materially differ from these
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estimates and could significantly affect the effective tax rate and cash flows in future years. Interest and penalties are classified as income tax expense in the Consolidated Statements of Operations.
Prior to the 2012 Separation, our taxable income was included in the consolidated federal, state and foreign income tax returns of Sears Holdings or its affiliates. Income taxes in these consolidated financial statements have been recognized on a separate return basis. Under a Tax Sharing Agreement between the Company and Transform Holdco (the "Tax Sharing Agreement"), Transform Holdco is responsible for any federal, state or foreign income tax liability relating to tax periods ending on or before the 2012 Separation and the Company is responsible for any federal, state or foreign tax liability relating to tax periods ending after the 2012 Separation.
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 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. As disclosed in Note 1, the Company recorded impairment charges of $2.1 million and $3.4 million on its property and equipment in 2018 and 2017, respectively. The Company utilized Level 3 inputs to measure the fair value of property and equipment, and intangible assets.
Recently Issued Accounting Pronouncements
ASU 2016-02 "Leases (Topic 842)"
In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-02, Leases (Topic 842): Amendments to the FASB Accounting Standards Codification® (“ASU 2016-02”), which supersedes the existing guidance for lease accounting, Leases (Topic 840). In order to improve transparency and comparability between companies, ASU 2016-02 requires lessees to recognize leases on their balance sheets, and modifies accounting, presentation and disclosure for both lessors and lessees. Our leases primarily consist of retail space, offices, warehouses, distribution centers and vehicles. We have completed our initial assessment of the standard as well as implementation of our leasing software, including data upload, and are continuing to finalize our calculations, including validation procedures. We continue establishing new processes and internal controls required to comply with the new lease accounting and disclosure requirements set by the new standard.
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ASU 2016-02 is effective for annual periods, and interim periods within those years, beginning after December 15, 2018. We are using the package of practical expedients that allows companies to not reassess: (1) whether any expired or existing contracts are or contain leases, (2) lease classification for any expired or existing leases and (3) initial direct costs for any expired or existing leases. We are making accounting policy elections to treat the lease and non-lease components of leases as a single lease component and to exempt leases with an initial term of twelve months or less from balance sheet recognition. Consequently, short-term leases will be expensed over the lease term. We are not electing to adopt the hindsight practical expedient and therefore will maintain the lease terms previously determined under ASC 840.
We will adopt ASU 2016-02 in the first quarter of fiscal year 2019 using the modified retrospective approach. The most significant and material impact of adoption will be the recognition of right-of-use (“ROU”) assets and lease liabilities on our consolidated balance sheets for operating leases, while our accounting for capital leases remains substantially unchanged. In addition, we are currently finalizing our assessment for ROU asset impairment and expect to recognize a cumulative-effect adjustment to the opening balance of retained earnings upon adoption. We do not believe the standard will materially affect our consolidated statements of earnings or cash flows. Our conclusions are preliminary and subject to change as we finalize our analysis. The Company will adopt this standard on February 3, 2019 and prior periods will not be recast in transition.
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 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 apply 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.
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The effect of the adoption of ASU No. 2014-09 on our consolidated balance sheet as of February 2, 2019 was as follows:
| Thousands | As Reported | ASU 2014-09 Effect | Excluding ASU 2014-09 Effect | |||||||||
| Prepaid expenses and other current assets | $ | 9,452 | $ | 1,226 | $ | 8,226 | ||||||
| Other current liabilities | 56,009 | 3,345 | 52,664 | |||||||||
| Accumulated deficit | (435,649 | ) | (2,119 | ) | (433,530 | ) | ||||||
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NOTE 2—NET SALES
During 2018, approximately 98% of our revenues were generated in the United States.
Net merchandise and service sales for 2018 were as follows:
| Thousands | 52 Weeks Ended February 2, 2019 | |||
| Merchandise | $ | 1,343,459 | ||
| Services | 79,969 | |||
| Other | 26,520 | |||
| Net sales | $ | 1,449,948 | ||
NOTE 3—ACCOUNTS AND FRANCHISEE RECEIVABLES AND OTHER ASSETS
Accounts and franchisee receivables and other assets consist of the following:
| thousands | February 2, 2019 | February 3, 2018 | ||||||
| Short-term franchisee receivables | $ | 584 | $ | 1,205 | ||||
| Miscellaneous receivables | 11,916 | 14,314 | ||||||
| Long-term franchisee receivables | 1,422 | 7,962 | ||||||
| Other assets | 2,277 | 5,106 | ||||||
| Allowance for losses on short-term franchisee receivables (1) | (584 | ) | (847 | ) | ||||
| Allowance for losses on long-term franchisee receivables (1) | (1,422 | ) | (4,928 | ) | ||||
| Total Accounts and franchisee receivables and other assets | $ | 14,193 | $ | 22,812 | ||||
(1) The Company recognizes an allowance for losses on franchisee receivables (which consist primarily of franchisee promissory notes) in an amount equal to estimated probable losses net of recoveries. The allowance is based on an analysis of expected future write-offs, existing economic conditions, and an assessment of specific identifiable franchisee promissory notes and other franchisee receivables considered at risk or uncollectible. The expense associated with the allowance for losses on franchisee receivables is recognized as selling and administrative expense. Most of our franchisee promissory notes authorize us to deduct debt service from our commissions otherwise due and payable to the franchisees, and we routinely make those deductions to the extent of available commissions payable. As of February 2, 2019, all franchisee receivables have been fully reserved.
NOTE 4—ALLOWANCE FOR LOSSES ON FRANCHISEE RECEIVABLES
The allowance for losses on Franchisee Receivables consists of the following:
| thousands | February 2, 2019 | February 3, 2018 | ||||||
| Allowance for losses on franchisee receivables, beginning of period | $ | 5,775 | $ | 8,242 | ||||
| Provisions during the period | 2,594 | 7,361 | ||||||
| Write off of franchisee receivables | (6,363 | ) | (9,828 | ) | ||||
| Allowance for losses on franchisee receivables, end of period | $ | 2,006 | $ | 5,775 | ||||
On November 2, 2018, the Company and a franchisee entered into a transaction consisting of agreements that terminated all of the franchisee's franchise agreements and sublease arrangements for 21 franchised locations. The agreements provided that the franchisee transferred ownership of all assets, management of stores, and certain rights to property leases. The assets the Company purchased included all store furniture, fixtures, and equipment. As of the transaction date, the franchisee was the obligor on promissory notes to the Company with a total carrying value, net of reserves, of $2.7 million. As part of the transaction, the Company waived the remaining unpaid principal on these promissory notes. During 2018, the Company recognized a loss of $2.7 million on the transaction.
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On June 7, 2017, the Company and a franchisee entered into a transaction consisting of agreements that terminated all of the franchisee's franchise agreements and sublease arrangements for 14 franchised locations (except with respect to one location as to which the Company would either assume the lease or enter into a lease directly with the landlord). The agreements provided that the franchisee transferred ownership of all assets, management of stores, and certain rights to property leases (in one instance pursuant to an Occupancy Agreement). The assets the Company purchased included all store furniture, fixtures, and equipment. As of the transaction date, the franchisee was the obligor on promissory notes to the Company with a total carrying value, net of reserves, of $5.5 million. As part of the transaction, the Company waived the remaining unpaid principal on these promissory notes and received a new promissory note from the franchisee in the amount of $1.5 million, which is payable in installments through December 11, 2022. During 2017, the Company recognized a loss of $5.5 million on the transaction.
NOTE 5—OTHER CURRENT AND LONG-TERM LIABILITIES
Other current and long-term liabilities consist of the following:
| thousands | February 2, 2019 | February 3, 2018 | ||||||
| Customer deposits | $ | 12,826 | $ | 16,655 | ||||
| Sales and other taxes | 7,165 | 9,221 | ||||||
| Accrued expenses | 23,097 | 17,755 | ||||||
| Payroll and related items | 12,115 | 7,140 | ||||||
| Store closing and severance costs | 2,645 | 4,655 | ||||||
| Total Other current and long-term liabilities | $ | 57,848 | $ | 55,426 | ||||
NOTE 6—INCOME TAXES
In connection with the 2012 Separation, SHO and Transform Holdco, as assignee, are parties to a Tax Sharing Agreement that governs the rights and obligations of the parties with respect to pre-2012 Separation and post-2012 Separation tax matters. Under the Tax Sharing Agreement, Transform Holdco is responsible for any federal, state or foreign income tax liability relating to tax periods ending on or before the 2012 Separation. For all periods after the 2012 Separation, the Company is responsible for any federal, state or foreign tax liability. Current income taxes payable for any federal, state or foreign income tax returns is reported in the period incurred.
We account for uncertainties in income taxes according to accounting standards for uncertain tax positions. The Company is present in a large number of taxable jurisdictions and, at any point in time, can have audits underway at various stages of completion in one or more of these jurisdictions. We evaluate our tax positions and establish liabilities for uncertain tax positions that may be challenged by local authorities and may not be fully sustained, despite the belief that the underlying tax positions are fully supportable. Unrecognized tax benefits are reviewed on an ongoing basis and are adjusted in light of changing facts and circumstances, including progress of tax audits, developments in case law, and closings of statutes of limitation. Such adjustments are reflected in the tax provision as appropriate. Pursuant to the Tax Sharing Agreement, Transform Holdco is responsible for any unrecognized tax liabilities or benefits through the date of the 2012 Separation and the Company is responsible for any uncertain tax positions after the 2012 Separation. For 2018 and 2017, no unrecognized tax benefits have been identified and reflected in the financial statements.
We classify interest expense and penalties related to unrecognized tax benefits and interest income on tax overpayments as components of income tax expense. As no unrecognized tax benefits have been identified and reflected in the consolidated financial statements, no interest or penalties related to unrecognized tax benefits are reflected in the consolidated balance sheets or statements of operations.
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The provisions for income tax expense for 2018 and 2017 consist of the following:
| Fiscal Year Ended | ||||||||||
| thousands | February 2, 2019 | February 3, 2018 | ||||||||
| (Loss) income before income taxes: | ||||||||||
| U.S. | $ | (54,629 | ) | $ | (96,166 | ) | ||||
| Foreign | 1,329 | 1,613 | ||||||||
| Total | $ | (53,300 | ) | $ | (94,553 | ) | ||||
| Income tax expense (benefit): | ||||||||||
| Current: | ||||||||||
| Federal | $ | (2 | ) | $ | 2 | |||||
| State | 302 | 215 | ||||||||
| Foreign | (136 | ) | 1,046 | |||||||
| Total | 164 | 1,263 | ||||||||
| Deferred: | ||||||||||
| Federal | — | (759 | ) | |||||||
| Total | $ | — | $ | (759 | ) | |||||
| Income tax expense | $ | 164 | $ | 504 | ||||||
The provisions for income taxes for financial reporting purposes is different from the tax provision computed by applying the statutory federal tax rate. The reconciliation of the tax rate follows:
| Fiscal Year Ended | ||||||
| February 2, 2019 | February 3, 2018 | |||||
| Federal tax rate | 21.0 | % | 33.7 | % | ||
| State income tax (net of federal benefit) | (0.4 | )% | (0.2 | )% | ||
| Federal tax rate change | — | % | (37.2 | )% | ||
| Valuation allowance | (21.0 | )% | 4.4 | % | ||
| Foreign taxes | 0.2 | % | (1.1 | )% | ||
| Other | (0.1 | )% | (0.1 | )% | ||
| Effective tax rate | (0.3 | )% | (0.5 | )% | ||
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The major components of the deferred tax assets and liabilities as of February 2, 2019 and February 3, 2018 are as follows:
| Fiscal Year Ended | |||||||||
| thousands | February 2, 2019 | February 3, 2018 | |||||||
| Deferred tax assets | |||||||||
| Bad debts | $ | 855 | $ | 1,543 | |||||
| Deferred compensation | 2,181 | 756 | |||||||
| Net operating loss | 72,192 | 54,580 | |||||||
| Property | 647 | 2,598 | |||||||
| Royalty-free license | 23,587 | 26,451 | |||||||
| Other | 10,538 | 7,803 | |||||||
| Sub-total deferred tax assets | $ | 110,000 | $ | 93,731 | |||||
| Valuation allowance | (104,978 | ) | (92,362 | ) | |||||
| Total deferred tax assets | $ | 5,022 | $ | 1,369 | |||||
| Deferred tax liabilities | |||||||||
| Inventory | (4,394 | ) | (730 | ) | |||||
| Other | (628 | ) | (639 | ) | |||||
| Total deferred tax liabilities | (5,022 | ) | (1,369 | ) | |||||
| Net deferred tax assets | — | — | |||||||
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act made broad and complex changes to the U.S. tax code that affected our fiscal year ended February 3, 2018, including, but not limited to, (1) reducing the U.S. federal corporate tax rate, (2) eliminating the corporate alternative minimum tax (AMT) and changing how existing AMT credits can be realized, and (3) various other miscellaneous changes that were effective in fiscal 2017. The Tax Act reduced the federal corporate tax rate to 21% in the fiscal year ended February 3, 2018. Based on Section 15 of the Internal Revenue Code, our fiscal year ended February 3, 2018 had a blended corporate tax rate of 33.7%, which is based on the applicable tax rates before and after the Tax Act and the number of days in the year.
The Tax Act also established new tax rules that affect fiscal 2018, including, but not limited to, (1) reduction of the U.S. federal corporate tax rate; (2) the elimination of corporate AMT; (3) a new limitation on deductible interest expense; (4) limitations on the deductibility of certain executive compensation; (5) limitations on the use of FTCs to reduce the U.S. income tax liability; and (6) limitations on net operating losses (NOLs) generated in tax years beginning after December 31, 2017, to 80% of taxable income.
The SEC staff issued SAB 118, which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.
In connection with our initial analysis of the impact of the Tax Act, we have recorded a discrete net tax benefit of $0.8 million in the period ended February 3, 2018. This net tax benefit consisted of a reduction in the valuation allowance by $0.8 million as a result of the elimination of the AMT credit as a deferred tax asset and corresponding establishment of a long-term receivable.
Our accounting for the following elements of the Tax Act is complete.
The Tax Act reduces the corporate rate to 21%, effective January 1, 2018. Our net deferred tax assets ("DTA") and deferred tax liabilities ("DTL") decreased by $35.2 million with a corresponding net adjustment to the valuation allowance for the year ended February 3, 2018. A deferred tax benefit of $0.8 million was recorded in the period ended February 3, 2018 as a result of a reduction in the valuation allowance due to the elimination of the AMT credit as a deferred tax asset and corresponding establishment of a long-term receivable. During fiscal 2018, the balance of the receivable was increased $0.2 million due to an IRS adjustment and
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related payment of additional AMT associated with a recently completed IRS exam and $0.5 million of the receivable was reclassed to a current asset reflecting the portion expected to be received within 12 months.
We account for income taxes in accordance with accounting standards for such taxes, which require that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the financial reporting and tax bases of recorded assets and liabilities. Accounting standards also require that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion of or all of the deferred tax assets will not be realized.
Management assesses the available positive and negative evidence to estimate if sufficient future taxable income will be generated to use the existing deferred tax assets. In performing the assessment for 2018, a significant piece of negative evidence evaluated was the cumulative loss incurred over the three-year period ended February 2, 2019. The loss was evaluated as book loss adjusted for non-deductible and non-recurring items such as goodwill impairment, sale of property, store closing costs, franchise income/expense and software expenses. Such objective evidence limits the ability to consider other subjective evidence such as our projections for future growth.
On the basis of this analysis and significant negative objective evidence, management has determined the full valuation allowance is still necessary for the year ended February 2, 2019. The valuation allowance increased by $12.6 million for the current year which was offset by the increase in net DTAs mainly for the increase in operating loss carryover. As of February 2, 2019, a valuation allowance of $105.0 million is recorded for the full amount of the net deferred tax assets. Changes in the valuation allowance are recorded as a non-cash charge to income tax expense. A valuation allowance release resulted in a tax benefit of $0.8 million in the year ended February 3, 2018 due to the elimination of the AMT DTA and corresponding establishment of a long term receivable. We will continue to evaluate our valuation allowance in future years for any change in circumstances that causes a change in judgment about the realizability of the deferred tax assets.
At the end of 2018 and 2017, we had federal net operating loss carryforwards (“NOL”) of $281.1 million and $210.7 million, respectively, which will expire between 2036 and 2038 though the 2018 NOL has an indefinite life. At the end of 2018 and 2017, we had state NOL carryforwards of $16.6 million and $13.1 million, respectively, which will expire between 2019 and 2039 though some of the 2018 state NOLs have an indefinite life. We have credit carryforwards of $3.3 million which will expire between 2023 and 2039.
We file federal, state and city income tax returns in the United States and foreign tax returns in Puerto Rico. SHO was also a part of the Sears Holdings combined state returns for the years ended February 2, 2013 and February 1, 2014. The Company has completed its federal audit for the tax return ended January 30, 2016 and all matters have been resolved. Currently, the Company is under audit for two separate state returns for fiscal years 2013 through 2016.
NOTE 7—RELATED-PARTY AGREEMENTS AND TRANSACTIONS
According to publicly available information, ESL Investments, Inc. and its investment affiliates including Edward S. Lampert (together, "ESL") beneficially own 58.8% of our outstanding shares of common stock and control Transform Holdco and its subsidiaries.
The Operative Agreements, among other things, (1) govern specified aspects of our relationship with Transform Holdco (as assignee of the Operative Agreements), (2) establish terms under which subsidiaries of Transform Holdco are providing services to us, and (3) establish terms pursuant to which subsidiaries of Transform Holdco are obtaining merchandise inventories for us. The terms of the Operative Agreements were agreed to prior to the 2012 Separation (except for amendments entered into after the 2012 Separation that were approved by the Audit Committee of SHO's Board of Directors) in the context of a parent-subsidiary relationship and in the overall context of the 2012 Separation. The costs and allocations charged to the Company by Sears Holdings do not necessarily reflect the costs of obtaining the services from unaffiliated third parties or of the Company itself providing the applicable services. The Company has engaged in frequent discussions, and has resolved disputes, with Sears Holdings about the terms and conditions of the Operative Agreements, the business relationships that are reflected in the Operative Agreements, and the details of these business relationships, many of which details had not been addressed by the terms and conditions of the Operative Agreements or, if addressed, in the past were, and in the future could be, in dispute as to their meaning or application in the context of the existing business relationships. Many of these discussions have resulted in adjustments to the relationships that the Company believes together are in the Company's best interests. On May 11, 2016, SHO and Sears Holdings entered into amendments to most of the Operative Agreements.
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The following is a summary of the nature of the principle related-party transactions between SHO and Transform Holdco (as assignee of the Operative Agreements):
| • | We are party to an agreement with Transform Holdco (as assignee from Sears Holdings) pursuant to which Sears Holdings consummated the 2012 Separation. The agreement, among other things, provided for as part of the 2012 Separation the allocation and transfer, through a series of intercompany transactions, of the assets and the liabilities comprising the Sears Hometown and Hardware and Sears Outlet businesses of Sears Holdings. In the agreement SHO and Transform Holdco agree to release each other from all pre-2012 Separation claims (other than with respect to the agreements executed in connection with the 2012 Separation) and each agrees to defend and indemnify the other with respect to its post-2012 Separation business. |
| • | We obtain a significant amount of our merchandise inventories from Transform Holdco. This enables us to take advantage of the amount and scope of Transform Holdco's purchasing activities. The Operative Agreements include an Amended and Restated Merchandising Agreement with subsidiaries of Transform Holdco (the "Merchandising Agreement") pursuant to which they (1) sell to us, with respect to certain specified product categories, Sears-branded products including KCD Products and vendor-branded products obtained from Transform Holdco's vendors and suppliers and (2) grant us licenses to use the trademarks owned by subsidiaries of Transform Holdco, or the "Sears marks," including the KCD Marks in connection with the marketing and sale of products sold under the Sears marks. The initial term of the Merchandising Agreement will expire on February 1, 2023, subject to one three-year renewal term with respect to the KCD Products. We pay, on a weekly basis, a royalty determined by multiplying our net sales of the KCD Products by specified fixed royalties rates for each brand’s licensed products, subject to adjustments based on the extent to which we feature Kenmore brand products in certain of our advertising and the extent to which we pay specified minimum commissions to our franchisees and Hometown Store owners. The Operative Agreements also provide for related logistics, handling, warehouse and transportation services, the charges for which are based generally on merchandise inventory units. We also pay fees for participation in Transform Holdco's Shop Your Way program. |
| • | We obtain our merchandise from Transform Holdco and other vendors. Products which we acquired from Transform Holdco, including KCD Products and other products, accounted for approximately 60% and 78% of our total purchases of inventory from all vendors for 2018 and 2017, respectively. The loss of or a reduction in the amount of merchandise made available to us by Transform Holdco could have a material adverse effect on our business and results of operations. |
| • | Transform Holdco (as assignee from Sears Holdings) provides the Company with specified corporate services pursuant to the Operative Agreements. These services include tax, accounting, procurement, risk management and insurance, advertising and marketing, loss prevention, environmental, product and human safety, facilities, logistics and distribution, information technology (including the point-of-sale system used by the Company and our dealers and franchisees), online, payment clearing, and other financial, real estate management, merchandise-related and other support services. Transform Holdco charges the Company for these corporate services generally based on actual usage, a pro rata charge based upon sales, head count, or square footage, or a fixed fee or commission as agreed between the parties. |
| • | Transform Holdco (as assignee from Sears Holdings) has licensed the Company until October 11, 2029, on a royalty-free basis, to use under specified conditions (1) the name "Sears" in our corporate name and to promote our businesses and (2) the www.SearsOutlet.com (our license to use "SearsOutlet.com" on a web platform not operated by Transform Holdco will expire on February 1, 2023), www.searshomeapplianceshowroom.com, www.searshometownstores.com, and www.searshardwarestores.com domain names to promote our businesses. Also, Transform Holdco has licensed the Company until October 11, 2029, on an exclusive, royalty-free basis, under specified conditions to use for the purpose of operating our stores the names "Sears Appliance & Hardware," "Sears Authorized Hometown Stores," "Sears Hometown Store," "Sears Home Appliance Showroom," "Sears Hardware," and "Sears Outlet Store." |
| • | Transform Holdco (as assignee from Sears Holdings) has assigned to us leases for, or has subleased to us, many of the stores that we operate or that we have, in turn, subleased to franchisees. Generally, the terms of the subleases match the terms, including the payment of rent and expiration date, of the existing leases between Transform Holdco (or one of its subsidiaries) and the landlord. In addition, a small number of our stores are in locations where Transform Holdco currently operates one of its stores or a distribution facility. In such cases we have entered into a lease or sublease with Transform Holdco (or one of its subsidiaries) for the portion of the space in which our store will operate, and we pay rent directly to Transform Holdco on the terms negotiated in connection with the 2012 Separation. We also lease from Transform Holdco office space for our corporate headquarters. |
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| • | SHO receives commissions from Transform Holdco for specified sales of merchandise made through www.sears.com and www.SearsOutlet.com, the sale of extended-service plans, delivery and handling services and relating to the use in our stores of credit cards branded with the Sears name. For certain transactions SHO pays a commission to Transform Holdco. |
The Operative Agreements may be terminated by either party upon a material breach if the breaching party fails to cure such breach within 30 days following written notice of such breach or, if such breach is not curable, immediately upon delivery of notice of the non-breaching party’s intention to terminate.
The following table summarizes the transactions with Sears Holdings included in the Company’s Consolidated Financial Statements:
| Fiscal Year Ended | ||||||||
| thousands | February 2, 2019 | February 3, 2018 | ||||||
| Net Commissions from Sears Holdings | $ | 50,964 | $ | 66,557 | ||||
| Purchases related to cost of sales and occupancy | 689,599 | 958,560 | ||||||
| Services included in selling and administrative | 40,027 | 60,822 | ||||||
We incur payables to Transform Holdco (and incurred payables to Sears Holdings prior to mid-February 2019) for merchandise inventory purchases and service and occupancy charges (net of commissions) based on the Operative Agreements. Amounts due to or from Transform Holdco are non-interest bearing and, except as provided in the following sentences of this paragraph, are settled on a net basis and have payment terms of 10 days after the invoice date. In accordance with the Operative Agreements and at the request of Transform Holdco, the Company can pay invoices on two or three-day terms and receive a deduction on invoices for early–payment discounts of 43 basis points or 37 basis points, respectively. The Company can, in its sole discretion, revert to ten–day, no–discount payment terms at any time upon notice to Transform Holdco. The discount received for payments made on accelerated terms, net of incremental interest expense, results in a net financial benefit to the Company. The Company paid invoices on either two or three–day terms and received discounts of $2.1 million and $4.2 million in 2018 and 2017, respectively, which are reflected in the consolidated statements of operations.
We paid Seritage Growth Properties $0.6 million and $1.1 million in 2018 and 2017, respectively, for occupancy charges for properties we lease from Seritage. Edward S. Lampert is the Chairman of the Board of Trustees of Seritage.
NOTE 8—FINANCING ARRANGEMENTS
In October 2012 the Company entered into a Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent, which provided (subject to availability under a borrowing base) for aggregate maximum borrowings of $250 million (the "Prior Facility"). Under the Prior Facility the Company initially borrowed $100 million which was used to pay a cash dividend to Sears Holdings prior to the 2012 Separation.
On November 1, 2016, the Company and its primary operating subsidiaries, entered into 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 $250 million (the "Senior ABL Facility"). The Senior ABL Facility, which amended and restated the Prior Facility in its entirety, provides for extended revolving credit commitments of specified lenders in an aggregate amount equal to $170 million (the “Extended Revolving Credit Commitments”) and non-extended revolving credit commitments of specified lenders in an aggregate amount equal to $80 million (the “Non-Extended Revolving Credit Commitments”). The Extended Revolving Credit Commitments will mature on the earlier of (1) February 29, 2020 and (2) six months prior to the expiration of the Operative Agreements entered into with Transform Holdco as assignee and its subsidiaries in connection with the 2012 Separation (the “Subject Agreements”) unless they are extended to a date later than February 29, 2020 or terminated on a basis reasonably satisfactory to the administrative agent under the Senior ABL Facility. The Non-Extended Revolving Credit Commitments were not extended by the Non-Extending Lenders in accordance with the Senior ABL Facility and matured on October 11, 2017. Unamortized debt costs related to the Senior ABL Facility of $1.3 million and $3.5 million are included in Prepaid and Other current assets on the Consolidated Balance Sheets as of February 2, 2019 and February 3, 2018, respectively, and are being amortized over the remaining term of the Senior ABL Facility.
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As of February 2, 2019 we had $93.0 million outstanding under the Senior ABL Facility, which approximated the fair value of these borrowings. 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 February 2, 2019 was $27.7 million, with $7.2 million of letters of credit outstanding under the facility.
The principal terms of the Senior ABL Facility are summarized below.
Prepayments
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.
Security and Guarantees
The Senior ABL Facility is secured by a first lien security interest on substantially all the assets of the Company and its subsidiaries, including, without limitation, accounts receivable, inventory, general intangibles, investment property, equipment, cash, cash equivalents, deposit accounts and securities accounts, as well as certain other assets (other than intellectual property and fee-owned interests in real property) ancillary to any of the foregoing and all proceeds of any of the foregoing, including cash proceeds and the proceeds of applicable insurance. The Senior ABL Facility is guaranteed by the Company and each of its existing and future direct and indirect wholly owned domestic subsidiaries (other than specified immaterial subsidiaries).
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 the Company’s election, either (1) an adjusted London inter-bank offered rate (LIBOR) plus a borrowing margin ranging from 3.50% to 4.50%, (the rate was approximately 6.50% at February 2, 2019), and in each case based on availability under the Senior ABL Facility, or (2) an alternate base rate plus a borrowing margin, ranging from 2.50% to 3.50% (the rate was approximately 8.5% at February 2, 2019), and in each case based on availability under the Senior ABL Facility.
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 negative covenants that, among other things, limit or restrict the ability of the Company and its subsidiaries (including the guarantors) to, subject to certain exceptions, incur additional indebtedness (including guarantees), grant liens, make investments, make prepayments on other indebtedness, and engage in mergers or change the nature of the business of the Company and its subsidiaries (including the guarantors). The Senior ABL Facility also imposes various other requirements, which take effect if availability falls below designated thresholds, including a cash dominion requirement with additional borrowing base reporting requirements in addition to a requirement that the fixed charge ratio at the last day of any quarter be not less than 1.0 to 1.0. The Senior ABL Facility also limits SHO’s ability to declare and pay cash dividends and to repurchase its common stock. The Senior ABL Facility would not have permitted us to pay cash dividends or to repurchase our common stock as of February 2, 2019. The Senior ABL Facility also contains affirmative covenants, including financial and other reporting requirements.
Events of Default
The Senior ABL Facility includes customary and other events of default including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties, cross default to other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of guarantees or security interests, material judgments, change of control, failure to perform a "Material Contract" (which includes the Merchandising Agreement and other Operative Agreements) to the extent required to maintain it in full force and effect, the failure to enforce a Material Contract in accordance with its terms, or Transform Holdco terminates the "Separation Agreements" (which include, among other Operative Agreements, the Merchandising Agreement and the Services Agreements).
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The Senior ABL Facility provides that the Company's inability to obtain from its independent registered public accounting firm a report and opinion that "shall not be subject to any 'going concern' or like qualification or exception" constitutes an event of default, which would give the Senior ABL Facility lenders the right to accelerate the maturity of all outstanding loans, among other actions. The Senior ABL Facility lenders have waived through October 31, 2019 any default resulting from the Going Concern Uncertainty.
Term Loan Agreement
On February 16, 2018 the Company’s three operating subsidiaries, Sears Authorized Hometown Stores, LLC, Sears Home Appliance Showrooms, LLC, and Sears Outlet Stores, LLC, as borrowers, and the Company, as guarantor, entered into a Term Loan Credit Agreement with Gordon Brothers Finance Company, as agent, lead arranger, and sole bookrunner, and Gordon Brothers Finance Company, LLC, as lender (the “Term Loan Agreement”). The Term Loan Agreement provides for a $40 million term loan (the “Term Loan”), which amount the Company has borrowed, and is outstanding, in accordance with and subject to the terms and conditions of the Term Loan Agreement. The Company used the proceeds of the Term Loan to pay down borrowings under 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.
Unamortized debt costs of $0.9 million related to the Term Loan are netted against the Term Loan on the Consolidated Balance Sheets as of February 2, 2019 and are being amortized over the remaining term of the Term Loan.
The principal terms of the Term Loan Agreement are summarized below.
Security and Guarantees
The Term Loan Agreement is secured by a second lien security interest (subordinate only to the liens securing the Senior ABL Facility) on substantially all the assets of the Company and its subsidiaries (the same assets as the assets securing the Senior ABL Facility), including without limitation accounts receivable, inventory, general intangibles, investment property, equipment, cash, cash equivalents, deposit accounts and securities accounts, as well as other assets (other than intellectual property and fee-owned interests in real property) ancillary to any of the foregoing and all proceeds of any of the foregoing, including cash proceeds and the proceeds of applicable insurance. The Term Loan Agreement is guaranteed by the Company and each of its existing and future direct and indirect wholly owned domestic subsidiaries (other than specified immaterial subsidiaries).
Prepayments
The Term Loan is subject to mandatory prepayment in amounts equal to the amount by which the outstanding Term Loan exceeds the borrowing base specified in the Term Loan Agreement plus a reserve to be maintained against the borrowing base for the Senior ABL Facility (the “push-down reserve”), which reserve will be equal to total outstandings under the Term Loan Agreement that exceed the Term Loan Agreement’s borrowing base, if such excess were to arise. If any additional reserves are imposed by the Senior ABL Facility agent against the borrowing base under the Senior ABL Facility or if, under certain circumstances, the agent under the Term Loan imposes reserves against the borrowing base under the Term Loan Agreement, the Company may be required to make additional prepayments under the Term Loan. The Company may not reborrow amounts prepaid.
Interest; Fees
The interest rate applicable to the Term Loan under the Term Loan Agreement is a fluctuating rate of interest (payable and adjusted monthly) equal to the greater of (1) three-month LIBOR (the rate was approximately 2.73% at February 2, 2019) plus 8.50% per annum and (2) a minimum interest rate of 9.50% per annum. Customary fees are payable in respect of the Term Loan Agreement, including a commitment fee and an early prepayment fee.
Covenants
The Term Loan Agreement includes a number of negative covenants that, among other things, limit or restrict the ability of the Company, the Borrowers, and the Company’s other subsidiaries to, subject to exceptions, incur additional indebtedness (including guarantees), grant liens, make investments, make dividends or other distributions with respect to, or repurchase, the Company’s capital stock, make prepayments on other indebtedness, engage in mergers, or change the nature of the business. In addition, upon excess availability falling below a specified level or the occurrence of an event of default the Company would be subject to a cash dominion requirement. The Term Loan Agreement also provides that the Borrowers will not permit availability under the Term Loan Agreement and the Senior ABL Facility to be less than 10% of a combined loan cap.
The Term Loan Agreement also contains affirmative covenants including, among others, financial and other reporting and notification requirements, maintenance of properties, inspection rights, and physical inventories. The Company and the Borrowers also agree that the Company and the Borrowers will cause the push-down reserve to be established and maintained when and if required by the Term Loan Agreement. The Term Loan Agreement borrowing base generally means specified amounts of credit card receivables and inventory (net of reserves), minus the loan cap for the Senior ABL Facility and availability reserves. The borrowing base under the Term Loan Agreement may be further reduced if the agent under the Senior ABL Facility or, under certain circumstances, the agent under the Term Loan elects in their respective applicable discretion to impose additional reserves against the borrowing base under the Senior ABL Facility or the Term Loan.
Events of Default
The Term Loan Agreement includes customary events of default including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties in any material respect, cross default to the Senior ABL Facility and other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of the Term Loan Agreement and the other related loan documents (including the guarantees or security interests provided therein and other Term Loan loan documents (including an agreement with the Company, Transform Holdco, and the agents under the Senior ABL Facility and the Term Loan Agreement)), material judgments, change of control, and failure to perform a “Material Contract” (which includes specified Operative Agreements) to the extent required to maintain it in full force and effect, failure to enforce a Material Contract in accordance with its terms, or termination (including as a result of rejection in an insolvency proceeding) by Transform Holdco of "the Separation Agreements” (which include specified Operative Agreements) and cessation of business activities in the ordinary course.
The Term Loan Agreement provides that the Company's inability to obtain from its independent registered public accounting firm a report and opinion that "shall not be subject to any 'going concern' or like qualification or exception" constitutes an event of default, which would give the Term Loan Agreement lenders the right to accelerate the maturity of all outstanding loans, among other actions. The Term Loan Agreement lenders have waived through October 31, 2019 any default resulting from the Going Concern Uncertainty.
NOTE 9—SUMMARY OF SEGMENT DATA
Our two reportable segments are Hometown and Outlet. The Hometown reportable segment consists of the aggregation of our Hometown Stores, Hardware Stores, Home Appliance Showrooms and Buddy's Home Furnishings Stores business formats. The Outlet business format also represents a reportable segment. These segments are evaluated by our Chief Operating Decision Maker to make decisions about resource allocation and to assess performance. Each of these segments derives its revenues from the sale of merchandise and related services to customers, primarily in the U.S. Sales categories include appliances, lawn and garden, tools and other.
Selling and administrative expense includes losses on franchisee notes receivables and IT transformation costs of $17.7 million and $22.6 million for Hometown in 2018 and 2017, respectively, and $10.8 million and $19.1 million for Outlet in 2018 and 2017, respectively. Costs associated with accelerated store closings totaling $13.4 million in 2018 ($13.7 million in Hometown; $(0.3) million in Outlet) and $14.8 million in 2017 ($7.0 million in Hometown; $7.8 million in Outlet), were included in Cost of sales and occupancy and Selling and administrative expense.
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| 2018 | ||||||||||||
| thousands | Hometown | Outlet | Total | |||||||||
| Net sales | ||||||||||||
| Appliances | $ | 659,401 | $ | 406,233 | $ | 1,065,634 | ||||||
| Lawn and garden | 169,012 | 16,846 | 185,858 | |||||||||
| Tools and paint | 79,313 | 12,989 | 92,302 | |||||||||
| Other | 50,792 | 55,362 | 106,154 | |||||||||
| Total | 958,518 | 491,430 | 1,449,948 | |||||||||
| Costs and expenses | ||||||||||||
| Cost of sales and occupancy | 768,624 | 358,128 | 1,126,752 | |||||||||
| Selling and administrative | 240,955 | 108,127 | 349,082 | |||||||||
| Impairment of property and equipment | 1,007 | 1,082 | 2,089 | |||||||||
| Depreciation and amortization | 6,263 | 6,111 | 12,374 | |||||||||
| Gain on sale of assets | — | (1,358 | ) | (1,358 | ) | |||||||
| Total | 1,016,849 | 472,090 | 1,488,939 | |||||||||
| Operating (loss) income | $ | (58,331 | ) | $ | 19,340 | $ | (38,991 | ) | ||||
| Total assets | $ | 225,919 | $ | 117,852 | $ | 343,771 | ||||||
| Capital expenditures | $ | 4,812 | $ | 1,626 | $ | 6,438 | ||||||
| 2017 | ||||||||||||
| thousands | Hometown | Outlet | Total | |||||||||
| Net sales | ||||||||||||
| Appliances | $ | 805,490 | $ | 446,118 | $ | 1,251,608 | ||||||
| Lawn and garden | 204,371 | 19,024 | 223,395 | |||||||||
| Tools and paint | 103,706 | 14,289 | 117,995 | |||||||||
| Other | 63,655 | 63,298 | 126,953 | |||||||||
| Total | 1,177,222 | 542,729 | 1,719,951 | |||||||||
| Costs and expenses | ||||||||||||
| Cost of sales and occupancy | 931,078 | 440,330 | 1,371,408 | |||||||||
| Selling and administrative | 283,294 | 136,273 | 419,567 | |||||||||
| Impairment of property and equipment | 2,581 | 776 | 3,357 | |||||||||
| Depreciation and amortization | 5,378 | 7,661 | 13,039 | |||||||||
| Total | 1,222,331 | 585,040 | 1,807,371 | |||||||||
| Operating loss | $ | (45,109 | ) | $ | (42,311 | ) | $ | (87,420 | ) | |||
| Total assets | $ | 281,805 | $ | 130,883 | $ | 412,688 | ||||||
| Capital expenditures | $ | 4,156 | $ | 5,072 | $ | 9,228 | ||||||
NOTE 10—COMMITMENTS AND CONTINGENCIES
We are subject to various legal and governmental proceedings arising out of the ordinary course of business, the outcome of which, individually and in the aggregate, in the opinion of management, would not have a material adverse effect on our business, financial position, or results of operations, or cash flows.
NOTE 11—LOSS PER COMMON SHARE
Basic loss per common share is calculated by dividing net loss by the weighted average number of common shares outstanding for each period. Diluted income per common share also includes the dilutive effect of potential common shares. In periods where the Company records a net loss, the diluted per share amount is equal to the basic per share amount.
The following table sets forth the components used to calculate basic and diluted loss per common share attributable to our stockholders.
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| Fiscal Year Ended | |||||||
| thousands except income per common share | February 2, 2019 | February 3, 2018 | |||||
| Basic weighted average shares | 22,702 | 22,702 | |||||
| Dilutive effect of restricted stock | — | — | |||||
| Diluted weighted average shares | 22,702 | 22,702 | |||||
| Net loss | $ | (53,464 | ) | $ | (95,057 | ) | |
| Loss per common share: | |||||||
| Basic | $ | (2.36 | ) | $ | (4.19 | ) | |
| Diluted | $ | (2.36 | ) | $ | (4.19 | ) | |
For 2017, unvested shares of restricted stock of 14,000 were excluded from diluted earnings per share through the date of forfeiture. There were no unvested shares of restricted stock that were excluded from diluted earnings per share in 2018.
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NOTE 12 — EQUITY
Stock-based Compensation
Under our stock-based employee compensation plan, referred to as the Company's Amended and Restated 2012 Stock Plan (the "Plan"), there are four million shares of stock reserved for issuance pursuant to the Plan. We are authorized to grant stock options and to make other awards (in addition to restricted stock and stock units) pursuant to the Plan. The Company has made no stock-option awards under the Plan.
A total of 14,000 shares of restricted stock were granted under the Plan to an eligible individual in the second quarter of 2015 and were forfeited in the first quarter of 2017.
During 2015 the Company granted a total of 159,475 stock units under the Plan, which were payable solely in cash based on the Nasdaq stock price on the vesting date. As of February 2, 2019, 34,091 of these stock units had been forfeited and the remaining 125,384 stock units vested in accordance with, and subject to the terms and conditions of, governing stock-unit agreements and the Plan.
During 2017 the Company granted a total of 262,788 stock units under the Plan, which were payable solely in cash based on the Nasdaq stock price on the vesting dates. As of February 2, 2019, 46,834 of these stock units had been forfeited and 149,748 had vested. The remaining 66,206 stock units will vest, if at all, on January 30, 2020 in accordance with and subject to the terms and conditions of governing stock unit agreements, including forfeiture conditions, and the Plan. The fair value of these awards vary based on changes in our Nasdaq stock price at the end of each reporting period.
On January 18, 2018 the Company granted a total of 361,393 stock units under the Plan, which were payable solely in cash based on the Nasdaq stock price on the vesting dates. As of February 2, 2019, 22,514 of these stock units had been forfeited and 116,224 had vested. The remaining 222,655 stock units will vest, if at all, in two substantially equal installments on January 30 in 2020 and 2021 in accordance with and subject to the terms and conditions of governing stock unit agreements, including forfeiture conditions, and the Plan. The fair value of these awards vary based on changes in our Nasdaq stock price at the end of each reporting period.
The shares of restricted stock referred to above in this Note 12 constituted outstanding shares of the Company's common stock. The recipients of the restricted stock grants had full voting and dividend rights with respect to, but were unable to transfer or pledge, their shares of restricted stock prior to the applicable vesting dates. The stock units referred to above in this Note 12, which were, and are, payable solely in cash based on the Nasdaq closing price of our common stock at the applicable vesting dates, do not constitute outstanding shares of the Company's common stock. The recipients of the stock unit grants have, with respect to their stock units, no rights to receive the Company's common stock or other securities of the Company, no rights as a stockholder of the Company, no dividend rights, and no voting rights.
We are authorized to grant stock options and to make other awards (in addition to restricted stock and stock units) to eligible participants pursuant to the Plan. The Company has made no stock-option awards under the Plan. We do not currently have a broad-based program that provides for awards under the Plan on an annual basis.
We account for stock-based compensation using the fair value method in accordance with accounting standards regarding share-based payment transactions. During 2018 no stock-based compensation expense was recorded and during 2017 we reversed $0.1 million in total stock-based compensation expense related to the forfeiture of unvested restricted stock.
During 2018 and 2017, we recorded $0.7 million and $0.3 million, respectively, in compensation cost related to the then outstanding stock units, which are included in Selling and administrative expenses in the consolidated statements of operations and Other current liabilities in the consolidated balance sheets. At February 2, 2019, we had $0.3 million in total estimated unrecognized compensation cost related to the remaining non-vested stock units, which cost we expect to recognize over the next approximately 2.0 years.
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Share Repurchase Program
On August 28, 2013 the Company's Board of Directors authorized a $25 million repurchase program for the Company's outstanding shares of common stock. The timing and amount of repurchases depend on various factors, including market conditions, the Company's capital position and internal cash generation, and other factors. The Company's repurchase program does not include specific price targets, may be executed through open-market, privately negotiated, and other transactions that may be available, and may include utilization of Rule 10b5-1 plans. The repurchase program does not obligate the Company to repurchase any dollar amount, or any number of shares, of common stock. The repurchase program does not have a termination date, and the Company may suspend or terminate the repurchase program at any time. Shares that are repurchased by the Company pursuant to the repurchase program would be retired and would resume the status of authorized and unissued shares of common stock.
At February 2, 2019, we had $12.5 million of remaining authorization under the repurchase program. The Company has not repurchased any shares under the repurchase plan program since late 2013. The Senior ABL Facility and Term Loan Agreement each limits the Company's ability to declare and pay cash dividends and to repurchase its common stock and each would not have permitted the Company to pay cash dividends or to repurchase its common stock as of February 2, 2019.
NOTE 13—DEFINED CONTRIBUTION PLAN
We sponsor a Sears Hometown and Outlet Stores, Inc. 401(k) savings plan for employees meeting service-eligibility requirements. The Company offers a discretionary matching contribution. The expense related to the savings plan has been determined in accordance with U.S. GAAP and the Company accrues the cost of these benefits as incurred during employees' tenure of employment.
Expenses for the retirement savings plan were as follows:
| thousands | 2018 | 2017 | ||||||
| 401(k) Savings Plan | $ | 1,258 | $ | 1,056 | ||||
NOTE 14—SALE OF ASSETS
On August 10, 2018, we completed the sale of a property in Newington, Connecticut. The sale price of the property was $2.8 million net of closing costs, and we recorded a gain on the sale of approximately $1.4 million when the sale was completed in accordance with the terms and conditions of the Purchase and Sale Agreement. We did not sell any owned property in fiscal 2017.
NOTE 15—STORE CLOSING CHARGES
Accelerated Closed Store Charges
In accordance with accounting standards governing costs associated with exit or disposal activities, expenses related to future rent payments for which we no longer expect to receive any economic benefit are accrued as of when we ceased to use the leased space and have been reduced for estimated sublease income. Accelerated store closure costs were as follows:
| Thousands | Lease Termination Costs (1) | Inventory Related (1) | Accelerated Depreciation (2) | Other Charges (3) | Total Store Closing Costs | ||||||||||||||
| Fiscal year ended February 2, 2019 | $ | 237 | $ | 11,730 | $ | 1,431 | $ | 1,425 | $ | 14,823 | |||||||||
| Thousands | Lease Termination Costs (1) | Inventory Related (1) | Accelerated Depreciation (2) | Other Charges (3) | Total Store Closing Costs | ||||||||||||||
| Fiscal year ended February 3, 2018 | $ | 9,665 | $ | 4,527 | $ | 979 | $ | 224 | $ | 15,395 | |||||||||
| (1) | Recorded within cost of sales and occupancy in the Condensed Consolidated Statements of Operations. Lease termination costs are net of estimated sublease income, and include the reversal of closed store reserves when a lease agreement is terminated for an amount less than the remaining reserve established for the store. |
| (2) | Recorded within depreciation and amortization in the Condensed Consolidated Statements of Operations. |
| (3) | Recorded within selling and administrative in the Condensed Consolidated Statements of Operations. |
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Closed Store Reserves
Store closing reserves of $2.6 million and $4.7 million are included within other current liabilities in the Consolidated Balance Sheets at February 2, 2019 and February 3, 2018, respectively. Changes in the store closing reserves are as follows:
| 52 and 53 Weeks Ended | ||||||||
| Thousands | February 2, 2019 | February 3, 2018 | ||||||
| Store closing and severance costs reserve, beginning of period | $ | 4,655 | $ | 7,659 | ||||
| Store closing costs | 13,392 | 14,416 | ||||||
| Payments/utilization | (15,414 | ) | (17,420 | ) | ||||
| Store closing and severance costs reserve, end of period | $ | 2,633 | $ | 4,655 | ||||
NOTE 16—SUBSEQUENT EVENTS
On March 25, 2019 the Company completed the sale of a property classified as held for sale included in Property and Equipment, Net in the Condensed Consolidated Balance Sheet as of February 2, 2019. The sale price of the property was $0.9 million net of closing costs, and the carrying value of the asset was $0.9 million as of February 2, 2019.
The Company expects 40 to 45 Hometown stores will close or initiate closure in the first quarter of 2019 as a result of decisions by dealers and franchisees and the Company's decision to close a limited number of Company-operated stores. Based on the Company's prior experience, this likely will result in reduced costs, more productive use of capital, and improved profitability for the Company. The closures, if they occur as anticipated, are expected to result in total one-time charges of between $5.0 million and $6.0 million during the first quarter of 2019 for inventory markdowns and write-offs and other store-closing costs.
On May 3, 2019 the Company entered into (i) a First Amendment to Amended and Restated Credit Agreement (the “ABL Amendment”), among Sears Authorized Hometown Stores, LLC, as the Lead Borrower, Sears Home Appliance Showrooms, LLC and Sears Outlet Stores, L.L.C., as borrowers (collectively, the “Borrowers”), the Company, as parent, Bank of America, N.A., as administrative agent and collateral agent (in such capacities, the “ABL Agent”), and the ABL lenders party thereto, amending the Amended and Restated Credit Agreement dated as of November 1, 2016 among the Borrowers, the Company, the ABL Agent and the ABL lenders party thereto from time to time (the “ABL Credit Agreement”), and (ii) the First Amendment to Term Loan Credit Agreement (the “Term Loan Amendment”), among the Borrowers, the Company, as parent, Gordon Brothers Finance Company, as administrative agent and collateral agent (the "Term Agent"), and the Term lenders party thereto, amending the Term Loan Credit Agreement dated as of February 16, 2018 among the Borrowers, the Company, the Term Agent and the Term Lenders party thereto (the “Term Loan Agreement”).
The ABL Amendment and the Term Loan Amendment generally provide for the following, among other things: (1) the definition of “Change of Control” is amended to provide that a Change of Control occurs if the Permitted Holders (as defined in the ABL Credit Agreement and the Term Loan Agreement) beneficially own more than 75.0% of the Company’s common stock; (2) under specified conditions cash in excess of $2.0 million must be applied to pay amounts outstanding under the ABL Credit Agreement and the Term Loan Agreement under specified circumstances; (3) the ABL lenders and the Term lenders waive until October 31, 2019 any default arising as a result of the Going Concern Uncertainty; and (4) the ABL lenders and the Term lenders consent on a limited basis to the Loan Parties (as defined in the ABL Credit Agreement and the Term Loan Agreement) negotiating and entering into specified acquisitions with Permitted Holders upon compliance with specified conditions, including a requirement that the acquisition agreement must contain a condition precedent to the closing of the acquisition requiring payment in full in cash of all outstanding loans under the ABL Credit Agreement and the Term Loan Agreement. The Term Loan Amendment changes the "February 16, 2023" reference in the definition of "Maturity Date" to February 29, 2020.
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Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Sears Hometown and Outlet Stores, Inc.
Hoffman Estates, Illinois
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Sears Hometown and Outlet Stores, Inc.(the “Company”) as of February 2, 2019 and February 3, 2018, the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the two years in the period ended February 2, 2019 and February 3, 2018, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at February 2, 2019 and February 3, 2018, and the results of its operations and its cash flows for each of the two years in the periods ended February 2, 2019 and February 3, 2018, in conformity with accounting principles generally accepted in the United States of America.
Going Concern Uncertainty
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has recurring operating losses and uncertainty in its financial performance and cash flows, and is dependent upon obtaining additional capital or refinancing its debt agreements to fund operations which raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/BDO USA, LLP
We have served as the Company's auditor since 2012.
Chicago, Illinois
May 3, 2019
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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Exchange Act. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Annual Report on Form 10-K.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the Company's fourth fiscal quarter ended February 2, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management's Report on Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Exchange Act. The Company’s internal control system was designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the reliability of financial reporting and the preparation and fair presentation of published financial statements.
All control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can only provide reasonable assurance with respect to the reliability of financial reporting and financial statement preparation and presentation.
Management assessed the effectiveness of the Company's internal control over financial reporting as of February 2, 2019, with the participation of our principal executive and principal financial officers. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework (2013). Based on management's assessment, management believes that as of February 2, 2019, the Company’s internal controls over financial reporting were effective based on those criteria.
In accordance with the rules of the Securities and Exchange Commission this Annual Report on Form 10-K is not required to, and does not, include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting.
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Part III
Item 10. Directors, Executive Officers and Corporate Governance.
Information required by this Item 10 with respect to directors, the Audit Committee, audit committee financial experts, and executive officers is included under the headings "Item 1. Election of Directors," "--Corporate Governance-Director Independence," "--Audit Committee Financial Experts," and "--Executive Officers," respectively, of the 2019 Proxy Statement and is incorporated herein by reference. Information required by this Item 10 with respect to Section 16(a) beneficial ownership reporting compliance is included under the heading "Other Information--Section 16(a) Beneficial Ownership Reporting Compliance" of the 2019 Proxy Statement and is incorporated herein by reference.
SHO has adopted a Code of Conduct, which applies to all employees, including our principal executive officer and our principal financial officer and principal accounting officer, and a Code of Conduct for our Board of Directors. Directors who are also officers of SHO are subject to both codes of conduct. Each code of conduct is a code of ethics as defined in Item 406 of SEC Regulation S-K. The codes of conduct are available on the Governance section of our website, www.shos.com. Any amendment to, or waiver from, a provision of either code of conduct will be posted to the above-referenced website.
During the Company's 2018 fiscal year there were no changes to the process by which stockholders may recommend nominees to the Board of Directors.
Item 11. Executive Compensation
Information regarding executive and director compensation is incorporated herein by reference to information under the headings "Item 1-Election of Directors-Executive Compensation," and "Item 1-Election of Directors-Compensation of Directors" of the 2019 Proxy Statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information regarding security ownership of specified beneficial owners and management is incorporated herein by reference to the material under the heading "Item 1. Election of Directors-Amount and Nature of Beneficial Ownership" of the 2019 Proxy Statement.
Equity Compensation Plan Information
The below table reflects information, as of February 2, 2019, about securities authorized for issuance under our equity compensation plans.
| Plan Category | (a) Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights (1) | (b) Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights (1) | (c) Number of Securities Remaining Available for Future Issuances Under Equity Compensation Plans (Excluding Securities Reflected in Column (a)) | |||||
| Equity Compensation Plans Approved by Security Holders | — | — | 3,674,609 | (2) | ||||
| Equity Compensation Plans Not Approved by Security Holders | — | — | — | |||||
| Total | — | — | 3,674,609 | (2) | ||||
(1) We have not issued any options, warrants, or other rights under the Sears Hometown and Outlet Stores, Inc. Amended and Restated 2012 Stock Plan that are exercisable for the purchase of shares of our common stock.
(2) A total of 4,000,000 shares of stock are reserved for issuance under the Company's Amended and Restated 2012 Stock Plan, consisting of restricted stock, stock units representing rights to receive cash or shares of our common stock, stock options, and stock appreciation rights. As of February 2, 2019, a total of 288,861 stock units were outstanding.
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Item 13. Certain Relationships and Related Transactions, and Director Independence
Information regarding certain relationships and related transactions with Transform Holdco, director independence, and independence of members of the Audit Committee of the Company's Board of Directors is incorporated herein by reference to information under the headings "Relationships and Transactions with Related Persons" and "Corporate Governance" of the 2019 Proxy Statement.
Item 14. Principal Accountant Fees and Services
Information regarding principal accountant fees and services is incorporated herein by reference to the material under the heading "Item 4. Ratification of Appointment of Independent Registered Public Accounting Firm—Independent Registered Public Accounting Firm Fees" of the 2019 Proxy Statement.
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Part IV
Item 15. Exhibits, Financial Statement Schedules.
Documents filed as part of this report:
| (1) | Financial Statements |
Financial Statements filed in Part II, Item 8 of this Annual Report on Form 10-K.
(2) Schedules to Financial Statements:
All financial statement schedules have been omitted because they are either inapplicable or the information required is provided in the Company's Consolidated Financial Statements and Notes thereto or included in Part II, Item 9 of this Annual Report on Form 10-K.
(3) List of Exhibits
Incorporated herein by reference is a list of the Exhibits contained in the Exhibit Index.
Item 16. Form 10-K Summary
Not Applicable
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| Sears Hometown and Outlet Stores, Inc. | ||
| By: | /S/ E. J. BIRD | |
| Name: | E. J. Bird | |
| Title: | Senior Vice President and Chief Financial Officer | |
| Date: | May 3, 2019 | |
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities stated and on the dates indicated.
* Will Powell Will Powell | Director, Chief Executive Officer and President (principal executive officer) | May 3, 2019 | ||||
* E.J. Bird E.J. Bird | Director, Senior Vice President and Chief Financial Officer (principal financial officer and principal accounting officer) | May 3, 2019 | ||||
* Alberto Franco Alberto Franco | Director | May 3, 2019 | ||||
* James F. Gooch James F. Gooch | Director | May 3, 2019 | ||||
* John E. Tober John E. Tober | Director | May 3, 2019 | ||||
* Josephine Linden Josephine Linden | Director | May 3, 2019 | ||||
* Kevin Longino Kevin Longino | Director | May 3, 2019 | ||||
* CHARLES J. HANSEN By Charles J. Hansen, Attorney in Fact | May 3, 2019 | |||||
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Exhibit Number | Document Description | |
| 3.1 | ||
| 3.2 | ||
| 3.3 | ||
| 4.1 | ||
| 10.1 | ||
| 10.2 | ||
| 10.3 | ||
| 10.4 | ||
| 10.5 | ||
| 10.6 | ||
| 10.7 | ||
| 10.8 | ||
| 10.9 | ||
| 10.10(1) | ||
| 10.11(1) | ||
| 10.12 | ||
| 10.13 | ||
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| 10.14 | ||
| 10.15(1) | ||
| 10.16 | ||
| 10.17 | ||
| 10.18 | ||
| 10.19 | ||
| 10.20(1) | ||
| 10.21 | ||
| 10.22 | ||
| 10.23 | ||
| 10.24 | ||
| 10.25(1) | ||
| 10.26 | ||
| 10.27(1) | ||
| 10.28 | ||
| 10.29 | ||
| 10.30 | ||
| 10.31(2) | ||
| 10.32(2) | ||
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| 10.33(2) | ||
| 10.34(2) | ||
| 10.35(2) | ||
| 10.36(2) | ||
| 10.37(2) | ||
| 10.38(2) | ||
| 10.39(2) | ||
| 10.40(2) | ||
| 10.41(2) | ||
| 10.42(2) | ||
| 10.43(2) | ||
| 10.44(2) | ||
| 10.45(2) | ||
| 10.46(2) | ||
| 10.47(2) | ||
| 10.48(2) | ||
| 10.49(2) | ||
| 10.50 | ||
| 10.51 | ||
| 10.52 | ||
| 10.53 | ||
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| 10.54(3) | ||
| 21(3) | ||
| 23(3) | ||
| 24(3) | ||
| 31.1(3) | ||
| 31.2(3) | ||
| 32.1(3) | ||
| 101(4) | ||
| (1) | The Securities and Exchange Commission granted the registrant's request for confidential treatment for the omitted portions of this Exhibit. The registrant has separately filed the omitted portions with the Securities and Exchange Commission. |
| (2) | A management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K pursuant to Item 15(b) of Form 10-K. |
| (3) | Filed herewith. |
| (4) | Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections. |
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