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 3, 2018
, the Company or its independent dealers and franchisees ("our dealers and franchisees") operated a total of
900
stores across all 50 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 "Separation") from Sears Holdings Corporation ("Sears Holdings").
We operate through two segments—the Sears Hometown and Hardware 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 8 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
As of
February 3, 2018
, the Company or our dealers and franchisees operated a total of
768
Sears Hometown and Hardware stores located across all 50 states, Puerto Rico, and Bermuda.
Our Hometown segment operates through three distinct formats: Sears Hometown Stores ("Hometown Stores"), Sears Hardware Stores ("Hardware Stores"), and Sears Home Appliance Showrooms ("Home Appliance Showrooms"). Each format has its owns website.
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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 3, 2018
, there were
713
Hometown Stores in all 50 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 706, and we operated
seven
, 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 24,000 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 3, 2018
, there were
19
Hardware Stores in 10 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
nine
, and we operated
ten
, of these stores.
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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 3, 2018
, there were
36
Home Appliance Showrooms in 12 states. Home Appliance Showrooms also sell products and services through our website www.searshomeapplianceshowroom.com. Franchisees operated
23
of these stores, and we operated
13
stores.
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In
2017
revenue from our Hometown segment was
$1,177.2 million
.
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
2017
Outlet’s most significant merchandise category was home appliances, which made up
82.2%
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 3, 2018
, Outlet operated
132
locations in 33 states and Puerto Rico, of which all offer a wide range of outlet-value products. Outlet also sells products and services through our website www.searsoutlet.com. As of
February 3, 2018
, we operated
118
Outlet Stores and franchisees operated
14
Outlet Stores.
In
2017
revenue from our Outlet segment was
$542.7 million
.
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 and Lowe’s, 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. Sears Holdings' 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. We believe that, historically, the Hometown Stores, the Hardware Stores, and the Home Appliance Showrooms generally did not compete significantly with Sears Holdings' stores. 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 Sears Holdings' stores has increased. In addition to being the principal merchandise vendor for the Hometown business, Sears Holdings also continues to provide some e-commerce services and support to SHO, and Sears Holdings' online sales compete with our business.
We believe that the results of operations for our businesses in fiscal 2017 were, and will continue to be, adversely affected by the continuing growth at other retailers of online sales of merchandise in our important product categories, especially home appliances. Our rights to engage in our own online initiatives that would leverage www.sears.com, and our rights to engage on our own terms and conditions in our own online initiatives that would be independent of www.sears.com, were constrained significantly by our agreements with Sears Holdings until those agreements were amended in May 2016, which amendments granted us contractual rights to transactional Hometown websites, subject to various conditions. Our Hometown websites launched in November 2016. The constraints prevented us from conducting and growing our online business during a period of significant growth in that channel.
As a consequence, we believe that the constraints which delayed the launch of our websites adversely impacted our ability to conduct and grow our online business during 2017 and our results of operations during 2017.
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 highly fragmented 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 and Lowe’s. With respect to as-is appliances, which represent 61% of the Outlet segment's 2017 sales, there are no national competitors.
In addition, as we continue to expand our product lines into categories such as mattresses and furniture, we expect to face additional competition from other discount retailers that focus on those product categories. While Sears Holdings' 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 Sears Holdings' stores generally do not sell in what we believe are significant volumes to consumers. Consequently, we believe that, historically, the Outlet Stores have not competed significantly with Sears Holdings' stores. As our Outlet business expands its merchandise offerings (for example, our recent increased emphasis on mattresses and furniture), the level of competition between the Outlet Stores and Sears Holdings' stores may increase.
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.
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 10 brands for home appliances. 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 all 50 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.
The fact that our Hometown Stores are primarily operated by dealers allows us to leverage their knowledge, experience, motivation, and capital.
Our Hometown Stores are primarily owned and operated by individual dealers. Under both our dealer model and our franchise model, SHO provides inventory (on a consignment basis), branding, and marketing to the stores and the dealer or franchisee is responsible for start-up costs, lease payments, and other operating costs including payroll. Our dealer and franchise models allow us to leverage the entrepreneurial spirit of our dealers and franchisees and their local trade-area knowledge to better serve their customers. In addition, these models free up capital and enable us to focus on strategic planning, marketing, and pricing strategies. We regularly evaluate the performance of franchised and dealer stores and require compliance with established customer service and other operational guidelines.
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. For example, our initiatives to increase product offerings include expanding furniture in our Outlet Stores and adding mattresses in our Home Appliance Showrooms.
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 launched e-commerce capabilities for our Hometown segment and 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 Sears Holdings 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.
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 includes 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 Sears Holdings 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 78% of total purchases in 2017 compared to 80% in 2016. We expect the percentage of total purchases of inventory acquired from subsidiaries of Sears Holdings to decrease in the future as we increase our direct purchases from other merchandise vendors.
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 we believe will lead to higher customer loyalty and profitability for the Company. Year-over-year leasing comparable store sales increased 105% in fiscal 2017. Our leasing share of the total business more than doubled versus the prior year, growing to 6.2% share in the 2017. 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 2017, commercial sales grew 23%. 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 52% of stores participating in 2017 versus 42% in 2016.
Transform our IT Infrastructure
. We are replacing the large majority of our information technology infrastructure, which has been provided by Sears Holdings since the Separation, with new systems and processes. We expect this change will provide much greater strategic and operational flexibility, allow better control of our systems and processes, and reduce some of the risks relating to our relationship with, and dependence on, Sears Holdings. See also "We rely on Sears Holdings 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 rightsizing total inventory investment to each store's turnover as well as seeking to keep the 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 has closed a full-line department store.
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
2017
was home appliances, representing approximately
73%
of net sales.
We are party to an Amended and Restated Merchandising Agreement (as amended, the "Merchandising Agreement") with Sears Holdings, Kmart Corporation, ("Kmart") and Sears, Roebuck and Co. ("SRC") (Kmart and SRC are wholly owned subsidiaries of Sears Holdings) pursuant to which Kmart and SRC (1) sell to us, with respect to certain specified product categories, Sears-branded products (including products branded with the KCD Marks ("KCD Products")) and vendor-branded products obtained from Kmart’s and SRC’s vendors and suppliers and (2) grant us licenses to use the trademarks owned by Kmart, SRC or other subsidiaries of Sears Holdings, 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 February 1, 2020 with our right to exercise one three-year extension with respect to KCD Products subject to specified Sears Holdings termination rights and other conditions in the Merchandising Agreement. We expect that our Hometown business will continue to rely on Sears Holdings for a significant majority of its inventory in
2018
.
For the year ended
February 3, 2018
, products that we acquired through Sears Holdings accounted for approximately 78% of SHO's merchandise purchases. Although most merchandise purchases are sourced through Sears Holdings, this percentage decreased from 80% in 2016. We expect this percentage to continue to decline as we fully operationalize more direct purchasing agreements. For example, fourth quarter 2017 purchases from Sears Holdings accounted for 74% of total purchases compared to 84% in the fourth quarter of 2016 and 76% in the third quarter of 2017. 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. We did not purchase merchandise under several of these agreements until 2018. Our Outlet business primarily relies on suppliers other than Sears Holdings for a significant portion of its inventory. For the year ended
February 3, 2018
, products that we acquired through Sears Holdings accounted for approximately 31% of total Outlet purchases.
As described in greater detail in Item 1A. Risk Factors of this Annual Report 1A, we have entered into agreements with Sears Holdings, 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 3, 2018
, 707 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 3, 2018
, 23 of our Home Appliance Showrooms, 9
of our Hardware Stores, and 11 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.
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.
Since the second quarter of 2015, franchising of additional Hometown and Outlet stores except to existing Company franchisees has been suspended by the Company.
Distribution and Systems Infrastructure
The majority of our merchandise comes to our stores directly from vendors or distributors (including Sears Holdings) through our agreements with Sears Holdings. Home delivery is provided by the selling dealers and franchisees, by Sears Holdings, 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 Sears Holdings 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 Sears Holdings to new, state-of-art business and technology infrastructure and systems see "We rely on Sears Holdings 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 Sears Holdings for warehousing and other logistics services.
We are party to a Services Agreement pursuant to which Sears Holdings Management Corporation, a wholly owned subsidiary of Sears Holdings ("SHMC") 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, 2020, 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 "Certain Relationships and Transactions" in the definitive 2018 Proxy Statement relating to our Annual Meeting of Stockholders to be held on May 23, 2018, which is incorporated by reference into Item 13 of this Annual Report on Form 10-K (the "2018 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
2017
,
2016
, and
2015
,
1.7%
,
1.6%
and
1.5%
, of our revenues, respectively, were generated in Puerto Rico. The vast majority of our long-lived assets are located within the United States.
Employees
As of
February 3, 2018
, we had 2,962 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.
Intellectual Property
We are party to several Store License Agreements with SRC pursuant to which SRC has granted us, 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 SRC pursuant to which SRC has granted us, 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 "Certain Relationships and Transactions" in the 2018 Proxy Statement.
In the Merchandising Agreement Kmart and SRC agree to (1) sell to us, with respect to certain specified product categories, Sears-branded products (including KCD Products) and vendor-branded products obtained from Kmart’s and SRC’s vendors and suppliers and (2) grant us licenses to use the trademarks owned by Kmart, SRC, or other subsidiaries of Sears Holdings (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. Quarterly data on the revenue, cost, and net income of the business is available in the Quarterly Financial Data in Note 9 to our Consolidated Financial Statements included herein.
History and Relationship with Sears Holdings
Our Sears Hometown and Hardware and Sears Outlet businesses operated as part of Sears Holdings’ from their inception through the Separation.
In connection with the Separation, we entered into various agreements with Sears Holdings which, among other things, (1) govern certain aspects of our relationship with Sears Holdings following the Separation, (2) establish terms under which subsidiaries of Sears Holdings will provide us with services following the Separation, and (3) establish terms pursuant to which subsidiaries of Sears Holdings will obtain merchandise for us. The terms and conditions of these agreements (as amended, the "SHO-Sears Holdings Agreements") were agreed to in the context of a parent-subsidiary relationship and in the overall context of the Separation (except for amendments that were approved by the Audit Committee of SHO's Board of Directors after the Separation). Accordingly, the terms and conditions of the SHO-Sears Holdings Agreements may be more or less favorable than those we could have negotiated with unaffiliated third parties. See also "Certain Relationships and Transactions" in the 2018 Proxy Statement.
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.
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, Sears Holdings
We depend on Sears Holdings to provide us with most key products and services for our business. Consequently, if Sears Holdings is unwilling, unable, or otherwise fails to provide these key products and services or if Sears Holdings’s brands are impaired, we could be materially and adversely affected.
We rely heavily on the products and services provided by Sears Holdings or its subsidiaries (the "key products and services") including the following:
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Inventory procurement from third-party vendors, including KCD Products and other products which collectively account for a majority of our revenue;
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Logistical, supply chain, and inventory support services;
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Accounting and financial reporting services;
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Risk management, tax, and insurance services;
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Online, computer and information technology infrastructure (including the point-of-sale system used by the Company and our dealers and franchisees) and support;
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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 Sears Holdings until their expiration at which time we will be required to renegotiate with the landlords directly;
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Our stores continue to use the Sears brand name, and other intellectual property owned by Sears Holdings through our license agreements with Sears Holdings;
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Our stores continue to participate in the SYW program and rely on the customer data and other information provided by the SYW program; and
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Our stores continue to accept Sears-branded credit cards.
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As a result of our dependence on Sears Holdings, we are exposed to the risk that Sears Holdings will become unable or unwilling to fulfill its contractual obligations to us in accordance with their terms. Sears Holdings 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 Sears Holdings' computer systems and infrastructure, (4) risks related to Sears Holdings' ability to access capital markets and other financing sources, (5) risks associated with what appears to us to be Sears Holdings' increasing inability to obtain merchandise on commercially reasonable terms for its businesses and for resale to us, and (6) risks related to what appears to us to be Sears Holdings' declining financial condition and results of operations.
SHO receives from Sears Holdings specified portions of merchandise subsidies collected by Sears Holdings from its merchandise vendors and specified portions of cash discounts earned by Sears Holdings as a result of its early payment of merchandise-vendor payables (together "Vendor Funds"). If SHO's portion of Vendor Funds were to decline, SHO's results of operations and cash flows could be adversely affected to a material extent.
We have been taking action to reduce our dependence on Sears Holdings 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 Sears Holdings-related risks. We will continue to evaluate actions that will enable us to reduce our costs and risks by reducing our dependence on Sears Holdings.
We believe it is necessary for Sears Holdings to continue to provide products and services to us in accordance with the SHO-Sears Holdings Agreements to facilitate the continued successful operation of our business. Sears Holdings has no obligation to provide assistance to us other than to provide the products and services required to be provided pursuant to the SHO-Sears Holdings Agreements. Although Sears Holdings is generally obligated to provide us with these products and services until February 1, 2020, 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 Sears Holdings for some products and services for the entire duration of the SHO-Sears Holdings Agreements. In addition, to the extent that our growth depends on expanding the
number of stores we operate, we may need to rely on Sears Holdings to supply the same products and services in new regions, trade areas, and store formats. When Sears Holdings 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 Sears Holdings. See "Certain Relationships and Transactions" in the 2018 Proxy Statement.
The service fees we are obligated to pay to Sears Holdings are not firm and higher service fees could result.
The Services Agreement provides that it will expire on February 1, 2020 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 Sears Holdings' third-party providers providing services and (2) Sears Holdings' right to increase fees for services if a change in legislation, regulation, business conditions, or Sears Holdings’s operations results in an increase in Sears Holdings’s costs associated with one or more of the services.
We depend on Sears Holdings and other vendors to provide our inventory.
Our Hometown and Outlet businesses rely on Sears Holdings (or its subsidiaries) for a significant portion of their inventory, including KCD Products. For the year ended
February 3, 2018
, products which we acquired through Sears Holdings accounted for approximately 78% of our merchandise purchases. Hometown merchandise purchases are sourced predominantly through Sears Holdings.
If we are unable to obtain adequate amounts and assortments of merchandise from Sears Holdings, 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 Sears Holdings currently obtains merchandise for us may not be willing to continue to sell merchandise to Sears Holdings on terms and conditions that it believes are commercially reasonable. During the fourth quarter of 2017 we experienced a growing inability to obtain from Sears Holdings sufficient quantities of Craftsman tools 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 Sears Holdings ("Other Vendors") for a significant portion of Outlet inventory. For the year ended
February 3, 2018
, purchases from Other Vendors accounted for approximately 69% 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 Sears Holdings 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 Sears Holdings (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 Sears Holdings 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 Sears Holdings for a variety of key products and services. Our various agreements with Sears Holdings (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 Sears Holdings after February 1, 2020. Our business plans with respect to approximately the next 18 to 24 months depend to a significant extent on Sears Holdings’ willingness and ability to continue to provide us with these key products (including KCD Products) and services. Any failure to maintain Sears Holdings as a service provider, or any actions by Sears Holdings, 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, disruptions in the computer and communications hardware and software systems provided by Sears Holdings could harm our ability to run our business, result in the compromise of confidential customer data, lead to costly litigation, and damage our reputation with our customers. 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 Sears Holdings, 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 Sears Holdings 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 strategic and 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, Sears Holdings. The new infrastructure and systems should enable us, and we currently intend, to replace many of the corporate services provided by Sears Holdings 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 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
$34.4 million
for fiscal 2017. We expect a decline in BPO-related corporate expenses in fiscal
2018
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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 system); 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 Sears Holdings 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 Sears Holdings, 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 Sears Holdings and Other Vendors. For the year ended
February 3, 2018
, products which we acquired from Sears Holdings, including KCD Products and other products, accounted for approximately 78% 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 Sears Holdings could have a material adverse effect on our business and results of operations.
Pursuant to the Merchandising Agreement, subsidiaries of Sears Holdings have agreed to sell non-Sears-branded products to us until February 1, 2020. If we want to continue to purchase non-Sears-branded products from Sears Holdings after February 1, 2020 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 Sears Holdings 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 Sears Holdings) 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 Sears Holdings the use of our current store names, specified domain names, and specified trademarks used to brand our products.
We license from Sears Holdings 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, 2020 or, if renewed for the renewal term, February 1, 2023. 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 Sears Holdings to use the domain name "searsoutlet.com" on a web platform not operated by Sears Holdings will expire on February 1, 2020. For additional information regarding our license rights see "Certain Relationships and Transactions" in the 2018 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 in connection with an insolvency proceeding with respect to Sears Holdings one or more of these agreements (or other then-available rights to use the KCD Marks, the store names, or the domain names) were rejected or otherwise 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings' 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings 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 Sears Holdings 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 "Certain Relationships and Transactions" in the 2018 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 SHC or its subsidiaries terminated each of the Merchandising Agreement, the Services Agreement, the Store License Agreements, the Trademark License Agreement, the Tax Sharing Agreement
between the Company and Sears Holdings (the "Tax Sharing Agreement"), and the Employee Transition and Administrative Services Agreement between the Company and SHMC. 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 54% of our consolidated revenue during fiscal year
2017
. Sears Holdings 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 Sears Holdings. If Sears Holdings 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' Craftsman business (the "Stanley Purchase"), including the Craftsman brand name and related intellectual property rights. The Stanley Purchase provides Stanley Black & Decker, Inc. with the rights to develop, manufacture, and sell Craftsman-branded products in non-Sears Holdings and non-Company retail, industrial, and online sales channels across the U.S. and in other countries. As part of the agreement, Sears Holdings 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 Sears Holdings' license right to sell specified Craftsman-branded products to the Company is exclusive. The Company believes that the Stanley Purchase 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, Sears Holdings 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 Sears Holdings 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, 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 Sears Holdings restrict our ability to expand into certain geographic areas.
Currently, Sears full-line stores, Kmart stores, and certain specialty retail stores owned by Sears Holdings 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 Sears Holdings 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.
In connection with the Company’s operation of its websites, the Company has agreed in the Services Agreement to pay to Sears Holdings a fixed commission on web to home sales transacted on the Company's websites. The Company has also agreed in the Services Agreement to pay a higher fixed fee to Sears Holdings on these customer sales outside of specified territories when the customers find the Company's offers through the Company's eCommerce marketing, subject to exceptions.
As a publicly traded company separate from Sears Holdings, we may experience increased costs resulting from a decrease in the purchasing power we enjoyed pre-Separation.
Prior to the Separation, we were able to take advantage of Sears Holdings’ size and purchasing power in procuring services, including advertising, shipping and receiving, logistics, store maintenance contracts, employee benefit support, insurance, credit and debit card interchange fees and other services. Following the Separation, we have been a smaller company than Sears Holdings. We do not yet have direct access to all of these services from other vendors on terms that are comparable to the terms of services that were available to us as part of Sears Holdings prior to the Separation. Although Sears Holdings continues to reduce the number of stores that it operates and although its financial condition is not strong, our contractual relationships with Sears Holdings continue to make available to us at least some of these services on favorable terms. As a result we plan to continue to leverage our ongoing relationship with Sears Holdings to seek to obtain the benefits of its purchasing power (which is subject to the risk that Sears Holdings may be unable to continue to purchase for us the merchandise and services we seek on commercially reasonable terms, which risk we believe is growing). This will enable us to continue to purchase Craftsman and Kenmore merchandise, and to enable us to continue to purchase other available merchandise on terms that are financially beneficial to us. At the same time we are expanding our direct purchasing relationships with many of our most important vendors. Despite these actions, we may be unable
to obtain goods, technology, and services at prices and on terms as favorable as those available to us prior to the Separation, which could increase our costs and reduce our profitability.
We may have been able to receive better terms from unaffiliated third parties than the terms we received in our agreements with Sears Holdings.
The agreements related to the 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-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 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 Separation relate to, among other things, the principal actions needed to be taken in connection with the Separation, indemnification, and other obligations among Sears Holdings and us, and the nature of the commercial arrangements between us and Sears Holdings following the Separation. For additional information see "Certain Relationships and Transactions" in the 2018 Proxy Statement.
We may not be able to continue to resolve successfully future contractual disputes and other conflicts with Sears Holdings.
Several of our agreements with Sears Holdings, 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 Separation (other than the post-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 Sears Holdings and us; the nature, quality and pricing of services Sears Holdings has agreed to provide to us; tax, real estate (including sublease obligations) and other matters arising from the Separation; defense and indemnification arising from losses caused by Sears Holdings; 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 Sears Holdings’ stores and websites.
If Sears Holdings seeks the protection of the U.S. bankruptcy laws, our ability to operate our business and our financial performance could be materially and adversely affected.
If Sears Holdings' seeks the protection of the U.S. bankruptcy laws, the automatic-stay provisions of the United States Bankruptcy Code could prohibit SHO’s attempts to collect (including by set off) amounts due from Sears Holdings that arose prior to its filing of a bankruptcy petition, and Sears Holdings’s unpaid pre-petition obligations to SHO could become general unsecured creditor claims of Sears Holdings that could become relatively valueless. Examples of Sears Holdings' unpaid pre-petition obligations to SHO could include (1) amounts that Sears Holdings collects on behalf of, but does not remit to, SHO, such as vendor subsidies, credit card income, and merchandise credits, (2) amounts that SHO pays to Sears Holdings to pay to others on SHO's behalf but that Sears Holdings does not pay, such as for SHO merchandise purchases from third parties, occupancy costs, and utilities, and (3) accounting adjustments and credits, such as Outlet merchandise cost credits.
We depend on Sears Holdings to provide us with key products and services in the operation of our business. For example, during fiscal year
2017
, merchandise acquired from subsidiaries of Sears Holdings, including Kenmore, Craftsman, DieHard and other products, accounted for approximately 78% of total purchases of all inventory from all vendors. If Sears Holdings seeks the protection of the U.S. bankruptcy laws, a court could, among other things, permit or require Sears Holdings to reject or otherwise terminate one or more of its existing agreements with us, including without limitation the Merchandising Agreement, the Services Agreement, the Store License Agreements, and store leases and subleases (many of which are subleased to our dealers and franchisees). Sears Holdings could also choose, or be required, to sell assets, such as its rights to the Kenmore and Diehard marks and its remaining rights to the Craftsman mark and its rights to the trademarks and service names under which we operate our stores that are used by us in the operation of our business, to satisfy Sears Holdings' obligations to its creditors. If Sears Holdings' contractual obligations to us are terminated or assigned to others or if Sears Holdings sells to third parties rights to assets that we use in the course of our business, we could be materially and adversely affected. A termination of our agreements with Sears Holdings could require us to, among other things, find different service and product providers, possibly on short notice. Even if we are able to find replacement products and services, these products and services may not be of the same type or quality as those which are currently provided by Sears Holdings. If we are forced to enter into new contracts for replacement products and services, the new contracts may have terms and conditions that are less favorable to us than those to which we are currently bound. Different products and services, especially if lower in quality and value, and potential increased costs from less favorable contract terms could materially and adversely affect our ability to do business and our financial performance.
If Sears Holdings seeks the protection of the U.S. bankruptcy laws, the consequences to the Company with respect to its rights under the Senior ABL Facility could be materially adverse. For example, (1) the lenders under the Senior ABL Facility could become uncomfortable lending to the Company due to its close contractual relationships with Sears Holdings, (2) the Senior ABL Facility provides for significant lender discretion, such as the ability to reduce loan advance-rates, which could reduce the amounts that the Company could borrow, (3) 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 (4) Sears Holdings’s rejection or termination of all of the agreements between the Company and Sears Holdings specified in the Senior ABL Facility would 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. The consequences to the Company with respect to its rights under the Term Loan Agreement also could be materially adverse. For example, (1) the Term Loan Agreement provides for significant lender discretion, such as the ability to 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 cause the Company's breach of a covenant under the Senior ABL Facility that limits indebtedness, (2) Sears Holdings’s rejection or termination of all of the agreements between the Company and Sears Holdings specified in the Term Loan Agreement would 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.
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.
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 Sears Holdings, which obtains a significant portion of inventory from vendors located outside the United States. Some of these vendors often require us to provide, through Sears Holdings, lengthy advance notice of our requirements in order to be able to supply products in the quantities we request. This usually requires us, through Sears Holdings, 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 the current or 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:
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Expansion into the suburban and rural trade areas in which many of our stores operate;
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Lower pricing, particularly with respect to new, in-box appliances (which, among other things, makes the pricing of our Outlet merchandise less compelling);
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Expanding the offering of free delivery and installation of merchandise and other consumer benefits;
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Expanding online sales;
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Extension of credit to customers on terms more favorable than we offer; and
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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 3, 2018
, 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 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 profitably, 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 and additional non-cash provisions for losses on franchisee receivables. During our
2017
fiscal year we entered into franchise termination agreements with, or otherwise terminated, franchises in 32 locations.
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 operating standards or 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:
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Actions by our competitors, including opening of new stores in our existing trade areas or changes to the way these competitors conduct business online;
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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;
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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;
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The availability on commercially reasonable terms of the various types of inventory that we need to sell for the profitable operation of our stores;
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Changes in our merchandise strategy and mix;
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Real estate and maintenance costs for our existing stores;
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Changes in population and other demographics;
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Timing and effectiveness of our promotional events;
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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
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The growth of online shopping in which we may not be able to fully participate
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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, may be able to exert substantial 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 could have substantial influence over many, if not all, actions to be taken or approved by our stockholders, and will have a significant voice in the election of directors and any transactions involving a change of control, among other matters affecting the Company.
The interests of ESL, which has investments in other companies (including, according to publicly available information, ownership of more than 50% of the outstanding common stock of Sears Holdings) may from time to time differ from, or be opposed to, the interests of our other stockholders.
Edward S. Lampert is the Chairman of the Board and the Chief Executive Officer of Sears Holdings.
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 all fifty 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.
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 Sears Holdings’ 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 "Sears Holdings Systems") to collect, process, and store this information. Sears Holdings 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 Sears Holdings' associates, our associates, and the associates of our dealers and franchisees. The Sears Holdings 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 Sears Holdings' 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 Sears Holdings 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 Sears Holdings Systems. There is no guarantee that our reliance on the Sears Holdings Systems and related security measures provided by Sears Holdings will protect information against unauthorized access or that the Sears Holdings Systems and related security measures are adequate to safeguard against data-security breaches. On April 4, 2018 Sears Holdings announced a data breach incident leading to unauthorized access to customer payment information in September 2017. Sears Holdings also indicated that the breach was found and resolved in October 2017 with no impact to customers or internal systems. If the Sears Holdings Systems experience a significant data-security breach or if Sears Holdings or SHO fails to detect and appropriately respond to a significant data-security breach, with respect to our customer, associate, or Company information, we could be exposed to government enforcement actions and private litigation. In addition, our customers could lose confidence in our ability to protect their information, which could cause them to stop shopping with us altogether. Kmart, owned by Sears Holdings, announced in October 2014 that its payment-data systems had been breached and on April 4, 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.
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 Sears Holdings 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 Sears Holdings currently operates one of its stores. In such cases we entered into a lease or sublease with Sears Holdings (or one of its subsidiaries) for the portion of the space in which our store will operate and pay rent directly to Sears Holdings (or one of its subsidiaries) on the terms negotiated in connection with the Separation. If
we are unable to negotiate leases or subleases with Sears Holdings (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 3, 2018
, we leased 94 Company-operated Sears Outlet store locations under long-term agreements with landlords that are unaffiliated with Sears Holdings, leased 23 locations with landlords affiliated with Sears Holdings, operated two locations that were co-located with a Sears Appliance and Hardware store which were leased by the Hometown segment, and owned two buildings. Additionally, we are the obligor on nine leases which are sublet to our franchisees that are unaffiliated with Sears Holdings and one lease is sublet to franchisees with landlords affiliated with Sears Holdings, and four 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, 66 of our 132 Sears Outlet leases will expire within the next three years and, with respect to 27 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 3, 2018
, our Sears Hometown business leased 29 Company-operated locations under long-term agreements with landlords that are unaffiliated with Sears Holdings and leased one Company-operated locations under long-term agreements with landlords affiliated with Sears Holdings. Additionally, we are the obligor on an additional six 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 3, 2018, our Sears Hometown and Sears Outlet businesses leased 12 locations and seven locations, respectively, 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.
A number of the leases for both our Outlet and Hometown stores were negotiated by and entered into by a subsidiary of Sears Holdings. 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 Sears Holdings 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 leasing 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 Sears Holdings, 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 Sears Holdings 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 3, 2018
we had approximately
$137.9 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 other obligations could have important consequences for holders of our common stock, including, but not limited to:
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our ability to satisfy obligations to lenders may be impaired, resulting in possible defaults on and acceleration of our indebtedness;
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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;
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a substantial portion of our cash flow from operations could be dedicated to the payment of the principal and interest on our debt;
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we may be increasingly vulnerable to economic downturns and increases in interest rates;
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our flexibility in planning for and reacting to changes in our business and the retail industry may be limited; and
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we may be placed at a competitive disadvantage relative to other companies in our industry.
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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. See also "If Sears Holdings' seeks the protection of the U.S. bankruptcy laws, our ability to operate our business and our financial performance could be materially and adversely affected" in this Item 1A.
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 may have future capital needs and may not be able to 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. See also "If Sears Holdings' seeks the protection of the U.S. bankruptcy laws, our ability to operate our business and our financial performance could be materially and adversely affected
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in this Item 1A.
We may be unable to secure additional financing or financing on favorable terms 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.
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:
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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;
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Actual or anticipated fluctuations in our operating results due to factors related to our business;
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Our ability to decrease our reliance on products and services provided by Sears Holdings and ability to diversify our supply chain;
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Success or failure of our business strategy;
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Sears Holdings' financial performance, condition, and prospects, including the risk of insolvency proceedings;
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Our relationship with Sears Holdings;
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Actual or anticipated changes in the U.S. economy or the retailing environment;
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Our quarterly or annual earnings, or those of other companies in our industry;
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Our ability to obtain third-party financing as needed;
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Announcements by us or our competitors of significant acquisitions or dispositions;
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The failure of securities analysts to cover our common stock;
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Changes in earnings estimates by securities analysts or our ability to meet those estimates;
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The operating and stock price performance of other comparable companies;
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Overall market fluctuations;
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Changes in laws and regulations affecting our business;
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Actual or anticipated sales or distributions of our capital stock by our officers, directors or significant stockholders;
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Terrorist acts or wars; and
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General economic conditions and other external factors.
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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.
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 up-to-date 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 would not have permitted us to pay cash dividends on our common stock as of February 3, 2018.